Five steps for a new approach to risk management

There has been a lot of discussion – and differing opinions - around how risk management must change in light of the financial crisis. But to find the path to recovery, there is perhaps some consensus emerging about what steps risk managers must now take. And with tight deadlines to conquer – such as the FSA’s October deadline for liquidity risk – there needs to be a quick fix to enable them to complete these rapidly and effectively. Below is a roundup of the five areas that should take priority. 

Understand where risk models underperformed during the credit crunch - what are the lessons for best practice?

At the heart of the previous failures in risk, which were arguably made universally by banks, was not the systems themselves, rather the data upon which they relied. As well as uniting data with a single universal truth, risk managers must lead the charge in reconciling risk with regulations, ensuring the internal and external stories match. They must also extend the parameters of their risk models, allowing for a far greater number of factors.

How can we clearly communicate model limitations to senior management, the board and others?

Risk managers are in the prime position to drive banks’ responses to the crisis. However, they must first determine the best approach to reunite the internal teams, rebuild internal trust and demonstrate the value of robust risk modelling. This calls for clear communication across the bank to agree what best practice looks like and what steps must be taken to accommodate the new approach.

Have we got a satisfactory stress testing model and infrastructure for liquidity, market risk, and credit risk?

Regulations such as Basel I & II introduced standard calculations and business as usual market risk models as well as credit modelling. However, the focus on liquidity risk, spearheaded by the FSA in the UK, introduces a new requirement.  In addition to putting in place more far-reaching models quickly, banks must implement stress testing and scenario models to determine factors such as Individual Liquidity Guidance.

Are our stress testing models joined-up?

Stress testing must encompass market, credit and liquidity risk. However, the new approach must also contain the ability to stress test each scenario. And as each new model is defined, they must be embedded into the systems to create a unified process.

Is our modelling and stress testing process nimble enough?

While the FSA is not the only regulator to tackle liquidity risk it is the first. As such, it is setting the benchmark for other regions to meet and there will inevitably be further regulations emerging. Therefore, the modelling and stress testing processes need to be such that they can evolve to meet these additional requirements.

By introducing the measures, along with rigorous stress testing and powerful calculation engines, risk managers will arguably be in the best position to meet the challenge of a dramatically changing risk landscape and re-establish trust in their position.