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Sophisticted risk mngements Holy Gril without hving rel understnding of its fundmentl elements nd how difficult it cn be to impose them

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11. Getting There


I very much fear that institutions throughout the world view risk management--often "sophisticated risk management"--as a Holy Grail, without having a real understanding of its fundamental elements and how difficult it can be to impose them. This, I believe, is particularly true in developing countries with traditions or cultures that emphasize relationships more than legally enforceable obligations.

Moreover, even for organizations that operate in a culture--such as the United States--that is more risk-oriented, risk management techniques can threaten traditional ways and thoughts. Managers who are already in important decisionmaking posts and staff who do not yet have the technical skills necessary for risk management are especially likely to find change disruptive, mechanical, and lacking in the all-important qualities of judgment and experience that they, of course, already have in considerable abundance. Do not misunderstand me. I am not an opponent of experience and judgment, and I do believe that building a risk management system that is designed to be automatic is foolhardy. My point is that change is difficult at any institution or set of institutions. It is even more difficult if the change is not consistent with the cultural and institutional environment and/or the skills of the management and staff.

Difficulty with staff expertise is why the first steps for effective risk management probably should be the least technical and the ones with the best chance for payoff in the short run. I am thinking of accountability, clear lines of authority and responsibility, and--to avoid conflicts of interest--the crucial separation of business line management from risk management and internal control. As I noted earlier, the latter alone could have saved Barings.

The next step, I suggest, is to begin thinking about returns in terms of the risk-return nexus, the RAROC I noted earlier. Just that simple way of thinking about an investment decision goes a long way in improving risk management. The best deal--especially for leveraged institutions like banks--is hardly ever the one with the best rate of return. Rates of return are provided to compensate for risk. If rates of return are high, it is because they are compensating for a high level of risk. Risk means variability, and leveraged institutions like banks have little tolerance for loss. That is why banking institutions must reduce and manage risk exposures, think of yields on a risk-adjusted basis, and realize that financial leverage can magnify the impact of losses as well as gains.

A critical concern in developing a basic risk management process involves developing or attracting personnel with the skills necessary to apply risk management tools in meaningful ways. In the eighteenth and nineteenth centuries, bankers used to send their sons to work for competitors in financial centers in order to learn the latest techniques and then bring them home. Some of that still goes on--although not so much for relatives any more--with time often spent at the organization's own foreign branch or at a business school rather than at competitors. Expertise was also transferred in the past by local branches of foreign banks training local residents. In the twenty-first century these are all still excellent ways to import skills in banking in general and risk management in particular. Limiting foreign presence may be the worst thing for local banks--insulating them from competition and making the import of valuable human capital and expertise more costly.

Risk management implies significant limits on the ability of highly leveraged financial institutions such as banks to provide badly needed venture capital; it implies that financial systems need more than banks. They need nonbank financial institutions that are less leveraged than banks and have much longer term liabilities. They also need functioning capital markets, including foreign providers of long-term and equity capital. These other elements may constrain local banks, but they bring blessings, too. They create instruments and institutions that are stronger, more diversified, and easier to manage during periods of financial stress. They also provide greater stability to financial systems and alternative funding sources for borrowers




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