drzik - new directions in risk management

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New Directions in Risk Management

John Drzik

Mercer Oliver Wyman

abstract

Following the 1991 recession, financial institutions invested heavily in risk manage-

ment capabilities. These investments targeted financial (credit, interest rate, and

market) risk management. I will show that these investments helped reduce earn-

ings and loss volatility during the 2001 recession, particularly by reducing name

and industry-level credit concentrations. I also suggest that the industry now faces

major risk challenges (better treatment of operational, strategic, and reputational

risks and better integration of risk in planning, human capital management, and

external reporting) that are not addressed by recent investments and that will

require development of significant new risk disciplines.

keywords: credit cycle, financial institutions, risk management

Risk management has been an area of explosive development over the last decade

in both business and academia. Financial services has been the business sector inwhich risk management has made the most rapid progress, and the single most

significant change in practice has been the approach to credit risk management

taken by commercial banks. In the early 1990s, pioneering banks started to

migrate from the traditional judgmental buy and hold approach to credit to a

more quantitative, market disciplined approach to credit underwriting, pricing,and portfolio management. The new credit paradigm began to spread, taking

hold first among large North American banks and a few European leaders, then

spreading to others.

There are many new directions for the development of risk management, whichbuilds on the foundation built in the last decade. Potential new directions will be

explored toward the end of this article. Before looking forward, though, we will look

back at the last decade, both at general developments and at results. Specifically we

will examine whether banks in the United States, where risk management develop-

ments were earliest, performed better through the recent recession (versus their

Address correspondence to John P. Drzik, Chairman, Mercer Oliver Wyman, 99 Park Ave., 5th Floor,

Journal of Financial Econometrics , 2005, Vol. 3, No. 1, 2636


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performance in the recession of the early 1990s). In short, did advances in risk

management tangibly improve bank performance when times got tough?

DEVELOPMENTS DURING THE LAST DECADE

Banks invested heavily in risk capabilities during the 1990s and early 2000s. Their

ability to measure and quantify risks improved tremendously during those years,

as new methodologies were developed to cover first market risk, then credit risk,and now operational risk. A common language of risk, rooted in economic

capital, emerged to allow the aggregation and comparison of unlike risks.

Risk management practices also improved significantly during this period.

Risk limits and limit monitoring practices became more prevalent and more-

sophisticated, with banks increasingly setting limits at multiple levels (individualcounterparty limits, for instance, complemented by aggregate risk grade andindustry limits). Most banks introduced portfolio management disciplines, as

they increasingly recognized the risk impact of geographic and industry concen-

trations and began to move away from the traditional buy and hold approach to

credit origination and ownership.

Organizationally the risk function also assumed greater prominence in banks

management structures. Ten years ago themost senior risk professional at most bankswas the chief credit officer (CCO), who spent most of her time reviewing individual

loans. Today, most banks chief risk officers (CRO) have vastly expanded responsi-bilities and influence. CROs are typically responsible for virtually all types of risksthat banks face, are frequently key participants in their institutions strategicplanning

process, and often report directly to the president, chief executive officer (CEO), or

even the board. Banks have also placed greater emphasis on risk and risk manage-

ment in their reporting to the outside world, with information on risk levels, risk-

adjusted performance, and risk management processes featured prominently in

annual reports, analyst presentations, and the like.

As banks were deepening their risk management capabilities, other market

participants were also evolving. Regulators and rating agencies necessarily dee-pened their understanding of risk measurement and management approaches to

keep pace with developments at leading financial institutions. More generally, the

financial markets also continued to develop; previously illiquid asset classes have

become more liquid as new trading markets have developed and as new risktransfer vehicles, such as securitizations and credit derivatives, have been created.

REAL PROGRESS?

A key question, though, in reviewing this impressive set of developments, iswhether they really made a difference. To test how a decades worth of invest-ments in risk management have performed in practice we examined two tests for

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Figure 1 Quarterly change in GDP. Source of data: National Bureau of Economic Research.


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recession (and than the average postwar recession). Neither real gross domestic

product (GDP) nor industrial production fell as steeply as in other recessions. At the

same time, the postrecession recovery was also shallower than the recoveries that

followed the 1990 recession and other preceding recessions. Payroll employmentfigures failed to grow at all following the official end of the 2001 recession, and growth

in real personal income has been relatively anemicboth phenomena that probably

exerted some continuing postrecession pressure on bank credit performance.

Banks were also somewhat better positioned going into the 2001 recession than

they had been going into the 1990 recession. Capital:asset ratios for the banking

industry as a whole were roughly 56% in 1989, but had climbed to about 78% in2000. The extra capital cushion that was present in 2000 had the effect of allowing

banks greater flexibility and resources with which to weather the recession.

While the two recessions were clearly not identical, and bank starting pointswere different, our sense is that they do still provide a basis for judging whetherchanges in bank risk management had a tangible impact over the last decade. So,

setting aside for now differences between the recessions, we can turn to the

central question: Did banks perform better in the more recent recession?

The data overwhelmingly support the conclusion that banks performed, not

a little better, but much better during the 2001 recession than during the 1990

recession. As shown in Figure 2, credit quality was substantially better. Althoughnonaccruing loans rose in each recession, the peak in 2001 was nowhere near

% Non-Accruing

Loans

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3.5%Non-Accruing Loans/Leases as a % of

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Banks and Savings Institutions

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the peak in 1990 and the degree of increase from the prerecession years was much

more moderate. Figure 3 demonstrates that loan charge-offs followed a similar

pattern, peaking in each recession, but with 2001 levels substantially lower than

1990 levels.Why did banks enjoy superior credit performance in the most recent reces-

sion? Our hypothesis is that the performance differential reflects a combination of

better risk-taking decisions and more efficient redistribution of risks. Banks

ability to gauge the creditworthiness of borrowers increased substantially during

the 1990s, and underwriting processes were retooled to take advantage of these

improvements. As a consequence, banks were able to do a better job picking andchoosing which credit risks they wished to underwrite. Of importance is that

banks after 1990 also developed a healthy respect for concentration riskthe

impact of having too many highly correlated risks. Concentration limits put inplace during the 1990s helped ensure that in 2000, most banks had reasonablydiversified portfolios, and hence were not as badly hurt by exposures to particular

industry sectors or geographies.

Banks were also able to pass through risks to the capital markets more effectively

as loan markets became more liquid and as credit risk transfer vehicles such as

Net Charge-

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Net Charge-Offs

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derivatives and securitizations became more prevalent. As a result, credit risks

(and ultimately credit losses) were increasingly likely to be borne not by the highly

leveraged banks that structured and originated loans, but by less-leveraged investors

who acquired these risks from the originating banks. As such, the relatively moderateloss experience for banks in the last recession understates the losses by investors as a

wholewhich has sharpened the focus on credit risk management at insurers, pen-

sion funds, and other end-investor segments that were hit with these losses.

U.S. banks were also judged by the analyst community to weather the recent

recession well. As shown in Figure 4, between 1989 and 1991, ratings agencies hit

U.S. banks with a significant number of downgrades and very few upgrades.During the 19992001 period, in contrast, downgrades increased only slightly,

and were in fact outnumbered by upgrades.

Evidence also suggests that banks didnt just learn how to avoid losses duringthe 1990s, they also learned how to be more appropriately compensated for riskstaken. We analyzed credit pricing relative to underlying risk at dozens of financial

institutions during the 1990s and found a very consistent pattern. In the early 1990s,

credit pricing was relatively flat. Less creditworthy corporations frequently did

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not pay banks much more for credit than did their more creditworthy peers. By theend of the 1990s, this pattern had changed substantially. While it remained true that

many banks still underpriced high-risk credits and overpriced low-risk credits,

market pricing displayed much greater sensitivity to underlying risk than it had at

the beginning of the decade.

This sea change in pricing practices has had a major impact on bank per-formance and should ultimately make banks much more attractive businesses

from an investors perspective. The performance of bank equity during the last

recession suggests that investors may in fact be beginning to take note.

Bank equities underperformed the broader market in 1990, reflecting inves-tors beliefs that banks were recession sensitive and prone to substantial earnings

surprises in a down credit cycle During the period around the 2001 recession in

Spread

Credit Quality

Required Economic Pricing

Illustrative 2001 Pricing


Spread

Credit Quality

Required Economic Pricing



Figure 5 Economic versus actual pricing, 1990 versus 2001. Source of data: Mercer Oliver Wyman.



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Our conclusion: risk management made a difference. While the 2000 reces-sion was admittedly a less severe test for banks than was the 1991 recession, thesubstantial improvement in bank performance has to be at least partly attribut-

able to better risk management practices. An improved ability to measure risk,

improved decision-making processes about which risks to take, improved diver-

sification of bank credit portfolios, improved pricing, and an improved ability to

pass risk through to the capital markets all added up to real progress: fewer lossesand better risk-adjusted returns. Banks still have many ways in which they can

further improve their risk management, but the performance in the recent reces-

sion suggests some, if not most, of the investments over the last decade paid off,and therefore looking for future new development directions makes sense.

WHATS NEXT?

While progress in the last decade was substantial, there are several major new

challenges to be addressed. We have highlighted four below:

Conquering the Unknown in Risk Measurement

Investment in risk measurement technologies over the last decade has concentrated

on credit risks and market risks These can be described as known risks since

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Figure 6 S&P 500 versus S&P financial index, 19892003. Source of data: Standard & Poors.



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Many major risks, though, are virtually untouched by these new measure-

ment techniques. Operating risks, for instance fraud, suitability, or legal risks,

have generally not been modeled and quantified by most banks. However, banks

are well aware of these risks and generally have some processes in place tomitigate damage from them. However, the risks are unknown in the sense

that they are not yet well measured and the cost/benefit analysis of proposed

changes to practices in these areas is hard to evaluate.

Over the next decade, a key direction for risk management will be to convert

unknown risks to known risks by developing measurement techniques that

are suitable and effective for the new challenges.

Connecting Risk Management to Business Strategy

Arguably risk managements greatest value to banks comes from helping to shapebusiness decisions. Which growth strategies offer the best risk-adjusted returns, and

ultimately the greatest shareholder value creation? Which new customer segments

should be pursued? What new products and services are required? Which risks areworth taking, and which are not? The challenge for risk management is to develop a

way of partnering with business management to answer these questions, while

continuing to play an independent, objective control function.

Mercer Oliver Wyman recently surveyed the CROs of more than 40 large

financial institutions to discuss their roles in driving the strategic directions of

their institutions. We also asked these CROs [as well as chief financial officers(CFOs) from the same institutions] whether they were satisfied with their invest-

ment in risk measurement tools and whether they felt that the institution wasderiving real business benefit from those tools. The results showed an interesting

correlation. Institutions that reported deriving real business benefit from risk

measurement investments were overwhelmingly the same institutions thatreported that the CRO was a major participant in the strategic planning and

strategic capital allocation processes. Where the CRO was not involved, or was

only weakly involved, in these planning processes, we heard a different story: at

such institutions, advanced risk measures were used primarily for control pur-poses, and there was a general sense that real business decisions were not muchimproved.

Given that generating attractive organic growth levels is a core strategic thrust

for most banks, a critical new direction for risk management practitioners will be to

help line executives channel their growth ambition into areas where the overall risk

level is considerable, and strong risk-adjusted returns can be achieved.

Achieving Greater Transparency

The current business environment, with its pointed emphasis on corporate govern-ance is making it critical for banks to explain their risk profiles publicly with



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of advanced risk measurement techniques. All will require continuing education

before the market as a whole reaches a common understanding of risk. The benefits

of achieving this common understanding, though, will be considerable and will

extend far beyond the Sarbanes-Oxley compliance motive that is driving much ofthe current effort to increase transparency.

For one thing, it is worth noting that, despite their strong relative perfor-

mance in recent years, banks valuations remain depressed relative to nonbank

peers. The price/earnings (P/E) ratio for the global financial services sector as a

whole, for example, averages about 35% lower than the same ratio for the non-

financial sector. An explanation for part of the discount is the opacity in the risksof financial institutions (banks are described by some as blind pools of risk).

Investors simply dont believe that they have a clear enough or complete enough

picture, and hence they worry about the potential for unexpected earnings sur-prises in the future (skeletons in the closet).

Transparent, understandable, and consistent reporting on risk is one way for

banks to win over investors and help to mitigate this 35% P/E discount. If opacity

explains any significant part of the 35% discount, this new direction could have a

very material effect for bank executives and shareholders.

Changing the Way Human Capital is Managed and Rewarded

Human capital management is a major challenge for the risk management func-tion of most large financial institutions. A decade ago, the risk management

function, if it existed at all, was likely small, and was populated almost entirelywith technical experts. Today, risk management is typically a major unit; at some

institutions, literally thousands of employees report up to the CRO. Among the

consequences of this explosive growth are

CROs can no longer be technical experts only, they must increasinglybe strong leaders and general managers as well.

The risk management function must develop the capacity to attractand retain large numbers of staff from a wide range of backgrounds:

Some with technical qualifications, others with more generalbusiness skill sets.

Some internally grown in the risk function, others trans-ferred/seconded from the line, others hired from outside.

The risk function leadership must be able to manage a complexmix of talented professionals, define career paths for them, andhelp them manage their careers in the organization



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to create a firmwide risk culture in which all employees constantly think about

risk-reward trade-offs. However, relatively few firms, even financial institutions,

provide the risk management function with a significant voice in deciding how

incentives are determined for line risk takers and line executives in the organization.Making risk management a strong participant in setting compensation policy and

levels will be a controversial, but probably necessary step toward creating the

much-desired organization-wide risk culture.

These four areas alone are a challenging agenda for risk professionals to

tackle in the coming years, and it is far from an exhaustive agenda. Risk manage-

ment will continue to be an area of investment in the financial services sector, anda growing discipline in nonfinancial corporations as well. As the tangible suc-

cesses of risk management developments in this last decade are increasingly

recognized, these trends will only accelerate.



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