Risk is not an exact science, but there are specific trends that should impact decision makers this year.

Trend #1: Compliance risk for financial institutions

The Basel II international banking regulations’ recommendations include specific guidelines for ensuring banks have enough capital to cover potential losses. These accords have been revised and updated frequently to specify more stringent capital requirements and risk management.

Trend #2: Project management risk

Aerospace, construction, engineering, and oil and gas industries have huge risks inherent in their mega-sized projects. Budget overruns and missed deadlines are all too common and often involve taxpayer dollars. The trend of better management of megaproject risks has been strong over the last five years, with more sophisticated techniques being applied.

Trend#3: Operational risk for financial institutions

Operational risks for financial institutions can be more difficult to define and manage than other traditional financial risks. As margins remain tight for many lending institutions, managers are taking risks inherent in their firm’s operations more seriously.

There is a wide range of internal or external threats, i.e. disruption due to natural disasters, employee fraud, and failed transactions. Transactional risk or “failed transactions”  is gaining importance because of its widespread nature and major cost to banks.  Efficient transactional operations reduces the need to grasp at fees and helps keep banks out of trouble.

Trend #4: Audit risk

Expect to see internal auditors, particularly of banks and insurance companies, demand more risk analysis – on a continuous basis and in formal yearly reviews. Audits are more likely to be conducted as the needs of the business demand rather than only on scheduled dates.

1,419 executives worldwide were surveyed.  Almost half of the companies with 10,000 or more employees have a chief risk officer vs. 11% three years ago.

Respondents were asked to identify the risk management capabilities they consider most critical to the performance of their organization and their company’s success in achieving them. Thirty-four percent of respondents said their company performed well at linking risk information to strategic decision-making, while the same percentage said they consider their companies successful at embedding a risk-aware culture at all levels.

Thirty percent said their companies performed well at embedding risk management practices and responsibilities within strategy and operations. Twenty-eight percent of respondents said their organizations performed well at ensuring that all decisions remain within the organization’s risk tolerance, while the same percentage said their companies were successful at driving risk-mitigation activities and proactively indentifying current and emerging risks.

Risks rising in importance
Participants in the survey were asked to identify the top ten risks of the most important in the past three years.  The majority cited natural disasters, next in popularity was the continued slow recovery, and  lastly, human resources issues, such as talent retention and acquisition. Half of the respondents said brand reputation had grown in significance over the past three years, while 49% cited business continuity planning, 48% legal risks and 46% new regulations/more enforcement. Almost 50% of respondents also cited capital scarcity as a risk that had grown in importance.   Electronic/data communications/information security risks were cited by 42%.

Conclusions

• The past three years have seen more companies recognizing the importance of enterprise-wide risk management and, often for the first time, adopting practices to implement it.
• 41% of companies say they are deepening and extending the ties between risk management and strategic planning.
• A good risk management group should operate like a boutique firm, with everyone an expert in a particular area who can be asked to do deep-level work.
• A truly successful risk management culture is focused on driving sustainable and profitable growth rather than simply protecting against downside losses and operational risks

In the backlash that has occurred since, risk management has become the primary focus of the Financial Stability Board (FSB), and with good reason.

In an effort to prevent future economic crises resulting from SIFI failures, the FSB has developed a proposal for living wills, or effective resolution regimes, for financial institutions. The FSB criteria for an effective resolution regime are outlined in  Key Attributes of Effective Resolution Regimes for Financial Institutions .

The objectives of living wills include:   Ensuring continuity of financial services   Protecting client assets  Allocating losses to shareholders while respecting the hierarchy of claims  Not relying on public solvency support  Avoiding unnecessary destruction of value  Providing speed, transparency and predictability for orderly resolution  Legally mandating cooperation, coordination and information exchange with relevant resolution authorities  Ensuring orderly market exits by non-viable firms  Enhancing market discipline and offering incentives for market-based solutions

In the event that risk management measures fail and a financial institution becomes no longer viable, the FSB proposal recommends that the living will should have provisions for two important activities: stabilization and liquidation. Stabilization is necessary for ensuring the continuity of vital financial services and may be achieved through sale of the firm to a third party or creditor-financed re-capitalization.

After or concurrent with stabilization measures, the liquidation phase must protect insured depositors, insurance policy holders and other retail customers, while winding down business operations in an orderly manner.  SIFIs are by definition critical to the success or failure of an economy. It is for this reason that measures beyond standard risk management practices should be required.

A living will allows authorities to resolve a failed financial institution or large company while minimizing risk to the taxpayer and ensuring continuity of critical financial services. However, implementing living wills as part of a larger risk management strategy should not be limited to just the 29 SIFIs that have been identified by the FSB. All large companies and financial institutions should have a living will in place in the event that existing risk management systems fail.

- By Robert Pestreich, Harrison, Stone & Associates