Forging Best Practices in Risk Management

Abstract

This paper approaches risk management from three perspectives: firm-level risk measurement, governance and incentives, and systemic concerns. These are three essential dimensions of best practices in risk management; although we discuss each dimension separately, they are interrelated. The paper begins with a brief review of salient changes and unmet challenges in risk measurement in the wake of the financial crisis. It proceeds with a discussion of the interplay between volatility regimes and the potential for risk amplification at a system-wide level through simultaneous risk mitigation at the individual firm level. Quantitative risk measurement cannot be effective without a sound corporate risk culture, so the paper then develops a model of governance that recognizes cognitive biases in managers. The model allows a comparison of the incentive effects of compensation contracts and leads to recommendations for improving risk management through improved contract design. The last section takes a systemic perspective on risk management. Risk managers must recognize important ways in which market dynamics deviate from simple, idealized models of hedging an individual firm’s exposures. Firms’ collective hedging, funding, and collateral arrangements can channel through the financial system in ways that amplify shocks. Understanding these effects requires an appreciation for the organization of trading operations within firms. The article concludes with a summary and recommendations.