Some people really like to take risk, while others try to avoid it. If you have ever read literature about risk management, it also becomes readily apparent that such information has been designed to work quite effectively as a sleep aid. We wanted to turn that idea on its head, so we focus today on how to use risk management more practically in a community bank.
Whatever you currently know about risk management, consider that a new survey finds 62% of people say poor or lax risk management at financial institutions was the single largest cause of the current financial crisis. Other reasons cited included complexity of financial instruments (59%), market speculation (57%), predatory lending (50%) and misaligned incentive compensation practices (44%). One could argue all of these other factors are also risk management related in one way or another, so it is good to have this discussion to get a better handle on things.
It is important to realize early on that risk management concepts, measurement tools, models and other components are still in their infancy. That is good, because no one can really rebut what you are saying when you are caught spouting risk management concepts in the lunch room. Since few will be able to challenge your thesis, have at it as you enjoy the camaraderie over a tuna sandwich.
As we have all learned from the credit crisis, some key concepts have surfaced that bear consideration when it comes to risk management, however. The first of these, from a practical standpoint, is to set a process whereby management team members periodically conduct an analysis defending the business model and strategy. It is up to the entire team to press buttons, consider weaknesses and review strategy to make sure you are setting the bank up for as much success as you can. Things change as we have all seen and some change quite rapidly, so bankers have to test, challenge and probe each and every facet of the bank to make sure it still holds up given the changed environment.
Next, bankers should take a close look at strategy through the lens of volatility of earnings. The key is to balance risk and reward, but the way each bank does that can vary widely. Consider whether your bank is best positioned to focus on specializing, diversifying (by region, business line, etc.) or otherwise. Think about the business model, figure out how you will track and monitor volatility of earnings and develop a plan that works in multiple scenarios to ensure you are prepared.
The third area to consider relates to disruption. This can be business disruption due to regulation, economic conditions, credit quality, competitors, or other factors. Stress testing various areas of the bank to understand what events cause strain on capital so you can prepare for such events in advance is critical to ensuring long-term viability in any situation. Remain flexible, know what steps you will take before the storm clouds show up on the horizon and continually test and retest and you are well on your way.