Market participants and academics have progressed beyond simple measures of risk to what can be described as Risk Management 2.0 (the next generation). The first generation entailed the simple measurement of distribution parametrics (e.g., standard deviations and correlations), which can be called the statistical risk management of the known or measurable. The next generation goes into greater depth concerning the rich variety of risks that cannot easily be measured. Risk Management 2.0 addresses the broader issues of information and knowledge regarding downside event risk.
Although important progress has been made in risk management, no holistic framework encompasses the spectrum of possible risk problems. To fill this gap, scholars affiliated with the Wharton Financial Institutions Center formed a group to develop a broader risk schema for KuU-based measures, representing the known, the unknown, and the unknowable. KuU provides a conceptual framework for discussions of risk.
Drawn from the proceedings of a Wharton conference, The Known, the Unknown, and the Unknowable in Financial Risk Management: Measurement and Theory Advancing Practice expands the discussion of how to structure the investigation of risks that do not easily fall into measurable buckets. A KuU-based perspective advances risk discussions beyond issues of measurement to include ignorance and complexity.
The creation of a conceptual framework begins with a focus on the spectrum of risk knowledge, which is limited in both measurement and theory. Known risks are measurable; their data can form distributions or be used to simulate risks based on countable events. Unknown risks cannot be easily or objectively measured, and they include those that have not even been acknowledged. Unknowable risks are “black swan” events—that is, those that cannot be identified in advance. Both the unknown and the unknowable risks are distressingly common and more dangerous than what we devote most of our time and energy to measuring.
The issues arising from the spectrum of KuU risks are not new. We can obtain a flavor of them in Frank Knight’s writings on risk and uncertainty and in John Maynard Keynes’s treatment of subjective and objective distributions. Unfortunately, most subsequent risk management research has focused on known data, even though the largest failures in risk management have occurred with problems unrelated to measurement. Current economic policy issues clearly revolve around the “animal spirits” of investors and their willingness to take unknown risks.
Accordingly, managers must learn to think outside traditional frameworks of measurement to capture broader issues of risk. For example, the application of leverage to known or, especially, unknown risks is extremely dangerous. The prescription that capital should be conserved to cover risks not yet even thought of is an intriguing solution.
Uncertainty also applies to situations in which our fundamental assumptions or models are found to be invalid. The greater the unknown risks, the greater the flight to safety—a clear market driver during the recent financial crisis. Problems of “time and ignorance,” the focus of the Austrian school of economists, are real.
The 15 articles that make up this book are divided into two parts, covering the theoretical basis of the KuU framework and the practical aspects of its implementation. The more practitioner-oriented articles deal with the reality that many risks are difficult to measure. Consequently, measurement problems are only a small part of risk control. Potentially more important are the methods for sharing risks in contracts and insurance mechanisms and organizing the management of those risks. A key theme throughout the book is that the traditional measurable risks taught in textbooks are easy to manage but infrequently encountered in practice. Given a set of prices, a standard deviation can be calculated, but the number of cases in which volatility can be measured and used as an effective gauge of risk is limited. How can investors create the right management environment without even knowing the states of the world? The unknown and unknowable issues drive the discussion toward incentive mechanisms and contract design.
Among the authors represented are some of the brightest minds in financial economics, including Nobel Prize winners and leading players in finance and central banking. The editors have arranged the articles to form a strong foundation in current theoretical thinking. For example, the work on the decision maker’s perspective provides essential background before the book moves on to such topics as mild and wild randomness. Issues involving the theory and measurement of knowledge account for about a third of the articles, which could constitute a tome in their own right. The book’s clear objective, however, is to apply the discussion of a risk spectrum to the practicalities of managing a business. Not neglected in this regard are the extreme events feared by all—namely, financial crises.
The practitioner-oriented articles discuss the risks in specific industries. In the case of banks, the contributors point out that market risk is just one type of risk and may be the easiest to control, which is not to say that managers invariably do a good job of managing it. Operational and business risks are much more significant to a bank’s bottom line yet far more difficult to measure. Real estate risks entail an especially high level of the unknown, given the long-term nature of the investments and the lack of adequate pricing.
Also featured in the practitioner section is an exploration of the roles of various players in the risk management process. An article on the responsibilities of the chief financial officer offers practical insights on the spectrum of risks that management faces and the available options for dealing with them in the capital markets. A central banker describes how, from his perspective, crisis management and the concept of systemic risk are rooted in the framework of unknowns. The article on insurance brokers discusses their role as providers of information about risks. Unknowns exist between players, and risk is clearly associated with relative knowledge in the trading process.
Like any compendium of articles, The Known, the Unknown, and the Unknowable in Financial Risk Management has quality control problems. Some of the general articles on philosophical and epistemological issues regarding information and the known are very insightful and useful for any risk manager. Although the practitioner articles also contain worthwhile insights, they are less concerned with the nuances of the KuU framework, which is the book’s primary focus.
Two important takeaways make this book a worthwhile read. The first is that quantitative risk measurement has limits and risk mitigation will never be complete. Risk is often murky in the real world. Risk management is not the same as risk control, and we must accept our limitations. Second, risk knowledge requires investment. Understanding or managing risk is not static and demands flexibility and adaptability. There is no such thing as a risk management rule book. The KuU perspective requires the ongoing generation of new frameworks and improvements in measurement, theory, and conceptualization. In addition, research on risk inevitably blurs into research on understanding how returns are generated. The risk–return trade-off cannot be isolated or compartmentalized. Ultimately, discussing knowledge management may be more fruitful than discussing risk management.