An erosion of confidence: EIU research summary and opinion

Research reveals a need for enterprise risk awareness, risk culture

The financial crisis has exposed major fault lines in the management of risk at the world’s financial institutions. Although risk management is by no means entirely to blame for the current situation, there is a strong consensus that it has failed to provide the appropriate oversight and ensure that necessary controls are in place. As a result, there is considerable soul-searching underway in the financial services industry, with major institutions seeking to conduct a root-and-branch overhaul of their approach to managing risk.

Recent research conducted by the Economist Intelligence Unit on behalf of SAS illustrates both the scope of the proposed reforms and the scale of the challenge ahead. In March 2009, we conducted a global survey of 334 senior financial services professionals, of whom 50 percent were C-level and all have responsibility for risk. We then carried out a program of interviews with high-profile commentators, including Alan Greenspan, former chairman of the Federal Reserve; Nassim Taleb, author of The Black Swan; and Peter Bernstein, founder of Peter L Bernstein Inc. In May 2009, we published a report written by Phil Davis, entitled After the Storm: A new era for risk management in financial services , which brought these two strands of research together. We are very grateful to SAS for their support in enabling us to conduct this research.

The report reveals an industry that remains shell-shocked by the events of the past 18 months. There is limited confidence in the ability of financial institutions to increase revenues or profitability over the next year, while less than one-third of respondents to the survey say that they are seeing confidence returning to their businesses.

This erosion of confidence is having a dramatic impact on the kind of business that financial institutions are willing to carry out, with a significant retreat to familiar, domestic lending and other activities. More than two-thirds of respondents say that they expect a greater focus on domestic business over the next year, while less than one-third are increasing their focus on overseas developed markets, and just over one-third on emerging markets.

There is also limited confidence in the tools that are currently used to manage risk. Less than half of risk professionals in the industry believe that the principles of risk management remain sound, which suggests that some very fundamental questions are being asked about this crucial aspect of the industry. These doubts are well encapsulated by Peter Bernstein, founder of Peter L. Bernstein Inc, an economic consultancy, who was interviewed for the report shortly before his death in June 2009. “Does history really tell us anything about what lies ahead?” he asked. “Relying on the long run for investment decisions is essentially relying on trend lines. But how certain can we be that trends are destiny? Trends bend. Trends break. Today, in fact, we have no idea where any trend lines might begin or end, or even whether any trend lines still exist.”

Major concerns about the shortcomings of current approaches to risk are prompting significant change in the industry. More than half of respondents say that they have conducted, or plan to conduct, a thorough overhaul of their risk management. Key areas of focus, according to the survey, are likely to be the strengthening of risk governance, a move toward a firmwide approach to risk, the deeper integration of risk within the lines of business, and improvements to data quality and availability. Respondents say that the need for reform is being driven, in particular, by executive management, but regulators are also starting to apply the pressure.

Regulatory road map
Charles Beach, regulation and compliance partner at PricewaterhouseCoopers, who was also interviewed for the research, highlights the importance of good governance and the need to embed responsibility for risk within the business. “Although aggressive risk taking is currently out of favor, it will remain essential to value creation,” he explained. “Explicit definition of the firm’s risk appetite is a fundamental part of developing an effective strategy. How risk appetite is then cascaded into risk limits and risk-adjusted performance measurement is equally important to ensure that front office decision making is truly linked to strategy. Responsibility for risk management must lie primarily with the business, not over-relying on the risk function.”

Asked about the barriers to improving risk management in their organization, respondents point to poor data quality, lack of expertise and a lack of risk culture among the broader business as being the most significant. This theme of a lack of understanding between the risk function and the business certainly seems to be significant. Asked about the areas where communication most needs improvement, respondents point to the channels between the risk function and lines of business as requiring most attention. Elsewhere, just 40 percent of respondents say that the importance of risk management is widely understood throughout the company, suggesting that more needs to be done to embed risk culture and risk thinking more deeply in the institution.

Steve Fowler, Chief Executive of the Institute of Risk Management, highlighted the importance of ensuring that risk is well understood as a concept throughout the organization, and pointed to where some of the existing shortcomings might lie. “In banking, the risk function takes primary responsibility for dealing with risk, rather than for embedding risk management throughout the business, and this surely can’t be a sensible approach. The key is risk awareness and creating a risk culture, not letting a single function deal with it as if it were a business line in itself.”

The financial crisis has prompted a much broader discussion around the role of policymakers and the areas of regulation that require attention. In essence, there is a recognition that rules need to be tightened in order to prevent the kind of problems that gave rise to the current crisis. But at the same time, there is an understanding that regulation should be constructive so that the industry can return to health over the longer term. Asked about the initiatives that they thought would be most beneficial to the financial services industry, respondents pointed to greater disclosure of off-balance-sheet vehicles, stronger regulation of credit rating agencies, and the central clearing for over-the-counter derivatives as being three among the top four that have the greatest potential benefit. Although these are wide-ranging initiatives, there seems to be a common theme across all of them; namely, the requirement for greater transparency and disclosure to facilitate the more effective management of systemic risk issues.

In general, however, the respondents were fairly pessimistic about the ability of policymakers to put in place the appropriate measures and provide the necessary oversight. Just three in 10 respondents to the survey are confident that policymakers can formulate an effective response to the crisis. Regulators, in particular, are singled out as being a potential weak spot, with less than one-third rating their handling of the financial crisis as good or excellent (a lower proportion than for either central banks or governments). In terms of specific regulatory interventions, respondents are most confident in the ability of regulators to maintain overall stability of the financial system, with 53 percent expressing confidence here. Far lower proportions are confident in their ability to monitor credit ratings and prevent conflicts of interest; secure the implementation of compensation policies that support long-term shareholder value; or coordinate the work of regulators across borders.

The major challenge for all policymakers in the months ahead will be to put in place a system that not only protects against the kind of malfeasance that gave rise to the current crisis, but to pre-empt any future problems that might affect the industry. This, of course, is very difficult to achieve, as Alan Greenspan, former chairman of the Federal Reserve, explained in an interview for the report. “The important lesson is that bank regulators cannot fully or accurately forecast whether, for example, subprime mortgages will turn toxic, or a particular tranche of a collateralized debt obligation will default, or even if the financial system will seize up,” he says. “A large fraction of such difficult forecasts will invariably be proved wrong.”

Hoping for a risk-free environment
There is no such thing as perfect risk management or foolproof regulation. The financial services industry operates in a world of inherent uncertainty, when each new cycle brings new challenges and unforeseen risks. The best that we can hope for is that the industry and policymakers learn from the mistakes of the past and create a system that, over time, increases in resilience and provides an appropriate framework through which the industry can take risks in a controlled and calculated way.

Many institutions have already started the process of change, and are subjecting their risk management processes and functions to a thorough overhaul. Old and inadequate systems are being discarded and, in their place, new approaches are being established. At the same time, the most successful financial institutions realize that a retreat from risk will not lead to future prosperity, however appropriate this course of action might seem in the current environment. In the final analysis, they recognize that risk is not a function within a firm, it is the firm.

Rob Mitchell is a Managing Editor in the Economist Intelligence Unit's Industry and Management division.