Integrating Systemic Risk into Modern Portfolio Theory and Practice

Conventional wisdom holds that the performance of investment managers should be measured against some broad market index such as the S&P 500. The broad market averages provide a useful benchmark because they are assumed to be beyond the influence of investment managers and provide a way of capturing what financial economists call “systematic risk,” which is the part of total risk that cannot be avoided through portfolio diversification. But one clear limitation of such an approach to performance evaluation is that by focusing on risks and rewards at the portfolio level only, it fails to consider risks and rewards at a systemic level, where the performance of all portfolios is increasingly likely to be affected. The author begins by making the case that the performance evaluation and collective decision‐making of investment managers could have the effect of increasing the level of systematic risk in both the markets and the real economy. Then, after suggesting that the strength or weakness of environmental, social, and governance (ESG) frameworks can have substantial effects on overall market returns, he discusses a number of efforts currently underway to integrate ESG factors into portfolio‐level decision‐making. The author closes by urging asset owners to take the following three steps to help bridge the gap between investment decision‐making and ESG consequences: (1) acknowledge the connection between investment decision‐making and systems‐level risks and rewards; (2) determine which systemic frameworks are most appropriate and useful for their purposes; and (3) implement investment practices that allow them to manage systemic‐level risks and rewards while simultaneously achieving competitive financial returns in their portfolios. With the help of new measurement and management tools, asset owners can strengthen systemic frameworks, communicate the importance of ESG performance to their investees and investors, and align their efforts with those of governmental and non‐governmental organizations to limit systemic risk.     

Enterprise Risk Management Through Strategic Allocation of Capital

This article presents a conceptual framework for operationalizing strategic enterprise risk management (ERM) in a general firm. We employ a risk‐constrained optimization approach to study the capital allocation decisions under ERM. Given the decision maker's risk appetite, the problem of holistically managing enterprise‐wide hazard, financial, operational, and real project risks is treated by maximizing the expected total return on capital, while trading off risks simultaneously in Value‐at‐Risk type of constraints. This approach explicitly quantifies the concepts of risk appetite and risk prioritization in light of the firm's default and financial distress avoidance reflected in its target credit rating. Our framework also allows the firm to consider a multiperiod planning horizon so that changing business environments can be accounted for. We illustrate the implementation of the framework through a numerical example. As an initial conceptual advancement, our formulation is capable of facilitating more general ERM modeling within a consistent strategic framework, where idiosyncratic variations of firms and different modeling assumptions can be accommodated. Managerial implications are also discussed.     

The use of multi‐level modelling in risk research. A secondary analysis of a study of public perceptions of genetically modified food

Many studies have examined the relationship between various individual variables and people's perceptions of genetically modified (GM) food. A problem with this type of research is that contextual factors are completely ignored. This article explores the use of multi‐level modelling in the field of risk research, by re‐analysing a recent British study of public perceptions of GM food. As the study employed a multi‐stage sampling strategy, it could be used to examine simultaneously the individual and spatial variation in trust and the acceptability of GM food. While the geographical variation in acceptability was largely due to compositional differences between the sampling points, a geographical variation in trust remained after controlling for individual differences. The analysis demonstrated that city‐dwellers commonly have more trust in the regulation of GM food than other respondents. Next to being associated with a number of socio‐demographic variables, both acceptability and trust were related strongly to voting intention. Moreover, the results suggest that there is a link between vulnerable groups, feelings of exclusion, and (dis)trust. The article is concluded by arguing that multi‐level modelling provides new opportunities for simultaneously examining the individual and contextual basis of public perceptions of controversial risk issues.     

Should Derivatives Be Privileged in Bankruptcy?

Derivatives enjoy special status in bankruptcy: they are exempt from the automatic stay and effectively senior to virtually all other claims. We propose a corporate finance model to assess the effect of these exemptions on a firm's cost of borrowing and incentives to engage in derivative transactions. While derivatives are value‐enhancing risk management tools, seniority for derivatives can lead to inefficiencies: it transfers credit risk to debtholders, even though this risk is borne more efficiently in the derivative market. Seniority for derivatives is efficient only if it provides sufficient cross‐netting benefits to derivative counterparties that provide hedging services.     

Between risk and precaution – reassessing the future of GM crops

Contemporary problems tend to be inherently ‘post‐normal’ in their intimate intermeshing of scientific and contextual concerns. Yet we struggle with this mix, constrained by analytical frameworks that admit one or other of these concerns but not both. While this segregation of material and social domains has been central to the western intellectual tradition, alternative understandings transcending these distinctions have recently been developed. This paper applies some of these insights to risk. Using Actor–Network Theory risk is conceived as a dynamic entity manifested by the relationships between material and social domains rather than as something correlating to either one or other of them. This interpretation illuminates the systemic nature of contemporary problems and the solutions they necessitate underlining, in particular, the significance of matters of scale and complexity. Applied to the risk society it advances insights concerning the pervasiveness of scientific logic and its embodiment by leading institutions, while applied to public participation and HAZOP it emphasizes the benefits of unhindered, intersubjective communication. Harnessing these insights an approach of ‘epistemic pluralism’ is proposed for ‘post‐normal’ problems in which conventional insights and methods are pragmatically combined with those of the form elaborated here.     

An integrated approach based-structural modeling for risk prioritization in supply network management

Supply networks are complex and suffer always from various risks. An effective supply chain management requires suitable strategies to mitigate them. In previous literature, there has been a range of research into risk in firms but little in supply networks. This can be explained due to the huge number of risk variables and their direct and indirect interrelations that may suffer all supply chain partners (firms). Therefore, for better risk mitigation, a risk prioritization step is vital. To this end, the purpose of this paper is to propose a new integrated approach based on two structural modeling tools. Firstly, interpretive structural modeling has been used to present a hierarchical model showing the interrelationships between the risk sources. Secondly, MICMAC analysis has been used to quantify and classify the risk variables based on their mutual influence and dependence. The objective is to ascertain the key risk variables and theirs relationships. These prioritized risk variables provide a useful tool to supply network managers to focus on those key variables that are most essential for effective risk management strategies. A real case study in food industry is provided in order to illustrate the application of the proposed approach. The findings may be useful to the practitioners in risk management and may also interest academicians, since the method used here can be applied in other areas of industrial management as well.     

Yesterday's Heroes: Compensation and Risk at Financial Firms

Many believe that compensation, misaligned from shareholders’ value due to managerial entrenchment, caused financial firms to take risks before the financial crisis of 2008. We argue that, even in a classical principal‐agent setting without entrenchment and with exogenous firm risk, riskier firms may offer higher total pay as compensation for the extra risk in equity stakes borne by risk‐averse managers. Using long lags of stock price risk to capture exogenous firm risk, we confirm our conjecture and show that riskier firms are also more productive and more likely to be held by institutional investors, who are most able to influence compensation.     

Climate policy uncertainty and risks taken by the bank: Evidence from China

This paper studies the relationship between three types of risk borne by banks and climate policy uncertainty (CPU). We use panel data for 210 commercial banks in China from 2009 to 2020. This paper has the following main conclusions: Firstly, climate policy uncertainty significantly reduce the passive and active risks borne by banks and increase the insolvency risks borne by banks; Secondly, the impact of CPU on the passive risks borne by listed banks is greater than that of unlisted banks, and the impact of CPU on the active and insolvency risks borne by listed banks is less than that of unlisted banks; Thirdly, the impact of CPU on the three types of risks borne by banks is most pronounced among rural banks and state-owned banks and least pronounced among joint-stock banks. After a series of robustness tests, such as the system GMM approach, different sample periods and controlling for endogeneity, the results of this paper remain robust. We also used the difference in difference (DID) method to study the policy dynamic effects of the 2016 Paris Agreement, and we passed a parallel trend test. Our results provide insights for policy makers and investors. Policy makers should formulate visionary policies in order to minimize the adverse effects of CPU; investors should keep an eye on the implementation of climate policies and pay attention to the impact of policies on the economy, so that they can adjust their investment strategies rationally.     

The determinants of integrating policy-based and community-based adaptation into coastal hazard risk management: a resilience approach

Abstract

A growing number of studies focus on improving the understanding of how the households’ adaptations can be encouraged in the process of coastal hazards and risk management. Particularly, this process is undergoing a major paradigm shift as it moves from an approach dominated by policy-based adaptation to another one in which community-based resilience building is favored. Thus, this article aims to apply a resilience approach to improve the knowledge about how public measures influence private autonomous adaptation behavior, through a transdisciplinary investigation of household adaptation behavior and its determinants. The Resilience Framework of Household Autonomous Adaptation to Climate- and Weather-Related Hazard Risks (ROHACHR) is proposed and combined with a focus group meeting and multivariate analysis to compare pre-disaster, during a disaster, post-disaster adaptations, and resilience behavior of households. Using an empirical survey of the households in three coastal municipalities in Taiwan, we examine the relationships between public measures and private adaptations that provides three distinguishing types of household behavior: ‘core’, ‘trust in governmental aid’, and ‘awareness and structures’. Results show that providing hazard risk information may be one step toward encouraging private autonomous adaptations. Several factors that help foster resilience also appear to be influential in households’ adaptation decisions, such as specific and positive governmental aid, information trust, and social capital. Based on these results, it shows that the ROHACHR is useful to characterize households’ adaptation and resilience behavior and explain how they respond to public measures. Finally, the policy implications of our findings for improving resilience of coastal communities and encouraging public-private collaboration in the process of hazard risk management are discussed.     

Survive the droughts,I wish you well: Principles and cases of liquidity risk management

Short‐term, liquid assets are highly valued by lenders, but pose liquidity risk management challenges to borrowers. Basic principles to meet those challenges are to conduct liquidity stress scenario analysis; to form business plans for each stress scenario; to hold enough capital to sustain the planned, post‐shock balance sheet; and to hold a large enough liquidity reserve to survive the transition from the pre‐ to the post‐shock balance sheet. Historical failures, like Northern Rock, Bear Stearns, and MF Global have a lot to teach about implementing these principles. While regulatory frameworks constrain liquidity positions, they are no substitute for firm‐specific liquidity risk management.     

Long‐Run Stockholder Consumption Risk and Asset Returns

We provide new evidence on the success of long‐run risks in asset pricing by focusing on the risks borne by stockholders. Exploiting microlevel household consumption data, we show that long‐run stockholder consumption risk better captures cross‐sectional variation in average asset returns than aggregate or nonstockholder consumption risk, and implies more plausible risk aversion estimates. We find that risk aversion around 10 can match observed risk premia for the wealthiest stockholders across sets of test assets that include the 25 Fama and French portfolios, the market portfolio, bond portfolios, and the entire cross‐section of stocks.     

Aquaculture: an emerging issue for public concern

The present paper reviews the literature on the risks and benefits of aquaculture. By bringing together sources from both natural sciences and social sciences, we provide a synthesis of perspectives on the relatively novel activity of modern aquaculture. This review consists of three parts: first, a background to aquaculture; second, an overview of the scientific risks and benefits; and third, an introduction to the related public perception issues. We establish five main risk‐related areas: human health, environment, organizational, fish welfare, and social issues and utilize these to highlight potential divergences in expert and lay perceptions. Drawing on findings from the risk perception literature, particularly those related to previous food‐related controversies, it is argued that aquaculture incorporates a range of issues, which have already been shown to be a catalyst for public concern. As such, we conclude that, in addition to natural science studies, aquaculture requires a social science approach in order to be able to anticipate and address future controversies in a timely and efficient manner. However, to date, only few articles address aquaculture from a social science perspective, and the present paper is offered as a step in this direction.     

Risk Culture: What It Is and How It Affects an Insurer's Risk Management

This article conceptualizes risk culture and sheds light on the role it plays in insurers’ risk management frameworks. The article follows a cognitive, dynamic approach, arguing that risk culture is the product of organizational learning about what has or has not worked for it in the past. Within their local context, the members of a group learn which of the typically centrally prescribed formal risk management policies and procedures and which espoused risk philosophies actually work in practice in the sense of behavior that is formally or informally encouraged or discouraged, rewarded or punished. While the formal risk management framework defines which processes to use, which limits to obey, and which values to aspire to, it is the risk culture that defines which rules and norms are perceived to be rational and important. The insurance literature commonly argues, and practice suggests, that it is necessary to achieve consistency in order to effectively embed risk management. Nevertheless, inconsistent basic assumptions at the deepest level of risk culture are a likely feature of local subgroups. However, what is rational and efficient to one subgroup might be random and dangerous for the organization as a whole.     

Ireland's innovative governmental policies promoting internationalisation

The importance of innovation is reflected in the policy strategies that have been adopted by countries that have gained competitive advantage over the last two decades. In today's competitive global economy, Ireland has been acknowledged for its governmental policies and policy dynamics that have created a competitive market site for FDI. These policies have been based on continual policy innovation. The purpose of this paper is to analyse the governmental policies and policy dynamics within the Irish context of internationalisation. From this analysis a model of government influence on FDI in Ireland is developed. The main conclusions are that the success of the Irish model of internationalisation can be attributed to its innovative character. If Ireland's success is to extend into the future, it will have to continue to pursue innovation in the approach it adopts to internationalisation.     

Responding Public Demand for Assurance of Genetically Modified Crops: Case from Japan

Genetically modified (GM) crops provide a classic example of risk characterised with uncertainty and ambiguity. This article analyses the risk management of GM crops in Japan as a case and investigates how the Japanese government has responded to the growing public demand for safety assurance of new agricultural and food varieties. It argues that, while the government realised the need to respond to public reluctance in consuming GM food by adopting more resilient and discursive management, it has faced a dilemma to incorporate the new type of approach into conventional risk assessment. This tension was reflected in the process and policy outputs of the consensus conference on GM crops, which was ambiguously placed in the risk management process. This article shows the dynamics of opting for policies to manage scientifically uncertain risks in particular socio‐political and institutional contexts. Such understanding can suggest ways towards enhanced policy debates.     

Floriculture du Suroît inc.*

Floriculture du Suroît inc. is a SME in the horticulture field. It cultivates and sells geraniums, but a new subsidiary, Les Roses de Caroline, recently start the culture of roses. Floriculture has just obtained a governmental subsidy and, for the first time, the company will have to produce audited financial statements prepared in accordance with GAAP. Thus, the two owners will have to choose between two accounting frameworks, that is, International Financial Reporting Standards (IFRS) or Canadian Accounting Standards for Private Enterprises (ASPE). Many differences exist between these two frameworks. More specifically, IFRS provide specific standards related to agricultural activity and investment properties, while ASPE do not. In addition, ASPE permit many choices between accounting treatments, which should be carefully analyzed. The owners are neophytes in accounting matter. Thus, they need help for accounting issues.     

How do policymakers and think tank stakeholders prioritize the risks of the nuclear fuel cycle? A semantic network analysis

In recent years, the importance of stakeholder involvement and of integrating diverse perspectives into risk management has gained increasing recognition. However, it remains a challenging task to identify all potentially relevant stakeholders and to reliably describe their deeply held beliefs regarding the risks associated with complex industrial systems. For example, the development of advanced nuclear fuel cycles presents such a case. Based on a review of policy-making literatures and a content analysis of congressional records, we identify federal agencies and nonprofit policy institutes (also known as ‘think tanks’) as key stakeholders that are representative of those actively involved in making high-level decisions on the US nuclear energy policy. Using a semantic network analysis approach, we visually delineate the thematic areas of each party’s perceptions concerning fuel cycle risks. The results show that although governmental and think tank stakeholders share common concerns in areas such as nuclear waste management, the economics of nuclear facilities, and proliferation, they tend to focus on distinct aspects of each area. Moreover, while governmental stakeholders are primarily concerned with the environmental and local impacts of nuclear fuel cycles, think tank stakeholders focus more on the relative advantages and disadvantages of nuclear energy compared to other alternative energy options. Implications for risk management and risk communication are discussed.     

Calibrating CAT Bonds for Mexican Earthquakes

This article examines the calibration of a real parametric catastrophe bond (CAT bond) for earthquakes sponsored by the Mexican government, which is of a high interest as it delivers several policy‐relevant findings. The results demonstrate that a combination of reinsurance and CAT bond is optimal in the sense that it provides coverage for a lower cost and lower exposure at default than reinsurance itself. A hybrid CAT bond for earthquakes is also priced in order to reduce the basis and moral risk borne by the sponsor and to reflect the value of the loss by several variables.     

Improving the relevance of risk factor disclosure in corporate annual reports

This research develops a model for assessing the quality of risk disclosures and applies the proposed model to four companies in the food production and processing sector. We contribute to the literature by extending prior work on risk disclosure quality using a longitudinal approach to assess the quality of risk reporting. While previous studies have described disclosure practices, this paper adopts a normative approach to disclosure. By suggesting a way of improving risk reporting disclosures, the paper provides guidance for current and future company managers. In line with previous research, this paper identifies certain problems with existing risk disclosures. Results suggest that company managers prefer providing disclosures that are symbolic rather than substantive. We argue that institutional factors and proprietary costs contribute towards and can explain this behaviour. In suggesting a way forward we highlight the role that stakeholders including managers, users, regulators and auditors can play in improving the quality of risk reporting. Flexibility in reporting could be maintained by adopting a properly monitored ‘comply or explain’ approach.