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.

This function cannot be simply outsourced, as risk management and portfolio management are two sides of the same coin. In contrast, it makes sense to outsource the risk measurement function to external service providers, as setting up the required infrastructure in-house would be costly. Specialised providers have a head start because of their continuous investments in data collection and preparation, models, reporting tools and staff.

Some companies have tried to let their in-house risk management units fulfil the risk measurement function. As a consequence, teams of risk managers spent most of their time collecting and evaluating data. In some cases, it actually took several months before companies were able to create complete transparency in their securities portfolio and its risk exposures. In contrast, whoever uses a specialist external service provider is able to achieve, in a timely manner, the level of transparency essential for effective risk management. Competent providers also assist in the solving of technical problems when inspecting portfolios and products, for example, where various capital market products are managed across different platforms. It is certainly helpful when the financial institution’s technology or information managers ensure that the technical infrastructure facilitates an inspection of all portfolios and products. This of course costs money, and one thing is clear: risk management and risk measurement don’t come free. It would be a mistake, though, to view these functions solely as net cost items, independent of alpha generation. Portfolio management and risk management are two sides of the same coin and, over the long term, one side can only function when the other side functions. This realisation is now slowly catching on, as the market for risk management services continuously grows.

A good risk manager follows an approach that is not too focused on individual parameters, as the individual risk measures depend on the specific perspective and the underlying instruments. For instance, while structured credit products (such as collateralised debt obligations) are exposed to an interest risk, their prevailing exposure is credit risk.

These multiple risks must be appreciated in their interrelationships, while at the same time understanding the relevant risk models and their respective limits. As the past few months have demonstrated, this requires risk managers to possess a high level of intuition. Many of the models used are no longer suited to analyse the capital market products, newly developed in the course of the US mortgage boom, as they are based on extremely limited data sets. Some organisations have been far too focused on potential crisis scenarios in individual market segments over the past few months. The fact that virtually all market segments took a dive in unison caught them unawares. During this phase, those companies who recognised the importance of risk management and measurement early on and acted accordingly will have an edge. This has been a painful experience for those financial institutions who failed to learn this lesson.

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