Best Practice: The Risk Behind Every Reward

by Richard Northedge and Peter Bradley, KPMG Agenda, 07 December 2009

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Risk Management

tags:
best practice steps credit risk external risk KPMG liquidity risk LTCM operational risk risk manager scenario analysis systemic risk

This article first appeared in KPMG Agenda, Issue 4, Oct/Nov 09.

Risk management is in the dock, accused of partially precipitating recession. Yet paradoxically, the magnitude of the crisis has taught many companies one salutary lesson: those who fail to grasp that every reward comes with a risk attached – and misunderstand that risk – are in trouble.

“The credit crunch has highlighted not only financial risks – but all risks,” says Oliver Engels, an internal audit, risk and compliance services partner based in KPMG’s German firm. “One reason we had the credit crunch was companies measuring liquidity risk, credit risk and operational risk – but not all the other risks.”

For René Stulz, chair of banking and monetary economics at Ohio State University, it is too simple to blame the discipline of risk management: “The fact that an institution makes an extremely large loss does not imply that risk management failed or that the institution made a mistake.”

After studying the collapse of Long Term Capital Management (LTCM), the U.S. hedge fund rescued in 1998 by a US$3.65 billion Federal Reserve bail-out, Stulz notes: “The only argument one could make is that managers took risks they should not have, but that is not a risk management issue as long as the risks were properly understood.

Rather, it is an issue of assessing the costs of losses versus the gains from making large profits.” Stulz points out that top management held large stakes in the big U.S. banks that collapsed recently and had every incentive to avoid taking risks knowingly – but still their institutions went under.

He identifies half a dozen mistakes companies commonly make: relying too much on historical data; focusing on narrow measures; overlooking knowable risks outside the normal risk classes; overlooking concealed risks; failing to communicate and not managing in real time.

Preparing for the Next Crisis

On the big question – how do you prepare for the next crisis? – Stulz urges companies to take a leaf out of the disaster management handbook: use scenario analysis to understand the ways a crisis might unfold, and plan how you would respond to each.

Stulz says risk managers should not rely solely on statistical models: they must think about how crises could unfold. “Such a scenario requires economic and financial analysis. It cannot be done by risk management departments populated only by physicists and mathematicians.”

One concept whose time may finally have come is enterprise risk management (ERM). Mike Nolan, global head of risk and compliance for KPMG and partner in the U.S. firm, says the old worry – that it was hard to gauge ROI on ERM programs – is no longer valid. He says there are plenty of quantifiable ERM outputs: decreased variability in financial results, as well as reduced hedging and capital costs. “Used proactively, ERM can help avoid the risk management failures that precipitated the current crisis,” he says.

The obvious thing to do – appoint a risk manager – can, Engels warns, be damaging if it means others no longer feel responsible for risk. “You need a person called a risk manager for binding things together. It does not have to be at board level, but the risk manager should have direct access to the CFO or CEO. At some companies, the job is too far down the food chain.”

As risk management moves up the agenda, it could overburden companies. Engels warns: “A lot of companies have risk, compliance, internal control and internal audit – so you have four risk assessments. That’s wrong.” He proposes a single assessment that looks at risk in terms of each of the requirements, with each function being represented on the risk committee.

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