Stressing the limits of risk

Events of the past year have led some commentators to believe financial-risk-management systems are actually rather useless as they were unable to predict losses incurred from the latest crisis. These conclusions are tempting indeed, especially since many firms involved have committed substantial resources towards applications that are designed to measure risk, at least from a regulatory standpoint.

Compliance can only cover risks that are standard to an entire industry. Regulators might rely less on rating agencies and incorporate time-to-default or failure-to-pay directly into their next set of rules, but with the explosion of risk in the financial industry, regulators run the risk of always being one-step behind. Firms that are keen to profit from financial innovation cannot expect regulators to cover all their tracks.

A stochastic simulation of credit-default-curves through hazards implied from spreads or defaults, as well as copula-based projections of time-to-default or failure-to-pay have been around for quite a few years now, so perhaps a change of approach is long overdue.

Top tier institutions seem to have recently split into two different groups. On one side are the majority of firms that use financial-risk-management to fix limits and supervise trading activity. This approach tends to concentrate risk management and policy driven government compliance into one single department high up into the organization. Here, risk management is mostly tactical as well as centralized, with risk managers often considered ‘gatekeepers’ whereas traders are antagonized as ‘gatecrashers.’ 

In the other group are institutions that have managed to turn financial risk management into an asset by providing the right tools to those who make the decision. This federates traders and risk managers alike, so both work in the company’s best interest. Risk management becomes more strategic than tactical and helps traders make better decisions right from the start, rather than having to troubleshoot at a later stage, or even worse hide their losses from management until they get out of control.

All firms that have recently incurred larger than expected losses all share one thing in common; their policy towards financial risk management has mostly been tactical rather than strategic This seems to apply even for different types of losses; be it failure to simulate distress on default sensitive debt, poor diversification of counterparty exposures or even unqualified trades from unauthorized middle office personnel.

The events of the past year will perhaps have the impact needed to change the way risk management is used throughout the enterprise. For this to happen, both end-users and financial risk management providers must change their ways.

Application providers must finally become competitive, moving away from the multimillion-dollar monolithic proprietary systems that monopolize large quantities of personnel and require board approval. They must setup and supply powerful and flexible applications that are user-friendly and yet secure, which can run on a wide spectrum of hosts and adapt to numerous problems at very competitive prices.

As for end-users, they must become more knowledgeable in the field of risk, but only to the extent that is directly relevant to their job. That way they can finally appreciate the tremendous advantage these techniques have to offer when it comes to making better investment decisions.

For example, a trader can rapidly use probabilistic measures to understand how his exposure will perform as it evolves over time and conditions in the marketplace change. Whereas his management must understand the effect of his counterparty’s exposure to concentration risk, amongst others. If this is the case, traders will finally be given the tools that allow them to take full responsibility for their positions, rather than having to assume others with vested interest have performed their duties in all due diligence.