Risk Management Trends: 2011 and 2012

By Randy Heffernan, Vice President at Palisade Corporation

A common thread through many of the risk analysis trends we see is the increased application of quantitative risk analysis trends like Monte Carlo simulation, decision trees, and optimization. Here are three trends that best represented that thread.

2011 Trend #1: Cloud computing and risk analytics

In 2011, there was a lot of talk about “everything” moving to “The Cloud.” Major technology players such as Google and Microsoft aggressively promoted the benefits of cloud computing through their Google Apps and Microsoft Azure offerings. Many industries -- ranging from aerospace to pharmaceuticals -- inquired about performing risk analysis in the cloud. The benefits were many: cost savings, reduced IT hassles, simplified interfaces, and cheaper hardware. The cloud was here, and the industry needed to get on board!

In actual fact, very few made the switch in 2011. Some may still do it, but many decided that working on their own local hardware still had a lot to offer: computational speed, not having to rely on an Internet connection, and, most important, control: control over your own data, and control over your own risks. When your company’s lifeblood is housed in a data center a thousand miles away, there is a leap of faith in trusting that the data center’s security measures are sufficient to protect you.

Furthermore, if something did happen, how do you know where you rank on the priority list? Cloud providers have more than one client. Contrast that with maintaining your own systems, with your own staff you can call anytime, anywhere, and the attractiveness of the cloud waned noticeably in our experience in 2011.

Particularly in our business, which is to provide risk analytics software and solutions, the computational and data requirements can be significant. Trusting the capacity and timeliness of the cloud is not generally the optimal choice for our clients.

2011 Trend #2: Compliance risk for financial institutions

The Basel II international banking regulations recommendations include specific guidelines for ensuring banks have enough capital to cover potential losses. These accords have been revised and updated frequently since 2008 to specify more stringent capital requirements and risk management.

In 2011, Monte Carlo simulation was a key tool increasingly used to meet these requirements. Through simulation, banks can “stress test” their capital reserves and assess the probability of potential losses. Monte Carlo is unique in that it easily allows the consideration of extreme events. Financial institutions can “hone in” on weak points, identify potential causes of losses, modify strategies, and experiment with different mitigation plans. Then, they can simulate again to determine their plans’ effectiveness. Through this iterative process, banks are using Monte Carlo to comply with Basel II and remain competitive. We expect to see this continue into 2012.

2011 Trend #3: Project management risk

Industries such as aerospace, construction, engineering, and oil and gas have long had huge risks inherent in their mega-sized projects. Budget overruns and missed deadlines are all too common and often involve taxpayer dollars. The trend of better management of megaproject risks has been strong over at least the last five years, but in 2011 we saw more unified and sophisticated techniques being applied in this area.

Often, project managers and cost estimators perform separate analyses on projects and bring those results together. Schedulers focus on how long phases or tasks may take, while estimators try to determine how much materials and labor will be. In 2011, we saw more efforts toward integrating those efforts. There is obviously overlap, and to effectively manage a project those dependencies must be accounted for.

Estimators have long used Monte Carlo simulation as a tool to get a handle on uncertain costs. More recently, the technique has been applied to schedules, simulating different durations and dates. In 2011, we began to see the emergence of more unified cost and schedule simulations. We expect this trend to continue more strongly in 2012, with new tools being developed to address this need. Looking ahead, it will be simpler for schedulers and cost estimators to analyze their joint project risks from a single platform.

Predictions for 2012

In the New Year, risk analysis will see a focus on finance and renewable energy. Here are three predictions.

Prediction #1 for 2012: Operational risk for financial institutions

Operational risks, particularly for financial institutions, can be more difficult to define and manage than other traditional financial risks. Credit risk and market risk are well understood, for example, and models have been built to understand and mitigate against losses in these areas for years. However, as margins remain tight for many lending institutions post-2008, managers are taking risks inherent in their firm’s operations more seriously.

Operational risk can include a wide range of internal or external threats, such as disruption due to natural disasters, employee fraud, and failed transactions. This last element -- transactional risk -- is gaining prominence heading into 2012, mainly because of its widespread nature. Basically, every failed electronic transaction costs banks money. Each individual failure may not be much, but over time it can add up to millions. As banks and other lenders charge more fees to cover transactional costs -- credit card feeds, ATM fees, overdraft fees -- many are realizing that looking at reducing costs can be just as effective.

Recent headlines underscore the need for efficient operations and the establishment of this trend. Take the class action against Bank of America for allegations of deliberately sequencing customer withdrawals in order to charge more overdraft fees, for example. Efficient transactional operations reduces the need to grasp at fees and helps keep banks out of trouble.

Monte Carlo simulation is a technique increasingly used to manage transactional risk. By simulating millions of transactions, Monte Carlo can “stress test” a bank’s translational system. The results of Monte Carlo analysis can tell the probability of failure, and identify the drivers leading to that failure. It’s similar to the application of Monte Carlo in the realm of Six Sigma and Lean analysis, where it is used to test processes and designs to assess the likelihood of performance within tolerance specifications.

Prediction #2 for 2012: Audit risk

Auditors have long had to manage risks as part of their duties. In 2012, expect to see internal auditors, particular of banks and insurance companies, demand more risk analysis: on a continuous basis and in formal yearly reviews. Audits are more likely to be conducted as the needs of the business demand -- such as when there is an organizational change -- rather than only on scheduled dates.

The types of risks auditors face will be varied and range from Sabanes-Oxley compliance (related to the 2011 compliance risk trend already noted) to employee fraud to breaches in IT. Thus there is overlap with the trend in better operational risk management as well.

Prediction #3 for 2012: Renewable energy

Green energy is not a new trend for 2012, but the application of techniques long used in oil and gas is. Renewable providers are realizing the need to sell green energy in terms of dollars and cents, just like fossil fuels. As such, they are applying Monte Carlo simulation and decision trees to make the case for investment in everything from wind farms to biofuel plants. Sark7, a renewal energy consultancy based in Amsterdam, just completed such an analysis on a biofuel plant in order to attract investors. Without the hard, reproducible, auditable numbers that show all risks having been taking into account, investors and other stakeholders will not get behind these types of initiatives.

There is no doubt about the overall environmental benefits of reducing our carbon footprint, but when it comes to individual projects, you had better be able to prove viability. Look for more green project analyses to resemble old-school proposals in 2012 and beyond.

Prediction #3 for 2012: Renewable energy

Risk is not an exact science, but there are specific trends that should impact decision makers in the year to come.

Randy Heffernan is vice president at Palisade Corporation, makers of risk and decision analysis software @RISK and the DecisionTools Suite. Heffernan holds a Bachelor of Science degree in Business Management and Marketing and an MBA from Cornell University.
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