Banks lost billions of dollars in operational failures in 2012. Reducing such losses in the future will come from banks changing the way they think about risk. How firms build a culture of risk management, placing responsibility for risk management on the shoulders of everyone at the firm, can be a source of competitive advantage in a world of risk.
Ensuring accountability at all levels is key to effecting better risk management. Whether it is at the leadership level, the risk management function or the employee/trader level, everyone should view risk management as part of their role in life. Modern investment banks are complex, multi-faceted organizations. It is impossible to identify and manage risks without leveraging the eyes and ears of the whole trading team. Here we look at three places where the culture of investment banks needs to change to embrace accountability for risk management more effectively: first, by breaking down the barriers between the different risk management disciplines: second, by breaking down the barriers between the risk management function and business units; and third, by ensuring that leadership’s business strategy takes responsibility for risks as well as rewards.
First, firms need to break down the barriers between the different disciplines of risk management: market, credit and operational. Risks do not come neatly packaged as operational risk or market risk or credit risk: large significant failures have elements of each. Yet the way banks have delegated responsibility to risk functions and built up walls around the different risk disciplines, means that they tend to want to view risks in separate silos, reducing their ability to identify and address them effectively. Problems like identifying a rogue trader or executing the operational and business requirements of say, hypothetically, the break-up of the Euro, are complex and multi-faceted requiring business managers, market risk, credit risk and operational management to work together. How to bring these folks together can be a challenge in an investment banking environment where they come from different academic backgrounds and may be viewed with suspicion by one another. Furthermore, each function works to different mandates.
One way to start to break down these barriers is having market, credit and operational risk managers working together in risk teams on common projects and risk issues. Teams can be organized business by business, region by region with team leaders given responsibility for ensuring information sharing takes place and top risks within a portfolio of risks, prioritized effectively. Leadership roles can be shared across all disciplines to ensure that the various disciplines feel equally valued and thus contributions from each fully encouraged. A formal structure can also be useful where the team leader is termed chief risk officer (Chief Risk Officer) for a particular business with market, credit and operational risk coverage officers his/her direct reports. This is a model that has recently been implemented at some of the major banks and the results to date have been encouraging. It ensures a senior person is familiar with each of the key risk areas and can be independent of business management while enjoying its full respect.
Second, breaking down the barriers between risk disciplines is only the start. It is also important to break down the barriers between the risk function and the rest of the firm. While there should be accountability within risk for failures, ultimate responsibility for failures lies with business management. Counter-intuitively, firms with strong independent risk cultures seem to have found themselves with bigger risk problems to deal with. Those firms where risk management is embedded and integral to the business, where in a real sense every employee is a risk manager, tend to be most successful in managing risk. As well as establishing embedded risk managers and appropriate incentive structures, this means developing an ethical culture. An ethical culture is one that demonstrates a clear sense of purpose,sets clear expectations for behavior and engenders a sense of ownership in its employees. Traders must know, for example, that the consequences of bad behaviors will be applied consistently, regardless of seniority and that there are equally, consistently applied rewards for good behavior. Claw backs on compensation could be one effective tool for promoting such a culture in investment banks but require much greater transparency and consistency around their application if they are to become so. Are claw backs to be applied, for example, for inappropriate or risky behaviors or for trades that in the short-term were profitable but in the longer-term were not? Will traders be given two or three chances before action is taken by management to activate a claw back. Without a clear message on what is acceptable and what is not, it is unlikely that behaviors will be modified.
[Using Big Data to Combat Big Risk]
Third, firm management must embrace a risk based approach to business strategy. Warren Buffet’s long standing distaste for technology stocks because of his claim to not understand technology,is a good example of this type of risk management approach. Firm management should be constantly assessing the businesses within its portfolio to ensure the risks are fully understood and can be effectively managed. After the 2008 financial collapse, many business commentators noted the size and complexity of many of global banking institutions and queried if they were not too large and complex to manage. Bank of America’s growth strategy at the time had led to its acquisition of Countrywide and Merrill Lynch. The costs of those acquisitions in terms of lawsuits with investors and penalties to regulators are still being paid today. Clearly the risks from those acquisitions at best were poorly understood and at worst were not at all considered. Since that time, many firms have moved aggressively to reduce their business portfolios in line with risks that they feel unable to effectively manage. Citibank is one example of a bank that has done so. UBS is another; in North America, for example, it recently sharply reduced its presence in fixed income trading markets. Such steps have been rewarded by investors in enthusiasm for its stock.
Despite all the investment made in risk management tools and frameworks, the costs to the industry from complex risk incidents were larger than ever before in 2012. It is a good time to step back and re-focus risk management efforts on the next stage of development: first, creating a strong, inter-connected, multi-disciplinary approach to risk management; second, embedding risk management within the culture of the firm by articulating and following through on an ethical approach: and third, developing a risk management based business strategy that emphasizes prevention rather than cure by investing in businesses whose risks it understands and can manage effectively and divesting from those it cannot.