The Future of Risk Forecasting: The Shortcomings of Risk Management and Risk Forecasting Provide Important Lessons-Namely, That a Firm's Leadership Needs to Make Risk a Priority and a Key Part of Strategic Decision Making

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Why Were the assumptions and outputs of risk models that now seem unrealistic not challenged more robustly? Why was funding risk apparently managed poorly, despite being necessary for a smoothly functioning bank?

Politicians, regulators, and shareholders are now asking bank boards of directors and senior managers these uncomfortable questions. As banks scramble to perform postmortem examinations of precisely what went wrong with their approaches to risk management, a number of key lessons are emerging.

Some deficiencies in risk forecasting during the crisis can be characterized as a "failure of imagination" by risk managers. They just did not recognize how bad things could get. Perhaps most can sympathize with this very human error. Just a few years ago, crude oil reaching $50 per barrel or the volatility index (VIX) hitting 40 would have been viewed as extreme scenarios. Yet in July 2008, oil was trading at around $147 per barrel, and by the fourth quarter the VIX was above 80.

The current environment, in which we have witnessed unprecedented levels of volatility and correlation, has laid bare the causal linkages between market, credit, liquidity, and other kinds of risks. For example, there have been several instances of bank-specific liquidity concerns creating a perception of heightened bank-specific credit risk concerns, which in turn prompted systemic counterparty risk issues.

Stress tests and scenario analyses were supposed to prepare banks for weathering such crises. But these and other risk-forecasting tools were deficient in a variety of ways. Moreover, it has become clear that coming up with the "right answer" in terms of a risk forecast is only half the battle. Risk managers also must have a direct line to senior management in order to offer advice or warnings. And this leads us to the first key lesson:

1 Build a strong risk management culture. Prior to the financial crisis, it was commonplace for business leaders to view the risk management function as performing a compliance role while also providing periodic updates of some key risk characteristics of their activities. In broad terms, a change in corporate risk culture is needed so that risk management is viewed as an integral part of decision making throughout an organization. Steps that may need to be taken include the following:

* Ensure that chief risk officers (CROs) and the risk function are in the loop. Risk managers must be actively involved in strategic decision making and in an ongoing dialogue about business activities.

* Executives and boards must take responsibility for risk. Setting risk appetite and ensuring that risk management functions have the right infrastructure in terms of staffing, reporting, and control must become a core part of executives' and board directors' responsibilities. They also must adopt a more skeptical approach to the apparent success of business units or products beyond historical norms and assess if any undue risks are being taken.

* Risk management and forecasting also should be used in strategic decision making. Too often regarded as simply a regulatory and compliance function, an empowered risk group should play a vital role in defining business strategy. In addition to questioning whether existing activities are sensible from a risk-adjusted return/exposure perspective, risk managers also need to become involved in a similar dialogue when it comes to potential business strategies and opportunities.

2 Use a panoply of risk forecasting/management tools and know the limitations of each. Relying too much on any one risk forecasting tool is dangerous because all of them have their limitations. Value at risk (VaR), stress testing, and scenario analysis all have important roles to play, but they should always be used in combination.

* Do not rely too much on VaR. The strengths and limitations of VaR have been widely discussed for the better part of a decade. …