Risk Management: Critical Success Factors

M. JayadevIndian Institute of Management, Lucknow

28th November 2005jayadev@iiml.ac.in

7th Bank Educationists’ Conference 2005, November 28th and 29th

Risk Management: Conventional thinking

Risk management is perceived as a cost center whose primary purpose is the reduction of financial risks that are seen to be undesirable virtually ‘a priori’. It is viewed as a necessary evil

Risk Management: Modern approach

Banks leverage their internal risk management processes into potentially significant efficiency gains and new product development opportunities. Risk is a vital component of business and critical source of innovation and growth

Risk Controllers

Efficiency Enhancers

Risk Transformers

Effectiveness of Internal Risk Management Processes: Three Business Models

Classical Risk Controllers

Risk management as a cost center

More focused on minimising the gaps between actual risk exposures and target risk exposures (examples: gap reports, exposure norms)

These firms significantly emphasis on VaR policy measures, hedge ratios, collateral management etc..Third party services on risk management and risk transformation products, and services often meet the risk management needs.Suppliers of risk transformation solutions are swap dealers, clearing houses, exchanges, derivative instruments etc..Significant amount is spend on consulting services and on consulting firms.

Efficiency Enhancers

Focus on strategy of risk management rather than on tactical implementation issues.

Use of risk control tools not just for classical risk control but rather to operate their businesses more effectively.

Paramount importance on strategic consulting services rather than pre-canned software solutions and over used policy and procedure templates.

Risk Transformers

Risk management is viewed primarily as a business opportunity.

Risk management: Critical Success Factors

Corporate Governance

Line Management

Product Management

Customer Management

Knowledge Management

Corporate Governance

Risk appetite and policy

Organisational Structure

Risk culture and corporate values

Corporate Governance

Sound internal risk management process requires independence of risk management decisions from risk taking activities to preserve the integrity of the risk management processes.

Governance characterizes the relation between that internal risk management process and new business opportunities.

Incorporate economic value, risk adjusted returns and expected losses in the performance metrics.

Better information about economic profit and incentives built around economic profit are expected to lead to value adding behaviour.

Key success factors for a sound governance process include:

a) independence between risk-taking and risk controlling areas of the firm;

b) clear determinations of risk tolerances by senior managers, and directors;

c) regular outside reviews of the process

Role of Senior Management

To coordinate the risk management process in a way that limits risk while eliminating duplication of hedging, controls and costs

To design incentive system that encourages line managers to carry out the corporations’ risk management goals

Line Management

In commercial banking risk management is a multilayered process, with each manger down the chain partly responsible for his/her portfolio of assets or risks, and senior management overseeing the process from the top.

Line Management: Key sources of conflict

Offense Vs Defense

Policy and Policing

Partnership

Line Management: Key challenges

Conflict resolution between line and staff

Incentive alignment

Introduction of non-financial risk measurement

Product Management

Risk transformation products (including trading and clearing products)

Advisory services: Includes consulting services provided concerning any aspect of a risk management process, as well as transaction structuring advisory services

Decision support systems; which have wider applications to the risk management process.

Product design: Assessing the risk profile of the customer and his willingness to pay for that risk profile. This is essentially risk-based pricing.

Customer Management

Exploring the opportunities for economies of scope and riding on the informational advantage through multi product dealings with customers.

Balanced alignment of corporate strategy, operations and culture

To whom do we sell risk management products and services?

What specific risk management products and services do we sell?

With whom do we compete?

How do we win?

Leverage the internal risk management processes to an external set of products and services. For this shift, banks have to organize itself for success, drive attitudes and behaviors within the firm to organize itself for success, drive attitudes and behaviors with in the firm toward a new strategic customer-centric vision, and fill any critical skill gaps.

Operational excellence of the risk management process is probably the key ingredient to sound customer management

Knowledge Management

Organisational learning involves joint contributions of individuals towards organisational problems.

The ability to learn depends on experience, ability, and, actions of individuals

It is not alone metrics and data are important, but the quality of dialogue between the top management and managers around risk variables. Value from risk management system is generated out of this dialogue.People at all levels should understand interactions among the business units

Dialogue among various parts of organization is essential and it is part of organizational reengineering.

Knowledge Management: Dimensions

Content

Process

Culture

Infrastructure

Content

Which knowledge is relevant for strategy and ongoing operations.The goal of knowledge management is to determine critical knowledge requirements for achieving strategic goals and improving operational efficiency.How the models are being applied and the lessons learned by line offices while using the models.

Process

Defining and redefining objectives

Creating and updating knowledge

Storing and disseminating knowledge

Assign tasks and responsibilities of knowledge management

Define new roles like, knowledge sponsor, knowledge integrator or steward, knowledge base architect, and knowledge base administrator

Culture

Corporate culture should support the creation and exchange of knowledge

Knowledge management must ingrain into the culture of the firm that risk is vital for business, innovation, and growth and risk management is a source of opportunity as well as a means of maintaining the required internal controls.

Infrastructure

Define the requirements for IT infrastructure

Integration of knowledge management tools in to IT infrastructure

Board-Approved Policies and Procedures, and Business Goals

Governance

Communication Between Risk Management and Business Lines

Knowledge Management

Enhance Customers Relationship Management & Communication

Customer Management

Product Management

New Product Financings to Exploit Internal Comparative Advantages

Control Risk

Oversee, Audit Tune, and

Realign Identify Risks and

Determine Tolerances

Measure Risks

Monitor and Report Risks

Efficiency Enhancers

Risk Controllers Risk TransformersThe Risk Culture of a Firm

Business ProcessesExamples of Outcomes

Source: The Risk Management Process, Christopher L Culp page 224

References

Christopher L Culp, The Risk Management Process: Business Strategy and Tactics, John Wiley and Sons, 2001.James Lam, Enterprise Risk Management: From Incentives to Controls, John Wiley and Sons Inc, 2003George Dallas (ed), Governance and Risk, McGraw Hill,2004.

Thank You