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PREVAILING RISK ATTITUDES

An efficient mental risk-return calculus is a critical component for business success under uncertainty.
. . . the overall risk perception held by the public is often worse than reality. Risk management can assist you in making more profits in areas where over-conservative investors stay out. The upside is that, if risk is really low, your rivals will be over-valuing the risk. The downside is that, if risk is really higher than you think, you will stand to pay the price of the risk hazard or damage.
The efficient portfolio theory and mainstream mathematical models only set a basic foundation for analysis; they do not represent the risk management goal itself. Thus, they can become inclined to set a level of return that is not proportionate to an acceptable level of risk. We have seen that investors and managers often inadvertently end up being risk-seeking.
Sophisticated financial modelling can lead companies into a false sense of security where theory has not been adequately back-tested to check if it conforms to reality. Thus:

• they have lower assessment of the risk probability and impact;
• the impact of worst-case scenario is less dramatic than imagined;
• the maximum return is potentially higher than thought;
• such phenomena of risk misperceptions are often observed in practice, but not always admitted.

Weak banks and companies that are more prone to failure have inherent shortcomings such as a CEO and board that are likely to embark on unsuitable strategic missions. Reputation and prestige of the guilty party, as we have seen in the Credit Lyonnais case, may be enough to stop adequate risk management exercises taking off in the first place.
Furthermore, the internal checks and balances offered by the oversight board may have been overidden, so defects in the company’s structure are prevalent.
At the lower organisational level, there will be risk management weaknesses that allow major errors to occur. The Leeson or Rusnak cases are examples of a failure to incorporate suitable control elements. Financial modelling errors are examples of less glaring unintentional mistakes in risk management.
Setting up a departmental risk management function will monitor a risk hazard, and train staff. Under the trend of short-termisim in career and instant gratification, there are limits to how much passive personnel watching can achieve.
It is traditionally incumbent upon the industry watchers and regulators to monitor the operations and losses on a “watch list”, then to sound alarm bells. Yet, this corporate warning is too late for many shareholders. The auditors are meant to perform a regular financial health-check, as is done before a merger or acquisition.