Effective risk modelling in financial services

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Andrwe MoselyAndrew Mosely, Deputy Managing Director, writes on design and business analysis

Comments yesterday by UBS Chief Executive Sergio Ermotti, drawing attention to the downsides of the current risk-averse culture in financial services, may draw opprobrium in some circles – not least in the UK where popular newspapers still put bankers in the stocks with phone-hacking journalists, grafting politicians and weight-gaining celebrities.

However, the business community must welcome the sentiment. The Financial Times’ editorial today makes the very good point that society lauds the risk-taking of the entrepreneur, while reviling the risks taken by the banker – but that one could not exist without the other.

The difference, of course, is supposed to be that the entrepreneur must risk his own livelihood, while the banker risks other people’s money. That separation, however, is not always clear-cut, as banks cannot survive if they lose more money than they gain, and entrepreneurs rely on lending to innovate. As with all business, mutual self-interest drives the relationship.

Corporate and individual risk, business and lending are inextricably bound up with each other, and moral hazard is an unavoidable by-product. However as recent experience demonstrates, this does not mean that it can be disregarded.

Striking the right balance with effective risk modelling is a key issue of corporate governance, not just for Mr Ermotti and his fellow chief executives, but also for the boards and chairmen who oversee their work. At arms-length from the day-to-day work of the bank, they should provide a valuable outside perspective, and a check against an attitude to risk that is either too cautious or needlessly reckless.

Their ability to do that, however, is dependent on the quality of information that they have on the running of the business – with their time limited, the information they receive must be carefully chosen. If it does not give a clear impression of the business’s risk exposure, and of possible returns, then the board’s ability to do its job will be severely curtailed.

Of course, the same criteria should go for the information the chief executive uses to make operational decisions. That is why the production of the board report is such a potentially useful process.

Rather than simply offering a narrative account of the preceding period, the board report ought to offer a clear and objective assessment of the business’s overall position, and a consistent view of possible scenarios and their likelihood. That can help foster a healthy and productive approach to risk – something of benefit not only to banks, but to companies of all types.

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