Some banks have an idea, albeit vague, about performing risk assessments. But few have made real progress in planning or actually implementing a Risk Assessment Program. Here is a practical approach that demystifies the process so you can get going!
Boards of directors have become increasingly aware of the need to manage the wider range of risks across the banking enterprise. They are looking for ways to meet their fiduciary responsibilities, manage their own personal liability and improve the business. They are asking about, and in some cases, are pushing strongly for a more coordinated and comprehensive process of managing risks − enterprise risk management (ERM), in other words.
At the heart of any ERM program is the risk assessment. And for some banks, the ability to perform a risk assessment poses a significant challenge.
Most bankers are already functioning at full capacity and adding to their workload will not be easy. Moreover, what exactly does ERM work look like? C-level officers are frequently at a loss on how to get started or how to make meaningful progress. They may question how risk assessments will enable them to more effectively manage compliance issues.
A “core risk assessment project” is a practical way to take advantage of what is currently being done in the bank and move forward while managing costs in a tight budgetary environment. The starting point is to identify the effectiveness of risk-related activities the bank has already put into place. Gaps can then be identified and prioritized, leading to significant progress on the journey to a more integrated, efficient and value-driven approach to risk management.
Enterprise risk management has been discussed since before Y2K (remember that?), yet it has been rarely implemented effectively. Professional associations, internal audit groups, bank directors and chief risk officers have been hearing about ERM at conferences and seminars and there is no shortage of articles about ERM in trade publications. However, the discussion has remained largely academic and not actionable. In that light, the regulatory agencies have taken up ERM as a principal focus in their examination process and here’s how the OCC views the issue:
“The OCC expects bank management and the board to oversee all new, expanded, or modified products and services through an effective risk management process. Failure to provide an effective risk management process is an unsafe and unsound banking practice. An effective risk management process includes: (1) performing adequate due diligence prior to introducing the product; (2) developing and implementing controls and processes to ensure risks are properly measured, monitored and controlled; and, (3) developing and implementing appropriate performance monitoring and review systems. The formality of the bank’s risk management process should reflect the size of the bank and the complexity of the product or service offered. Depending on these factors, it may be appropriate for the bank to establish an executive management committee to oversee development and implementation of bank products and services.”
While there is a genuine need for risk management, it is unreasonable to expect senior executives to fully understand the risks, and the interrelationships of the risks that their people are taking, without the use of improved tools and better methods.
In many organizations, operational risks are being managed but frequently in haphazard and fragmented ways. Many banks lose sight of the big picture and do not sufficiently link risk management activities to their business strategies. Some risks are being identified and managed, but only with limited coordination. Other key risks are not even on the radar screen. Many activities are restricted to a controls-based approach with individual requirements being managed too narrowly. There is minimal or no coordination to take advantage of the value available in aggregating these risk management activities within an effective overall risk management approach.
The consequences of fragmented approaches can result in substantial reputational exposure and regulatory criticism. The challenge most community banks face is getting beyond the talking stage and understanding what needs to be done, and then getting on with it in a coordinated, uniform manner that does not require “reinventing the wheel” every year.
Let’s look at the benefits of a well established risk assessment program:
- It establishes the inherent risk for each area under review
- It establishes thresholds for risk appetite and risk tolerance
- It establishes the Key Risk Indicators (KRIs) in a way that promotes a broader understanding of risks
- It provides for measuring the probability of an adverse event or condition and the consequent impact
- It provides a “residual” risk that establishes an overall risk profile for the bank
- It puts in place a process to highlight the key risks, set an action plan, and then establish accountability for risk mitigation
- It provides a consistent, uniform way of looking at risk at three different but connected levels: from a management perspective; from a Board perspective and from a bank examiner’s perspective
- It enables organizational alignment to manage the risks and control the costs
- It allows the bank to take on and effectively manage risks that its competitors cannot
Risks to banks are categorized in operational, financial reporting and compliance areas – the three objectives of the integrated framework modified by the Committee of Sponsoring Organizations (COSO) in 2013. The illustration below looks complicated, but you needn’t fret about it. Just know that this universal framework has been designed to help foster an understanding of the dimensions of risk for those persons charged with risk program development. We’ll demystify all of this for you as you read further.
COSO’s visual model for ERM resembles a complex Rubik’s Cube®, and it is daunting to many bankers. In addition to the three risk objectives mentioned, there are five stages in the COSO ERM integrated framework representing what is needed to achieve each of the objectives (operational, reporting and compliance).
Reading from top to bottom, the five components start with “Control Environment” and conclude with “Monitoring Activities,” and there is a clear sequence of activities; some of the interim stages include “Risk Assessment” and “Risk Response.”
The remaining visible side of the cube outlines different levels of the organization. The categorization starts at the broadest level, the entity (or entire enterprise) and proceeds to a subsidiary level. This element of the model is designed to be tailored to each business line of the bank depending on organizational structure. Judging from the complexity of the COSO ERM model, the accompanying framework and separate risk assessment techniques, implementing ERM using this model as a starting point will not happen in most banks unless they have considerable resources and flawless project management skills.
So, What’s the Solution?
Enterprise risk management is a worthy goal for all banks, regardless of size. Risk management activities need to be tied to strategy and ultimately built into everyday business processes. The following project plan can enable banks to identify and coordinate activities they already have begun, identify risks not adequately managed, close gaps, and move forward. The steps of this plan are: 1) organizing your team; 2) establishing a framework; 3) assessing risks; 4) inventorying current risk-response activities; and, 5) closing the gaps.
Leveraging existing knowledge and programs will go a long way to helping reduce the effort in getting started. For example, internal audit, the compliance officer, the IT security officer and your risk officer (if you have one) have probably already conducted some type of risk assessment.
Here’s how to do it. . .
- Organize the Effort: Bring resources together to coordinate your activities
To start on the right foot, it is important to assemble the right people and agree on timelines and objectives. Organizing requires assembling all the department heads and managers who have responsibilities for risk management activities to oversee the project and guide what will be done, when and by whom. The risk assessment processes need to be built with these stakeholders in mind and designed to suit the needs of the bank. Since the risk assessment is ultimately strategic in nature, it will never succeed without support from the Chief Executive Officer and other C-suite officers. It may be helpful to include the Chief Financial Officer, Chief Operating Officer, Internal Audit Director, Legal Counsel and, of course, the Chief Risk Officer, if you have one, into the process.
- Establish a Framework Around Risk: Develop a model but keep it simple.
The risk assessment model should be comprehensive and useful, particularly for smaller banks where investment in risk assessment tools may have limitations. At TraceRisk, we have found that Software-as-a–Service (SaaS) offers the most cost-effective and readily implementable solution for performing the risk assessments. The approach to get started is one that works from a basic and logical model: Identify – Assess – Mitigate. “Identification” means knowing the key risks (KRIs); the “Assessment” stage involves scoring the probability and impact of events and conditions; and, the “Mitigation” phase means dealing with residual risks (mitigation).
A common understanding of some other key terms will be helpful so team members are on the same page when it comes to comprehending risk concepts, performing risk assess-ments and implementing risk management. Here are some of the most common terms:
- Risk Appetite: The amount of risk that a bank is willing to seek or accept in the pursuit of its long term objectives.
- Risk Tolerance: The boundaries of risk taking outside of which the bank is not prepared to venture in the pursuit of its long term objectives.
- Risk Universe: The full range of risks which could impact, either positively or negatively, on the bank’s capabilities.
- Risk Capacity: The amount and type of risk the bank is able to support in pursuit of its business objectives.
- Risk Target: The optimal level of risk the bank wants to take in pursuit of a specific business goal.
- Risk Limit: Thresholds to monitor that actual risk exposure does not deviate too much from the risk target and stays within the bank’s risk tolerance/risk appetite. Exceeding risk limits will typically trigger management action.
- The Business Context: This includes understanding the state of development of the bank as a business, its size, industry sector, geographical spread and the complexity of the business model.
- Risk Management Culture: This addresses the extent to which the board (and its relevant committees), management, staff and regulators understand and embrace the risk management systems and processes of the bank.
- Risk Management Processes: This refers to the extent to which there are processes for identifying, assessing, responding to and reporting on risks and risk responses within the bank.
- Risk Assessment: This refers to the bank’s identification of inherent risk, the probability of adverse events or conditions, the impact of such events or conditions, the resultant residual risk, an explanation of how risk conclusions were reached and what actions are planned or taken relative to the level of residual risk.
- Risk Management Systems: This means the extent to which there are appropriate IT and other systems to support the risk management processes.
- Risk Capacity: The resources, including financial, intangible and human, which a bank is able to deploy in managing risk.
- Risk Management Maturity: The level of skills, knowledge and attitudes displayed by people in the bank, combined with the level of sophistication of risk management processes and systems in managing risk within the bank.
- Risk Capability: A function of the risk capacity and risk management maturity which, when taken together, enable a bank to manage risk in the pursuit of its long term objectives.
- Propensity to Take Risk: The extent to which people in the bank are predisposed to undertaking activities the impact, timing and likelihood of which are unknown, and which is influenced by financial, cultural, performance and ethical considerations.
- Propensity to Exercise Control: The extent to which people in the bank are predisposed to take steps to change the likelihood, timing or impact of risks, influenced by financial, cultural, performance and ethical considerations.
- Performing the Actual Risk Assessment: Avoid getting lost in the details. Start off by thinking broadly about risk and then become more detailed.
Most community banks are already doing a good deal of risk management, but the processes and reporting are often isolated, inconsistent and fragmented. Risks related to internal controls over UDAAP for example, are under scrutiny because of Dodd-Frank. ECOA risks are managed centrally in many banks while at others, it is de-centralized. In some banks, Fair Lending risks are never even measured at all! At this point it is important to ascertain how much your bank is already doing to manage risk. Your team will need to interview key people and ask questions in an open-ended way using Key Risk Indicators (KRIs) as guidance (the “Identification” phase).
Likely candidates to interview include the Compliance Officer, the BSA Officer, the Security Officer (physical and IT/Data) the Chief Credit Officer, heads of business units and your marketing officer. Use Key Risk Indicators to establish a dialogue that brings out the reality of compliance risk without suggesting what it should be.
Rather than thinking in narrow terms, start off by thinking about the largest risk your bank faces: not achieving its overall business objectives. These objectives emerge from the strategic direction set at the highest levels of the bank. Then, begin to identify what the top 10 risks at your bank could be and how they affect the bank’s overall strategic objectives. Confining your list to 10 key risks (or 5, or 15, depending on your bank) in this early stage will keep your team focused on the big picture rather than becoming mired in details.
Once you have corralled the top 10 risks, you can break them down by subject, regulation, department or any other criteria that suits your bank or approach so you can begin to assess the specific risks and get closer to the actual “residual risk” levels (the amount of risk left over after mitigation techniques have been applied). This is the “assessment” phase.
A good assessment tool will help you identify a universe of 25 to 40 risks per subject (i.e., products, services, functional areas) so you can learn where risks reside throughout the bank and you can assess their significance. Residual risks will not be the same for any two banks. For some banks, the significance of their geographic area poses higher risks than other financial institutions. In other cases, product risk will have higher risk implications. Still others may face bigger risks when it comes to pricing. It is up to the team to collaborate across the bank’s array of products and services to identify, understand and mitigate the residual risks.
Developing strong risk assessments will not require discontinuation of existing risk activities and starting from scratch. Instead, you can build on existing activities that have proven value and transfer the data into a risk assessment analysis model to achieve a more holistic outcome.
- Identify Gaps and Prioritize: Compare your inventory of current risk responses to the top 10 priorities.
Now that you know the risks that can impede achievement of your bank’s business objectives, along with the risk response activities currently being conducted, you can study the residual risks. Which risks are being adequately managed? Which ones are missing from the radar screen? Where is an initiative already in place that help you to better understand and manage risks?
Once the residual risks by subject have been assessed, the next step is to develop an approach to close the gaps (this is the “mitigation” phase). This begins with prioritizing which gaps have the greatest potential to derail achievement of your bank’s business objectives. Which would require the greatest deployment of human or financial capital? Which ones would demand outside resources? Which ones could be accomplished in the shortest time?
Many elements of your bank’s existing structure may be sufficient and will be retained, but significant gaps will probably be found. These may be in risk management leadership, risk assessment methodology, specific technical skills, common processes or technological capabilities. Internal cultural biases or paradigms may need to be changed as well.
After weighing the urgency and the resources required, you then can develop specific strategies to close the most critical gaps. While keeping the desired end result in mind, each of the strategies can be slotted into an implementation plan, complete with action steps and a timeline. A process will need to be established for ongoing reporting of the progress to mitigate the risks, as well as periodic reassessment of the risks being tracked.
Discuss ways to move forward with members of your team and let members of this group direct you to the appropriate people for answers. Also, be alert for new risks, whether arising from the environment, regulatory changes, competitors or new products. You’ll need to include recommendations to guide the bank to improve ongoing risk assessment processes. Decisions will need to be made on how to best manage a risk and where it should be managed. Will you centralize certain activities, or embed them in specific processes or business units?
Assessing risk is a journey. A well-defined and supported risk assessment project enables the bank to “jump start” the process, rather than delaying moving forward because the concept seems grandiose, costly and unworkable. In fact, delaying further on assessing enterprise risk can very likely lead to regulatory action in the form of a “Matter Requiring Attention” or worse, compelling your bank to develop and implement a risk assessment program within a timeframe set by the regulators. Nobody wants that.
It’s best to take stock of existing risk assessments as well as risk-response activities and build on them right now. At the end of the project, your executive management group, the Board of Directors and your risk assessment team will realize the value of implementing the risk assessment model and continuing the risk management journey.
To learn more or to see how the TraceRisk solution can save you tons of time and dollars, call Derek Yankoff, Chief Design Officer at (877) 711-4824
or email him at firstname.lastname@example.org
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 OCC Bulletin 2004-20
 TraceRisk has this approach built right in on over 75 Subjects and 3000 KRIs.