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Managers Can Take Steps to Improve Risk Forecasting

Risk management will take on an increasingly important role this year as financial firms struggle to survive the fallout from last year's market mess.

Financial institutions are in a bit of a crisis mode right now, and mutual fund companies, banks and other financial services are already tightening controls, repositioning key people and escalating communications, said Bill Schlich, head of global banking and capital markets at Ernst & Young, during a recent webcast titled "Navigating the Crisis."

"People are realizing that things need to be changed," Schlich said. "We are moving down that path. Strategic decisions of firms are now being done with risk management at the table. You need to make sure that everyone feels like they are part of the risk process."

The financial engine of the economy runs on the ability of banks and other institutions to take risks, but now, more than ever, it is crucial for firms to manage that risk. Firms need to continue to invest wisely and correctly, and a successful risk management team can be a lighthouse during stormy weather.

"It would be a mistake to say, 'We can't afford to invest in risk management,'" Schlich said. The economic climate is changing so rapidly that most of the current risk measurements are now inadequate.

"Risk management will need to continually evolve," said Hank Prybylski, global head of financial service risk management at Ernst & Young.

Prybylski said the rapidly changing financial environment demands that firms create a risk-aware culture that brings everybody on board. Success will depend on strong leadership and cooperation by the CEO, senior executives and the board of directors.

"Risk identification helps to get an entire firm working together," he said. "Moving the culture of your organization is probably the hardest thing you can do."

The key question right now is whether the firm-wide risk committee is making the right decisions, Prybylski said.

"Effective risk governance turns on timely, important and actionable information," said Donald Vangel, special adviser to the office of the chairman at Ernst & Young.

Strong risk reporting is fundamental to achieving effective, enterprise-wide risk management, but there are still many challenges today, such as poor data quality, gaps in data flow and the sheer amount of information being amassed, frequently referred to as data dumping.

"Statistical models offer a false sense of reality," Schlich said. What firms really need is a point of view; something that brings all the information together to tell a story, he said.

"The goal of reporting is to provide information to leadership so they can make decisions," he said. "What information do they need to see?"

More Sophisticated Models

A recent survey of investment firms by Ernst & Young found that 14% of respondents have a consolidated view of risk across their organizations and only 9% have an enterprise-wide risk reporting program in place.

"A lot of risk information is static," Prybylski said. "We clearly need more sophisticated models. We don't need to be over-relying on quantitative models. People spend 95% of their time gathering data and only spend 5% of their time doing data analysis. It's important to make tangible progress along the way and [create] a risk report that leads you to make a decision."

Financial institutions must move away from a reactive, compliance-driven risk reporting model, the Ernst & Young study found. New reports must tie quantitative risk data to forward-looking qualitative commentary. The focus needs to be on broader business implications, not silos.

Risk discussions should include people from different lines of business and include the functional and regional heads, as well as board members, the study found. Together, this new team can create an executive summary that clearly identifies risk implications.

Forecasting Risk

In the Ernst & Young survey, only 13% of respondents have a risk forecasting process in place, despite its growing significance.

"We need to do more forecasting and continue to look for more outcomes," Schlich said. Forecasting allows organizations to say, "What do we need to do if this occurs?" he said. "How would we react to that?"

Until recently, risk forecasting has been relatively short-term in nature, he said.

Risk forecasting has been very effective in managing credit risk, the study found, although reputational and operational risk have been more difficult to predict.

Maintaining public support of financial institutions should be a critical objective, Vangel said. During the last boom, "businesses were allowed to grow almost without constraint. Risk management control had been viewed as subordinate."

This lack of internal controls has led to a widespread crisis of confidence, fueled by a lack of transparency, Vangel said.

"Human behavior got us here," he said, and the current problem is inadequate capital at hand for growth. "The industry has come through this crisis with less capital than we thought they would. Capital provides for strength, and liquidity is about agility," Vangel added. Regulators are very concerned with these gaps, he said, and they could be forced to move in to fill the vacuum if the industry does not move quickly. "Any prudential regulations responding to these issues will be looking at risk management issues," he said.

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