Aside from the Internet, few issues in the financial services industry have commanded as much attention in recent times as that of enterprisewide risk management. Fewer still are as significant to a financial institution's profit motive.

While the infamous collapse of Barings and several other trading- related losses of scandalous proportion sent shock waves around the financial services industry, the events did little more than scare most money center bank CEOs into eyeballing current operational risk management controls in an attempt to ensure that their respective institutions didn't turn up on the evening news. Only a handful of risk pioneers-CIBC, Bankers Trust, J.P. Morgan, Commerzbank and DG Bank-have been focusing on the implications, from a strategic risk management (SRM) point of view, of integrating market and credit risk.

Savvy financial industry players recognize that risk management is a continuum; what's sometimes lost in the evolution of risk initiatives is the real impetus for firmwide risk management: the ability to calculate risk-adjusted return on capital (RAROC).

In the past few years, firms have been moving from a tactical to a strategic approach to risk management. "The strategic (view) is in my mind a more board-level type thing. It's trying to decide how (one) wants to position the bank with regard to risk management. What are our goals? What is an acceptable level of risk? And what do we need to know about our exposures to better manage the bank or institution as a whole?" says Debbie Williams, founder and a principal of Needham, MA-based Meridien Research.

banking the way it will be

In many ways, the lack of proactive, "big-picture" risk management among bankers is no surprise. Historically, it's been very difficult for the banking industry to match investment in technology in any way to increased profitability, according to Williams. "That's just as true for risk management technology as for any other technology," she says. "If it's unclear exactly how to match the investment to the bottom line-what the relationship is (between technology investment and profitability)-why are people going to do this?"

In the old banking paradigm, risk management really focused strictly on credit risk, which prompted many bankers to live by the 3-6-3 rule: lend money at six percent, borrow at three percent and be on the golf course by 3 p.m. The advent of asset liability management changed all that, says CIBC's Bob Mark, executive vice president of corporate treasury and market risk management. "There was now a recognition of the fact that a bank's net interest income was very subject to the switching of highly volatile interest rates," he says.

Times have changed. As money center banks began to move into trading product, the industry began to consider creating groups-largely composed of ex-trader and quant types-to focus on market risk management. With the rise of derivatives, players began to scrutinize credit-related issues. Now, credit derivatives are blurring the line between market and credit risk. "The world is changing rapidly. Now throw on top of that securitization and liquification of the balance sheet," says Mark, who some industry players refer to as the "godfather of risk" (a recognition he shares with Till Guldimann, executive vice president of Mountain View, CA-based Infinity Financial Technology and formerly of J.P. Morgan fame). "The whole dynamics have changed; we have a very tight integration between the worlds of trading market risk and trading credit."

These same principles that have been applied to trading room risk management are now applicable across the enterprise. The caveat: Bank CEOs must learn to view the enterprise as a portfolio of market and credit risks (see chart). CEOs are concerned about regulatory capital, economic capital and liquidity to fund growth in the balance sheet, says Mark, adding: "Risk management, I would argue, is becoming more and more a part of day-to-day thinking in institutions; it's on the table while business decisions are being made. This affects how a bank manages a book of businesses as a portfolio."

facing down challenges

As such, it's really an expansion of Markowitz's portfolio theory to more and more markets, according to CIBC's Tony Peccia, vice president of the bank's risk advisory group. "It started out that you shouldn't be managing individual stocks; you should be managing a portfolio of stocks," he says. "Today, you should be managing a portfolio of market risk. Now we're saying that you should be managing a portfolio of market and credit risk." The upshot for bankers is that, as technology allows this to be achieved, and as products in the marketplace disaggregate between what's market risk and what's credit risk, the migration to SRM is more a requirement than an option.

Critical to the emergence of SRM is the removal of the delineation of horizontal and vertical risk management. Infinity's Guldimann says that the evolving trend positions CEOs as SRM arbiters who must integrate horizontally across the top and vertically across products; additionally, infrastructure must support the convergence of market and credit risk to enable banks and financial institutions to look at return versus risk and allocate resources accordingly. "Any tool that you can give (financial institutions) that allows them to take a scarce resource-that being capital-and use it to produce more money, the happier they are. It's the same at the CEO and board level as it is at the trader level," says Meridien's Williams.

Despite the obvious benefits of SRM, the organizational, political and operational challenges of implementation are enormous. For starters, bank CEOs need to get their arms around the risk management issue, generally speaking. Williams contends that, in many ways, it really is an infrastructure issue first and foremost: how do you get at the data housed in silos across the enterprise?

Secondly, getting buy-in-and feedback-from trading room managers and loan officers is critical to the successful implementation of SRM.

As CEOs of financial institutions increasingly focus on SRM and RAROC, more focused, better targeted business decisions will follow. SRM is not just about looking at profitability or return; it's about gauging the return for a given level of risk. Peccia says that CIBC wants to sees its risk management evolve to the point where, for example, it can determine the return on risk for a loan manager who makes $1 million but needs a credit limit of $100 million, versus a trader who makes $1 million but needs trading authority of $10 million. "Unless you have an integrated approach that allows you to look at those two situations okay, they're both earning $1 million, but how do you translate the $100 million credit risk with the $10 million trading authority. There has to be a common approach," he says, "so that you are talking about a dollar earned per dollar at risk."

future of srm in banking

Sources say that the most effective implementation of SRM will likely invoke compensation plans tied to RAROC, beginning in the trading room.

In the trading environment alone, sources say major effects can be achieved with SRM. One such result: Different from the traditional limits put on traders, a handful of institutions are actually charging risk back to business units. Rod Beckstrom, CEO of Palo Alto, CA-based C*ATs Software, argues that SRM is a dynamic, interactive process of risk-based pricing, risk-based capital charges, and risk-based limits, all of which drive the firm to greater profitability. "Traders have been doing risk- adjusted pricing for market risk for a long time," he says. "But they haven't been doing it relative to the entire firm."

At first blush, traders are not crazy about being charged for credit and market risk in lieu of abandoning limits. These charges, however, can actually enable traders to achieve higher limits, which, in turn, will allow them to trade more. "You can get rid of limits once you really start pricing risk," says Beckstrom. "After you start pulling the whole bank together to get the diversification benefit of risk they actually like it." Firms like J.P. Morgan are trying to compensate traders not just based on P&L, but also risk-adjusted performance.

At present, some progressive organizations are moving toward the establishment of a risk committee, which sources say makes sense theoretically, but could be problematic fundamentally. "Risk needs to be uniformly defined," says Meridien's Williams. Beckstrom contends that the risk committee that will ultimately emerge in the industry will be composed of the following: senior representatives from IT, capital markets, derivatives, research, credit, and CFO/comptroller.

Adds Peccia: "As banks make incremental changes in RAROC, as various components of risk and similarities between them (emerge), as more and more of the balance sheet of the bank becomes tradable-either directly through loan sales in secondary markets, securitization or credit derivatives-more and more people will start thinking about (SRM) in a common way."

- sraeel tfn.com

Strategic Risk Management: Managing Risk Across the Enterprise as a Portfolio of Market and Credit Risks

CEOs of financial institutions are increasingly focused on risk- adjusted return on capital as it relates to firmwide strategic risk management (SRM). The following three aspects are critical to successful implementation:

Establish common policies. Policies that are used to measure and manage market and credit risk must have a common and consistent approach. A senior risk policy function which integrates policy from a risk perspective, as opposed to a product point of view, is advisable. Currently, no institution has fully achieved this level of SRM.

Near-term reality: incremental steps during a five-year period toward the creation of common policies for market and credit risk.

Create common methodologies. The way a swap is viewed should be no different than the way a loan is viewed and vice versa. What's important is the institution's value at risk (VAR) and the factors that determine VAR. A consistent, unified approach would allow institutions to make the right risk-reward trade-offs. Currently, most institutions do not measure risk on a common basis, so a dollar of credit risk is not equal to a dollar of market risk.

Build the right infrastructure. Banks need to build both people and technology infrastructures to allow risks to be captured and managed in an integrated fashion. People must have the right skills; credit officers must start thinking more like trading risk managers. As loans become more tradable and securitized, loan officers will have to look at risk not only as a one-time decision, but also as a dynamic commodity that can be adjusted to suit the institution's desire and changing conditions. n

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Strategic Risk Management: Managing Risk Across the Enterprise as a Portfolio of Market and Credit Risks CEOs of financial institutions are increasingly focused on risk-adjusted return on capital as it relates to firmwide strategic risk management (SRM). The following three aspects are critical to successful implementation: Establish common policies. Policies that are used to measure and manage market and credit risk must have a common and consistent approach. A senior risk policy function which integrates policy from a risk perspective, as opposed to a product point of view, is advisable. Currently, no institution has fully achieved this level of SRM. Near-term reality: incremental steps during a five-year period toward the creation of common policies for market and credit risk. Create common methodologies. The way a swap is viewed should be no different than the way a loan is viewed and vice versa. What's important is the institution's value at risk (VAR) and the factors that determine VAR. A consistent, unified approach would allow institutions to make the right risk-reward trade-offs. Currently, most institutions do not measure risk on a common basis, so a dollar of credit risk is not equal to a dollar of market risk. Build the right infrastructure. Banks need to build both people and technology infrastructures to allow risks to be captured and managed in an integrated fashion. People must have the right skills; credit officers must start thinking more like trading risk managers. As loans become more tradable and securitized, loan officers will have to look at risk not only as a one-time decision, but also as a dynamic commodity that can be adjusted to suit the institution's desire and changing conditions.

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