Publication in June 2015 of the results of the UK Government’s Fair and Effective Markets Review was just one of many steps taken this summer to improve understanding of risk in markets and firms and therefore increase standards of risk culture and risk governance. The Financial Stability Board (FSB) has been active on this front too. The UK review will bring the so far largely unregulated ‘FICCs’ markets – fixed income, commodities and currencies, which represent more than 80% of the trading in London markets – within regulatory scope; the FSB aims to do the same for asset managers and other ‘shadow banks’ globally. In addition, the European Securities and Markets Authority (ESMA) is moving rapidly towards mandating professional qualifications and continuing professional development across its empire. This all comes on top of the new UK senior managers regime, which takes effect in March 2016.
Supporting overarching goalsRisk culture and effective risk governance, edited by Patricia Jackson, is a welcome addition to any director’s or senior manager’s briefcase. Barclays Chairman Sir David Walker says in his foreword: “Probably the greatest challenge facing chairmen, boards
and
Meet the author
Patricia Jackson is the Head of Financial Regulatory Advice for Europe, the Middle East, India and Africa at EY. She has over 25 years' experience in the banking and regulation sectors, as well as with the Bank of England.top management is how to ensure that the risk culture of an organisation supports the overarching goals.” With over 25 years’ experience in the banking and regulation sectors, including with the Bank of England and the Basel Committee, Jackson draws on both ‘hard’ and ‘soft’ risk management skills to look at risk culture in the round.
'Disaster myopia' The essence of risk culture, says Jackson, is the creation of an environment where decisions by individuals or business lines, and even more importantly the executive committee, will be in tune with the risk goals of the board. “If senior management does not know that large risks are being run, if appropriate controls are not in place and appropriate procedures are not exercised, if risk expectations are flouted, then no amount of ‘town halls’ and newsletters on values will create a strong risk culture. At a strategic level, a risk culture may fail because of over-optimism, or what the economic literature calls ‘disaster myopia’ – a lack of focus on potential extreme events or poor outcomes, or a belief that they will not reoccur.”
Changes in regulation and in firms’ and markets’ dynamics mean that mechanisms and techniques will be required to ensure that risk culture is embedded in financial institutions’ decisions. And there needs to be more intensive scrutiny within firms of wider factors driving behaviour. There is rapidly growing awareness that other industries, such as oil and gas, nuclear power and transportation, can provide important insights for financial firms.
This was part of the story behind the excessive risk taking in the run up to the crisis in the banking industry. The general theme across many failures in risk culture is the lack of sufficient focus on low-probability, high-impact events. If a low-probability event could destroy or substantially weaken the firm, efforts to test for it need to be doubled and redoubled, but it may take a new event to provide the imperative.
Maintaining alertnessQuestions every board should address are: how can they know how much risk is being run, how can they ensure that risks are kept within sustainable levels (ie, that the appropriate controls and contingency plans are in place) and how can this state of alertness to risk be maintained, even in benign periods?