How can we strengthen organisations and the financial system to mitigate risks and prevent disasters such as the devastating financial crisis of 2007-2009? Distinguished speakers from industry, academia and government recently shared their perspectives on risk management and governance at a summit organised in Mumbai by the ISB’s Centre for Investment.
The dangers of overdependence on financial models to predict crises, the importance of good corporate governance and conduct and persistent flaws in the world financial system were among the many timely and thought-provoking issues canvassed at the first Risk and Governance Summit held in Mumbai on August 23, 2012. The summit was hosted by the ISB’s Centre for Investment in partnership with Deloitte.
In his keynote speech, Anand Sinha, deputy governor of the Reserve Bank of India, set the tone for the summit with a wide-ranging talk that articulated several themes that resurfaced throughout the day.
The Limitations of Risk Models
A key theme that emerged concerned the use of models – abstract, largely quantitative depictions of complex financial systems – to manage risk. The global financial crisis of 2007-09 “triggered an intense interest in the nature of quantitative financial models and their inability to predict disasters,” he said, and called for “a paradigm change in risk modelling.” He suggested that quantitative models should be treated as a supplement to decision making and that “primarily, qualitative judgement, experience and common sense should be the guiding factors.” Adding a cautionary note, he said, “There are risks beyond those that are measured by risk models.” His view was echoed by that of Eckhard Platen, professor of quantitative finance at the University of Technology, Sydney. Platen also commented on the limitations of modelling. “Quantitative methods are warning us,” he said, “and should be taken into account. There hasn’t been a perfect model and never [will be] a perfect understanding. However, there are warning signs.” Elaborating on the shortcomings of the current usage of models, Richard Apostolik, president and CEO of the Global Association of Risk Professionals reiterated “nobody is looking at [modelling] in terms of groupthink.”
In his address, speaking within the context of the global financial crisis, Sinha observed there was a “fundamental lack of expertise” among bank directors, particularly among independent directors. There was, he said, “a general disconnect between the risks being taken by the banks [and] those that their boards of directors perceived them to be taking.” Incomplete information hampered decision making, leading to complacency. He also pointed out that risk management was based on silos. “As the overall picture of the risks was not available to the boards or the top management, the consequent controls and mitigating measures also turned out to be inadequate.”
This concern was later reiterated by Usha Thorat, director of the Centre for Advanced Financial Research and Learning (CAFRAL) and former deputy governor of the Reserve Bank of India in her closing address.
Thorat noted that directors of public sector banks who were appointed to represent particular groups sometimes felt disempowered because they lacked knowledge of banking practices. Under her direction, CAFRAL had been conducting workshops “just to be able to give a little more confidence to directors who may not have knowledge of risk management.”
A Sustainable Approach
The next keynote speaker, Chanda Kochhar, managing director and CEO of ICICI Bank, identified four elements that could strengthen bank management: the right approach to governance, strong risk management, strong systems and appropriate incentives.
Corporate governance, Kochhar noted, “drives sustainable value creation by balancing the interests of different sets of stakeholders, making the right trade-offs between risks and returns and ensuring a long-term perspective.” Its benefits would elude companies that viewed it as a burden. “The attitude has to be that we will incorporate this because we believe it is good for us and for everybody associated with us,” she argued.
Another risk that could have deep implications for organisations and ought not to be overlooked, in her view, was “reputation risk”. “[The] trust of our stakeholders, once eroded, is very difficult to revive, however well capitalised and profitable a bank may be. One has to always strike a balance between good market performance [and] good corporate conduct,” she said.
Strengthening Risk management
Banks should see risk management as a function that can help deliver sustainable returns. Speaking of her own experience at ICICI Bank, Kochhar remarked that she constantly saw a tussle between the business functions and the risk management functions. “If ever ything was cool or if they were always at loggerheads, the whole environment would become dysfunctional. But a slight tension is the healthiest way to operate,” she stated.
Building Effective Systems
Investing in systems that safeguard data integrity may seem mundane, but it is critical to risk management. “The same risk may reside in different parts of an organisation but unless it is seen in aggregation, the organisation will never know what the extent of risk is. [Global banks during the financial crisis] had very sophisticated and complex risk management techniques, but the approach of looking at [total risk] I think that was missing,” she warned.
The importance of balance was highlighted in a different context by Apostolik. “There is a balancing act,” he said, “between costs and the effectiveness of regulation.” In the United States, he remarked, some organisations found that they needed to hire more than 300 lawyers to address issues pertaining to the Dodd-Frank Act.
Apostolik raised an issue that had not been mentioned by other speakers, that is, the resolution and recovery of failing organisations. “There are so many inconsistencies in [recovery and resolution] in different jurisdictions around the world. It’s inevitable that we will have more bank failures, more bankruptcy [and] economic disruptions because of that. The whole area of recovery and resolution really needs to be looked through in greater detail,” he stated.
Thorat seemed to share Platen’s sense of foreboding. “We may have averted a very deep depression,” she said, “still, I think [there is a] huge amount of risk out there which comes again out of imbalances not having gone out of the system … It’s a really dysfunctional financial world that we are living in.” She concluded with a discussion of the difficulties of cross-border regulation. “We are all national regulators working with international financial institutions,” she said. Multinational companies operate all over the world, but ultimately come under national tax jurisdictions administered by national regulators. “There is fundamental inconsistency,” Thorat argued, “There cannot but be regulatory arbitrage, however much we have tried to harmonise the international rules.”