Insight: risk management

Firms have been measuring and managing their risks for a long time, but there have been so many innovations and developments in this field in the past four years that it is tempting to regard risk management these days as a new science.

Two important changes have taken place. Financial firms in general, but banks in particular, have started to be much more systematic in the way in which they allocate economic capital across their operations. To allocate capital they have developed a new class of models for measuring their portfolio risk and the contributions to it of individual exposures. At the same time, new markets have emerged that permit banks to transfer risk through credit derivatives, securitisations or reinsurance contracts.

These developments have been mutually reinforcing, as the models banks use to measure risk enable them to identify which risks it would be better to sell on to other market participants. On the other hand, the need to analyse possible risk transfer transactions, combined with its complexity, has generated lots of work for modellers.

Risk transfers may entail traditional hedging of individual credit exposures, interest rates or other market risks. Or they may involve more sophisticated transactions such as basket credit derivatives, securitisations or reinsurance, in which the risk transferred depends on the joint performance of a group of individual exposures or risks. It is generally when multiple exposures are involved that more sophisticated analysis is required to capture the interdependence of multiple risks.

The initial impetus for the recent developments in risk management has come in banking. Banks have highly levered balance sheets with large gross assets sustained by a relatively small amount of net worth or capital. They are particularly concerned about catastrophic risks, such as default, because any worry about solvency leads to steep increases in borrowing costs that may threaten the bank’s ability to carry on its business. They are, therefore, naturally very concerned with capital adequacy.

Banking regulators have also significantly ramped up the pressure on banks to invest in risk management systems. The Basel II proposals issued by the Basel committee on banking supervision involve allowing banks to categorise their exposures according to their default likelihood.

The banks’ own internal ratings systems are the basis for the assessment of default likelihood. By developing carefully audited internal systems for assigning default probabilities to all their credit exposures, banks have developed a rich source of data that can be used in quantifying risk and bundling up sub-portfolios ready for risk transfer.

Over the last few years, I have worked as a special adviser to the Bank of England, and through this role I have been closely involved in the development of the Basel II proposals. During this period, a wave of risk management innovation has swept through the banking industry.

Originating first in the top US and European banks, it is now filtering out to medium and smaller institutions. And increasingly, there are signs of activity in non-bank financial sectors, such as insurance, and in large non-financial firms, such as the car manufacturers and oil companies.

The changes in firms and in the market have created a role for a new type of risk manager who understands the arcane new language of value-at-risk, expected shortfall, and other technical terms; and can interpret and use the output from portfolio risk models to mitigate the risks faced by their organisations.

Typical questions the risk manager needs to answer within a financial firm are: what level of capital should the firm hold given the risks in its book? How could a securitisation be structured so as to reduce risk to a given extent? How should the pricing of loans, say in a bank, be influenced by the incremental risk that those loans add to the bank’s total risk?

Outside the financial sector, treasury departments face similar issues. Many companies recognise that bearing tradable market risk, such as currency or interest rate risk, is undesirable unless hedging costs are excessive. Similar arguments apply for counter-party risk if the counter-parties involved are well-known ‘names’ for whom credit risk is actively traded in a liquid market.

Increasingly, non-financial firms are exploring whether the technology of risk transfer developed by banks, insurance companies and the like can be brought into play to help manage risks and develop new funding sources. Examples include utility companies, who may find that securitising receivables on their billing may transfer risk, but also unlock new sources of funding in the form of investors willing to buy senior claims on the pool of securitised assets.

Much of the knowledge needed by a risk professional has still not been written down in books or articles and remains an oral tradition among experienced risk management experts. That said, professional qualifications in risk management are now on offer by certifying associations like GARP and PRMIA.

But it is hard or indeed impossible to find in depth instruction except through learning by doing and experience. It’s one reason why we at Tanaka Business School have introduced a specialist MSc in risk management, offered jointly with credit rating agency Standard & Poor’s, to fill the gap.

Developments in risk management are too systematic and widespread to constitute a fad or a temporary enthusiasm. What has occurred is a systematic change in the way in which financial firms manage their risks.

The spin-offs and opportunities the technology of risk management offers large non-financial firms are substantial. But whether they will catch on and generate wider changes outside banking and insurance remains unclear.

At the very least, the banking industry has put down a marker for new approaches to managing risk and non-banks must make up their minds what they can learn from it.

Professor William Perraudin is director of the MSc Finance and risk management programmes at Tanaka Business School at Imperial College London