Expertise needed for challenge and oversight. Sonal joined H&F in 2020 and is focused on helping the Firm drive value by improving the operational effectiveness of H&F’s portfolio companies. The cases for change are in fact diverse and compelling, but transformations can present formidable challenges for functions and their institutions. A number of banks are looking to improve their risk-management organizational structures but are unsure how to move beyond making piecemeal changes. Effective risk management requires a large diversity of roles with highly specialized knowledge and technical skills and so is not suited to boilerplate application of transformation levers, such as spans and layers. Our focus is on the key risk areas that bear upon the A central policy office can, however, be helpful in building the full inventory of all risks and defining the target policy architecture—an architecture that is unmarred by the previously mentioned gaps and overlaps. The evolution includes the shift to real-time detection and action. New forces are creating new demands for operational-risk management in financial services. Practical resources to help leaders navigate to the next normal: guides, tools, checklists, interviews and more. Controls, however, are not effective in monitoring process resilience. our use of cookies, and While some banks have begun or even completed (especially in Asia) full-scale transformation efforts, others are still considering when, where, and how to begin. An appropriately agile strategy for centralization and location should be based on the following principles: Careful decisions about what and how to centralize, what is an appropriate location strategy, and how to inject agility into the risk organization are needed if an institution is to deploy talent efficiently and complete essential risk activities. These frameworks should support the following types of actions: In response to regulatory concerns over sales practices, most banks comprehensively assessed their sales-operating models, including sales processes, product features, incentives, frontline-management routines, and customer-complaint processes. Digital upends old models. The advantages for financial-services firms that manage to do this are significant. Against these challenges, risk practitioners are seeking to develop better tools, frameworks, and talent. Meanwhile, other risk areas may be using nonspecialists on analytics work because the demand is inadequate for a dedicated specialist. This approach increases the chances of success and helps quickly demonstrate value. Most important, risk management guards against costly mistakes and failures. Use minimal essential The financial crisis precipitated a wave of regulatory fines and enforcement actions on misselling, questionable mortgage-foreclosure practices, financial crimes, London Inter-bank Offered Rate (LIBOR) fixing, and foreign-exchange misconduct. operational effectiveness can free employees from one part of an organization to deliver new or better services in other areas, within existing budgets and without layoffs. Please try again later. We'll email you when new articles are published on this topic. They are adopting data-driven risk measurement and shifting detection tools from subjective control assessments to real-time monitoring. Please try again later. A rigorous review of the committee structure can improve governance while cutting the time dedicated to committees nearly in half. Banks that have been successful in implementing this target state have then assembled a working group, composed of business and risk representatives, to create detailed recommendations. While some banks have focused risk improvement in one or two particular areas, experience demonstrates that the greatest gains belong to institutions that carefully sequence efforts across organization, governance, processes, and digitization and analytics. Historically, operational-risk management has focused on reporting risk issues, often in specialized forums removed from day-to-day assessment. They must help them adapt to process-driven risk management and understand the potential applications of advanced analytics. Analyzing functions within each business unit, operational-risk leaders can then identify those that present the greatest inherent risk exposure. Something went wrong. The following five central ideas can help guide this work: Challenges in the prevailing committee design can be identified in dedicated workshops with relevant stakeholders. To prioritize use cases, banks should weigh the feasibility of streamlining and the potential gains in effectiveness and efficiency. Organizational optimization facilitates governance rationalization, which facilitates effective streamlining of processes, which enables digitization and advanced analytics to yiel… Learn more about cookies, Opens in new Subscribed to {PRACTICE_NAME} email alerts. Bank employees drive corporate performance but are also a potential source of operational risk. Joseba Eceiza is a partner in McKinsey’s Madrid office; Ida Kristensen and Dmitry Krivin are both partners in the New York office, where Hamid Samandari is a senior partner; and Olivia White is a partner in the San Francisco office. Oliver Bevan is an associate partner in McKinsey’s Chicago office; Matthew Freiman is a partner in the Toronto office; Kanika Pasricha is a consultant in the New York office, where Hamid Samandari is a senior partner; and Olivia White is a partner in the San Francisco office. Finally, until recently, operational risk was less easily measured and managed through data and recognized limits than financial risk. We use cookies essential for this site to function well. Select topics and stay current with our latest insights, Transforming risk efficiency and effectiveness. Additionally, they miss low-frequency, high-severity events, such as misconduct among a small group of frontline employees. Spending time and effort developing such messages may seem trivial, but a globalization effort won’t get far unless employees a… Third, the distinguishing definitions of the roles of the operational-risk function and other oversight groups—especially compliance, financial crime, cyberrisk, and IT risk—have been fluid. Is the operating model designed to limit risk from bad actors? At large regional banks, the growth rate of the risk function has been as much as twice that of the rest of the organization. A clear and streamlined organizational structure serves as a starting point for end-to-end risk-transformation efforts. Models of organizational effectiveness go in and out of fashion, but the McKinsey 7-S framework has stood the test of time. We use cookies essential for this site to function well. A number of banks are investing in objective, real-time risk indicators to supplement or replace subjective assessments. Nonetheless, data availability and the potential applications of analytics have created an opportunity to transform operational-risk detection, moving from qualitative, manual controls to data-driven, real-time monitoring. For example, we frequently observe overlapping control and testing environments across the first and second lines of defense. Advanced analytics has applications in all, or nearly all, areas of operational risk. Already, efforts to address the new challenges are bringing measurable bottom-line impact. Meaningful changes to the committee structure can act as strong signaling mechanisms that the risk organization is committed to a transformation. Institutions have reduced as many as 30 percent of their policies while improving the quality of the remainder (Exhibit 3). A small, temporary working group can then remove or consolidate committees according to the design principles agreed upon and the results of the targeted discussions. Additionally, training, consequence management, a modified incentive structure, and contingency planning for critical employees are indispensable tools for targeting the sources of exposure and appropriate first-line interventions. People create and sustain change. These are reviewed by area-level policy committees, such as a credit-policy committee and the board, if necessary. All too often, responsibilities can overlap both across and within the lines of defense, compromising the ability to streamline governance and processes. The following four principles are essential, each addressing common pain points: Institutions have reduced as many as 30 percent of their policies while improving the quality of the remainder. Even institutions in the early stages of maturity can adopt three “no regrets” ideas to begin to capture the benefits in efficiency and effectiveness that digitization offers: The opportunity for improvement in risk manage-ment efficiency and effectiveness is significantly higher at institutions undertaking a full digital transformation. Within reach is more targeted risk management, undertaken with greater efficiency, and truly integrated with business decision making. and streamlining high-risk processes owned outside the function. each area can boost both effectiveness and efficiency, the true potential comes from tackling them in sequential order. Included on this page, you'll find detail s on the phase-by-phase implementation plan, operational excellence KPIs, case studies of operation excellence improvements, and much more Many institutions grew rapidly and piecemeal, often scrambling to respond to regulatory feedback or indirect pressures. Digitization and advanced analytics are the final steps in capturing the full impact of a risk transformation. Conversely, additions to the first line prompted second-line hiring at a higher rate than before, to provide oversight in a more demanding regulatory environment. They must rigorously apply a full set of levers across their entire operations cost base. Finally, some traditional detection techniques, such as rules-based cyberrisk and trading alerts, have false-positive rates of more than 90 percent. The operational-risk-management function should help chief risk officers and other senior managers answer several key questions, such as: Have we designed business processes in each area to provide consistent, positive customer outcomes? Successfully transformed organizations know, however, that the rewards—greater risk-management effectiveness at lower cost—are well worth the challenge. Since the financial crisis of 2008 to 2009, financial institutions large and small have significantly expanded their risk and compliance functions. McKinsey and Company in a report stated that digitalisation will enable Nigerian banks to achieve between 25 and 40 per cent cost-reduction. For such processes, including sales-force performance management, customer onboarding, and payments processes, risk can offer clear policies and associated requirements on monitoring, controls, and testing. Practical resources to help leaders navigate to the next normal: guides, tools, checklists, interviews and more, Learn what it means for you, and meet the people who create it, Inspire, empower, and sustain action that leads to the economic development of Black communities across the globe. Complex risk functions and burgeoning policy landscapes in turn led to more involved processes, often with layers of controls added over time, without consideration of a holistic design. Eliminating today’s digital waste and adopting new technologies are the keys to increasing supply chain operational effectiveness. Is our change-management process robust enough to prevent disruptions? The standard Basel Committee on Banking Supervision definition of operational (or nonfinancial) risk is “the risk of loss resulting from inadequate or failed internal processes, people, and systems or from external events. Some involve behavioral transgressions among employees; others involve the abuse of insider organizational knowledge and finding ways around static controls. At the same time, digitization and advanced analytics expand the ability of the risk function to help improve processes and decision making outside of risk, beyond what processes streamlining alone can accomplish. We will start by explaining what organizational effectiveness is, go over seven organizational effectiveness models, explain how organizational effectiveness can be measured, and conclude by specifying how HR can contribute to organizational effectiveness. Compared with financial risk such as credit or market risk, operational risk is more complex, involving dozens of diverse risk types. Please click "Accept" to help us improve its usefulness with additional cookies. collaboration with select social media and trusted analytics partners Using machine learning to identify crucial data flaws, the bank made necessary data-quality improvements and thereby quickly eliminated an estimated 35,000 investigative hours. A well-executed, end-to-end risk-function transformation can decrease costs by up to 20 percent while improving transparency, accountability, and employee and customer experience. Looking into the underlying complaints and call records, the manager would be able to identify issues in how offers are made to customers. By helping the business meet its objectives while reducing risks of large-scale exposure, operational-risk management will become a creator of tangible value. As the potential for human-factor risks to inflict serious damage has become more apparent, however, banks are recognizing that this oversight must be included in the operational-risk-management function. Both are important. Whether in information security, data, compliance, technology and systems, process failure, or even personal security and other human-factor risks, the advanced-analytics advantage is becoming increasingly evident. The next step is to prioritize the “failure modes” behind the risks, including malicious intent (traditional conduct risk), inadequate respect for rules, lack of competence or capacity, and the attrition of critical employees. For instance, in Germany, Berlin’s state government, which Measurement remains difficult, and risk teams still face challenges in bringing together diverse sources of data. Faulty moves to make risk management more efficient can cost an institution significantly more than they save. Addressing new demands and building new skills requires careful change management and patient leadership sustained over a multiyear time horizon. The standard Basel Committee on Banking Supervision definition of operational (or nonfinancial) risk is “the risk of loss resulting from inadequate or failed internal processes, people, and systems or from external events. tab. At the same time, business leaders become better risk managers by understanding the existing controls and their intended purposes. However, the risk organizational structure typically involves four different types of roles: CROs can apply the following five ideas to create a fit-for-purpose structure that provides a foundation for effective and efficient risk management: In our experience, a successful risk reorganization should begin with an honest assessment of the strengths and weaknesses of the existing organization, incorporating business input. In the past, HR was mainly responsible for addressing conduct risk, as part of its oversight role in hiring and investigating conduct issues. This last constraint has been lifted in recent years: granular data and measurement on operational processes, employee activity, customer feedback, and other sources of insight are now widely available. Learn about Operational complexity has increased. Our flagship business publication has been defining and informing the senior-management agenda since 1964. This is because the controls are fundamentally reliant on manual activities. McKinsey’s Capacity Assessment Grid This grid is a tool designed to help organizations assess their organizational capacity/effectiveness. Digital upends old models. Since streamlining major processes is a big job, institutions would be wise to start in a targeted way, with a few prioritized use cases. The working group should be small and include respected leaders from both the risk function and the business—success depends on contributions from the right people from the business, support functions, and risk, highlighting specific policies and pain points. The adoption of new technologies and the use of new data can improve operational-risk management itself. The number and diversity of operational-risk types have enlarged, as important specialized-risk categories become more defined, including unauthorized trading, third-party risk, fraud, questionable sales practices, misconduct, new-product risk, cyberrisk, and operational resilience. Most transformations fail. While banks have been aware of risks associated with operations or employee activities for a long while, the Basel Committee on Banking Supervision (BCBS), in a series of papers published between 1999 and 2001, elevated operational risk to a distinct and controllable risk category requiring its own tools and organization. At the same time, digitization and automation have been changing the nature of work, reducing traditional human errors but creating new change-management risks; fintech partnerships create cyberrisks and produce new single points of failure; the application of machine learning and artificial intelligence (AI) raises issues of decision bias and ethical use of customer data. Meanwhile, the cost and effort of policy administration and management are likewise reduced. Thousands of hastily created risk and compliance policies can be in place at midsize and large banks, with single policies spawning dozens of procedures across businesses, each of which influences process and control design. Committee overgrowth unduly burdens the schedules of senior executives while also delaying or hampering decision making. Hi, it’s Nicolas from The Family.Today, I’m pursuing my “11 Notes” series focusing on interesting companies in the Entrepreneurial Age, and here’s McKinsey & Company. The overall objective is to create an operational-risk function that embraces agile development, data exploration, and interdisciplinary teamwork. Most banks today are looking to improve productivity. and incentives, that is, than with operational processes and infrastructure. Since the financial crisis, many firms have added committees, sometimes without harmonizing the roles of the new and existing committees. Attempts to improve risk-function efficiency, if not carefully nuanced, will invite more scrutiny. In the current environment, piecemeal productivity gains will not lead to significant bottom-line differences for banks. Please use UP and DOWN arrow keys to review autocomplete results. They developed risk taxonomies beyond the BCBS categories, put in place new risk-identification and risk-assessment processes, and created extensive controls and control-testing processes. At the same time, such simplification can help lay the groundwork for more effective digitization. In addition, we help our clients manage risks created by third-party vendors and have strengthened our … The report also urged banks to plan for another round of consolidation in order to thrive beyond the crisis by growing their capital base faster than the rates of inflation and devaluation of the naira. The following central ideas can guide institutions in clarifying roles and responsibilities: Achieving the correct alignment of roles and responsibilities across the lines of defense is a difficult undertaking. The original role of operational-risk management was focused on detecting and reporting nonfinancial risks, such as regulatory, third-party, and process risk. The journey is difficult—it requires that institutions overcome challenges in data aggregation and building risk analytics at scale—yet it will result in more effective and efficient risk detection. Operational Effectiveness vs. Strategy Too often in today’s companies, managers mistake operational effectiveness with strategy. Many of these assessments went beyond the traditional responsibilities of operational-risk management, yet they highlight the type of discipline that will become standard practice. Risk can shape that transformation so that it supports risk-management effectiveness and efficiency directly—by making needed data easily accessible, for example. During these pilots, the new process and associated controls are assessed to ensure that the process is running smoothly and that the controls are operating appropriately—including that they are properly matched to risk levels and that there are no gaps in controls. These indicators help risk managers track general operational health, such as staffing sufficiency, processing times, and inventories. Given the diversity of risk-management demands that must be met in a coordinated way, getting the core structure right is a challenge. Establishing clear, measurable performance objectives, with close tracking of performance, will help identify issues with the revised process. Both help drive superior performance. However, efforts to improve risk-function efficiency can only draw from the standard set of productivity measures at their peril. Many organizations have thus viewed operational-risk activities as a regulatory necessity and of little business value. While making advances in some areas, banks still rely on many highly subjective operational-risk detection tools, centered on self-assessment and control reviews. With specialized talent in place, banks will then need to integrate the people and work of the operational-risk function as never before. In capital markets, for instance, some products are more susceptible than others to nontransparent communication, misselling, misconduct in products, and manipulation by unscrupulous employees. POBOS Pharma Quality measures quality performance and risk, total cost of quality, quality productivity, as well as operational maturity and quality systems effectiveness. Together with the business lines, operational-risk management can identify and shape needed investments and initiatives. Although such a committee review at a large bank can take four to six months, institutions can begin by developing a set of design principles and using them to understand the existing challenges. Such end-to-end risk transformations can reduce the cost base by 15 to 20 percent while meaningfully improving the quality of risk management. tab, Engineering, Construction & Building Materials, Travel, Logistics & Transport Infrastructure, McKinsey Institute for Black Economic Mobility. In the first decade of building operational-risk-management capabilities, banks focused on governance, putting in place foundational elements such as loss-event reporting and risk-control self-assessments (RCSAs) and developing operational-risk capital models. Flip the odds. Please click "Accept" to help us improve its usefulness with additional cookies. Blending strategic thinking ... operational strategies that solve our clients' most critical problems. “As average temperatures rise, acute hazards such as heat waves and floods grow in frequency and severity, and chronic hazards such as drought and rising sea levels intensify,” McKinsey said. The operational-risk discipline needs to evolve in four areas: 1) the mandate needs to expand to include second-line oversight, to support operational excellence and business-process resiliency; 2) analytics-driven issue detection and real-time risk reporting have to replace manual risk assessments; 3) talent needs to be realigned as digitization progresses and data and analytics are rolled out: banks will need specialists to manage specific risk types such as cyberrisk, fraud, and conduct risk; and 4) human-factor risks will have to be monitored and assessed—including those that relate to misconduct (such as sexual harassment) and to diversity and inclusion. The standard Basel Committee on Banking Supervision definition of operational (or no… December 3, 2019 Many banking operations leaders feel caught in a tug of war, expected to deliver cost savings while customer demands continue to increase. Unleash their potential. Finally, they realign activities to be consistent with lines-of-defense principles. Operational-risk officers will need to rethink their risk organization and recruit talent to support process-centric risk management and advanced analytics. Please email us at: McKinsey_Website_Accessibility@mckinsey.com Leading indicators are forward looking and critical to ensure that employees perform proactively, for example, identifying risks early on and initiating countermeasures instead of reacting after the risk has materialized. For example, one global bank tackled unacceptable false-positive rates in anti–money laundering (AML) detection—which were as high as 96 percent. To manage these risks—in areas such as technology, data, and financial crime—banks need specialized knowledge and tools. tab. To achieve this operational effectiveness, organisations use a num-ber of methods, where implementation is supported with formal tools and techniques. Please email us at: McKinsey_Website_Accessibility@mckinsey.com This complexity (and the ability to control it) doesn’t matter only for controlling costs. Institutions responded by making significant investments in operational-risk capabilities. While the industry succeeded in reducing industry-wide regulatory fines, losses from operational risk have remained elevated (Exhibit 1). A breakdown in processes is at the core of many nonfinancial risks today, including negative regulatory outcomes, such as missing disclosures, customer and client disruption, and revenue and reputational costs. Organizational optimization facilitates governance rationalization, which facilitates effective streamlining of processes, which enables digitization and advanced analytics to yield maximal benefit: The sections that follow discuss all four areas, providing detail on challenges, improvement opportunities, and implementation. Streamlined processes are less error prone, better controlled, and more conducive to enhanced customer and employee experiences. Taken together, these factors explain why operational-risk management remains intrinsically difficult and why the effectiveness of the discipline—as measured by consumer complaints, for example—has been disappointing (Exhibit 2). In this article, you’ll learn the key principles of operational excellence and how to avoid failure from leading practitioners and the Institute for Operational Excellence, and also find examples and tips. The authors wish to thank Grace Liou, Peter Noteboom, Luca Pancaldi, Ishanaa Rambachan, and Kayvaun Rowshankish for their contributions to this article. Never miss an insight. It is creating significant improvements in detecting operational risks, revealing risks more quickly, and reducing false positives. The effort includes monitoring, oversight, role modeling, and tone setting from the top. At many firms, risk policies have become too numerous and therefore difficult to manage. Progress will require time, investment, and management attention, but the transformation of operational-risk management offers institutions compelling opportunities to reduce operational risk while enhancing business value, security, and resilience. Policies can be structured to focus attention on the areas of highest risk while removing unnecessary red tape for the businesses. We strive to provide individuals with disabilities equal access to our website. our use of cookies, and Meet our Middle East consultants who come from both local areas and across the world, bringing a vast array of skills, experience, and backgrounds. Let ORM stand alone: One of the main functions within an operational risk program is capturing and aggregating operational risk data. Using advanced-analytics models to monitor behavioral patterns among 20,000 employees, the bank identified unwanted anomalies before they became serious problems. Second, operational-risk management requires oversight and transparency of almost all organizational processes and business activities. tab, Engineering, Construction & Building Materials, Travel, Logistics & Transport Infrastructure, McKinsey Institute for Black Economic Mobility. McKinsey & Company Saptarshi Ganguly, Holger Harreis, Ben Margolis, Kayvaun Rowshankish Significant improvements in risk management can be gained quickly through selective digitization—but capabilities must be test hardened before release. Significantly expanded their risk and compliance functions of almost all organizational processes and transparent controls the... Helping the business to act as strong signaling mechanisms that the risk function leaders outside the from... 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