As companies attempt to dust themselves down after the financial crisis, what role does risk management have in the recovery? Nathan Skinner puts the big questions to Zurich Financial Services’ group chief economist Daniel Hofmann
What are the biggest risks to economic recovery?
The most significant risks currently facing the world economy include: the potential for further fiscal crises within the eurozone and all economies with rapidly ageing societies; the collapse of asset price bubbles; and a slowing in the Chinese economy to less than 6% growth. Critically, many of these risks are global in their nature and they all present a major threat to economic recovery.
As we look to rebuild our financial systems, gaps in global governance continue to threaten a stable and lasting recovery. Yet the burden of excessive regulation is a risk that should be taken very seriously indeed. Realignment of capital requirements and structural regulation is inevitable, but the extent to which regulation reaches into the markets poses a significant risk to a return to stable economic growth.
To prepare for the future, companies should take a broader view of the number and type of risks that they consider and look further ahead than they might have in the past. Keeping an understanding of the linkages between different risks will be fundamental in making companies aware of the risks they face.
What were the biggest risk management mistakes in the run-up to the financial crisis?
At the heart of the crisis was an overextension of credit coupled with an overuse of leverage. It was partially masked by financial innovation – mainly securitisation – which made it difficult for market participants to comprehend the interlinkages between asset classes and risk exposures. This is another way of saying that institutions failed to aggregate system-wide data – a particularly important factor.
Data in smaller entities of the global financial system was never analysed on a macro level.
Subprime mortgage lending in the USA, for example, was wrongly assumed to be an issue only for the institutions in the sector. The overarching problem was clearly a failure to factor in the way in which risks were interlinked and the extent to which they posed systemic challenges.
How should the financial services industry rethink its risk management? And how can diversity in risk management approaches help?
Much of the discussion around this is from the inside out – looking within financial services for solutions, which we should. But if we wish to truly recalibrate our understanding of risk management, then it is crucial we look elsewhere for inspiration: from the outside in.
Zurich and the World Economic Forum recently outlined some of the different approaches we might consider, which on a systemic level include driving diversity, which means the financial sector could encourage diversity and contrasting approaches to risk management to immunise itself against a lethal risk.
Most other risk industries, such as airlines, learn immense amounts about the risks they face by simulating them. There is no reason why financial firms could not do this as well.
Failure by some institutions must be considered acceptable, or even preferable, and we do need to address the problem of banks being ‘too big to fail’. The FSA in the UK has incorporated this approach in its requirements for institutions to create ‘living wills’ to help limit the impact of their failure on the whole system.
Does risk management in the financial services industry need fundamental reform?
Yes. The problem is systemic and we need reforms to match the global size of financial institutions. Arguably, reform does not need to limit the different type of risks that are taken.
Any wholesale reform must also recognize the diversity of institutions and industries that falls under the umbrella of financial services. What is best for investment banks is very different to what is best for the insurance industry or for high street banks. Any reform must take this into account or risk smothering the entire financial sector. This in itself remains a real threat to economic recovery.
How can organisations empower risk managers?
It is a challenge for the culture of the organisations themselves. Risk management must be part and parcel of a firm’s culture. It must be anchored firmly at the top level – with the board of directors and with senior management. At the same time, there must be a sound and principled governance to ensure that risk thinking is practised at all levels.
Ultimately, risk management has an eminent strategic role to play. Risk is intimately connected to reward: there is no reward without risk, but too much risk can nullify reward. How can individual risk managers hope to deal with macro or systemic risks over which they may personally have very little control?
The financial crisis has reminded us that risks cannot be analysed in silos. We must broaden our perspective and accept that the definition of global risk goes beyond its geographical context. It covers a broad spectrum of areas, all capable of influencing the success and profitability of our organisations. It extends from the economic and financial sphere all the way to geopolitical and environmental arenas. Add to this the fact that many risks are interconnected, and we begin to see the true complexity of predicting and managing global risks.