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Shifting Financial Risks Critical Survival Factors

 

Financial services companies offer dozens of elaborate risk management services.
A wide range of financial products, collectively known as derivatives,
designed to help industry players hedge risk, has grown to a multi-trillion
dollar industry. The mutual fund industry, which offers the benefits of
portfolio diversification to the retail investor exploded during the 90’s
market boom. So, after all this, what really is risk management?
The essence of risk management lies in maximizing the areas where we
have some control over the outcome while minimizing the areas where
we have absolutely no control over the outcome and the linkage between
effect and cause is hidden from us.
At first glance, this emphasis on risk management would appear to be a
logical approach to operating in a risk business. The irony is that the
increased reliance on risk management tools changes the assumptions the
tools are based on as market participants change behaviors toward risk
and return.
The science of risk management sometimes creates new risks even as it
brings old risks under control. Our faith in risk management encour-
ages us to take risks we would not otherwise take. On most accounts that
is beneficial, but we must be wary of adding to the amount of risk in
the system. Research reveals that seat belts encourage drivers to drive
more aggressively. Consequently, the number of accidents rises even though the seriousness of injury in any one accident declines. Derivative
financial instruments designed as hedges have tempted investors to
transform them into speculative vehicles with sleigh-rides for payoffs
and involving risks that no corporate risk manager should contemplate.
The introduction of portfolio insurance in the late 1970s encouraged a
higher level of equity exposure than had prevailed before. In the same
fashion, conservative institutional investors tend to use broad diversifi-
cation to justify higher exposure to risk in untested areas—but diversi-
fication is not a guarantee against loss, only against losing everything at
once.2
But do these issues have any impact on professionals at work? Risk and
risk management have everything to do with people.
In the financial services industry, the velocity of money is dramatically
changed. It moves in huge quantities in milliseconds. It requires a very
different skill set [not only] in the risk management arena . . . but also
in the people and client relationship.
It affects the organization, and it affects the culture of the organization.
I think in some cases our instincts are to move to a command-and-con-
trol environment, tend to limit the judgment, to limit the execution
risks over large employee bases.

Adopting a risk mindset, making risk-based decisions, and planning for
change are three critical survival factors (CSFs) for dealing with Shifting
Risks.

CSF 1:Adopt a Risk Mindset

You’ve got to have risk on your mind. I asked an experienced banking
consultant what professionals need to be able to do in this risk environ-
ment. The answer is to be a good risk manager as an employee.
Successful people, in addition to being creative, are going to have to be
good risk managers. You start out with the notion that banking is a risk
business. It’s about taking risk, not about avoiding the risk. If there was
no risk, you’d make no money . . . So you need to figure out what the
risk tolerance of the institution is and what risk is prudent to take. Then
you must measure the actual risk you are taking. If you are taking more risk than you are being paid for, or taking more risk than you think you
are taking, then you are not being an effective risk manager.

A bank CEO shared his perspective about his institution and risk:
We’ve got to balance our focus with regard to risk. We’ve got to know
what our risks are. We’ve spent a lot of money and organizational time
this year on building risk management compliance and organization.
We are now trying to overlay this risk management compliance and
organization on how to manage these risks. However, we have an
uneven focus, in a way.
During the year we had some operational risks that were blown out of
proportion. We had a wire transfer fraud—it turns out that almost all
of our operational deficiencies, since I’ve been here, have been finan-
cially irrelevant.

CSF 2:Make Risk-Based Decisions

Sift through it.
They’ve got to have the skill to be able to see [!@#$] and be able to sift
through [it] because there’s lots of that. For instance, somebody comes up
with a model: I’ve covered five recessions within the last hundred years,
my model predicts within two standard deviations when the next uptick
is going to be in the recession. But look at this example of the Russian debt
crisis. You didn’t predict that. And you couldn’t possibly have predicted
that. The fact is that all these tools are very limited. One of the things that
this thing has done is to reinforce the humility of the field. People coming
out of the universities, these guys could rule the world. Surprise! We are all
human beings and we have limitations.

The people who will be successful will be those who not only can func-
tion but also can flourish in a fast-changing environment.
I think you are looking for a person who can accept uncertainty in shift-
ing organizations. I think you look at a person’s past to find out when
they have been in roles where there has been uncertainty and look at
their response to that. Have they seized it? Have they used it as an oppor-
tunity in which to show their colors by being able to carry out two dif-
ferent alternative strategies up to the very last minute and then they go
to the manager and say, “I know you have asked me for this but I’ve con-
sidered that there might be an alternative.” If, between the time the
manager asks you for an assignment and the time you have to deliver it,
other events in the marketplace cause something else, [you] might be bet-
ter off coming up with multiple solutions and then waiting for the day
of delivery to say, “This is what I planned for the first implementation
strategy, but this [other] one seems to be more timely.”

CSF 3:Plan for Change
Planning for change may be the ultimate survival paradox. You plan to get
a handle on the future, yet which future is going to show up?
We have to become comfortable with change. It’s a dualism, it’s a para-
dox . . . It’s a world of dualisms . . . We want to create such consisten-
cies as to create planned outcomes, and at the same time we have to be
open for the possibility of immediate and dynamic change in the strate-
gies and tactics that we are using based on the market forces that are
changing around us.
Plan to change your plan. Get ready to get ready. There was a lot of dis-
cussion at this point. Here’s input from a senior consulting executive:
You have to keep a balanced view and, yes, you’ve got this great plan,
but as you are planning, you have to have a plan to change your plan.
That this will never be executed in the way that you would like it to be
executed. And that’s hard because people spend so much of themselves,
they get vested in it.
The moral of the story is that things can change in an instant. We have
all been a witness to that. Examine activities and processes; create contin-
gency plans; think of alternatives. Ask questions. Be prepared.
■ What happens if the new tax bill does not pass?
■ Will clients be interested in this product if interest rates rise instead of fall?
■ What will we do if our back-up processing system fails?
■ How will we adjust our portfolio if those credit spreads do not return to normal?
■ On whom can we depend if we have to close our new foreign branches?
Be prepared to change.

 

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