For over 10 years, I taught an insurance course on “Identifying Risk.” While this is still the most vital part of any risk management process, prioritizing the identified risk is a close second. By prioritizing, I mean, “what is the best allocation of our time and resources to handle the risk of a loss?” For example, surely more time, energy, and resources should be spent on the prevention and financing of a major embezzlement loss, as opposed to glass breakage at a branch office. While the advent of Basel III still applies to international and megabanks, the emphasis on risk management of all assets is clear. It won’t be long before such emphasis is applied to the community bank.
There are three (3) questions the bank risk manager must answer in order to prioritize and “handle” the risk properly:
1. What is the economic effect on the bank’s finances should this loss occur?
This is the first question that should be asked. For example, a loan officer (and/or loan committee) should determine how financially crippling it would be to the bank in the event a customer defaults on a particular loan. Moreover, how disastrous would an earthquake be to the bank’s buildings AND those buildings that are collateral for loans?
2. What is the probability of a loss by this risk?
Virtually everything is “possible.” However, the practical risk manager must deal with the most probable first. In the major loan example above, if the borrowers’ financials are in order, and the loan is properly collateralized, the “probability” of a major loss to the bank through default is slight. However, all possibilities of major losses to the bank should be addressed in some form or fashion.
3. What financial and physical protections can be taken to reduce or eliminate the financial loss effects to the bank?
In the loan example above, the collateral obtained is one form of protection. Making sure this collateral is protected by insurance is another.
The bank has four (4) options in protecting its assets: 1) Avoid the risk; 2) Assume the risk; 3) Finance the risk, and 4) Transfer the risk. Although this is really a topic for another newsletter, the bank could avoid the risk by simply not having it in the first place. For instance, a bank could decide to not have any branches in any known earthquake area, thus effectively avoiding this risk.
The bank could also assume the risk, whereby there are two (2) types of assumption: “intentional” assumption and “unintentional” assumption. An example of intentional assumption would be lost from an identified risk, such as building glass breakage.
The bank could decide to pay for the loss out of cash. A loss from an “unidentified risk” would result in an unintentional assumption. The bank could finance the risk by setting up a Loss Reserve to pay for these contingencies. Finally, the bank could transfer the loss, either to a third party or by purchasing a particular insurance policy that covers such a risk.
Prioritizing risk is essential in the Risk Management process, one that will become more important in the future of banking. Carefully handling this process may very well determine the ultimate success or failure of a financial institution.