Fed Gov Kroszner Says Survival of Financial Institutions Hinges on Strategic Risk Management

Financial institutions will not survive the coming radical transformation in financial services unless they implement a strategic risk management framework, in the view of Federal Reserve Board Governor Randall S. Kroszner. In remarks at the annual risk management conference in Baltimore, he said that strategic risk management must be interwoven into all aspects of the firm's business and should be part of the calculus for all decision-making. Strategic decisions about what activities to undertake should not be made unless senior management understands the risks involved, he added.

In building a rigorous strategic risk management framework, he continued, financial institutions must reexamine both their internal practices and their external environment, and understand how closely the two are connected. In other words, external factors have an impact on internal practices, but those internal practices, because financial markets are so interconnected, can in turn have an impact on how the institution is viewed externally.

Whether transactions take place on an organized exchange or in the so-called over the counter market is another important aspect of the strategic risk management choices undertaken by an organization. When contracts are traded on an exchange, clearing and settlement, for example, may have less uncertainty associated with them. In addition, an exchange that has a centralized counterparty can reduce uncertainty about counterparty risk and help avoid market dislocations that can arise from such uncertainty. Thus, market infrastructure and its impact on how organizations are connected to each other can have a large impact on market confidence in times of stress.

Noting that compensation is also linked to risk management, the senior official said that a good risk-sensitive compensation regime, properly embedded in a strong strategic risk management framework, can bring about changes in behavior so that the firm's employees refrain from taking on risk beyond the firm's risk appetite

According to the governor, a risk-sensitive compensation framework will help provide the right employee incentives and establish a better link between the actions of those employees and the firm's overall risk profile. Institutions should be particularly sensitive to employee activities that could either impair access to funding or disrupt liquidity. Directors must understand the consequences of providing too many short-term and one-sided incentives.

He suggested the use of deferred compensation, since the risks of certain investments or trades may not manifest themselves in the near term. It also makes sense to try to match the tenor of compensation with the tenor of the risk profile and, thus explicitly, take into account the longer-run performance of the portfolio or division in which the employee operates.