Mastering Risk: The Balance Between Risk and Reward

FINANCIAL INSTITUTIONS CONSULTING, INC.
http://www.ficinc.com/

September 22, 2005

TODAY'S TOPIC - MASTERING RISK: THE BALANCE BETWEEN RISK AND REWARD
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By Charles B. Wendel

Last Friday, the Financial Times began a four-part series titled "Mastering Risk," dealing with issues related to strategic, financial, and operational risk management.

The lead-off article of the series ("A delicate balance between risk and reward") merits particular focus by financial services executives who need to generate loan growth while managing risk. The accompanying summary blurb describes the essay as follows: "A common perception of risk is that it is something to be avoided and minimized. But if they want to succeed in the long term, businesses also need to remind themselves that risk-taking is a powerful source of reward and opportunity."

In the authors' (Eamonn Kelly and Steve Weber) view, winning businesses will "embrace risk and make the most of the opportunities it presents." However, most banks we know, particularly community and regional players, run from risk rather than embrace it. The authors rightly suggest that companies need to rethink their approach to risk and, selectively, learn to embrace it.

Why Companies Avoid Risk

Three factors drive risk avoidance.

"Hard-wired human psychology of loss aversion…it hurts more to be at risk of losing $10 than it feels good to have a chance to gain an equivalent amount." In the banking world we have frequently heard a variation on this theme: "No one ever got fired for not doing a loan. People get fired for doing bad loans." Risk inaction or minimization is personally safer.
"Leftover experience of the 1990s." Whether it be the 1990s, the negative impact of September 11th, or another event, banks operate with elephant-like memories that are often used to squash initiatives that would involve changing current risk criteria. Bad results from activities of five, ten, twenty years ago are often dredged up as reminders of why not to do something.
"The extraordinary innovation in risk management tools, which allow sophisticated hedging, repackaging, and pricing of risk within increasingly liquid marketplaces." Intriguingly, the authors state that if a company makes a practice of selling off its risk to others, in the future it will "most probably be described by one word: unprofitable." Basically, these companies are cutting into their returns because of risk-related fears.

The Cost of "Coping"

How does management deal with risk today? They exploit "coping strategies that manage downside risk" that involve one or more of four activities:

Risk modeling. However, as the Long Term Capital Management debacle showed, "models have limitations, and it is often the case that the more finely tuned the model, the more catastrophically it tends to fail when the world moves outside the parameters for which it was designed." In addition, senior management can never really understand what is driving the assumptions; transparency is poor.
Elevation of risk within the corporate hierarchy. We met with one bank recently at which 25 percent of loan decisions are reviewed by the Board. But do they ever turn down a loan? Virtually never. Risk elevation does not equate to risk management enhancement.
Offloading the risk through multiple layers of hedging and insurance. However, this also involves "giving up control of significant pieces of the value chain and allowing others to control it to their advantage." It indicates a largely passive approach to risk management and a strategy of risk avoidance that reduces returns.
Acting conservatively. The authors state, and we agree strongly, that companies can become too conservative: "Conservatism at some point has to yield to growth strategies; the key is to know when to move…the smart hopeful will always beat the fearful." We have seen banks struggling for growth also struggling internally to broaden a risk philosophy that has been narrowed over recent years in light of loan performance problems. Instead of learning from the past for future growth, banks frequently eliminate or avoid areas in which they have developed hard-won lessons.

The authors state that coping strategies will be available to all players but will not be "a source of significant and sustained [competitive] advantage." In short, advantage will go to those who seize the upside of risk.

Seizing the Upside of Risk

Going forward, what do the authors see as the optimal approach to risk management? Success "will require treating uncertainty as a powerful starting point for innovation and renewal, rather than simply a threat to be minimized…It will require new approaches to experimentation and learning, and greater investment in the ongoing development of decision-making executives. It will require more emphasis on the nurturing and sustenance of internal and external human networks, and a strategic conversation that places risk as a source of discovery and opportunity."

Too few banks see risk as "a source of discovery and opportunity." And, while there are always dangers in doing so, the authors correctly state that alternative approaches to risk are limited, particularly in light of increased market efficiencies. To make better returns you need to do more than just cope with risk; adaptability and responsiveness are key.

This may all sound intriguing, but what is its practical significance for a typically conservative and somewhat slow-moving bank? A few brief starting points:

Determine areas of internal expertise. Does the bank possess extraordinary knowledge concerning certain industries, product types, etc?
Diagnose past "mistakes." Understand what went wrong in the past and why/how similar problems can be avoided going forward.
Quantify the economic benefit of taking on greater risk, whether related to industry, product, company quality, or other criteria. The associated reward needs to overcompensate for any additional risk.
Create a risk champion. Banks requires a well-respected inside leader to challenge past approaches and biases.

Inevitable, a strategy of simply coping with risk will result in slower growth and lower returns, an unsustainable approach. Selectively embracing risk offers banks an opportunity to distinguish themselves in the competitive marketplace and generate above-average returns.

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QUOTE OF THE WEEK

"Learning from failure is one way that management can avoid the crises that are often the downfall of a business."

-- Joel Baum, Professor, Univerity of Toronto

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FIC is a strategy consulting firm addressing issues related to growth and profitability for financial services clients. We emphasize practical, bottom-line results for your company. For more information about our consulting services or if you have questions or comments, please e-mail info@ficinc.com.

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