Forging Best Practices in Risk Management

73 Pages Posted: 7 Aug 2015

See all articles by Mark J. Flannery

Mark J. Flannery

University of Florida - Department of Finance, Insurance and Real Estate

Paul Glasserman

Columbia Business School

David K.A. Mordecai

New York University (NYU) - Courant Institute of Mathematical Sciences

Cliff Rossi

University of Maryland

Date Written: March 26, 2012

Abstract

This paper approaches risk management from three perspectives: firm-level risk measurement, governance and incentives, and systemic concerns. These are three essential dimensions of best practices in risk management; although we discuss each dimension separately, they are interrelated. The paper begins with a brief review of salient changes and unmet challenges in risk measurement in the wake of the financial crisis. It proceeds with a discussion of the interplay between volatility regimes and the potential for risk amplification at a system-wide level through simultaneous risk mitigation at the individual firm level. Quantitative risk measurement cannot be effective without a sound corporate risk culture, so the paper then develops a model of governance that recognizes cognitive biases in managers. The model allows a comparison of the incentive effects of compensation contracts and leads to recommendations for improving risk management through improved contract design. The last section takes a systemic perspective on risk management. Risk managers must recognize important ways in which market dynamics deviate from simple, idealized models of hedging an individual firm’s exposures. Firms’ collective hedging, funding, and collateral arrangements can channel through the financial system in ways that amplify shocks. Understanding these effects requires an appreciation for the organization of trading operations within firms. The article concludes with a summary and recommendations.

Suggested Citation

Flannery, Mark Jeffrey and Glasserman, Paul and Mordecai, David K.A. and Rossi, Cliff, Forging Best Practices in Risk Management (March 26, 2012). OFR 12-02. Available at SSRN: https://ssrn.com/abstract=2640260 or http://dx.doi.org/10.2139/ssrn.2640260

Mark Jeffrey Flannery (Contact Author)

University of Florida - Department of Finance, Insurance and Real Estate ( email )

P.O. Box 117168
Gainesville, FL 32611
United States
352-392-3184 (Phone)
352-392-0103 (Fax)

Paul Glasserman

Columbia Business School ( email )

3022 Broadway
403 Uris Hall
New York, NY 10027
United States
212-854-4102 (Phone)
212-316-9180 (Fax)

David K.A. Mordecai

New York University (NYU) - Courant Institute of Mathematical Sciences ( email )

New York University
New York, NY 10012
United States

Cliff Rossi

University of Maryland ( email )

College Park
College Park, MD 20742
United States

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