JOURNAL OF FINANCIAL ECONOMETRICS-2005-Drzik-26-36

Journal of Financial Econometrics, 2005, Vol. 3, No.
1, 26–36
New Directions in Risk Management

John Drzik
Mercer Oliver Wyman
abstract
Downloaded from http://jfec.oxfordjournals.org/ at Cambridge University Library on March 19, 2013

Following the 1991 recession, financial institutions invested heavily in risk manage-
ment capabilities. These investments targeted financial (credit, interest rate, and
market) risk management. I will show that these investments helped reduce earn-
ings and loss volatility during the 2001 recession, particularly by reducing name
and industry-level credit concentrations. I also suggest that the industry now faces
major risk challenges (better treatment of operational, strategic, and reputational
risks and better integration of risk in planning, human capital management, and
external reporting) that are not addressed by recent investments and that will
require development of significant new risk disciplines.
keywords: credit cycle, financial institutions, risk management
Risk management has been an area of explosive development over the last decade
in both business and academia. Financial services has been the business sector in
which risk management has made the most rapid progress, and the single most
significant change in practice has been the approach to credit risk management
taken by commercial banks. In the early 1990s, pioneering banks started to
migrate from the traditional judgmental ‘‘buy and hold’’ approach to credit to a
more quantitative, market disciplined approach to credit underwriting, pricing,
and portfolio management. The new credit paradigm began to spread, taking
hold first among large North American banks and a few European leaders, then
spreading to others.
There are many new directions for the development of risk management, which
builds on the foundation built in the last decade. Potential new directions will be
explored toward the end of this article. Before looking forward, though, we will look
back at the last decade, both at general developments and at results. Specifically we
will examine whether banks in the United States, where risk management develop-
ments were earliest, performed better through the recent recession (versus their
Address correspondence to John P. Drzik, Chairman, Mercer Oliver Wyman, 99 Park Ave., 5th Floor,
New York, NY 10016, or e-mail: jdrzik@mow.com.
doi:10.1093/jjfinec/nbi007
Journal of Financial Econometrics, Vol. 3, No. 1, ª Oxford University Press 2005; all rights reserved.
Drzik | New Directions in Risk Management 27
performance in the recession of the early 1990s). In short, did advances in risk
management tangibly improve bank performance when times got tough?
DEVELOPMENTS DURING THE LAST DECADE

Banks invested heavily in risk capabilities during the 1990s and early 2000s. Their
ability to measure and quantify risks improved tremendously during those years,
as new methodologies were developed to cover first market risk, then credit risk,
and now operational risk. A ‘‘common language’’ of risk, rooted in economic

capital, emerged to allow the aggregation and comparison of unlike risks.
Risk management practices also improved significantly during this period.
Risk limits and limit monitoring practices became more prevalent and more-
sophisticated, with banks increasingly setting limits at multiple levels (individual
counterparty limits, for instance, complemented by aggregate risk grade and
industry limits). Most banks introduced portfolio management disciplines, as
they increasingly recognized the risk impact of geographic and industry concen-
trations and began to move away from the traditional ‘‘buy and hold’’ approach to
credit origination and ownership.
Organizationally the risk function also assumed greater prominence in banks’
management structures. Ten years ago the most senior risk professional at most banks
was the chief credit officer (CCO), who spent most of her time reviewing individual
loans. Today, most banks’ chief risk officers (CRO) have vastly expanded responsi-
bilities and influence. CROs are typically responsible for virtually all types of risks
that banks face, are frequently key participants in their institutions’ strategic planning
process, and often report directly to the president, chief executive officer (CEO), or
even the board. Banks have also placed greater emphasis on risk and risk manage-
ment in their reporting to the outside world, with information on risk levels, risk-
adjusted performance, and risk management processes featured prominently in
annual reports, analyst presentations, and the like.
As banks were deepening their risk management capabilities, other market
participants were also evolving. Regulators and rating agencies necessarily dee-
pened their understanding of risk measurement and management approaches to
keep pace with developments at leading financial institutions. More generally, the
financial markets also continued to develop; previously illiquid asset classes have
become more liquid as new trading markets have developed and as new risk
transfer vehicles, such as securitizations and credit derivatives, have been created.
REAL PROGRESS?
A key question, though, in reviewing this impressive set of developments, is
whether they really made a difference. To test how a decade’s worth of invest-
ments in risk management have performed in practice, we examined two tests for
U.S. commercial banks: the 1990 and 2001 recessions.
To be fair, the two recessions were somewhat different in nature and severity. As
seen in Figure 1, the 2001 recession was somewhat shallower and briefer than the 1990
28
Percent Change
(Real Dollars)
2.00%
1.50%
Journal of Financial Econometrics

1.00%
0.50%
0.00%
-0.50%
-1.00%
1993
1994
1996
1986
1987
1988
1989
1990
1991
1992
1995
1997
1998
1999
2000
2001
2002
2003
1990 Recession 2001 Recession
Quarter
Figure 1 Quarterly change in GDP. Source of data: National Bureau of Economic Research.

recession (and than the average postwar recession). Neither real gross domestic
product (GDP) nor industrial production fell as steeply as in other recessions. At the
same time, the postrecession recovery was also shallower than the recoveries that
followed the 1990 recession and other preceding recessions. Payroll employment
figures failed to grow at all following the official end of the 2001 recession, and growth
in real personal income has been relatively anemic—both phenomena that probably
exerted some continuing postrecession pressure on bank credit performance.
Banks were also somewhat better positioned going into the 2001 recession than
they had been going into the 1990 recession. Capital:asset ratios for the banking

industry as a whole were roughly 5–6% in 1989, but had climbed to about 7–8% in
2000. The extra capital cushion that was present in 2000 had the effect of allowing
banks greater flexibility and resources with which to weather the recession.
While the two recessions were clearly not identical, and bank starting points
were different, our sense is that they do still provide a basis for judging whether
changes in bank risk management had a tangible impact over the last decade. So,
setting aside for now differences between the recessions, we can turn to the
central question: Did banks perform better in the more recent recession?
The data overwhelmingly support the conclusion that banks performed, not
a little better, but much better during the 2001 recession than during the 1990
recession. As shown in Figure 2, credit quality was substantially better. Although
nonaccruing loans rose in each recession, the peak in 2001 was nowhere near
% Non-Accruing
Loans
3.5% Non-Accruing Loans/Leases as a % of
Total Loans/Leases for Commercial
Banks and Savings Institutions
3.0%
2.5%
2.0%
1.5%
1.0%
0.5%
0.0%
1986 1988 1990 1992 1994 1996 1998 2000 2002
Figure 2 Credit quality. Source of data: SNL Securities.

30 Journal of Financial Econometrics
the peak in 1990 and the degree of increase from the prerecession years was much
more moderate. Figure 3 demonstrates that loan charge-offs followed a similar
pattern, peaking in each recession, but with 2001 levels substantially lower than
1990 levels.
Why did banks enjoy superior credit performance in the most recent reces-
sion? Our hypothesis is that the performance differential reflects a combination of
better risk-taking decisions and more efficient redistribution of risks. Banks’
ability to gauge the creditworthiness of borrowers increased substantially during
the 1990s, and underwriting processes were retooled to take advantage of these

improvements. As a consequence, banks were able to do a better job picking and
choosing which credit risks they wished to underwrite. Of importance is that
banks after 1990 also developed a healthy respect for concentration risk—the
impact of having too many highly correlated risks. Concentration limits put in
place during the 1990s helped ensure that in 2000, most banks had reasonably
diversified portfolios, and hence were not as badly hurt by exposures to particular
industry sectors or geographies.
Banks were also able to pass through risks to the capital markets more effectively
as loan markets became more liquid and as credit risk transfer vehicles such as
Net Charge-
Off Rate
2.0%
Net Charge-Offs
1.8%
1.6%
1.4%
1.2%
1.0%
0.8%
0.6%
0.4%
0.2%
0.0%
Q1 1995
Q1 1996
Q1 1997
Q1 2002
Q1 2003
Q1 1994
Q1 1998
Q1 1999
Q1 2000
Q1 2001
Q1 1988
Q1 1989
Q1 1990
Q1 1991
Q1 1992
Q1 1993
Figure 3 Credit losses. Source of data: SNL Securities.

derivatives and securitizations became more prevalent. As a result, credit risks

(and ultimately credit losses) were increasingly likely to be borne not by the highly
leveraged banks that structured and originated loans, but by less-leveraged investors
who acquired these risks from the originating banks. As such, the relatively moderate
loss experience for banks in the last recession understates the losses by investors as a
whole—which has sharpened the focus on credit risk management at insurers, pen-
sion funds, and other end-investor segments that were hit with these losses.
U.S. banks were also judged by the analyst community to weather the recent
recession well. As shown in Figure 4, between 1989 and 1991, ratings agencies hit

U.S. banks with a significant number of downgrades and very few upgrades.
During the 1999–2001 period, in contrast, downgrades increased only slightly,
and were in fact outnumbered by upgrades.
Evidence also suggests that banks didn’t just learn how to avoid losses during
the 1990s, they also learned how to be more appropriately compensated for risks
taken. We analyzed credit pricing relative to underlying risk at dozens of financial
institutions during the 1990s and found a very consistent pattern. In the early 1990s,
credit pricing was relatively ‘‘flat.’’ Less creditworthy corporations frequently did
40
20
+
0
20
40
60
80
100
1986
1987
1988
1989
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
Figure 4 U.S. bank upgrades/downgrades, 1986–2003. Source of data: Moody’s Investor Services.
Spread
Required Economic Pricing

Illustrative 2001 Pricing
Illustrative 1990 Pricing
Credit Quality
Figure 5 Economic versus actual pricing, 1990 versus 2001. Source of data: Mercer Oliver Wyman.
not pay banks much more for credit than did their more creditworthy peers. By the
end of the 1990s, this pattern had changed substantially. While it remained true that
many banks still underpriced high-risk credits and overpriced low-risk credits,
market pricing displayed much greater sensitivity to underlying risk than it had at
the beginning of the decade.
This sea change in pricing practices has had a major impact on bank per-
formance and should ultimately make banks much more attractive businesses
from an investor’s perspective. The performance of bank equity during the last
recession suggests that investors may in fact be beginning to take note.
Bank equities underperformed the broader market in 1990, reflecting inves-
tors’ beliefs that banks were recession sensitive and prone to substantial earnings
surprises in a down credit cycle. During the period around the 2001 recession, in
contrast, banks actually outperformed the broader market. By late 2003, banks
had basically regained their peak prerecession valuations; the broader S&P 500,
while recovering, was still substantially below its most recent highs.
Index
600
S&P 500 Financials Index

500
400

300
200 S&P 500 Index
100
0
Sep-89
Sep-90
Sep-91
Sep-92
Sep-94
Sep-95
Sep-96
Sep-97
Sep-98
Sep-00
Sep-02
Sep-03
Sep-93
Sep-99
Sep-01
Figure 6 S&P 500 versus S&P financial index, 1989–2003. Source of data: Standard & Poor’s.
Our conclusion: risk management made a difference. While the 2000 reces-
sion was admittedly a less severe test for banks than was the 1991 recession, the
substantial improvement in bank performance has to be at least partly attribut-
able to better risk management practices. An improved ability to measure risk,
improved decision-making processes about which risks to take, improved diver-
sification of bank credit portfolios, improved pricing, and an improved ability to
pass risk through to the capital markets all added up to real progress: fewer losses
and better risk-adjusted returns. Banks still have many ways in which they can
further improve their risk management, but the performance in the recent reces-
sion suggests some, if not most, of the investments over the last decade paid off,
and therefore looking for future new development directions makes sense.
WHAT’S NEXT?
While progress in the last decade was substantial, there are several major new
challenges to be addressed. We have highlighted four below:
Conquering ‘‘the Unknown’’ in Risk Measurement

Investment in risk measurement technologies over the last decade has concentrated
on credit risks and market risks. These can be described as ‘‘known’’ risks, since
their frequencies, severities, and loss probabilities can be measured, or at least
reasonably estimated. This category of risk would also include the traditional
mortality and hazard risks measured by the insurance actuarial community.
Many major risks, though, are virtually untouched by these new measure-
ment techniques. Operating risks, for instance fraud, suitability, or legal risks,
have generally not been modeled and quantified by most banks. However, banks
are well aware of these risks and generally have some processes in place to
mitigate damage from them. However, the risks are ‘‘unknown’’ in the sense
that they are not yet well measured and the cost/benefit analysis of proposed
changes to practices in these areas is hard to evaluate.
Over the next decade, a key direction for risk management will be to convert
‘‘unknown’’ risks to ‘‘known’’ risks by developing measurement techniques that

are suitable and effective for the new challenges.
Connecting Risk Management to Business Strategy

Arguably risk management’s greatest value to banks comes from helping to shape
business decisions. Which growth strategies offer the best risk-adjusted returns, and
ultimately the greatest shareholder value creation? Which new customer segments
should be pursued? What new products and services are required? Which risks are
worth taking, and which are not? The challenge for risk management is to develop a
way of partnering with business management to answer these questions, while
continuing to play an independent, objective control function.
Mercer Oliver Wyman recently surveyed the CROs of more than 40 large
financial institutions to discuss their roles in driving the strategic directions of
their institutions. We also asked these CROs [as well as chief financial officers
(CFOs) from the same institutions] whether they were satisfied with their invest-
ment in risk measurement tools and whether they felt that the institution was
deriving real business benefit from those tools. The results showed an interesting
correlation. Institutions that reported deriving real business benefit from risk
measurement investments were overwhelmingly the same institutions that
reported that the CRO was a major participant in the strategic planning and
strategic capital allocation processes. Where the CRO was not involved, or was
only weakly involved, in these planning processes, we heard a different story: at
such institutions, advanced risk measures were used primarily for control pur-
poses, and there was a general sense that real business decisions were not much
improved.
Given that generating attractive organic growth levels is a core strategic thrust
for most banks, a critical new direction for risk management practitioners will be to
help line executives channel their growth ambition into areas where the overall risk
level is considerable, and strong risk-adjusted returns can be achieved.
Achieving Greater Transparency

The current business environment, with its pointed emphasis on corporate govern-
ance, is making it critical for banks to explain their risk profiles publicly with
greater clarity and detail than ever before. Risk is still a complex and technical
subject, so achieving transparency will not be easy. Internal constituents, analysts,
ratings agencies, investors, and regulators all have varying levels of understanding
of advanced risk measurement techniques. All will require continuing education

before the market as a whole reaches a common understanding of risk. The benefits
of achieving this common understanding, though, will be considerable — and will
extend far beyond the Sarbanes-Oxley compliance motive that is driving much of
the current effort to increase transparency.
For one thing, it is worth noting that, despite their strong relative perfor-
mance in recent years, banks’ valuations remain depressed relative to nonbank
peers. The price/earnings (P/E) ratio for the global financial services sector as a
whole, for example, averages about 35% lower than the same ratio for the non-

financial sector. An explanation for part of the discount is the opacity in the risks
of financial institutions (banks are described by some as ‘‘blind pools of risk’’).
Investors simply don’t believe that they have a clear enough or complete enough
picture, and hence they worry about the potential for unexpected earnings sur-
prises in the future (‘‘skeletons in the closet’’).
Transparent, understandable, and consistent reporting on risk is one way for
banks to win over investors and help to mitigate this 35% P/E discount. If opacity
explains any significant part of the 35% discount, this new direction could have a
very material effect for bank executives and shareholders.
Changing the Way Human Capital is Managed and Rewarded

Human capital management is a major challenge for the risk management func-
tion of most large financial institutions. A decade ago, the risk management
function, if it existed at all, was likely small, and was populated almost entirely
with technical experts. Today, risk management is typically a major unit; at some
institutions, literally thousands of employees report up to the CRO. Among the
consequences of this explosive growth are
CROs can no longer be technical experts only, they must increasingly

be strong leaders and general managers as well.
The risk management function must develop the capacity to attract
and retain large numbers of staff from a wide range of backgrounds:
Some with technical qualifications, others with more general

business skill sets.
Some internally grown in the risk function, others trans-
ferred/seconded from the line, others hired from outside.
The risk function leadership must be able to manage a complex
mix of talented professionals, define career paths for them, and
help them manage their careers in the organization.
The risk management function is also increasingly impacting how human

capital is managed elsewhere in the institution. Most institutions articulate a desire
to create a firmwide ‘‘risk culture’’ in which all employees constantly think about
risk-reward trade-offs. However, relatively few firms, even financial institutions,
provide the risk management function with a significant voice in deciding how
incentives are determined for line risk takers and line executives in the organization.
Making risk management a strong participant in setting compensation policy and
levels will be a controversial, but probably necessary step toward creating the
much-desired organization-wide ‘‘risk culture.’’
These four areas alone are a challenging agenda for risk professionals to
tackle in the coming years, and it is far from an exhaustive agenda. Risk manage-

ment will continue to be an area of investment in the financial services sector, and
a growing discipline in nonfinancial corporations as well. As the tangible suc-
cesses of risk management developments in this last decade are increasingly
recognized, these trends will only accelerate.

JOURNAL OF FINANCIAL ECONOMETRICS-2005-Drzik-26-36

Uploaded by

Document Information

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

JOURNAL OF FINANCIAL ECONOMETRICS-2005-Drzik-26-36

Uploaded by

Copyright:

Available Formats

Journal of Financial Econometrics, 2005, Vol. 3, No.

New Directions in Risk Management

Downloaded from http://jfec.oxfordjournals.org/ at Cambridge University Library on March 19, 2013

keywords: credit cycle, financial institutions, risk management

DEVELOPMENTS DURING THE LAST DECADE

Downloaded from http://jfec.oxfordjournals.org/ at Cambridge University Library on March 19, 2013