Let's take a look at the governance of financial institutions from a risk management perspective:
Traditional governance focuses on the organisation-structure, decision-structure, influence and power-weights of all stakeholders. Governance Risk Management focuses on how to optimize and monitor risk and value creation for all stakeholders.
Financial Risk Management Monitoring
After defining a companies Mission, Risk Appetite and Strategic Plan, the year-targets and key indicators are not only translated into a tight budget (b) of 'sales targets' and 'profits', but also into 'balance sheet budget targets' (b).
It takes a real well defined 'Governance Risk Management' to split the balance sheet into such parts (Assets, Liabilities & Capital) that responsible officers in the company are able (and can take responsibility) to monitor the actual values (a) monthly or quarterly to the final or adjusted budget values (b).
Officer Role Division
In a well managed and structured financial company the risk-financial roles of the companies officers can be defined as follows:
AIRCO Management
Once the targets are set and responsibilities are defined, the hard part of managing a financial institution starts: Cooperation between the Actuarial, Investment, Risk and Capital Organisation (AIRCO) Chiefs.
During a budget year, all individual defined AIRCO budgets and actuals continuously change in practice.
As capital risk development is the complex result of Asset and Liability volatility, capital management and monitoring by (primarily) the CRO manager becomes extra complex. Especially in market crises situations (tail risks), where traditional (linear) correlations between AIRCO components fail by definition. It's the responsibility of the CRO to continuously balance between all stakeholders interests in narrow cooperation with the CAO and CIO, while staying on track with regulatory requirements.
This task is not easy, as AIRCO Management is not a one dimensional mission or game:
ALC-Team
To manage the complex of AIRCO effects, it's often helpful to set up an Asset Liability Capital Team (ALC-Team) within a financial institution. Main task of this team is to manage risk and returns across all AIC-axes in line with the strategic plan, the defined risk-return appetite and actual regulatory requirements.
The ALC-Team consists of the CAO, CIO an CRO and could in practice be chaired by the board's CFO, or CFRO.
This ALC-Team :
Pitfalls
One of the most tricky pitfalls in capital management is that a financial institution tries to solve all budget variances and regulation changes only by adjusting its investment policy.
If adjusting is done 'on the fly', without considering the risk-return targets and (even worse) through the mental filter of just one of the stakeholders interests (e.g. 'shareholder value), a financial company implicitly risks to lose track of the overall strategic business targets.
If an economic or regulatory change influences the risk-return objectives, all possible instrumental options to respond, have to be taken into account. One of the most forgotten instruments to respond to market changes, is 'product management' or (new) 'product development'.
Yet, nevertheless the fact that existing (product) contracts are (short term) often hard to adapt, 'product management' is one of the most vital instruments to apply regarding the management of long term risk-return objectives.
Therefore AIRCO Management requires a planned an controlled Stakeholder Management Process in a financial institution.
Stakeholder Value (Risk) Management
Managing a company's stakeholder value implies that the effects of the economic, regulatory and own-company changes on the risk-return objectives are continuously balanced across all stakeholders (Shareholders, Clients, Asset Managers, Board/Employees).
Apart from 'HR value management', regarding possible board and employee reward and benefits adjustments, the instruments to manage and balance Stakeholder Value:
A-1 Asset Value management
C-1. Capital Management
C-2 Shareholder Value management
L-1 Product Value Management
L-2 Client Value management
are presented in the next chart:
Conclusion
Managing a financial institution in this challenging financial decade (2010-2020) is a complex operation with multidimensional regulation and business risk-return targets. Financial Boards have to manage more truths at the same time in a highly volatile economic risk-return environment.
Surviving in this complex world urges boards to step from a traditional predictable managing approach to a more responsive managing approach, where stakeholders value is continuously monitored and adapted to the real world environment.
This new 'survival approach' urges to improve communication, process information and reporting across Assets, Liabilities and Capital Management within the organisation.
Establishing an ALC-Team approach could be a first step to improve the control on risk-return management within the organisation across all stakeholders and actively using all 'stakeholders value tools' in a balanced way.
Last but not least, the role of the Chief Actuary Officer should be more clearly defined. The CAO is, in line with Client Value objectives, primarily responsible for an adequate liability en product management, that's key in balancing the risk-return objectives of a financial institution.
Success!
Links/Sources
- Cartoon: Government Risk Management by Todd Nielsen
- Risky Business – Making Phenomenal Decisions
(While Not Forgetting the Risk)
Governance Risk Management
Traditional governance focuses on the organisation-structure, decision-structure, influence and power-weights of all stakeholders. Governance Risk Management focuses on how to optimize and monitor risk and value creation for all stakeholders.
Financial Risk Management Monitoring
After defining a companies Mission, Risk Appetite and Strategic Plan, the year-targets and key indicators are not only translated into a tight budget (b) of 'sales targets' and 'profits', but also into 'balance sheet budget targets' (b).
It takes a real well defined 'Governance Risk Management' to split the balance sheet into such parts (Assets, Liabilities & Capital) that responsible officers in the company are able (and can take responsibility) to monitor the actual values (a) monthly or quarterly to the final or adjusted budget values (b).
Officer Role Division
In a well managed and structured financial company the risk-financial roles of the companies officers can be defined as follows:
- CIO
The Chief Investment Officer is primarily responsible for managing the asset actuals A(a) versus the (adjusted) budget A(b). So the CIO has to manage [A(a)-A(b)] in terms of value and within defined the investment risk budget.
- CAO
Although often unremarked, an important part of the role of the Chief Actuary Officer is to manage the actual liabilities L(a) versus the (adjusted) Liabilities budget L(b).
This is no easy job, as most longevity and (risk free) discounting of the liabilities are hard to influence.
Wrapping up: The CAO is responsible for managing [L(a)-L(b)].
Often the role of the CAO seems to be limited to insurers or pension funds. However, also banks need an actuarial officer, as more and more (product) risks on the bank's balance sheet become economic, demographic and bio-related (mortality, disability, lifestyle).
- CRO
Often the Chief Risk Officer is seen as someone at arms length reporting about risks to the (supervisory) board. However, one of the main roles of the CRO is to monitor Capital and Capital Requirements. He/She is responsible for realizing the sustainability of the company by managing the (adjusted) Capital budget C(b) while being confronted with continuously changinge Capital actuals C(a). So the CRO is responsible for monitoring [ [C(a)]-C(b)].
AIRCO Management
Once the targets are set and responsibilities are defined, the hard part of managing a financial institution starts: Cooperation between the Actuarial, Investment, Risk and Capital Organisation (AIRCO) Chiefs.
During a budget year, all individual defined AIRCO budgets and actuals continuously change in practice.
As capital risk development is the complex result of Asset and Liability volatility, capital management and monitoring by (primarily) the CRO manager becomes extra complex. Especially in market crises situations (tail risks), where traditional (linear) correlations between AIRCO components fail by definition. It's the responsibility of the CRO to continuously balance between all stakeholders interests in narrow cooperation with the CAO and CIO, while staying on track with regulatory requirements.
This task is not easy, as AIRCO Management is not a one dimensional mission or game:
- Run-off
Often AIRCO Management is merely based on regulatory AIRCO requirements, based on run-off portfolios and one-year period confidence levels (e.g. 99.5% [Solvency-II] or 99,9% [ Basel-II/III] ).
- Continuous business model
However this run-off approach is only based on a kind of default situation with a very low probability (< 1%). It's much more likely (> 99%) that a financial company will exist for more than one year.
Therefore, adding one or more variations of 'continuous business model approaches' to the existing run-off approach on a board's table, will give the board a more (realistic) insight on the heavy an balanced decisions to be taken to continue and control a sustainable risk-return strategy.
ALC-Team
To manage the complex of AIRCO effects, it's often helpful to set up an Asset Liability Capital Team (ALC-Team) within a financial institution. Main task of this team is to manage risk and returns across all AIC-axes in line with the strategic plan, the defined risk-return appetite and actual regulatory requirements.
- proposes board adjustments and monitors the risk-return targets and matching policy
- makes clear what the often paradoxical and/or conflicting effects of risk-return management are for all stakeholders on basis of different future business continuity models (e.g. Run-off, Continuous business, etc.)
- Makes clear and advises what measures the board can take due to the impact on ALC of different business models views, changes in economic risks and changes in regulation.
- operates on basis of ALC reporting information,"Own Risk Assessment" reports, external Economic Risk Reports and external Regulatory Change Information.
Pitfalls
If adjusting is done 'on the fly', without considering the risk-return targets and (even worse) through the mental filter of just one of the stakeholders interests (e.g. 'shareholder value), a financial company implicitly risks to lose track of the overall strategic business targets.
If an economic or regulatory change influences the risk-return objectives, all possible instrumental options to respond, have to be taken into account. One of the most forgotten instruments to respond to market changes, is 'product management' or (new) 'product development'.
Yet, nevertheless the fact that existing (product) contracts are (short term) often hard to adapt, 'product management' is one of the most vital instruments to apply regarding the management of long term risk-return objectives.
Therefore AIRCO Management requires a planned an controlled Stakeholder Management Process in a financial institution.
Stakeholder Value (Risk) Management
Managing a company's stakeholder value implies that the effects of the economic, regulatory and own-company changes on the risk-return objectives are continuously balanced across all stakeholders (Shareholders, Clients, Asset Managers, Board/Employees).
Apart from 'HR value management', regarding possible board and employee reward and benefits adjustments, the instruments to manage and balance Stakeholder Value:
A-1 Asset Value management
C-1. Capital Management
C-2 Shareholder Value management
L-1 Product Value Management
L-2 Client Value management
are presented in the next chart:
Managing a financial institution in this challenging financial decade (2010-2020) is a complex operation with multidimensional regulation and business risk-return targets. Financial Boards have to manage more truths at the same time in a highly volatile economic risk-return environment.
Surviving in this complex world urges boards to step from a traditional predictable managing approach to a more responsive managing approach, where stakeholders value is continuously monitored and adapted to the real world environment.
This new 'survival approach' urges to improve communication, process information and reporting across Assets, Liabilities and Capital Management within the organisation.
Establishing an ALC-Team approach could be a first step to improve the control on risk-return management within the organisation across all stakeholders and actively using all 'stakeholders value tools' in a balanced way.
Last but not least, the role of the Chief Actuary Officer should be more clearly defined. The CAO is, in line with Client Value objectives, primarily responsible for an adequate liability en product management, that's key in balancing the risk-return objectives of a financial institution.
Success!
Links/Sources
- Cartoon: Government Risk Management by Todd Nielsen
- Risky Business – Making Phenomenal Decisions
(While Not Forgetting the Risk)
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