FRIDAY, AUGUST 18, 2017
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Banking on Risk

Reacting to the last several months of turmoil in the capital markets, I want to discuss an area where Lean Six Sigma professionals who work in banking and financial services should focus their attention, acquire new skills, and start having an impact –?? enterprise risk.

A couple of years ago, one of my former colleagues investigated the contribution of Lean Six Sigma to shareholder value at a small group of well-known banks.  He researched public statements by these companies to quantify their self-attributed savings. He then developed a crude expected shareholder value multiplier based on price-to-earnings ratio. Multiplying self-attributed savings, which he assumed flow to the bottom line, by the shareholder value multiplier led my former colleague to conclude that Lean and Six Sigma created at least $4-6 billion in shareholder value for these banks.

Conventional wisdom leads me to believe that recent turmoil in the credit markets wiped out these gains. The stock prices of many investment banks, asset managers, commercial banks, mortgage finance companies, monolines, and other major participants in structured finance are trading new two-year lows. While each firm and industry segment has its own unique issues, weak risk management is a common storyline.

Looking ahead to the trends for 2008 and 2009, strengthening risk management practices is an imperative and a mammoth challenge for banking and financial services companies and their executives. The global interconnectedness, complexity and volatility of capital markets necessitate a holistic, innovative approach. Conventional practices do not stand up to the challenges in 2008 and beyond.

Exogenous Pressure

Curing the current ills will depend on fortifying balance sheets, and regulatory intervention will increase the pressure on business and operating models. Banking and financial services firms can look forward to:

  • Economic uncertainty: Recent economic data and interest rate cuts by the Federal Reserve Bank in the U.S. indicate an economic slowdown has begun. Its severity and duration cannot be predicted, but banks will feel the effects of a lingering mortgage-market crisis, rising consumer credit defaults, and disruptions affecting commercial lending, structured finance products, and securitization. Some forecasters predict future shocks, such as a decline in commodity prices or downturn in commercial lending, that further threaten banks.
  • Capital boosting and cost cutting: In response to economic pressures, banking and financial services executives will continue to seek capital to fortify their balance sheets, increase their safety and soundness, and weather the economic downturn. Many banks will pursue cost savings as part of restructuring operations, becoming more efficient or both. Cost cutting may be mild or severe, if a bank is facing adverse circumstances like insolvency.
  • Increasing regulatory scrutiny: Regulatory are reacting to the turn of events in the capital markets in 2007. Scrutiny of capital adequacy, liquidity, credit risk and management practices will pick up. Supervisory actions and matters requiring board attention will grow in number. Contingency planning and quality assurance for safety and soundness will receive new attention, as regulators push banks to find and adopt industry best practices that safeguard against future crises.
  • Questions about information and systems for risk management: Over the last decade, many firms began initiatives to implement systems that address credit, financial, and operational risk, as well as compliance with laws and regulations. Broadly speaking, these systems are designed to ensure compliance failures are prevented or detected and managed. The capability of these systems â?? looking at risk through an integrative lens â?? may be called into question. Banks may be required to rethink their information systems strategies and redesign their applications for managing risk. Likewise, information asymmetries in the capital markets may receive new attention, leading firms to question what they thought they know about collateral underlying securities, concentration risk, economic and valuation models and accounting practices.
  • Investigations, lawsuits and jawboning in the town square: The effects of mortgage defaults, credit-card delinquencies, public outcries about banking practices, stock-price volatility, and growing losses foretell banks facing a new wave of investigations by state attorneys general, shareholder lawsuits and pressure from consumer advocates. Stories in the press bear this out. The open question is how loud and deafening the trends will be over the next two years.

My own background has convinced me of the need to extend the disciplines of Lean Six Sigma to processes for creating governance structures, compliance monitoring, and managing operational risk.  Perhaps banks will benefit from a higher degree of knowledge integration (e.g., transplanting gauge methods to credit risk management).

Endogenous Defense Starts with Dialogue and Knowledge

In many respects, the current state of banking and financial services is the product of thousands of decisions about risk taking. Clearly, reward seeking won out, and we now face a period of living through the consequences of risks not being properly managed. Lean and Six Sigma are proven tools for optimizing reward by eliminating waste, creating capacity and reducing variation. Resilience and reliability are a new frontier for Lean and Six Sigma, and the focus is squarely on transforming how risk is managed.

How Lean and Six Sigma contribute to the field of risk management is a story waiting to be told. For starters, I encourage Lean Six Sigma professionals to build the relationships, internal networks, and critical mass necessary to transplant their best practices to the risk management and compliance functions at banks and financial services firms. In conjunction, I recommend seeking new knowledge about relevant aspects of credit, financial and operational risk, as well as regulatory trends that will weigh heavily on operating models and expenses.

Lean and Six Sigma is a knowledge-based profession, and its value comes from connecting best practices to problems, so performance can be improved.  Clearly, for banks and financial services firms, enterprise risk is a huge problem to be solved in 2008.

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Comments

JConsidine

Charles, excellent post, as always. In a prior life, we did practice enterprise risk management, in response to some issues which arose from a lack of "systems thinking" when it came to addressing or even knowing about risks that faced our business.

Later LSS projects that had an impact or implication vis a vis risk reduction were extremely difficult to value, especially given the non-profit structure of the firm.

Is reputation risk a part of your calculus for ERM?

Reply
Charles McKinney

Our enterprise risk management relies heavily on information and communications to manage operational and reputational risk. Risk measurement in these areas is an emerging discipline, and it is much less evolved for reputational risk. I am not aware of companies that formally quantify reputational risk, save for the normal emphasis on measuring customer satisfaction.

Reply
JConsidine

I imagine publicly traded firms may be able to quantify in terms of market cap/price per share hit when reputation issues strike. Sadly, there are far too many examples which can be studied (Marsh, Aon, Tyco, et al)

Reply
Anand from Banking Software

Information is useful…
Excellent post…

Reply


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