Risk investment in the downturn - Ernst & Young - Global

By William Schlich

Bankers across the globe struggling to manage through the credit crunch and into profitable futures would do well to revisit a lesson they first learned at a tender age: Life is a balancing act.

The right strategies will balance among risks, costs and opportunities – a balance that often gets upset when asset values are climbing and revenues are rolling in.

Yet as financial firms manage costs by delaying or canceling spending and shedding jobs and in some cases business units, the danger is that risk-management investment will be curtailed severely, leaving banks unprepared for the next major market event.

Credit crunch, retrenchment and the housing bubble may be a blessing in disguise

Right now, banks need to determine their enterprise-wide risk tolerances, then strike a balance between investing to monitor and maintain those targets and creating revenue potential. Many will find they’ll need to buffer their process controls and technology.

There are plenty of reasons why a financial firm would want to avoid substantive new investments now: The credit crunch has extended to even the most short-term funding markets, the air continues to hiss out of the housing bubble and U.S. employment ranks are shrinking at the fastest rate in five years.

Equally troubling, the commercial real-estate market has begun showing signs of joining the residential sector in a downturn, a development that historically has deepened and extended recessions. Wall Street already is feeling the sting of this retrenchment: January marked the first month in years that no new securities created were from commercial loan pools.

But all this pain may well prove to be a blessing in disguise if it compels senior managers, boards and controllers to work together to establish firm-wide risk appetites then plan to reach and maintain those levels.

Two areas of risk management to invest in: process controls and technology

Following conversations about risk appetite, most banks will almost certainly find that they’ll need to make new investments in their risk-management architectures. The good news is that they’ll also spot areas where they can hold costs thanks to the broader restructuring going on in their businesses: If a bank is winding down a mortgage operation, say, the need to build up risk-management processes around it isn’t as great. (The catch: Management has to be realistic about whether it may want to restart a business line down the road and act accordingly.)

Improving process controls will mean investing in staff. This is not to say that there aren’t well-qualified professionals now overseeing the daily reporting and measurement functions of global firms. Rather, firms will need to add professionals with additional skill sets in order to elevate the impact of these actions to a level where they can serve as long-term strategic tools for firms.For example, at many firms the most important daily control consists of compiling daily profit-and-loss tallies and running so-called value-at-risk reports that are supposed to capture the firms’ maximum downside from trading positions and other transactions.

These are both crucial functions, but they aren’t enough on their own, as noted in a report recently unveiled by regulators from five countries, including the Federal Reserve. In taking a hard look at the risk-management practices of 11 global firms, the report’s authors found that “dependence on historical data makes it unlikely that a VaR-based measure could ever capture severe market shocks that exceed recent or historical experience, highlighting the importance of supplementing VaR with other views on risk.”

Those “other views” will come not only from additional stress testing and portfolio valuation exercises. They also will come from the insights of finance executives and other controllers who have been empowered to expand their daily roles and help manage the well-being a nd growth of their entire firms, not just individual functions and units. The ideal finance function will itself be a balance: The chief financial officer and his staff won’t be making all the final decisions on transactions but will be able to step up and act when a bank’s risk exposure moves away from agreed-upon parameters.

The right processes and technology creates more valuable risk views

The second major investment many firms will want to make to properly balance risks, costs and opportunities will be in technology. This is going to be an investment in time and mindset perhaps as much or even more so than in software.

Many firms would benefit from better front-end systems that can be used not only to execute transactions, but also to capture and measure data and use that information to manage risk across all business lines. Such technology is readily available and already employed at many firms – but not enterprise-wide. Trading and reporting systems for every business line must all tie together to provide a holistic view of risk.

There is another crucial benefit to having both additional, elevated process-control professionals as well as uniform risk-management systems. Firms that have both are better positioned to foresee the true risks presented by new products – not just the opportunities – and manage them accordingly.

Product creation cannot continue to be independent of controls. In the previously mentioned report from regulators in five countries, firms were taken to task for relying exclusively or largely on outside views of risk on complex products, such as those offered by rating agencies. Firms that work to put the right processes and technology in place as new instruments are being created will have the risk views they’ll need to know when to pull back, hedge or sell.

Strike the right balance now

Inevitably, new products will come to market. Companies and governments will get new funding options, investors will earns returns and banks will see new revenue streams. But so, too, will come another market event that puts these benefits in jeopardy. The financial firms that strike the right balance now will have the best chance to emerge healthy when that happens.

See the full text article in American Banker.

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The views expressed herein are those of the author and do not necessarily reflect the views of Ernst & Young LLP.