Better risk management discipline might have helped prevent the credit crisis

Banks must go back to basics and create a framework with three key lines of defence

London, 30 October 2008 - While a number of external factors have been blamed for the credit crisis, banks with better risk management discipline have prevented the huge losses seen by other financial institutions, argues a report published by Booz & Company, a leading global management consulting firm.

The authors of the study, Bringing back best practices in risk management, argue that the relentless drive for profits in the boom years led to a weakening of the risk culture of many organisations. In a generally benign pre-crisis environment this led to veiled, yet intense pressures on risk management departments to approve risky transactions.

As Charles Teschner, partner of Booz & Company, commented: “During the boom years, banks overstretched themselves and took on increased risks on their balance sheets that they did not necessarily understand.”

The report argues that a return to basics – in particular a strong risk culture combined with a sharp focus on the three effective “lines of defence” is essential for future financial stability. The three areas of risk management that must be observed are:

1. Front Office. There are three key characteristics of the front office in organisations that manage risk successfully – sustainable risk-return thinking; usable, up-to-date risk-related information; and respect for limits and other basic controls.

2. Risk. Effective risk managers need to go beyond the traditional role of ‘limit cop’ and also require a supporting organisational structure with the authority to enforce actions and impose sanctioning mechanisms where appropriate. Additionally they must understand the key principle: “how does the business make money?”

3. Internal Audit. To act as an effective steward of the policies and procedures approved by the board, internal audit teams need to have both a good understanding of the business and a deep understanding of risk management. This line of defence must also develop a strong critical approach to each functional discipline, performing more than just a ‘checking the checkers’ role.

Dr. Peter Golder, principal at Booz & Company commented: “A strong risk culture, combined with a sharp focus on the three effective ‘lines of defence’ would have prevented many losses – and actually did so at a small number of banks. Three lines of defence, all staffed with capable individuals imbued with a strong sense of risk awareness are at the heart of effective risk management.”