Thinking about theory and practice: What it means to reach effective risk management decisions in banking

Abstract

It is a commonly held misbelief in risk management in banking that the application of logic and mathematics in economics and finance serve as panacea for all the challenges risk managers face. Against the background of lurking traps on this terrain of risk management, the call for an avoidance strategy cannot be ignored. This paper outlines five guidelines that should be met on the way towards decision-making competency in risk management: (1) Adopt intellectual modesty to come to the insight that every approach to risk management can be maladaptive. (2) Effective risk management is ascribed to well-informed decision-making, where the risks are known and understood by decision-makers. (3) Understanding risks does not culminate in risk control, but it creates room for more systems-oriented regulation. (4) Reaching awareness of a latent paradox: effective risk management and mitigation can be ineffective when viewed over time. (5) Practical wisdom is the trump card for determining decisionmaking competency: formal modelling is no substitute for human judgment in evaluating risks.