SERIES: Your Perspective on Risk - Part 2: Risk Perception

Henrik Merkelsen from the Copenhagen Business School in Denmark provides a view into the usage of the word "risk" in contemporary English language.  I noted in Part 1 of this series that risks are managed according to cultural perceptions: If risk is described by a culture as a danger or hazard, the culture is risk-averse, and the management of an organization within that culture sees risk as something to be avoided or mitigated.

This is the second part of a series on differing perspectives of risk between and within cultures.  The posts in this series are based on a small section of my doctoral dissertation.* You can find Part 1 by scrolling down below this blog entry or clicking here.

Scenario - What do you see? 

What do you envision when you see read the following scenario?**  

Noah sits under a boulder that may (or may not) dislodge from a ledge above him. 

Do you see:

• That Noah was placed under a boulder?
• The boulder's potential to dislodge and fall on Noah?
• Noah places himself under a boulder?

Your answer to that question determines whether you have the tendencies to take risks or to avoid them.  Interestingly, your answer will also reflect the culture in which you matured.  If you manage risk capital in a company or if you regulate a certain industry, your viewpoints will show up in your capital requirements.

* Risk Culture and Its Influence on Firm Value and Performance [© Tara Heusé Skinner, 2016, International School of Management, Paris].
**Adapted from Merkelsen, H. (2011). The constitutive element of probabilistic agency in risk: a semantic analysis of risk, danger, chance, and hazard. Journal of Risk Research, 14(7), 881-897. 

SERIES: Your Perspective on Risk - Part 1: Risk in Cultural Context

This is the first in a series on differing perspectives of risk between and within cultures.  The next few posts are based on a small section of my doctoral dissertation:  Risk Culture and Its Influence on Firm Value and Performance [© Tara Heusé Skinner, 2016, International School of Management, Paris].  I've worked to take out "academic-ease" so it won't bore you to death.

The definition of risk is hotly debated in the academic literature (trust me). One of my favorite studies was performed by Henrik Merkelsen* (Copenhagen Business School, Denmark) who looked at the concept of risk within contemporary English language, noting that semantic distinctions of the word risk may be different in “other languages and historical epochs.” My doctoral thesis postulates (in part) that the meaning of risk is based on not only historical context and language but on cultural perceptions as well. 

Risk as “the uncertainty of possible outcomes” is the traditional and neutral definition (neither positive nor negative). But when you describe that outcome as “a situation or event where something of human value is at stake” as Merkelsen notes, risk translates to “chance” (a neutral and perhaps, positive term) or to “danger” or “hazard”—decisively negative terms.
In my research, I found that risks are managed according to cultural perceptions. If risk is described by a culture as a danger or hazard, the culture is risk-averse, and the management of an organization within that culture sees risk as something to be avoided or mitigated, not something to be capitalized on. Consequently, the regulators in a risk-averse culture will demand more capital held for a (seemingly imminent) negative event. 

How a culture perceives risk determines whether an organization in that culture is risk-averse or risk-taking, and whether its management holds (or is required to hold) capital aside or makes it work for them.

...Click here to continue to Part 2.   

*Merkelsen, H. (2011). The constitutive element of probabilistic agency in risk: a semantic analysis of risk, danger, chance, and hazard. Journal of Risk Research, 14(7), 881-897.

Risk Capital and More Lessons from the Titanic

In last week's blog post, I summarized an illustration I use to explain the differences between Regulatory, Equity, and Risk (economic) Capital, equating each type of capital to the lifeboat capacity of the RMS Titanic in 1912.  

The ship was built to hold 64 large lifeboats carrying a total of over 4,000 people--more than enough as the ship itself could only house a maximum of 3,547 passengers and crew.

More than required...

Moreover, the British Board of Trade (the regulators) required that a ship of Titanic's size had to carry 16 lifeboats for 990 people.  Management (White Star Line) met the 16 lifeboat requirement and then some...the larger lifeboats aboard the Titanic could hold 70+ people each for a total of 1,178 ("equity capital").

...but less than necessary

Although equity capital exceeded regulatory capital in this case, "risk capital" fell short of the 2,224 passengers and crew on board.  As equity capital held should be equal to at least risk capital, would 32 lifeboats have saved all 2,224 aboard?**

Economic Capital Before the Financial Crisis

We see the problem for a naval disaster that occurred over 100 years ago.  What about the latest financial disaster from 2007-09?  If economic capital was truly in play pre-2007 crisis, why was there a crisis?

Economic Capital is the best estimate of required capital that banks use to manage their own risk; it is an internal measure, based on a bank's estimate of its own appetite for risk.  The conclusion, therefore, is that economic capital failed, not because it is a useless measure but because banks' conclusions about risk matched those of the White Star Line:  Risk of sinking is quite low when you are aboard the "Unsinkable."  



* Details from Wikipedia, see RMS Titanic article.
**Probably not.  Even though the lifeboats could have held 1,178, only 32% (710) of the passengers and crew survived.  That's a study in operational risk that I'll get to in a later post.  

Capital vs. Capital vs. Capital

When Economic (Risk) Capital was the talk of the financial services industry, I included a simplified explanation of it in my risk management course at the American Bankers Association's Stonier Graduate School of Banking. Subsequently, I wrote an article on it, entitled Risk capital and lessons from the Titanic, when I was with the Risk Research and Quantitative Solutions group at SAS Institute.  Thankfully, even after my departure from that organization, the article still lives in cyberspace, though my byline has been removed (and rightly so).  In summary:

• Equity Capital - the amount of operational capital (cash) that the management of a financial institution deems necessary to operate its business.
• Regulatory Capital - the amount of equity capital required of a financial institution by its regulator.
• Economic, or Risk, Capital - an estimate of the worst possible decline in the financial institution’s amount of capital at a specified confidence level, within a chosen time horizon, saving for a "rainy day."  It gives senior management insight into a worst-case scenario.

Ideally, financial institutions should hold equity capital of an amount equal to risk capital.  Setting capital aside, so to speak, for a very bad day.

In my course and in the SAS article, I equate three different types of capital to the lifeboat capacity on White Star Line's Best-in-Class (for 1912) luxury passenger ship, the RMS Titanic.  

Capital illustrated:

• The regulatory body for passenger ships in early 20th Century England was the Board of Trade.  It required that 10,000+ ton vessels such as the Titanic carry only 16 lifeboats with a capacity to hold 990 people.  In this case,
• "Regulatory Capital" = 990 
• The management of White Star Line made the decision to carry 16 lifeboats able to hold 1,178 people, more than what was required by the Board of Trade.  
• "Equity Capital" = 1,178  
• Risk capital, given the worst-case scenario:
• "Risk Capital" = 1316 passengers + 908 crew = 2,224

Uh oh.