Keeping up with Old ERM Programs – 10 Investor Questions (7)

Riskviews was once asked by an insurance sector equity analyst for 10 questions that they could ask company CEOs and CFOs about ERM.  Riskviews gave them 10 but they were trick questions.  Each one would take an hour to answer properly.  Not really what the analyst wanted.

Here they are:

  1. What is the firm’s risk profile?
  2. How much time does the board spend discussing risk with management each quarter?
  3. Who is responsible for risk management for the risk that has shown the largest percentage rise over the past year?
  4. What outside the box risks are of concern to management?
  5. What is driving the results that you are getting in the area with the highest risk adjusted returns?
  6. Describe a recent action taken to trim a risk position?
  7. How does management know that old risk management programs are still being followed?
  8. What were the largest positions held by company in excess of risk the limits in the last year?
  9. Where have your risk experts disagreed with your risk models in the past year?
  10. What are the areas where you see the firm being able to achieve better risk adjusted returns over the near term and long term?

They never come back and asked for the answer key.  Here it is:

One of the most difficult things to accomplish in any organization is continuing to do well the things that were well developed in the past but that are not longer on the “front burner”.

Top management needs to limit attention to the most pressing problems.  So an existing program that is working well is just not likely to get much, if any, top management attention.  Continuing to get it right for the old tried and true parts of the organization is however of vital importance to the success of the organization.

Therefore Middle Management needs to be the keeper of these programs.  In some organization, this actually puts them at odds with top management priorities. Some Middle Managers, the lifers who are more loyal to the organization than to the current top management, will manage to do this under almost all circumstances, risking even their own positions to keep these vital programs going.  Other Middle Managers will feel that they are more loyal to the current management who put them in their positions.  They will reduce resources and even Middle Management attention to these old programs.

So far, this discussion could be about anything.  It does apply to risk management along with many other programs.  Old risk management programs are the base that new Enterprise Risk Management programs are built upon.  The old risk management programs are usually what creates the actual risk level of the firm that ERM then tries to manipulate.  However, if the firm brings in too many new risk managers who do not understand the importance of the old risk management programs, then they are likely to let them wither.

This is a major factor that causes the presumptions of the ERM program to be untrue or unstable.

The trick to this question is that the answer will tell you whether the CEO  is aware of any of this dynamic.  CEOs can be temporarily very successful by shifting all management attention to new products, or markets or programs, such as ERM.  For some period of time, the old risk management programs will continue to operate without any management attention, giving the firm a short free ride.  Eventually, those programs will wither away and the company will start to be hurt because the failure of these old programs that had an unrecognized, but bery real benefit.

A clear example of this is the area of Credit Risk underwriting.  Ten to fifteen years ago, every major financial institution had large credit underwriting staffs and a very carefully administered system for reviewing and coming to an agreement on credit quality of each opportunity for a loan or other extension of credit.  But with the development of trading desks, credit underwriting lost the attention of management.  Eventually, it simply stopped happening in many institutions,  Credit shifted to the trading paradigm.  However, the credit underwriting had a purpose and when it stopped happening, the presumption that credit positions had certain characteristics slowly had less and less meaning.  Until at the height of the credit crisis, a large number of institutions all believed and acted on that belief that very low credit quality positions in sub prime mortgages were actually of the very highest quality.  A small amount of work by an experienced credit underwriting team would have shown that presumption to be totally untrue.  (One firm who didn’t do credit underwriting, but did believe in reality checks sent their traders to spend some time each quarter applying for mortgages in the hottest markets.  Those traders wouldn’t touch any mortgage related exposure.)

So the best answer to this question would be for the CEO to understand the old risk management programs that create the presumptions that their visions for the future are based upon.  And to hear that the CEO values those programs.  As to how the firm keeps those programs going, the fact that the CEO can say the above two statements is probably enough in most firms.  As long as they do not undermine their words by cutting off funding to those old programs.

For extra credit, see if the CEO can actually list these old programs.

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