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In a Special Comment published Tuesday, Moody's Investors Service examined the wide-ranging weaknesses that many banks have displayed in managing their risks and that the global financial crisis has exposed. As part of its rating assessments, Moody's is placing even greater emphasis on its dialogue with banks on how risk information influences the decision-making process at the highest levels of the organisation.
Following Moody's risk management methodology, the report reviews some of the main features of the financial crisis, identifies some initial lessons learned and highlights the implications for analysts and investors. "In most cases, the industry debate has focused on pure risk management failures, in particular those of risk models in measuring risks accurately. However, we believe that the broader issue of how risk is managed at the highest level of the organisation is central to understanding banks' weaknesses in managing their risks," said Alessandra Mongiardino, author of the report.
The report notes that the market focus on quarterly results and the compensation structure of risk takers drove management at many banks to focus on short-term earnings, to the detriment of due consideration of the related risks. Boards of directors often lacked the technical expertise or the appropriate information to perform the necessary checks and balances effectively. The report also observes that the risk management function did not always have the necessary authority. "Risk managers faced significant challenges in having their voice heard, in particular in a period of booming revenues, low market volatility and perceived ample liquidity," said Mongiardino. Another issue identified in the analysis was the weakness of the stress-testing framework of many banks, and its limited impact on management decisions.
In this perspective, Moody's analysis also highlights how important it is for a bank to ensure its strategic and tactical decisions are taken on the basis of sound risk information. For this reason, the rating agency intends to expand its dialogue with banks on the coverage and communication of risk information to the senior management and the board and how this feeds into banks' decision-making.
However, the full risk profile of a bank and its ability to manage risks are inherently opaque, in particular for complex institutions. Any assessment of a bank's risk management practices therefore needs to take account of this opacity.
