Seldom do financial institutions find a path of unexpected economy and functionality-especially in the enterprise landscape where legacy- system integration inevitably creates costly, time-consuming complications. In fact, while many financial institutions are still struggling to implement enterprise market risk systems to meet value at risk (VAR) compliance, and reluctantly anticipating the further investments to be required by enterprise credit risk systems, they could be implementing both systems for the price of one.
No, this is not a holiday software markdown, but simply the nature of the newest credit risk systems. They are developed to handle the integrated market and credit risk analysis required by counterparty credit- risk and credit-limit management in complex derivatives portfolios. They easily manage the credit- risk analysis associated with lending and other credit-related activities.
The market risk measurements provided by these credit risk systems can be more accurate and granular than measurements from market risk systems developed to generate VAR information for regulatory compliance. The reason is that an advanced credit risk system must track every trade or position with every counterparty in order to manage intraday limits through full-blown Monte Carlo simulations, as well as to provide department or enterprise reporting. Many market risk-only solutions, relying only on parametric analysis, operate on aggregated data in which transaction-level details are lost.
The fact that few institutions have implemented advanced credit risk systems first is probably because the regulatory and market pressures have initially focused on market risk analysis. However, several factors are conspiring to make advanced credit risk analysis a better choice for new enterprise risk management systems.
More important, these credit risk systems offer extremely rapid payback because they enable control of a key overhead factor-risk-based capital allocations. By extending integrated market and credit risk analysis to the level of the trade, counterparty, book, portfolio or enterprise, these systems introduce the opportunity to manage people, pricing, policies and customers by the risk created or mitigated. Aggressive users of these systems have seen dramatic reductions of required capital and thus increased profitability.
Another element contributing to a first choice of a modern credit risk system, rather than simple market risk, is that credit risk accounts for more than 70 percent of losses in financial services. Losses related to market risk are a fraction of the remainder.
Finally, there is the inevitable progression of information management in financial institutions toward enterprisewide data integration and the associated ability to drill-down to each source of risk-whether the customer, the transaction, the interest-rate volatility or the intraday status of an individual credit limit. Managers who first chose a foundation architected for parametric market risk systems may find that this infrastructure will not serve for their credit risk solutions as well. Far- sighted institutions will opt for systems supporting rapid, real-time, detail-level analysis across multiple legacy systems.
Admittedly, advanced credit risk systems are initially more expensive than parametric market risk systems, but the advantages are clear. A single system supporting integrated market and credit risk management offers one implementation project instead of two, invaluable information on risk-adjusted profitability and a platform that complies with other enterprise applications requiring transaction-level data integration from legacy systems.
The early choice of an advanced enterprise credit risk system eliminates wasted effort and expense in the future. It also offers dramatic potential to enhance profitability today.