Risk decision making should be based on proper analysis of relevant, timely and accurate information not subjective fears, says Nathan Skinner

The virtual collapse of the world’s financial system in the wake of some spectacularly bad decision making by some has changed the way people think about risk. It is a classic human trait, when we witness something up-close that affects us personally our response is immediately disproportionate. The perception of risk becomes more important than the reality.

After the horrific terrorist atrocities of September 11, which were played out live to a global TV audience of millions, the number of people travelling by commercial aircraft plummeted—despite the fact that statistically air travel is one of the safest ways of getting around. The fear of being the victim of a terrorist hijacking, or another aerial disaster, was so overpowering that more people took to the roads as an apparently safer means of travel. That increase in the level of traffic on the roads has been directly linked to a startling growth in traffic accidents. Irrational risk aversion actually contributed to more deaths on the road.

Apply this same argument to the current state of risk aversion in the corporate world. Some businesses are making subjective decisions about what risks they are prepared to take. Well respected and highly successful institutions have fallen foul of the economic crisis which has accelerated through the global economy with destructive and horrifying speed. That has made everyone a little edgy.

“Counterparty risk is currently everyone's biggest fear.

Counterparty risk is currently everyone’s biggest fear. Organisations are scared of being dragged under if their business partners fail. Without access to the proper details about a third party’s accounts and financial position organisations are erring on the side of caution.

Credit insurers, for example, have withdrawn from certain markets which they perceive as too risky. They have been lambasted for this. Businesses, who sometimes rely on credit insurance to operate, want the insurers to spend more time analysing the risks and working together to mitigate them rather than writing off whole sections of the market.

Some risk managers could be accused of similarly arbitrary decision making when their insurance partners, AIG and others, were dealt severe blows by the financial apocalypse. Rather than assessing what the real risks were to the solvency of AIG Insurance—a separate entity to the parent company—some clients decided to jump ship. In so doing, they may have left themselves exposed without insurance from anyone.

“Illogical risk decisions can lead to more danger.

The job of the risk manager is to distinguish between myth and reality. To present to his or her seniors accurate information about the level of risk to help them make sensible decisions about the risks they want to take in order to reap commercial rewards. With the right information at their fingertips companies can take on more of the risks they want in an environment which, as far as possible, they can control.

The problem is that recent events, while definitely creating a more risky trading environment, have also revealed the complete inadequacy of some supposedly sophisticated risk information systems. Around the world banks spent literally billions on models, tools and other resources to help them quantify the risks in their business models. Regulators wanted them to focus on risk management so they asked the banks to set aside capital to offset those risks. The banks, seeking bigger and bigger market share, decided to pervert the rules by creating ever more complicated instruments to mask the risks—that meant instead of hording capital they could lend more of it out (and make more money). They ended up tripping over their own shoelaces.

The danger is that witnessing these failures companies will give up altogether on risk management. That would not be a smart move, illogical risk decisions can lead to more danger. The risk function is crucial to a successful enterprise and it should be treated with the respect it deserves. Risk managers themselves need to learn from their mistakes. They should make sure they have the skills, expertise and business knowledge to present the right information to their seniors. It is essential that this information is accurate, timely and persuasive.