THE THIRD CRITICAL PIECE OF RISK MANAGEMENT
FOR SUSTAINABLE EARNINGS
Author: Rich Weissman
DMA President and CEO
"PROFIT RISK" AS A FUNDAMENTAL RISK MANAGEMENT DISCIPLINE
Managing a bank or credit union is all about managing risk. As financial intermediaries, risk management is the key driver of our business. Those who do it well are successful, and those who do not are unable to survive. Every bank or credit union CEO knows this, and if he/she is managing his/her institution well, then risk management is at the front-and-center in providing management discipline.
In its simplest form, risk management consists of applying a quantitative discipline to predicting future events based on known variables which correlate to future values. It consists of applying the following 5 disciplined steps in a consistent and regular way:
· Risk identification, where the risk category is explicitly defined.
· Risk quantification, where the risk is explicitly defined in quantitative terms.
· Risk measurement, where the risk is explicitly measured according to a wide variety of metrics and ratios (including scores) which have been statistically established.
· Risk strategies development and implementation, where specific strategies and tactics are developed and executed with specific risk management goals and objectives that are quantified.
· Risk evaluation and improvement, where risk measurements are tracked and evaluated on a regular basis with specific action items for improvement.
Traditionally, risk management in the financial services industry focused on two important areas: credit risk and asset-liability risk. These two risk areas focused on the quality and composition of the balance sheet:
· Credit risk, the oldest form of risk management, is meant to apply discipline and structure in determining who is given credit, for how much, under what circumstances, and with what collateral, so as to set interest rates and loss rates, and to price accordingly, and then to reserve for projected losses based on that quality of the credit. From risk ratings for businesses to scoring for consumers, developing methods for evaluating credit risk was an important advance in creating tools that assessed credit criteria and potential losses. From these, the ability to manage loan rates and loss provisions was significantly enhanced. By putting together standardized credit forms and review committees, and along with various credit bureaus, D&B ratings, and Fair Isaac, financial institutions have the ability to manage the degree to which the interest rates have been set and reserves established so that they are in sync with future losses based on the quality of the credits within each loan portfolio.
· Asset-liability (ALM) risk, a more recent form of risk management, is meant to apply discipline and structure in determining the appropriate tenors (or terms) of the balance sheet, from both the deposit gathering and lending sides, so as to provide for a balance sheet that is relatively co-terminus or "balanced" so that risk is minimized as the rate curve changes over time. From matched funding, secondary market sales, participations, and swaps/collars/caps, developing methods for evaluating asset-liability risk was an important advance in creating tools that assessed asset-liability mix through treasury and ALCO functions. From these, the ability to manage portfolio tenors and interest rate fluctuations was significantly enhanced. By putting together treasury functions and ALCO committees, and along with ALM systems, financial institutions have the ability to manage the degree to which the deposit and loan portfolios are in sync with future mis-matches within the balance sheet.
Further, more sophisticated analyses of risk came out of these risk management methods, focused on capital and the risk to capital. RAROC (risk adjusted return on capital) exemplifies the more sophisticated risk management tools utilizing credit risk and asset-liability risk.
(Of course, there is also operational risk, ensuring that the operational policies and procedures are in place and are accomplished on a day-to-day basis. Operational risk differs from the financial risk of credit and ALM, in that operational risk focuses heavily on making sure that the institution has the right controls to mitigate losses from fraud or inadequate operational procedures. Although an important form of risk management, operational risk operates on a different risk level that differentiates it from credit and ALM risk.)
"PROFIT RISK" IS ALL ABOUT THE INCOME STATEMENT
Typically, most financial institutions have dedicated resources for credit risk and asset-liability risk (and operational risk as well), and many have dedicated risk management areas with specialists in each. Without doubt, having these disciplines in these 2 critical risk areas allow us to better manage future credit and interest rate volatility. The reason why these 2 risk areas have dominated our risk management focus is because they are about the balance sheet, and as an industry, balance sheet growth has been the dominant driver for defining success for a bank or credit union.
And, we’ve had crises relative to these risk management components. Certainly, the S&L debacle was all about poor asset-liability management risk, and the current financial crisis is all about poor credit risk. Right?
Well, yes … but only in part, and the financial services industry is in for a rude awakening if we think that simply "fixing" these 2 risk components, particularly credit risk for the current crisis, is enough. There is an additional risk component that played a critical role, and this risk component is not understood by most banks and credit unions. Indeed, only a handful of financial institutions understand and even fewer manage to this risk component
This risk component is different from others in that it looks specifically at the income statement, and not the balance sheet, in an altogether different way. This new piece of the risk management equation has been sorely overlooked, and the lack of management of the risk embedded in the income statement, different from credit risk and asset-liability risk, has hurt the industry in profound ways.
It is a recent concept developed by DMA in the past 10 years, and it is called "Profit Risk™". And, now with the current financial crisis, there is great interest in this DMA concept and the DMA measurement tools for "Profit Risk", as the industry tries to find new ways to manage risk. The industry desperately wants to understand the current crisis and wants to avoid future ones, appreciating that without a sustainable income statement, a bank or credit union cannot ensure its long-term viability and it becomes susceptible to a meltdown scenario.
The implications of "Profit Risk" are far-reaching. It helps explain how financial institutions have meltdowns and how these meltdowns could have been anticipated (and were in many ways by DMA) and could have been mitigated (and were for many DMA clients).
Over the past 25 years, as banks and credit unions focused on volume selling, with marketing, product, and pricing activities geared towards pumping up the balance sheet and increasing market share and footprint, a focus on understanding the income statement took the back seat. First, until the current crisis, there was plenty of income to be had, and understanding its dynamics in a highly detailed way was not viewed as critical to managing risk by many management teams. Second, there appeared to be more than sufficient capital so that concerns about income sustainability were not viewed as critical to managing risk as it pertained to capital adequacy.
Things have changed, and the financial services industry is now listening and beginning to understand the DMA concept of "Profit Risk".
In its simplest form, "Profit Risk" is based on understanding the critical concentrations of the income statement, and assessing the SUSTAINABILITY of the income statement based on those concentrations. "Profit Risk" is a detailed and systematic methodology for assessing concentrations in a highly quantitative way, with specific risk measurements, typically performed on a monthly basis.
MANAGING RISK MINIMIZES VOLATILITY AND IMPROVES EARNINGS
Banks and credit unions will find that successfully managing "Profit Risk" can also add directly to the bottom-line. Not only does attention to the discipline of "Profit Risk" help minimize income volatility and allow for greater sustainability of income, it can also increase income on an absolute and consistent basis. Over the years, DMA’s careful monitoring and research of critical "Profit Risk" metrics and ratios have demonstrated a direct correlation between improvement in "Profit Risk" measurements from a risk perspective and absolute earnings growth. Minimizing "Profit Risk" ultimately adds to the income statement and capital.
NEXT STEPS – EXECUTING A "PROFIT RISK" CULTURE AND DISCIPLINE
Banks and credit unions need to implement the necessary steps to take control of "Profit Risk" and develop a culture of "Profit Risk" management similar to the culture of credit risk and asset-liability risk (and operational risk as well). It is a discipline that needs to be developed and followed with the same intensity and focus of other risk management areas. These steps include:
· Employing a "Profit Risk" measurement system with "Profit Risk" metrics and ratios.
· Creating the internal role of "Profit Risk" manager who heads up a "Profit Risk" committee.
· Developing a "Profit Risk" plan with goals, milestones, and specific action items.
· Assessing "Profit Risk" metrics and ratios, and plan progress on a monthly basis.
· Reporting on "Profit Risk" metrics and ratios, and plan progress to the "Profit Risk" committee, and reporting on progress to management committee and to the board of directors on a regular basis.
At DMA, we have developed a proprietary system designed for managing "Profit Risk" (it is called IDM™ Integrated Database Management System) that integrates the detail line items of the complete General Ledger(s) of each bank or credit union, with detailed information from each operating system for every account that every customer or member has with the bank or credit union. A unique and detailed income statement is created for each account such that each account’s unique non-interest income (based on the fees generated specifically from each account), non-interest expense (based on the transactions and behaviors and the costs associated with those for each account), and margin allocation (based on the specific interest rate and funds transfer pricing for each account) is assessed at the unique customer or member account level. Because each customer or member account behaves differently, has different balances, rates, fee income, and transactions, the unique income statement on the micro-level accounts for each of those discreet characteristics. The totality of all customer or member account income statements balance back to the General Ledger and to the income statement on a bank-wide or credit union-wide basis. This process is repeated each month with the month-end close of the current General Ledger and operating systems.
With this information in hand, DMA has developed a series of "Profit Risk" metrics and ratios, covering a broad range of measures that utilize the detailed customer or member income statements in a variety of levels. These measures are given in detailed reports and assess the concentrations of the income statement in a variety of critical ways. Acceptable "Profit Risk" ranges are established and "Profit Risk" goals are created. Specific action and decision plans for "Profit Risk" improvement are developed, implemented, and tracked monthly. DMA works with its clients in helping them to develop a "Profit Risk" culture and discipline and in working with the "Profit Risk" measurements for risk management and earnings improvement.
THE REGULATORS ARE CLOSE BEHIND
There is no question that as the regulators look for new tools to assess future performance in the financial services industry, they will turn to "Profit Risk" as a critical component. DMA has already been contacted by, and had interest expressed by, the regulators who are seeking to find additional risk management tools. They may soon start demanding that banks and credit unions formally manage "Profit Risk", requiring committees, reports, goals, and very clear action plans.
Those banks and credit unions that quickly learn and start to manage "Profit Risk" as a serious discipline, worthy of the same attention of credit risk and asset-liability risk (and operation risk), will be those who will perform better in the future, and be ahead of the curve on a regulatory basis.
Safety and soundness is the key to the future, and "Profit Risk" is an important new concept and tool that must be an integral part of that future.
DMA’s award-winning approach, system, measurement analytics, and strategic concepts provide a foundation for profitability risk management and growth for financial institutions throughout the U.S. and Canada. DMA focuses banks and credit unions on managing for income sustainability by integrating management, finance, marketing, and sales. DMA is a premier provider offering its state-of-the-art IDM™ Integrated Database Management System, research and analytic support, and the DMA Institute Think TankTM for driving cross-functional activities for increased bottom-line performance in these tough economic times. DMA is built upon its mantra that "only the most informed and profitable will survive and prosper". Founded in 1996, DMA is a member of the American Bankers Association (ABA), Credit Union Executive Society (CUES), Financial Managers Society (FMS), New England Financial Marketing Association, Western Independent Bankers (WIB), and Association for Management Information in Financial Services (AMIfs). DMA has also been recognized with national financial industry awards including "The Best of the Best", "Supplier of the Year, and "Best Practices", among others.
For more detailed information on "Profit Risk", contact DMA by e-mail to Reggie Beason at: reggie.beason@DMAcorporation.com ; or call DMA at 503.597.0088
This article, the term "Profit Risk", the DMA "Profit Risk" measurements, and the DMA research behind the concept are the exclusive property of DMA and cannot be reproduced in part or in whole.