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RAROC developer: Getting serious about risk

RAROC architect says banks can't ignore risk managers anymore

RAROC developer: Getting serious about risk

Financial risk discussion often comes wrapped in arcane terminology and methodology that can render the subject opaque, at least to the neophyte. But not when you speak with Dan Borge.

Here's an example from his 2001 book, The Book of Risk, on the concept of leverage:

   
 
  When Dan Borge and the Bankers Trust team created "RAROC," or Risk Adjusted Return On Capital, the concept was considered rocket science. Not too far off, because Borge had been an aeronautical engineer before entering banking.
   

"When you leverage a risk, you magnify all of its potential outcomes, good and bad. If you can lift a 500-pound rock with a 3-foot lever, you can use the same force to lift a 1,000-pound rock with a 6-foot lever. A 6-foot lever has twice the lifting power of a 3-foot lever. It also hits you in the face twice as hard if you lose your grip at the wrong moment."

The engineering analogy comes naturally to Borge-pronounced "Bor-gy"-because his early training came in that field. The humor is his own, born of life. As a young man, he was part of a 5,000-man team designing the Boeing Super Sonic Transport, once America's competitive bet against Europe's now-grounded Concorde. After watching four years go down the pipe, when the SST got cancelled, and finding engineering of standard jets less interesting, Borge went to business school and then graduate business school. New York's Bankers Trust snapped him up in the late 1970s. Charles Sanford, then a division executive and later head of the bank, wanted his help in formularizing an idea completely new to the industry: Not all risks are alike.

Today, when risk models, risk-based deposit insurance, and risk-based capital standards have long existed, that almost seems quaint, like referencing DOS in a Windows 8 world. Today bankers face the potential implementation of controversial Basel III standards, which Borge deems far too complicated and prone in time to being gamed.

But in 1980, when Borge gave Sanford a five-page memo simply titled, "Framework for a Bank-Wide System of Capital Allocation," it was rocket science.

"And I was actually a rocket scientist," says Borge, "who converted to being a financial guy."

What he and Sanford cooked up, and developed with a willing team and an often-unwilling banker cadre, became both an industry standard and the foundation of much that came later: Risk Adjusted Return on Capital, known as "RAROC."

Sanford, initially head of trading and sales at Bankers Trust, "wanted a system he could use to judge the quality of the profits made by different trading desks because he already knew that there was a vast difference in the risk they took to generate a given profit," says Borge.

"Way back in the Stone Age, everybody judged a bank's capital adequacy by dividing its accounting assets by its accounting equity," Borge continues. "Sanford felt, correctly, that that was a pretty crude measure. Even back then banks had a wide variety of risks, and a bank that was very high risk could look well-capitalized." Sanford's intent was to devise a system, with controls, that gave a bank the means to accurately measure risk, "so he could argue to the regulators that we didn't need as much capital as they thought we did."

The first job wasn't convincing the regulators, but the company's bankers. Says Borge: "They thought we were nuts."

 
Out of the ivory tower
To Borge, risk management isn't an arcane science, but a way of handling life. Indeed, his Book of Risk was a rocket scientist's clear explanation to the layman of how risk-based analysis could help evaluate not only business decisions, but everyday ones. He and Sanford spent years with their team devising ways to adopt this philosophy to banking, often to veterans who claimed it was impossible, and, if not impossible, undesirable.

"We didn't know it was impossible, so we did it anyway," says Borge. By 1986, the bank felt it not only had something that worked, but something beyond what many competitors did. Risk management had had its vindication.

Borge not only has the ability to talk about risk management like a human being, but also possesses a dry wit tinged at times with irony. In discussing the evolving risk management function, he believes many banks still haven't fully embraced risk management for what it can do.

"Before the crisis," says Borge, "the chief risk officer's primary duty was to take a bullet in case of trouble."

During much of the pre-crisis, crisis, and post-crisis period Borge served as a risk-management consultant with large consultancies-he's independent now-and he felt risk managers too often did their thing off to the side, producing analyses, charts, and graphs that top executives gave short shrift to when business kept booming.

Here's where the "bullet" came in. "A bank would report a big loss for a quarter, and people would ask, ‘How did that happen?' Management would reply: ‘Our (former) risk guy, well, he really screwed up, and we had no idea what was going on'," says Borge.

The veteran risk man flatly says that that's an unacceptable answer. "That's no excuse for a  CEO," says Borge. "Painting a target on the back of your CRO is not the way to manage risk."

Accountability is an essential of a risk management culture, according to Borge. Many institutions have the tools and the people in place, but adopting a risk-management culture takes an organization-wide commitment, he says.

"I think we still have a long way to go," says Borge.

 
Building, and living, risk culture
Once the industry found itself enmeshed in the financial crisis, risk management and risk culture were overshadowed. "Everybody understandably went into fire-suppression mode, and they could only fix things that they saw as immediately compelling," says Borge. "Building a risk culture is more of a long-term, slow, and difficult process." Actually, if a bank approaches this correctly, he says, the task never ends.

Ask Borge where to begin, and he doesn't give you a chart or a PowerPoint deck. He talks about people.

The central challenge to building, and using, risk management: "Managers don't understand what risk managers do, and risk managers don't understand what managers do."

"This is a very hard problem to solve," says Borge. "It's not just a matter, at times, of ill will or stupidity. It's a matter of very different roles."

Borge faced that when implementing RAROC and learned that simply imposing an approach wasn't always the best solution.

Bankers would resist the system, claiming its perspective failed to reflect the way their units did business.

"We'd hear, ‘This will screw up our business'," says Borge. His side would retort that maybe a shakeup was in order, because current practice wasn't reflecting the real risks each unit posed to the bank.

A standard response evolved: "We'd rather fix the airplane in flight than wait for it to crash. And if you've got a better idea, we're open to suggestions."

Borge says this worked. "Most of the time, that stance either shut people up, or, more importantly, it gave them an incentive to do something better-which they often did." Borge explains that so long as the units' ideas and the evolving RAROC were consistent, "we would happily adopt it."

Building a risk culture begins with the board. Borge stresses that he's not encouraging an adversarial relationship with management, but a questioning one. The board must ask, get answers, and ask more, digging down into a view of what's going on in individual business units.

"Now, the board is in no position to waltz into the office of the head of corporate lending dictating how to run the business," says Borge. The key instead is to work through the CEO to make sure line units appreciate that the board takes risk management seriously.

Risk management systems play a critical part. Board members must insist on reports that provide understandable analytics, not just a pile of indecipherable data.

Ultimately, he says, "you need the reports and the rules. But you've got to make sure the CEO and board are on the hook for changing the organization's approach so you can trust them to not do something stupid or reckless. And that's a cultural effort."


Risk management and regulators
RAROC and the efforts of Bankers Trust helped get things rolling in Washington as risk-based approaches to capital developed. Borge sees good and not-so-good in the execution over the years.

In the 1980s, when Bankers Trust and others were pushing an alternative to the traditional capital approach, regulators bought into the concept, eventually-partially. Basel I was the result, and Borge says there were good points to it, but he found it too simplistic. Basel I left too little differentiation between asset categories, in his view, and treated all loans identically.

"We asked the regulators why they were treating all loans the same," says Borge, "and they said they didn't want to engage in credit allocation. On the face of it, that was actually not a bad response."

Basel II came along later, and then the proposals for Basel III.

"The structure got more complicated," says Borge, "and with every degree of complication, the potential for gaming the system increased. As a result, the regulators began playing Whac-A-Mole with banks. They'd fix one risk problem and the banks would either figure a way around it, or they'd figure a way to take a new risk that wasn't covered."

Bankers are worried about Basel III and Borge says they should be: "It's way too complicated. You could spend your life trying to figure that thing out. And I'm not sure the complications are going to be worth it."

Finance moves much more quickly than regulations can, says Borge, and invariably, unless updates came frequently, the final form of Basel III will become outdated. "And then pretty soon we'd be back where the rules are not reflecting the current risks."

Borge believes the regulators appreciate this to a degree-efforts to relate compensation to risks and the ongoing push to make boards encourage risk-based culture are examples.

"But culture and behavior are very difficult to change from the outside," he adds.

 
Forgotten essential: Your own program
Ultimately, Borge believes it's critical to avoid making Basel III and related disciplines too complicated because that squeezes out tailored, bank-level initiatives. That's often been the case.

"What happens a lot is that banks just give up on their own risk measures," says Borge. "It becomes hard enough to comply with regulators' requirements, so they don't have the energy and resources left to do their own system. So, in effect, the risk-based capital requirements become the default risk management requirements for banks. Ideally, banks should be optimizing their decisions relative to their own risk assessments and their own constraints."

Why is the "local" view so important? Borge points to a common issue during the crisis-securitized mortgages rated AAA.

Borge says the regulators put few constraints on these, prior to the crisis, and low capital burden, thanks to the favorable rating. For many banks, that was good enough-until it wasn't good at all.

"A bank with its own risk culture, one that was working even halfway effectively, might have looked more closely at the risks," says Borge. "They might have said, ‘Whoa! We ought to dial back on these things-even though the regulators will let us pile them on all day long'."

Steve Cocheo

Steve Cocheo’s career in business journalism has taken him to all 50 states and nearly every corner of banking in institutions of all sizes. He is executive editor of ABA Banking Journal, digital content manager of ababj.com, and editor of ABA Bank Directors Briefing. He coordinates the popular Pass the Aspirin and First Person features and wrote the booklet series Focus On The Bank Director. He is the only journalist to have sat in on three federal banking exams, was a finalist for the Jesse H. Neal national business journalism awards, and a winner of multiple awards from the American Society of Business Publication Editors.

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