Imageby Eve Crabtree 

Despite huge losses caused by the financial crisis of 2008, and the collapses of many high profile financial institutions over recent years, risk management is still not as robust as it should be in the financial sector. Part of the problem is cultural. After all, financial services operate in an arena where risk and reward are part of the game: high-risk investments often lead to high-reward payouts and vice versa, but of course, sometimes the risk far outweighs the reward, which is where problems occur.

The current financial crisis, which dates back to 2007, is a good example. While the actual causes are a subject to much debate, most commentators agree that the subprime mortgages were at least partly, if not wholly, to blame, and when Wall Street began bundling mortgages together and came up with what they referred to as new, “innovative” mortgage products, they fed them to investors hungry for high-reward products. However, nobody had the foresight to examine the risk, and the finance sector failed to see the mass defaults these mortgage products created, resulting in the subprime scandal that many think was at the heart of the financial crisis.

New products

The subprime scandal revealed a complete lack of risk management in the finance sector when it comes to the development of new products. The finance industry has to cope with rapid changes, particularly when new markets emerge, and this often leads to a rush to take advantage of these valuable new opportunities. In turn, this haste often leads to the undisciplined introduction of new products, and a failure to asses the risks associated with them.

After the subprime crisis, the knee-jerk reaction was to introduce more regulation or at least more rigorous enforcement of current rules, but it has been argued that regulation won’t solve the fundamental problem, and that a lack of a robust risk management culture within the finance sector is really what caused the crash. There is some evidence for this too. In the UK, regulation has always been more rigorous than in the United States. For instance, collective investments are strictly controlled, and investment institutions have to form open-ended investment companies (OEICs) to limit risk. The managers of these OEICs have to create new shares whenever money is invested in new products, limiting any risk to the existing business. This regulation, in theory should reduce risk for when things don’t go right, but while OEICs and ICVCs (investment companies with variable capital) remain less risky investment opportunities while still offering high rewards for investors, even this regulation didn’t stop Britain from becoming one of the worst hit European countries following the global financial crisis.

Risk management culture

What is needed in financial institutions across the globe is not more regulation, but a more robust risk management culture. At the moment, identification of risk is slow and haphazard, and often takes a back seat compared to the potential rewards of new products. A robust risk culture should start from a position of weighing risk first, bringing it to the fore of the decision-making process, and allowing all decisions and new opportunities to be risk adjusted and not based solely on which opportunities offer the greater possible returns.

At the moment, most financial institutions are poor at understanding or estimating risk limits. This lack of certainty causes confusion as to what is an acceptable risk, and often leads to an institution working to risk models that are rarely assessed. Because these risk models go unchallenged, overconfidence develops and assumptions are made on new products based on old outdated risk models. A more robust risk management culture would see financial institutions regularly challenge existing risk models, especially when it came to new products and opportunities,

Encouraging risk management

Because risk is not at the forefront of the culture of financial institutions, risk models often become internal control policies and that remain hidden away so that they are often not followed at all. Auditing of risk models rarely takes place and there is usually no check and balance system for people taking risks. What needs to happen is that risk auditing needs to be robust and independent, ensuring the decision-making process is always based on current, up-to-date, risk models.

Encouraging this approach is not easy. Because in the finance sector profits are essentially derived from risk, which results in a lot of short term thinking. The current culture is based on incentives that focus on short term gains. If an investor makes money in the short term, he or she is rewarded. By extending incentives to cover a longer period, where short term returns are not rewarded until they become proven investments could go a long way in helping develop a more robust risk management culture. Realize that a quick profit today could very well end up as a huge loss tomorrow, should underpin any incentive scheme, because if this isn’t encouraged, what happened during the subprime fiasco, could easily happen again.