Re-Examining Existing Risk Management

Rapidly changing economic and market conditions give rise to unusual changes in risks for many organizations.We take two very critical issues in such a situation. Issues that can bring down an empire in an instant.

1. Performance liked executive compensation
If we look back into the historical large scale losses, there is a strong link to such losses occurring because of the way compensation was structured. When compensation and bonuses are linked to performance, there is a tendency to take excessive risks, put a lot more at stake to make quick profitable bets and in turn be rewarded well. Many traders across the globe undertook such large scale positions, and continued to add to these open positions if they were resulting in losses hoping to make up in the end. Often these would be hidden, mis-reported etc.

In the absence of such compensation structure, there would not be enough incentives to expose the organisation to such large scale losses. In India, the derivative contracts entered into by CFOs of manufacturing companies is another example to place bets and make profits for an otherwise support function.

Secondly, when the business booms, there is often a complacency factor that creeps up. Policies and procedures are put on the back burner because business is top priority. Audit and risk department are comforted by the fact that if all necessary checks and balances and approvals were to be taken, the business would have been lost. After hearing these statements for over 10-12 times, these support watch dogs stop questioning and start accepting this as a way of life. Even the CEO starts to sign off on proposals that excessively add risks to the overall risk profile of the organisation.

So, what are the lessons learnt from the above issues. Well, firstly, there is a need to re-align the compensation structure to prevent large scale risks. Secondly, no matter whether you are beginning a race or nearing the finish line. You can never drive a car fast without brakes or should we say, never drive a car fast and purposely not apply brakes to slow down. Risk Management practices are like brakes. They need to be used where appropriate.

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