It may have taken a financial crisis to get us here, but the risk management function is finally looked to as a true strategic player. The crisis really changed the context of risk management – both from a business perspective and in the way risk managers view the portfolio.
This new risk culture has impacted the way we do business. For instance, in the past, business line units would onboard assets with little understanding of the risk implications of their choices. We saw this in lending organizations – their intense pressure to grow volume started a rapid influx of alternative and sub-prime credit.
There’s been a dramatic shift away from that disjointed approach. Now, we see business unit heads looking to grow business – but they’re looking more closely at risk profiles, risk tolerances and limits. And they have a better appreciation for risk-adjusted returns.
Effect of portfolio management choices
In the past, the front office would typically evaluate an investment on its merits alone. But with the tools and techniques we have today to run sensitivity analyses and stress simulations very quickly, brokers, traders, loan officers and originators can assess the potential risk-return profile of an asset. And they look at that within the context of the entire portfolio.
Simulation is another good way of comparing two different investments that may have similar rate-term structures and that on the surface may look fairly comparable in projected returns. By applying sensitivity and/or stress simulation techniques, investment officers can quickly gauge which conditions may cause one asset to perform better than the other.
Getting a future perspective
No risk manager has perfect insight into the future. But understanding the possible performance outcomes under different scenarios can help with:
- Selecting appropriate assets.
- Paying the right price.
- Devising hedging or other loss mitigation strategies.
You can also look at this in the context of limits: Trading or acquisition limits of particular exposures can be managed at an individual, geographic or portfolio level, for example. These limits can be monitored dynamically, and as markets or exposures change, individual trades or investment decisions may be altered to lessen the exposure in a particular area throughout the rest of the day. Having the information about each asset’s effect will give you a more complete perspective.
Mistakes to avoid
When the economy is strong and losses are low, risk managers may not be as diligent about risk management. They can become comfortable with their existing modeling and tend to rely too heavily on historical data and performance. In those situations, the approval process for updating models in production can seem bureaucratic and time consuming. With markets moving and changing faster than ever before, it is even more important to be diligent in updating and calibrating performance models.
This is an area where the high-performance, in-memory analytics platform can be very beneficial. Model calibration and testing can be performed quickly, shortening the time it takes to update models in production.
While many of the issues related to developing and calibrating models more quickly and efficiently can be solved by investments in technology, it is also critically important for risk managers to expedite their policies and procedures for operationalizing updated models. At the same time, risk managers and executives must continue to apply the crucial human judgment that’s needed to assess the appropriateness of the models and their assumptions.
Competitive advantage will be gained by those firms that invest in technology and streamline critical processes, including:
- Investing in advanced analytics.
- Adopting new technologies.
- Continually calibrating and challenging their models.
- Applying human judgment to the results.
Regulators also need to invest in technology. They have to be able to look at institutions independently but also in aggregate – how they behave, how they interact, what the performance correlations are. There are issues like geopolitical and contagion risk in today’s globalized economy that we didn’t have 20 years ago. So regulators need to be a bit savvier. They need to invest in tools and technology to help them look at how to manage risk from a systemic perspective rather than just an individual bank level.
Taking a look at the technology
You must continually invest in technology – and not just because of transparency requirements for regulatory compliance. There are tremendous cost and efficiency gains that can be made with these newer technologies. The technologies can help with internal cost containment through automation. They can help tremendously with integration and aggregation. They also provide repeatability. Lastly, these technologies will help you make better informed decisions about investments and risk management. Everyone is trying to extract more out of thinner and thinner margins. Investing in technology and understanding it in terms of ROI can provide much higher value today than it ever has.
NOTE: This article is a adaptation of a full-length interview by the Argyle Journal, “Improving the Portfolio with The Power to Know.” Read the entire interview for more insights from Tom Kimner.