Deputy Governor, CBN, Chiedu K. Moghalu
Deputy Governor, Financial System Stability, Central Bank of Nigeria (CBN), Dr. Chiedu K. Moghalu, recently spoke on “Risk-Ability: Risk Management Knowledge and Infrastructure for Nigeria’s Financial Services Industry,” at a Chief Risk Officers’ retreat. Obinna Chima, who was there presents the excerpts:
From the tulip mania in Holland in the mid-1630s to the ultimately disastrous speculative rush for the shares of the Mississipi Company promoted by John Law and his Banque Royale in Paris in the early 1700s, from the South Sea Bubble in London in the same period (to which Sir Isaac Newton lost a princely £20,000) to the great Wall Street Stock Market boom of the 1920s that preceded the Great Crash of 1929 and the Great Depression and on to the global financial crisis of 2008 – 2009, the history of finance over the past 500 years has been marked by frequent booms and busts.
Historical evidence suggests, as the famous American economist John Kenneth Galbraith put it, “that the financial memory should be assumed to last, at a maximum, no more than 20 years. This is normally the time it takes for the recollection of one disaster to be erased and for some variant on previous dementia to come forward to capture the financial mind.”
If this is so, and we are condemned to cycles of financial implosions that wipe out economic value, is the modern science of risk management doomed? It isn’t. The future is always uncertain. But as the experts in the science of risk management assert, it is quite possible - and necessary – to manage the financial risk that uncertainty brings with it. There are three ways to look at, or define risk management.
The first is to view risk management as a pure defensive play in which we sacrifice growth and hold on to whatever value we already have, and perhaps transfer as much risk as possible through risk transfer mechanisms such as insurance.
A second approach is to see risk management as the balance between risk and reward.
A third, more technical way of looking at risk is to understand the difference between risk and uncertainty, in which the former is seen as expected loss (or costs) of which the probability can be statistically quantified, while the latter represents unexpected loss (or costs) – in other words a variability that cannot be quantified.
Risk is a significant and inevitable aspect of business activity in a market economy. Business grows mainly by taking risk. The greater the risk, the higher the potential return and so the business unit must strike a trade-off between the two.
Risk is also a pervasive part of organisational strategy, with profound implications for the success or failure of any business undertaking.
This is particularly relevant for banking business which performs three main functions – financial intermediation, asset transformation, and money creation. These roles are fraught with obvious risks. Financial intermediation, the process in which money deposited in banks for safe keeping by individuals or organisations is loaned out to borrowers, may be affected by the risk that depositors demand their money at a rate faster and larger than the reserves the bank has kept from deposited funds.
Asset transformation, the process of creating new assets (loans) from liabilities (deposits) runs the risk that a change in market interest rates may dilute the profit a bank makes in its loans since a bank must charge interest on its loans that is higher than the interest it pays on its deposits.
And money creation, the process in which additional money is generated in the financial system by the repeated lending of an initial deposit in a bank through the principle of the fractional reserve, can create inflationary or other macroeconomic risks as the amount of money created in a fractional reserve banking system depends on the level of reserves banks are required to maintain from deposits. Thus, risk taking is an integral part of and constitutes a major characteristic of banking business.
Risk Management Practice in Nigeria
Although there has been noticeable improvement in risk management practices across Nigerian banks following the intervention of the CBN to avert massive bank failures in 2009 and the subsequent reform measures, risk management practice in the Nigerian financial services industry is still at a rudimentary stage and is beset by a number of challenges.
Chief among these challenges is the acute dearth of knowledgeable and skilled risk professionals. Most of the available risk experts appear to be concentrated in certain banks, yet even in these institutions, those with risk experience may not be fully involved in major strategic decisions.
This is further exacerbated by the pervasive poor knowledge of risk management by members of the board of many banks as revealed by the result of the diagnostic study commissioned by the CBN in the wake of the banking sector crisis in 2009. In hindsight, it was apparent that senior management and directors did not appreciate the nexus between their banks’ business strategies and risk appetite and the implications for risk management within the organisation. Several factors are responsible for this state of affairs.
These include: the absence of formal training institutions offering risk management curricula as several risk management practitioners do not possess formal qualifications and technical depth, but merely became risk managers “on the fly”.
Secondly, the absence of an industry-recognised risk management qualification and certification programme or system to foster the development of professional talent in the different areas of risk management such as credit, operational, liquidity and market risks. Thirdly, the absence of a holistic, well-structured and well-coordinated approach to talent development tailored to meet the contemporary challenges in the industry, including in the area of risk management and corporate governance.
Also, there is lack of strategic partnerships and alliances with tertiary institutions, local and global associations of risk professionals on risk management training and education, the absence of a competency framework that supports the development of skilled and capable workers in the industry including in the area of risk management and low priority accorded to the development of capacity by some banks particularly in the area of risk management and corporate governance for members of the board and management.
Regulatory Initiatives to Promote Risk Management
In line with global best practices and as part of the on-going reforms of the banking sector, the CBN has commenced the implementation of risk-based supervision of banks in Nigeria. As a complementary effort, the CBN is currently in the process of adopting and implementing the Basel II/III capital accords beginning in December 2012.
The adoption and implementation of these initiatives will foster better risk management and corporate governance in banks, as well as improved regulatory supervision and industry transparency. This has practical consequences for the role and responsibilities of bank directors and senior management.
In addition, as a follow-up to the stress test conducted in 2009 at the request of the CBN, plans are underway to conduct another round of assessments on commercial banks before the end of 2012 as part of a Financial Sector Assessment Program (FSAP), a technical assistance programme facility provided by the International Monetary Fund (IMF) and the World Bank.
The CBN has also strengthened the supervision of off-shore Nigerian banks. There is an on-going cross-border supervisory co-operation and coordination with other jurisdictions where Nigerian banks have presence. In order to get a more accurate sense of the state of risk management in Nigerian banks, the CBN has taken two important steps. The first is the creation of, and recruitment for a specialist Risk Management Team in the Bank’s Banking Supervision Department that houses the regulator’s bank examiners.
Second, the Committee of Governors of the CBN has instituted a process of regular dialogue between the banks’ leadership on the one hand, and chief risk officers, chairmen of the board risk committees and credit committees of deposit money banks on the other. These dialogues enable the regulator to provide policy guidance to bank risk managers. There is also an evolving effort to set up a forum of Chief Risk Officers (CROs) of banks to provide a platform to periodically discuss risk issues in the industry at large.
Furthermore, the CBN is developing a framework for the resolution of banking crisis in future, with strong scenario planning. This is in addition to a strong macro-prudential framework that anticipates and addresses the several macroeconomic imbalances, shocks and systemic exposures to which the banking and wider financial system in Nigeria is vulnerable, including global economic dynamics.
The move by the CBN from a compliance-based supervisory system to a risk-based supervisory system marked a paradigm shift in thinking, both on the part of the regulator and that of the operators.
While the compliance-based system has not been jettisoned, the CBN is now increasingly focused on risk and encouraging strong risk management in the banks and other financial institutions under the Bank’s regulatory purview. We have made significant progress both in the determination of inherent risks and in the assessment of Risk Management, but more work needs to be done regarding the latter.
The implementation of Basel II/III standards in the banking industry will serve as an enabler to this process. Our supervisory process places heavy reliance on the work of Chief Risk Officers and on the effectiveness of the risk management function.
Considering the identified skills and capacity gaps and the paramount importance of having in place a sufficient pool of skilled talent to drive and support effective risk management in financial institutions, the following strategies are recommended: Firstly, professionalise risk management education in Nigeria through the development of qualification and certification programs by registered professional bodies and training providers such as RIMAN and Credit Risk Management Association of Nigeria (CRIMAN).
Secondly, establish an accreditation and assessment system for risk management training providers in the financial services industry. Thirdly, to develop a holistic competency framework that addresses critical competency gaps among bankers and supports the development of risk management professionals in the financial services industry.
The Bankers’ Committee is currently developing a competency framework for the Nigerian banking industry which is expected to contribute towards addressing identified capacity gaps.
Fourthly, there is also the need to forge strategic partnerships and alliances with global professional associations such as the Global Association of Risk Professionals (GARP) and the Institute of Risk Management (IRM) in the United Kingdom to leverage cutting-edge best practices in risk management. Similar partnerships should be forged with local professional associations, corporate learning centres, industry learning organisations and tertiary institutions on risk management training and education.
Also, financial institutions should invest in and allocate adequate resources to enhance capacity development through recruitment and training of competent specialist risk professionals as well as training of the general workforce and board members on risk and risk management. Finally, there is need to create collaborative partnership and support by industry regulators towards capacity development in the industry.
The CBN has supported and will continue to support capacity development initiatives in the industry as well as robust investments in Information Technology and data infrastructure to facilitate effective risk analysis and measurement remain essential.
I began by noting that risk management cannot predict the future. But, if there is any lesson from the global financial crisis and its second-round effects that, together with weak corporate governance and the absence of a risk-aware culture in most Nigerian banks pre-2009 led to a near collapse of the banking system, it is that risk management does matter.
Since risk is embedded in the very fabric of banking, managing it ought to be second nature for practitioners in the financial services industry even if its record is always a mixed one.
But we have to first understand risk and the rising essence of risk management. As experts have noted, “we need to make sure we are at least as literate in the language of risk as we are in the language of reward.”
It should be heartening, then, if the following plaint were to represent the future of Nigeria’s banking industry: “first he sat in the back seat and then he had his foot on the break, now he’s got one hand on the steering wheel! Is there no end to the risk manager’s advancement into every aspect of risk-taking in a financial firm? Next he’ll be right there in the driving seat, with traders, salesmen, corporate financiers and chief financial officers doing his bidding. So, is the risk manager turning into something else”?