Responding to Risk

I like to think about risk in terms of its probability and consequences (or impact). I believe that when looking at credit opportunities and performing borrower analysis, our awareness of both of these factors is crucial to our ability to maintain credit quality and avoiding ugly surprises.

I encourage you to think about your response to risk. And note that I am not limiting you to the subject of "mitigating risk," the more commonly used phrase. Rather, consider your complete response to borrower risk: how you protect your institution on a broader level. To do so, you need to start by assessing the probability that a risk will occur and its likely consequences.

We can summarize the probability and impact of risk in a simple table:

Low Probability
Low Impact		High Probability
Low Impact
Low Probability
High Impact		High Probability
High Impact

Simply put, most institutions expend almost all their effort on the right-hand column.

Now, it makes perfect sense to respond to high probability, high impact challenges to repayment. Certainly you have to closely examine this risk and take steps to protect your interests.

Unfortunately, however, the next level of response is usually limited to other high probability threats. Why? Because they are easy to see.

In fact, they are so easy to see that financial institutions often overlook that “southwest quadrant”—the risks that aren't very likely, but that can have a devastating impact on the borrower's business if they occur. As a result, those institutions frequently experience very painful consequences. Consider these examples;

  • Pandemic (Swine Flu has been designated an epidemic by the WHO.)
  • New Terrorist Attack (“Terror” can actually take a multitude of forms.)
  • Collapse of Utility System (cell towers, power grid, etc.)
  • Significant Weather Event in Major Metropolitan Area (Anyone remember Hurricane Katrina or the San Fransisco/Oakland earthquake?)

The first response to risk, then, is to identify it properly. If you are overlooking some rare, but potentially catastrophic turns of events, you are not protecting your institution.

After that, it is common to focus on lessening the impact, and there are several strategies available for doing that:

  • Developing secondary sources of repayment, such as more collateral or guarantees
  • Using hedging or derivatives to mitigate the financial impact of trouble in the borrower's business
  • Transferring some of that risk, perhaps through participations, by both selling off risk to other institutions or taking part in transactions that will reduce your portfolio concentrations
  • Taking advantage of government programs that provide backing or insurance against a complete disaster in your borrower's health
  • Managing lending limits and explicitly monitoring concentrations to ensure that you do not set the stage for a really hard fall when a couple of borrowers go south on you

That said, don't overlook opportunities to reduce the probability of negative events. If you do a good job of risk assessment by clearly identifying the high-impact items, even if they are unlikely, you may pick up threats to the business that others have missed, or at least underestimated.

In that case, work with your customers to help them find ways to reduce risk. They may be able to take steps to reduce the probability of a specific threat becoming a reality. Or they may be able to make changes that will lesson the "domino effect," making it less likely that a serious problem in one area of their business will bring the whole company to the brink of disaster.

Too many institutions seem to have the philosophy, "take the risk, and structure your way out of it." If you take a two-pronged approach to responding to risk, tackling both the probability and consequences of the challenge, you will assess risk more accurately, have more options for containing or reducing overall risk, and perhaps push some of the risk management responsibility back onto your borrower.

The result? A healthier borrower in a healthier portfolio!

Jeff Judy is a financial services consultant and business trainer. He has provided financial services training in Europe and Asia, as well as throughout the U.S. His interviews and articles have appeared in trade journals, such as Independent Banker, more general financial media such as Finance and Commerce and Northwestern Financial Review, as well as in the internal publications of various corporations. Judy consults with company boards on issues such as strategic planning and market identification, trains staff to execute best practices that support the corporate vision, and advises educational and trade associations on curriculum related to financial services and risk management

Join Jeff Judy at one of the Seattle Bank’s upcoming credit seminars, which will be held at various locations across the district in September 2009. Register online now to reserve your spot at one of these upcoming events!