Bayesian Risk Management

Chapter 9From Risk Measurement to Risk Management

Financial firms measure risk with the intention of managing it more wisely. It is now time for us to make the transition from measurement to management. The first three sections of this book have been dedicated to risk measurement. It is worth reviewing the results of those sections first to revisit the many ways Bayesian risk measurements can supply useful information for risk management, and to provide a synthetic view of the Bayesian approach to the models used in finance and risk management.

The second and final part of this chapter argues that a genuinely Bayesian form of risk management accompanies Bayesian risk measurement. I describe a process of risk governance for firms operating in environments of incomplete information based on the controlled deployment of prior knowledge throughout the organization. When prior knowledge is explicitly formulated and communicated through a firm's risk systems, senior management can maintain decentralized control of the firm's risk-taking activities via the effect that prior knowledge has on posterior estimates and model probabilities. The results of ongoing sequential learning may also be compared retrospectively to management's priors as a means of corroborating or falsifying conjectures about markets or new ventures. Thus, Bayesian risk management represents a fundamental contribution to the rational management of the firm in situations characterized by sparse, incomplete, and even ...