We translate uncertainties into calculable risks
What are the greatest risks facing banks at present? How is the growing trend towards protectionism to be interpreted? How important are common sense and intuition in the risk management space? We hear from Joachim Oechslin, Senior Advisor - Risk Management at Credit Suisse, who always has to consider the worst case scenario in his work.
The interview was held on December 18, 2018.
Mr. Oechslin, what risks have you had to deal with in your work over the past few weeks?
The risks related to the high level of volatility in the financial markets. For us as risk managers, the operational impact of higher volatility is that we always need to carry out additional analyses. For example, this volatility can have a significant effect on our credit portfolio so we need to have a clear view of the situation at all times.
What effect did your analyses have exactly?
Let me give you a simple example: The loans that we grant are often secured against collateral in the form of securities. The political and economic uncertainty in recent weeks caused many share prices to fall. This didn’t have a dramatic effect but it triggered a margin call for a handful of loans, meaning that the client had to supply additional financial collateral. That is, to some extent, courant normal in the financial markets and it generally works without any problems. These margin calls are a specific consequence of higher volatility.
And now for a general question: What is the main objective of risk management at Credit Suisse?
It is critical for our success that we conduct all our business activities in a risk-conscious and responsible manner. When doing so, we try to determine the probability that key economic factors will develop in a particular way in the future. In other words, we translate uncertainties into calculable risks and manage them in that way. Our primary objective is to maintain our financial strength and reputation and, at the same time, to ensure that we allocate our risk capital to our most profitable areas of business.
How do you do that?
We have created a dedicated governance structure – i.e. a framework – for risk management. It has a First Line of Defense and a Second Line of Defense. Before entering into a transaction, the employee has to assess it according to risk criteria. That is the First Line of Defense. Once transactions reach a certain size and entail a certain level of risk, our Risk Management team performs a completely independent assessment. That is the Second Line of Defense and its importance has increased enormously within the finance industry in recent years. At the start of my career, the independent risk management process involved a small number of people but today, around 3,500 specialists work in my area alone.
How do you take the countless individual transactions that entail different levels of risk and translate them into a risk profile for the entire bank?
Our balance sheet, which totals around CHF 800 billion, consists of assets and liabilities. Both sides of the balance sheet react to changes in interest rates, share prices, exchange rates, volatility and many other factors. We work with thousands of variables that are correlated. If parameters in the capital markets change, we try to understand how this will alter our balance sheet. And we look at an individual risk and ask ourselves: How high is the probability that a loss will occur? We then compare that with our risk capacity and ask ourselves: What impact would that type of loss have on our equity capital? Analyzing these scenarios is one of our main tasks, which is why hundreds of physicists, mathematicians and economists constantly model our balance sheet. At Executive Board level, we regularly define the level of risk that we are willing to take. Regulatory capital requirements are, of course, a key parameter in this context.
What were the biggest risks to the bank that you identified in the past few months?
Two topics were especially prominent in recent months: The normalization of US interest rate policy and the trade dispute between the US and China.
Where do you see risks in US interest rate policy?
It is both right and important for the long period of ultra-low interest rates to come to an end. This change of monetary policy is the right approach for the US, where the economy is currently developing very soundly. While the US can afford a rate hike, this poses a major challenge for other parts of the world. In Europe for example, growth momentum has slackened again. In the emerging markets, there is a certain risk that money will flow into dollars because of higher yields in the US. These capital flows put pressure on emerging markets, and particularly on their currencies.
Have you already observed any effects of the trade tensions between the US and China?
In China, share prices and the currency have come under pressure. In the US – but also in other countries – there are signs that the additional trade barriers are having a negative impact on decisions about capital spending by companies. This dispute is a big topic that will preoccupy us for some time.
What is your interpretation of growing protectionist tendencies?
I think the increased protectionism is also a sign of political populism. The security framework and economic order that were established after the Second World War are based on principles such as values-based multilateralism and the reliability of geopolitical relations. These principles are being called into question, which further increases uncertainty.
In your role as a risk manager, how do you deal with this type of political uncertainty?
Political populism is very difficult to assess because a lot of things can happen that we have never experienced in the past. How will it affect the trading activity of large blocs or mutual economic dependencies that have become greater than ever before as a result of globalization? Quantitative risk models are of limited help when it comes to parameterizing these new, non-linear risks.
What can you do in these cases?
Where political risks are concerned, what is needed is more and more imagination, common sense and intuition. We have to be able to analyze and interpret the latest developments. Incidentally, humans cannot simply be replaced by robots or algorithms in this context. You have to think ahead and ask the right critical questions: What will happen if the multilateral system crumbles? What could happen that has never happened before?
The famous "Black Swan."
Precisely. In the insurance business, for example, experts think about catastrophic natural events that have never happened before but could materialize. One of the most important tools to cover such extreme events are scenarios.
Do you carry out simulations for specific risks?
All the time. Stress scenarios are a vitally important tool.
What are the risks for which you have carried out simulations recently?
Examples include a hard landing for the economy in emerging markets, especially in China; a sovereign debt crisis in the US; a real estate crisis in Switzerland; the impacts of an increasingly protectionist US trade policy; and the various possible outcomes of the Brexit negotiations.
Have reputational risks become more important or is that the wrong impression?
That is correct. The importance of reputational risks – and of managing them – has increased significantly.
What do you attribute that to?
There is no question about the fact that trust in banks was eroded as a result of the financial crisis and their reputation was tarnished. This entire industry needed to learn lessons from this. For example, the Too Big To Fail discussion was not just about financial aspects – it also concerned the economic importance and responsibility of financial institutions. This is another reason why we have to pay much more attention to our reputational risks today than many other companies do. In addition, many conflicts of interest around the world are being played out through financial institutions to a greater extent than they were in the past.
Can you give an example of that?
Take climate change. The Paris Agreement aims to limit the rise in the global temperature to well below 2° Celsius. The question of how that objective should be achieved has been a topic of heated debate around the globe. We have seen for some time that efforts are underway to increasingly conduct these discussions using financial institutions as a platform – partly in a way that is intended to have a public impact, such as at annual general meetings.
How do you deal with that?
Globally active banks do business throughout the world. When making decisions, it is not easy to achieve a balanced outcome that is accepted locally, globally and in our home market. The scope of our role as a financial intermediary is very broad. When conducting our business, we have to carefully weigh up different – sometimes very different – risks and interests. Staying on the subject of the environment, fracking is a form of oil and gas extraction that is relatively well known in the US but not in Europe. In Switzerland, people have to understand that in the US, business relations are maintained with companies in this sector and that is seen as socially acceptable in that country. By the same token, people in the US need to understand that this form of energy extraction is highly controversial in Europe and Switzerland because of its potential environmental risks.
How do you strike a balance?
This is an ongoing process. It is a question of getting to know the different positions and perspectives and engaging in a dialogue with the different stakeholders and achieving some form of rapprochement. As a bank, we have to form an opinion about politically and socially relevant issues. Returning to the topic of fossil fuels: The West has benefited from this energy source for a good 200 years. Would it now make sense and be financially viable for other countries to suddenly stop using them – or would a gradual transition to other sources of energy be a better way? That is just one of the many relevant questions on which we as a bank have to develop a position and then align our business activities accordingly.