Technological advances, new competitors and product innovations, and volatile economic conditions are among factors making bank executives' jobs unlike anything their predecessors could imagine. Consider risk management. As recently as 10 years ago, a bank was considered ahead of the curve if it had adopted technology that let it analyze and manage risks associated with basic balance sheet items, such as deposits and loans. Today, such asset and liability management systems are standard at most financial institutions, and truly progressive bankers are considering how to manage risk throughout the enterprise. No longer is a simple snapshot of assets and liabilities adequate. Instead, systems are being installed that offer moving pictures across a broad spectrum of market, operational, and credit risks. The idea is to help bankers get a better handle on the full spectrum of risks so that they can more efficiently deploy capital. And bankers using some of these new comprehensive systems say they work. Yet some experts caution that these systems' technological complexity could put them out of reach for all but the most sophisticated financial institutions. "We have all these fancy models and the discussion of them is so complex," said John Dorman, president and chief executive of Treasury Services Corp., Santa Monica, Calif. "If it takes a Ph.D. to understand a discussion of risk, how many bank managers do you think are going to be able to understand and make good decisions" based on information from these models? This information can only become valuable, Mr. Dorman suggested, if management processes keep pace with the marketplace. One institution that appears to understand that maxim is Toronto Dominion Bank. Dave Tanner, vice president, asset and liability management, says his $90 billion-asset bank employs within its risk management ranks a group of people with doctorates in such areas as mathematics, physics, and quantum mechanics. But Mr. Tanner, who has degrees in both engineering and business administration, said risk analysis at the bank is balanced by pragmatism. The pragmatist, explained Mr. Tanner, is the banker who understands that, despite the time, effort, and money that go into building sophisticated risk models, the models can't predict perfectly. These models make predictions based upon historical analysis, explained Mr. Tanner. But history rarely repeats itself exactly; different events can change the balance of risk dramatically. "The models will not be able to predict the outcome of event risk," Mr. Tanner warned. With this awareness, bankers are more likely to balance what the models predict against their gut feelings. At Toronto Dominion, said Mr. Tanner, that balance is struck in a centralized risk policy group consisting of "rocket scientists" and senior managers. The policy group coordinates all aspects of risk management - including but not limited to market, operations, and media risks and disaster recovery planning - and reports directly to the bank's board of directors. The result, suggested Mr. Tanner, is better risk management decision- making.
Better risk management doesn't come cheap, however. Mr. Tanner estimated the total cost of installing just one system for asset and liability management at about $2 million. That includes hardware, software, and internal development time. And an asset-liability system is just one of many risk management systems Toronto Dominion has adopted. Others help gauge risk in foreign exchange operations, derivatives, and other trading activities. Banks aren't the only organizations investing a lot in risk management. Plenty of intellectual capital is being expended by vendors to develop risk management technology, for example, Cats Software Inc., a Palo Alto, Calif., company that specializes in integrated risk management and derivatives trading solutions. David Gilbert, vice president and general manager of Cats' risk management division, holds a doctorate from Harvard himself. And he has 16 employees with doctorates - in mathematics, finance, and physics - developing the modeling framework that supports Cats' risk management products. "The barrier to entry to this business is knowledge," explained Mr. Gilbert. System developers, he said, must understand how various financial instruments work and the principles of complex pricing models. "We've got to have the same talent as the best of Wall Street does," he said. Other suppliers agree. But rather than staff up with holders of doctorates, many vendors have opted for partnerships that bring advanced mathematics and related skills to product development. Treasury Services, for example, has forged a partnership with Kamakura, a Japanese firm with the advanced mathematical research skills needed to develop risk analysis models for complex derivatives transactions, Mr. Dorman said. And Sendero Corp., a Scottsdale, Ariz., company that specializes in asset-liability management systems, has allied itself with Global Advance Technologies of New York for advanced analytics capabilities to support its product line, according to Elliot Rosen, Sendero's president. "The evolution in the industry is causing a higher demand for people who have advanced financial engineering and mathematics-type backgrounds," said Mr. Dorman. The implications of this change are dramatic. As the technological tools for managing risk evolve, banks are able to develop sophisticated new products - products that can help retain customers without creating new risks. "Banks are getting very creative in the way they design products," noted David LaCross, chief executive of Risk Management Technologies, Berkeley, Calif. Mr. LaCross said he sees product development as an important consideration for banks using his company's risk management system, Radar. "When we market our system, we want it to be used to make money, we don't want it to be used as a defensive mechanism," he insisted. While the natural state of a bank's balance sheet may create exposures to a sudden downturn in interest rates, it's possible to design and market products to customers that have the opposite effect, explained Mr. LaCross. In other words, a bank doesn't need complex financial instruments, like derivatives, to hedge against risk; it can structure deposit and loan products in a way that incorporates the kinds of risk profiles derivatives offer. "If you can offer products to customers that provide the same results as derivatives, you're in a good position," said Mr. LaCross. "It mitigates risk and adds value to the customer." The key is to create these products with an enterprisewide focus on risk analysis, said Mr. LaCross. Although in the past that may have seemed a formidable task, the proliferation of high-tech data repositories and advanced analytics - like computerized Monte Carlo simulations - make the job more feasible, Mr. LaCross said. In Monte Carlo simulations, changes in cost or value are calculated simultaneously for numerous interest rate or market scenarios. The result is a range of outcomes representing different risk levels and probabilities. "It produces much more accurate" information, said Mr. LaCross, on which banks can act. This capability is particularly critical in product development, observed Sendero's Mr. Rosen. "There's almost been too much of a focus on the latest whiz-bang way of analysis on the fringes," he said. A bank that focuses too much on the fringes, he suggested, will quickly lose sight of structural risks, which encompass the largest parts of a bank's balance sheet. Mr. Rosen said he doesn't fault the analytical tools used for risk management on the fringes. But he does believe these tools could work better if more widely applied across a bank's balance sheet. "We think there are improved analytics that can be applied to the balance sheet," he said. But when you get right down to it, software tools alone can't protect a financial institution against the myriad risks in today's marketplace. Understanding is required of where to find the correct data to feed into a risk analysis system and how to interpret and apply the analysis. "Clearly, you need better tools to build a better house," said Jerry Weiner, chief executive of Interactive Planning Systems, a Norcross, Ga., firm that markets profitability measurement tools, mostly to community banks. "But it's not the tool that drives this; it's how the people use it." Patricia A. Murphy is a regular contributor to Management Strategies.