**5. Seven dreadful mistakes in risk management**

Beyond looking at the economic crisis from a pessimistic angle, it is undeniable the existence of a brink of light considering the whole context – indeed the financial turmoil of the last years can be seen as an opportunity for change and learning from own or peer mistakes [27].


### **5.1. Excess = Aggressive policies in risk lending**

 *"… lend, lend, lend … we'll first get hold of the customers and afterwards make a fortune out of the interest rates …"* 

Strengthening Risk Management in the Midst of Downturn Times 323

Wheras risk should be aligned to capital or liquidity positions, one of the mistakes incurred by companies is the failure to access cross-information. Such lack of information flowing fluently preempts that risk is managed by incentivizing business lines and consequently, it

*" … if the capital level gets too low we'll see later on how to inject more from another source …"* 

Within an increasingly regulated market, Banks and financial institutions could be forced to build-up capital and liquidity buffers in the good times to secure their survival in a Financial Crisis. Many companies which have gone bankrupt in the last years, incurred this mistake and failed to have such buffers filled at the required levels. Therefore this is a clear

Regardless the risk management function should be independent of day-to-day operations, risk components are not something that can be left out of the daily operations – risk limits, stop-loss limits, exposure limits and counterparty limits should be key elements covered by

<sup>18</sup> " . " *<sup>i</sup> Valuation Prod A x y*

The role of structured products is mainly aimed at the design of investment products and customers' risk coverage. These products are highly subtle to market variations and therefore, too complex and time consuming methods for valuating these products allow

In a high competitive and changing environment, such as the financial sector, it's an imperative for Banks and financial institutions to predict and prevent all potential challenges and threatening situations they may face at some point in time. Companies that have not defined severe, plausible and extreme scenarios in their management models have been more vulnerable and negatively affected by the crisis. Those organizations that have been better off, was because in the past the spectrum and range of possible risk scenarios

more room for mistakes and less time to react to the volatility of the markets.

**5.7. Extreme scenarios = Lack of extreme scenarios** 

*" … - what if …? - forget it; it will never happen .."* 

*z*

 

cannot be ensured that internal pricing reflects the current bear risk.

**5.4. Disorders … in capital levels = Inadequate capital levels** 

area where former industry players should have learned the lesson.

*" … have you considered your counterpart risk? … - Do I really need it?"* 

any business line and considered when defining targets and objectives.

**5.6. Too complex … = Complex valuation of structured products** 

**5.5. Uncovered counterpart = uncovered counterpart risk** 

**Figure 4.** Seven Dreadful Mistakes in Risk Management

Excessive risk lending to others results in a sudden drought in available credit with catastrophic effects on business. Individuals are often more driven by their own interests, short-term impressive increases in market share and revenue, but under the assumption that this will continue for an indefinite period of time. Unfortunately, this attitude has a cost – forgetting the collective good of the whole group.

#### **5.2. Inefficiency = Inefficient risk scoring techniques**

*" … - This risk scoring model does not seem very accurate - … - Don't worry, just apply the thumb rule - …"* 

There is a high number of companies that use outdated, static or inflexible assumptions to elaborate their risk scoring models. It is key that such models are funded on the bases of a balanced combination of quantitative and qualitative data. On the one hand, quantitative data can be considered "*the facts*", but complementarily, the use of qualitative data can contribute to a more flexible and dynamic risk assessment processes.

Apart from that it is also a poor practice over-reliance on credit agency risk scoring. The right approach should be for companies to look for consistent and independent risk measurement methods, validating and challenging constantly their obtained results against those provided by others, for instance credit agencies.

## **5.3. Faulty management = Illiquidity derived from faulty management of assets and passive**

*" … – ups, it seems the firm is losing liquidity – … well but competitors are going for it and as long as ASSETS = PASSIVE … it's fine …"* 

Wheras risk should be aligned to capital or liquidity positions, one of the mistakes incurred by companies is the failure to access cross-information. Such lack of information flowing fluently preempts that risk is managed by incentivizing business lines and consequently, it cannot be ensured that internal pricing reflects the current bear risk.

#### **5.4. Disorders … in capital levels = Inadequate capital levels**

322 Risk Management – Current Issues and Challenges

**Figure 4.** Seven Dreadful Mistakes in Risk Management

forgetting the collective good of the whole group.

*thumb rule - …"* 

**and passive** 

**5.2. Inefficiency = Inefficient risk scoring techniques** 

contribute to a more flexible and dynamic risk assessment processes.

those provided by others, for instance credit agencies.

*long as ASSETS = PASSIVE … it's fine …"* 

Excessive risk lending to others results in a sudden drought in available credit with catastrophic effects on business. Individuals are often more driven by their own interests, short-term impressive increases in market share and revenue, but under the assumption that this will continue for an indefinite period of time. Unfortunately, this attitude has a cost –

*" … - This risk scoring model does not seem very accurate - … - Don't worry, just apply the* 

There is a high number of companies that use outdated, static or inflexible assumptions to elaborate their risk scoring models. It is key that such models are funded on the bases of a balanced combination of quantitative and qualitative data. On the one hand, quantitative data can be considered "*the facts*", but complementarily, the use of qualitative data can

Apart from that it is also a poor practice over-reliance on credit agency risk scoring. The right approach should be for companies to look for consistent and independent risk measurement methods, validating and challenging constantly their obtained results against

**5.3. Faulty management = Illiquidity derived from faulty management of assets** 

*" … – ups, it seems the firm is losing liquidity – … well but competitors are going for it and as* 

*" … if the capital level gets too low we'll see later on how to inject more from another source …"* 

Within an increasingly regulated market, Banks and financial institutions could be forced to build-up capital and liquidity buffers in the good times to secure their survival in a Financial Crisis. Many companies which have gone bankrupt in the last years, incurred this mistake and failed to have such buffers filled at the required levels. Therefore this is a clear area where former industry players should have learned the lesson.

#### **5.5. Uncovered counterpart = uncovered counterpart risk**

*" … have you considered your counterpart risk? … - Do I really need it?"* 

Regardless the risk management function should be independent of day-to-day operations, risk components are not something that can be left out of the daily operations – risk limits, stop-loss limits, exposure limits and counterparty limits should be key elements covered by any business line and considered when defining targets and objectives.

#### **5.6. Too complex … = Complex valuation of structured products**

$$\text{If } \dots \text{Valutation } \text{Prod. A } = \left( \left[ \bigvee \overline{\chi} \cdot \bigotimes \underbrace{\mathfrak{f}}\_{=\text{\textbullet}} \right] \oplus \sum\_{-\infty}^{\infty} \nabla \lambda z\_i \right) \dots \text{\textbullet}$$

The role of structured products is mainly aimed at the design of investment products and customers' risk coverage. These products are highly subtle to market variations and therefore, too complex and time consuming methods for valuating these products allow more room for mistakes and less time to react to the volatility of the markets.

#### **5.7. Extreme scenarios = Lack of extreme scenarios**

#### *" … - what if …? - forget it; it will never happen .."*

In a high competitive and changing environment, such as the financial sector, it's an imperative for Banks and financial institutions to predict and prevent all potential challenges and threatening situations they may face at some point in time. Companies that have not defined severe, plausible and extreme scenarios in their management models have been more vulnerable and negatively affected by the crisis. Those organizations that have been better off, was because in the past the spectrum and range of possible risk scenarios they considered was more complete and consequently in difficult times they have had more margin to react and launch mitigation actions.

Strengthening Risk Management in the Midst of Downturn Times 325

2. Heavily involved Executive Board 3. Vanguard tools and systems

**Figure 5.** Quickwins in Risk Management

**6.1. Independent risk management function** 

**6.2. Heavily involved executive board** 

processes and acts on an autonomous way and thinking Global.

thus, inspires such culture and principles to the rest of the organization.

The Risk Management function has to be separated from daily operations. In this sense, The Bank counts on a Risks Management Unit, with its own Head of Department reporting directly to the Executive Board. Such Unit is responsible for risk admission and monitoring

The Senior Management of The Bank is aware of the importance of Risk Management and

5. Sustainable risk quality 6. Objective decisions

4. Integrated risk control and management

Having said this, the key to overcome such mistakes is based upon prudent management of risk, which entitles:

