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Introduction to Investment Risk
A walk in the investment maze faces millions every day in our global trading community.
There are countless investment opportunities right under our noses. Some are good, others
smell instinctively bad. But, how are we to know if the whiff of the business opportunity is
really “off”, or does our nose fail us? The scent of prestige used to be a leading indicator for
investors. Yet, there have been spectacular failures at Andersen, Enron, Global Crossing, Tyco,
Worldcom, Marconi, Equitable Life, Swissair and Sumitomo. These show that the value of a
“big name” ﬁrm can be dubious. What have we really bought into?
Management theory, backed up by advanced information technology, would like to come
closer to guaranteeing a sound investment choice. Investment experts bring the risk and return
together. But, the danger is that ﬁnal selection is still based upon prestige and not value.
It is worse when this value is exposed as fraudulent. An analytical survey of fraud in the
USA found that ﬁrms were losing about 6 % of their revenues to occupational fraud and staff
abuse. This was estimated to be worth 400 billion. Furthermore, even good companies suffer
from strategic misdirection by the executives, and their investors may ﬁnd themselves on the
sidelines watching the ship go down. We can be average at investing, and if the boat is sinking
we are even worse at inﬂuencing the decisions of large corporations. H. Ross Perot said that
trying to change the plans of the General Motors leaders was like: “Teaching an elephant to
DREAM VERSUS RUDE AWAKENING
Modern business theory has, undoubtedly, left us richer to manage our investments. Pricing
theories and various portfolio models have provided a foundation for building future wealth.
Later and more sophisticated theories have incorporated a discount for that omnipresent element
in all business activities – risk.
No enterprise is immune to the dangers that constitute risk. Yet, risk is in itself a good
driving force to promote greater or more productive effort – the stock market feeds off two key
motivators: fear and greed.
Greed is a unidimensional factor that eggs us on to increase proﬁts. There is no law that
deﬁnes greed as an intrinsic criminal offence; CEOs and directors have been quick to extract
as much pay and beneﬁts from a company before they leave. Yet, excess greed comes before
a fall. They should come to fear regulator and shareholder activists’ counter-attacks. Fear is
the expression that we are about to suffer damage in some manner, primarily ﬁnancial loss on
the markets – we call the damage a potential hazard. Excess fear leads to stasis, and eventual
business ruin. Risk is an ever-present factor in any enterprise, and proﬁt is regarded as a proper
reward for bearing the risk in the ﬁrst place. The notion of a risk-reward ratio comes in, and
the concept of “acceptable level of risk” is a natural result.
Association of Certiﬁed Fraud Examiners, Fraud Survey of 2608 Companies, 1996.
TLFeBOOK2 Investment Risk Management
Risk management is the modern discipline that answered the call to handle business risk; the
prime example being company failure. Many of the failures listed above cannot be attributed to
criminal acts – corporate fraud and CEO theft reﬂect sentiment that is ﬁne for the sensationalistic
press, less so for the court room. Furthermore, a company director is rarely brought to court for
losing control of a company. It is extremely unlikely that they would have the personal assets to
come close to refunding their shareholders in full. Insurance premiums are rising, and there is
no guarantee that pay-outs are increasing pro rata; you get an insurance company’s assessment
of damage, not your costs of replacement. In view of these shortcomings, traditional legal and
insurance avenues of redress are not to be leant on as a crutch. A new look at risk management
This book targets those risk factors that threaten a loss in our portfolio value or investment.
We adopt a view of business investment as a closed project. This enables us to use a more
disciplined analysis of what governs enterprise success, and that involves project management.
We focus upon what constitutes investment risk; how organisations handle investment risk;
how we can manage investment risk better. Brieﬂy speaking, we can bring sound engineering
and actuarial tools to examine risk and risk management in depth. Forensic accounting is
needed for a deeper investigation of a company over its statistics and corporate personalities.
These views are, oddly, absent in many business books on risk management. These ﬁnancial
engineering methods are useful for the banking and fund management sector.
Everyone harbours a dream, and high proﬁts without risk are the ideal in the ﬁnancial
world. Saving is the obverse of consumption and real-life pressures come to the fore to make
achieving this dream more problematical. Returns are dropping on average, as the recent falls
in the global stock exchanges have shown. Furthermore, the world’s population is continuing to
age, certainly so in the major developed nations. Pension funds are now reducing their beneﬁts
and/or ﬁnding themselves under-capitalised. So, where is the dream now?
The changing demographics mean that, per capita, fewer people of working age are support-
ing more retired folk. Pensions form the biggest average holding by value of any household,
more expensive than their personal house. Add up all these pensions and they form the largest
fund of private households in most Western countries. Pension fund managers and institu-
tional investors now exert a larger block vote upon corporations than the majority of private
investors. For example, CalPers and Teachers TIAA-CREF are large funds in the order of 148
and 270 billion, respectively. They are inﬂuential in the ﬁeld of corporate governance – one
example being their near-success in scotching the HP–Compaq merger.
Sadly, people often devote more attention to their house and all its accoutrements, rather than
choosing their investment. They pore over home furnishings or kitchen equipment, but their
choice of pensions comes last. Some CEOs, like Dennis Kozlowski of Tyco, preferred to use
company funds to help deck out his apartment in style. It is no surprise that the public patience
with modern corporate leaders is wearing thin. The CEOs’ avowed duty to shareholders is now
plainly exhibiting a tenuous link to reality.
People are beginning to experience real disappointment when their pension returns are given
upon retirement. A Robert Maxwell comes along occasionally to rob a pension fund, or an
Equitable Life fund catastrophe occurs to destroy public conﬁdence in the future. But these
crooks are in the minority. Can the public prosecutors ever prove conclusively that there was
any criminal activity within the Tyco, Marconi or ABB losses? Given this doubt or mistrust,
TLFeBOOKIntroduction to Investment Risk 3
should the public pull all their money out of pensions and invest it elsewhere? If so, where?
This disillusioned attitude alone would lead to a strain on the pensions system, particularly
that managed by the professionals.
It is said that wars are fought over oil; yet, the 21st century could see the real investor battling
over corporate proﬁts, and the pension funds will ﬁgure largely. The changing demographics
of the larger older population stresses pension funds to provide for the retired. There will be a
stark separation of expectations and reality as people struggle with the net sums left to survive
on. The new deﬁned contributions plans and the closing of some pension funds to new entrants
further splits the retired world into the haves and the have-nots.
Yet, investment funds such as Fidelity Investments – the world’s biggest fund, will deﬁnitely
continue to be numbered among the “haves”. Furthermore, with nearly 900 billion in assets
under management, such funds will move stock markets around the world through their sheer
size and inﬂuence. Investment funds will continue to exercise signiﬁcant authority upon how
money is invested.
More recently, some funds have become vocal advocates for socially responsible investment,
such as the Coalition for Environmentally Responsible Economies (CERES) with more than
300 billion in assets. It is not just a mere focus upon corporate proﬁts, but an explicit drive
for accurate institutional reporting. These are to be conducted under stricter ethical guidelines
on environmental, economic and social grounds.
Recent years have not been entirely kind to funds. Fund managers could have lulled them-
selves into projecting glowing consistent returns of 10+ % p.a. on the stock market. Now, a
long-term average of 4 % to 6 % p.a. could seem more probable. We have to link reality to a
suitable investment risk vision. Furthermore, a fall of −25 % was not only realistic, but a sad
result in many stock exchanges during 2002.
We are faced with the snowballing prospect of client and business pressures to “beat the
market” in ﬁnding returns to investment. Over-eagerness is an enemy of caution, and that can
only lead to added danger or “unreasonable risk”. We look to restore a balance between risk
and return within this book.
This book looks at the uneasy marriage between investment and risk. Given the importance and
increasing role of funds within the markets, there is an emphasis upon institutional investors. We
have aimed this book towards those who work in the banking, fund management and insurance
sectors. It does not take a pure accounting, engineering, IT, banking legal, or insurance treatment
of risk – such a limited stand would probably impoverish proﬁtable analysis. There is input
from the actuarial and the forensic accounting professions, and methodologies from the project
This is a synthetic view of risk management, also looking at the organisations that operate
in the ﬁnancial sector. The manner in which people work together to reduce risk is analysed in
organic risk management. Previous studies of risk management have concentrated too much
on the mechanics and numbers – this is not a healthy ﬁxation.
“The global 100 investors: the most inﬂuential investors on the planet.” Lori Calabro and Alix Nyberg, CFO Magazine, 25 June,
TLFeBOOK4 Investment Risk Management
This has tended to cover a multitude of reasons for risk or business hazard. The dangers of
operational risk, and proposed solutions, will be detailed in later chapters. This introduction
to the category of risk known as operational risk is within Chapter 1.
We look at the concept of risk, and the undeniable link it has to return in Chapter 2 “The
Beginning of Risk”.
The basic union between risk and return is detailed in the summary of results borne out in
the early study of portfolio management within Chapter 3 “Investing under Risk”.
The divorce between reality and theory has worsened under recent corporate failures. Shining
the occasional spotlight on previous business cases helps the reader to understand the course
of investment history in Chapter 4 “Investing under Attack”.
Explanation of the leading trends in investment theory and ﬁnancial regulation offer the
beneﬁt of making better-informed decisions based upon an investment methodology. These
are examined in Chapter 5 “Investing under Investigation”.
So, learning danger signs from past failures offers a proﬁtable business warning radar for
professional investors. These are outlined in Chapter 6 “Risk Warning Signs”.
Technology has played a large part in the development of risk management as a modern
business discipline. We examine some of the state-of-the-art ﬁnancial techniques and their
associated IT-based risk management systems in Chapter 7 “The Promise of Risk Management
Yet, technology never solved all our business problems. There is some prospect that de-
mystifying current investment dogma will offer a better and balanced return in the future. We
present an overall view of realistic risks in Chapter 8 “Realistic Risks”.
Over-simpliﬁcation of some business ideologies led us into a false lead of risk management.
One symptom was the classic “one-size-ﬁts-all” business response.
Financial leaders have reworked business theory and regulations into a more appropriate
cogent investment strategy. One such development is the release of the new banking regulations
for banks around the world known as the “Basel II” guidelines. Their new views on banking
risks are outlined in Chapter 9 “Risk-managed Banking and Basel II”.
The evolving paradigms on investment risk have led to new ideas on modelling risk. These
are summarised in Chapter 10 “Future-Prooﬁng against Risk”.
Visiting the past has shown us the potential graveyard of many previous, proud companies
and investment dreams. Even a current examination of the current state of investment risk
management demonstrates the splintered thinking of the business community. The business
orthodoxy is hide-bound by mechanistic theory; we require treatment of corporations more
like living beings requiring “organic” risk management. These can, and should be, joined up
by integrated risk management detailed in Chapter 11 “Integrated Risk Management”.
Whether we engage in simple personal investments, or much larger and more complex
corporate business decisions, we can all beneﬁt from risk management to preserve the value
of our investments. These are summarised in Chapter 12 “Summary and Conclusions”.
The Beginning of Risk
We look at what risk entails at the beginning. These hazards are linked to the actual result,
but humans tend to focus on the danger only when it materialises. The fear of investment
failure has led to risk management emerging as a more visible business skill and discipline.
We introduce risk management within an investment project management methodology. The
three investment risks: credit, market and operational are deﬁned.
Recent ﬁnancial disasters are listed as case studies. There is a greater need to ﬁnd true
information about companies and their leaders getting beyond their reputation. These form
part of our warning system in our risk management methodology.
RISK AND BUSINESS
Proﬁts are created through business activity, with bread often used as slang for money. Risk and
business come together more often than a peanut butter and banana sandwich. Yet, risk is the
banana skin upon which many businesses slip. Look at the recent crashes of those considered as
“safe investment vehicles”. As if the collapses at Enron, Andersens, Worldcom and Equitable
Life were not enough, these came on the public crashes of dot-coms. A lot of banana skin, but
no bread for those poor investors.
Thus, it is surprising to some that the ﬁnancial sector, while claiming to be well risk-
managed professions, continues to experience losses on a signiﬁcant scale. The increasing
public opinion is that Wall Street (or the City of London) is a road that leads from a shark-ﬁlled
pool at one end, to a graveyard at the other. Maybe, we have to get used to conducting risk
management for ourselves to ward off attack. Investing is becoming akin to swimming with
CASE STUDY: THE SHARK AND ITS RISK
This type of natural risk is feared on the shores of the USA, Africa and Australia. The
attack can kill in seconds in the larger and more deadly species. Within other countries, it
is considered a delicacy; gourmands in Asia relish eating sharks’ ﬁn soup as an appetising
dish. So, the jaws of this shark are potentially fatal, while the other parts are very tasty. Risk
is a different among people according to their cultural risk appetites. Others prefer just to
avoid the fatal risk completely.
1. The potential death from a shark attack is a “hazard” phenomenon in the ﬁrst line of risk
2. The intrusion into its path is the second element or “risk catalyst” in a shark attack.
Within the process, the victim is open to injury through “risk exposure”.
TLFeBOOK6 Investment Risk Management
3. The third element is the “risk result” or event. Death is rare within the total population,
so it can be termed a low-frequency, high-impact risk.
However, for interested observers, in truth, the real statistics for shark-attack fatalities
are not generally very high. The shark attack is a potential risk for all swimmers in tropical
marine waters, but bees, wasps and snakes are responsible for far more deaths. The annual
likelihood of death from lightning is 30 times greater than a shark attack in the USA.
Statistics point to far higher chances of dying from drowning or cardiac arrest than from
any shark attack. Many more people are killed driving to and from the beach than by
One characteristic danger sign of many sharks is that it is a relatively fast-moving aquatic
with a prominent dorsal ﬁn. There are some familiar warning signs for investors too. Yet,
substandard companies that lose your money or suspect business counter-parties do not
necessarily exhibit such glaring warnings. Nevertheless, we can establish a corporate risk
proﬁle to sway us from investment-risk sharks.
Corporate victims from bankruptcy or share price collapse are more frequent. A careful
observation of the whole investment market distribution of probabilities, outcomes and their
utilities, is necessary to proﬁle the risks from suffering such a bad attack. Just as an intuitive
view of this shark-risk proﬁle is strongly biased to overestimating the downside risk and
the ﬁnal risk event (death), the rarity of company bankruptcy attack has had a perceived
lower risk or probability.
Most non-ﬁnancial industries characterise risks as hazards. Yet, the end result need
not be a loss event; in fact, there are several event results where there is a happier and
more proﬁtable event. There is a one-in-a-million risk that you will win the jackpot lottery
prize. Then, we can apply mathematical and computer techniques to derive analytical
Deﬁning a risk event, and categorising it in the frequency-impact risk matrix is one start
for analysing risk. Then we can see how a loss occurs. A loss, then, is a three-step process,
starting by a hazard, with the help of contributing factor or catalyst, a risk event itself, and
with it a concomitant loss or result (see Figure 2.1).
The chances of this hazard resulting are conceivably higher when there are deep individual
and political connections involved.
Hazard Risk catalyst Risk result
Failure of public Appointment new Near-bankruptcy
bank with extreme CEO with highly with huge
government ambitious global government bail-out
involvement market goals
Figure 2.1 Structure of a risk
Florida Museum of Natural History, 2002.
TLFeBOOKThe Beginning of Risk 7
CASE STUDY: THE RUIN OF CREDIT LYONNAIS (CL)
This was a proud bank that expanded rapidly from 1987 onwards. New drives then aimed
to take CL to a global scale that would rival the major US investment banks. The ambitious
growth was fuelled by hubris and additional funds from the French government. A business
culture locked in the depths of the Paris Elysee ´ sought to be as skilled and powerful as the
top global US ﬁnancial players. This goal was a goal that pushed CL towards bankruptcy.
The catastrophic moves inadvertently linked strategic risk with a lax risk management
function. Middle ofﬁce risk management played no signiﬁcant part when political power
and individual ambitions were supremely dominant. The bank nearly went bankrupt after
1993; its bail-out estimated variously in the region of 25 billion.
However, spectacular corporate implosions need not be attributed to political chicanery
or dot-coms. SwissAir and Equitable Life are examples of highly respected companies that
had the gloss taken off in no uncertain terms. Investors should take the responsibility to arm
themselves with the required company information to beware the hazards that lurk under the
label of “operational risk”.
Sources of historical data could prove beneﬁcial for potential investors. We have to go
outside the usual ambit of corporate proﬁts or ﬁnancial losses quoted in the newspapers and
online media. We need analysis to determine actual company performance, as distinct from
company PR and spin.
Take the once-respected engineering ﬁrm, ABB.
CASE STUDY: ABB ENGINEERING
A glorious reign for Percy Barnevik seemed to good to be true. He was reckoned to be
Europe’s top CEO for quite some time. The ABB share price fell 80 % from its peak share
price of over 50 SFr in 1999. It has lost 96 % of its peak value into 2002 (Figure 2.2). Then,
he and his colleague were meant to take 136 million in a pension pay-off. The directors
prosper and the company suffers. There was a mini-revolt among many investors. Barnevik
ended up with less. The ABB bonds had become graded by Moody’s in 2002 as junk.
Ironically, the shares of ABB rose signiﬁcantly in 2003 once it had agreed a rescue plan
for its US subsidiary Combustion Engineering (CE), amidst its rising asbestos legal claims.
The extent of damages in the 1950s reappearing as a hazard 50 years later shows that our
risk horizon can be too short. A loss database or a risk register has to be compiled that
details such hidden legal risks.
In fact ABB survives, but its reputation is slightly tarnished. Some newspapers will look
upon this episode unkindly, especially as they were probably among those that put a halo
upon Barnevik’s head as the most-respected European CEO. There is no suggestion that
ABB was pushed among the junk of many tech shares that went bankrupt. Actually, the
ABB share price recovered partly as investors began to separate perceived reputation from
real company worth.
See “A new scandal at Credit ´ Lyonnais”, Economist, 11 January 2001 and “Credit ´ Lyonnais”, Erisk case study, March 2002.
“ABB shares rise on asbestos claims deal”, Financial Times, 17 January 2003.
TLFeBOOK8 Investment Risk Management
Figure 2.2 ABB share price (SFr) 1995–2002
Source: Bloomberg, January 2003.
What we have witnessed are the countless dot-com scams that were publicised following
the extensive media coverage and US lawsuits. The dot-com shares were being “pumped and
dumped” by reputable brokers and investment banks. The UK Financial Services Authority
(FSA) has somewhat belatedly taken measures against “spinning”, but it is unlikely that
investors who have lost from the popular IPOs will recover much of their original assets.
It seems the regulatory authorities can seek to prevent future ﬁnancial malfeasance, but
cannot recover compensation for investors, especially when another pump-and-dump scam
occurs. It is more like “bread yesterday, bread today, but never bread tomorrow” for the
Investors’ conﬁdence has fallen to epic lows, and continued dissatisfaction is expressed
by investor disillusionment in company management following recent corporate accounting
scandals. The regulator is called in to monitor the business environment, but a lot of this seems
to be after the crash. We live and breathe in a market where having ﬁnancial regulators around
means in no way that investment risk is dead. A common recurring problem arises when the
public buys seemingly riskless or “safe” investments from licensed ﬁnancial companies. Risk
perception has become separated from actual risk.
The next crisis is going to be borne by unaware consumers again, and they need protection.
That is what laws and ﬁnancial regulations are for; but the true success of any code is that
companies and individuals:
FSA press release, www.FSA.gov.UK, FSA/PN/102/2002, 23 October 2002.
“Private share ownership in Britain 2002”, www.Proshare.org.uk, 23 September 2002.
ABB share price (Sfr)The Beginning of Risk 9
Table 2.1 US white-collar crime
Number of Financial institutions –
% cleared % arrests business victims number of victims
Fraud 33.12 79.52 47 907 2989
Bribery 61.78 93.22 16 0
Counterfeiting/Forgery 29.83 88.70 55 676 5310
Embezzlement 38.37 86.74 17 627 182
“Measurement of white-collar crime using uniform crime reporting (UCR) data”, Cynthia Barnett, FBI statistics,
follow these regulations;
be punished for contravening these regulations;
suffering loss from illegal business activity can seek to obtain some form of compensation.
Numerous headlines in the news show the get-outs. Bernie Cornfeld of “Fund of Funds”
infamy ﬂed to the Bahamas. BCCI lost billions for account-holders. No one from Andersen or
Enron has yet been jailed for their part in the scandal. Asil Nadir of the failed Polly Peck ﬂed
to Cyprus and was never extradited. Ernest Saunders had his trial stopped for his Alzheimer’s
disease, from which he recovered. Peter Young of DMG was deemed mentally unﬁt after
appearing for trial wearing a woman’s dress. These cases took a lot of time and money to
come to court. In most examples, shareholders got little compensation or next to nothing. Both
punishment and ﬁnancial redress are missing. Naturally, public dissatisfaction with the legal
How are you going to protect yourself in the ﬁnancial markets? The most public view of
regulation is to guard yourself against numerous forms of investment fraud or con-tricks.
The plain truth is that white-collar crime pays well, it is the fastest-growing business, and there
is little risk of being put away. See Table 2.1.
Securities and commodities fraud in the USA was reported as 40 billion per year in 2001.
So it is worth keeping an eye out for this risk hazard.
Banking risk and sharks
Yet, there is not a single government or agency on this planet that can legislate against risk
Taking “appropriate measures...to prevent ﬁnancial crime” does not mean that ﬁnancial services
companies should have to spend enormous sums on reducing ﬁnancial crime to zero. That is not
Financial regulatory authorities tend to be underfunded and understaffed. Often, even if
punished, only minimal ﬁnes are meted out for the guilty parties, and few lawsuits are launched
every year compared to the number of customer complaints. Worse still, the downsizing trend
means that ﬁnancial regulators and banks will be less well-equipped to police the risk arena.
“Securities and commodities fraud”, www.fbi.gov 2002.
“The reduction of ﬁnancial crime”, House of Commons Standing Committee, 15 July 1999.
TLFeBOOK10 Investment Risk Management
The ratio of internal audit staff to total staff in some institutions today can be as low as 60 % of
what it was about ﬁve years ago and banks are bigger, trading more complex instruments, and
money is moving faster around the system.
So, within the ﬁnancial markets the odds of detection and punishment are both relatively
being caught; and
RISK MANAGEMENT AS A DISCIPLINE
The idea of risk management is certainly not a new one; it is certainly as old as that great risk
mitigation practice – building an ark. The business theme is the same, believe that the risk
event can strike us, act constructively to mitigate or lessen the damage when it strikes us.
1. There is the ﬁrst school of investment risk management – the fatalistic business philosphy;
you are inevitably going to be hit by a risk event, so better be covered. Bear the load yourself –
retaining the risk under self-insurance. Risk management means keeping a contingency fund
for your company.
2. This is can be the second paradigm of investment risk management – the technological
school. We are mathematically and technically developed in our understanding of risk
event, so we can avoid or mitigate risk through smart moves in advance.
Risk management is the study and practice that offers some answers for choices in the ﬁnancial
markets. Many of these models are mathematically based, aided by sophisticated computers
and telecoms. Given all the collected brains, university degrees, sophisticated mathematical
models, powerful computers and market reports, we should feel pretty reassured.
Yet, why do some companies continue to make such appalling business decisions? One
possible answer is that the investor passes the money, and management mandate, over to the
CEO to run the company. But, does it mean that Buffett is asleep at the wheel? No. Company
directors are going to make money for you if properly monitored and goaded; inevitably, they
slip up now and then, so prod them when needed.
3. This is maybe the third school of investment risk management – the watcher school.
Another view is that the huge amount and complexity of numbers and accounts cloud the
central issues, we just have to watch our staff and business partners. Technology in a global
economy enabled Nick Leeson of Barings or John Rusnak of the AIB in USA get away
with “rogue trading”. All were human-based errors and they should have been monitored
4. This is the organic risk management school – there is a need to link up separate initiatives
in order to deal with various risk events and the actions of human beings, so better integrate
all these developments for “joined-up” thinking. Thus, there is little understanding of how
human staff behave or adequate integration of high-technology. Integrating all the risk
management technology, plus knowledge of investor behaviour leads us forward. Recent
developments in banking, insurance, law, accountancy, IT, project management and forensic
accountancy will provide us stronger holistic organic risk management.
“Operational risk”, Middle Ofﬁce, spring 1999.
TLFeBOOKThe Beginning of Risk 11
Deﬁne objectives and the scope of what we are trying to achieve
Estimate what staff, skill mix, budget and time required
Identify the risks that face us, now and later
Study and estimate the probabilities of these hazards occurring
Estimate the impact (proﬁt or damage) associated with these hazards
Collate these choices in a matrix for evaluation
Recommend best decisions available under various conditions
Devise risk management plan
Assign key staff for completion of project
Allocate risk management budget
Implement risk management IT systems
Run investment risk model
Execute risk management decisions:
ignore risks (prepare to bear all burden yourself)
mitigate risks (lessen damage e.g. write a hedging contract)
transfer risk to insurer
sell off risk operation to an external party
Take on partners and business counterparties
Monitor and amend risk management plan where necessary
Log experiences in a risk register or loss database
Recommend follow-up actions
Figure 2.3 Risk management of an investment project
The last school puts business processes and actions within a methodology. This can be
outlined within an investment project as shown in Figure 2.3.
Humans and risk
Whatever view we take, given the size and complexity of managing companies, we rely upon
“experts” to keep a watch out. So, risk hovers around even the most “respectable” company to
its very core. Thus, we have entered into the grey forest of artistic accounting and interpretation.
The inability of some notable corporations to state the true health of their accounts is a worry that
we must address. The Andersen–Enron case demonstrates some of the ground for confusion.
We have tended to focus too much upon auditors and analysts’ lack of common sense
or ethics. Numbers and balance sheets are not even half the corporate and investment
problem – they are just a common symptom. We need to thrust our noses purposefully into
companies, past the ﬁnancial details, and into the corporate reality of how human staff operate.
We investigate two cases of retail store theft.
Centre for Retail Research, UK, 2002.
TLFeBOOK12 Investment Risk Management
CASE STUDY: HIGH-STREET RETAIL STORE LOSSES
UK high-street stores lose more goods to shoplifting than any other EU country, an asset
loss worth approximately £4 billion. This is about 2 % of annual turnover, against Germany
1.19 %. A lot of this loss is an “inside” job – UK company staff are responsible for 28 %
of the merchandise stolen. We can see that banks often lose some of their annual turnover
likewise, and a part can be considered an “insider job” too.
The costs of security control and surveillance is somewhat negated by the inability of
the UK justice system to deal with the large numbers of store thieves. Nationally, 675 000
thieves were arrested in 1999, but fewer than 10 % make a court appearance. Of these,
only 4000 are given a prison sentence. Threat of imprisonment can become viewed as
We have included an example of shoplifting and theft, but we have not expressed the sig-
niﬁcance of fraud. Businesses acknowledge the negative impact of fraud, which costs UK
companies and public agencies around £15 billion per year. The costs of prevention and inves-
tigation add a further £1.8 billion to the total. The summary of personnel checks, corporate
research and the formation of a loss database now become seen as a necessity for sound busi-
ness in the light of the potential damage suffered. A loss database under Basel II could be part
of the answer to documenting a bank’s equivalent of pilfering or leakage.
It is interesting to know how many banks and investment funds do not conduct such basic
exercises. It is not just risk management, it is the concept of business pure and simple. As we
have seen, banking fraud and poor trading supervision can enable staff to lose millions. Worse
still, our experience in banking risk management has shown that the omission of such sound
business monitoring can be costlier, if not deadly.
CASE STUDY: ALLIED IRISH BANK (AIB)
John Rusnak was sentenced to 7 / years in prison. He traded foreign currency for Allﬁrst,
the US arm of Allied Irish Bank. He pleaded guilty causing losses of 691 million in a
trading fraud to make hundreds of thousands of dollars in bonuses.
Former US comptroller of the currency, Eugene Ludwig, conducted an investigation that
cited Mr Rusnak for fraud, but he also criticised AIB for creating the conditions for this
fraud to continue for such a long time. AIB’s lax management and weak corporate controls
sowed the seeds of down that eventually grew into one of the largest banking scams since
the rogue trading of Nick Leeson that led to the collapse of Barings.
Such operational errors also occur in Western banks to an alarming degree. They will
continue to do so as long as banks and investment funds have business operations and practices
that are vulnerable to suffer extensive loss. These companies are vulnerable because their risk
culture is sloppy and has atrophied, just like the risk sensors that help us avoid being bitten by
snakes. The problem with some banks is that: once bitten, not really any shier.
Department of Trade and Industry, www.DTI.gov.uk, 2002.
“Jail for £430 m rogue trader”, Economist, 17 January 2003.
TLFeBOOKThe Beginning of Risk 13
The state of the investment game
Much of the ﬁnancial industry story has been built upon foundations of professional invest-
ment management and accounting. Risk management as a discipline took off in recent years
within the banking and investment funds sector. Front-ofﬁce sales are backed by in-house
investment analysis and efﬁcient regulation. These generate huge amounts of information
and analyses. A truck-load of data and associated computer processing techniques have been
Lately, the ﬁnancial “experts” have tended to jump on the bandwagon and subject the corpo-
rate numerical data to intensive analysis. Much in vogue is the variety of mathematically based
modelling techniques. These models include computing variables for Value-at-Risk (VaR),
Asset-Liquidity Management, Asset-Liability Management, CAMEL and Capital Adequacy
Ratios and so on. These techniques are believed by many to offer adequate protection for the
But, we feel that there is something missing to the aggregate ﬁnancial expertise in the market.
The mathematically based causal modelling can lead us to ignore some human-based risks.
This is where organic risk management can help us. The loss database is just one possible tool
for compiling a list of human-based risks.
These are potentially damaging corporate actions that are difﬁcult to detect from balance-
sheets and numerical data. The Enron–Andersen catastrophe showed that mathematics and the
number-crunching have limited use outside the bounds of competence, ethics and common
sense. We are faced with a myriad of risks.
Risk is the possibility of an event happening. Risk is often associated with negative outcomes;
although there are some beneﬁcial possibilities too, people generally connote risk with loss or
damage. We normally take the insurance and everyday life custom of linking risk automatically
with an unpleasant event. It is necessary to consider to recap on our views of risk within a
hazard – the risk of an outcome or event;
danger or risk catalyst that allowed this risk to occur;
impact of the event upon your group;
risk management – the process in which you can limit or avoid the potential damage.
There are four risk types that we wish to examine in depth within this book.
1. Reputation risk
2. Market risk
3. Credit risk
4. Operational risk
These last three are the same major risk types outlined in the latest Basel II banking regula-
“New capital accord – an explanatory note”, Basel Committee on Banking Supervision, January 2001.
TLFeBOOK14 Investment Risk Management
The time-worn way to avoid risk was the tactic of keeping silent (“there is no danger, keep
shtum”), or hiring a big name with a good reputation to reduce your investment risk.
Thus, taking on the services of the top Wall Street or London City investment banks,
lawyers, accountants and specialists was a sure way or reducing risk because they were “safe”
business partners. One of the drawbacks of this method is that we are relying on heuristics
that are either unfounded or out of date. The rule of thumb: “prestigious reputation = great
CASE STUDY: EQUITABLE LIFE
The notion that a large, old and well-established ﬁrm means a “good risk” took a bit of a
knock after the Queen’s bank (Barings) of England went down after the Leeson disaster.
History repeats itself when we are faced with a respected company founded in the 18th
century facing a struggle for survival. It seems to have been a case of damage by acting
in a risk-ignorant and not by intention or criminal act. Damage limitation provided by the
UK life insurance company Equitable Life shows us where risk management often comes
in after a risk hazard surfaces, not before.
1. The damage from the mis-selling scandal was quite severe, many funds found culpable
of selling inappropriate pensions to the public.
2. Most funds were enamoured of the guaranteed annual repayment whereby the funds
essentially bet that they could assure the policy-holder of a ﬁxed amount each year upon
The stock-market slump threatened their ability to pay out to customers, plus it jeopardised
the capital adequacy base.
The new management went on a damage-limitation exercise. This eventually succeeded
in keeping the company aﬂoat, despite hard knocks to its former prestige. It is a process
of reputation risk recovery, which could not have been conducted by a low-level risk
management exercise. In this case, top management:
recognised the hazards;
evaluated the impact of the risks;
allocated vast resources to damage control;
set about retrieving reputation and clients’ trust;
put in procedures to limit further similar damage in the future.
A better use of communication and efﬁcient PR could have triumphed over mechanistic
risk management. Equitable Life was under such ﬁnancial pressure that it dropped 50 000
pensioners from its schemes. Pay-outs fall, the number of lives insured decreases and the
number of satisﬁed policy-holders has shrivelled to almost zero. If only they had known
beforehand. Equitable Life struggles on, but survives. We can just regret that these damage-
limitation measures were not done before, but post facto (see Figure 2.4).
Financial Times, 16 November 2002.
TLFeBOOKThe Beginning of Risk 15
Total solvency £m
Figure 2.4 Equitable Life monthly solvency Dec 2001 – July 2002
Credit risk is the ancient hazard of suffering loss because of not being able to extract the
promised return from a business partner. We also include counterparty and country risk within
this category. Various examples exist: sovereign risk on issue of bonds and debt default such
as the Russian economic crisis of 1998, or the Argentinian debt crisis in 2002.
Few banks only lend to one sector but actively diversify their portfolio. A modern bank
(Commerzbank, 2001) shows how it makes arrangements for the projected level of domestic
bad debt. See Figure 2.5.
Market risk is the loss in value of the bank or fund’s portfolio caused by changes in price
(or price-related) factors. Currency rate, interest rate, equity price levels, volatility levels are
changes or risks that come under this heading. A bond-dealing desk taking positions is a typical
Figure 2.5 Credit risk
Source: “Provisioning for borrower risks by customer group – ‘Commerzbank in 2000’,” Annual report,
TLFeBOOK16 Investment Risk Management
example of a portfolio under market risk. The large foreign exchange market trading feeds of
these risks for good and bad where those who estimate the market risk well beneﬁt, whilst
those who calculate market risk wrongly generally fail.
This is a wide-embracing term that refers to the danger of losses from business system or process
failure. This can include mechanical and human operations, faults in procedural design and
system function. The Basel Committee on Banking Supervision adopts a narrower deﬁnition:
“. . . the risk of loss resulting from inadequate or failed internal processes, people and systems
or from external events.”
It includes legal risk and all errors from trading and settlement not previously covered in
the above categories, to the criminal/fraudulent actions, up to the IT and system failures from
human and external changes. Strategic, systemic and reputational risks are excluded. These
are the categories of risk that are often said to be the hardest to model and predict – the human
When we have redesigned bank business processes, created dealing operations, or inspected
fund managers, we work in a complex network of people and their varying skills. Some of
these skills and experience are not really deﬁnable in numerical terms, but involve an element
of intuition. Thus, investment risk management is an art, and not a science in many ways.
Risk management used to be a staid and reactive exercise, where the auditors would be
called in after a company crashed or suffered loss. Now, it has become a specialist ﬁeld in
its own right encompassing several disciplines geared towards a proactive stance to mitigate
against risk consequences.
Formerly, risk management was just like an optional feature that you could choose to buy
later. Lately, risk management is becoming an inherent part of the processes of wealth creation
and a sought-after skill. We include some of the essential skills for modern risk management.
The variety of risk is so wide, and potential damage so deep, that risk management has
become high proﬁle in itself. See Figure 2.6. Directors are less able to pay lip-service to
operational risk because of the high impact when the hazards happen. Compliance was such
a boring and low-key event that companies devoted fewer resources to it. Now the regulators
are devising stricter rules, and the public wants to see that these are met by the company, that
directors do not wish to face the reputation risk of being known as inept or hiding something
disastrous when it comes to complying with the disclosure regulations.
Risk management skills often involve a combination of ﬁnancial training and an intuitive
sense to sniff out suspect investment opportunities or partners. It has a strong mathematical
foundation, but recently, some of this modelling has demonstrated weak underpinning. So, we
come back to having a good “nose” for business – intuition and experience, instead of paper
Then, we deﬁne where we come into the grey area that calls for the artistic gift of subjective
interpretation. The Andersen–Enron–WorldCom (AEW) cases demonstrate where confusion
led to crooked chicanery. Then, we deﬁne where we come into the nebulous area that calls for
the artistic gift of subjective interpretation. Yet, we can hover above the company risk horizon
and see dangers surrounding us.
“Sound practices for the management and supervision of operational risk”, Basel Committee for Banking Supervision,
www.BIS.org, July 2002.
TLFeBOOKThe Beginning of Risk 17
Operational risk (external) Strategic risk (external)
Outside Internet hacker Loss of tied supplier
Weather damage Change of government
Electrical supply or circuit fire New compliance regulations
Strategic risk (internal)
Operational risk (internal)
Bad process design
Improper M&A targets
Loss of talented staff
Wrong product mix
Loss of customer contact
Figure 2.6 Risks inside and outside the corporation
The concept of an AEW risk-alert system would work in the same way as an AEW (airborne
early warning) radar detects potential enemy action. It is tempting to point the ﬁnger at An-
dersen’s accounting arm and try to ﬁx the fault just there. Risk management is truly concerned
with the fundamental source of errors and lack of control in modern corporate business, not
just the symptom. The post-Enron quick-ﬁxes and assurances must offer superﬁcial comfort.
We offer a view on the investor’s AEW corporate risk-alert system in Chapter 6.
RISK AND DAMAGE
The fact is that although ﬁnancial regulatory procedures for protecting the investor are well
documented, ﬁnancial redress and net loss are less well recorded. This means that even when
the stock exchange and the regulatory organisations have given a good-housekeeping seal of
approval to large numbers of listed companies, some records of company operations and the
more truthful balance sheets take an opposite view. The imperfect relay of information, or
interpretation by the investors, shows a divorce between extant risk and likely damage.
The ﬁnance industry wallowed in a “If it ain’t broke, don’t ﬁx it” mentality for decades.
Mistakes were made partly because of lack of proper execution in planning for extreme events,
matched to negative impact. Every business builds a risk register with relative probability and
associated impact. See Figure 2.7.
The different risk impacts and frequencies need to be dealt with by different people with
various risk management skills. This varies from company to company, and from risk culture
to risk culture. Where losses occur, these should be recorded in the loss database.
Insurance and fund managers form a highly organised risk-seeking profession that aims to
share these risks for proﬁt. It tries not to take on too much risk, or even too much risk that it
does not understand. Otherwise, it stands the risk of dying as a business.
Insurance, even with its avowed expertise in risk management, is just as likely to face
insolvency, as the crashes in their stock-market portfolios have revealed. Because banks, in-
surance companies and pension funds have a large slice of the entire stock market capitalisation,
TLFeBOOK18 Investment Risk Management
Figure 2.7 The risk register (frequency vs. impact)
corporate inadequacy can force a sell-off of shares in their portfolios. This can create a systemic
or pro-cyclical risk where continued selling destroys the stock-market value. See Figure 2.8.
The threat of stock-market crash or some terrorist activity after September 11th may seem so
uninsurable that some clients opt-out or go for self-insurance (bear the risk burden yourself).
Otherwise, pay higher insurance premiums. A large corporation can retain a large risk because
of the size and strength of its balance sheets.
Risk retention or self-insurance is troubling the insurance industry. Insurers’ efforts to cope
with loss of business have tried to offer alternative products or to cut premiums – both carry
considerable risk. Cutting premiums or guaranteeing the pay-outs endangers the very same
insurance companies that are meant to protect investors. Risk retention is also a prospect
that troubles some investors – there is a tacit admission that they take a bet on an extremely
low-frequency, high-impact risk. This means that their company can go bust, with little com-
pensation for the investor. Business looks more like a gamble at the horse races.
There are loop-holes when we seek to protect ourselves through the ﬁnancial regulators, the
legal system, accounting or insurance. The validity of auditing and due diligence can be called
into question. Rushed business diagnoses are superﬁcial, and their foundations for deﬁning a
business conclusion are clearly limited.
“New capital accord – an explanatory note”, Basel Committee on Banking Supervision, January 2001.
TLFeBOOKThe Beginning of Risk 19
Life insurance company Stock market crashes. Profits Life company reneges on
guarantees annuity pay-outs dry up. Life insurance and guaranteed annuity pay-out.
in a rising market. Fund pension fund capital falls so Pensions reduced or entrants
guarantees pension. Stock- alarming regulators. to scheme excluded. Clients
market performance varies. Guaranteed annuity or threatened with bankruptcy of
company. Policy-holders take
losses on annuities.
Hazard Risk catalyst Loss result
Figure 2.8 Risk in a life insurance company or pension fund
These severely reduce the effectiveness of traditional risk management avenues. The growing
feeling among investors is that prevention is better, and cheaper, than a cure.
Accumulating a pool of corporate information might come in very useful. These avenues
are explored in further depth in the following chapters. Some are:
Traditional sources of corporate news in current events coverage.
Prior company case studies and relevant industrial experiences from media sources logged
in a “risk register”.
A deeper investigation of performance track-record of key company staff, counter-parties
and business partners under detective and forensic accounting initiatives.
Additional company reports ﬁled under the Basel II new banking regulations.
Procedure for early warning (AEW).
Those who have suffered enough from previous investments understand that reputation
risk means perceived corporate value becomes rapidly uncoupled from real worth. We can
now attempt to detect and discard undesirable business elements from our future plans using
these data sources. One of the ways we can help to achieve this is to use an investment risk
methodology. This is outlined in succeeding chapters within a view of a methodology for an
investor’s closed-end project, i.e. a launch and a desired end. So, when it comes to investing
or building a portfolio, the increasing feeling is to do everything yourself.