Five Risk Management Lessons From Pixar

I read an interview in McKinsey Quarterly with Ed Catmull, one of the co-founders of Pixar, about his management approach for keeping the business innovative (here; registration may be required).  I hoped this article would provide an interesting window into a different sector.  When I finished reading the article, I had found something very different instead.  I had learned a number of useful lessons about the design and implementation of risk management:   

1.  That clear business objectives inform risk taking.  Are there clear business objectives?  How do they relate to risk management?

2.  The impossibility of delivering absolute clarity. Is risk management striking a balance between providing clarity and enabling staff at all levels to respond to challenges as they arise?   

3.       The importance of running experiments.  How do/can we experiment with risk management?  Is this about testing risk metrics?  Product features and claims?  Changes to underwriting criteria? 

4.       Articulating business culture to make it less dependent on key individuals and ensure it resonates beyond senior management.  How do we ensure that the ‘tone from the top’ is echoed by middle management?  

5.       The important distinction between assuming and spreading risks and their focus on the former.  How close is the risk management oversight to product development and risk taking? 

So the next time you watch a Pixar movie, remember that there is a fair amount of risk management behind the scenes. 

This post is part of the series "Aspects of Risk Management".  Other articles are available here.  

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‘Nudging’ Meets Enterprise Risk Management?

It is no exaggeration to say that behavioural economics has become mainstream.  With hindsight, this is not really surprising because the assumptions underpinning economic theory have always been regarded as just that: assumptions. 

The key innovation of behavioural economics are the identification of specific circumstances where there are systematic departures from rational decision making and the development of context-specific predictions of behaviour.  Broadly speaking, departures from rational decision making are referred to as ‘biases’ because outcomes are poorer than the optimal outcomes under rational conditions.  These biases may affect preferences, beliefs or decision making.   Box 1 below shows some common types of biases.

Box 1: Sample of Common Types of Biases Affecting Decision Making

Type	Bias	Description	Example of bias in consumer decision making
Preferences	Reference dependence	Assessments are influenced by the reference point for the assessment ― typically the status quo ― or by a fear of losses.  Depending on the context, this can encourage either too much or too little risk taking.	Purchase decisions are driven by alternatives or product features which are irrelevant to the consumer.
Beliefs	Over-extrapolation	Predictions are made on the basis of few observations believed to be representative from which a real pattern or trend is inferred and, as a result, uncertainty is over- or under-estimated.	The quality of financial advice is assessed on the basis of few successful investments even if these could reflect pure luck.
Decision making	Rules of thumbs	Decision making is simplified by adopting specific rules of thumb such as choosing the most familiar and avoiding the most ambiguous.	Products at the top of a list or offered by large companies are selected.

Another innovation of behavioural economics is the notion that it is sometimes possible to address those biases, and thereby enhance outcomes, by making small changes to the environment ― hence the number of books about behavioural economics with the word ‘nudging’ in the title.  I have come across nudging considerations in terms of sales (e.g. how the default option affects customers’ choices) and in terms of public policy (e.g. the introduction of cooling-off periods in financial services). 

One of the key motivating aspects of enterprise risk management is its effectiveness.  This is not just a challenge concerning an outcome at a particular point in time.  The main aspect of the challenge is putting in place a process that drives enhanced effectiveness.  This is an aspect that has not escaped EU supervisors framing risk and capital requirements for banks and insurers in the EU, which require assessments of risk management effectiveness. 

So how could these two meet?  An assessment of risk management effectiveness could seek to identify behavioural biases that affect the management of risk across the business: for example, in terms of underwriting and investments.  Consider again the biases set out in Box 1: which ones could be relevant to risk management?  If we identify the biases that shape risk management, we can also assess their materiality and consider whether there are ways of addressing them through changes in the operating environment.  If you have any thoughts about how these biases, or others, could affect risk management, I would be very interested to hear them.

This post is part of the series "Aspects of Risk Management".  Other articles are available here.  

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Risk Reviews: Not 'a Bridge Too Far'

The role of a Chief Risk Officer (CRO) and her team in the context of a three-lines-of-defence model in financial services can be best described, in my view, as ‘to protect and enable’ (click here for an earlier post on the subject).   Consistent with that, financial services supervisors in the UK and EU refer to the oversight role that the CRO's team provides. 

There are many issues and considerations in embedding effective risk management in financial services businesses.  At one level, oversight requires the CRO’s team to develop the appropriate engagement with the business to provide support, to challenge and to ensure that risk management features ultimately in decision making.  This may result in recommendations for senior management. 

On its own, this is unlikely to be adequate to evidence appropriate and effective oversight for two reasons.  Firstly, the rationale for covering certain business areas or aspects would not be evident.   Secondly, there may be overlaps with the areas reviewed by Internal Audit. 

The answer is not to restrict the engagement between businesses and the CRO’s team.  Instead, the CRO should put in place a programme of risk review which is coordinated with Internal Audit to avoid overlaps or underlaps.

A structured programme of risk reviews requires consideration of the risks to which the business is exposed and their materiality, as well as business cover.  For example, it would not be sensible to cover just one business area, even if that is the main source of risk. 

The key aspect of the development of a programme of risk reviews is identifying a number of potential reviews that map into a grid of risks, materiality and business areas.  The list of reviews is then whittled down in discussions with the CRO and the leadership team to a programme that is consistent with the scale of the business and the maturity of the CRO’s team.

The Board (or a Risk Committee) should review the proposed programme of risk reviews.  Some businesses require a combined submission from Internal Audit and the CRO to identify a complete assurance landscape.  The CRO’s team should then plan the reviews, including setting out terms of reference agreed upon with the business and delivering them throughout the year.  The CRO should also provide regular reports to the Board about the findings of the various reviews and management delivery of recommendations.

Overall, a programme of risk reviews complements Internal Audit’s activities because of the involvement of the CRO’s team on a real time basis in key business processes such as business planning and product development.  Experience suggests that overlaps with Internal Audit can be avoided and that performing these reviews enables the CRO team to get even closer to the business and embed risk management ― ‘to protect and enable’.   

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Feedback Loops and Enterprise Risk Management (ERM)

One should not take things for granted and this also applies to ERM.  In the case of ERM, this would mean identifying feedback mechanisms about the effectiveness of ERM to provide assurance to boards about the value generated.  This should also generate further insights to enhance ERM’s value added.  

This connection between ERM and value has not escaped supervisors.   On a company level, EU directives covering prudential regulation of banks and insurers include requirements that aim to formalise these feedback mechanisms.

While boards and regulators may be interested in the effectiveness of ERM in specific companies, there seems to be less evidence at an industry level.  Wouldn’t it be useful to understand the link between ERM effectiveness and the role and experience of the CRO? How does board oversight contribute to ERM effectiveness? 

These are challenging questions, which are considered in a recent working paper by Cristina Bailey, assistant professor at the University of New Hampshire, using data for publicly traded US insurers.*  There is a fair amount of statistics and econometrics in this paper which would have been covered through peer review.  There are differences between regulatory requirements on the two sides of the Atlantic, which could challenge the ability to infer from US data for Europe.  However, it would seem that ERM effectiveness is driven by the underlying business rather than regulatory requirements and that the lessons should be transferable. 

So what can we learn from this paper?  There are a number of measures of ERM effectiveness and benefits.  The effectiveness of risk management can be gauged by reference to the ratings awarded by S&P for risk management.  There are five possible ratings: very strong, strong, adequate with strong risk control, adequate and weak.  In the paper, ERM is defined as holistic risk management and is associated with the top two S&P ratings.  ERM benefits can be considered by referring to the volatility in stock returns.  ERM benefits can also be inferred using a measure of strategic industry positioning defined as the difference between the return on assets for the insurer and the top quartile.

Normally, it is important to consider the experience that the CRO brings to the role.  A number of experiences are specifically identified: oversight (e.g. prior experience as CEO or COO), financial (e.g. accountancy qualification or prior role as CFO or financial controller), industry (previous employment in the insurance industry) and risk (previous experience as a CRO or a senior risk management position). 

The analysis suggests that the breadth of the CRO’s experience is positively related to ERM effectiveness after controlling for a wide range of relevant factors.  However, this logic does not seem to apply to the expertise of the risk or audit committee.  But before you despair about the value of effective risk governance provided by a board committee, consider the impact on ERM benefits mentioned earlier by reference to volatility or strategic industry positioning.  The breadth of expertise of the committee members turns out to be a significant determinant of the ERM benefits. 

This result is a useful reminder of the difference between outputs (effective ERM) and business outcomes (e.g. risk reduction).  A potential way of pulling together these results is as follows: a CRO with broad expertise can successfully shape the effectiveness of ERM.  However, the wider ERM benefits depend on shaping the overall direction of the company which requires, amongst others, board committee members with a similar breadth of experience to act on the outputs that the CRO leading an effective ERM system would generate.  The above points to the importance of the qualities of CROs. 

Headhunters Hedley May have also published an interesting paper on the role of the CRO – and the risk function – based on discussions with CROs in banking, insurance, investment management and other stakeholders.**  Their analysis seems to support the above hypotheses about the difference between an effective ERM system and delivering business benefits such as lower volatility.  The qualities of a good CRO were found to include relationship building, influence and an ability to synthesise. These would provide the CRO with appropriate credibility in front of the board to go beyond an effective ERM and affect business decisions.

* ‘The Effect of Chief Risk Officer and Risk Committee Expertise on Risk Management', (forthcoming, www.ssrn.com)

** ‘The Post Financial Crisis Chief Risk Officer: The Teenage Years’, 2015

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Out Outsourcing?

Well, not really.  But I am sure you have heard regulatory concerns about the lack of appropriate controls around outsourcing in financial services.  It is therefore not entirely surprising that the UK’s Prudential Regulation Authority (PRA) has recently fined a bank £1.2 million for failures in the controls associated with outsourcing (here).  There are, however, a number of interesting points about this enforcement case that have broader lessons about the supervisory expectations associated with the use of outsourcing in financial services.

1.  The regulatory expectations with respect to outsourcing within a group or to a third party outside the group are the same.  I have heard this before but I was still expecting to see a recognition that there may be a difference.  I could not really find an obvious distinction in the enforcement notice.  This is particularly relevant in financial services where brands are typically a collection of companies, sometimes with a core staff serving a number of companies, in particular with respect to finance (and, in insurance, actuarial).  This also has implications for risk functions which will also need to articulate how their oversight relates to the various companies.

2.  The outsourcing arrangements are documented appropriately in a timely manner. While putting contracts in place within a group is probably understood to be a regulatory expectation, there are two important dimensions that this case highlights.  The first of these is the importance of putting contracts in place at the outset and undertaking due diligence; bear in mind point 1 above.  This also includes signing the contracts!  Secondly, in the case of internal outsourcing involving a control function, it is important that the roles and responsibilities of the various parties are clearly defined.  This can include determining the different roles of people and teams probably sitting near each other.

3.  The legal form of the outsourcing provider does not matter.  A JV form that effectively provides an outsourcing activity should also be treated as outsourcing. 

4.  The consequences of a lack or breakdown of controls matter a great deal.  If the finance function is outsourced within the group, then a breakdown can have severe financial implications (e.g. unauthorised payments) and can include misreporting of the capital and liquidity position to the PRA.

Last but not least, the response when the issue is discovered remains crucial.  In this case, it involved terminating certain outsourcing contracts and putting in place new ones, transferring finance teams to the relevant company and ensuring operational separation of the Bank from the rest of the group.  In addition, the bank commissioned a firm of accountants to review the matter, undertook its own review of all outsourcing contracts and was subject to a skilled persons review by the PRA.  As in other cases, the fine may not have been the largest cost to the bank.

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This post is part of a series of posts on the practical lessons for risk management from enforcement cases.  The posts are all brought together in the page Enforcement Cases of the blog.

Risk Management Lessons From the Co-op Bank's Demise

One of the fallouts from the financial crisis in the UK was the demise of the Co-op Bank as part of the Co-operative movement.  The UK regulators (the PRA and the FCA) investigated the causes of the bank’s demise and issued simultaneous enforcement notices earlier this year (here and here).  The key failures identified by the regulators are summarised in Box 1. 

One of the key points for the press was the regulators decision to waive any financial penalties, reflecting the financial conditions of the Coop Bank.  However, from a risk management perspective, the enforcement notice represents an interesting catalogue of lessons in risk management for both banks and insurers: 

1.  Risks and business strategy go hand in hand.  It is difficult to manage risks effectively in the absence of a clear and comprehensive strategy for key lines of business. 

2.  A ‘cautious’ risk appetite statement is not enough.  Business decisions still must be evidenced as ‘cautious’ in practice even if this happens on a qualitative basis. 

3. The remit of the risk function includes valuations and accounting decisions.  This is particularly relevant in terms of the challenge and governance to (changes to) assumptions associated with discretionary features about valuation e.g. about the timing of redemption of capital instruments.   

4.  Policies are more than documents.   Compliance with policies must be evidenced.  A complex and changing business reality cannot be captured through prescriptive policies.  Certain discretions must be factored into decision making processes.  The risk oversight should cover how those discretions are applied in practice.   

5.   An open and cooperative relationship with the regulators is not just about issues.  It includes updating the supervisor regarding concerns about the position of senior individuals leading to intended changes.

6.  An effective risk culture is an outcome of business decisions about risk.  This was one of the concerns of the regulators.  The regulator’s articulation of an effective risk culture is interesting: ‘A culture in which accepted orthodoxies are challenged, action is taken to address risks on a timely basis and risk and control functions carry real weight is likely to support prudent management.’  In a nutshell, a risk culture is not end in itself but the means to support prudent management.

The enforcement notice mentions other issues regarding the shortcomings of the risk management oversight and internal audit. 

Finally, it is worth noting that the period of time formally considered by the regulators stretches from July 2009 – weeks before the Co-op Bank’s merger with the Britannia Building Society – to December 2013 – when it ceases to be a wholly owned subsidiary of the Co-op Group.   I don’t think the shortcomings just materialised in July 2009. 

This suggests that the perceived connection between responses to the financial crisis and strengthening risk management may not have been as widespread as it might have seemed.  The shortcomings are clearly serious and while they may not be critical when taken individually or addressed within a short period of time, it is the cumulative impact that had the effect of bringing the Co-op bank's demise.    

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This post is part of a series of posts on the practical lessons for risk management from enforcement cases.  The posts are all brought together in the page Enforcement Cases of Crescendo ERM blog.

Capital Markets, Financial Crisis and ‘Diversions’

Sometimes the same word can have different meanings in different languages.  One example is 'diversion'.  In English it means typically a different way.  However, in Spanish 'diversion' means having fun.  I guess that when you take a different way, it can be fun.

Once upon a time, I spent time assessing the efficiency of UK equity markets.  The key idea was that if markets are efficient and there is no manipulation (e.g. information leakage), then we should be able to use the logic of event studies and test that there are no abnormal equity price movements before a corporate announcement.  I moved on, and the initial work was eventually carried out.  It was published by the FSA (here) and as far as I can recall, it made it as far as the front page of the Financial Times! 

I thought that it would be a good diversion from my current activities to read something about capital markets.  I came across an interesting paper on market efficiency published in Institutional Investor (here).  The paper was written in the wake of the award of the 2013 Nobel Prize in Economics to three economists, including Eugene F. Fama and Robert J. Shiller.  What made the award interesting is that it recognises the challenges of assessing efficient markets; Fama pioneered the notion of efficient capital markets and Shiller has challenged it.  (The third Nobel laureate was Lars Peter Hansen who, as I understand it, deserves it for his work on the maths of finance.)

The paper is an interesting tour of many years of research by the authors – applied and academic.  It explains in simple language the ‘joint hypotheses’, i.e. the need to test jointly the assumption of efficient capital markets with an equilibrium pricing model, usually capital asset pricing model (CAPM), and the potential implications, e.g. the market may be efficient but assets may not be priced according to the CAPM

The paper also provides a clear articulation of the challenges to the efficient market hypotheses.  One of the responses is to test alternatives to the CAPM model, e.g. momentum strategies.  One of them is that there are behavioural biases, e.g. investors overreact to both good news and bad news, and capital markets are not efficient.  Overall, the authors come out in favour of efficient markets, ‘at least as the base case’, without committing to a view that markets are ‘perfectly efficient’.  One of the implications of less than perfect efficiency of capital markets is that market arrangements, including regulation, matter to some degree.

In my view, the best point made in the article is the consideration of the link between belief in market efficiency – ‘market fundamentalism’ – and the recent (or ongoing) financial crisis.  As the authors put it, financial crises are not created by someone buying something that he thinks is a fair deal in an efficient market.  Financial crises are created by people that think that markets are inefficient, i.e. an impossibly good deal is available and will continue to be available.   

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Is the Governance Map Also the Territory?

One of the financial crisis’s lessons for regulators has been discovering the ‘accountability firewall’ of collective responsibility which prevents actions against individuals even if they are approved for specific roles.  This was one of the lessons from the UK Parliamentary Commission on Banking Standards from 2013.

UK regulators have been tasked with the challenge of breaking down that ‘firewall’ for both banks and insurance.  The UK has had a regime of approved persons for some time.  The PRA and the FCA have been consulting on proposals aimed at strengthening the accountability of senior management.  For insurers, this is referred to as the Senior Insurance Managers Regime (SIMR).

The proposals may well increase the scope of senior managers, and will strengthen conduct requirements that apply to them.  It seems to me that the most innovative (and, dare I say, revolutionary) aspect of the proposals is the requirement that firms produce a ‘governance map’.   As with all good ideas, it is simple.  The regulator identifies a set of responsibilities and then asks firms to map them to senior managers who are subject to regulatory approvals and sanctions.  

The list of responsibilities is long.  For example, the list for insurers is as follows:

1.       ensuring that the firm has complied with the obligation to satisfy itself that persons performing a key function are fit and proper;

2.       leading the development of the firm’s culture and standards;

3.       embedding the firm’s culture and standards in its day-to-day management;

4.       production and integrity of the firm’s financial information and regulatory reporting;

5.       allocation and maintenance of the firm’s capital and liquidity;

6.       development and maintenance of the firm’s business model;

7.       performance of the firm’s Own Risk and Solvency Assessment (ORSA);

8.       induction, training and professional development for all the firm’s key function holders;

9.       maintenance of the independence, integrity and effectiveness of the whistleblowing procedures, and the protection of staff raising concerns;

10.   oversight of the firm’s remuneration policies and practices.

For banks, there is no direct equivalent to 7 even if there is an ICAAP.   However, the list includes the following additional responsibilities:

1.       funding is also mentioned in 5. above as well as an additional responsibility in respect of the bank’s treasury management functions;

2.       developing a firm’s recovery plan and resolution pack and overseeing the internal processes regarding their governance;  

3.       managing the firm’s internal stress-tests and ensuring the accuracy and timelines of information provided to the PRA and other regulatory bodies for the purpose of stress testing; 

4.       safeguarding the independence of and overseeing the performance of the compliance function, internal audit and risk function respectively; these are three different responsibilities.

There are some interesting differences between banking and insurance.

The overall message is rather simple: there is an individual presumption of responsibility in the event of a breach.  In those cases, the relevant individual will need to demonstrate that he took reasonable steps to prevent the breach in the relevant area. 

Firms’ senior managers will spend time discussing the mapping of responsibilities.  This may well be the easy part.  Undoubtedly, the challenge for senior managers will not be the map, but the territory, i.e. how to manage the relevant responsibility.  For some responsibilities there will processes, teams and awareness within the company to ensure that something happens; think of item 7 above, the ORSA.  In other cases, the challenge will be determining which business function will assume the relevant responsibility and what approaches, processes and resources will be needed as evidence that reasonable steps were taken.  What should be done to prove that ‘firm’s culture and standards’ are developed and embedded?  

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Securitisations and Solvency II: An opportunity? Or one to be missed?

To put it mildly, securitisations did not a get a good reputation as a result of the financial crisis.  Things are now changing.   This is illustrated well in a discussion paper from the Bank of England and the European Central Bank extolling the virtues of securitisations (here).    It is difficult to disagree with the key message; securitisations can be a win-win transactions that enhances the ability to redistribute risks more efficiently in the economy while enabling institutional investors to access a wider pool of investment.  

The Solvency II Delegated Acts (‘implementing measures’) built up a more favourable capital treatment for securitisations.  It is now recognised as a category of its own for the purposes of spread risk.  This evolution can be evidenced in the Commission’s Impact Analysis published at the time of the publication draft Delegated Acts (here).  As recognised in the Delegated Acts, this even includes recognising the name ‘securitisation’ instead of the name used in the Solvency II Directive in 2009: ‘investment in tradable securities or other financial instruments based on repackaged loans’.

As one would expect, the calibration of the standard formula spread risk for securitisation reflects the maturity of the exposure and its credit rating.  However, there is an interesting innovation.  The Delegated Acts identify two types of securitisation exposures: ‘good’ and ‘bad’, or in policy terms, type 1 and type 2.  The criteria are set out in the Delegated Acts and are quite detailed.  

Exposures of type 1 must meet 20 conditions including a rating of ‘BBB’ or above, the seniority of the exposure in the securitisation, SPV arrangements, listing in an OECD or EU exchange, and backing by residential loans, commercial loans or auto loans and leases.   The list of conditions is somewhat shorter for securitisations that were issued before the Delegated Acts came into force. Type 2 securitisations are simply those not meeting these criteria.  

Figure 1 shows the significant difference that meeting the conditions for type 1 makes to the capital charges.  It is a noticeably a more important consideration than the rating or maturity of the exposure.  

Figure 2 shows an alternative view of the spread risk capital requirements for type 1 securitisations compared against the equivalent ones for corporate bonds of equivalent ratings.   The differences aren’t that large in particular for short maturities.

All this raises a number of interesting considerations for an insurer’s capital management strategy. 

Firstly, there may be tactical adjustments where insurers find that they are holding type 2 securitisation paper as part of the Solvency II implementation work.  In this case, the insurers may seek to dispose of these investments before 1 Jan 2016 to avoid the capital increases that Figure 1 suggests.  However, given insurers’ relatively small holdings of securitisations, this may not be a material issue.

The bigger issue is the extent to which there is an appetite to consider the capital treatment of type 1 securitisation as a more strategic opportunity and readjust investment strategies.  Indeed, would it be possible to do so before 1 Jan 2016 to enhance the matching of cash flows of annuity liabilities and subject to Matching Adjustment? 

In any event, Figure 2 above suggests that there may be an interesting question about the risk and return trade-off of corporate bonds versus type 1 securitisations.  Would the returns from securitisations be sufficiently higher to justify the additional capital requirements?  Figure 2 suggests that for low maturities, e.g. up to 7 to 10 years, this could be finely balanced in particular for ‘BBB’ bonds.  If so, would insurers be willing to tilt their investment strategies to include more type 1 securitisation?  The answer to this question requires appropriate consideration, cash-flow matching including risk appetite, stress testing and governance.   

However, even if the risk and return trade-off mentioned above appears appropriate, it seems that there may be a limited supply of type 1 securitisations.  If so, there would be a limited opportunity for insurers in the short to medium term.  This would be more of an opportunity for investment banks to structure securitisation transactions.

This post is part of a series of posts on Solvency II.  To see the list, click here. 

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Reverse Stress Testing (RST): The Return of ‘Adequacy’

RST is one of the additional challenges that financial regulators have added following the financial crisis.  I spoke today on the subject at an event organised by the Institute of Risk Management. 

The effective implementation of RST builds on the articulation of the underlying business model.  This is something that UK supervisors have put on the agenda recently to signal a more holistic approach to supervision.  I have written a number of posts on the subject which you can access here.   

There are a number of challenges to deliver a RST.  The return of ‘adequacy’ might seem an odd title for my presentation.  It seeks to convey a simple message about the main challenge of RST: the assessment and judgement about the resilience of the business model.  It’s a ‘return’ because the term ‘adequacy’ used to be more prominent.  You may remember the Capital Adequacy Directive before it became the Capital Requirement Directive.  Anyway, the graph below seeks to illustrate the challenge of adequacy, which also serves to bring on a page the various stress and scenario tests that banks and insurers are considering on a regular basis. 

The key message from the graph is that if business failure scenarios are ‘close’ to the 1-in-200 scenarios, the adequacy of the business model and the strategy could be challenged.  Management may need to consider how to mitigate the risks to the business model. 

The full set of slides is available here.

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