Commentary

Specialised Risk Management Disciplines and their integration with Enterprise Risk Management

2015: CRO to his Risk Champions “Remember, back in the day when we had a silo approach to risk management?”

So many varied threats face organisations today, that the silo based approach to risk management must become a distant memory as we create a culture of holistic, integrated risk management that infiltrates the entire organisation.

Our series of articles over the past year has covered specialist risk management disciplines from business continuity, project, sustainability, credit and market risk perspectives.  Each specialised area has its place under the broader umbrella of Enterprise Risk Management, which, strategic in its focus, requires the specialised risk management disciplines for greater risk management maturity and the mitigation of specific risks.

Business Continuity Management (BCM) manages the ‘black swans’ or risks of high severity and low probability that may interrupt business for significant periods of time.  Response and resumption plans, no matter how simple, are invaluable in a crisis to mitigate loss of people, revenue, assets, and reputation, to name a few.

Project Risk Management is essential at all stages within a project, and is critical for projects of all sizes.  Both internal and external factors contribute to project risks, which if not identified early, at each stage in a project, will have a significant impact.  Pre-empting and managing project risks will improve investor confidence, quality of delivery and achievement of financial and timing targets.

Sustainability Risk Management, similar to Enterprise Risk Management, is broad and needs to touch all parts of an organisation to ensure the protection of intangible assets through management of economic, social and environmental impacts.  Sustainability Risk Management manages risks, but also focuses on harnessing opportunities, for example business efficiencies, social upliftment and environmental conservation.

Operational risk management, with its specific risk management and reporting tools such as Loss Data Collection, Control Self Assessment and Key Risk Indicators, take existing and historic information into account, allowing for the understanding of risk triggers, impacts, losses, control failure points and operational inefficiencies.

In the financial services sector, a significant area of risk management is Credit Risk Management which is required for the protection lenders and consumers.  The regulatory environment and high level of risk maturity required to manage credit risk sees the establishment of credit policies, risk appetite frameworks, risk adjusted pricing, counterparty management and capital management, amongst others, to ensure financial institutions do not experience major losses.  Credit risk tools assist in the management of credit risk, through Credit Risk Management Reporting Systems, Quantitative Calculation Engines and Qualitative Scoring Guides.

Consumer Credit Risk Management is required for the management of risks faced by lenders before and after granting loans through selecting customers with acceptable risk profiles, targeting the right customer with the appropriate offer, managing customers, understanding repayment behaviours and determining effective collections strategies.   Credit Risk Management is not only the responsibility of risk managers, but all personnel involved within the consumer credit life cycle. 

Liquidity Risk Management is becoming a focus, particularly after the Global Financial Crisis and the inability of organisations to raise funds for their daily operations.  Liquidity Coverage Ratios are required to ensure banks hold sufficiently liquid and high quality assets. Net Stable Funding Ratios encourage banks to adopt stable and longer term funding of assets and business activities.  The pricing of illiquid assets is also a critical component of Liquidity Risk Management as institutions need to be aware of the potential gaping in prices of illiquid assets during times of crisis.

Market Risk Management has traditionally limited to banks and large financial institutions. However the market risk inherent in many, if not all, non-financial institutions, such as corporate entities, small businesses and even individuals, should not be overlooked. For example, the interest rate on a home loan and the return on a money market fund, an equity portfolio or the value of a home are obvious examples of market risk exposure.  Calculating VaR (Value at Risk), scenario analysis and stress testing are key components of Market Risk Management.

To conclude this series, it is evident that organisations of all sizes, industries and sectors should have integrated risk management in their best interests, to ensure that all critical activities and operations will be addressed by good risk management leading to confident decisions being made and carried out and exposures monitored.

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Post-Crisis Changes and the Impact on Liquidity Risk

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Market Risk Management Market Risk affects us all

Market Risk Management has traditionally been a discipline limited to the domain of banks and large financial institutions. However the market risk inherent in many, if not all, non-financial institutions, such as corporate entities, small businesses and even the individual, should not be overlooked.

Take as an example an airline. One of the major inputs into the profitability of any airline is the cost of fuel, directly correlated to the price of crude oil. By being aware of, understanding and limiting the impact of spikes and unexpected hikes in the cost of oil, for example by hedging via an option based strategy, the airline can significantly reduce its risk to losses and improve its bottom line in times of crisis. Conversely, uninformed or bad hedging techniques could significantly erode potential profits. Being locked into a high futures price when the cost of oil drops, would be an example.

Similarly, consider the risk each individual faces on not only debt, but also assets. The interest rate on a home loan and the return on a money market fund, an equity portfolio (via direct investment or an individual’s pension fund) or the value of a home are all obvious examples of market risk exposure.

Post-Crisis Changes to Regulations

Market Risk Management has had a number of fairly significant changes as a result of the global turmoil experienced over the past few years. The Basel committee published revisions to the Basel II market risk framework, in which they admit that certain key risks were not being captured in the prior framework and that these contributed to large losses during the recent crisis.

The revisions published in July 2009 introduce an incremental risk capital charge to supplement the current VaR (Value at Risk) based framework. The incremental risk charge serves to make provision for both default and migration risk (i.e. the change in price as a result of actual or expected credit rating changes) of certain credit products. A Stressed VaR requirement has also been introduced, which provides a more realistic estimate of capital requirements during periods of stress such as those experienced post the Bear-Sterns and Lehman’s collapses.

In addition, banks now also have to justify factors which are used in the pricing of their instruments, but are left out of the VaR calculations. Market risk data must now also be updated at least monthly, while banks must be in a position to update more frequently if required (eg in times of stress).

Further Considerations

Even with these new regulations, the Market Risk practitioner must still be aware of the limitations of results which may be based on unreliable data, the old adage of junk in- junk out definitely applies here too. Take as an example the issue of stale prices. Many banks have inadequate checks in place to ensure that the prices they use to value portfolios and measure market risk are actually updated. Just because the system receives a price feed from one of the main data providers on a daily basis does not mean that the price for an instrument is accurate. This is in no way the fault of those data providers, as they are in turn dependant on third party data, however the end user must ensure checks are in place to measure the frequency of actual price changes, not simply how often the price is received or updated from the source system. Stale pricing of assets was a major contributor to the uncertainty during the recent financial crisis. Lenders were using stale prices to measure the value of collateral held, and when they woke up to the fact that the prices their systems were showing were outdated, inaccurate and severely inflated, significant financial damage was inevitable.

Also of concern, and a matter which is addressed in the new regulations, is the significant change in price which can occur from the time when a decision is made to liquidate a collateral position, to when the asset is actually sold. Legal notification and procedural requirements, maximum realistic daily trading volume, and the significant downward pressure on bid levels as a result of excess asset supply all have a severe impact in the eventual value recovered from collateral positions in times of stress.

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Consumer credit risk

 “An investment in knowledge always pays excellent interest.” - Bob Stenson

It is of vital importance to understand the risk a consumer presents to a business before granting that consumer any type of loan. In this part of the series we will provide an overview of risks faced by lenders before and after granting a loan and the key strategies for managing these risks effectively.  Emphasis will be placed on selecting customers with acceptable risk profiles, targeting the right customer with the appropriate offer, managing customers, understanding their repayment behaviour and effectively determining a collections strategy for each customer.

Key risks faced by the lender

The availability and accessibility of information is critical for businesses to position themselves within the current, highly competitive markets.  The challenge for lenders is to obtain such information on customers to determine their reliability at the acquisition phase.

The most important risk a lender faces is the failure of any counterparty not meeting the obligations in accordance with the agreed terms.  This causes the lender to incur losses and eventually pose a threat to the financial position of its creditors.   The rapid changes experienced throughout the financial world are apparent in our lifetime and the volatility of the main drivers in the economy drastically impacts the manner in which consumers cope with the repayment of the obligations which they are legally bound by. 

Another key risk to lenders is the inability to recover capital and interest once a customer has failed to make a loan payment.  The lender needs to weigh up the unavoidable legal costs and time spent to administrate these processes with the financial benefits gained in recovering missed payments. 

If a customer is late in making a payment or doesn’t make payment at all poses a settlement risk to the lender as they lose out on a potential investment opportunity due to the failure of the counterparty to settle the transaction on time.

Key strategies for managing and mitigating credit risk

It is vital for lenders to establish sound credit risk within its business and create a culture of risk awareness among all participants in the credit granting process.  Credit Risk Management (CRM) is not only the responsibility of risk managers and ownership needs to be taken by all personnel involved within the consumer credit life cycle. 

Collateral management is arguably one of the most effective and widely used techniques under CRM.  In the case of funded protection lenders must consider the liquidity, market value, life span and transfer of legal ownership of collateral provided in credit agreements.  If collateral is not adequate to cover loss of funds or the credit agreement does not specify ownership of assets in the event of default by the counterparty, lenders will not have satisfactory protection to cover loss of funds.  In the case of unfunded protection lenders must consider the protection provided by the parent or third party to obtain sufficient cover for potential losses.  Lenders needs to make sure that credit agreements stipulate levels of protection provided by the back-up party in the event of default. 

Lenders must obtain enough information at acquisition phase to prevent future disappointment.  If lenders can screen customers carefully at acquisition phase the potential loss of funds during portfolio management phase can be reduced significantly.  Qualitative- and quantitative tools are available to lenders to screen customers at this point of the consumer credit life cycle and to only accept customers with acceptable risk profiles.  Another important factor to consider is the targeting of customers with the appropriate offer, implying that lenders can reduce the risk by charging a higher rate for the product and determine the appropriate loan amount as this will directly affect portfolio loss. 

During portfolio management phase lenders must maintain a fitting credit monitoring and measurement system to continuously examine risk profiles of customers on the active loan book.  Credit Risk behavioural scorecards and VAR calculators are used to monitor behaviour and tendencies of customers during the active phase.   For monitoring systems to be successful, however, a certain level of data quality is critical. Lenders must capture and retain sufficient data to re-measure the adequacy of assumptions and techniques used to assess portfolio dynamics.

The use of CRM techniques has revamped the lending industry and lenders can conduct business with greater confidence, although complete cover against financial loss is almost impossible.  The need for an appropriate collection strategy for each customer needs to be put in place to recover as much as possible in the event of financial loss.  Continuous monitoring of portfolios will aid in recovering debt and in anticipating an account going into arrears and proper communication with customers can preempt an account becoming delinquent after a series of missed payments.  Another important aid in reducing unacceptable customer behaviour is the reporting of “bad customers” to a central data reporting system. 

The rewards of a sound credit risk environment are becoming more apparent as lenders make use of these techniques in mitigating risks associated with consumers on a daily basis.

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The Use and Value of Credit Risk Tools

Any financial institution will know that not all credit or loan applicants can be trusted.  There is always a risk that the borrower will default on a loan repayment, and it is through the use of Credit Risk Tools that banks, lending firms, and other financial institutions can protect themselves.

With risk management moving to the centre of strategic decision-making across the financial services industry, many institutions are revamping their approach to understanding and mitigating risks faced.  Data and information management systems remain significant impediments to an overall understanding of risk exposures, while regulatory uncertainty makes it difficult for organisations to plan for the long term.  It is, thus, critical that financial institutions need to ensure that the tools for managing and reporting on credit risk will add value.  Measurement should not take place for the sake of measuring but tools should be used to enable management to make quick, trusted and meaningful decisions.

In this edition we will be discussing the different types of tools that can be used across the credit lifecycle to manage credit risk, namely Credit Risk Management Reporting Systems, Quantitative Calculation Engines and Qualitative Scoring Guides.

Credit risk management reporting systems are essential for the purposes of compliance, prediction, analysis and decision making. Various off-the-shelf reporting systems are available, but our experience has revealed that an internally built engine can prove more cost effective and value adding as it is more appropriate to the organisation’s level of risk. Financial institutions often spend large sums of money on tools and resources that populate lengthy, repetitive reports with generic commentary, whilst an internally build engine will cost significantly less and focus on the specific needs of the organisation.

For reporting systems, it is essential to have a risk report repository where output data generated for reports is stored and accessed for ad hoc queries, historical reporting and comparisons. The ultimate challenge in reporting lies in the ability to access comprehensive; up-to-date; accurate and predictive information.

Quantitative calculation engines are a collection of mathematical and statistical methods used in the solution of managerial and decision-making problems and should be developed specifically for a purpose or target market. Although technology is widely acknowledged to be a key component of effective credit risk management, it may become a financial barrier if used incorrectly. 

Different quantitative tools are used at each stage in the credit lifecycle: 

• At Acquisition stage, they include: Spreading tools, Scoring/Rating tools and Market Rates Feeds.
• In Portfolio Management stages tools include Limit & Exposure Systems, Credit VAR calculators, Behavioural Score Cards, Default models, Concentration Analysis and Collateral Database tools.
• During Collections and Recovery stages, tools include loss databases and legal documentation systems.

Qualitative scoring guides involve the quantification of a variety of qualitative factors in an individual or organisation’s background to reflect their creditworthiness.  Recently, a major bank ended up with a 96% bad debt rate on accounts for the unbanked market  as a result of developing a scoring model on the incorrect target market. The unbanked are those without an account at a bank or other financial institution and/or are considered to be outside the mainstream, either immigrants or people in extreme poverty. 

In our experience, the unbanked market can be catered for by focusing on the qualitative measures that credit analysts use and change the judgement call into a behavioural scoring engine. The information from credit bureaus is often not available and various sets of financials are provided(those submitted to SARS, accountants or the financial institution may often differ!).  Qualitative measures can be as simple as considering the lighting in the potential client’s shop or the quality of the staff’s uniforms.

Effective credit risk management is dependent upon using the correct tools to target the specific needs of institutions by achieving an integrated view of risk across the organisation. If deployed correctly and effectively, credit risk management can become a value-enhancing activity that goes beyond regulatory compliance and results in a competitive advantage to institutions that execute it appropriately.

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