June 11, 2012

The seminal events of 2008 brought into focus the stability of financial markets and the systemic risks that may accumulate over time. When leading institutions failed and financial instruments that represent a significant share of trading became illiquid for extended periods of time, public policy options were exhausted very quickly. In April 2009, the G20 Summit ended with the acknowledgment by member governments that regulatory regimes and governance practices needed a major overhaul.

Consequently, we have witnessed the creation of a new, international Financial Stability Board, new standards on capital adequacy and liquidity from the Basel Committee on Banking Supervision, the Dodd-Frank Act and the Volcker rule. Debate on all of these measures still continues. However, the impact on the behavior of institutions is already profound and the industry is taking steps to clean up its act without waiting for regulations to be finalized.

According to the Chartis Research RiskTech 100, "Today many financial institutions view real-time risk intelligence as mission critical, especially within trading and capital markets." This realization is not merely defensive, with most firms are seeking to gain a competitive edge as they plan to upgrade their decades-old systems and technical architecture supporting risk management.

[To read about Big Data's increasing role in risk management, read: How to Make Big Data Consumable.]

A more positive mindset is emerging from the inevitability of new investments in technology, processes and architectures that incorporate lessons from the credit crisis. Firms realize the technology investments may actually lead to more agile, competitive businesses. The consensus seems to be that now is the time for bold moves.

Regulatory Compliance ROI?
The Economist Intelligence Unit conducted a survey about the relationship between emerging requirements on regulatory compliance and enhancing competitiveness in early 2011. Approximately 160 senior executives in financial services across Western Europe (including EU-based operations of U.S. and Japanese institutions) participated. Fifty-one percent of the institutions had over $75 billion in assets globally; 48 percent were C-level officers.

When asked what impact the regulations would have on their own lines of business, 40 percent indicated positive impact on revenues and 51 percent indicated negative impact, but only 7 percent foresaw positive impact on profitability. A full 74 percent voted for negative impact on profitability. The same sample also indicated positive impact by 43 percent versus negative impact by 11 percent on reputation with investors. On impact on the risk-management practices, 57 percent voted positive versus 6 percent voting negative.

In the same survey, the participants agreed (strongly or slightly) by 79 percent with the statement that a proactive approach to regulatory compliance can be a source of competitive advantage. They also agreed (68 percent) with the statement that the proactive investments to meet regulations will benefit areas other than compliance.

Risk Management: The Fund Manager's Perspective
The attitudes toward risk management are changing on the buy side as well as the sell side. The exchanges are investing in value-added services to provision analytics and enriched data, as well as build their capacity for market surveillance. While alternative approaches and innovations are emerging, each is motivated by a desire to improve compliance in a cost-effective way and each represents a fresh look at managing risks to capital.

Pension funds and endowments are looking for strategies to cover their liabilities more effectively, as they have suffered sharp portfolio losses. Managers are determined to avoid a repeat of the last three years and are no longer content with passive investing styles. The current trend is to view liabilities as streams in which valuations fluctuate and are modeled on a temporal dimension. As these funds rely on alternative investments in their allocations and invest more cautiously in hedge funds, they are also adopting dynamic portfolio modeling techniques more aggressively. Prior to the crisis, portfolio managers aimed at a desired range for returns over a longer, defined-time horizon. Now, the goal is to actively monitor portfolio returns over much shorter time windows and to maximize the ability to monitor option volatilities by decomposing risk factors by asset, sector and trading venue.

In credit risk-management practice, the time-tested models and exposure-estimation techniques failed for a number of reasons. Decoupling of trade pricing, risk pricing and collateral valuations clearly led to a false sense of confidence. For a long time, risk analysis for asset-backed securities did not include counterparty risk analysis (except as monthly or quarterly adjustments), and risk sensitivities calculated by instrument did not adequately reflect the risk factors relevant to the portfolios. The latencies and temporal shifts in the way information flowed and was delivered to decision makers turned out to be misleading and distorted.

The refined approach relies on more active management of credit valuations: It's becoming the norm to run full portfolio simulations to derive marginal exposure and credit valuation adjustments (CVA) using updated credit-default swap (CDS) prices and ratings. Centralized desks that manage counterparty exposure using portfolio-contingent CDS pricing and pre-deal marginal exposure to counterparty and collateral valuation volatilities are two trends that are being adopted widely and rapidly.

As confidence in major ratings agencies has declined, credit risk managers are considering adopting the techniques of marginal analysis that are now used to manage debt portfolios (and are described previously). For proper governance, understanding the component risks by sector, geography, line of business, asset class and counterparty has become essential. Monte Carlo simulations are now more widely used to calculate marginal risk contributions for much narrower windows of time, with these models showing default probabilities for scenarios that represent specific stress conditions.

Redefining Risk
Other innovations question our routine understanding of risk and try to move away from monolithic definitions, looking more carefully at situational variables to quantify risks to capital. Research from behavioral economics and psychology are finding their way into innovative approaches to risk analysis, reflected in new models that incorporate investor response to different economic situations and news. The general framework for quantifying risk centers is on the capital asset pricing model (CAPM) and Value-at-Risk (VaR). The classic CAPM represents risk as beta, which is covariant with market volatility.

Higher beta indicates an asset covaries highly with market and hence commands a higher price. However, the beta is the same regardless of economic cycles or market direction. Academic research has for some time challenged this feature of the model, as investor sentiment and behavior is different in down markets than it is in up markets. An asset that declines faster in value in a down market, even as its fundamentals may be relatively better, is bound to be less attractive and riskier to an investor whose overall wealth is also in decline and hence has limited capacity for risk budgeting. Actual practice is catching up with research, and different betas for downside and upside markets are finding their way into new models. In fact, we can expect multibeta CAPM models to come into fashion more and more, as they allow for different covariances by region, asset class, capitalization range and strategy.

It is inevitable that considerable energy and investment will be dedicated to revamping the compliance and governance infrastructure of financial institutions, and some of that will be a redemptive exercise to regain public trust. The good news is found in the details of a far more rigorous response to the shortcomings that became apparent in business practice and methodology. The scrutiny and attention that risk analysis and compliance is receiving, along with concomitant new ideas and innovation, may deliver a far more stable financial system.

As Vice President of the financial services group at Sybase, and SAP company, Sinan Baskan is responsible for developing solutions for lines of business in the financial services sector. He has held various positions in the product engineering, professional services and marketing organizations at SAP.