Risk Assessment and Risk Management in Economics

Posted: 11 Jul 2016

See all articles by Andreas Oehler

Andreas Oehler

Bamberg University

Tim Alexander Herberger

Andrássy University Budapest; Bamberg University; IU International University; Dr. Theo and Friedl Schöller Research Center (FAU)

Stefan Wendt

School of Business, Reykjavik University

Date Written: July 9, 2016

Abstract

Risk is a core aspect of decision-making in economic situations. This covers decision-making on both the corporate and the individual level, and also economic policy making including regulatory issues. However, risk is not limited to economic situations. Instead, risks may arise in every area of life which leads to the necessity of differentiated approaches to risk management and policy making depending on individual characteristics and risk exposures but also on respective situations in specific areas of life.

The economic idea of risk management is based on the assumption that all possible states of the nature and the probability of their occurrence are known. Real-life economic situations, however, are characterized by ambiguity, which signifies a considerable lack of information regarding both potential outcomes and the probability of their occurrence. In order to mitigate the lack of measurability of ambiguity, simplifying assumptions therefore allow corporate decision-makers, policy makers and regulators alike to measure and evaluate risk and to apply risk models based on statistical loss distributions. Based on these models and distributions specific risk adjustment strategies can be implemented and monitored. To date, the academic discussion has to a large extent been characterized by these simplifying assumptions as well. Little attention has been paid to the risks that arise from the simplifying assumptions made in risk management. Our aim is to fill this gap in the literature. Specifically we focus on model risk, which follows either from (1) the use of a model that does not fit the situation (overoptimism), (2) the use of a model in a different way from or with a purpose other than that allowed (ignorance), or (3) the non-use of a model that would fit the situation (agnosticism).

Model risk is treated only occasionally in the literature. However, in recent years, model risk has been discussed primarily in the context of financial institutions, such as banks, insurance companies and so on. With regard to the banking sector this development was fostered mainly in the context of supervision and regulatory measures included in the Basel accords (especially Basel II). Recently, models and their appropriateness have received increased attention even beyond a particular economic focus, namely in the political discussion of the stability of system-relevant banks and politically enforced stress tests of allegedly system-relevant financial institutions.

In this chapter we analyse the causes of model risk and possible adverse consequences for stakeholders. Specifically, we focus on potentially inadequate decision-making and on illusion of control. In addition, we discuss possibilities to mitigate model risk on the basis of model risk management. Furthermore, we infer potential for further research on the adequacy of economic models.

Keywords: risk assessment, systemic risk, risk management, model risk

Suggested Citation

Oehler, Andreas and Herberger, Tim Alexander and Wendt, Stefan, Risk Assessment and Risk Management in Economics (July 9, 2016). Available at SSRN: https://ssrn.com/abstract=2807382

Andreas Oehler (Contact Author)

Bamberg University ( email )

Kaerntenstrasse 7
Bamberg 96045
Germany
+49 951-863-2536 (Phone)
+49 951-863-2538 (Fax)

HOME PAGE: http://www.uni-bamberg.de/bwl-finanz/

Tim Alexander Herberger

Andrássy University Budapest ( email )

Pollack Mihály tér 3
Budapest, 1088
Hungary

HOME PAGE: http://www.andrassyuni.eu

Bamberg University ( email )

Kaerntenstrasse 7
Bamberg, 96045
Germany

IU International University ( email )

Erfurt
Germany

Dr. Theo and Friedl Schöller Research Center (FAU) ( email )

Lange Gasse 20
Nürnberg, Bavaria 90403
Germany

HOME PAGE: http://www.schoeller-forschungszentrum.de/

Stefan Wendt

School of Business, Reykjavik University ( email )

Menntavegur 1
Reykjavik, 101
Iceland

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