Cutter AdvantEdge
Issue 62, October 2008
Risk Management - Time for a Rethink
As we all wait to see whether the worst of the turmoil in the markets is finally over, or merely taking a breather before the next storm, the blame game has started with a vengeance.
Many organizations’ policies, practices and supporting technology were simply not strong enough to withstand what the markets threw at them. Take, for example, Lehman Brothers. In their 2007 annual report, Lehman said they had “a culture of risk management at every level of the firm”. Maybe so, but that’s no help if the risk management practices are relaxed in hot market conditions where profit becomes king.
How do firms get it right while anticipating the inevitable demands from Regulators and their own Boards of Directors?
Beyond Value At Risk
Ever since 1996 Value At Risk (VaR) has been the mainstay of risk management in financial services firms. VaR measures, within a certain level of confidence, the overall market risk under normal trading conditions over a specific time frame. Of course, what we are all going through at the moment is anything but normal markets conditions. So that’s one problem with VaR.
The second problem is, in many ways, an extension of the first: a lack of integration between credit risk and market risk. The dramatic increase in structured products, the viability of which is dependent on the credit quality of the counterparty, has turned credit risk into a major component of portfolio risk. Many firms recognize that VaR cannot be the sole indicator of portfolio risk. Market and credit trading patterns, such as evaluating patterns in credit-default swap spreads, are also an opportunity to uncover problematic investments. VaR can also be complemented by using additional stress testing and sensitivity analysis which reflect more accurately potential market conditions. New approaches, such as principal components and copulas, are also gaining more traction.
Rethinking Risk Management: The Five Musts
With markets still volatile, most firms are being forced to rethink their risk practices and tools right now and, in particular, address the problem of credit and market risk integration.
As they look at the options available, they should keep in mind the Five Musts for any solution.
- It must enable an enterprise-wide and holistic approach to risk so that market, credit and operational risk can be seen together.
- It must incorporate various methodologies for calculating VaR (parametric, Monte Carlo and historical) and offer stress testing, scenario analysis and what-ifs, as well as credit risk analytics such as Probability of Default, Loss Given Default and Earnings at Default.
- It must allow users to create and adjust models and scenarios to reflect user assumptions.
- It must support a wide range of asset classes including structured instruments, derivatives, commodities and private equity.
- It must easily interface with internal legacy systems (often an overlooked problem).
Lining Up Your Risk Options 
Many firms still use proprietary systems, largely because they have what they may think is a special or unique approach to risk management. But vendor solutions have developed considerably in recent years, particularly those that can be integrated with trading platforms and collateral management systems and so provide real-time risk management. Add in their in-depth modelling and overall flexibility and they are hard to beat.
Firms are also facing the challenge of managing the huge volumes and types of data needed to drive risk systems and must ensure that the data is clean. Solutions that provide modelling and risk toolkits as well as the underlying data needed to run the analysis are particularly attractive. Some vendors take this a stage further and offer a completely managed service.
So, apart from the Five Musts, what else should you be considering when looking for a solution?
- Target user
Who will be using your system? Will it be the Middle Office Risk Manager assessing start-of-day positions, or will it be the Front Office Portfolio Manager checking intra-day positions and adjusting risk characteristics pre-trade? - Risk discipline and asset coverage
Do you want a system for market risk, credit risk or integrated risk? What about assets? Do you want it to cover traditional instruments or complex derivatives? - Deployment
Are you going to supply all the data to fuel the system or are you looking for a solution that does it for you so that all you do is add positional information? Do you want the system to integrate with your OMS, accounting systems or collateral management system?
Conclusion
The Regulators and your own Board of Directors are bound to take a long, hard look at risk management. Without doubt, to get ahead of the game, this is the time to reassess your risk management practices and architecture.