Risk Mitigation Lies in Diversity

The CRMPG report is a dramatic response to the current credit crisis. What financial institutions and governing bodies are now discovering is that 1) risk has never been managed but merely reported, 2) risk was not accurately assessed but clumsily quantified, and 3) that there is systemic risk in driving entire segments of the industry toward uniform hedging tactics under similar business scenarios.

1) Risk was not previously managed, merely reported: Reporting risks, even accurately, does not protect anyone against those risks should they occur. Risk is now being elevated to a corporate priority - risk managers have the power to qualify a balance sheet, and communicating and managing risk policies with appropriate transparency has become a shareholder priority. Risk managers need to come out of the audit departments and sit in between the CEO and the CFO of a firm.

The new role of the Chief Risk Officer will consist of defining risk policies and insuring they remain aligned with the corporate strategy as mandated by the shareholders. To do this, CROs need to distil the risk policies into achievable, measurable targets for each and every centre of operation of the firm. Notions of market, credit and especially operational risks must be present everywhere in the company, from the board to the blue collars. This is nothing short of implementing a new corporate culture.

2) Risk was not accurately assessed but clumsily quantified: Models are only as good as the scenarios they have been calibrated for and as appropriate as the assumptions they rely on. If the results inspired by Value at Risk (VaR) methodologies looked satisfactory by back testing results from the perspective of siloed asset classes over the last ten years, most models have now become irrelevant due to the cross-asset nature of today's markets.

The globalisation of financial markets has created new and unpredictable correlations. Securities, over-the-counter and interbank markets are deeply interlinked via collateral management and securitisations. Credit markets have forever linked equities and fixed income markets in a complex non-linear fashion.

The new approach consists of identifying the key risk factors truly underlying a firm's exposure and assessing their impact on the very positions of that firm. Firms need to drill through the underlying risks as the securities they hold are sensitive to and asses the potential impact on themselves, on their customers, and on their capacity to react or to fund their positions. Each individual firm would therefore have a different sensitivity to similar risk factors. This is a brand new, hands-on approach to risk based on know-how, experience, expertise and deep knowledge of one's market, products and clients, rather than an ivory-tower math-intensive modelling exercise.

3) There is systemic risk in driving entire market segments toward uniform hedging tactics: The solutions to all risk mitigation issue lies in diversity. Different timeframes in investors' strategies, hedgers opposite exposures and different crisis management tactics are what keep markets in balance at all times. By focusing the financial industry on credit quality, pointing at methodologies and even models to measure risks and allocate economic capital, the regulators would create systemic risk themselves. Driving all participants toward uniform asset and liability management strategies would expose the industry to contagion.

Precepts and regulatory recommendations need to encourage the diversity of strategies, tactics and risk policies. Regulators are core to defining the spirit, and some boundaries, to keep the markets fair and efficient, but can let individual firms be free to define their own governance rules, control procedures and risk mitigation strategies. Regulators of the securities and banking industries, potentially supplemented by data providers, can then combine their efforts to gather everyone's information and produce global views of exposures, chosen strategies and typical methodologies, so that each individual firm can benchmark their own undertakings against such a monograph.