Risk Management

01:43 PM
Promod Radhakrishnan, Oracle
Promod Radhakrishnan, Oracle
Commentary
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Why Is ERM In Financial Services Stuck In A Reactive Mode?

Five years after the financial crisis, firms still haven't created a holistic risk management approach.

The most recent economic crisis forced most financial services institutions to revamp their approach for risk management, with a special focus on breaking down the siloed approach that had historically dominated the industry. However, a move to an ideal risk management state is still a long way off.

Promod Radhakrishnan, Oracle
Promod Radhakrishnan, Oracle

There has definitely been some progress in the approach towards risk management in financial services organizations after the housing bubble induced market crash of 2008. We passed through a few years where there was continuous media and public glare on the way risk management was conducted, and this was to say the very least partly responsible for some of the progress. Apart from a knee-jerk move to strengthen risk management teams by recruiting qualified talent, most institutions came around to internally admitting, and subsequently working on eliminating, challenges created by strong silos that had crept in to the risk management space.

Most of the larger institutions have strengthened their technology and operations infrastructure for credit risk and operational risk, adopted more rigorous frameworks for stress testing, made early progress in liquidity risk monitoring and most importantly, made a slow but steady move towards bringing the CFO, CRO (Chief Risk Officer) and ERM (Enterprise Risk Management) offices closer. In addition, capital market institutions have been forced by Dodd Frank to make some progress towards more open reporting and risk management for OTC derivative instruments. Having said that, has enough progress been made to help prevent a repeat of further systemic crashes?

Tactical, But Not Strategic

To say the least, we are yet to reach that ideal state. Most of the changes in risk management policies and procedures, and supporting investment in technology and non-technology infrastructure, have been reactive in nature. The intense regulatory and public focus on Core and Tier 1 ratios for capital adequacy forced investment in better ways for assessing and tracking regulatory capital, and in some cases, economic capital too. The Lehman bust forced institutions to look at aggregated counter-party exposures and get a view on liquidity in a more real-time fashion. And stress testing by regulators forced institutions to adopt a more comprehensive approach to consider the right factor variables and stress boundaries to ensure compliance.

[For more info on how the business is approaching risk, read: Survey Highlights Risk Management In Business Strategy.]

However, not many large institutions have the ability even now to get a real-time view of several risk factors including liquidity risk, save alone a view of aggregated risk across credit risk, market risk, operational risk, liquidity risk and other pillars. But the availability of pre-packaged solutions is not to blame.

If you look at the risk technology infrastructure in many large institutions, you would probably see multiple platforms (mostly vendor products) for measuring credit risk, market risk and operational risk, and also for calculating regulatory and economic capital at an enterprise level. Stress testing is possibly still reactive (as in, driven by regulators) and liquidity risk platforms are probably still evolving. You would then see a significant amount of activity to satisfy the latest regulatory mandate, Dodd Frank or FATCA being the flavor of the day in most cases. But, you will in all likelihood not see a concerted view to measure aggregate risk across the main pillars and across other pillars like legal risk, reputational risk etc, and slow or no progress towards such a view on a real-time basis.

One would be tempted to reach a conclusion that lack of availability of integrated cross-asset, cross-risk pillar solutions are the primary reason for this state. However, it is probably the nature of the beast and the lack of commitment towards taming the same that is a better reason. There are enough pre-packaged solutions, and risk analytical infrastructure solutions (including the one from Oracle) in the market, so that is probably not the prime reason. And, even if there is a dearth of solutions to measure aggregated risk factors, it is the lack of push from the user community that probably is the factor.

To move beyond a traditional silo-based approach to an aggregated, enterprise view requires significant investment in terms of defining and implementing an enterprise-level risk management infrastructure. This also involves ensuring a strong data governance mechanism -- you really cannot measure aggregated counter-party exposure at various levels, or monitor liquidity risk across multiple LOBs without having clean and comprehensive reference data, a golden view of transactional and holding data and a analytical infrastructure capable of processing such data to provide intelligent output. In most large institutions, this would most likely require a significant re-hash of existing data infrastructure and governance models at an LOB and enterprise-level, which requires significant capital commitment. In a situation where ROEs are already down to single digits because of product and capital allocation changes forced by an avalanche of regulations, financial services institutions are often hard pressed to allocate that kind of capital.

A Vicious Cycle

This is pretty much a vicious cycle, causing these institutions to have a reactive strategy to risk management, which in turn leaves them ill-prepared for future systemic shocks. The only way to get over this situation is for the institutions to integrate risk management as part of their operational philosophy, and build risk-adjusted models in to everything including capital allocation, bonus determination and product strategy. As long as management attention continues to be on business and product 'flavors of the day' that yield the fattest spread, fattest non-interest fees, or for that matter fattest return on allocated capital, you can expect to see minimal attention to the above 'philosophy'.

But, for enabling this change in philosophy, financial markets have to 'measure' and reward (through stock prices) performance of financial services institutions using clear, risk adjusted metrics. As an example, if the market continues to look at pure ROE, profit margin and top line growth factors to implicitly drive P/E factors and stock prices, there is only an increased incentive for financial services shops to focus on possibly higher-risk off-balance sheet approaches for fee income, and on 'creative' product and business structure re-engineering to work around regulatory mandates. Main street reform agendas would possibly continue to blame 'Wall Street' for reverting back to old ways and throwing caution to the winds.

Until and unless such a change occurs in the way the market measures and rewards financial services stocks, we would possibly continue to see budgets driven towards product and business strategies driving maximum profit margins, and hence see risk management remain as a reactive support function which gets intermittent attention driven by event-specific factors. And this probably explains why we so are quickly (in less than 5 years!) back to a situation of irrational market exuberance and sub-optimal risk pricing for higher risk assets, especially in the fixed income market.

The views expressed in this article are my own, and do not necessarily reflect the views of Oracle.

About The Author: Promod Radhakrishnan is Head of Sales (Consulting Services) for Americas with Oracle's Financial Services Global Business Unit. As part of the sales leadership team for this specialized group focused on financial services clients, Promod manages and directs the development and implementation of go-to-market strategies and sales plans for banking and capital markets information technology solutions across all of the Americas. Prior to Oracle, Promod was with Cognizant's Banking & Financial Services Practice, leading sales and client relationship for a few strategic clients in South East US.

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Jon Skinner
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Jon Skinner,
User Rank: Apprentice
11/15/2013 | 9:11:26 PM
re: Why Is ERM In Financial Services Stuck In A Reactive Mode?
Whilst not all regulation is good and I agree with the sentiment that risk management should be higher minded than mere optimization of reg capital usage, Basel III is one of the better elements of the regulatory response to the 2007-9 crisis in that ROE will now be much closer to a return on risk metric which captures off balance sheet derivatives and secured financing risks in a meaningful way and the leverage ratio should for the first time reflect the embedded leverage in those off balance sheet instruments - oh and these will largely be available on the same basis given Basel III disclosures across US, EU, Swiss and Japanese banks where previously accounting regime differences made comparison difficult. I am already aware that Basel III has kicked off intent to move beyond the mere regulatory view in some organizations. Hopefully then capital re-regulation will help participants improve along the lines you suggest - even if other regulations are in a more parlous state.
IvySchmerken
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IvySchmerken,
User Rank: Author
11/15/2013 | 2:56:10 PM
re: Why Is ERM In Financial Services Stuck In A Reactive Mode?
If firms are still lagging in developing an enterprise wide risk management technology/infrastructure, then they are vulnerable to market events. While you say they've made progress in certain areas such as measuring counterparty and credit risk, their data siloes work against risk aggregation. Ultimately, you say the market values the FS stocks based on P/E and ROE, which leads FS firms to dabble in high-return off-balance sheet derivatives. Isn't that how they got in trouble the last time around?
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