From Cost Centre to Strategic Asset

In the relentless pursuit of value creation, businesses strive to serve customers, reward investors, empower employees, and contribute to society. Lenders (including non-traditional providers of credit e.g. private credit funds), as the facilitators of capital flow, play a unique role in this ecosystem, connecting those with surplus funds to those who need them, helping to fuel economic growth. But this vital function comes with inherent risks. This article delves into the crucial role of risk management in banking, exploring how it underpins sustainable value creation, and examining the challenges that lenders must overcome to unlock its full potential.

The fundamental purpose of business is to create value

Businesses exist to create value. This does not necessarily mean simply generating profits, despite this often being a key performance indicator. Rather it encompasses a range of areas, including:

1. For customers: Providing goods and services that meet their demands, offering solutions that enhance their lives;
2. For investors: Generating returns that exceed their cost of capital; 
3. For employees: Creating jobs, providing opportunities for growth and development, and offering a rewarding working environment; and
4. For society: Contributing to economic growth, whilst addressing societal needs, and acting responsibly towards the environment. 

In a market-driven system, the pursuit of value is what motivates innovation, competition, efficiency and capital allocation. Businesses that create more value are rewarded with higher profits, stronger balance sheets, market share and survival in a highly competitive environment. 

To survive, businesses can’t solely focus on short-term profits without considering longer-term value creation for all stakeholders. Businesses that prioritise value creation build sustainable relationships with customers, attract and retain talent and ultimately gain competitive advantage. 

In essence, prioritising value creation is essential to long term success. It helps guide strategic investment decisions, such as seeking to enhance products and services, improves efficiency, or expand into new markets. In this way, value creation becomes the underlying principle driving sustainable and successful businesses in a competitive market.

Bridging the gap: Lenders as facilitators of value creation

In its simplest form, banks act as financial intermediaries playing a crucial role in credit allocation by connecting investors with surplus funds (savers) with those who need capital (borrowers). So, in essence, lenders help channel available resources towards more productive uses, fostering investment and economic activity. 

The reliance on lenders in the economy demonstrates how they have evolved as a special type of business providing unique services to both sides. As part of their role as intermediaries, they have rich information about the types of resources that are in demand as well as their supply, whilst also understanding the preferences of both borrowers and investors. It is this information asymmetry that gives banks such a dominant role in resource allocation in the economy; a role which they get rewarded for by creating efficiency in the allocation process. 

Banks also help smooth this allocation process along a multi horizon path for their customers. For example, when a customer has excess funds, they can be deposited with their bank to earn future returns. Conversely, when a customer needs funds, they can turn to their bank for a loan, to be paid back from future income. As a result, lenders’ payment systems connect both spatially and temporally as part of their role in maturity transformation.

Nevertheless, as the saying goes: “with great power comes great responsibility”. As a result of their role as intermediaries, lenders have a responsibility to safeguard the capital of their investors (i.e., savers and shareholders) and as a result act as delegated monitors or assessors of their borrowers, ultimately making decisions as to who gets access to funds. Due to the scale of the economy, and their speciality, lenders can provide this assessment, decision-making and monitoring services at a lower cost than investors. 

How does risk management figure into this relationship?

To generate value to investors, banks need to generate excess returns, whilst safeguarding their invested capital. Modern financial theory, based on the Capital Asset Pricing Model (CAPM), suggests that expected excess returns can only be realised by taking risks. 

In its simplest form, lenders are taking risks when they make lending decisions to provide funds to their customers (or borrowers) in exchange for expected returns. In doing so, they create value for their investors, customers and wider society. Yet there is always a chance that these funds are not recovered, resulting in losses. Excessive risk-taking behaviour, poor pricing, market volatility and poor risk management can all result in bank failure or insolvency for institutions, as well as in loses for their investors. 

Sustainable value creation therefore hinges on striking an optimal balance between risk and return. This requires sophisticated risk management practices that accurately identify, assess, mitigate, and monitor various forms of risk. Robust risk management not only safeguards investor capital but also reduces earnings volatility and bolsters investor confidence, attracting further investment and enabling banks to better serve their customers and the wider economy. Effective risk management in banking is not just a business imperative but a public benefit, underpinning financial stability and sustainable economic growth.

Removing the shackles: Creating competitive advantage through risk management

With the development of computational technology and the explosion of data, there is significant potential to gain competitive advantage and create sustainable value through risk management. Yet, realising this potential requires banks to overcome a number of constraints, including: 

1. Uncertainty when identifying and quantifying emerging risks: Traditional risk models often struggle to accurately identify and quantify emerging risks like climate change, cybersecurity threats and geopolitical instability, making it difficult to develop effective mitigation strategies.
   
2. Legacy systems and data silos: Many lenders still rely on outdated IT infrastructure and struggle to integrate data across various departments and systems. The lack of a unified view of risk hinders comprehensive risk assessment and decision-making.
3. Regulatory complexity and burden: The financial crisis of 2008 led to a surge in regulation, creating a relatively compliance-heavy environment. While necessary, this can divert resources from proactive risk management and innovation for example developing internal capabilities that use alternative data for early warning indicators.
4. Short-term focus and profit pressure: The pressure to deliver short-term profit can overshadow the importance of long-term risk management investments, leading in some cases to underinvestment in risk infrastructure and talent.
5. Talent gap and resistance to change: Attracting and retaining skilled risk professionals remains challenging due to the competitive job market in risk. Additionally, cultural resistance to change within organisations can also hinder the adoption of new risk management practices and technologies.
6. Cost of implementation and maintenance: Implementing and maintaining advanced risk management systems and technologies can be expensive, particularly for smaller institutions with limited resources.
7. Over-reliance on traditional historic data: Relying solely on historical data to predict future risks can be misleading, especially in today's rapidly changing business environment. This highlights the need for more dynamic and forward-looking risk assessment approaches.

Addressing these constraints requires a multi-faceted approach, including investing in technology, fostering a strong risk culture, attracting top talent, and embracing a more proactive and holistic approach to risk management.

Reframing credit risk as a utility

The ability of banks to effectively manage risk is paramount, not just for their own stability and profitability, but for the health of the entire economy. By viewing risk management not as a cost or constraint but as a strategic enabler, banks can unlock significant value for all stakeholders. Here are some practical questions for institutions to consider:

1. For Board Members and Senior Executives:

• Champion a Culture of Risk Awareness: How do we ensure risk awareness is embedded in all strategic decisions and across the organisation? 
• Invest in Risk Management Infrastructure: Are we prioritising investments in modern risk management technologies and systems to enhance data analytics, modelling, and reporting capabilities? 
• Attract and Retain Top Talent: How do we attract, develop, and retain skilled risk professionals to navigate the evolving risk landscape and drive innovation?

2. For Risk Management Professionals:

• Embrace Technology and Data Analytics: How can we improve data literacy within the risk management team and leverage alternative data and advanced analytics to enhance risk identification, assessment, and monitoring?
• Develop a Forward-Looking Risk Perspective: How can we go beyond historical data to anticipate and prepare for emerging risks?
• Foster Collaboration and Communication: How can we break down silos and promote open communication channels to ensure a holistic view of risk across the organisation?

Risk management shouldn't just be about checking boxes; it should be about looking ahead and driving strategic advantage. By continuously challenging themselves to evolve, institutional risk functions can become catalysts for innovation and resilience, contributing to both the success of their institutions and the stability of the financial system as a whole.

In the next article in this series, we will challenge the industry to rethink how it defines and measures returns on regulatory investment.