Insufficient or non-existent risk management is expensive. The latest demonstration of this has been the billion dollar losses suffered by many banks in the wake of the US mortgage crisis. While an increasing number of financial institutions employ risk managers, this alone is not sufficient. A lot of ground also needs to be made up in the area of risk measurement, as risks can only be managed if they have been both identified and quantified within the securities holdings. Michael Marks and Rob Goldstein of BlackRock Solutions map out what they claim is a superior approach to risk management for institutional investors.

The broader diversification across various asset classes, the increasing use of derivatives and the use of new financial instruments give rise to a growing complexity within the financial markets.

This process is also associated with an increase in the variety of risks inherent in capital investments. Therefore, anyone wishing to generate sustainable profits in the capital market needs sophisticated risk management, with its base and prerequisite being a thorough understanding of one’s own securities holdings and the risks hidden therein.

This may sound easy, but many financial institutions have demonstrated false economy. It would be hard to explain the billion dollar losses accrued over the course of the sub-prime crisis during the past few months in any other way. While some banks employed several dozen risk specialists prior to the crisis, other financial institutions could count their specialists on the fingers of one hand. Given the size of their portfolios and risk positions, this number proved to be too small.

Of course, even the best risk management would not have offered total protection from any losses, as any investment involving risk exposure can still go awry. In return for good yields, the assumption of certain risks would be acceptable; the crucial point is, however, the extent of these risks. Risk measurement and risk management are a safeguard in order to prevent more money being put at risk than the investor can afford.

Before the crisis, many investors considered the purchase of certain capital market products to be a good bet, as ratings and equity capital requirements appeared to be favourable relative to the earnings outlook. Often, this assessment was based on statements made by rating agencies, but ratings alone are not enough.

Only a fundamental analysis of the risk/return profile can provide a thorough understanding of the underlying risks of capital market products and limit loss exposure. Many financial institutions have realised this and appointed risk managers (or ‘chief risk officers’). Their task is to implement the results of risk measurement, which reveals risk exposures and the interrelationships between the various securities classes, in the portfolio management.

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