Moody’s: Banks Still Lacking in Using Risk Information
Moody’s is placing even greater emphasis on its dialogue with banks on how risk information influences the decision-making process at the highest levels of the organisation.
Excerpts from Managing Risk in Light of the Financial Crisis: Some Initial Lessons Learned
The market turmoil of the past two years has triggered a wide-ranging reassessment of the global financial system and a need to understand the causes that led to a financial crisis of a severity not seen since the Great Depression. One of the main areas of attention has been the failure of many financial institutions to manage their risks adequately. In most cases, the industry debate has focused on pure risk management failures, particularly the shortcomings of risk models in measuring risks accurately, without addressing the broader issue of how risk is managed at the highest levels of the organisation and how information on a bank’s risk profile is communicated internally and externally and is used to influence the decision-making process.
Our analysis shows that weaknesses in the way risk was managed in financial institutions can be found across all the four dimensions of our framework. Our findings are summarised below:
- The market focus on quarterly results and the compensation structure of risk takers drove management at many banks to focus on short-term earnings, to the detriment of due consideration of the related risks.
- Boards of directors often lacked the technical expertise or the appropriate information to perform the necessary checks and balances effectively.
- The risk management function typically did not have sufficient authority to have its voice heard, in particular in a period of booming revenues and low market volatility and perceived ample liquidity.
- Financial innovation grew rapidly over the past decade. With a prolonged benign environment and more complex products, a robust stress-testing framework became an essential tool in the risk management armoury. However, this either was insufficiently developed, lacked the necessary infrastructure or did not have sufficient impact on management decisions. Often assumptions were not sufficiently severe and sizeable concentrations built up beyond banks’ risk tolerance levels. As a consequence, many banks found it difficult, or were unable, to withstand the shocks that occurred in the financial crisis without external intervention.
Despite market and regulatory pressure on banks to improve their risk disclosures, public information on their actual risk profiles remains opaque for most banks, particularly in the area of market risk. Moreover, while a sound risk culture is crucial for effective management of a firm’s risks, it is very difficult to gauge the “true” risk culture of a firm from the outside.
Information on a bank’s risk oversight at board level as well as the organisation of its risk management function and the presence and reporting line of a dedicated Chief Risk Officer (CRO) provides some insight into its risk governance. Meaningful information on compensation policies can also shed some light on the way the risk dimension is taken into account in setting incentives. In terms of quantitative indicators, looking at multiple risk dimensions at the bank and its financial indicators – including measures of leverage – and, most importantly, at the trends in both risk and financial measures can help investors understand its risk profile and how this evolves over time.
Our analysis highlights how important it is for a bank’s strategic and tactical decisions to be taken on the basis of sound risk information.
In this perspective, Moody’s intends to expand its dialogue with banks on how risk information influences the decision-making process at the highest levels of the organisation. This will focus in particular on the coverage and communication of risk information to the senior management and the board and how this feeds into banks’ decisions, at both the tactical and the strategic levels.
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