beautiful banking - darling consulting group (dcg)

The RMA Journal February 2016 | Copyright 2016 RMA 44

operationalrisk

Insights from the World’s

Beautiful Game

BeautifulBanking

February 2016 The RMA Journal 45

by Drew H. boecHerGrowinG up in Upstate New York, some of my fondest memories from childhood were made on the soccer field. I still re-member the competitive spirit I felt each time I put on my cleats to challenge my brothers and the neighborhood kids in a friendly match.

When most people think of soccer, they picture the intricate footwork and great athleticism that go into scoring

amazing goals. But an often overlooked part of the game is the layers of strategy involved in planning a win. While my competitive soccer days are long behind me, I still apply many of the strategic les-sons I learned on the soccer field to help banks build winning risk management processes.

In this article, I will share some ways in which banking strategy is similar to soccer strategy:

• Players require clarity on a game’s primary objective in order to succeed.

• Players must understand their offen-sive and defensive responsibilities.

• Competing at the highest levels re-quires players with diverse and spe-cialized talents.

• Building sustainable success requires

long-term vision and strong leader-ship.Understanding these four similarities

will assist you strategically at your bank, likely more than you might imagine. Let me begin with a journey back to my freshman year in high school, where as a 14-year-old I first gleaned soccer in-sights from a charismatic coach, Harold Celadon.

Primary objective of a Soccer Game “This is a soccer ball,” said Coach Ce-

ladon in a thick Italian accent to his eager team, perhaps borrowing

a sentiment from a legendary American football coach,

Vince Lombardi. Like Lombardi, our soccer coach assumed nothing regarding his players’ knowledge of the beau-tiful game and he started each season at the very beginning.

Coach Celadon then asked us, “Who can tell

me the primary objective in a game of soccer?” Consecu-

tively, three of my World Cup-hopeful teammates replied,

• “Score goals!”• “Dominate play!”• “Win!”

“Close, and all true,” replied the coach. “But these are secondary objectives and largely result from clarity around your primary objective. Do you want to know the primary objective?”

My confused teammates responded affirmatively and drew close to hear the coach whisper, “The primary objective of a soccer game is to score more goals than your opponent.”

Primary objective of bankingCoach Celadon’s remarks were certainly surprising to me when I first heard them. He broke down the objective of a soccer game into its simplest component—scor-ing more goals than you give up. So what Sh

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is our primary objective in banking? While individual banker responses

would be as nuanced as those of our soc-cer players, the simplest goal in banking is to earn profits (offense) while man-aging risk (defense). For someone who wants to use more elegant language, we might say something like “to optimize risk-adjusted returns” or “to achieve strategic objectives within management’s risk tolerance level.” However, the basis of success in soccer or banking requires finding the right balance of offense and defense.

Like soccer strategies, individual bank strategies are extremely varied. In soccer, the right mix of offense and defense de-

wHile inDiviDual banker responses would be as nuanced as those of our soccer players, the simplest goal in banking is to earn profits (offense) while managing risk (defense).

pends on the skill of your team members and the skill of your opponents. Similarly, for banks, the right strategy depends on the current economic and business con-ditions. Some mutual savings banks and credit unions have strategic objectives in close proximity to nonprofits; however, even these institutions must earn posi-tive risk-adjusted returns to serve their communities. On the other hand, larger stock-issuing banks are more clearly focused on generating excess returns to shareholders as they serve their custom-ers and compensate staff.

Strategic implications of Primary objectivesAfter sharing the primary objectives, Coach Celadon continued, “Achieving your primary objective involves putting more balls in your opponent’s net than you permit your opponent to put in your net.”


The soccer coach next asked the players whether they preferred play-ing offense or defense. This was a trick question that the coach asked each year and, as always, players blurted out their preferences.

• “I’m offense.” • “I’m a defender.” • “I’m terrible on defense.”

“You are not yet clear regarding the primary objective of the game of soccer,” the coach replied. “If you had clarity on the objective, you’d realize that when our team has the ball, we are all on offense, and when the other team has the ball, we are all on defense.”

He continued, “When on offense, our shared goal is to score. When on defense, our shared goal is to prevent our oppo-nent from scoring and retrieve the ball.”

A similar soccer philosophy was la-beled “total football” and successfully applied by Dutch soccer clubs and the Netherlands national team during the 1974 FIFA World Cup.1 This influential tactic held that any field player—for-ward, midfielder, or defender—must be able to play any other field position.

banking: Three lines of Defense are Three lines of offense So it is with banking. Risk management is increasingly discussed in the context of three lines of defense. While there is much industry chatter (and training) around the “three lines of defense,” we’d be well served to consider our soc-cer metaphor.

In soccer formations, there are three general levels of position players: for-wards, midfielders, and defenders. The forwards most often, but not always, score goals. The defenders most often, but not always, prevent the other team from scoring. The midfielders are typical-ly liaisons between forwards and defend-ers. They score goals more frequently than defenders and prevent opponents’ goals more often than forwards. Figure 1 shows the positions and their banking counterparts.

First line of Defense: ForwardsIn banking, the forwards are our business lines—the sales and retail professionals—who most often generate institutional revenue and metaphorically score most of the goals for the team. Yet, even cli-ent-facing business units have defensive risk management responsibilities. For example, while the business lines’ main responsibility is revenue production, they often develop models to assist with risk mitigation. Indeed, the business lines at most banks contribute their expertise to develop credit risk rating models, al-lowance models, and even behavioral assumptions used by other functions within the bank.

Similar to our soccer players who pre-fer offense, many model developers in revenue-producing business lines would prefer not to play the defensive side of risk management. Unfortunately, this means that sound defensive strategies, such as detailed model documentation or sensitivity tests around impactful as-sumptions, are overlooked. These players should be coached on the importance of contributing on both offense and defense. Documentation of modeling processes is a common banking challenge, quite often

FiGure 1: THree lineS oF Soccer anD bankinG

identified by examiners as a risk manage-ment shortcoming.

Realizing that documentation is a very important component of the risk man-agement process, banking executives are assigning a more appropriate level of priority to upgrading the quality of model documentation. The validators at my firm, Darling Consulting Group, have often seen a direct correlation between the quality of model documentation and the strength of model risk management processes. This requires the contribution of our banking forwards on both sides of the ball.

Second line of Defense: MidfieldersOur banking midfielders commonly think of themselves as “the second line of defense.” This self-concept orients their work toward risk management over revenue production. These players might be coached to better support the forwards in offensive revenue pursuits, while still maintaining the strength of their impor-tant defensive risk-mitigation role.2

Indeed, many chief risk officers, and bankers in the second line of defense, find themselves in enterprise risk manage-ment (ERM) departments with emphasis on “risk management.” Specifically, ERM staff (including CROs) view themselves as the second line of defense between business-unit risk takers (first line of defense) and the audit function (third line of defense).

A common way to think about the purpose of ERM is through SWOT analysis. Institutions use SWOT—short for strengths, weaknesses, opportunities, and threats—to examine their internal and external opportunities and risks. From this perspective, shown in Figure 2, today’s ERM programs largely focus on the right-hand side of SWOT: weaknesses and threats.

Enterprise Strategy Management

While ERM, as a discipline, has made significant risk management strides (de-fense), the coming decade holds more promise for ERM improvement and a positive impact on strategy (offense).

Forwards

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Returning to our SWOT analysis, we can think of ERM as a subcomponent of the broader enterprise strategy management (ESM), shown in Figure 3.

ESM involves risk management as well as finding opportunities on the way to value preservation and value creation. Rather than simply critiquing first-line models and activities, our second-line midfielders might have a productive role in shaping strategy.

For example, rather than contemplat-ing only defensive responses to a limited suite of Federal Reserve scenarios (base-line, adverse, and severely adverse), ERM team members might contribute to iden-tifying opportunities that arise in those three scenarios. Specifically, we’ve ob-served that a few proactive management teams have begun using the Dodd-Frank Act stress test (DFAST) scenarios during acquisition due diligence (by applying top-down credit stress-testing models to potential targets).

Third line of Defense: DefendersIn banking, the defenders are the audit team members who most often ensure a solid control environment within the risk management framework. Surpris-ing to many, even audit activities can contribute to advancing organizational revenue goals. For example, models in a

risk management framework often have too many manual entry points where er-rors can surface. An audit team member’s recommendation to automate such pro-cesses not only mitigates risk, but also improves organizational efficiency.

Audit can sometimes take the most detached perspective in viewing organi-

zational processes, just like the defenders in soccer have the fullest view of the field from their positions. The defenders are often the players that find the right angle to pass the ball downfield to initiate the attack. Similarly, audit teams in banks have the right perspective to recognize unproductive processes and communicate this useful information to the other lines.

In soccer, poorly performing teams of-ten have too much space between lines at inopportune times. In fact, this strategic failure is a primary contributor to soccer losses at all levels of competition. Simi-larly, in banking, collaboration between the three lines of defense (three lines of of-fense) is critical to organizational success.

Professional-level Soccer: communica-tion and TalentAn astute soccer observer would likely tell you that effective communication and proper strategic spacing are two of the most critical components for winning a game, at any level. Any parent who has watched children playing often observes that teams with even modest communica-tion skills often win. At the high school

FiGure 2: SwoT analySiS FraMework For buSineSS objecTiveS

FiGure 3: enTerPriSe STraTeGy ManaGeMenT (erM)

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source: builders advisory network

source: builders advisory network


level, unsuccessful teams often get into trouble by leaving too much space be-tween lines. Professional players consis-tently communicate with their teammates to ensure proper spacing and to execute the game plan.

Perhaps the biggest differentiator be-tween professional and amateur leagues is in the players’ balance of talent on both the offensive and defensive sides of the ball. The best players have mastered the fundamentals and typically demonstrate an unusual level of creativity beyond the basics.

Even among many leagues with ex-tremely talented professionals, some teams stand out from the rest. These teams have brought together the right mix of talented individuals, each play-ing vastly different roles, to execute the beautiful game at the highest level.

Professional-level banking: communication and TalentIn banks of all sizes, effective communi-cation and collaboration across all three lines of defense are critical to properly mitigate risk and maximize opportunities in an increasingly competitive banking world. As with soccer, the best bank-ers can conceptualize opportunities for revenue-producing strategies (offense) and can also conceptualize risk mitiga-tion strategies (defense) around revenue-producing activities. The talent level of a bank’s team is growing increasingly important.

The largest banks (over $10 billion in the U.S.) have become more aware of the need for an expanding and diverse set of team skills and talent. For example, banks approaching (or recently cross-ing) the $10 billion mark enter a world where higher-level modeling has become a minimum expectation.

Executives at these institutions must make some important strategic decisions around obtaining talent for complex sta-tistical modeling. They should ask them-selves the following questions:

• How do we best use our internal quan-titative resources for maximum benefit?

• Do we outsource the development of statistical models used to project credit losses in different economic environ-ments?

• Do we still hire internal quantitative resources in situations where we’ve outsourced complex model develop-ment?

• Do our second and third lines of de-fense require quantitative resources?

The world’s largest banks, of course, have the resources and awareness to hire large quantitative teams. As we progress down in asset size, the number of quan-titative resources (or the decision to hire such resources) is less obvious. From close observation, I believe that most banks would be well served by hiring at least two quantitative resources in the first line. This permits rotation between one person per-forming quantitative work (for example, developing statistical models) and another quantitative resource providing a quick (first line) reality check.

Given the shortage of quantitative re-sources with deep banking experience, these specialized talents may need to be recent graduates or people who know little to nothing about banking. There-fore, banking executives, in their role as coaches, must ensure that quantitative team members get the general banking training required.

At professional levels of soccer, a team can acquire a combination of very talented players, yet fail to achieve the ultimate goal of scoring more goals than their oppo-nents. The sports world is full of examples of “dream teams” that failed to win the championship for one reason or another.

Similarly, we have seen banks that hired a plethora of top-level quantitative resourc-es, yet still have fundamental deficiencies in their risk management process. The lack of effective communication between the different lines within a bank—and the lack of appropriate governance to establish the right spacing between the different lines—can render even the most talented teams ineffective.

Many of us at Darling Consulting Group have had the opportunity to look at ERM

processes at a wide variety of banks. In our experience, we have observed many situations where better communication and coordination between the three lines of defense would have helped get the bank closer to its ultimate risk management ob-jectives.

For example, business lines may not adequately consider the assumptions em-bedded within their models. Assumptions can sometimes be treated as factual because the assumption has not been challenged in a long time. Model risk management may also be reluctant to challenge the way things have always been done.

In soccer games, it is often the right strategy for forwards to pass the ball back to the midfielders to reset the offensive attack because the midfielders have a different perspective on the passing lanes. Likewise, putting more trust in the second line of defense to challenge entrenched practices and methodologies is often beneficial to institutions seeking the ultimate objective of increasing profitability and improving risk management.

long-Term vision and leadershipThe metaphor to this point has focused on factors for success in a single soccer match (perhaps equivalent to a short-term period in banking, such as the current quarter). As in banking, sustainable success in soccer requires long-term vision and strong lead-ership. Indeed, the most successful soccer clubs find visionary leaders, such as Dutch coach Rinus Michels, who take a long-term view as they envision sustainable success. The road of any team has inevitable ups and downs, but a solid coach can enable conditions for sustainable success.

Regardless of which team you support, the success of Manchester United under the leadership of Alex Ferguson from 1986 to 2013 is impressive, and he is one of the most admired and respected managers in the history of the game. In fact, Sir Alex was knighted in 1999 for his service to the game during the middle of his tenure with Manchester United.

A banking lesson from Sir Alex might be this: Without a strong leader in charge—someone who has confidence in himself


and in his system—a team will not suc-ceed, no matter how brilliant the indi-vidual players. Perhaps the greatest skill of a leader is to recruit talented individuals and convince them to embrace a team ob-jective bigger than their own. As business writer Jim Collins expressed in his book Good to Great, the best leaders “start by getting the right people on the bus, the wrong people off the bus, and the right people in the right seats. And they stick with that discipline—first the people, then the direction—no matter how dire the cir-cumstances.”

beautiful bankingAs on the soccer field, the greatest bank-ing teams have strong leaders who are obsessed with getting the right people in the right places and removing those who can’t subordinate their egos to the team

objective. Like the best soccer teams, the most successful banks have unusually ef-fective communication.

Quantitative resources are those highly effective communicators who contribute to training other lines (including the more senior executives) so they can provide the effective challenge required for best per-formance. Executives contribute strategic insights freely to team members on all lines, enabling quantitative team members to build models leveraging these insights. All lines move forward in a coordinated, strategic direction, fully cognizant of their defensive risk management responsibili-ties.

Indeed, when the right leadership com-bines with the right mix of talented players (with proper thought diversity), observing beautiful banking is, for at least one soc-cer aficionado, as much fun as watching

a Champions League final with Coach Celadon. Good luck in your pursuit of beautiful banking!

notes

1. “total football” was invented by dutch coach rinus

michels and applied in the 1960s and 1970s at

dutch soccer clubs and the national team. fifa

named michels “coach of the century” in 1999.

2. some cros and regulators see the second line’s

role as solely defensive. the ideas expressed here

expand this traditional view, and wise bankers will

remain aware of current regulatory viewpoints.

Drew H. boecher, cfa, is managing director at

darling consulting group. he has two decades of

experience in evaluating asset-liability management

and assessing bank credit risk. he can be reached

at [email protected].

beautiful banking - darling consulting group (dcg)

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