It’s clear that the risk management function needs to evolve beyond using a limited set of tools for measuring and reporting exposures – typically disjointed from the optimal allocation of capital. Risk management should provide an integrated view wherein risk and return measurements are two sides of the same coin. Both sides are crucial in the optimal allocation of capital to competing alternatives within the firm.
This is the fifth article in a series of articles where we discuss the need to evolve the risk management framework. In our previous articles, we looked at various reasons firms failed to react effectively to the recent shocks. We also analyzed traditional methods firms use to manage risk. In article number four, “Risk management: Shifting from a portfolio-theory view to an optimization view of risk management,” we began laying out the bones of a new risk management framework built on analytics rather than discrete, quantitative exercises. This new framework would provide a broader, integrated view of risk.
Although value at risk (VaR) is dynamic and provides measures of risk, it does so over very short horizons wherein structures don’t evolve or change. A more global methodology would encompass a broader view of risk, return and market volatility, and anticipate liquidity available in the market. Combining these functions into a common set of decision capabilities would shift the risk paradigm beyond the narrow use of quantitative exposure monitoring into a more conclusive, proactive analytics framework.
Benefits of a broader view
Increased decision capabilities would provide a dynamic method of allocating capital and would link risk with the path of return, anticipating multiple paths or outcomes that include shocks and adjustment costs that change as a function of market outcomes. In particular, liquidity prices will vary depending on market outcomes. Under current risk management frameworks, the price of liquidity is assumed to be a constant. Obviously, if it is first order, and is first order at times of shock when asset positions need to be reduced because the risk cushion is insufficient, risk models dramatically underestimate risk and lead to incorrect capital allocation decisions. As a result, given biased-high estimates of return and biased-low estimates of risks, firms allocate too much capital to illiquid positions and, even more so, where position values and risks are hard to measure. And, if many firms make the same mistake, the financial system is unable to handle the simultaneous need to liquidate their clients’ risks – and the risks of the financial firms themselves – without suffering catastrophic losses.
Our focus is to advocate a broader view of risk that includes the optimization of return, management of capital and impact of the market on price and liquidity to create a robust framework for risk management. Firmwide risk management is translated into firmwide optimization.
Building on this framework, banks and other financial services firms can apply or test a range of strategies to ascertain the level of risk that best suits the long-term interests of the firm. Additionally, this is a dynamic process to be applied on-demand as market conditions change, or as capital allocation strategies are refined with the addition of new information. The significant change in thinking is a better unification of the components needed to achieve returns while simultaneously incorporating risk components.
In our next segment, we’ll dig deeper into the subject of capital optimization by asking whether a firm should rely on capital diversity or capital optimization to protect against catastrophic losses during shock. We’ll lay out each strategy and then discuss the pros and cons. The article also discusses the need for a programmatic approach to handle portfolio rebalancing on a daily basis.
If you’ve missed past articles in this series, go back and read: