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Home > Capital Markets Best Practice > The Perfect Storm—Why Did No One See It Coming? The Missing Piece in Risk Management

Capital Markets Best Practice

The Perfect Storm—Why Did No One See It Coming? The Missing Piece in Risk Management

by Nigel Walder

Executive Summary

With hindsight, the author suggests a practical process for re-inputting the people element to create an “early warning system” to prevent another perfect storm.

  • In a near-global systemic meltdown, a contributing factor was inadequate transparency through the levels of the organization.

  • As financial regulation revisions bite, there is an opportunity to re-input the “people” element in offering an early warning.

  • By encouraging contributions at all levels through a systematic approach, CEOs, CFOs, risk, and top management can be more aware earlier of potential problems.

  • Encouraging a climate of more openness would help, but this does not work in all cultures.

  • The real challenge remains to extend that transparency as far as the regulator.

Introduction

It’s been an unforgettable 12 months, with multi-billion write-offs every week, well-established firms collapsing, fire sales, runs on banks, and as near to a totally global systemic meltdown as any of us will ever want to get. And we’re not out of it yet.

How can such well-established firms get it so wrong? Why did the risk departments and regulators fail so dramatically? Hindsight is a wonderful thing, but I firmly believe that one of the major contributing factors is the lack of transparency within financial service organizations; not only to the shareholders, but to senior management as well. When you combine this with record trading volumes, the complexity and opacity of derivatives, and the apparent acceptance of a greed culture, we clearly were hit hard by the perfect storm.

As an organization specializing in putting people and their input back into automated operations in the financial services arena, we have been very cynical for the last six or seven years about the traditional operational risk department’s focus. In a nutshell, it was clear to us that you cannot risk to manage trading and operational activities from the center of an organization, unless you have very strong personal input from the coalface, and total change in the culture.

Coming from the coalface, it has been clear to us that senior risk managers have very little visibility as to what is going on across the length and breadth of their organization, particularly where whole swathes of processes have been or are being outsourced, or sent offshore. In fact, I’d broaden that statement to say that most senior management struggle to have transparency over their own operation, let alone a risk manager.

My own background is in applications development. As a former chief information officer (CIO) at NatWest Global Financial Markets, I think of myself as someone who focuses on business problems and tries to generate sensible solutions to those problems. That is not quite the way things have been played in the regulatory field in financial services. Instead of a sensible approach to a business problem, we have a situation where the regulator sets the boundaries and the various players then push the envelope as hard and as creatively as they can.

So, when I watched the implementation of regulatory regimes such as Sarbanes-Oxley and Basel II, and saw the industry trying to “game” the regulations as they emerged, it seemed inevitable that these well-intentioned regulations were unlikely to serve their intended purpose. This is despite the fact that there is very little in the regulations that best practice or sensible management wouldn’t cover. Indeed, the firms thought they were being smart, whereas in reality most got a very poor return on investment from implementing solutions to such regulations.

The Role of Outsourcing and Offshoring in Complicating Control

Of course, the financial industry—both the banks and the life companies—have been under tremendous competitive pressure over the last decade. This has driven them to look for efficiencies wherever possible, and has pushed the move to outsourcing and offshoring faster than is reasonable.

I know some senior operations heads in large banks who resigned because they were being asked to offshore processes so aggressively that they knew they could not do this in the time frame being set for them, while still retaining control.

Using Systems to Reconnect Senior Management with the Coalface

In an earlier era, management in banks could go round and talk to their people. Issues would emerge, and management would get a real feel for what was going on. Today, senior management has become detached from what is going on in the trenches. To combat this, what is needed are systems that directly address the necessity for gathering the views of people at every level of the organization, from the most junior sign-off levels upwards.

At a simplistic level, this can be achieved through a narrative workflow approach that forces sign-off at every level for specific processes, and collects subjective views at the same time from the person responsible for the sign-off. An example of the latter would be asking the person concerned to rate whether the item they were signing off was “issue-free,” on a scale of one to seven, say, where one was issue-free, and seven was critical. At the same time, the system should capture a narrative explanation of the individual’s input.

A manager at the next level up might judge that something that his junior rated as serious was in fact not an issue at all, because they had a better and deeper view of the matter. So they in turn could rate the issue. However, their view would not eradicate the junior’s view, which would stay on the system.

When this system of sign-off and issue rating is translated into a dashboard approach, it means that a senior manager or CEO looking at a bunch of green indicators, which seem to show that all is well, could drill down through the various levels until they can see the warning lights that were implemented right down at the coalface, as they started to appear. They would also see a written account of why a particular junior person felt that there was an issue. This would put people back into automated processes, and give management a measure of control that would otherwise be sadly lacking.

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