In the influx of changing business priorities and competition in banks across the world, the greatest emerging risk for banks could be on account of the waning role clarity between ‘Risk taking function (RTF)’ and ‘Risk Control function (RCF)’.
In the right perspective, they will always be distinct and different with lingering conflict of interest and must stay separated while the objective is unanimous.
As emphasized in Bank for International Settlement (BIS) principles for risk management, banks should be able to develop a working relation to avoid organizational “silos” that can impede effective sharing of information across the organization. Necessary cooperation between the RTF and RCF should of course never compromise their special independent role of the risk control function. But the challenge lies in articulating coordinating function without compromising their roles and responsibilities of abating risk. As a rule, this separation of RTF and RCF should reach up to the top layer of hierarchy of decision-making level of the organization.
Risk management culture must imprint a compatible ecosystem where the different business and reporting lines, both those that take risk on behalf of the bank – RTF team and those that assess and control it – RCF team should be able to present their views directly to the decision-making level with ultimate objective to stem risk. The bank must be responsible for ensuring and overseeing a strong risk governance framework, and must be able to carry this responsibility. This requires a
systematic approach.
It includes development of a strong risk culture, a well-developed and explicit risk management policy regarding determination of risk appetite in each business lines and risk adjusted return, application of up-to-date methodologies for measuring financial risks, and institutionalizing a well-defined lines of responsibilities of RCF and RTF as fulcrum of its structure.
Critical role of RCF
An effective RCF is the foundation of professional risk management in banks. With changing risk climate in banks and greater connectivity with international markets, RCF was reorganized as aseparate unit and was established by many commercial banks with its own reporting line to the board taking into account the overall regulatory dispensations.
Such reorganization part of preparing for a robust integrated risk management but the perception ofincreased riskiness of the environment certainly accelerated the need. RCF is responsible for overseeing risk-taking activities across the institution assumed by line management in different lines of business functioning at the behest of RTF.
The important aspect is that RCF should have the authority it needs to oversee conduct of RTF. The RCF should be independent, with sufficient stature, resources and direct access to the board. Risk reporting to the board requires careful design in order to convey bank-wide, individual portfolio and other risks in a concise and meaningful manner.
Reporting should accurately communicate risk exposures and results of stress tests or scenario analyses and should provoke a robust discussion of, for example, the bank’s current and prospective exposures with market intelligence data. Data analytics and peer bank analysis will be necessary. RCF should be the expert mind of the bank to analyze the risk implications of existing lines of business, extent of exposures and then direct the prospective business in coordinating with RTF. A balance should be maintained between the independence of the risk control function, on the one hand, and smooth horizontal information flows from RTF on the other hand.
Role of RTF
In pursuit of commercial banking that works for profit, the main organizational challenge is to reconcile the business orientation of the revenue-generating functions of RTF. Its extent of connect with RCF will decide the effectiveness of RTF. This balance has to be managed at an apex level of hierarchy responsible for ultimate decision-making. May be by the subcommittee of the board on risk management. A broadly similar, but wider challenge of diversity exists also among different types of banks which is ownership neutral. Their problem of organizing risk control and management is more complex than in state owned entities.
The organizational architecture must therefore accommodate more distinct functional lines even within the bank’s different operational lines of business such as retail, agriculture, SME or export credit that has a great link with the profitability of the bank. RTF is all about bringing about equilibrium in risk adjusted return without allowing conflict of interest to dither quality of risk management. Central Bank guidelines and bank’s own loan and business policy should guide the RTF.More sensitive are functions dealing with treasury and investment that are subject to market volatility. Effectiveness of risk management of RTF depends on maintaining harmony with credit and recovery policies and its execution function.
Internal transparency and disclosure standards
RTF has to keep a seamless flow of information and data transparency emanating from field to factor it in business risk assessment. External market intelligence information can be strategically just as important as internal management information.
Therefore, banks need to reconsider from time to time their transparency and communication on their risk profile guided by heat map. As a matter of principle, banks should develop a bottom up information flow from field to RCF so that change in customer preferences that alters risk perception can be factored at policy level on a dynamic mode so that banks can remain aligned to the business realities. A constant interface between the two teams – RTF and RFC can create an umbrella protection to the business. RTF should develop a sustained risk appetite policy which emanates from an assessment of how taking on more risk affects the opportunities that the bank can capitalize on. This assessment can change as the bank’s opportunities change. Consequently, a bank’s risk appetite cannot be inflexible.
At the same time, however, the risk appetite is not determined in such a precise way that a small shift in opportunities will affect it. Risk appetite should be compatible to business philosophy of the bank. Optimization of risk appetite is essential to harness full potentiality of markets. Low appetite may hurt the business growth.
Way forward
Given the technology and information flow in the market, risk management as a science is set to use artificial intelligence and can become more effective in mitigating risk. But it may not be practically possible to draw a blueprint of what a bank’s risk function will look like in future—or predict all forthcoming disruptions.
As technological advances, vulnerability increases with macroeconomic shocks and volatility, or banking frauds and cyber-crimes begins to pose greater challenge, the degree of preparedness has to be further improved to fine tune risk combat strategy. Taking the developments and capabilities of banks in risk management, fundamental trends do permit a broad sketch of what will be required of the risk function of the future. The trends furthermore suggest that banks can take some initiatives now to deliver short-term results while preparing for the coming changes.
By acting now, banks will help risk functions avoid being overwhelmed by the new demands. But in order to better ring fence risk management architecture, the duality of role of RTF and RFC must be protected while keeping the end state objective of abating risk remaining same.
(The author is Director, National Institute of Banking studies and Corporate Management – NIBSCOM. Noida, India. The views are his own)
