Risk management is a tool for strategy, not just compliance

Bank executives have been digesting the current and potential costs of complying with new risk management regulations. Those likely to succeed in the more assertive regulatory environment will be the bankers who use risk management as more than merely a means for compliance with regulations. Such processes offer the opportunity to influence both the bank’s wider business strategy and its policy framework.

Of course, bank executives have always balanced risk and reward from a strategic perspective. But for many banks, the amount of risk they are willing to assume in the course of doing business is only reflected in wider policy by increasing board oversight or by providing investors with a better idea of the risks that the bank intends to assume.

These policy goals are reasonable. But the real difficulty lies in linking the bank’s overall risk appetite to decisions made further down the business chain. After all, these are the decisions that actually determine the risks assumed by the bank.

Indeed, the bank’s risk appetite shapes not only its business strategy, but its credit limit framework, capital management and incentive compensation structures. Managing risk-appetite implementation effectively will require these mechanisms to be set up – through targets and controls – to work as actionable levers.

To do so, organisation is crucial. Boards should consider assigning accountabilities to C-level executives and a risk committee with board and senior executive members. They can then provide sorely needed guidance to influence the translation of strategic risk appetite to actual business practice through the levers described.

Long-term view

One such lever – and one that receives a lot of attention – is remuneration. Since the financial crisis, regulators and policy-makers have pushed banks to restructure remuneration in a way that reduces incentives for bank staff to take excessive risks. This alone will do much to adjust compensation according to the level of credit risk assumed by the bank, especially as success or failure in managing credit risk is the key driver of long-term performance for many banks.

One example of a counterproductive incentive is the golden parachute, where an often sizable pay-out is given to executives leaving the firm in whatever circumstances. In recent years this has often been seen as a reward for failure. Instead, positive incentive structures should be implemented, such as the increased use of share-linked schemes and deferral periods.

To benefit from these guidelines, executives will note that credit risk measurement has to be accurate and timely. For this, banks need to organise the overall credit rating and scoring process in a way that is efficient, logical and transparent. Information needed for key management reports should be available throughout the bank.

Such information provides management with an opportunity to check that resource allocation and credit risk policy reflect the bank’s key markets, rather than yesterday’s reality. Many banks have changed focus or moved into new markets since the financial crisis, and others will follow over the coming years. Access to this information also allows management to make sure that the credit models in use are accurate and use the latest technology with up-to-date data.

Allocating exposure

Of course, this is not always the case. For example, the rush to comply with Basel II has led to placeholders in areas such as loss given default (LGD) modelling. Under the foundation approach, banks use fixed LGD ratios prescribed by the regulator. A more rigorous alternative is a hybrid approach, which combines statistical analysis, based on internal and external data, and expert judgement in a transparent way to produce results that are more accurate, detailed and robust.

There is no doubt that banks’ interests would be served better by a long-term and strategic view on risk management that implements models such as the hybrid approach described, and applies risk appetite to management levers, such as remuneration, instead of taking the shortest route to compliance.

Indeed, a more holistic view of risk management will improve banks’ competitiveness by strengthening the connection between strategic risk-setting at the top of the bank and long-term profitability through the careful control of management levers and credit risk exposures, as well as other risks, both quantitative and qualitative.

Michael Baker is a senior director at data and analytics provider S&P Capital IQ.