Getting Independence Right
Independence of the risk function is very important. But often, the wrong part of the risk function is made independent.
It is the RISK MEASUREMENT AND REPORTING part of the risk function that needs to be independent. If this part of the risk function is not independent of the risk takers, then you have the Nick Leeson risk – the risk that once you start to lose money that you will delay reporting the bad news to give yourself a little more time to earn back the losses, or the Jérôme Kerviel risk that you will simply understate the risk of what you are doing to allow you to enhance return on risk calculations and avoid pesky risk limits.
When Risk Reporting is independent, then the risk reports are much less likely to be fudged in the favor of the risk takers. They are much more likely to simply and factually report the risk positions. Then the risk management system either reacts to the risk information or not, but at least it has the correct information to make the decision on whether to act or not.
Many discussions of risk management suggest that there needs to be independence between the risk taking and the entire risk management function. This is a model for risk disaster, but a model that is very common in banking. Under this type of independence there will be a steady war. A war that it it likely that the risk management folks will lose. The risk takers are in charge of making money and the independent risk management folks are in charge of preventing that. The risk takers, since they bring in the bacon, will always be much more popular with management than the risk managers, who add to costs and detract from revenue.
Instead, the actual risk management needs to be totally integrated within the risk taking function. This will be resisted by any risk takers who have had a free ride to date. So the risk takers can decide what would be the least destructive way to stay within their risk limits. In a system of independent risk management, the risk managers are responsible for monitoring limit breaches and taking actions to unwind over limit situations. In many cases, there are quite heated arguments around those unwinding transactions.
Under the reporting only independence model, the risk taking area would have responsibility for taking the actions needed to stay within limits and resolving breaches to limits. (Most often those breaches are not due to deliberate violations of limits, but to market movements that cause breaches to limits to grow out of previously hedged positions.)
Ultimately, it would be preferable if the risk taking area would totally own their limits and the process to stay within those limits.
However, if the risk measurement and reporting is independent, then the limit breaches are reported and the decisions about what to do about any risk taking area that is not owning their limits is a top management decision, rather than a risk manager decision that sometimes gets countermanded by the top management.
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