Judgment versus Risk Management Science: Are We Getting the Balance Right?

Samuels, David, The RMA Journal

This article argues that the drive toward objectivity on risk and capital is a good thing, so long as the industry accepts that the role of the new risk numbers is to support and enhance management judgment. But if either regulators or banks are tempted to think that the new risk numbers will lead to automatic answers, they will make mistakes in their risk-based decisions.

Recent banking regulations and the search for competitive advantage are encouraging institutions to base their decisions on a new generation of risk and capital metrics. This has given rise to worry in some quarters that "objective" risk information might begin to circumscribe, or even supplant, the traditional role of management judgment across a range of important bank activities (Table 1).

The challenge for top executives is to foster a culture in the bank (policies, attitude toward risk quantification, systems) that builds the right balance between judgment and objective numbers across a diverse range of decision making. It's a balance that often changes as businesses mature and evolve and as more risk information becomes available. Let's explore how to get the balance right in four critical areas: loss reserving, risk-based pricing, capital adequacy, and start-up businesses.

Loss Reserving

In the ongoing debate among securities regulators, banking regulators, and the accounting profession over how banks should calculate their allowance for loan and lease losses (ALLL), all parties agree on one thing: Banks must start to calculate reserves in a more systematic, rigorous, and objective manner that reduces the role of subjective management judgment.

Part of the momentum for this comes from the suspicion that banks use provisioning to flatten out volatile earnings over time. For external observers, the benefit of objective risk measurement is that it should lead banks to provision more as their objective expectations about credit losses increase (or less as they …

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Publication information: Article title: Judgment versus Risk Management Science: Are We Getting the Balance Right?. Contributors: Samuels, David - Author. Magazine title: The RMA Journal. Volume: 88. Issue: 8 Publication date: May 2006. Page number: 16+. © 2007 The Risk Management Association. COPYRIGHT 2006 Gale Group.

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