Finding balance in risk management practices is imperative for financial institutions. Many companies have learned that tightened lending requirements and a renewed focus on collections over the past several years has come at a detriment to doing business.
The significance of establishing a risk appetite aligned with the business goals of the company has been at the crux of surely many discussions in the financial world.
Rather than being a wet blanket that douses progress, risk management is most effective when done in partnership with the business through early and proactive involvement.
For financial institutions, risk management is based on the world as they know it. When that world changes, risk strategies must also change. Before the financial crisis, risk was often seen simply as a department but not necessarily a board-level discussion of the appropriate level of risk appetite for the entire organization.
A recent Ernst and Young and the Institute of International Finance report identified that many European banks have increased their risk expenditure and adopted an enterprise risk approach in response to Basel III compliance, as well as many other new regulations and capital requirements.
Since the crisis, North American financial institutions are also recognizing the value of this type of board-level involvement in managing risk. While risk parameters in lending are now almost too restrictive, balance is being sought (and achieved) as companies learn how to lend appropriately in the new normal. That starts with identifying your institution’s risk appetite.
One example of risk exposure given in a recent presentation was a situation where products and marketing decided they wanted to launch a new product; a small business credit card. The team had experience in underwriting small business loans and felt they understood the risks.
They moved ahead with the development and launch of a new card product without consulting their chief risk officer because they believed it would be a great additional offering for the bank. After the card was rolled out, issues arose because not all of the necessary risk factors had been taken into consideration.
The credit card was being sold to a much broader base than their original loan program and began encountering issues that were not anticipated. They immediately called the CRO and asked for guidance. They learned the hard way that the risk department should have been brought in on the front end to achieve a successful product launch. Instead, it was a mad scramble to repair the damage that was likely preventable.
In this example, the bank did not have a clearly defined risk appetite that was embedded across the organization. Had the risk department been involved from the beginning, the issues they encountered could have been avoided or at the very least minimized.
Based on what they learned a new process was incorporated to avert unnecessary risk exposure in the future. In marketing and underwriting, they developed a process to ensure their response and risk models align with the business objectives of the organization (whether those are based on profits, market share, customer experience, brand position, etc.).
The risk and compliance groups are brought in early to ensure the right data is being collected and the scoring models are working properly. Also, they have incorporated a feedback loop from collections and recovery to learn how to make better decisions on the front end.
Once the appropriate level of risk appetite is determined, loss models and alternative data can also help institutions better understand their risk exposure. Six to 10 years ago loss models were only updated every few years.
Today’s technology accelerates the process to build, test and implement new models allowing institutions to address market changes more quickly. Further, several alternative data sources are now being incorporated into the development of new models to improve their accuracy. This new data provides more comprehensive insight to customer behavior.
With a greater awareness of the impact of taking on too much risk, risk management is no longer something that is only addressed when bad things are happening. Chief risk officers can’t serve as policemen, nor should they be considered as an impediment to progress.
Understanding risk appetite and balancing profitable and unprofitable customers allows financial institutions to be confident in the amount of risk they are taking. Institutions showing the strongest risk management facilitate early and often collaboration between departments and ensure marketing, underwriting and risk decisions are driven by the strategic objectives of the organization.
Karen Gordon is the public relations manager for Zoot Enterprises, located in Bozeman, Mont. Her email is email@example.com.