Risk is Everybody’s Business: Moving Toward Integrated Risk Management
Risk modelers, accountants and economists must collaborate closely to collect more timely and accurate data, to improve decision making and to enable financial institutions to more effectively mitigate emerging risks, like climate change and cyberterrorism.
Friday, June 2, 2023
By Cristian deRitis
Risk professionals need to break out of their narrow confines and recognize both the necessity and benefits of partnering with colleagues across their organizations. Recent bank failures have underscored the necessity for risk modelers, accountants and economists, in particular, to work in greater alignment.
Traditionally, risk modeling and accounting functions have been distinct and separate disciplines, but effective risk management cannot be achieved without integration between these groups. While derivative pricing models and copulas may be intellectually stimulating, the advanced mathematics of risk have limited value if the underlying data supporting model estimation is incorrect or misunderstood.
Moreover, addressing future risks, such as cyberterrorism and climate change, will be impossible without all groups within an organization working closely together.
Economists, finance professionals and accountants have traded friendly barbs since the beginning of time. Economists cannot count, financiers use creative accounting, and accountants have no sense of humor when it comes to decimal points or rounding.
While all in good fun, these stereotypes are grossly outdated. The truth is that these professions depend heavily on each other. Accurate accounting, for example, is critical for providing the data needed to develop and monitor both risk and econometric forecasting models.
For their part, accountants are increasingly tasked with using market signals and forward-looking forecasts in their estimates of asset values and credit losses for financial reporting, by rules such as FASB's Current Expected Credit Losses (CECL) and International Financial Reporting Standards (IFRS) 9.
Accountants are relying heavily on the work of credit risk modelers and economists to provide them with loss estimates and economic scenarios that they can deem “reasonable and supportable.” A closer relationship and a better understanding of the underlying processes and assumptions across all of these disciplines is necessary to ensure that both estimates and the management decisions based on such estimates are accurate and robust.
The Integrated Risk Management Trend
If risk managers need any guidance, they can look to other professions that have already moved toward more “integrated” approaches. Medical practices, for example, seek better outcomes for their patients by organizing teams of generalists and specialists who use a common medical records system to share information.
This coordinated approach combines both orthodox and complementary approaches to deliver comprehensive treatments that can account for the multiple ailments and conditions that an individual patient may have. Studies suggest that this approach often leads to higher quality and lower cost outcomes, benefiting both patients and practitioners.
Similarly, manufacturers now integrate their development, production, sales and marketing teams more closely to streamline their processes and improve designs continuously. A more integrated approach has even taken flight in pest management, leading to the development of more robust, sustainable and healthier ecosystems that limit the amount of pesticides released into the environment.
Risk management, of course, has also been moving in the direction of greater integration – but recent events and future risks highlight the need to accelerate this process. Numerous business failures and case studies have shown that risk management cannot simply be delegated to one team with limited insight and power to effect change.
For example, with respect to impacting the risk profile of customers applying for credit, a marketing department may have just as much (if not more) power as the underwriting department. Similarly, accountants and data scientists have the power to improve decision-making through the quality and timeliness of the information they provide, both internally and externally.
Risk truly is everybody’s business.
Accounting for Climate Change
Risk managers will also want to get to know their favorite accountant as they turn their attention toward modeling the impact of climate change on their portfolios. Timely, accurate data will be critical for updating credit loss estimates and limiting forecast volatility in real time.
“Carbon accounting” will become a growth industry in the future. However, unlike, say, financial risk accounting, it may not be handed over to artificial intelligence (AI) or machine-learning (ML) algorithms anytime soon. After all, before considering any tech-fueled models, carbon accounting professionals will need to interpret new regulations and standards for climate change.
Carbon accountants will be challenged to appropriately assess and differentiate Scope 1 emissions produced directly by companies from Scope 3 emissions produced by suppliers or their customers. Given the financial costs and penalties imposed by regulations (such as carbon caps and taxes), accountants will need to help firms comply with complex international treaties and assist financial reporting boards to develop standardized protocols.
What’s more, the concept of carbon offsets will further complicate calculations and require even more accountants for effective management. Businesses and consumers are already committed to doing the “right thing” when it comes to reducing their carbon footprint, but are struggling to determine the relative cost of their actions – or inactions. Carbon accountants and climate risk professionals will therefore be needed to ensure both transparency and compliance with new regulations.
New Climate-Driven Insurance Products
Risk professionals and accountants will also need to work closely together on the plethora of new insurance products that will be developed to address both climate risk mitigation and adaptation.
For example, insurance markets for heat stroke are already being developed in parts of the world that are particularly vulnerable to high wet-bulb globe temperatures. These areas tend to be home to some of the poorest populations, who often lack the financial resources to obtain medical treatment and who can ill afford to lose days of work to heat stroke.
Insurance policies will not address the underlying causes of climate change, but they can provide key data on climate-driven illness. Accurate accounting of climate-related sickness and costs will be critical, not only for actuaries and other risk professionals to price out insurance contracts but also for sending informative risk signals to individuals and governments.
Accurate pricing will assist policymakers to quantify the full cost of climate change, allowing them to make more informed and objective decisions around emission-reducing regulations and green investments.
New analytical methods and new sources of data will be needed to assess and manage risk management challenges presented by climate risk, cyber threats, deglobalization and shifting demographics. Innovations such as AI and ML can improve efficiency, but will require human oversight and direction to be effective.
It is clear that accountants are playing an increasingly important role in risk management. Financial and regulatory reporting requiring more risk-based measures of performance and solvency – and accountants are also providing more of the primary data necessary for risk analysis.
Climate change and cyberterrorism have further heightened the need for skilled accountants who can collaborate with modelers and economists. The complexity of measuring carbon emissions and offsets will give rise to new carbon accounting specialists. Similarly, the need for better data on the incidence and severity of cyber threats will require risk managers and accountants to work more closely together.
Technological advancements are also fueling the need for better integration. The current frenzy around AI is leading to predictions of dystopian futures with mass layoffs and social unrest. However, while machines may take over some routine functions, innovative technology is needed more than ever to free up more individuals to deal with an ever-growing list of global problems and risks.
Rather than “staying in their lane,” risk professionals need to broaden their lanes or do away with them altogether as part of an ongoing quest to develop more integrated risk management.
Cristian deRitis is the Deputy Chief Economist at Moody's Analytics. As the head of model research and development, he specializes in the analysis of current and future economic conditions, consumer credit markets and housing. Before joining Moody's Analytics, he worked for Fannie Mae. In addition to his published research, Cristian is named on two U.S. patents for credit modeling techniques. He can be reached at email@example.com.