Risk Management: The Vision and the Reality

RMA Journal, The, March, 2001 by James T. Gleason

This article is adapted from Risk. The New Imperative in Finance, published last year by Bloomberg Press. Global risk management is where institutions want to be, and, contrary to popular belief, the main stumbling blocks are not technological.

Risk is on the cusp of becoming the new currency within financial institutions. It is now possible to estimate the marginal impact of every major deal on the overall risk profile of the firm. Market risk and credit risk can be quantified and considered against the return a deal provides. Each deal's contribution to shareholder value or its risk-adjusted return on capital can be determined.

These measures create a framework for harmonizing activity at financial firms. A direct connection between the firm s appetite for risk, defined by senior management and the deals that are executed at the most granular levels, can now be created in the form of risk-adjusted pricing. Eventually, all deals will be charged for the incremental risks they create for the firm.

The Vision: Go Global

Global risk management (GRM) is a three-step process that, when implemented effectively, becomes the internal framework for ensuring that scarce resources within the firm, primarily capital, are channeled into their most productive use. In short, firms must intermediate financial risks more efficiently than the external markets. GRM can enhance the collaboration among all groups that create risk while simultaneously clarifying and enforcing senior management's risk appetite for various risks.

1. Consistent measurement. Current convention breaks all risks into three subsets: market risk, credit risk, and operational risk. A combination of Value-at-Risk (VaR)-based and stress-based models is currently the most complete way to quantify market and credit risks. Operational risk measures are available, too. The standards and models for risk measurement in the three subsets are sure to evolve, so the process must have "plug-'n-play" compatibility for model improvements.

The risk measures must be consistent with outside markets to prevent arbitrage. For example, the securities firm that charges capital for credit risk all the way down to the desk level bases its charges on the market spreads for each name (the spread above the risk-free rate that each name has in debt markets). Based on the spreads, the firm calculates a term structure for credit risk. This creates fluctuations in credit charges, which are not popular. However, since charges are based on market rates, arbitrage opportunities are eliminated, and arguments against it are stifled by market reality. Opponents say the spread contains a liquidity premium, or that it is too volatile. But it has worked. Traders are much more careful with credit risk now that they are charged for it even if the charges aren't perfect.

Compare this situation with that at another major institution, where charges for credit risk are not levied down to trading businesses. Because this institution does charge for market risk, internal arbitrage occurs. Recently, the trading group entered into a deal that created tens of millions of dollars of incremental credit exposure, enough to require approval for a big limit increase with that counterparty. The deal significantly reduced their market risk. The group effectively converted market risk into credit risk. They were being charged capital for the market risk and the credit risk was free, at least for them. This arbitrage opportunity; from market to credit risk, is available in many trading organizations. It will not end until credit risk management moves from the back office, where it has been relegated, and is fully incorporated into traders' dealing activities and incentives.

2. Allocation. The allocation of overall risk should be based on the marginal contribution each subportfolio makes to the aggregate levels of risk. A dealer/desk or business line whose set of deals actually reduces overall risk should get a credit instead of a charge. This is the only way to motivate the business to price the risk-reducing deals appropriately. The challenge of building an infrastructure to support this level of risk allocation is substantial as is the challenge of determining the marginal contribution of each portfolio and each risk.

There are several ways in which risk can be measured and charges in the form of capital allocated. [1] One method measures earnings at risk, whereas another is based on measures of asset volatility. The simplest approaches examine the risk/return profile of each deal, without attempting to see its marginal impact on aggregate risk. No models currently treat market and credit risk as dependent variables, which is generally acknowledged to be the case. None of these methods is the right one--rather, they all are. Even the crudest and simplest allocation methods are providing better guidance for incremental trading than the "limit" process which is currently in place almost everywhere.

3. Incremental dealing. Most institutions control incremental trading through risk limits. They provide room for more dealing in products, business lines, and specific deals that are perceived to provide the highest risk/return ratio. This limit process has been in place for a long time. However, limits are a tool for control, not efficiency. Centrally planned economies achieved remarkable control with their production quotas. They also achieved monumental inefficiencies. Limits within financial houses create similar inefficiencies and abuses. A senior credit officer once commented, "I've lowered limits to the trade group in Paris. Their operation stinks. They don't know what they are doing there." His power to set granular limits took him well beyond his job of defining the overall credit appetite for given counterparties. Granular limits also constrain the movement of credit availability to match shifting patterns of trade.