the new arsenal of risk management

The New Arsenal of Risk ManagementHarvard Business Review; Sep2008, Vol. 86 Issue 9, p92-100By Kevin Buehler; Andrew Freeman and Ron HulmeAbstract:The global banking system is facing a severe liquidity crisis: In the first half of 2008, major financial institutions wrote off nearly $400 billion, causing banks around the world to initiate emergency measures. Similar crises have occurred within recent memory: Think of S&Ls, the dot-com bust, and Enron. Risk is, quite simply, a fact of corporate life-but because risk-management research has increasingly emphasized mathematical modeling, managers may find it incomprehensible and thus shy away from powerful tools and markets for creating value. Buehler, Freeman, and Hulme, all with McKinsey, describe the evolution of risk management since the 1970s, show how new markets have changed the landscape in both financial services and the energy sector, and explain what it takes to compete in the current environment. To demonstrate how significant a factor risk can be when incorporated into strategy and organization, they take the case of Goldman Sachs - which, despite its reliance on highly volatile trading revenues, has so far avoided the big write-offs that have afflicted its leading competitors. The authors believe that this is because Goldman takes the antithesis of the typical corporate approach-its culture embraces rather than avoids risk. And, they say, Goldman very efficiently employs all four of the following factors: quantitative professionals, strong oversight, partnership investment, and a clear statement of business principles, with emphasis on preserving the company's reputation. Staying on the sidelines of risk management may have shielded some companies from crisis, but it has also prevented them from growing as quickly as they might have. In their companion article, "Owning the Right Risks," the authors outline a process that will enable executives in any company to incorporate risk into their strategic decision making. ABSTRACT FROM AUTHORSection: The Risk Revolution THE TOOLS DISCUSSIONS OF RISK usually come to the forefront in times of crisis but then recede as normalcy returns. As we write, the global banking system is facing a major credit and liquidity crisis. Losses from subprime mortgages, structured investment vehicles, and "covenant lite" loans are creating a credit crunch that may in turn trigger a global slowdown. In the past year major financial institutions have written off nearly $400 billion, and central banks around the world have initiated emergency measures to restore liquidity. Several other crises have occurred within memory: the U.S. savings-and-loan collapse in the 1980s and 1990s, Black Monday in 1987, the Russian debt default and the related dive of Long-Term Capital Management in 1998, the dot-com bust of 2000, and the Enron-led merchant-power collapse of 2001.The resounding message is that risk is always with us. Executives need to wake up to that fact. Unfortunately, a growing emphasis on mathematical modeling has rendered much of the risk-management debate and research incomprehensible to those outside the finance function and the financial services industry. As a result, many corporate managers have shied away from the powerful risk-management tools and markets created over the past three decades - and thus have forgone considerable opportunities to create value.Our aim here is to help managers understand both the advantages and the limitations of the markets and tools that are implicated in the credit and liquidity crisis. We will describe the evolution of risk management in recent decades, show how new markets have changed the landscape in both financial services and the energy sector, and explain what it takes to compete in the current environment. These analyses will help readers make sense of the crisis and will illustrate just how powerful a lens risk can be when applied to corporate strategy and organization. In the companion article published in this issue, we describe a process whereby executives in all companies can incorporate risk into their strategic decision making.The Idea That Changed the World For the first 70 years of the twentieth century, corporate risk management was largely about buying insurance. Risk management in the financial sector was also rudimentary: Bank regulators lacked tools for measuring risk in the system, so constructive intervention was difficult. Banks themselves had no way to control the interest-rate risk in their loan portfolios or to quantify and manage credit risk - in part because few alternatives to insurance existed. To be sure, some futures and options contracts were written and sold, but reliable tools for pricing them were rare, and the markets for these securities were thin and characterized by wide bid-ask spreads.The low level of interest in risk management was also to some extent a product of prevailing thought in finance, origin