Achieving effective risk management is the overriding goal, post-credit crunch

One year on from the collapse of Lehman Brothers, Insurance Agenda lists the key risk management lessons from the financial crisis:

Risk management needs to be given greater authority and attention

Corporate risk management has been the subject of significant reappraisal given the near collapse of the financial system. The overriding view is that risk managers lack influence in the companies in which they operate. During the boom times, it was too easy for traders to lean on the risk department and get their approval where it shouldn’t have been given. Non-executives, the ultimate risk managers, were also incapable of applying the brakes. The UK government’s Walker Review proposed measures to address these failures, including beefing up the role of non-execs and boosting the independence and ability of risk managers to challenge the board. It remains to be seen if they will enforce these requirements with sufficient vigour.

Incentives should reward long-term stability, not short-term profit

Sadly, greed was the hallmark of the great banking crisis of 2008. One of the main lessons is that financial incentives are perhaps the biggest factor in determining human behaviour. It wasn’t just the money-hungry traders that led the financial system off the edge of a cliff; thousands of fraudsters, large and small, proliferated in a system that rewarded far too heavily short-term financial success. Regulators have proposed action to ensure remuneration policies discourage excessive risk taking. Legislation has not had much success at curbing human behaviour in the past. Investors, shareholders and taxpayers will all be hoping that in the future it might.

Don’t believe everything the models say

Risk models were widely used by the financial sector but proved completely inadequate at signalling or averting imminent disaster, through a combination of bad risk management and inaccurate reading of the models. Also, most models were based on historical data that was incompatible with developments in the modern financial system and the phenomenon of systemic risk. The principal lesson here is not to rely too heavily on mathematical models. Institutions should pay more attention to the data that populates risk models and combine this with human judgment. Regulators are also much more eager for financial firms to use stress testing and scenario planning in their response to dramatic events.

Build reserves in the good times to draw upon during the bad

The amount of capital that banks held as a buffer between their assets and liabilities was at the heart of the crisis. Banks weren’t holding enough, so when it came to the crunch, taxpayers were forced to pump trillions into the system to prevent it from imploding. US and UK policymakers are leading the way in calling for banks to adopt counter-cyclical capital buffers that are built up in the good economic times so that they can be drawn on during the bad times. Many other firms, including insurance companies, plan to build bigger financial buffers over the next year.

Final thought

As the financial sector seeks to rebuild its reputation and regain trust among investors and regulators, the balance of power needs to shift back towards risk management. If risk managers can arm themselves with the appropriate levels of authority, clear visibility into their businesses, and the ear of senior management, they will become an integral part of any future recovery.

Key points

  • Risk managers need to be given greater influence and authority within their companies to challenge risky proposals
  • Regulators are aiming to modify human behaviour by proposing that companies’ financial incentives don’t encourage excessive risk taking
  • Institutions should mix risk modelling with human judgment, to enable better detection and aversion of disaster
  • Financial institutions should adopt counter-cyclical buffers: capital reserves that can be drawn on during difficult times