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Practical steps to recovery - Ten proposed steps to address risk management weaknesses in financial institutions
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spacerAs the world seeks to extricate itself from the worst financial crisis for many decades, fundamental questions are being asked about the role, responsibilities and limitations of risk management in the world's financial institutions. Were the tools available to risk managers fit for purpose? Was there appropriate expertise and leadership at a senior level to guide risk management? Did risk managers lack authority to rein in the excesses of risk-takers?

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Practical steps to recovery
Ten proposed steps to address risk management weaknesses in financial institutions

Managing risk in perilous times: Practical steps to accelerate recovery is a new report published by the Economist Intelligence Unit and co-sponsored by KPMG International. It explores current thinking around risk management and proposes ten practical steps that financial institutions could take to strengthen their governance and management of risk.

"Our research suggests that a consensus is gradually emerging around the steps that are required to strengthen risk management in the world's financial institutions," says Rob Mitchell, editor of the report. "From governance and leadership to a greater focus on communication and organisational structure, the changes required are widespread and far-reaching, but essential to strengthen the overall resilience of the financial system."

The report identifies the following ten steps to address current weaknesses in risk management:

1. Risk managers must be given greater authority. Even if risk managers have the right tools, information and expertise at their disposal, this counts for nothing if they do not have sufficient authority to escalate concerns and to curb excessive risk-taking. Risk managers need to have appropriate status within the organisation, and this needs to be thoroughly understood by business lines.

2. Senior executives must lead risk management from the top. Leadership and tone from the most senior level is essential. There should be appropriate board oversight of risk, usually through the audit committee or a risk committee. As the "owner" of risk in the institution, the chief executive must be seen to elevate the authority of risk management and build a robust, pervasive risk culture.

3. Institutions need to review the level of risk expertise in their organisation, particularly at the highest levels. Financial institutions must be confident that they have sufficient risk expertise at the most senior level. Executives and non-executives should have the tools and information at their disposal to understand the institution's risk appetite and positions.

4. Institutions should pay more attention to the data that populates risk models, and must combine this output with human judgment. No matter how sophisticated, models are limited by the quality of the data fed into them. Even with the best available data, no risk management tool should be used in isolation. Quantitative methods should always be backed up with qualitative approaches and the vital inputs of human judgment and dialogue.

5. Stress testing and scenario planning can help executives to respond appropriately. Stress testing must be integrated within the firm's overall risk management processes, and mechanisms should be developed to ensure that the results are communicated to senior management in such a way that they can formulate a clear response.

6. Incentive systems must reward long-term stability, not short-term profit. Certain aspects of the bonus culture and remuneration models for senior banking executives will need to be overhauled, with some of the rewards being withheld to match the maturity of the underlying business.

7. Risk factors should be consolidated across all an institution's operations. Conversations about risk appetite and risk capacity should not be restricted to the risk function, but should take place throughout the organisation. Equally, risk management should be tightly integrated into operations, and lines of communication should be clear enough that changes in risk levels can be escalated to the correct layer of authority before mitigation becomes impossible.

8. Institutions should ensure that they do not rely too heavily on data from external providers. Financial institutions must address their over-dependence on credit ratings, and supplement ratings with their own analysis, which should be continuously updated over the entire period of the investment.

9. A careful balance must be struck between the centralisation and decentralisation of risk. A central risk function, determined at a senior level, is essential in order to set an institution’s risk appetite, to implement and monitor controls and to provide oversight of the firm's risk position. However, risk should also be embedded in regional offices or business units, such that each profit centre has ownership of its own risks.

10. Risk management systems should be adaptive rather than static. The unprecedented scale and nature of the problems that befell the financial markets in late 2008 illustrates the need for continuous observations of the real world that are then fed back into the risk management system on a regular basis. This would enable the system to correct weaknesses and respond to changing business conditions.

The findings of the report are timely in light of the difficulties encountered by a number of banks in Europe and the United States, but also offer useful insights for banks in China as they chart their own strategies and risk management policies, argues Babak Nikzad, Financial Services Partner with KPMG China. "The kinds of exercises being implemented by international banks, including stress testing, risk modelling and reviewing incentive policies and the organisational position of risk functions, are all approaches that can be highly applicable to banks in China as they develop their risk and governance structures over the coming years," he remarks.

"There is no doubt we will go through another round of financial crisis in the not-too-distant future," Mr. Nikzad continues. "The survivors of the next round will be those who faithfully keep these basic principles at the forefront of their daily operations and do not get sidetracked by the temptation of short-term gains."

 

 
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Download featured report

Managing risk in perilous times - Practical steps Managing risk in perilous times - Practical steps to accelerate recovery
(PDF, 215KB)

Contact for more information

Babak Nikzad, Partner, Financial Services practice in Hong Kong

Babak Nikzad
Partner
Financial Services practice
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