Chapter 6: Control - Risk Management

Overview

Ultimately, the decisions we make and the strategies we set must all be understood in terms of the risk we take. A decision is not only about cost and expected return. We have to factor in the risk that costs or returns are not as expected. We can only do this analysis effectively if we have a single view of our business.

Every company in every industry, financial or otherwise , deals with these three key areas of risk:

• Customer risk

• Market risk

• Operational risk

Risk Management 101

Customer risk is the internally generated risk that we lose customers or they act in a way that damages our business.

Market risk is the externally generated risk of surprises in the marketplace ”downturns, recessions, inflation, volatility, normal business cycles, unexpected event triggers and other market conditions.

Operational risk refers to the category of internally generated risks that relate to systems failures and other operations- related surprises.

 

Customer risk, market risk and operational risk all derive from the same source ”lack of information. Inadequate information means a company doesn t know enough about its customers to keep them. It means a company can t identify market trends. It means a company isn t in control of its internal operations. One factor underlies all the categories of risk ” information. The less information a company has, the greater its risk.

The number one risk factor in any organization is lack of accurate information.

Companies need strategies and systems in place to minimize the risk profile and maximize the wealth creation potential of all their relationships ”customer, employee, partner and others. More than just the lifetime value of a relationship, the calculation of risk and return must include an option value of the potential relationship.

Option value, a relatively new valuation approach that is gaining currency in business, takes into account much more than the traditional straight-linediscounted, future value of an investment, or in this case a relationship. Option value also accounts for the potential returns of different possible paths, weighted according to their likelihood . It is a risk-return analysis that understands that multiple future possibilities exist for every investment and every relationship. A pharmaceutical company invests in research. The research may yield the expected results, or unexpected results. But unexpected results are not necessarily a sign of a lost investment. The results might lead the research in another direction that will pay off in the end, or it might not. Option analytics assigns a value to each of these potential paths. Relationship management at this level absolutely requires a company to have a single view of its business and a complete understanding of all its relationships.

Cultivating customers is the biggest reward potential most companies have. Accounting for the risk-return profile of customers is part of the new customer focus in the market. A single view of the business is essential to this calculation.

Here s one cautionary tale. A customer had multiple accounts with a bank ”a small business account and a private banking account were just two of the relationship touch points. Whenever the customer had revenues in the small business account the customer moved it into the private banking account. The result was that the small business group didn t value the customer s business and the private banking group did.

Instead of seeing one relationship, the bank saw multiple relationships. The bank could not see the bigger picture of the customer s total value. The small business group advised the customer they were going to charge new, higher fees because the customer didn t maintain adequate account balances . The customer pointed out that there was an adequate balance in the private banking account at the same bank. The small business group, unimpressed, responded that as far as they were concerned the customer was not valuable . The bank lost all of the customer s business.

Because the bank created a fragmented and ultimately unsatisfying relationship with its customer, it did not have a complete picture of its relationship to the customer. The bank was unable to assess the real return or the real risks associated with the customer.

Everything in a company should be focused on the bottom line ”and that s the profitability of customers. Financial risk issues are not separate. They are part and parcel of the risk-return profile of a customer. Every company, financial or otherwise, needs to make its finance division a partner with the rest of the organization.

An accurate customer profitability calculation must take into account the associated risk factors.

Risk management is about determining the right discount factor to account for the inherent risks taken to achieve a specific return. That means knowing your customers, the costs associated with maintaining the relationship and the risk of a change (either positive or negative) in that relationship. For example, a bank customer who uses a branch teller costs more to service than a customer who uses an ATM. But which of those two categories of customer tends to be more loyal? Unless that information is captured and available for analysis, any risk-return analysis will be fundamentally flawed.

A good risk management strategy is not just important to the bottom line. All companies, and financial institutions in particular, are rewarded disproportionately in the market for sound risk management practices. Stock prices go up. Shareholder value increases . On the flip side, the market exaggerates the risk profile of an unprepared company, which can send the stock value plunging.

Understanding the risk profile of customers is essential to any customer profitability driven business. In other words, it s important to every business. The financial industry has understood this longer than most. Unlike most other businesses, in financial services the customer can have a direct adverse impact on the business. In retail a customer may stop coming to a store, but in financial services a customer may default on their mortgage or a margin loan, leaving the company holding their debt.

Barclays Bank

At Barclays Bank the original impetus to centralize information resources was driven by their credit risk management needs. Being able to categorize the high, medium and low risk customers is critical to generating credit grades and risk-adjusted pricing, which is, after all, at the heart of their business. Credit risk is customer risk at a bank.

Financial services companies are required to abide by an array of credit risk regulations like the Basle II accord, a set of rules established in cooperation with the international financial community on credit risk issues. Economic capital analysis is intrinsic to the business. Barclays wants to know how much capital is allocated to each division of the business and the risk associated with that capital allocation. As with any financial services company, Barclays can t afford to risk not knowing enough about its customers.

 

Yet despite these risk management issues, banks have traditionally been horizontally siloed. Getting a snapshot of the true risk position of the institution on a customer-by-customer basis was virtually impossible . Credit card information was kept separate from mortgage information, which was separate from investment accounts and bank accounts. Insurance was completely cut off from the rest of the institution. In today s global market, financial institutions need to be more sensitive to their customers complete risk profiles.

The traditionally siloed nature of the financial industry was due, in part, to the regulatory climate. Regulations are changing and so is the financial industry in general.

TowerGroup

Mark Sievewright, President and CEO of the TowerGroup, says that one of the key areas of focus of any financial institution today has to be wealth management. The baby boom generation is the single most important target market. The demographic significance of the baby boomers for every industry cannot be underestimated. As Harry Dent has so colorfully put it, tracking the boomer demographic over time is like watching a pig move through a python.

Wealth management brings together banking, investment and insurance ”the full range of the financial industry s offerings.

Sievewright describes the new reality of the financial industry with his Five C s :

• Consolidation

• Convergence

• Customer Focus

• Channels

• Cost of Ownership

  In 1980 the top 20 banks held 19.5 percent of total assets. In 1998 that figure had doubled to 39.8 percent. The top 50 banks currently control more than 71.2 percent of total assets, more than twice what they controlled twenty years ago. The drive to consolidate comes from three key sources: the motivation to maximize value through economies of scale and scope, cost efficiencies and monopoly power. The result is that banks need an overwhelming amount of information to be able to understand their customers.

  The natural outgrowth of successful consolidation is convergence. Citibank is number one globally, across the range of potential strategic focus for a financial institution ”global credit cards, global consumer finance, emerging markets, global capital markets and global wealth management. Yet convergence creates its own challenges: the question of integration vs. co-existence, channel conflicts, branding conflicts and culture clashes . As with consolidation, convergence will only be successful with an information structure that centralizes and disseminates all the data in the company.

  Sievewright believes, with the next wave of businesses, expanding scale and scope will be achieved through partnerships and alliances, not mergers and acquisitions. Lower risk and more agile partners are a way of dealing with the need to consolidate and converge without the drawbacks of massive size . Partnerships and alliances may also be a superior method of dealing with the third C in the new market reality, customer focus.

  Becoming customer-centric is one of the surest ways to increase return on investment. A customer focus needs to be embedded into the business processes. The emphasis on customers at most companies was lost in the rush to adopt all sorts of new technologies and to get online. What companies forgot was that technology is not an end in itself. Technology serves a function and that function, at its core , should be to serve the customer better.

  True customer focus leads naturally to the fourth C, channels. To be truly customer-centric, a customer s experience dealing with a company across all channels should be seamless.

  Finally, in the fast-paced global economy of today, return on investment must happen quickly and be visible. Cost accountability is higher than ever. Companies need to decide which cost model works best for them and mine its opportunities ”outsourcing vs. in-house. CTOs have fewer chances to get IT right.

 

Sievewright s Five C s provide important insight into understanding any financial institution s overall risk management strategy, and financial institutions are the best examples of risk management in practice. But every company needs to realize that, in the end, everything comes down to risk management. Have a strategy.

Every interaction, connection and transaction is a potential risk.

Every industry, financial or otherwise, has risk factors built into the very nature of its business.

• Were deliveries on time?

• Was mobile phone service interrupted ?

• Did a customer leave unsatisfied?

• Did a stolen credit card get used?

These are all risks and it is only by using our information that we can stay on top of them.

A single view of the business is the prerequisite to a smooth-functioning corporate ecosystem. We ve seen it with customers, logistics and operations in previous chapters. Now we ve seen the important role of information resources in risk management. What does all this mean to the bottom line? We ll look at this in the next chapter.