Betting versus enterprise risk management.

• Author: Sabatini, Frank
• Position: QUICK STUDY

Betting and effectively hedging using enterprise risk management (ERM) shouldn't be confused with one another. Un fortunately, during the financial crisis, the two often have been mischaracterized, and it is important to make distinctions between betting and hedging.

Many financial institutions failed or sought government rescue because of the speculative bets made with their balance sheet positions. For those institutions and other industries that fared substantially better during the crisis, it's a reflection of the effectiveness of risk management practices such as hedging and integrating ERM into their corporate culture.

Betting measures success as a win or loss after the fact, analogous to gambling. In many instances, the bets leading to the financial crisis weren't consciously made. Many organizations were surprised by the losses incurred due to positions that frequently represented a significant part of their balance sheet. Positions in financial securities, such as subprime mortgage-backed securities or equity-based liabilities, were essentially risky bets that placed significant strain on these organizations.

Essentially, they speculated and took on too much risk. Frequently, these bets were taken for the purposes of increasing profitability, with the view that they represented low risk. However, the expected profits did not accurately reflect and punish the excessive risk taken (i.e. risk-adjusted profits). Unlike this type of speculation, if prudent ERM programs were in place, safeguards would likely have anticipated these results and indicated a need for different strategies in balancing risk and reward.

Those organizations that survived the crisis utilized sound ERM practices and limited their exposures to excessively risky positions. Utilizing sound hedging strategies, as opposed to speculation, a company's focus is centered on the net of two outcomes versus a chance of one specific payoff.

Successful risk management models include hedging programs that mitigate potential negative outcomes due to fluctuations in equity markets, securities, or interest rates or currency. Risk-based economic capital assessments, which are integral to an effective ERM process, also help limit exposure.

However, hedging is judged incorrectly as a winning or losing proposition, rather than valued for its effectiveness as part of an overall ERM strategy in mitigating risks. Analysts and the media have frequently mischaracterized hedging as having...