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Financial Services

THE FUTURE OF
RISK MANAGEMENT
TEN YEARS AFTER THE CRISIS

AUTHORS
Thomas Garside, Partner
Jonathan Mitchell, Engagement Manager
During the dog-days of August, a FTSE 100 financial institution, established more than
100 years ago and based in the North of England, suddenly announces a dramatic collapse
in their financial position, and blue-chip investors are left nursing major losses. However it’s
not 2007, it’s now 2017. Ten years on from the start of the Northern Rock crisis, it seems a
reasonable time to ask “so what has changed”?

The last ten years have seen a radical overhaul of risk management at UK banks.
The Northern Rock failure alone would no doubt have prompted big changes. But the
subsequent cascade of events drove massive government and regulatory intervention.
Over the last 10 years, the risk functions of banks have been dominated by the work required
to comply with an avalanche of new regulation.

UK banks have, for the most part, satisfied the new regulatory demands. As a result, they are
much better capitalised than they were in 2007 and with better liquidity and funding ratios.
Despite the risks arising from Brexit and the unwinding of quantitative easing, another crisis
ten years after the last one began seems unlikely.

The next ten years in risk functions will thus be quite unlike the last. The drivers of change
will not be financial recovery and regulatory compliance, but technology-driven changes
to banks’ business models and to the machinery of risk management. Ultimately, the
transformation brought on by these developments could be greater than the cumulative
changes of the last ten years.

Having sketched the story of the last 10 years, and the current state of play in risk
management functions, this report describes the developments that are likely over the
coming years and what CROs can be doing to prepare for them.

THE CRISIS AND ITS EFFECT ON RISK MANAGEMENT


The freezing of much of the wholesale money markets in the summer of 2007 exposed the
funding strategies of many bank and non-bank business models, triggering a cascade of
events that played out on both sides of the Atlantic (see Exhibit 1).

In just over twelve months, more than a dozen major financial institutions had been
rescued on both sides of the Atlantic, structured investment vehicles (SIVs) controlling over
$400 billion of assets had closed, and the first phase of the crisis culminated in the collapse
of Lehman Brothers on the 14th September 2008.

The last quarter of 2008 and the first of 2009 were the darkest days of the banking crisis.
Nearly all major banks in Europe and North America came under sustained pressure.
Morgan Stanley and Goldman Sachs were the only major institutions whose credit default
swap (CDS) spreads exceeded 400bps to survive bankruptcy or government recapitalisation.

Copyright © 2017 Oliver Wyman 1


Exhibit 1: TIMELINE 2007–2009
FTSE UK BANKS INDEX
1000
1 OCT 2007 8 SEP 2008 15 SEP 2008 3 OCT 2008
Increase in UK US Treasury rescues Lehman Brothers US creates $700 BN
deposit insurance Fannie Mae and files for bankruptcy govt. support
Freddie Mac for in the US programme (TARP)
800 $187 BN

14 SEP 2007
Northern Rock granted
emergency funding by 6 OCT 2008
Bank of England Hypo Real Estate bailed-out by Germany for €50 BN

600 Nationalisation of Icelandic banking system

13 OCT 2008
British Govt. £37 BN rescue
6 DEC 2007 17 MAR 2008
plan for RBS, Lloyds and HBOS
Cut to UK Bear Sterns rescued
interest rates by JP Morgan 21 OCT 2008
400 Germany rescues IKB
mortgage bank for €9 BN
29 SEP 2008
Nationalisation of
Bradford & Bingley;
Fortis partially
nationalised
200

18 SEP 2008 30 SEP 2008 16 Oct 2008 5 MAR 2009 2 APR 2009
Central banks inject Dexia receives UBS £3 BN Bank of England begins £75 BN G20 agrees $5 TN
billions of pounds €6.4 BN state state injection round of Quantitative Easing financial stimulus package
worth of liquidity injection
0

J F M A M J J A S O N D J F M A M J J A S O N D J F M A M J J A S O N D

2007 2008 2009

Source: Datastream

Bank regulation at the time helped to shape the crisis (see Exhibit 2), if only through the “law
of unintended consequences”. Whereas banks in Europe were subject to a brake on risk via
Basel II and Risk Weighted Assets (RWAs), in the United States, where Basel II had not yet
been implemented, banks were instead subject to a brake on their leverage ratio. Thus it
can be broadly argued that failing European banks blew themselves up with leverage, while
failing US banks blew themselves up with risky assets, the most vulnerable being banks
dependent on large quantities of short-term wholesale funding.

Copyright © 2017 Oliver Wyman 2


Exhibit 2: EURO VS US BANKS TIER 1 AND LEVERAGE RATIOS UP TO 2008
CET 1% RATIO LEVERAGE RATIO EFFECTIVE RISK WEIGHT
2007 2007 2000–2007

100%

8.1% 8.3%
80%
US
5.9%
60%
Estimated impact
of IFRS “gross-up”
3.8%
40%
3.1%

Equivalent leverage Europe


ratio of ~3.9–4.5% 20%

0%
UK Euro US UK Euro US 2000 2001 2002 2003 2004 2005 2006 2007
area area

Source: IIF, IBF, Bloomberg, S&P SNL, Oliver Wyman analysis

What had begun as a perceived issue with US sub-prime loans and structured products
now presented itself as a systemic crisis affecting entire economies. The resulting massive
government interventions were successful in largely stabilising the banking sector problem,
but at the cost of transferring large amounts of debt onto public balance sheets. The stage
was then set for the second phase of the crisis, the European sovereign debt crisis, the exit
from which is still a “work in progress”.

The weaknesses in the financial system and its regulation highlighted by the crisis shaped
the subsequent regulatory response. In addition to strengthening balance sheet ratios,
legislators and supervisory agencies also turned their attention to issues such as “too big
to fail”, the separation of trading and banking activities, the moral hazard implicit in pure
originate-to-distribute models, asset valuation under stressed market conditions, and the
credibility of risk models and RWA calculations (see Exhibit 3). But the ensuing deluge of
regulation and litigation has not been restricted to bank solvency and systemic stability.
A perception of widespread misconduct in banking has resulted in new regulations covering
sales conduct, market conduct (for example, LIBOR), conflicts of interest (for example,
equity research), financial crime and counter terror financing.

Since 2007 banks’ balance sheets and funding strategies have changed dramatically, with
higher (equity) capital ratios and more stable debt funding (see Exhibit 4). Over this period,
the influence of banks’ risk organisations has grown enormously as they have reshaped
themselves, going beyond the management of traditional financial risks to also work on
strengthening risk culture, controls and conduct.

Copyright © 2017 Oliver Wyman 3


Exhibit 3: REGULATORY TIMELINE SINCE FINANCIAL CRISIS
NUMBER OF THOMSON REUTERS REGULATORY ALERTS PER MONTH
6,000
IFRS9 Final NSFR Final PSD2 TLAC TRIM FRTB
MIFID II
SSM/SREP
CRD IV, Liikanen
CoRep,
4,000 FinRep PRA RRP
BCBS248

BCBS239

Revised LCR

2,000 EMIR/OTC
Basel 2.5 Dodd-Frank Basel 3

0
Jan Apr Jul Oct Jan Apr Jul Oct Jan Apr Jul Oct Jan Apr Jul Oct Jan Apr Jul Oct Jan Apr Jul Oct Jan Apr Jul Oct Jan Apr Jul Oct Jan Apr Jul Oct
2008 2009 2010 2011 2012 2013 2014 2015 2016

Source: Thomson Reuters, Oliver Wyman analysis

Exhibit 4: CET1 RATIO AND WHOLESALE FUNDING MIX FOR UK BANKS 2007–20161,2
PERCENTAGE NON-WHOLESALE FUNDING
90
Royal Bank of Scotland
HSBC Bank Nationwide
Lloyds Banking Group Building Society
80

70
Standard Chartered
Barclays
Lloyds Bank Plc
60 Bubble size
=
Total RWA
50 HBOS

2007 2016
40
3% 6% 9% 12% 15% 18% 21% 24%
CET1 RATIO

Source: S&P SNL, Oliver Wyman analysis

1. Non-wholesale funding % = (Total liabilities – wholesale funding) / Total liabilities, where wholesale funding includes financial liabilities and repurchase agreements,
excludes derivatives and customer deposits

2. RBS CET1 ratio shown is for 2008 as 2007 not reported.

Copyright © 2017 Oliver Wyman 4


WHERE ARE WE NOW?
The financial sector is now undoubtedly more robust. However, it is unclear the degree to
which total risk has reduced. Aggregate levels of indebtedness are still increasing, and risk is
shifting from private to public balance sheets, and from the old to the young (see Exhibits 5
and 6).

Exhibit 5: UK LEVELS OF INDEBTEDNESS1/GDP (EXCLUDING FINANCIAL


CORPORATIONS) 2007–2016
PERCENT OF GDP
300

200

100
Private balance
sheets

Public balance
0 sheets
2007 2008 2009 2010 2011 2012 2013 2014 2015 2016

Source: Eurostat, Oliver Wyman analysis

1. Indebtedness defined as debt securities + loans

Exhibit 6: HOME OWNER OCCUPIERS BY AGE 1981–2016


PERCENT
100

75

1981

50
1991

2001–02
25

2011–12

0 2015–16
16–24 25–34 35–44 45–64 65–74 75+

Source: ONS (English Housing Survey)

Copyright © 2017 Oliver Wyman 5


In several European countries there is still a large, and in some cases growing, legacy of the
crisis in the form of NPL stocks. Efforts at national and European levels to tackle this issue
have had mixed success. As Exhibit 7 illustrates, banking crises caused by asset bubbles
(Ireland and Spain, for example) can be overcome more quickly than crises caused by a loss
of economic competitiveness.

The dominating economic issue in the UK is Brexit. Executed badly, the credit quality of UK
businesses and households will deteriorate. At present, however, markets are not pricing
a risk premium into tradable UK corporate debt. The immediate credit-related concern in
the UK is consumer lending (see Exhibit 8). The BoE Financial Stability Report (June 2017)
and subsequent publications by both the PRA and FCA express concerns about lending
standards and future affordability for borrowers. There is also growing market interest in
what IFRS9 will mean for banks’ reported results, again most notably for consumer credit,
and in its sensitivity to economic deterioration – in both published accounts and in the
results of future regulatory stress tests.

The other obvious source of concern is the effect higher interest rates will have when,
eventually, the BoE lifts them. Low rates have encouraged leverage and inflated the value
of long-term assets. However, given the uncertainties created by Brexit and the consistent
approach of Mark Carney and the MPC, the likelihood of material rate rises anytime soon
must be judged as low.

And, even if credit conditions deteriorate, the much improved capital ratios and debt
funding maturities of UK banks make a repeat of the financial crisis unlikely. This conclusion
is supported by the Bank of England and EBA stress tests, in which UK banks remain viable
under scenarios similar to those of 2008–9 in combination with another round of heavy
misconduct fines.

Exhibit 7: NPL RATIO EVOLUTION FOR STRESSED EUROPEAN COUNTRIES 2007–2016


2010 INDEX COUNTRY (2016 NPL RATIO)1

500%

400%
Greece (36%)
Indexed to
2010 = 100% Countries
300% with remaining
NPL problem
and no clear
Portugal (13%1) downward trend
200%
Italy (17%)

100% Spain (6%) Clear downward


Ireland (15%1) trend in NPL ratio

0%

2007 2008 2009 2010 2011 2012 2013 2014 2015 2016

Source: IMF Global Financial Stability Report, ECB, Oliver Wyman analysis

1. 2016 figures as presented in the IMF Global Financial Stability Report; Portugal and Ireland data is for 2016Q3

Copyright © 2017 Oliver Wyman 6


Exhibit 8: UK HOUSEHOLD DEBT TO INCOME 2000–2016
PERCENT
150

Consumer lending
(2016 growth in debt = 6%)
100

Mortgage lending
50 (2016 growth in debt = 4%)

0
2000 2002 2004 2006 2008 2010 2012 2014 2016

Source: ONS, Thomson Reuters, Oliver Wyman analysis

THE IMMEDIATE FUTURE


The evolution of risk management over the last 10 years has been a response to the direct
financial impact of the crisis and to the regulatory agenda that followed. Without another
crisis, its evolution over the coming years will have different drivers. We think three will be
most important.

First, banks continue to operate in very uncertain political and social environments, with
almost no tolerance for further real or perceived misconduct. Second, the competitive
landscape, including both incumbent and disruptive players, will evolve rapidly over the
next five years and this will require a rethinking of many traditional risk management
approaches. Third, investors will ratchet up pressure on banks to consistently meet their cost
of equity and, in addition to constraining losses, risk management is an important part of
both cost containment and revenue growth.

In this context, we think six items should be near the top of a CRO’s current agenda:

1. MANAGING THE NEAR-TERM RISK TRAJECTORY


As noted, there is concern about UK consumer credit and its vulnerability to rising interest
rates and unemployment. Given the post-crisis actions of the Bank of England, credit
losses in the recent past have been benign. Banks must have confidence in their credit
loss forecasting (including under the new IFRS9 accounting standard which is expected to
increase CET1 sensitivity to regulatory stress tests by up to 50 percent) and their ability to
effectively manage significantly higher workloads in collections and recoveries by using
early-warning systems to detect “hotspots” and dynamically allocating scarce experienced
resources. In the next consumer credit cycle conduct issues will also be in focus, and banks

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will need to ensure that policies, processes, and behaviour incentives are carefully managed,
including questions relating to forbearance.

2. IMPROVING COST AND EFFECTIVENESS


The understandable risk aversion found in many banks can add multiple layers of controls,
going beyond the three lines of defence standard, and beyond what is required by the bank’s
agreed risk appetite. Operating models can benefit from a reset, most often for compliance-
related activities, where structures have evolved rapidly in response to new conduct and
regulatory requirements. Robotic process automation (RPA) is maturing and can now be
applied to an increasing number of standardised tasks. For example, it can reduce process
time by over 50 percent versus previously manual escalation decisions in a transaction
monitoring process, and (demonstrating the complexity of regulatory requirements)
“ChatBot” technology has been used to target a halving in the number of enquiries to
compliance teams. Risk functions must also promote the digitisation of the business. Risk
processes should be “baked in” to new products and workflows from their inception, and not
appended afterwards, which can create a drag on the speed and integrity of execution, and
damages the customer experience.

3. EVOLVING GOVERNANCE FRAMEWORKS AND


STRUCTURAL REFORMS
The finalisation of ringfencing, recovery and resolution planning, and now Brexit, throw up a
number of challenges for risk managers. As well as ensuring that new governance structures
can be shown to remain robust under stressed scenarios, the creation of new legal entities
will require the duplication of some activities and the fragmentation of capital and liquidity.
For institutions setting up or significantly expanding Eurozone entities, the additional
requirements of EU IHC entities under SSM supervision will need to be clearly understood
and planned for. Recent client engagements have highlighted the need for management
focus on the careful design of Eurozone entity operating models, and establishing
strengthened governance, risk and control frameworks, so as to avoid short- and medium-
term disruption, and to maximise efficiencies. Location strategies should be put under
renewed focus, particularly under shared service models, with some types of risk operations
(for example, FCC) migrating to mainly offshore or nearshore locations.

4. CONTROLLING NEW THREATS


Concerns around new risks relating to data and cyber risks are front of mind. With increasing
ambitions for the use of data (via big data and advanced analytics techniques) and its wider
distribution (as a result of PSD2), the risks associated with the inappropriate usage or loss
of control of data, multiply dramatically. Managing cyber risk requires banks to have staff
with the right skills, through recruitment or training, and to design effective governance
structures across Line 1 and 2 activities. We estimate that spend on cyber risk now accounts
for 6–8 percent of total IT budget, and that this is increasing. As elsewhere, efforts in cyber

Copyright © 2017 Oliver Wyman 8


security should be guided by risk-return trade-offs. Banks should not spend material sums
on avoiding threats whose probability consists in nothing more than being imaginable.

New risks are not limited to cyber. They can arise out of economic trends, geo-politics,
clients and counterparties, markets and competitors, legislation and regulatory activity,
internal processes and employees, and outsourcing. Properly assessing them requires a
rigorous framework and a management process which ultimately engages the Board. We see
banks increasingly looking to other industries – for example, airlines, pharmaceuticals, the
military – to learn how they continually seek to identify and manage new and critical risks.

5. CONTINUING TO (RE)BUILD REPUTATION AND STRENGTHEN


RISK CULTURE
The road to redemption is proving long for UK banks. They remain on the defensive with
the media, the public, politicians and regulators. Banks need to build and display better
risk cultures. Risk teams must engage with the business from the start of innovation and
digitisation processes to ensure that the bank’s reputation and risk culture is protected
under new and changing business models. The risk team must act as an enabler and advisor
to these initiatives rather than an ex-post approver. Raising awareness of risk requires not
only rules but training. We have successfully worked with firms to do this via scenario-based
workshops, bringing risk culture to life with real “dilemmas” faced by each business. Such
training works best when accompanied by a programme of “nudges” to reinforce learnings.

6. EXPLORING AND APPLYING NEW TECHNOLOGIES


AND ANALYTICS
The industry has entered an exciting period of technological and analytical innovation.
Banks’ abilities to assemble and manipulate data, and predict trends and propensities,
has changed out of all recognition from a decade ago. New data capture and connection
technologies mean that circumventing legacy system issues is less of a road block than
it has been. Most banks are actively exploring new analytical approaches, including AI
and machine learning. Many of these initiatives are being pursued on an experimental or
champion/challenger basis, and executed using a combination of internal, joint ventured
and crowdsourced resources. Optimising credit decisions in this way can be used to
reduce losses (for example, a 5–10 percent reduction in default rates for a given volume of
applications), grow lending volume (for example, a 10–30 percent increase in new business
while holding credit losses constant), and drive efficiencies (for example by reducing manual
decision making by 50 percent). In compliance, advanced pattern recognition and clustering
techniques have been proven to detect suspicious activity 12 months faster than legacy
systems. Advanced third party solutions are also being incorporated with greater frequency,
enabled by API technology.

Copyright © 2017 Oliver Wyman 9


LOOKING FURTHER AHEAD
With immediate concerns under control, what should a forward-looking CRO be working
on to future-proof the organisation? Because the range of possibilities is wider, risk teams
must prepare across a broad front, and develop increased flexibility to respond. We would
prioritise five areas:

1. CREATE AN AGILE RISK PLATFORM PREPARED FOR MULTIPLE


FUTURE SCENARIOS
The banking sector faces a range of future scenarios driven by digital disruption. While
there are “most likely” scenarios, there is still a wide range of possible end states over the
next 5–10 years. At one extreme, it is possible that a purely evolutionary path develops, with
banking incumbents continuing to rule and digital disruption constrained to the margins.
A more likely scenario is that banks continue to dominate, but winners are differentiated by
their ability to exploit new digital opportunities, and to interface or compete with new digital
players in areas where they have established a credible presence. Continuing to push the
range of scenarios, it is possible to envisage a more “even fight”, with current incumbents
and new entrants competing head-on across a wide range of customer segments and
banking services. At the extreme, we could see a scenario where incumbents have largely
been pushed out of many customer segments, and retreat to being utility providers of
balance sheet and cash management services. By definition, it is impossible to pick a single
planning scenario. As a strategic partner to the business, risk management teams should
be fully engaged in the strategic and scenario planning process, and master agile working
practices to accelerate their speed-to-change.

2. MODULARISE THE RISK FUNCTION


Under any of the above scenarios, banks and their risk management teams face a much
more modularised future. Risk managers should assess where each of their current and
future activities can best be performed. Could tasks that remain in-house be migrated to
offshore or near shore locations? Could they be delivered by a similar group elsewhere in
the organisation, such as behavioural analytics? Could they be automated/robotised, or
rely much more heavily on third-party applications? Many banks are already considering
which tasks may be more efficiently delivered by industry utilities or third-party solutions (for
example, AML checks), or where outsourcing or crowdsourcing of analytical development
offers advantages. Based on client work we have already undertaken, there is big difference
in the number of FTEs assigned to internal risk management teams under different industry
scenarios. Under an evolutionary scenario banks are expecting efficiency gains to bring
a 10–20 percent reduction in risk resources, whereas under a fully modularised outcome
internal risk FTEs could reduce by up to 80 percent. Under any likely scenario, vendor
management will become a more important capability for risk functions.

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Exhibit 9: THE RISK FUNCTION OF THE FUTURE WILL FOCUS MORE ON VALUE
ADDING AREAS
CURRENT RESOURCE LOCATION FUTURE RESOURCE LOCATION

Stategic risk advice


20% 35%

Traditional risk activities


50% 25%

Identification and advanced analytics


15% 15%

Management and operations


15% 25%

Source: Oliver Wyman analysis

3. BUILD THE NEXT GENERATION OF RISK TALENT


The changes outlined above mean that the skills required for tomorrow’s risk organisation
will be quite unlike today’s, with a refocusing of skills away from traditional “production”
activities and towards adaptable analytic and advisory skills (see Exhibit 9).

Success will require risk functions to attract and retain talent that will be competed for both
internally and externally across a range of industries. We consistently find that senior risk
professionals put talent management and influencing skills at the top of their leadership
development requirements.

4. CREATE DATA AS FLEXIBLE AS THE ORGANISATION


The more open-ended and query-driven nature of the regulatory “ask”, and the importance
of data flexibility and accuracy across both risk and finance systems, mean that much
remains to be done at many banks. Regulatory and accounting changes continue to
drive the overlap between risk and finance data requirements. Features of the risk data
architecture are often the result of quick responses to new regulation rather than based
on first principles and a target architecture. A number of institutions are exploring a
combined data utility across risk and finance which is independent of current processes and
technology. Exhibit 10 shows typical target architecture.

This is another area where risk and finance teams need to engage in a strategic dialogue with
other areas of the firm, for example, concerning the bank’s API strategies.

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Exhibit 10: INTEGRATED OLIVER WYMAN FRAMEWORK FOR FINANCE AND RISK DATA
INFRASTRUCTURE AND MANAGEMENT

FINANCE AND RISK REPORTING OPERATING MODEL

I. Data governance and organisation

II. Change management


Typically finance
(Accounting and controlling) Typically risk Typically treasury

Mandatory Internal Integrated risk Individual risk ALM and


external management measurement type risk liquidity

IV. Data service processes


standards and metrics

reporting reporting and and controlling measurement management


III. Data policies,

bank steering and controlling

1. Steering support (reporting and analysis)

2. Calculation and methodological capabilities

3. Data

4. Applications (software)

5. Infrastructure (hardware)

Finance and risk Finance and risk Finance and risk


reporting operating model data service model data reporting infrastructure

Source: Oliver Wyman

5. DELIVER ON ANALYTICS AND AUTOMATION


Drawing on the learnings from experimentation with advanced analytic and automation
techniques, risk teams should construct a portfolio of ambitious initiatives to deliver more
effective and efficient decision making. These will include big data applications, pattern
recognition and real-time preventative controls, and increasingly ambitious robotic process
automation. Applying RPA within risk and compliance investigation processes can already
raise productivity by 30–40 percent. But recent advances in cognitive RPA can reduce
workloads by more than 70 percent, freeing up resources for higher value activities. The new
capabilities will need to be integrated into new digital businesses and digitised customer
journeys. Banks are already exploring “social listening” to track customer experience and
identify potential conduct issues. Model risk and model governance will also need to be
rethought, particularly with respect to third party management. The model set must be
continually managed for suitability, performance, and regulatory compliance. Asking the
question “will there be more or fewer models in the future?” does not always elicit the same
answer, as the challenges and costs of managing a large model set becomes more apparent.
Using machine learning across large and newly combined data sets has allowed some
institutions to reduce the number of models they use by an order of magnitude, while also
allowing a much higher frequency of model enhancement and recalibration.

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CONCLUDING REMARKS
Risk management is at a fascinating point in its evolution. Now recognised to be not
only fundamental to the bank’s financial stability and regulatory compliance, but also an
essential part of a bank’s strategy and operational effectiveness, risk management faces a
period of large scale change. Under any of the scenarios that may play out in banking, risk
functions will need to hone their abilities in many areas. They will need to be able to identify
and address new risks quickly, be more agile and modular, deliver new technology and
techniques rapidly, and work increasingly in partnership with finance, operations, and the
businesses. These changes will require them recruit, develop, and retain staff with skills that
differ significantly from those that are found in risk functions today.

Copyright © 2017 Oliver Wyman 13


Oliver Wyman is a global leader in management consulting that combines deep industry knowledge with specialised expertise in
strategy, operations, risk management, and organisation transformation.
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