Kaplan And Mikes Risk Management Framework

Introduction

In this essay we will attempt to explain the risk management framework outlined in Kaplan and Mikes and evaluate how it could be used to manage both operational risk and market risk in a bank. The essay will be spilt into 2 different sections (A and B). Section A will deal with the three risk categories described by Kaplan and Mikes;

1) Preventable Risks

2) Strategy Risks

3) External Risks

In this section we will also look cognitive biases and examine how these can lead to an organisation inadequately evaluating their risk.

In section B we will apply what we have learned to a real banking scenario and show how this framework can be used in the management of both market and operational risk.

SECTION A

Preventable Risk

Preventable

The management of strategy risk is therefore very important. Unlike preventable risk, a rules based compliance approach cannot be utilised to reduce strategy risk but rather a system to manage the strategy risk must be implemented so that the chances of the risk actually happening are reduced and controls are in place to effectively contain the risk should it occur.

Kaplan and Mikes have identified three approaches in the management of strategy risk;

a) Independent Experts

Independent experts can be brought in to an organisation to test the boundaries of a company’s risk management strategy by examining possible failures. This in turn will force employees to consider these possibilities prior to review. b) Facilitators

This approach is used within organisations that are diverse and complex. It involves the creation of a risk management team who are tasked with liaising with all of the operational managers across the organisation and the collation of information to allow for greater understating of a company’s risk profile c) Embedded Experts

An embedded expert is one who works within an organisation to continually monitor the company’s risk profile through working directly with line managers whose activities are the generation of new ideas and

In this section, through specific examples we will examine how these risks can be managed in relation to market risk and operational risk. In order to do this we must firstly understand what both market risk and operational risk are.

Market Risk

“Market risk can be defined as the risk of losses in on and off-balance sheet positions arising from adverse movements in market prices. From a regulatory perspective, market risk stems from all the positions included in banks' trading book as well as from commodity and foreign exchange risk positions in the whole balance sheet”.

We will use the example of foreign exchange and place it within the framework to examine how market risk can be managed (see table 1 below).

Preventable Strategy External

Credit

Market Excess FX in cash drawer Order / hold more sterling than would be normal the week prior to Cheltenham Travel disruption caused by Volcanic Ash

Operational

Liquidity

(Table