Risk Management: An Ever Expanding Role

An article by New York Institute of Finance instructor Tracy Williams.

Many wonder.  Some speculate. Few know. Most just hope to be prepared for it.  What will be the next big risk event in financial markets? What will be the colossal event that calls to mind the collapse of Long Term Capital or the mortgage crisis of 2008-09, an event similar to trading hiccups at Knight Capital, JPMorgan or MF Global?  Is there another “flash crash,” hedge-fund implosion or bankruptcy of a Fortune 500 company around the corner?

What is the next burst of an asset bubble? Will there be a sudden, out-of-control plunge caused by a high-frequency trader’s black box? When depositors or lenders flee large “systemically important” banks, will the impact cause havoc on the financial system?

And how will risk management units at financial institutions worldwide be prepared for it? Will they be ready to measure it and manage through it? Will existing hedges or ample balance-sheet capital provide a soft cushion? Will the amounts of capital regulators like to see be sufficient? Will banks survive a real-world “stress test”—not a hypothetical one?

Will they all have learned from lessons in the past?  Are there trends, insights, statistics, data, financial ratios or even an inkling that something amiss is on the horizon? Would it be triggered by a bumbling economy in China, uncertainty in global oil prices, or the technology that guides trading in stock markets?

Are they worried about the interconnectedness of financial markets and the “dark pools” of equity trading? Should they worry about the long-term viability of clients and counterparties with credit ratings that could slip to non-investment grade overnight?

Or should risk managers transform into compliance officers and be more worried about how to comply with vast amounts of regulation?

At financial institutions, in stable times, when profit engines hum and business is brisk, risk-management units remain quietly out of view. They aren't glamor-seeking and aren't permitted to be. You won't see risk-management "stars," as you do among the deal-doers in investment banking, particularly in mergers, venture capital or private equity.  How often do you see risk-management icons on the pages of the Wall Street Journal or in the deal summaries in the New York Times DealBook—except after a bank has incurred big losses?

If they are doing their jobs, senior risk managers in normal times are as busy as ever. They touch all aspects of the institution's business. They are charged with managing risks of all kinds--including those related to exposures, counter-parties, borrowers, portfolios, trading positions, balance sheets, and, nowadays, reputations, operations and non-compliance with regulation.

They are responsible for anticipating unforeseen risks, "tail" or unexpected scenarios, and even catastrophic events. They must unveil plans to manage these scenarios. They must implement programs or procedures to reduce or minimize existing risks (positions, exposures, borrowings, etc.).

When you read about a financial institution involved in a big headline-grabbing transaction or learn about its revenue increases, new clients, and expansion into foreign sites, risk-management units are hardly mentioned. Yet they are intimately involved in reviewing and approving all such business activity and sketching out what could go wrong.

On the other hand, when you hear about sudden losses at or a demise at such institutions as AIG, Lehman Brothers, Washington Mutual, Knight Capital, MF Global, or Bear Stearns, everybody--from pundits to regulators, from equity analysts to editorial-page editors--asks, "Where was the risk-management unit?”

"Why couldn't it have prevented the collapse or loss? Who approved the transaction, trade, client, counter-party, or deal? Why didn't it reduce the portfolio of loans or hedge the trading positions or notice the operations lapses or problems in the documentation?”

They wonder and probe: “Where were the risk-management decision-makers? How and why weren't the risks of these large positions properly managed?”

Often in these upsetting moments, risk management becomes the scapegoat, and the problems, errors or flaws tend to be related to one or more among the following:

 1) Credit and counter-party risks, which include the risks of lending money, doing any kind of business with corporations, trading firms, individuals and government entities, and executing and maintaining securities and derivatives trades with the same group. This includes long- and short-term risks, collateralized and unsecured risks. 

2) Market risks, which include all forms of risks from trading and/or maintaining positions in all securities and derivatives transactions. This includes risks from positions related to market-making, brokerage, specialist, clearing, and proprietary-trading activities. And it includes long- and short-term trades or mere settlement or clearing activity.

3) Operations, systems, and processing risks, which include risks arising from executing trades, doing money transfers, collecting and sending out data, processing and clearing securities, accepting and holding collateral, and systems glitches.

4) Documentation, regulatory and compliance risks, which include all risks tied to legal and regulatory issues and the documentation behind all business activity. More than before, it will include the risks of not complying with regulation or meeting regulators’ requirements for data or explanation.

5) Reputation risks, which was popularly added to lists of responsibilities the past decade (after embarrassments and slip-ups led to ugly Wall Street Journal headlines). It includes reputation issues that arise from doing business with questionable clients or in certain areas around the world or doing business in a questionable way.

6) Country and political risks, which include risks in conducting businesses in certain countries and geographic regions.

7) Collateral risks, which include risks of accepting certain types of collateral in transactions (including securities, cash, and hard assets) and risks that the collateral is under-valued or not transferable in certain cases.

8) Liquidity risk, which includes ensuring the bank has sufficient cash or access to cash to meet all obligations (short-term funding, commitments, etc.) within a defined period (30 days, e.g.). This includes, too, ensuring it has constant access to stable, reliable funding.

Risk-management units juggle all of these responsibilities, try as hard as they can to grasp, scope and quantify these risks, do all they can to project and anticipate worst cases, and are expected to have a plan to manage and reduce them. Miracle workers, some say, who must also have a solution, a game plan, an alternative, or simply a way out.

Right now, across all major financial institutions, the shrewdest teams of risk managers are huddling to decide what might be the next big event and devise a plan to manage through it.

Over the past two decades from Drexel Burnham and Enron to Washington Mutual, we've seen it all, or always thought we saw it all, until the next shocking loss or big bubble burst. But through it all, while fingers pointed directly to risk managers, the role of risk management always emerged as important as ever.


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