Understanding the CECL and Risk Management Connection: An Intro for Bankers

Risk management is quite down-to-earth, and very much like the things you do every day (on or off the job) to increase the chances that your day follows a smooth route with no unpleasant surprises.

So how come such a straightforward concept seems so esoteric and unreachable when we are talking about it in the context of a financial corporation?

The short answer is, it shouldn’t. And as we get into more details in later articles, you will become more and more convinced.

It may seem hard to believe that from such humble beginnings should come issues related to the Risk Management of Loan Portfolios. Are simple processes as described below really the basis for loan risk management? Is CECL for example, really derived from such ordinary principles?

Here is some good news if you are a banker: Yes, most definitely.

In future articles you will begin to see why risk management of a bank or insurance company is well within your grasp.

But first, let’s back-up to see how risk management can be viewed in ordinary layman’s terms.

Going For a Ride

cecl risk management conceptYou step on to this ultra-modern plane, electronic devices flashing and buzzing all around you. There are no flight attendants, and no pilot quarters. A low humming voice behind your right ear, calls out your name and tells you that your seat is 14A. You proceed to your seat, which adjusts to your body’s weight and shape without any effort on your part.

Fifteen minutes later, the plane rolls unto the runway and takes off. A calm, reassuringly life-like voice comes on over the intercom:

“Good morning, and welcome to Advanced Airlines intelligent flight service. Your plane is under the full control of the most up-to-date robotic technology. It will take you safely and on time to San Diego. We will be arriving at 11:29 a.m. Pacific Time. For those of you who have never flown on a completely computer-run plane before, please rest assured that you are in perfectly good hands. Let us know what we can do to make your flight even more comfortable. Please relax and set your mind at ease because nothing can go wrong…can go wrong…can go wrong…”

Nothing  could go wrong?

If you are on the plane at that moment, it is fair to say that you will not have a warm, fuzzy feeling about your safety.  Quite the opposite. You are (even though you do not think of it in those terms) the victim of poor risk management.

The aim of risk management is to check and double check and cross-check to make sure that you don’t find yourself 15,000 feet in the air listening to a machine telling you that nothing can go wrong…can go wrong…can go wrong.

To most people with an adequate serving of common sense, it must be obvious that risk management has been going on for several thousand years. So how come it has become such an important issue in the past 30 years?

The reason is very simple: The captains of industry and especially finance, have come to grasp the great advantage of applying this common-sense process to protecting corporations, not just mechanical devices such as planes run entirely by robots.

Who is Afraid of Complex Mathematics?

Talk about risk management long enough, and invariably the conversation begins to revolve around stochastic calculus, partial differential equations and Monte Carlo simulations.

Now let me state clearly up front: I live in that kind of mathematical world. It can be said to be my comfort zone. But that is not where we are going with this discussion. We want to keep things straight- forward and simple.

You may be familiar with the mathematical joke that we can transform the equation below:

Now believe it or not, both equations are saying the exact same thing (and believe it or not, there are actual people who would choose the latter over the former).

risk management math joke

In our discussion, we are going to stick to the simpler “1 + 1 = 2” approach.

So What IS Risk Management?

In its simplest description, risk management can be viewed as follows:

  • You have a goal
  • It is not a certainty that you will reach this goal: All kinds of obstacles can emerge to prevent you getting to where you are going
  • You take steps to identify those obstacles and prevent them from tripping you up

That is it, really. And we don’t have to think about banks, insurance companies, or even robot-driven planes at this point, to see the idea clearly.  We can relate it to something very regular.  Consider:

Today you are going to interview for your dream job. Your aim is to make sure you are among the candidates passed on to the next round.

All kinds of things could go wrong, such as:

  • Your car breaks down on the way to the interview (or the train service has a major glitch that will last 45 minutes)
  • Someone in the crowd accidentally spills coffee on the suit you are wearing for the interview
  • The set of questions the interviewer asks is in no way related to the questions you have been preparing for all week
  • And so on

Now notice that if, regardless of the emerging event, you will still get passed on to the next round, there is no risk: If you are going to be given the green light even if you arrive for the interview an hour late, or you come into the interviewer’s office wearing totally inappropriate attire, or you give the wrong answer to every question asked, then you can relax, because nothing can go wrong….can go wrong…can go wrong.

But you should be so lucky: In real life, there are dire consequences to emerging events that catch you off-guard. And there is the key expression at the root of risk management: “Off guard”. You need to have backup plans (and sometimes backup plans to your back up plans) to ensure you are not thrown out of balance by events.  For example:

  • Arrange to have two or more friends who are located along the route to the interview, willing and ready to come pick you up in case you get stranded
  • Have a second suit in your trunk, just in case
  • Take a much earlier train, so that even if there is a 45-minute delay, you still arrive on time
  • Think outside the box, and explore questions other than the ones you imagine you will be asked

Now you know

There is nothing mathematical, technologically complex, or frightening about risk management. It is very much like the things you already do every day (on or off the job) to increase the chances that your day follows a smooth route with no unpleasant surprises.

The next article will show how it got to be implanted in the heart of operational and financial management for banks, insurance companies and similar firms.

By Lloyd Foster,
ARM Senior Consulting Actuary