Risk: the Nature of the Beast

When I first started working in banking, I didn't have much idea about risk,

Then I was told about market and credit risk, the two major forms of trading risk in the mainstream markets.

Put simply: market risk is the risk of losses from trading whilst credit risk is the risk of the counterparty being unable to pay.

Simple.

Then came Barings Bank and the downfall of an institution that was a bedrock of investment banking.

The issue lay with Nick Leeson, who was trying to cover his unauthorized loss-making by taking bigger risks.  Unfortunately, bigger risk meant bigger losses and the market became intimate with operational risk.

Operational risk is the exposure internally to something going wrong.

That could be a rogue trader, a systems outage, an embezzling staff member or any other range of internal operational failures.

Over the years since then, there have been many other risk issues tabled: environmental risk, reputational risk and, most recently, liquidity risk.

When I wrote my first book back in 2007, there was no mention of a credit crisis, subprime or liquidity risk because the market failure of Bear Stearns, Northern Rock and Lehman Brothers were still to come.

We all believed that the good times rolled and roll they did ... right into the bad times.

Now we are aware of a liquidity crisis and so we deal with this one too.

Nevertheless, being aware of risk does not mean that risk is mitigated as there are so many other variables.

Just before the crisis hit, I remember presenting to the Royal Bank of Scotland's Risk Managers annual meeting in Gogarburn, the bank's headquarters.

These were the senior manager's representing all aspects of risk management worldwide for the group, and about 300 people attended.

The Chief Risk Officer took great delight in mentioning that there were around 2,500 risk managers in RBS globally.

What were they doing? you may wonder.

And the answer is: their jobs.

Each risk manager is managing an element of risk: market, credit, operational, liquidity, reputation and more.

The issue is that these are not joined up and, more importantly, are often used to offset each other.

Kweku Adoboli at UBS and Jerome Kerviel at Société Générale both felt encouraged to take greater risks to get greater returns by their management and team.

In other words, the culture created operational risk, and that risk was based upon gaining greater returns at the expense of market and credit risk indicators.

This should have been offset by the management radar, but often the management radar is muted by incorrect goals, objectives, remuneration and rewards.

Take RBS again.

When I asked about the difference between the RBS culture and the ABN attitude towards risk, they told me that RBS had final sign-off with the CEO whilst ABN gave ultimate veto to the Chief Risk Officer when it came to taking onboard risk.

This is the nature of the beast and the core of banking is to excel in risk management.

It is this core competence alone that differentiates the winners and losers.

You can have a 1% Tier One Capital Ratio in one bank that has risk management excellence and never lose a cent; meanwhile, you could have a 10% capital ratio in another bank which, if its risk management is under par, could lose you millions.

This is what we have seen in most institutions, with firms such as Goldman Sachs being highly adept at offsetting risk, sometimes at the expense of their clients; whilst others that appear to excel, such as JPMorgan, are never bulletproof as demonstrated by their London Whale.

So risk is a complex, multi-headed beast that must be tamed if a bank is operate without failures, but there will always be failures as no institution can be 100% risk-free.

If it were, it wouldn’t be a bank.