Top-Down and Building-Block Approaches to Risk Management

The senior management of an organisation will view the risk management process by looking at the overall risk from all sources. It is their responsibility to put in place a policy that will govern how much risk is acceptable. Indeed, in countries such as the United Kingdom companies are legally obliged to undertake a risk review and publish this in the annual report.

Within an organisation, the amount of risk that the firm considers acceptable will be translated into a hierarchy of risk limits. A commonly accepted criterion is for firms to seek to ‘maximise shareholder value’. This would suggest concentrating on the impact of risk on a firm’s market value or equity value.

Senior management may also decide on the overall exposures and the anticipated movements in the risk factors. For instance, concerns about the likely direction of changes in interest rates and their impact on profitability may lead to decisions about the type and maturity of debt in the balance sheet. However, because senior management may experience difficulties in reacting to changes within an appropriate timescale, such decisions are normally delegated to a specialist committee or individual. For instance, a common approach in banks is to delegate decisions about the right level of sensitivity to interest rates and choices about funding to an Asset Liability Management Committee (ALMAC). Given the objectives of a particular firm, senior management will have to decide to what level to delegate responsibility. There are three distinct approaches that can be adopted; these will be discussed in the later modules on the techniques for modelling and measuring risk. They can be termed an equity–value approach, an asset–liability approach and a transactional or cash flow approach. The different methods provide different insights and require differing amounts of information about the firm and its operations.

Equity Value

It is a tenet of finance that liquid capital markets are information efficient; that is, the price of financial instruments reflects known facts about the issuer. The market price of a security is a reflection of the consensus view on the worth of the asset. As new information arrives, market participants revise their assessment on the basis of the new information and act accordingly. This will cause prices to move; that is, to reflect the impact of the new information on the firm or the security’s cash flows. We can use this fact (even without being certain about the degree of market efficiency – a subject still very much debated by financial economists) to measure the effects of changes to equity values from our risk factors using standard statistical techniques (in this case multiple regression). The greater the price movement (or sensitivity) for a given change in the risk factor, the greater the market’s estimate of the firm’s exposure to the particular risk. Of course, such estimates are historical since they measure the impact after the fact.

Asset–Liability Management

Organisations have access to information that is not generally available to outsiders. This can be used for assessing their financial risks. The degree of sophistication used in measuring exposure in this way will depend on the availability, quality and cost of suitable data. The traditional approach is to focus on the accounting numbers through the budgeting and reporting process, although for risk management purposes this type of information may not be sufficiently timely, detailed or accurate to give exact measurements. Organisations can and do collect other data that is not strictly accounting information but that forms part of the information that these organisations collect on their operations and related outside parties, such as suppliers and customers.

Accounting methods have tended to involve scenario-building or maturity-gap and funding-gap type analyses based on accounting entries. Maturity- and fundinggap methods break up future assets and liabilities into discrete time intervals (for instance, by quarter years), and the mismatch between receipts and payments is used to determine the net amount of risk in any single period. This method is relatively simple to apply since it is often easier for firms to collect information on their assets and liabilities, which only change relatively slowly over time, than to have accurate forecasts of their future transactions or cash flows. Various measures of risk, for instance payback measures and so forth, can then be applied to the result to determine the firm’s sensitivity to changes in risk factors. For some kinds of organisations, non-accounting data are more useful than those present in the financial statements. Take an insurance company: the history of past claims and the characteristics of those insured provide the raw data for pricing insurance policies and setting premiums.

Transactions and the Cash Flow Approach

The standard textbook finance approach focuses on changes to cash flows as the key sensitivity measure. A transactions-based approach usually starts at the level of the single transaction, building up individual exposures and netting the differences where applicable in order to build an overall (net) position to be managed from the ground up. This is often done in large organisations, for instance in foreign exchange management, through factoring arrangements between subsidiaries in different countries. The different currency exposures are pooled, and only the net residual difference has to be hedged. Using this method to manage contingent and economic risks has the disadvantage that it requires knowledge of the future cash flows from the business. In most instances, this will be impossible to determine since such cash flows will not be known with certainty. Organisations could find themselves over hedging their risks.