Key Risk Indicators

Key Risk Indicators (KRI) are an important tool within operational risk management, facilitating the monitoring and control of risk. In so doing they may be used to support a range of operational risk management activities and processes, including: risk identification; risk and control assessments; and the implementation of effective risk appetite, risk management and governance frameworks.

Despite their usefulness, relatively little guidance exists on how to use risk indicators in an effective manner. Moreover it is an area that has proven to be particularly challenging for many organizations. Hence there is a need for further guidance in this area.

Care should  be taken when benchmarking a given set of key indicators against those monitored by other organizations. An organization’s risk exposures arise from its unique mix of business activities, corporate strategy and culture – meaning that few organizations have matching exposure profiles. Accordingly, the set of indicators which measure and monitor that exposure level are likely to be different. Hence the concept of a “one size fits all” set of key indicators set is not logical.

Indicators can be used by organizations as a means of control to track changes in their exposure to operational, market and credit risk. If selected appropriately, indicators can provide a means for identifying: 

• Emerging risk trends and issues on the horizon that may need to be addressed (via ‘leading’ indicators); 

• Current exposure levels; and 

• Events that may have materialized in the past and which could occur again (via ‘lagging’ indicators). 

The frequency with which an indicator is measured is an important factor. Generally, the more often an indicator is updated, the more useful the data it represents will be. However there can be occasions where more frequent measurement of the indicator will show only small changes in the risk profile. In such circumstances it is important to consider the longer term trend of measures before arriving at conclusions as to the overall changes in operational risk exposure.

There are four types of Key Risk Indicators

  1. Operational Risk - is defined as a risk incurred by an organization's internal activities.
  2. Market - is defined as a risk incurred by an economic event or events.
  3. Market Risk - is defined as a risk incurred by a market event such as in FX, Equities, Commodities, Etc.
  4. Credit Risk - is defined as a risk incurred by a deterioration in credit quality.

Examples of Previous Key Risk Indicators That Were Overlooked 

1. Credit Risk KRI - Rising home prices misread as an indicator of a strong economy. Rapid expansion in investment banks' leverage ratios after SEC rule change in 2004 allowed additional credit to flow into the mortgage market securitizations. Credit quality was largely ignored in the expansion of home financing.

  - 2 year fixed, stated income ARMs with 3 year prepayment penalities widely utilized. 

2. Market KRI - Federal Reserve embarks on a policy of tightening between 2004 and 2006 setting up Sub Prime ARM's for failure. 

3. Market KRI - Housing affordability Index at all time lows during 2004 to 2007 period. 

4. Market KRI - Home ownership rates at historic highs. 

5. Market KRI - Aggressive speculative activity in housing. 

6. Market KRI - Rates of home appreciation increase exponentially over long term historical averages. 

7. Market KRI - Housing bubbles developed in several foreign economies which were misread as strong economic fundamentals. 

8. Operational Risk KRI - Misrepresentations and fraud largely ignored through the origination and securitization process. 

Sample of Current Key Risk Indicators to be Monitored as Low (Green), Medium (Yellow) and High (Red) Risk

Market Key Risk Indicators 

1. Market KRI - Stock market investor margin debt surged to all time highs, surpassing for the past three months previous records set during both prior, the dot com and the housing, stock market bubbles. High margin debt potentially leads to negative selling feedback loop if markets become volatile. Could impact economy and housing if equity prices devalue far enough.  - Red 

2. Market KRI - Federal Reserve asset purchases tapered in an historically low M2 Money Velocity environment and multi-decade low stock market volume. Could lead asset prices to fall aggressively, as low volumes in equities leave markets susceptible to extreme volatility. Tapering of Federal Reserve asset purchases could negatively impact equity prices, as asset purchase appears to be highly correlated to equity prices.  - Yellow/red

3. Market KRI - Federal Reserve Quantitative Easing (QE) program potentially creating "money good" asset shortages in banking system.  Recent Treasury Borrowing Advisory Committee (TBAC) estimates as much as ~11 trillion in a stressed environment (page 70). June failure to delivers in Repo Markets may indicate such stress has waned likely due to tapper expectations. If stressed market occurs it could cause extreme volatility in credit and repo markets leading to a freezing of the shadow banking system - Yellow  

4. Market KRI – Structural deterioration in US employment data.  Shifting from full time employment to part time employment and falling labor participation rate as indicated by record and increasing Supplemental Nutritional Assistance Program (SNAP). These negative trends create a risk for sustained economic growth in the US economy.  Additionally, if a recession re-appears, this very weak employment situation will materially worsen.   - Yellow/Red

5. Market KRI – Internals of US employment picture weakening not only in part time to full time but in quality of employment. Construction / Manufacturing / Durable Goods jobs continue to weaken while food/beverage and retail jobs grow. Negative structural changes in US employment make up could deteriorate further due to regulatory (e.g. Obamacare) and economic environment causing economic expansion to deteriorate. - Yellow / Red

6. Market KRI - Record student loan debt currently stands at $1 trillion and expanding. 50% of all student loans are currently in default or deferral. 30% of 20 to 24 year olds are unemployed or not in school.  This record student loan debt is leading potential entrepreneurs to delay or abandon starting a business. This is a troublesome trend since 45% of all jobs created were by small businesses. - Yellow

7. Market KRI - Own to rent  investors (domestic and foreign) heavy acquisition of distressed properties driving property values higher in several key markets.  Currently 60% of all homes purchases in the US are done as all cash, indicating the level of participation of investors.  As acquisition costs increase and rental property supplies swell, rental rates are very likely to be pressured down. This dynamic would reduce the rate of return on the investment and could trigger investors to liquidate portfolios, adding inventory to the market. Just who is going to buy this inventory as a first time home buyer will not be a strong position. - Red

8. Market KRI - Spike in US mortgage rates adding downward pressure to housing recovery as recent data shows new home sales weakening by 13.4% and pending home sales missed by 1.3%.  If this trend continues, it could trigger big money investors to start liquidating their Real Estate holdings, adding further pressure to home prices, especially in the mid to lower price points. - Yellow/Red

Operational Risk Key Risk Indicators 

1. Operational Risk KRI -  Sizable amount of shadow housing inventory remains back logged in banks and servicers pipelines. - Yellow 

2. Operational Risk KRI – QM and ability to pay exposure due to regulatory confusion. Green / Yellow

3. Operational Risk KRI – HBoR issues related to modification request and foreclosure process - Yellow / Red

4. Operational Risk KRI – Federal Reserve loan officer compensation rules vague and ambiguous leaving lenders open to enforcement action. Green / Yellow

5. Operational Risk KRI – Home Value Code Of Conduct (HVCC) rules allow for lenders to own Appraisal Management Companies (AMC) leaving opportunities for the appraisal process to be corrupted Green / Yellow

6. Operational Risk KRI – Previous Private Label Mortgage product securitizations flaws could potentially lead to systemic damage in servicing of trouble mortgage assets.  Recent legal cases bring into question the validity of the MBS Trusts.

Credit Risk Key Risk Indicators

1. Credit Risk KRI - Deterioration in the internals of the US employment picture could create challenges for borrowers to continue to make payments. 40% of the US population makes less today (under $20,000) than the minimum wage in 1968 adjusted for inflation at $21,480.