Talk about risk—or get slammed by risk

In my prior blog post I discussed Collaboration, one of the essential attributes of a strong risk culture, which are:

• Vigilance—Being alert to emerging threats and opportunities.

• Agility—Deciding and acting in time.

• Collaboration—Being able to work together effectively on risk issues.

• Communication—Sharing information and ideas about risks.

• Discipline—Knowing and doing what is right from a risk perspective

• Talent—Attracting and motivating people who have the necessary risk knowledge and skills.

• Leadership—Inspiring, supporting, practicing, and rewarding good risk management.

This time I will discuss Communication—being able to exchange risk  information and ideas as quickly and as accurately as possible among those who need to know.

Essential signals must get through

Good communication is obviously necessary for effective collaboration (as discussed in my last blog), but communication is a large issue in its own right. Poor communication usually leads to poor business decisions and painful consequences.

In the human body, the nervous system carries messages that give us a fighting chance to survive the day. The brain tells the hand to grab food. The hand tells the brain that it is too close to the fire.

A bank’s communication system serves an analogous function. And if it goes awry, bad things can happen: losses are realized or opportunities are missed. In the financial crisis, many banks burned their fingers (or got their bodies incinerated) because their communication systems failed to alert them to dangerous risks.

A bank’s communication system consists of all the formal and informal channels over which information is exchanged—from the annual report to water-cooler gossip; from The Wall Street Journal to Twitter.

Bank management must pay attention to all these channels. This is no easy task.

Effective communication about risk issues is particularly difficult because of the issues’ complexity, their speculative nature, their susceptibility to cognitive biases, and the charged atmosphere in which they are often discussed.

What we have here, is failure to communicate

Let’s consider just one important example here:

Risk people and business people don’t speak the same language. This leads to miscommunication about risk that leads to bad decisions.

• Risk people believe that they are paid to avoid losses.

They try to quantify the downside by using risk models and historical data. They are comfortable with mathematics, statistics, and financial theory. They tend to lace their conversation with arcane terms unintelligible to outsiders.

Yet a risk model always requires simplifying assumptions, which guarantee that the model will be approximate, at best, even under ideal conditions. And it will be utterly wrong under some conditions. Even a model with robust assumptions can be undone with stale, erroneous, or incomplete risk data.

• Business people believe that they are paid to make profits.

They try to predict what will happen in the future and they rarely dwell on the past. They scour the details and complexities of their business to find imperfections, inefficiencies, and distortions that can be exploited for profit.

They steep themselves in the conventions and lore of their business. They lace their conversation with buzz words, acronyms, and comforting folk tales that can obscure changing realities.

Put these two mindsets on opposite sides of the table and here’s what you get:

• More than likely, the risk people do not fully understand the complexities of the business; they have a excessive bias toward avoiding losses; and they prefer to believe that future conditions will be similar to past conditions.

They compound their sins by communicating in geek speak.

• And it is more than likely that business people don’t fully understand the complexity or magnitude of the risks they are taking; they have an excessive bias toward chasing profits; and they prefer to believe that past disasters are not indicative of future results.

They compound their sins by communicating in biz speak.

It is no surprise that risk people and business people often fail to seek out, to  understand, or to trust each other’s opinions.

However, when they communicate effectively, risk people and business people can compensate for each other’s limitations and biases, producing better decisions for the bank.

Achieving a meeting of minds

These challenges aren’t insoluble. A bank can take action to improve its communication of risks:

• Adopt a bank-wide framework for defining, identifying, measuring, and managing risks.

Make this framework something that both risk people and business people are expected to use in their day-to-day business. Tear down the tower of Babel by establishing a common language.

• Increase the rotation of people between risk positions and business positions.

Educate risk people about business and business people about risk. Foster more relationships of mutual trust and respect based on personal experience. Fight the “Us versus Them” mentality.

• Change business policies and practices, so that risk people and business people are actively engaged with each other at each stage of the decision process, from inception to maturity.

• Do not confuse better risk information with more risk information.

Do not tolerate mindless data dumps or incomprehensible reports.

Insist on clarity, relevance, and the exercise of business judgment. The message should be tailored to the needs, priorities, and abilities of its audience.

• Insist on open and honest debate of risk issues.

This must be based on fully-shared information and ideas.

Don’t shoot the messenger bearing bad news.

Don’t ostracize unconventional thinkers.

Don’t tolerate group-think.

• Reward good risk management. Not just booking profits. Not just avoiding losses. But achieving a better balance of risk and return.

• State the bank’s risk management philosophy clearly and forcefully to all employees.

Let no one be able to claim that management was ambiguous on this point.

If you permit that, confusion and dysfunction will reign.

Where bad communication roosts, and what follows

Failure to communicate effectively about risks can occur in many parts of the bank:

• Between risk officers and transactors.

• Between business heads and top management.

• Between the risk function, and top management and the board.

• Between the bank and regulators.

• Between the bank and investors.

• And between the bank and its customers.

The consequences of poor communication of risks can range from unpleasant to catastrophic. It is imperative for bank management to identify weak spots and work hard to improve risk communication.