Chapter 11 The Future of Financial Risk Management – Essentials of Financial Risk Management

CHAPTER 11

The Future of Financial Risk Management

Predicting the future has always been a task fraught with risk. However, we will take the risk and put forward a few comments to conclude.

Risk management has always been an evolving field, but it seems that financial risk management is on the cusp of some potentially revolutionary changes. There are structural issues for financial risk management, technological issues, and finally issues that relate financial risk management to one’s corporate career.

Structural Issues for FRM

At the beginning of this book we mentioned some of the structural issues that are making financial risk management so relevant. These structural issues include globalization, the rise of financial technology, or fintech as it is now popularly referred to, cybersecurity, climate change, demographics, and how geopolitical issues are changing the face of business in general. Some of these are interrelated with technology issues which we will discuss in the next section.

Conceptually globalization is the main element changing the face of risk management. Globalization involves risk management on many different fronts. The most obvious is that business is now global and thus competition is now global. No business is left isolated or unaffected by global market events. Furthermore, globalization, combined with the omniscience of social media means that global events spread virtually instantaneously, and also literally spread in a virtual fashion. Events can, and are, lived vicariously and instantaneously via social media. Consumer shopping is now a virtual and global experience. Price risk is now also global and virtual, but the effects are real.

Globalization not only means the spread of competitors is greater, it also means that the competitors can have different strategies, different backgrounds, different business models, and different approaches and perceptions of risk. No longer are companies acting in a sea of similar characters. They now have to react to actors from different cultures.

The perception of risk aspect cannot be underrated. Risk perception differs between cultures but also differs between generations. For example, today’s stock market investors, and the conceptual collective that Boards are acting on behalf of, perceive investment risk very differently than investors did just a generation ago. Market risk premiums, the premium expected return for investing in risky assets, have been falling dramatically, and falling on a global basis. Once dividend-paying stocks were the darling of both Wall Street and Main Street, but now dividends are all but virtually forgotten. Everyone wants to talk about the stock that they bought that tripled in price within a month. No one seems to care anymore about a steady 4 percent dividend yield.

Part of the change in market risk premiums is likely due to the graying of the population. As the baby-boom generation moves into its peak retirement planning years, the available investment alternatives seem especially poor. As of late 2017, interest rates, and by extension bond yields, are at historically low levels. As baby-boomers look to place their retirement portfolios, they need to search for risk in order to get what they perceive to be acceptable absolute yields. Risk perception changes. This has significant implications for how companies position themselves in terms of business risk and financial risk. As the pressure rises for corporations to take on more business risk and financial risk in order to produce sufficient returns for investors, the need for financial risk management becomes all the greater. The margin of error is much smaller, and has more drastic consequences for being wrong than ever before.

This domestic pressure for enhanced stock price returns is multiplied by the easy availability of capital for entrepreneurs to start business disrupter companies such as Uber, or AirBnB, or Amazon. Companies in all industries are looking on with both pity and fear at industries like the newspaper industry that have been gutted by technology and novel business models.

Business risk has never been higher, but it has also probably never been as exciting. This climate of business risk though changes the dynamics for risk management. Furthermore, it is not whether risk management is more necessary than ever (it most definitely is in our opinion), but the question is if risk management is business. In other words, is risk management becoming more important of a business discipline, or is risk management just getting absorbed into the natural core of business activity without there being a distinction of it as a separate activity. Either way, the importance of possessing risk management skills increases.

Social media has also brought more complexity to risk management. You will recall from Chapter 1 that complexity arises when agents (consumers, competitors, investors, regulators, politicians, etc.) can interact, and can adapt or change their behavior or their decisions or their way of thinking. The prime example of complex situations is that we see the property of emergence. Thus stock market bubbles form and then burst; consumer fads grow and then fade away just as quickly; political movements such as Arab Spring or Brexit change the political landscape almost overnight, and so on. Managing complexity requires a different set of skills than the coldly analytical and complicated skills that are so well rewarded by university programs and certification programs, which grant degrees and certification based on correctly answering objective multiple choice questions, rather than showing wisdom gained through experience or the ability to have intuition about a situation.

This brings a demographic challenge for risk management beyond the differences in risk perceptions previously noted. In the past, risk management was for the most part staffed with experienced professionals who had the necessary experience to deal with situations. Like many industries though, risk management is dealing with a massive roll-off of experienced managers as the baby-boomers retire. The challenge is, will there be enough risk managers with the proper experience to take their place? It is a problem facing the trucking industry as well, but there is the prospect of self-driving trucks that has the potential to fill the forecasted shortfall of truck drivers. Do we want “self-driving” risk managers? Risk pioneer Felix Kloman, in a paper submitted to the 25th anniversary of The Institute of Risk Managers, predicted that risk management will be based on “sophisticated computer models, operated online will be modified by a sensible intuition born of long experience within the organization.”1 It seems that the sophisticated computer models aspect will be fulfilled, but what about the modification by “sensible intuition born of long experience”?

Technology Issues

Artificial intelligence, big data, real-time data, the internet of things; combined with “fintech” these elements together have the potential to dramatically change how financial risk management is managed. If it were not for the element of complexity, it really is quite possible that financial risk management could in the very near future be managed by an expert computer system. If we are wrong, and financial risk management is not as much of an art as it is a science, and it is simply a science, then the field will be quickly dominated by computers.

We do not believe that will happen. In the more basic field of investment management it has been tried again and again, with eventual failure being the consistent result. We believe in Felix Kloman’s previously stated dictum, that risk management needs “modification” by smart, creative, and intuitive risk managers. However, only a fool would deny the awesome potential that the emerging confluence of technologies can bring to risk management.

Technology is changing, and will continue to change how risk is assessed and managed. But technology is also changing risk itself. We have talked about the global nature and the speed, but data, digitization, machine learning, cybersecurity, personal data issues, complications of social media, and a host of factors and unintended consequences yet to be discovered are changing the very nature of risk.

Ultimately risk management is about people. Technology is changing how we interact with others, but risk is still about people. Technology can help us observe and measure and assess risk, but we still need people to manage risk. Undeniably, technology is going to play an increasing role in risk management, and particularly so in financial risk management since it is price based. (Computers can deal much better with objective numerals such as prices, than they can with subjective human elements such as feelings and emotions.) The successful risk manager will be the one who can combine the best of technology with the best of intuition.

Role of Financial Risk Management on a Personal Basis

If we are correct that risk management is increasing in importance, then it stands to reason that being competent, indeed being competitive in risk management, is key to one’s personal career progression.

Paradoxically, we see that risk management is simultaneously becoming a field of increasing specialization, and also becoming more mainstream in the corporate world. The tools and techniques required of a risk specialist are becoming ever more advanced and sophisticated. This had led to the rise of a variety of different risk manager certifications and advanced university degree programs devoted to financial risk management. While this is happening, it is also true that the general manager can no longer ignore risk, or assume it is the sole responsibility of a separate department. Risk management and risk knowledge are becoming the role of everyone.

The expectations on Board members in terms of risk management have probably been the greatest. Regulatory requirements, demands of stakeholders, and the pace of development of risk management practices and techniques have all accelerated. Board members are expected to be out in front of all of these changes; not necessarily on the specifics, but on the spirit of the changes and their potential. Increasingly, Board members are being selected for their experience and knowledge of risk management. It is no longer acceptable to be a passive Board member when the topic of risk management is brought up. Boards need to be proactive on risk, and that requires not only a knowledge of risk, but also an appreciation for the potential of risk management to be a major part of the competitive advantage of an institution.

Concluding Thoughts

Thus we come to the end of this chapter, and to the end of this book. As risk practitioners, we are very energized and excited about financial risk management. Although we cannot even dream about what the specifics of financial risk management might be 5 years from now, much less 20 years from now, we are highly confident that it will be dynamic, challenging, and full of potential for those creative and risk-loving enough to take it on.

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1F. Kloman. 2011. “A Snitch in Time”, Paper submitted for The Institute of Risk Management 25th Anniversary.