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1 August 2013 CFA Institute Journal Review

Risk Management Infrastructure as a Living Organism (Digest Summary)

  1. Chen Sui

The different elements of risk management and how they work together in financial institutions are similar to the complex and complementary systems of the human body.

What’s Inside?

Drawing an analogy between the elements of risk management and the systems of the human body, the author provides insight into risk management in financial institutions. Using six systems of the human body—skeletal, muscular, cardiovascular, brain, nervous, and immune—he focuses on the corresponding components of risk management and the issues that arise when the components are deficient or fail completely.

How Is This Article Useful to Practitioners?

In the human body, the skeleton serves as the foundation. In a risk management system, the foundation consists of the framework of policies and formal standards that define and govern the risks inherent in the institution’s activities. Crucial components of risk management should connect to these reference points just as parts of the body are connected to the skeleton.

Operating and information management systems provide the risk management equivalent of the body’s musculature system. The operating power of the risk management system comes from its ability to capture and analyze data. The more numerous and complex the institution’s activities, the more risk management power is required.

The cardiovascular system is similar to the flow of data. Comprehensive, timely, and accessible transaction and market data are the lifeblood of the risk management function. The continuous monitoring and testing of the data is a key function of risk management. Like the cardiovascular system, the condition of the data is a primary indicator of the condition of the financial institution.

High-performing risk management systems need leadership to be able to function effectively in times of crisis and not just during stable periods. Thus, leaders must be able to thoroughly understand the institution’s business, recognize early warning signals, and influence high-stakes decisions. This leadership role parallels the role played by the brain.

A firm’s culture of risk management plays the role of the nervous system; it helps carry the communication from the risk managers to all levels of the institution. The 2008 financial crisis highlighted cases in which the risk management culture was woefully deficient.

Finally, in countering threats to the organization and building resistance to threats, the skill and experience of the risk managers plays the role of the immune system. The author gives the example of the skill and experience that enabled some financial institutions to react quickly to warning signs and minimize their risk to the failing Lehman Brothers.

Abstractor’s Viewpoint

The author gives an interesting perspective on risk management. The holistic approach focuses on the importance of each individual component of effective risk management and the dangers to the whole institution when one or more components are deficient. Frequently, financial institutions focus on just a few of the components, usually the information and data systems, without addressing the amorphous aspects, such as culture, communication, skill, and experience. By using the human body as a comparison, the author manages to convey the dependence of an effective risk management system on all of the individual components and not just a few of them.

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