Over the last few years, capital and risk managers have made or reviewed investment decisions based on risk valuation techniques and capital allocations that measure how large a potential risk could be. At the same time, shocks that could result in a dramatic increase in the correlations between the firm’s seemingly diverse business activities were largely ignored.
Risk techniques such as diversification, value at risk and probability of default were all employed, but failed to anticipate systemic changes in the market’s structure. Although most firms used dynamic measures such as these to gauge short-run movements, they tended to depend on static risk cushions or extra capital to handle shocks in cases where the dynamic measures failed. New work is needed to measure the optimal size for risk cushions, determine how to dynamically adjust them and provide for partitioning of the cushion among the various asset categories to make more accurate risk-and-return trade-off evaluations.
The past ≠ the future
Market participants relied too heavily on recent experience to frame their views on risk, calibrate their models and contemplate the necessity and costs of adjusting their holdings or reducing risks in light of shocks and lack of liquidity in the market. They relied almost exclusively on the advantages of diversification across uncorrelated firm activities, and relied too heavily on a limited set of quantitative techniques to measure and react to unexpected market conditions. In a nut shell, portfolio theory dominated the investment landscape.
The problem: Firms maximized along a truncated view of possible investment paths and assumed that recent volatilities and observed correlations were the best indicator of future volatility and correlations. Low-observed recent portfolio volatilities, due in large part to low-observed correlations, led to the belief among regulators and market participants that the risks observed years ago were the risks of the past and that risk was now “understood.” As a result, market participants increased risks through leverage. They assumed riskier positions and reduced reserves for shocks.
Optimization = the future
We are proposing a new framework for looking at risk and the optimization of invested capital. Obviously, risk management is not risk minimization; risk management is optimization.
Risk management requires a thorough:
- Understanding of the rewards for the necessary capital needed to sustain each business activity.
- Grasp of how capital should be shared among competing activities.
- Knowledge of how to reserve for and include the costs of adjusting to shocks and computing the rewards.
Optimization allocates scarce capital among competing alternatives while taking into account not only the rewards when everything goes well, but also the adjustment costs to alter the risks at times of shock. For most organizations, the level of risk selected is a management decision. For example, a lowly leveraged firm will usually experience lower returns on equity than a more highly leveraged firm. The lowly leveraged firm, however, might experience much lower adjustment costs at times of shock.
While selecting the risk level can be a business decision, combining assets should be an optimization decision. Optimization requires an analytic framework that aggregates and incorporates financial metrics to provide decision tools and monitors for traders and managers. And, scenario analysis helps decision makers visualize and understand the impact of the risk decision and how shocks might compound losses if a scenario is realized.
The risk management framework must include:
- Determinants of the level of capital allocated to a strategy to compute return on capital.
- Consideration of the return on capital, including reserves needed to handle shocks and costs of reducing the firm’s risks.
- Optimization of the portfolio given the inputs and changes in market conditions that affect values of all assets, including lowly traded assets.
- Determination of levels of risk through scenario analysis and other measures of the firm’s staying power.
- Feedback and monitoring mechanisms to measure and determine the components of performance to learn from experience and make adjustments in model assumptions and calibrations.
- Operational controls, including compensation programs that don’t encourage and reward risk taking without commensurate performance.
- Transparency and reporting mechanisms to encourage decisions that are economic and understood by investors – new accounting systems.
- Capital structure risks such as the duration of debt obligations and the options embedded in financing alternatives.
There has been much conversation in the past two years concerning the consumption of human capital, time, and potential loss of financial capital in response to market shocks, including the subprime, Dubai and Greece crises. By implementing a more inclusive and robust framework that incorporates the various risk dimensions – capital, market and liquidity – the firm can react to various market shocks with more precision, take better advantage of the shocks and look for better arbitrage opportunities. Due to the stepwise and nonconcurrent nature of most firms’ risk exposure calculation processes – in conjunction with the decision process of whether to stay, exit or increase asset positions in the market – millions of dollars are lost in both the operational support process and the capital exposure process.
Shifting to a concurrent, proactive process that integrates the latest market information, portfolio updates, capital returns and a market view of liquidity on a scenario basis provides a more structured decision capability. This capability will allow firms to more consistently evaluate product structure and expected return against inflections in the market. Beyond the benefit of a closer alignment to risk and capital management policy, and a level of consistency expected by regulators, it also gives the firm an analytical framework that will provide a consistent process for making decisions.