The Rebirth of Risk Management

Sven Ludwig


August 1, 2012

The discipline of modern, quantitative risk management was born in the early 1980s. Banks began to understand the importance of measuring and pricing their financial risk, and it was the job of the risk manager to develop quantitative methods to do so. In light of the modern option pricing theory, the first generation of quantitative risk managers was employed in a purely mathematical capacity, tasked primarily with pricing risk.

The second generation of risk managers took these quantification concepts beyond mere measurement to a production role, where risk managers reported and, to a degree, controlled the risk. As the complexity and volume of trading increased, it became the role of the risk manager to align the bank's trading positions with its risk appetite through the monitoring of defined trading limits.

The third generation of risk management was based on a new mantra of proactive risk management. Interpretation of quantitative results became more important, and companies demanded a better balance between purely qualitative and purely quantitative approaches. They expected risk managers to actively engage with traders by contributing their expertise on trading from a risk perspective, thereby assuming a strategic role rather than an operational one. Banks recognized that risk appetite is finite and risk managers can play a crucial role in precisely allocating trading budgets through accurate risk management.

In the post-crisis era, the debate has focused on whether the financial sector relies too heavily on quantitative measures to the detriment of qualitative analysis, and critics can argue that the change from the first to the second generation took the quantification too far.

2012 and Beyond

Currently, the financial industry faces different drivers. Regulation has changed everything. The constraint on capital means that risk management is no longer about balancing risk appetite and risk actually taken; such is the shortage of available capital that internal fighting for funds is focused on risk-weighted assets. "Cost of carry," or the cost of holding a financial position, whether long or short, including all funding and regulatory costs, is becoming the driver of the financial institution's portfolio and business model. For most, this will be the decisive factor in achieving profit. This creates an important opportunity for risk management to cement a place within the highest echelons of an organization.

However, as risk managers ascend to a more senior and strategic status within their respective institutions, they face considerable challenges. This includes, of course, navigating the minefield of internal politics. But the chief hindrance is external: the massive increase in regulatory requirements (especially profitability calculations). This epitomizes the new complexity, for it is arguably the most complicated risk measure to be introduced to the financial risk management world

A Higher Profile for Risk Management

The increase in risk-based regulatory requirements is a double-edged sword for risk managers. On the one hand, it has elevated the role to an unprecedented importance. However, it has also greatly increased the risk manager's workload. The dilemma is how to manage the daily tasks, yet also find time to steer the strategy of the bank and contribute to its profitability.

The answer to this dilemma lies in a more efficient and holistic IT infrastructure. Historically, banks have struggled to calculate the impact of a single trade, let alone the combined effect of all of their trades. But the ability to make such connected calculations will help permanently manage and optimize the bank's capital allocation and therefore increase its profitability.

Only the risk manager can ensure this. Traders may optimize their portfolios based on market movements, but risk managers are monitoring and orchestrating limit checks, quantifying liquidity and funding ratios, and calculating the challenging profitability formulas, such as credit valuation adjustments and funding cost adjustments, as well as debt valuation adjustment and funding cost benefits.

By virtue of this regulatory responsibility, risk managers have the chance to claim the strategic initiative. Together with the chief financial officer's organization, they have all of the required expertise and access to the bank's important data. It will become the risk managers' task to determine the fair value (according to IFRS 39) of many positions. With the right tools, they will be able to uncover crucial correlations that could determine the best strategic mix.

But in order to avoid overburdening risk managers with regulatory reporting requirements, banks and other financial institutions must rethink the way risk managers are used and positioned within the institution.

Today's risk managers must help ensure the organization remains profitable and competitive. To do so, the CFO and the chief risk officer must collaborate at the board level, working together to make strategic decisions.

The rebirth of risk management means the rebirth of the chain of command. It is time for a new corporate tree.
Dr. Sven Ludwig is regional manager for Germany, Austria and Switzerland in SunGard's Adaptiv business unit.