One of the most topical concerns for financial services executives today is risk management.
The right combination of people, processes, systems, and technology makes it easier to manage an organization's risk tolerance, especially in relation to derivatives.
The complexity of derivatives requires information systems that track and control transactions and position inventory. Adding technology lets organizations use complex analytics to monitor risk and enhance exposure- reduction techniques.
The technology can definitely be costly, but the investment can offset the potential risk. The size and scope of the systems needed will depend upon the nature, complexity, and scale of an organization's derivatives transactions.
A substantial percentage of large dealers have initiatives under way to automate their entire transaction flows. Many are designing risk controls into their business processes.
Some of the approaches taken link various system and data components. This is often combined with rebuilding components to create the flexible information infrastructure necessary to provide aggregated risk management information.
Still, reliance on manual systems and procedures is not uncommon.
The most important challenge is integrating systems and data across front-office and operational areas and different types of risk.
The key is a management information system that processes, reports, controls, and audits derivative activities and measures and reports risk promptly, precisely, and in an integrated way.
Systems can be used to provide data capture, processing, settlement, and management reporting to ensure efficiency and compliance with management policies. In addition, models and functionality can be purchased or developed to help measure market, credit, settlement, and operational risk.
The following discussion incorporates the recommendations of the Group of 30, the international association of bankers and investment bankers who propose operating standards and guidelines for securities markets. Market Risk
A major benefit of systems technology is reducing the impact of market risk by monitoring the limits set by management as well as the valuation of the portfolio against current market value.
Analytics software can help monitor the variance between the actual and predicted volatility of portfolio value.
Stress simulations can suggest how portfolios would perform.
Revenue reports that quantify the contribution of various risk components and market risk measures can reduce market risks across derivatives to a common denominator, making aggregation, comparison, and risk control easier.
Different systems can be used to develop automated reconciliation procedures to create, review, and approve pricing models and valuation systems used by front-office and operations personnel.
One approach might be to compare the trader's valuations to those generated by independent models that have been protected from ad-hoc programming changes.
In forecasting cash investing, information systems could determine funding needs by evaluating currency over time, as well as assess the impact of credit provisions that produce cash or collateral receipts or payments. Credit Risk
It is vital to measure credit risk on a consistent and integrated basis across the organization.
Technology initiatives should be implemented to capture, link, and aggregate the information needed to manage the risk and perform scenario analyses and stress tests.
This is no small task, especially in the large dealers. Replacing current systems and integrate multiple platforms is likely to be a multiyear project.
The challenge of identifying credit risks with each counterparty and across all products is complicated by the diversity of trading and settlement systems, credit monitoring systems, and formats used to record derivative products.
Adherence to internal controls can be automatically monitored, as can assessment of credit risk before entering into a transaction with a given counterparty and over the life of the transaction.
To determine the likely credit exposure in a crash or some other type of volatile market, it is also a good idea to stress-test client positions. Settlement Risk
Since few derivative transactions are settled on a same-day basis, exposures can be significant when the full value of the security is at risk because delivery of the security is not synchronized with payments.
Automated systems can track these relationships as well as monitor the effects of cross-currency settlement risk.
Systems can monitor the limits set for the amount of settlement risk a firm is prepared to accept for a particular counterparty. Operational Risk
The potential for losses from human error, management failure, inadequate systems and control, or a combination of these can be termed operational risk.
Derivatives often involve extra operational risks because they are new, continually subject to innovation, and often recorded off-line from the firm's main accounting systems.
System functionalities can provide automated support to operational areas including confirmations, documentation, payments, and accounting. The key design ingredient is to use integrated systems, which will reduce the reconciliation of front-office to operational systems.
Checks and balances in the transaction process can be developed to support the flow of information from initiation to settlement and payment, ensuring that each trade has been properly analyzed and accounted for.
Right now, the industry is moving toward single-input systems, which include independent confirmation and verification functions.
For new financial products, systems can ensure that appropriate controls are in place before significant trading starts. This could help an organization ensure the potential rewards for trading the product before significant investments are made in technology or other infrastructure support.
These systems can also help an organization understand a client's financial resources, needs, and expertise before entering into a financial transaction. Success/Failure Factors
In using technology to mitigate risk, the organization must be articulate the purpose for which transactions are undertaken, the degree of risk involved, and how the transactions have been accounted for.
This includes being explicit about management's attitude toward taking risks, position management, accounting policies, and extent of penetration into certain types of instruments. Risks need to be identified, quantified, measured, managed, and controlled.
The entire system must work as an integrated business process, with the appropriate training and participation of all people involved in managing a component of risk.
Training is necessary to understand the complexity and the risks of derivatives. In addition, technology must remain focused on the people and procedures needed to control risk. To be avoided are:
*Inadequate tracking and enforcement of limits.
*Absence of independent trade-recording or deal-confirmation procedures.
*Failure to mark to market, with the assumption that hedges are effective without adequate checks.
It would be easy to identify organizations that have made invested too little in technology and incurred large losses.
However, technology will not solve the entire problem. It can be effective only if applied as part of a focused business and management process.
The need certainly exists to have products and business processes that are well understood and frequently audited. Trained professionals must be responsible for working together on each aspect of risk management, including market, credit, settlement, and operational risk.
Today's organizations need qualified, trained professionals to implement the correct combination of systems and technology into their business processes. Using technology to mitigate risk requires a broad understanding of risk taking, accounting policies, and the proper role of management.
In other words, real success depend on the synchronized integration of people, processes, and technology creation.
Ms. Clarke, a senior manager in New York with Ernst & Young, specializes in the application of information technology in the securities industry.