In April 1979, Paul Harvey told a story on his radio broadcast about a woman in Jackson, Miss., who was having all kinds of trouble driving to and from work.

She said it used to be easy. No traffic, no rat race.

But now -- wow! Cars coming from all directions!

Ever since she got her new glasses.

Risk Is Not a Bad Word

If a better glimpse of reality doesn't change circumstances, at least it should change our awareness.

Our world is undergoing an incredible transformation. Because of rapid technological advances, opening of global markets, and corporate America's. increasing focus on delivering value, the future of free enterprise looks very bright.

Yet it is unclear whether the American banking industry will play any role in this bright future.

To a great degree, the banking industry's future hinges upon developing a more pro-active and rigorous understanding of risk.

Bankers, regulators, lawmakers, and consumers must stop thinking of risk as a bad word, something to avoid or tightly control.

This line of thinking only encourages bankers to make passive, less-informed mistakes together -- like sheep rolling off a cliff.

Harmful Rigidity

Risk is an engine. It is the catalyst for any positive change in our society. It is the fuel for creativity and innovation.

Yet in this time of innovation, a time that demands speed, flexibility, knowledge, and individual empowerment, the banking industry has moved forcefully into a mode of rigid "command and control."

This is evident in laws such as the Federal Deposit Insurance Corporation Improvement Act and in internal management structures since the S&L crisis.

Now, the greatest threats to the banking industry are in bankers' misguided belief that risk management is achieved through regulatory compliance and rigid control systems within their organizations.

Change Needed

The banking industry's future is plagued by two major problems: a burdensome, rigid, and outdated regulatory structure and a need to dramatically improve the ability to take risk.

Bankers must accept responsibility for changing and improving their industry. If they want more freedom, deregulation, and the ability to take risk on their own terms, they must prove that they have increased their understanding of risk.

Additionally, they must demonstrate that they will accept more responsibility and take greater "ownership" of the risks they choose in a less controlled environment.

Maximizing Returns

Bankers must revolutionize their philosophy of risk management.

In the world of free enterprise, the objective is not to categorically reduce risk, to minimize risk, and certainly not to eliminate risk. Bankers are here to maximize risk-adjusted returns -- to move capital to arenas where it will be best utilized on a risk-adjusted basis.

They must remember that taking risk is not the same thing as gambling. Gambling is a zero-sum game that hinges on random luck. When bankers take risks -- intelligent risks, educated risks, active risks -- they use knowledge and creativity to stack the deck in their favor.

Process Has Been Fragmented

And when bankers take risks correctly, they have the power to create wealth. Winning this way does not require that someone else lose.

Why do banks seem to continually lose the battle with risk? The answer lies in the fact that the banking industry, among others, has disaggregated the fundamental process of risk taking, weakening the ability to manage risk.

Think how basic the process really is:

Banks invest capital that generates a return on the investment sufficient to compensate for the risk involved in the transaction.

To an individual, this algorithm is fairly straightforward. But in a bank, the interdependent components of capital, risk, and return have been fragmented all over the organization.

Because of this organizational design, banks do not force the balancing of risk and return strongly enough for these business units and individuals.

Wrong Focus

Banks push their loan officers to generate volume -- and ask them only parenthetically to keep an eye on risk.

Loan officers are not told to go out and maximize risk-adjusted equity returns. But that is just what they should be told.

Bank portfolio managers may make investment decisions, but usually these investments get quickly dumped into a balance-sheet melting pot, with the true consequences of this risk-return decision never to be known.

The problem is actually very simple:

The fundamental mission of a financial organization is balancing -- balancing risk and return, deploying capital to appropriately balanced transactions.

But when this process is fragmented so the balancing dynamics cannot be tracked and bankers can't learn from the outcomes of past decisions -- cannot assign "ownership" to the ultimate risk-adjusted return -- the industry is consigned to a future of boom and bust.

People, Not Rules

How can the banking industry improve its risk-management capabilities?

* Rely on the knowledge and the "ownership" of the risk managers, not on rigid rules and controls.

* Create an environment that encourages and requires constant learning. Only in such an environment can risk-management organizations increase their knowledge.

* Increase risk managers' ownership" of risk by aligning the goals of individuals with those of the organization. Actual co-ownership" of the risk and return is the optimal approach.

* Encourage candid debate in risk-management organizations.

* Do not allow badly performing risk managers to survive in the organization -- and conversely, let top-performing risk managers influence.

* Live the process; that is the only way to understand its complexity. Risk management is a never-ending process that allows the organization to learn, change, and improve its ability to survive.

* Use risk-adjusted return on capital as the common risk-measurement and analytical tool throughout the organization.

Plan Ahead

Finally, develop a formal risk-management plan that recognizes the complexity of the banking enterprise.

Ironically, though bank executives usually augment their institutions' strategic plans with financial plans, marketing plans -- sometimes even information systems plans -- only rarely are formal risk-management plans prepared.

It will be very difficult for the banking industry to effect worthwhile changes to its risk-management cultures without such plans.

Taking Responsibility

Our lawmakers must enact a long-term plan to create a more open, market-driven financial system.

The movement of capital cannot rest on the practice of regulatory arbitrage. Technology, global markets, and value-driven consumers will make it impractical to segregate the American financial system into simple, convenient pieces that never touch.

The financial system of the future should stress the two, key principals of enterprise: knowledge and ownership. Bankers must focus on these principles as they build their risk-management organizations.

It comes down to creating cultures in which bankers, having developed the instincts of successful entrepreneurs, act more as if the money entrusted to them were their own.

Subscribe Now

Access to authoritative analysis and perspective and our data-driven report series.

14-Day Free Trial

No credit card required. Complete access to articles, breaking news and industry data.