Strategic risk has become a major focus. Also, many companies are taking a broad view of strategic risk that doesn’t just focus on challenges that might cause a particular strategy to fail, but on any major risks that could affect a company’s long-term positioning and performance. There is no one-size-fits-all solution for risk management function, how risk is governed varies across industries and organizations. But there are five interrelated principles that underlie effective risk management within organizations in both good times and bad – integrity to the discipline of risk management, constructive board engagement, effective risk positioning, strong risk culture and appropriate incentives.
Below, we discuss these five fundamental tenets integral to ensuring the success of the independent risk management function.
INTEGRITY TO THE DISCIPLINE OF RISK MANAGEMENT
Integrity to the discipline of risk management means having a firm grasp of business realities and disruptive market forces, engaging in straight talk with the board and executive management about the related risks to achieving the organization’s objectives and the capabilities needed to reduce those risks to an acceptable level.
Integrity to the discipline follows from a strong tone at the top – what the C-suite stands for, how senior executives provide leadership with respect to the appropriate governance and behavior around doing the right things in the right way, and ensuring the affairs of the business are conducted in a fair and transparent manner and at arm’s length. If tone at the top is lacking, the executive team isn’t paying attention to the warning signs and the organization’s affairs are so complex that few can understand them, then risk management faces an almost insurmountable challenge to making a difference.
Consider the following common examples, some strategic and some tactical, of integrity failures:
- Not grasping business realities clearly –The global financial crisis is a good example of what can happen when the inherent risks associated with aggressive, growth-oriented market strategies are discounted, ignored or never considered. Breakdowns in time-tested underwriting standards, failures to consider concentration risks and excessive reliance on third-party assessments of structured products are among the root causes of the crisis. In many financial institutions, risk management was irrelevant.
- Not integrating risk with strategy setting – When risk is an afterthought to strategy, risk management fails to reach its full potential as a discipline. The critical assumptions underlying the corporate strategy must be understood at the highest levels of the institution and the external environment must be monitored to ensure that these assumptions remain valid over time. This era of disruptive change necessitates raising the line of sight for risk management to a strategic level.
- Not tying risk tolerance to performance – Risk is often an appendage to performance management. How does an organization even know that it is doing an efficient job of managing risk when it hasn’t delineated its risk appetite and risk tolerances at the level at which decisions are made? Performance and risk must be integrated, and to that end, defining thresholds linked to performance objectives is essential.
- Limiting risk management to a compliance activity – Integrity to the discipline means knowing that undertaking initiatives to manage uncertainty (risk) in the pursuit of business objectives is not strictly a regulatory compliance measure. Viewing risk management as a “regulatory” check-the-box exercise restrains its value proposition and contribution to the entity’s success.
These examples illustrate that integrity must permeate every aspect, every level and every action within the organization as it relates to managing risk. Hoping that risks are managed sufficiently while knowing that business realities are not actively monitored, risks are not really understood, tolerance levels are not set (or are ignored) or projects are performed solely to meet regulatory guidelines is an indicator that integrity to the discipline of risk management is lacking.
CONSTRUCTIVE BOARD ENGAGEMENT
Effective board risk oversight begins with defining the role of the full board and its standing committees with regard to the oversight process and working with management to understand and agree on the types (and format) of risk information the board requires. Directors need to understand the company’s key drivers of success, assess the risks in the strategy and encourage a dynamic dialogue with management regarding strategic assumptions and critical risks.
The scope of the board’s risk oversight should consider whether the company’s risk management system – including people and processes – is appropriate and has sufficient resources to deliver on expectations. The board should pay attention to the potential risks in the company’s culture and monitor critical alignments in the organization – of strategy, risk, controls, compliance, incentives and people. Finally, the board should delineate the most critical enterprise risks from the day-to-day risks of managing the business and consider emerging and interrelated risks – i.e., what’s around the corner?
EFFECTIVE RISK POSITIONING
While the positioning of the risk management function is not a one-size-fits-all prescription, there are fundamental principles that make it work. The board’s and executive management’s expectations for the Chief Risk Officer (CRO), or equivalent executive, and the risk management function must be carefully considered, and given those expectations, the function must be positioned for success as a separate line of defense. To this end, six key success factors increase the function’s chances of success:
- The CRO (or equivalent executive) is viewed as a peer with business line leaders in virtually all respects (e.g., compensation, authority and direct access and reporting to the CEO) and likewise down through the business hierarchy and across the organization.
- The CRO has a dotted reporting line to the board or a committee of the board and faces no constraints of any kind in reporting to the board.
- The board, senior management and operating personnel believe that managing risk is an organizational imperative and everyone’s job.
- Management values risk management as a discipline equal to opportunity pursuit.
- The CRO is clearly viewed as undertaking a broader risk focus than compliance.
- The CRO’s position and how it interfaces with senior line and functional management is clearly defined.
While these attributes may not be exhaustive, they represent a significant step forward in ensuring the risk management function is impactful, setting the tone for effectively functioning risk management. Taking one or more of these elements away produces a red flag that the risk management function may be unable to fulfill its expected role and lacks real authority or influence. Depending on the expectations, the function may be set up to fail.
STRONG RISK CULTURE
An actionable risk culture helps balance the inevitable tension between (a) creating enterprise value through the strategy and driving performance on the one hand, and (b) protecting enterprise value through risk appetite and managing risk on the other hand. While risk culture has gained traction in terms of relevancy in financial services in the post-global financial crisis era, the occurrence of reputation-damaging incidents, the decision-making processes preceding those events and the lack of response readiness once those events occurred has made risk culture a topic of interest in other industries, as well.
Culture is influenced by many factors. We’ve discussed two – the tone at the top and the quality of the board’s risk discussions. Other factors include:
- Accountability – Successful risk management requires employees at all levels to understand the core values of the organization and its approach to risk, to be capable of performing their prescribed roles, and to be aware that they are held accountable for their actions in relation to expected risk-taking behaviors.
- Effective challenge – A sound risk culture encourages an environment in which decision-making processes allow expression of a range of views, manage the effect of bias and facilitate reality-testing the status quo.
- Collaboration and open communications – A positive, open, collaborative environment engages the most knowledgeable people and leads to the best decisions.
Incentives that encourage risk awareness and risk-informed decisions help shape risk culture as discussed below.
Performance and talent management should encourage and reinforce maintenance of the organization’s desired risk behavior. The old saying, “What gets rewarded gets done” is as true with risk management as it is with any other business process. Disconnections in the organization’s compensation structure and an excessive near-term focus can lead to the wrong behaviors, neutralizing otherwise effective oversight by the board, the CRO and other executives.
For example, if lending officers are compensated based on loan volumes and speed of lending without regard for asset quality, reasonable underwriting standards and process excellence (e.g., their compensation is not adjusted for borrower and collateral riskiness, portfolio concentrations and the likelihood of unexpected losses), the financial institution may be encouraging the officers to game the system to drive up their compensation and thus expose the company to unacceptable credit risk.
This principle requires more than focusing on C-suite executive compensation and upper management. Just as important is an understanding of the incentive plans driving behavior in the sales force and on the “factory floor” where production occurs, as this is where individual “moments of truth” occur that add to, reduce or neutralize the buildup of risk within the organization every day.
QUESTIONS FOR EXECUTIVES AND DIRECTORS
In summary, following are some suggested questions that executive management and boards of directors should consider:
- Does executive management openly support each line of defense to ensure it functions effectively – e.g., the primary risk owners (lines-of-business leaders and process owners whose activities create risk), independent risk and compliance management functions and internal audit? Is there timely consideration of escalated matters by executive management and the board (the final line of defense)?
- Do primary risk owners identify and understand their respective risks and risk appetite? Do they escalate issues to executive management in a timely manner? Is the board of directors engaged in a timely manner on significant risk issues, particularly the critical enterprise risks?
- Are there any elements of ineffective positioning of the risk management function present in the organization? Is the CRO (or equivalent executive) viewed as a peer with line-of-business leaders? Does the board leverage the CRO in obtaining relevant and insightful risk reports? Does the CRO have a direct reporting line to the board?
- Is risk management a factor in the organization’s incentive and rewards systems? Is the risk/reward balance an important factor in key decision-making processes? Do information systems provide sufficient transparency to the entity’s risks?
- Has the board articulated its risk oversight objectives and evaluated the effectiveness of its oversight processes in achieving those objectives? Is the board receiving the information and insight it needs? If there are any gaps that may impede risk oversight effectiveness, is the board taking steps to address them?