The Decipline of Managing Risk October 3, 2007Posted by robzel in financial companies, New York Times, Risk Management, Zelcom Group.
Tags: American Banker, banking, Citi, finance, financial companies, lending, quantitative, Risk, Risk Management, subprime, Zelcom
There was a recent editorial by Joe Rizzi in American Banker titled the “The Mismanagement of Risk Management” (www.americanbanker.com). Unfortunately, you need a subscription to view the editorial. To summarize, the opinion piece describes how risk management has progressed from a judgmental “collection of ad-hoc practitioner rules of thumb into a bona fide discipline”. I would agree with this statement. However, Mr. Rizzi goes on to say that, “Risk Management has become a hyper-technical, specialist control activity with limited linkage to management or shareholders…A reliance on (statistical) models may encourage us to become lax and to amplify market volatility.” Mr. Rizzi goes on to argue that over-reliance on risk management techniques can lead to overconfidence by business managers which in turn can cause companies to take on too much risk.
While I think Mr. Rizzi makes some good points, he fails to point out that at least in some cases, business leaders fail to heed the advice given to them by their risk managers. Any seasoned risk manager knows that models or other statistical tools can start to break down in periods of rapid economic changes such as we are experiencing in the housing market. Further, these changes are not parallel across the credit spectrum, but tend to impact sub-prime groups more than prime groups. What tends to drive deaf ears are the high yields of subprime accounts coupled the ease of acquiring these account relative to prime accounts. The typical business manager is always facing the challenge of getting the most bang for each marketing dollar spent and subprime accounts always seem to be an easy way to boost a revenue number. In a economic downturn such as we are currently experiencing funding rates can begin to climb which pushes margins down. This again tends to push business managers to focus more on higher yielding subprime accounts to gain back some margin. In the end, this only exacerbates to problem.
There have been regulatory efforts such as Sorbanes-Oxley and Basel II that require better reporting and analysis of risk. While these regulations may have some mitigating effect, they do not necessarily prevent some of the blow ups that have occurred recently. I agree with Mr. Rizzi that, “…regulatory requirements can become a ceiling rather than a floor, which slows the development of risk management”.
Finally, Mr Rizzi argues that there should be less focus on quantitative risk management and more focus on including risk in “strategic planning, capital management, and performance measurement.” While I disagree that there should be less focus on quantitative risk management, I do agree that risk management should be viewed not as single cost avoidance strategy, but as a holistic quantitative way to evaluate business opportunities.
Many companies have moved in the direction of creating enterprise risk management type functions that focus not just on loss avoidance, but rather on creating profit. Unlike Mr. Rizzi, I do believe that while all employees should be focused on maximizing profit, it is necessary to create an organization with the proper checks and balances. In this regard, risk management or enterprise risk management functions need to have the ability to say “no”. At the same time, successful risk managers will also recognize they need to develop creative solutions that solve the collective business goals and objectives rather than just preventing business from happening. It is this constructive tension that tends to lead to effective business decisions and ultimately successful companies.