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Risk Management Starts at the Top

How to sort out strategies and weather the storm.

Fortnightly Magazine - October 2006

sale of energy and related derivatives. The role of the front office consists of executing deals, initial recording of the specific terms and conditions of a transaction, and related transaction support roles ( e.g., scheduling and nominations). Because of the potential trouble the front office can get the firm into, the infrastructure to control it—usually the middle office—needs to be totally separate.

The middle office polices and controls the front office, and needs to be independent of it. Its function is to assure that the front office complies with policies and risk limits as well as validating the models that are used to place a value on elements of the trading portfolio. (At Enron, traders often valued their own deals, which did not create transparent reporting.) The middle office functions fit well within the corporate risk management function.

The back office plays a vital role in controls by taking care of the accounting and financial reporting (reconciliation of trades, accounts receivable and payable) related to the settlement of trades. It is important that the back office be separate from the front office. All too often problems build up because, when a trader who has losses can take care of his own accounting, he can make sure trades go into a drawer rather than into a trading system that reveals his losses. The back office plays a vital role in preventing this from happening.

In conclusion, the term “risk management” may conjure up visions of corporate law enforcement types reining in free-wheeling traders and investigating fraud, and of directors deciding to get the firm out of “risky” activities. Risk management, in reality, is about all sorts of business decisions in the face of uncertainty—that is, risk—and asking these questions:

1. Should we avoid the risk? The glib answer is, “No risk, no reward.” Avoiding risk altogether will produce the same return as a Treasury bond. At the same time, the firm might want to avoid exposing itself to certain hazards.

2. Should we bear the risk? The organization that can should choose to do so as a result of a conscious decision, though, not simply as a default choice.

3. Can we reduce the hazard? That means implementing policies and procedures that enforce the risk-management goals, and careful attention to corporate governance.

4. Do we have policies in place that will reduce or contain the loss? Any large organization faces perils that will cause losses. It needs policies that keep those inevitable losses to a minimum.

5. Can we shift the risk? Passing on the risk to someone else costs money (insurance premiums and purchase of financial derivatives). Just because the other side of the transaction sees a profit in the deal, though, doesn’t mean that shifting the risk is a bad business deal.

6. Can we reduce the risk? Portfolio theory shows how to reduce risk through diversification, which means more that being in several different businesses that you don’t know anything about.

Ultimately, being in the energy business requires the energy supplier to face risk, and to do something about