Risk: Keeping Ahead of the Curve-A conference summary

Chicago Fed Letter, Jul 2008 by Cahill, Richard C, Brewer, Elijah III, Riley, Caroline, VanBever, Steven

The Chicago Fed's Supervision and Regulation Department, in conjunction with DePaul University's Center for Financial Services, sponsored a conference on March 6-7, 2008. The conference brought together bankers, supervisors, and academics to focus on comprehensive risk management, an extremely timely topic given the recent financial turmoil.

After William A. Obenshain, DePaul University, opened the conference and welcomed participants, Cathy Lemieux, senior vice president, Federal Reserve Bank of Chicago, described how management of all major banking risks has become much more complex and sophisticated in recent years.1 This evolution includes the development of comprehensive, firmwide approaches to managing risk. While some banks used the long period of stellar bank performance before the summer of 2007 to invest in improving risk management, other banks allowed risk management to become a lower priority than it had been. Despite the challenges of the current environment, Lemieux encouraged banks to continue to focus on long-term improvements to risk management. Doing this should reduce downside risks in the near future and promote greater financial stability in the long run.

Richard C. Cahill, then vice president, Federal Reserve Bank of Chicago, provided an overview of the recent subprime and credit market turmoil. He also posed a series of key questions to set the stage for the conference, including: What is the role of chief credit officers?, Is quantitative risk management getting too clever for its own good?, Can stress testing proride useful input to decision-makers?, Do current accounting practices still make sense?, What is the future of rating structured products?, Can confidence in the financial system be restored?, and Will risk management keep ahead of the curve?

Comprehensive risk management

Cahill also moderated a panel on comprehensive risk management (also known as enterprise risk management, or ERM), composed of three banks' chief risk officers and an attorney. The chief risk officers were James W. Nelson, Huntington Bancshares Inc.; Stephen V. Figliuolo, Citizens Republic Bancorp; and Beth D. Knickerbocker, Marshall and Ilsley Corp. According to Figliuolo, the purposes of ERM are to promote regulatory compliance without impeding the sales process; to identify, measure, monitor, and manage a comprehensive set of risks; to manage risk through process improvement, a proactive approach, and heightened awareness; and to make risk management part of the corporate culture. Nelson provided additional goals: to proactively address risks arising from a changing environment; to identify and communicate risks in an actionable manner; and to improve risk/return dynamics.

The three banks have adopted different structures to implement ERM. On the one hand, Huntington and Citizens Republic have opted for a centralized approach. On the other hand, Marshall and Ilsley uses a more decentralized approach, with "risk leaders" and corresponding subject matter experts embedded in business units, accompanied by a small riskmanagement staff at the corporate level.

The panelists identified a number of benefits from adopting comprehensive risk management. Some of these are improved risk reduction through earlier risk mitigation, increased coordination between business units and risk disciplines, and strengthened regulatory compliance. They also identified a number of challenges to successful adoption. Senior management across the company must support and "buy in" to the approach. In addition, staffing is difficult-i.e., obtaining personnel with both the technical skills and the softer skills necessary to influence the organization. Finally, the subjectivity and uncertainty of risk, compared with the certainty of return, make risk mitigation inherently difficult.

David M. Simon, an attorney with Wildman, Harrold, Allen, and Dixon LLP, concluded with a presentation on two litigation risks that lenders should manage: lender liability claims and the preservation of electronic information in connection with litigation. Some of the lessons learned from the 1980s and 1990s about lender liability claims are to adhere to internal policies relating to the transaction, to ensure contracts are carefully drafted and signed, and to adhere to standards of personal and corporate integrity.

Industry use of risk-management instruments

Beverly Hirtle, Federal Reserve Bank of New York, led a session on the banking industry's use of risk-management instruments. James T. Moser, Commodity Futures Trading Commission, documented a direct relationship between interest rate derivatives use by U.S. banks and growth in their commercial and industrial (C&I) loan portfolios.2 More specifically, the aggregate use of derivative instruments-in particular, interest rate options, interest rate futures, and interest rate forwards-is associated with higher growth rates in C&I loans. This positive association is consistent with earlier research findings that derivative contracting and lending are complementary activities. Engaging in derivative activities allows banks to lessen their systematic exposure to changes in interest rates, so they can increase their lending activities without increasing their total risk.