Taking a Hard Look at Risk Management

The Mortgage Bankers Association just issued an insightful report into the risk management practices at financial institutions leading up to the financial crisis of 2008.  The report is entitled "Anatomy of Risk Management Practices in the Mortgage Industry: Lessons for the Future" and is authored by Clifford V. Rossi from the University of Maryland. The findings in the report are very candid in their criticism of the financial institutions and their reluctance to acknowledge the risks being taken.  Here is one of the reported lessons to be learned in the aftermath of the crisis.

Risk managers may have been effective in identifying risks, however, many firms appeared tone deaf to these subject matter experts. If senior management had elevated the risk officer position to one that had direct or even indirect reporting to the risk committee on the board of directors, it may have helped staunch some of the risk taking that occurred. Further, executive management must inculcate a culture of risk management where all employees actively are on guard for risks that exceed the risk appetite of the company. One way to incent depository institutions to build strong risk functions and culture is for FDIC to strengthen risk-based assessments on deposit premiums reflecting the strength of the risk management organization and quality of the firm’s risk infrastructure. By blindly following the herd, the largest mortgage originators effectively competed themselves out of business. Reliance on information gathered from brokers and sales staff regarding the competition can be valuable to firms, however, the information obtained needs to be carefully vetted against specified corporate objectives. A clear vision of what risks the firm is willing to take must be part of the strategic roadmap, and deviations from that plan must be accompanied by sound analytics and information even if short-term losses of market share and key individuals are likely. A corollary to this recommendation is that risk vision and therefore business strategy must take a long-run view into account in shaping risk direction.

It is refreshing to see an organization like the Mortgage Bankers Association taking a hard look at what went wrong and how we can work to prevent a similar crisis in the future.  However, the report also reminds the reader that a similar crisis occurred only 20 years ago during the Savings & Loan debacle.  So, it is crucial for companies to take the necessary steps this time around or we could be having a similar conversation in the very near future.