Still Using Spreadsheets for Managing Risks? – Switch to Risk Management Software

Managing risk is essential in every organization to accomplish its key objectives effectively. Risk management not only requires a reliable process to capture risks, but also needs a mechanism to document and administer the organization’s response.

An appropriate risk management tool always helps the risk managers to identify, assess, and prioritize the risks which can be prevented. Here, we will discuss about spreadsheets – commonly used risk management tools and their true costs. We will also know about the best tool to replace spreadsheets for effective risk management.

Spreadsheets are commonly used management tools because they are
• Convenient to use: Many people believe that spreadsheets are convenient to collect, code, sort and analyze data. Yes, they are better than paper based management systems, but they are risky.

• Flexible to enter data: With some basic encoding, spreadsheets offer flexible arrangements of rows and columns to enter data. They allow the user to configure and enter information in a way that suits his unique needs. But risk management involves analysis of various factors and a spreadsheet may not be helpful.

• Low cost or free option: Spreadsheets are either available as freeware or at low-cost. That is why organizations use them extensively. But they fail to understand the fact that the true cost of a tool should be defined by the operational costs that affect the business on long-run; not by the initial cost of the tool.

Are they really beneficial?
Many business owners and risk managers today are using spreadsheets as risk management tools unaware of the risks involved (however some are aware). Here are the risks involved:

• Inability to process huge amounts of data: Although spreadsheets are a good solution for small volumes of data, the processing and calculation will become complicated with the continual growth.

• Time consuming: Risk management requires collecting great deal of information, which often results in huge number of spreadsheets interlinked to each other. A little change to the data structure becomes a great task. This makes risk managers spend countless hours validating data, double checking formulas, and updating values, which is as a time-consuming process.

• Complex to find mistakes: It is quite difficult to find mistakes in a spreadsheet with lot of data. It is often time consuming process to find where exactly the mistakes have occurred.

• Limits the depth of risk analysis: With each change made to a spreadsheet, links between the information are lost making it difficult to analyze relationships over time. Without these links, it becomes tough to link risks and their controls. Also they offer limited access to past and current data making it difficult to compare data overtime.

• Intensive labor: The process of risk management involves continuous updating of data and it increases day by day. Updating data and using spreadsheets effectively requires lot of time and effort. So intensive labor with good knowledge of using the shortcuts and formulas is compulsory.

• Lacks security: A user can accidentally or intentionally delete vast amounts of critical information. Spreadsheets are highly vulnerable to virus attacks, hard disk crashes, and other unexpected disasters.

Underlying costs of using spreadsheets
In general, people think that spreadsheets are free, but they never calculate the underlying costs that can impact the business. Following are the true costs of using them.

• Labor costs: As discussed earlier, it takes lot of effort to create, maintain, organize, and report using spreadsheets. However, the fact that these things require labor, which in turn results in huge costs to the company, is often ignored.

• Opportunity costs: Spreadsheets consume lot of your time and effort, which you can productively use for adding value to the organization. Many business owners, in fact, lose many opportunities hanging around with spreadsheets.

• Risk and non-compliance costs: Spreadsheets lack in company wide visibility, accountability, security and control which results in increased costs in terms of failed audits, unforeseen events, increased insurance costs and so on.

• Scalability costs: A small company can manage and use one spreadsheet to track all records. But as the business grows, the effort of maintaining and consolidating these records increases exponentially. At one point this process fails and negatively impacts the business.

• Human error costs: Spreadsheets are vulnerable to manipulation, which can dramatically impact the company. Moreover, with the increasing chances of human errors, it is difficult to consider that the data is valid and reliable. These human errors can cost a lot to the company.

Effective tool to replace spreadsheet – Risk Management Software
After seeing all the risks and costs involved with spreadsheets, one would certainly ask for a better tool to manage risks and here is the solution – the Risk Management Software. It can effectively replace spreadsheets in the risk management process. Following are the benefits of using risk management software.

• Effective control over GRC processes: Risk management software helps in the effective control over the GRC (governance, risk management, and compliance) processes with proper documentation and work flow. They also help managers in risk assessment and analysis, visualization and reporting.

• Data security: User can limit the availability of data by creating passwords. He can also give full access to all the data to a particular group of people within the organization. This feature eliminates the risk of manipulation of data.

• Real time recording: Recording and updating information regarding risks is easy using this software. You need not spend hours to update the data.

• Reliable audits: This software offers full protection to all the data in the system with fully automated backups. This allows auditors to extract robust and reliable audit trails without unnecessary effort and thus it helps them in identification of risks, and creation of risk management strategies.

• Automated risk reporting: It provides the user with clear information on their objectives and risks associated. It also informs about the required actions and scheduled dates to implement them to prevent risks.

• Clear and consistent reports: A unique feature of this software is that it provides clear and consistent reports making it easy for managers to view the risks in real-time.

How to choose effective risk management software
With growing demand of the risk management software, many companies offering this software evolved in the market. Therefore it is important to choose the effective one to reap the maximum benefits. Following are some tips to choose a good one.

• Reputed vendor: A well established and experienced vendor definitely offers standard products as he fully understands risk management standards.

• Maximum features: Before buying the product, make sure that it has all features to help you in managing the risks properly.

• Customer service and tech support: As this product is new for the organization, it is important to choose a company that offers 24/7 tech support and timely customer service. Moreover, as risk environment demands a constant change of compliance, make sure that the vendor is offering regular product updates and maintenance releases.

Strengthening the CFO’s Role in Strategic Risk Management

Strengthening the CFO’s role in strategic risk management to lead Capital intensive business in market volatility

Capital Intensive Businesses

Capital-intensive business exists with lower margins. Management is always expecting Return on Capital Employed (ROCE) above the cost of capital. The major businesses are Oil & Gas, Infrastructure, Construction, IT etc.

Market Volatility Challenges

Market volatility, ceaseless pressure on margins and demanding stakeholders increase the difficulties of thriving in an increasingly interconnected, interdependent and unpredictable global economy.

Many organizations have yet to adapt to this new state of the economic landscape. Doing nothing is no longer an option – they need to adjust and take action now.

Many organizations are now transforming their businesses to strengthen their organization to save costs, create more client-centricity, restore stakeholder confidence and/or embed new business models.

For many organizations, long-term success depends on the success of these transformation programs. To make it more challenging, the margin for error continues to be small, and the environment in which transformation needs to happen continues to increase in complexity.

Strategic Risk Management

• It’s a process for identifying, assessing, and managing both internal and external events and risks that could impede the achievement of strategy and strategic objectives.

• The ultimate goal is creating and protecting shareholder and stakeholder value.

• It’s a primary component and necessary foundation of the organization’s overall enterprise risk management process.

• It is a component of Enterprises Risk Management (ERM), it is by definition effected by boards of directors, management, and others.

• It requires a strategic view of risk and consideration of how external and internal events or scenarios will affect the ability of the organization to achieve its objectives.

• It’s a continual process that should be embedded in strategy setting, strategy execution, and strategy management.

Identifying concrete steps for CFOs to increase involvement in risk management for investment decisions

Concrete Steps to Increase the CFO’s Involvement in Risk Management

• Build a tight link between risk management and other Business Process

• Lead a corporate-level discussion of Risk Preference, Focusing on Risk Choice and select optimal mix

• Use Risk Analytics to communicate investment and strategic Decisions

Build a tight link between risk management and other Business Process

• Focus on foresee issues which will emerging in the future instead of current issues.

• On the basis of prioritization a guidelines to be issued for which Business performance metrics would be effected.

• Business Planners conduct adhoc analysis of upside versus risk, focusing most, if not all, of other attention on a single “Center Cut” scenario.

• Highlighting exactly where and how risk will affect the Business Plan

• Incorporating systematic stress testing using macro scenarios which will reflects possible impact on financial planning

• Applying probabilistic “financial at risk” modeling for major investment decision these efforts. (Cash in hand vs cash needs)

Lead a corporate-level discussion of Risk Preference, Focusing on Risk Choice and select optimal mix

• It is critical to have clear answers to the following questions before making decisions:

o What is the company’s competence in the market?

o Are the decision makers familiar with the risks involved including the tail risks and understand their potential impact?

o Is the company capable of surviving extreme events?

• Risk appetite articulates the level of risk a company is prepared to accept to achieve its strategic objectives.

• Risk appetite frameworks help management understand a company’s risk profile, find an optimal balance between risk and return, and nurture a healthy risk culture in the organization. It explains the risk tolerance of the company both qualitatively and quantitatively.

• Qualitative measures specify major business strategies and business goals that set up the direction of the business and outline favourable risks.

• Quantitative measures provide concrete levels of risk tolerance and risk limits, critical in implementing effective risk management.

Use Risk Analytics to communicate investment and strategic Decisions

• CFO plays an important role in financial and strategic aspects of investments and the evaluation of major decision. He leads the discussion and rival proposals and solutions and often hold powerful decision rights.

• Major Projects with value at stake comparable to total risk from current company operations are discussed and decided with qualitative list of major risks.

• The CFO is ensuring by defining right set of core financial and risk analytics to run for each option to ensure this value stake is brought to light and debated.

EXAMINING LEADING PRACTICES APPLICABLE TO CFOS THAT CAN AUGMENT A COMPANY’S FINANCIAL HEALTH

Best Practices applicable for Company’s Financial Health

CFO have several options to compete more effectively in the Risk Management decisions. Improving returns starts with rethinking where to play-and with four strategic steps that many companies often overlook when it comes to improving performance.

Where to play: A more profit-focused portfolio

• The most pressing issue for leadership teams in capital intensive industries is whether to stay in businesses in which margins have been relentlessly driven down. Many companies are choosing to exit low-profit businesses that once were considered to be core. As they rebalance their portfolios, they are migrating up the value-added chain, investing in related sectors where new technologies can provide competitive advantages.

• Profit pool mapping is an important tool for assessing whether and where it makes sense to do business. In heavy industries, management teams often are so focused on volumes and tonnage that they overlook where the biggest profit pools are. By understanding the sources and distribution of profits across their industry, companies can gain an inside edge on improving returns.

• The premium end of the business typically represents a very large proportion of the profit pool. The best opportunities often cluster there for companies competing in capital-intensive industries.

• Picking the right place to play in the value chain is also critical to improving returns-and the most profitable spot varies across industries.

Best Practices applicable for Company’s Financial Health How to win: Four strategic steps to improving returns

1. Improve the cost base and review capex continually –

• In capital-intensive industries where low returns have become endemic, reducing costs and improving capex efficiency are important ways to improve performance – New developing market entrants in capital-intensive industries have built a strong competitive advantage by keeping capex relatively low. By contrast, the focus on cutting costs at many established players means they sometimes lose sight of improving capex. One way to get the balance right: Develop a more disciplined approach to managing capex, and benchmark the company’s performance against the industry’s leaders.

• Cost discipline makes a critical difference. One-time efforts usually fail to deliver savings that stick, as our research shows. One explanation is that in tough times, management teams are quick to cut costs, but when the cycle swings up, they tend to take their eye off cost improvement and focus on growth-related priorities.

• Developing a rigorous approach to cost improvement and nurturing the right capabilities to optimize working capital can help capital-intensive companies outperform.

2. Build the lowest-cost position

• Geography is another key factor for improving returns. Investing in geographies that offer the lowest landed cost position can create a strong competitive advantage. It’s particularly important in asset-heavy industries where the one-time cost of closing and moving businesses is high.

• The best-performing firms revisit their geographic footprint regularly, as cost dynamics are constantly evolving.

• Companies that can choose the lowest-cost geography up front gain a competitive edge. Those in mature industries need to weigh the short-term downside against the longer-term benefits of reducing complexity.

3. Use mergers and acquisitions strategically

• Smart acquisitions can help improve performance significantly, but many companies get off to a bad start by investing at the top of the cycle, when prices are at their peak, simply because that’s when cash is available. Leadership teams that take a strategic, disciplined and long-term approach to M&A instead of a tactical and episodic approach can improve returns significantly.

• Companies that nurture M&A as a core competence derive the greatest value from them. Their leadership teams devote time to developing a structured roadmap of the most attractive potential targets, making it easier to acquire assets when the right opportunity comes along-and to target acquisitions at the bottom of the cycle.

• Companies that are most experienced in M&A build their capabilities over time. They search hard for merger or acquisition candidates that will add to their operating profit and fuel balanced growth. They pursue nearly as many scope deals as scale deals, moving into adjacent markets as well as expanding their share of existing markets. Most importantly, they create Repeatable Models for identifying, evaluating and then closing good deals. What they typically find is that there are plenty of good prospects to be pursued and that the risk involved decreases with experience.

4. Service ace

• For traditional capital-intensive industries, service can be a highly profitable business in its own right, generating better and faster return on investment than new production facilities, large-scale R&D programs or acquisitions.

• Indeed, for many industrial manufacturers, investing in service is the only way to sustainably grow profits in a tough economic environment. Investing in a service business also lowers capital intensity.

• Investing in a world-class service business can become a strategic ace, elevating a company above competitors in an environment where differentiation on products and cost is difficult to achieve. The range of service opportunities, some larger than others, will vary by industry and company. Here again, mapping profit pools can help identify the potential size of service businesses and those with the greatest returns.

o There is no question that companies in capital-intensive industries operate in a difficult environment today. But leadership teams that commit to a bold ambition have opportunities to break away from the pack and achieve double-digit returns significantly above the cost of capital.

Best Practices applicable for Company’s Financial Health-Getting there requires a strategic shift toward a more profit-focused portfolio:

• Find the most attractive profit pools in your businesses.

• Adopt a mindset of continual cost improvement and capex optimization.

• Look for opportunities to drive down the company’s landed cost footprint by investing in the right geographies.

• Develop strong in-house M&A expertise and a structured roadmap of potential deals.

• Invest in related service businesses

Leadership teams that take these steps will not only give returns a powerful boost, they also will help to rebuild competitive advantage and position their companies to win in a changed industrial landscape.

Reengineering Strategies to improve the link Between Risk Management and Business Planning Process

• Business process reengineering is one approach for redesigning the way work is done to better support the organization’s mission and reduce costs.

• Reengineering starts with a high-level assessment of the organization’s mission, strategic goals, and customer needs.

• Within the framework of this basic assessment of mission and goals, reengineering focuses on the organization’s business processes–the steps and procedures that govern how resources are used to create products and services that meet the needs of particular customers or markets.

• Reengineering identifies, analyses, and redesigns an organization’s core business processes with the aim of achieving dramatic improvements in critical performance measures, such as cost, quality, service, and speed.

• Reengineering recognizes that an organization’s business processes are usually fragmented into sub processes and tasks that are carried out by several specialized functional areas within the organization.

• The CFO Act focuses on the need to significantly improve the government’s financial management and reporting practices. Having appropriate financial systems with accurate data is critical to measuring performance and reducing the costs of operations

Management & Decision Support Structure

• Investigate suggestion for reducing costs and to make them practical and acceptable

• Obtain definite prices and costs

• Present recommendation in comprehensive report

People & Organization

• Organize around outcomes and not tasks

• Have those who use the output of the process perform the process

• Built control in process systems

• Treat geographically dispersed resources

Policies & Regulations

• Develop policies and procedures

• Comply with compliances

• Environmental compatibility

Information & Technology

• Information should go along with the process

• Link all activities

• Capture information at source

• Create reports and real time online updates

Frame for Assessing Reengineering

• Assessing the Organisation’s Decision to Pursue Reengineering

• Reassessing of Its Mission and Strategic Goals

• Identifying Performance Problems and Set Improvement Goals

• Engagement in Reengineering

• Assessing the New Process’ Development

• Appropriately Managing of Reengineering Project

• Analysis of the Target Process and Developed with Feasible Alternatives

• Completion of Sound Business Case for Implementing the New Process

• Assessing Project Implementation and Results

• Following a Comprehensive Implementation Plan

• Executives Addressing Change Management Issues

• New Process Achieving the Desired Results

FOCUSING ON RISK PREFERENCE AND CHOICES FOR CFOs CONSIDERATION TO DELIVER ECONOMIC PROFIT DURING TOUGH CONDITIONS

CFOs need to develop a stronger focus on the economic and performance drivers of their business and need to understand how the effective allocation of scarce resource will help them achieve financial objectives. The CFO must build a performance management capability that can:

• Provide visibility and analysis of information to support resource allocation

• Support the decision-making process by providing the right information to the right people at the right time

• Demonstrate the financial impacts of different decisions and scenarios to enable the organization to predict and compare outcomes

• Incentivize executives and managers to make decisions that maximize marginal contribution

• Enable a data-driven view on resource allocations across the entire value chain (to include corporate strategy; sales, marketing and customer service; supply chain manufacturing and production; finance, HR, legal and compliance)

• Identify the most critical decision points that drive economic performance

With a unique perspective across the entire business, CFOs can provide valuable insight into the decisions that create or protect marginal contribution across the value chain. Armed with a detailed understanding of how and where growth in sales leads to growth in profits, they can offer an objective assessment of fixed and variable costs, and then identify how a reduction in costs can maintain revenues while improving profit contribution.

• Establish a clear, forward-looking line of sight on relevant data for critical decision points

Finance must have access to a robust data set, built around the decisions that drive most economic value in the organization, including assessment of opportunity cost. This demands accurate, verifiable underlying data and an understanding of how the data relates to value chain decisions. This will enable the CFO to conduct scenario planning around these different decision points.

• Develop aligned performance management processes that drive rational decisions

Finance must be able to translate insights and understanding into the desired end product – rational decisions that maximize the desired economic return. Aligning traditional resource allocation processes with business objectives helps ensure repeatability and the sustainability of the organization.

• Ensure compliance and make sure that finance’s voice is heard

The CFO and finance function must be positioned appropriately within the organization to be able to influence decision-making and action. Additionally, finance professionals must improve communication and influencing skills to ensure that their voice is heard and their advice is valued and acted upon.

The Paradox of a Predictable Failure in Risk Management

The current crisis the world fell into two years ago had certainly the widest range of qualifying attributes: financial, economic, social, industrial, and maybe lethal as it dramatically affected and eventually destroyed lives beyond the point of no return. Described by contemporary economists as the worst ever crisis experienced by America for a hundred years, it was however another repetition of what seems to be a cyclical phenomenon: the 1929 crisis, the energy crisis in 1973, that of 1997, and more recently the internet bubble. And despite the lessons learnt from the past, with the technology evolving exponentially and the refined risk management, societies, corporations, institutions, and governments failed yet again by not having the right controls at the right time, substantially creating spiraling consequences that took investors and the wider public by surprise. The causes of the 2008 crisis raised numerous questions, some of them leading to the foundations of today’s capitalism and one of the common sins of humans: greed. Nevertheless, one could have hoped that, with the dynamic of industrial countries and the norms of audit and compliance such as those of Basel II and III, in which operational risk and credit risk are separated, the international financial system would be protected against the collapse of the bank sector. But this was without counting on the intrinsic failures of these very norms, standards and risk management tools.

As a matter of fact, the crisis finds its roots in a simplified scheme: the lack of accountability, mortgages and default on large amounts of money against little income, and finally the liquidity for which the same institutions failed to have sufficient capitalization to cover immediate large needs when the whole system started to present default cracks. The problem of sufficient capitalization became a recent issue with the rise in the prices of commodities, whereas speculators can highly leverage their buying power without offering a real financial counterpart in exchange. And that’s certainly why French President Sarkozy recently called for more regulations on commodity markets. However, progresses in that sense are yet to be commonly agreed or applied by governments and leaders of industrial countries.

Overall, today it is the review or maybe the prosecution of an entire system that is taking place. Questions and concerns from governments, investors, officials, and ultimately the public have found few relevant answers so far. The lack of accountability and transparency from the protagonists directly or indirectly involved in the crisis has raised anger and consternation worldwide. The cynicism displayed by bankers and financial institutions who announced remarkable profits for the last quarter of 2010 may be perceived as a new alarm bell ringing for another major financial crisis yet to come.

This paper presents some of the key issues the financial crisis brought into light in terms of risk management and lack of control from corporations, banks, auditors, credit agencies, and governments. It does not aim to provide a solution but rather gives the reader a fair understanding of what could have been avoided or improved and what may come again should the global financial modus operandi not be drastically changed.

Analysis of the Financial Crisis

An article published in the International Business Time, Financial Risk Management: Lessons from the Current Crisis… So Far, ideally summarizes thesubstantial work that has been done to date to analyze the recent economic crisis and cites examples such as: “Enhancing market and institutional resilience (Financial Stability Forum); Credit risk transfer (Working Group on Risk Assessment and Capital); Observations on risk management practices during the recent market turbulence (Senior Supervisors Group); Supervisory lessons from the sub-prime mortgage crisis (Basel Committee on Bank Supervision); Study of market best practices (International Institute of Finance), and; Risk management practices including the identification of risk management challenges and failures, lessons learned and policy considerations (International Monetary Financial Committee).”

Todd Groome, adviser in the monetary and capital markets department of the International Monetary Fund (IMF) interviewed by the same magazine, asserted that “the epicenter of the market crisis was sub-prime mortgages and structured credit products. With them came innovative financing, such as asset backed security CDOs (Collateralized Deposit Obligations) which were followed by more potent variations such as CDO-squares (baskets of CDOs), and synthetic CDOs (CDOs combined with credit default swaps).” Risks were often under-estimated partly due to product complexity and over-reliance on quantitative analysis, including that done by rating agencies which produced reports that were either wrong or purposely misleading. As Groome pointed out, “taking write-downs in illiquid markets will amplify the loss.”

The downfall in housing prices impacted market downfalls. As such, creation or destruction of wealth often relates to consumer spending and as such may be uncertain. Meanwhile, the direction is quite similar. If one goes down, the other tends to follow. Negative trend implies negative trend. Nevertheless, weak risk management isn’t the only reason. Banks and financial institutions regularly rely on data related to a particular period. However, economies can also experience a non-recurring event when the economy moves into unknown or grey areas.

On another plane, bad risk management still played a role. The problem is that despite the fact the models given in a particular circumstance may have been correct pretty much everyone who has them will use them, all at the same time. This phenomenon tends to increase systemic risk and as such it relates to technical market analysis. Indeed, if there is a consensus amongst users over a specific event, say a bullish trend, everyone is likely to follow that trend and buy at the same time, thus creating a momentum. But for how long will this last?

Cracks in Risk Management and Regulation Opacity

The recent crisis also highlighted a failure in risk management on a large scale, due to a failure of the techniques employed, and the fact that some of the risk managers were not well informed. The home market in the U.S. was the nest in which everything began. Low interest rates and government promoting home ownership by with no or little regulations played a role in the increasing demand for home purchases. Underwriters passed questionable loans over highly leveraged investors in order to create even more loans, fueling a spiral of non-recoverable dirty assets.

What is flagrant today, looking back at the whole process, is the fact that the risk assessment tools used by some investors, despite their sophistication, did not give a realistic picture of what was happening. In other words, although they were certainly giving sufficient information on the potential risks that lending huge amounts of money to low income individuals would create, the likelihood of such risk spreading to a rather large population was totally dismissed by the whole chain of command. Modeling rare events is certainly what the error is all about and not taking them into consideration was the effect that catapulted the system towards a major failure.

Nevertheless, numerous risk managers and experts rang the bell for potential upcoming issues several years ago and whilst greed and arrogance are the common denominators, the irrationality of the markets also comes into light. Clinging desperately to what was an announced disaster seemed to have been the pattern of behavior that inflated the bubble until explosion.

Another root of today’s financial debacle are the regulations applied to some of the instruments used in financial markets. CDOs for instance, often containing a non-negligible part of subprime risk, were heavily exchanged without proper scrutiny from the rating agencies. Transparency becomes a crucial element in the markets’ sustainability. And this is when the accounting standards play a key role for liability valuation and, hence, transparency. The snow ball effect is obvious: no regulations lead to poor transparency, which equally leads to disaster. The financial accounting has proven to be relevant to convey useful and accurate information to markets. Nevertheless, the concept of fair value, for example introduced by the International Accounting Standard Board (IASB) and Financial Accounting Standard Board (FASB), is to “record values for assets and liabilities which are as close as possible to the values these instruments would have in an open market.” As confirmed by Heckman in his essay Transparency and Liability Valuation, the IASB and FASB don’t recognize any difference between methods for valuation of assets and liabilities, which has proven to have perverse consequences as some companies can use the process to turn losses into profits, since liabilities can be valuated at current market price. This has led to the misreading of the balance sheets and profit and loss statements of unscrupulous companies, providing the wrong information to investors and to some extent regulators themselves.

Impact of Liquidity and Failure of the Bank System

The current crisis has shed a light on the fact that the enterprise risk management should not only emphasize the risks to asset and liability values but also the liquidity risk. Liquidity risk is the probability of not having sufficient financial means to cover up liabilities. To some extent, posting collateral poses a liquidity threat as well. In fact, selling off an immature asset engages a loss. As the markets fall into problems, liquidity issues can be drastically worsened as liquid assets become non-liquid.

Liquidity management works pretty much like capital management. As such, the liquidity protection comes with sufficient liquid assets. On the other hand, consistency between cash flows of assets and liabilities can reduce risks pertaining to liquidity. Nevertheless, these strategies may show some limitations during conditions of heavily disrupted markets when credits are unavailable or unsecured. G. Venter in Modeling and Managing Liquidity Risk confirms that “modeling liquidity risk can start with stress tests.” As such, the current market is an example of situations intimately involving assets, liabilities, and credit facilities when cash flow adequacy becomes preponderant. The idea behind the scene is to take into account in the models the different factors which dramatically impact markets. The correlation between price and liquidity comes into the picture and adequately modeling these possibilities can certainly be worth further research.

In 2006, a couple of years before the eruption of the financial crisis, Iyer and Peydro-Acalde discussed the potential risks of an interbank contagion in their research paper Interbank Contagion: Evidence from Real Transactions. They exposed and tested the impact of interbank dependencies over a fraud cause. Interbank markets are crucial to provide liquidity into the overall financial system and actively play a role in monetary policies worldwide as well. The research of Iyer and Peydro-Acalde came to the conclusion that “as the exposure to the failed bank increases, the runs stemming from the higher fraction of deposits held by other banks drastically increase. These results lend support to the theories of financial contagion due to interbank markets.” This is indeed the exact phenomenon observed in 2008 when major banks reached the potential bankruptcy threat. The interbank markets dried up, obliging governments to first inject cash through loans, capital sharing or even nationalization.

As such, the Iceland bank system is now a school case of its own. The three main Icelandic banks, namely Glitnir, Landsbanki, and Kaupthing, were tightly interconnected. With a high reliance on similar macroeconomic models and business partners, they appeared to be dangerously related to one another already on paper. The chain reaction triggered by the difficulties of one bank would mean diminished confidence in other banks, thus shrunk liquidity available from potential resources and financial partners. The worst part of the picture lies in the fact that these three banks encompassed the vast majority of Iceland’s financial system. Hence, one would have conspicuously assumed that a possible failure would have a dramatic impact on the Icelandic economy. However, the reality was often disguised by biased official reports about the financial health of the Iceland bank system, which certainly contributed to further deepen the crisis as investors would be grossly misled.

Eventually, the arrogance of the system ended up in a painful stake. Borrowing in wholesale markets became an issue and banks chose to open high interest savings accounts pretty much everywhere in Europe. As such, Icelandic banks, with government permission, used these savers accounts to provide the liquidity they could not obtain elsewhere. At the end of the story, deregulation and uncontrolled privatization of the financial system in Iceland led to its demise. Lack of ownership from supervisory regulators and governmental bodies and failure to recognize a systemic risk in an artificial economic growth widely contributed to the fall-out of the Iceland financial institutions and overall system.

Ultimately, when the banks were heading for failure the Icelandic government opted for a gamble on resurrection rather than closing the banks down. The government’s bet failed and Iceland suffered a systemic crisis in return.

As reported by the Telegraph in its 10 March 2009 edition, it was now a matter of “twenty billion dollars here, $20bn there, and a lush half-trillion from the European Central Bank at give-away rates for Christmas. Buckets of liquidity are being splashed over the North Atlantic banking system, so far with meager or fleeting effects.” A very alarming situation, quite unreal as one may have observed.Numerous economists are now warning the world’s central banks to focus on the right issue now rather than later. Creating further liquidity without proper backup means such as gold or a strong economy is likely to fuel the disaster.

York professor Peter Spencer, chief economist for the ITEM Club, said at some point that the global authorities had just weeks to get this right: “The central banks are rapidly losing control. By not cutting interest rates nearly far enough or fast enough, they are allowing the money markets to dictate policy. We are long past worrying about moral hazard.” For instance, in Europe, the European Central Bank (ECB) was facing a dilemma with a record high inflation forecast at 4.1 per cent in July 2008, the highest since the monetary union advent. Meanwhile, the worse is probably yet to come as fragile countries such Iceland, and now Spain, Italy and Greece, which are sharply falling into recession, may be running out of liquidity and may have to be backed up by other European members. The question at the end is: Will the European tax payers accept to pay this bill when their own country is at risk? Hence, this may show the true reality of the Eurozone: the weak solidarity of a supposedly mature organization, in fact not quite yet ready for the real thrill.

Finally, major banks like Citigroup, Merrill Lynch, UBS, HSBC and others have recently stepped forward to reveal their losses. Two years after the crisis hit the world, the IMF (International Monetary Fund) estimated the total losses to reach $2.28 trillion. But it seemed to have been just a beginning.

Passing the Risk: Who is Next?

As described above, financial crises appear to be repetitions of History. Working cyclically, they differ from their inherent nature though. For instance, the current crisis rose from the weakening of the U.S. home market and became a global crunch. Furthermore, the fact that the problem spread from financial and banking sectors to the entire economy at a global scale in such a short time made it a quite unique momentum. Increased speed, advanced communications and information technologies evolving exponentially have created a greater risk with deeper and long lasting consequences as ever before. Global markets with stronger interdependence and high complexity are paradoxically more prone to correlated risks.

Most people are driven by the simple desire to succeed and do well financially. This means they work harder, enhancing productivity, creativity and innovation. But where and when does this legitimate feeling get overtaken by greed and unscrupulous envy? Why does a minority change the principles of innovation into a gambling leverage for immediate profits?

If one considers some of the past economic crises such as the London Market Excess (LMX) fall out in the late 80’s and the equivalent substitutes during the following two decades, they all started at some point from promising innovations. These initiatives were all new and seen as very profitable during the early stages. And they all implied a promise on huge benefits, fast and furious. However, the promise turned hopes into ruin and despair. Out of the multiple questions this series of dramatic and unfortunate events can raise, some of them could pose the problem of the impact of risk management that is meant to promote innovations that work and praise individuals for their will to succeed.

Two important factors can shed some light: the fact that new communication means have propelled the finance community to another level of instant profits driven by frenetic greed. Rumors, news whether good or bad instantaneously drive markets to their best or worse. Data signification is amplified far beyond comprehension in a momentum that magnifies exponentially in spiral dive fallout when not controlled adequately. And on another plane, looking at the amplitude of the issue, there is no doubt that financial markets, industries and economies are now fully interdependent. The impact economic and financial shocks can create are far beyond the spectrum of a region or even a nation and can be wide-spread on a global scale instead. While the LMX fall out was limited to the reinsurance market in U.K., the Internet bubble at the beginning of the past decade had a wider range globally but yet remained restricted to investors who had placed financial interests in the sector. From a weakening home market in the U.S., the 2008 crisis shortly developed into a global financial issue bringing down economies, industries and sometimes governments worldwide.

A parallel can be made between the LMX spiral and the subprime fiasco that ignited the global crisis. CDOs and similar financial products were created to temper the risks generated by unscrupulous investments by diluting them into cleaner credits. However, the plan did not work as expected and spread all over the credit system. In fact, Schwartzman (2008) confirmed that the LMX spiral and subprime debacles share similar roots by saying: “an attempt to mitigate risk by spreading it to market participants, a series of new and complicated instruments not understood by most people and not even well understood by market professionals, a pool of unsophisticated investors not adequately advised of the risk they were taking on, a collection of unscrupulous brokers who took advantage of the situation to increase commissions by encouraging as many deals as possible with no concern as to how they might play out in the future, and huge profits that continued as long as nothing happened to change the situation on the ground.”

Conclusion: Towards a New Order?

Following the debacle of the financial and banking systems in 2008, one could have hoped that executive managers would be taking a more serious insight of what risk management is all about. Indeed, their priority has always been to successfully run corporations in which investors had shares and interests. As such, incentives based on performance should have sent a clear message to these top executives who should have then adjusted the risks they were willing to take for their company and somehow as well as for themselves as professionals. But this is the theory of should have happened and not what happened at the bottom of the chain. Indeed, the fiduciary responsibility of many was not met.

Meanwhile, the vast nebula created around financial markets has, until recently, hidden the fact that the credit crisis was in the end caused by unscrupulous people who were seeking short term profits rather than long term growth. Lenders with few scruples did take advantage of credulous borrowers, and fortunately or unfortunately these lending businesses disappeared killed by their own counterproductive strategies. Borrowers lied about their incomes to live in homes they could not afford in reality and were given full consent by lenient banking institutions. This spiral of controversial and ineffective stubbornness towards failure could have been stopped or maybe controlled if a relevant structure of regulations had been put in place. Improved and stricter regulations on loans policies could have avoided a large chunk of the crisis dramatic effects, but will those rules, if ever truly and transparently implemented, ever prevent futures crises?

Unfortunately, history reminds us that for each regulation or procedure created there is a loophole that can be exploited. Hence, the whole issue lies in the effective design of regulating systems, taking into account the various risks inherent to the relation between economies and private investments. Better focus on the matter would certain reduce systemic problems in the future and it is becoming now a serious concern in Europe and the U.S. who are looking at introducing enhanced reforms on the regulatory system and the quality of rating agencies. Improved risk management is now a definite requirement. The systems in place today are too limited to encompass the numerous issues they are intended to address. Hence, weak risk management systems imply more risk. The role statistical and probabilistic models play in the equation is far from being negligible. However, they often tend to focus on the wrong perspectives such as the occurrence of a major loss in a year rather than the likelihood of a Black Swan event for instance. As such, models must not be considered as finite and should evolve and adapt in correlation with their environment. The key to prevent markets from dramatically failing beyond control may also simply lie in the capability of predicting these rare events, a concept that is yet to be fully understood and mastered.

Risk Management Policies In Financial Services: Hedge Funds

Many financial services make use of a well-structured risk management policy to manage their day-to-day exposure to risk, including exclusive investment entities such as hedge funds. For many years hedge funds were considered the high-stakes bad boys of the investing world; an image that the industry despised and rejected in the public eye, yet celebrated behind the closed doors of their high-rise offices and their swanky exclusive nightclubs. Over the past 36 months the hedge fund community has stepped up their efforts to shed the negativity and weariness that is often associated with them. Of course in some ways this “risky market gambler” perception was always unfounded, especially considering hedge funds use complex strategies and investment vehicles to hedge away systemic and market risk.

Due to their size and unique capital structure, hedge funds were previously allowed to operate outside the stringent oversight of investment regulators, but this has changed over the past decade. While hedge funds continue to abstain from using the comprehensive risk management ‘best-practices’ of other financial services such as banks and large fund managers, they have certainly increased their use of risk management policies. These processes have evolved to monitor not only how their range of investments mitigate inherent market risk for their investors, but also how they conduct their business in general.

The organizational risk philosophy at any particular hedge fund typically reflects the interest-level and commitment of that fund’s top traders and officials. The greater these managers believe in not chasing greater return at the expense of risk compliance, the stronger the fund’s risk policy is embedded throughout the entire fund’s other personnel. Many hedge funds now employ a Chief Risk Officer and have doubled their expenditures on risk management processes and risk compliance. They are increasingly seeking individuals who have obtained at least one risk management certification, focusing on credit and financial risk. These changes are the result of not only clearer minds within the hedge fund management community, but also from changing investor expectations. While hedge fund have always used complex quantitative risk management models to quell investor fears, most managers will tell you that in the past few investors know, or cared to know, how they worked. While this sentiment has not dramatically changed during these past few months, there are changing expectations from investors, especially large institutional money managers, in regards to transparency, risk analysis processes, and how business is conducted. Fund managers typically benefit from long investment time-horizons and leeway from their investors, but even traditionally ‘sticky’ investors are demonstrating a willingness to pull assets out of hedge funds if managers do not comply with the changing risk expectations.

As a consequence of the 2008 financial upheaval the fund community has witnesses the creation of a series of private oversight groups, such as the ‘Hedge Fund Standards Board’. These self-regulatory bodies are creating industry benchmarks and best-practices in risk management, and from which the community can develop their own risk policies.