Risk Assessment as Due Diligence in Finance


Questioning the foundations of the economy
In the previous post, issues were raised about the Canadian financial system: Is Canada relatively immune from a deepening depression in the US and Europe? Are Canadian banks, in particular, on solid ground? The main implication I am trying to point out for risk managers is that, in whatever context you happen to be working, a multi-faceted risk assessment that questions common assumptions is needed.

In prior posts I’ve asked how financial risk assessment might benefit from a wider analysis, proper to an enterprise and system-wide view that considers risk in many domains. I’ve emphasized that risk assessment is distinct from both legal analysis and financial model stress tests. That such an approach is necessary is demonstrably the opinion of financial experts themselves (see quotes of Bennett Voyles, Peter Bernstein, and Allyson Huemann). They encourage people to look at qualitative aspects, and look at the big picture. This necessarily means questioning the limits of the discussion imposed by mainstream corporate media.

Financial analysis: projects and investments

The leader of a financial risk workshop I attended explained that financial analysis already benefits from background research that builds corporate wisdom, in the form of an internal risk rating system. FIs gather historic data on investment projects. Such databases can constitute a competitive advantage to guide investment decisions. But if managers do not have such a resource, then they tend to have to rely on the services of rating agencies, or investment banks that are promoting the securities. In many cases, the integrity of these are impugned. The workshop leader told participants not to rely on them. Rather, we must do our own due diligence. The question then is how to build an analysis of sufficient quality and depth, especially when the magnitude of the proposed project or investment warrants the effort.

Advanced planning practice

Environmental scan, which investigates current practice, trends, innovations and emerging risks in the industry under consideration , can be compiled by drawing on academic, government and private sources.

Future scenarios planning constitutes a worthwhile exercise to compare draft strategic plans against visions of the future.  In this case, a “stress test” is more than just changing the input variables in a financial model. Rather, it breaks down implicit assumptions. Examples:

a. build a scenario in which the US dollar undergoes hyperinflation;
b. build a scenario in which severe asset deflation prevails.

Together, these practices give individual project and investment analysis a wider and better informed context within which to identify risk.

Comprehensive risk assessment is best achieved in a multi-disciplinary round table. In a session that goes deep enough, you might, for example, scrutinize the field practices underlying the creation of collateralized debt obligations (mortgage-backed securities) or other financial instrument.

These are the kinds of advanced planning and risk analysis practices that can contribute to the performance of due diligence in finance and investment.

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