While official reports have now declared the end of the recession, global regulatory action is gaining vigour. Like the great Terror of the French Revolution, no-one and nowhere is safe from investigation. In recent times, one such avenue under increased scrutiny pertains to the off-exchange trading books known as ‘dark pools’ – trades not displayed on order books. Equities markets functioned perfectly during the financial crisis and the finger of blame for the downturn has been pointed very firmly in other directions. However, regulators appear zealously committed to ensuring that such a crisis never occurs again.

Key findings

• Prevalence – Reliable statistics have proven hard to obtain, with wide disparities between quotes figures. In general though, trading under this guise is a much rarer occurrence in Europe than in the United States.
• Source of risk – While several market participants find no concrete rationale behind the intense regulatory focus, the lack of transparency and elusive data on the prevalence of dark pools underlie the source of the alarm.
• Regulatory action – Legislation in the United States and Europe appears to raise concern over the creation of a two-tier market, growing volumes of dark pool trading and the deepening fall of public confidence in financial markets as a consequence of a lack of transparency
• Effectiveness of regulation – Several participants believe that regulations are unnecessary. They are described variously as results of political expediency, misinterpretation of the source of the crisis and inability to recognize the benefits of dark pools.  There are fears that this form of trading may even seize to exist.

Conclusion

With regulation gaining currency, the prospect that the market for dark pool trading may be fundamentally altered is very plausible. However, it is uncertain whether regulation in its current form is adequately equipped to eliminate the perceived risks with this practice.  

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The various models utilised by the financial sector for monitoring risk exposures and valuating products have been heavily criticised by industry commentators over the last 12 months. Much blame has been apportioned to model risk, in particular VaR and its failures being cited as a factor in the demise of the global economy.

Key findings

• Current Practices – None of the banks interviewed for the research had a fundamental definition of model risk management but had a form of management or governance process to oversee model accurancy through validation.
• Benefits of Model usage –  There are many perceived benefits associated with the use of models throughout the financial industry. These advantages have been heightened by continuous technological advances.
• Criticism and drawbacks – There has been much criticism of the various models used by financial institutions of late, with much of this negative attention being focused on misinterpretation and blind reliance on model output.
• Vetting and Validation methods – Models will not be abandoned because of past failures and will continue to play a significant role in the foreseeable future. Therefore, for maximum effectiveness to be derived, there needs to be a process under which new models are vetted extensively and existing models are continuously validated.
• Future Initiatives – In view of the criticism directed at ineffective models, Lepus wanted to find out if banks were responding to this through greater investment in regards to model risk management. The responses suggest that much of the criticism is unjustified and that the players of the financial industry are ultimately confident in the abilities of these models.

Conclusion

Risk management is both a science and an art. Theoretical models will always play a vital role in risk management. However, for models to be effective they must be used carefully and in conjuction with risk managers’ own judgement. This will ensure that each model is used in the right situation and that it remains accurate to changes in the financial climate. Models have shown themselves to be vulnerable when relied upon too highly and effort is not made to fully understand the associated outputs.

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To a certain extent, it can be stated that the weight the opinion of the risk manager carries has increased of late. However, at some banks, traders are still able to execute unauthorised trades in pursuit of higher revenues, resulting in the risk managers’ engagement with the legal department. This is an example of a more extreme scenario, and at each bank there will be a somewhat different culture and/or ethos. Moreover, the relationship with the traders will depend on a number of different factors; one such factor being the proximity between the risk manager and the trader.

Key findings

• Location of Risk Employees – It should be noted that there was a common approach across the interviewed sample. All of the participants indicated that there is somewhat of a combined approach, and risk managers tend to be located both on the trading floor and away from it on other floors in the building.
• Seniority of Employees – All of the banks acknowledged that the level of seniority on the trading floor varies and there are both senior and junior people that are currently located there.
• Consistency – Banks should aim to develop, implement and maximise consistency, taking into account specific regional or jurisdictional anomalies and/or requirements.

Conclusion

The location of the risk managers will vary and depend on a number of different factors. One of the main issues is space and the amount of people already on the trading floor.

All of the banks spoken to have market risk managers situated on and off the trading floor. In addition, there is a combination of senior and junior personnel. On average, the banks are more focused on policing the front office and serving the board and the regulatory body than assisting the front office. This is somewhat expected given the increase in different proposals and directives from the regulators around the world. 

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Failures of large institutions across the globe over the past 2 years, were partly contributed to by the breakdown in communication between the risk manager, senior management and the boardroom. Whilst many financial institutions complied with the ensuing legislation by aligning risk and finance functions, the credit crisis highlighted that a silo’d culture still prevailed, even in such areas where risk and finance shared similar responsibilities. 

Key findings

• Who is driving alignment – Many regulatory bodies have issued legislation over the last decade to promote transparency and accountability, complying with these has aligned the two functions. The Board and CEO’s also realised that they must improve standards to protect their positions and investments.
• Current Relationship between Risk and Finance – There are inherent similarities between risk and financial employees. However currently there seems to be a preference for keeping the two functions separate, concentrating on their individual specialities and only coming together on tasks that regulators are requiring them to do so.
• Benefits –  One of the underlying benefits to a company of risk management that is fully integrated with finance, as well as the rest of the business, is that everybody has a sense of the institution’s risk appetite. Even traders become aware that they too ‘own risk’.
• Alignment of technology systems and IT – While there seems to be some IT and technical overlap at banks, currently this is still minimal. Though banks do admit to seeing benefits from some cost saving measures due to overlap, there does not appear to be any major changes to fuller alignment in the near future.  
• Future Trends – Many financial institutions appear to be opting for a middle ground, which moves the functions closer through greater collaboration on a number of tasks, using common processes and sharing goals, but whilst maintaining their distinctive roles, perspectives and skill sets.

Conclusion

Financial institutions that align risk closest will reap the benefits of developing risk and return oriented views of the business. This perspective will not only allow them greater transparency in day-to-day dealings and control processes, but this will also make financial and risk reporting and compliance a much easier task.

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Emerging markets can be defined as a nation’s economy that is progressing toward becoming advanced, as shown by some liquidity in local debt and equity markets and the existence of some form of market exchange and regulatory body.

Emerging markets generally do not have the level of market efficiency and strict standards in accounting and securities regulation to be level with advanced economies (such as the United States, Europe and Japan), but emerging markets will typically have a physical financial infrastructure including banks, a stock exchange and a unified currency. 

Key findings

• Overview of the market – Key areas of emerging market territories where banks are active include the Middle East, Brazil, Argentina, Africa and particularly in Asia still too. Banks spoken to for this report commented on the importance of a presence in Dubai and also Hong Kong and Singapore.
• Popularity of risk – Due to recent events in the markets, the risk control departments in general were definitely more important than in the past. Finally staff and their influence have greatly increased as a result of the financial turmoil. This was also highlighted earlier this year in much of the mainstream press. 
• Major risk issues – There are several major risk issues that are effecting banks at the moment across the emerging markets. Across the board, banks mentioned liquidity as a key issue. Also of concern was reputational risk, which was considered of paramount importance in emerging market countries. Banks said that they did not expect these issues to change over the coming year.
• Challenges in emerging markets – Emerging market challenges were considered plentiful. In short, they are people, competition and economic climate. Another issue was attempting to prize people away from other banks and also making sure that once they worked for the company that they stayed there. Recruitment and retention was a major issue that all banks discussed as a major challenge in emerging markets.

Conclusion

Emerging markets have been and continue to be, a topical area for risk departments in major financial institutions. Back in 2003, its importance was recognised when 10 international banks adopted the Equator Principles that dealt with the thorny issue of reputational risk in emerging markets.

The coming year in the emerging markets sector looks to be an interesting one but future initiatives will be minimal as the financial industry treads more carefully in the wake of the crisis.

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The sub-prime contagion and the subsequent credit crunch have been essential in driving banks to reconsider their risk management practices and methodologies. What makes this crisis unique, amongst other things, is the unprecedented volatility that we have seen during 2008. More importantly, this volatility was not limited to any particular asset class, but was evident across the board. Various risks were simply not captured, deemed plausible or accounted for. This has resulted in great pressure both internal and from the regulatory entities all over the world. A lot is still uncertain, i.e. the direction which risk will take and exactly what the different regulatory bodies will require and impose upon the banking industry.

Key findings

• Organisation of market risk – There is a somewhat similar approach at the banks spoken to where market risk is a combination of a control function and a business facilitation unit. This is of no surprise given that business and risk go hand in hand. There is need for the business and risk to have frequent dialogue and well established communication channels.
• Strategy – the participating banks were asked to indicate whether or not they have integrated between their market and credit risk functions. Once again, there is no one size fits all as far as the integration of these two areas is concerned. However, it is important to note that all of the banks spoken to see the merits of such an undertaking and there has been some progress, such as closer communication between the two areas.
• VaR – The most recent and ongoing crisis has highlighted that banks should not rely on one any one single risk metric or tool. The role of VaR has certainly changed, and all of the banks spoken to have raised the importance of stress testing and scenario analysis.

Conclusion

The organisation of market risk is paramount, and this is definitely more so the case in these volatile and turbulent markets where there is a need to prove to investors, regulators and senior management that processes and methodologies are robust and comprehensive. Some of the main challenges being faced were highlighted to be data and quality issues, general contractions across the markets, regulatory pressures and liquidity issues. The role of VaR has changed and VaR as a tool has been under immense scrutiny. The banks spoken to supplement their VaR tool with other metrics/tools, mainly stress testing and scenario analysis. At most of the banks spoken to VaR was not the primary tool in the first place, and there may even be less reliance on this tool in the future.

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Much has been said about risk divisions, particularly in the wake of the brutal financial meltdown last year. However, risk divisions are upping their game in changing the methods of how they do business. Though banks may not agree on which areas of market and credit risk should overlap at present, the move to integrate the two is definitely on the cards for the future.

Integration of credit and market risk has been on the cards for a long time. There are many reasons for this that shall be expanded on in this report. However, in light of the financial furore at the end of last year, banks have been forced to reassess the way they manage risk and consequently they have begun to look more seriously at aligning the activities and responsibilities of credit and market risk.

Key findings

• Overview of the market – Current regulation is conceptually based upon the distinction between market and credit risk. However, some risk factors may also influence both market and credit risk.
• Benefits of merging credit and market risk – Banks said that they had noticed a decline in the number of firms that now had separate credit and market risk divisions. The key benefits of amalgamating the two divisions are cross fertilisation, blend of skills, and greater communication between the divisions.
• Systems silo – While the divisions are often merged, banks have stressed that they still have a separate system dedicated to credit risk calculations and another separate one from market risk calculations. Systems innovations are not likely to change imminently in order to keep up with these changes. 

Conclusion

There has been significant progress made in the merging of credit and market risk divisions in financial institutions in recent times. However, there is still work to be done in this area. It is by no means complete. For those firms that have merged the divisions, they still have separate systems and skill sets. As one commentator said, it is all very well wanting to merge the two divisions but there is no distinctive system to support the two methodologies at the moment. From research Lepus conducted, it is clear that such a development is all a long way off.  

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Retail lending differs substantially from wholesale lending, and while sophisticated scoring methods are employed for classifying and/or measuring delinquency and default probabilities for individual retail credits, internal economic capital models are less fully developed for retail. Even though retail lending represents a substantial business line for most universal banks, there are several reasons why portfolio credit risk modeling has received less attention on the retail side.

Key findings

• Retail loan portfolios – A tier-2 European bank believes that most of the industry still views retail portfolios as relatively homogeneous sets of small dollar transactions that might have relatively higher, but largely predictable, expected loss characteristics. However, the growing relative size and increased volatility of retail portfolios are attracting increased attention from bank risk managers and regulators.
• Homogenous pools – While significant progress has been made in understanding the risk of commercial credits, far less research has been undertaken on measuring credit risk in retail portfolios. Research uncovered that some banks use a non-parametric ‘recursive portioning model’ which is highly suitable for grouping together the individual retail claims into homogenous pools, according to the probability of default and it overcomes some of the disadvantages of the more common parametric methods.
• Retail loans classification models – Two European banks cited that in recent years there has been a shift away from discriminant analysis in favour of logistical regression, which has the advantages of imposing fewer formal statistical requirements on the operating figures and producing more robust results.
• Future trends – Two leading European banks inferred that going forward banks will initiate a critical review of existing rating and scoring processes. Both respondents added that if participants are to benefit fully from the demonstrated effects of reducing capital cushioning, it is essential that they choose not only an efficient and selective algorithm, but that they also ensure that data quality is high and meets the demands of Basel II.

Conclusion

This report illustrates some of the main non-parametric and parametric models that are currently used by banks and confirms that the ability to separate sound from potentially defaulting borrowers with greater precision through the formation of homogenous pools reduces regulatory capital requirements.

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Valuing different instruments and products is integral in the financial services industry as it affects multiple parties involved in any given deal or transaction. In the recent past, there has been an increasing awareness and interest in independent third party valuation services. It is with this in mind that this section of the research report focuses on the organisation of, and approach to, valuations, and more importantly the role that risk has in this process at a number of buy-side firms

Key findings

• Current practice – The general trend appears to be one where risk is involved in the valuation process. Eighty percent of the interviewees confirmed that risk is involved at some point in the process. Naturally the extent of involvement and the exact role will vary by institution.
• Strategy – At the second firm, the only firm spoken to where at the moment there is currently no risk involvement as far as the UK is concerned, the possibility of migrating to more of a global approach to reflect the US and other European Offices, where the risk function is more involved, was acknowledged.
• Organisation – The interviewed firms were asked to indicate whether they use consistent or different methodologies for valuations of proprietary positions and valuations of funds where the firm is the investment manager. it is important to note that some of the firms spoken to do not have any proprietary positions.
• However, where the firms are investment managers for the most part and have proprietary positions as well, the general trend appears to be one of prudence, and consistency to a large extent.

Conclusion

The role that the risk team has in the valuations process will vary amongst the numerous players in the industry. However, it is abundantly clear from the testimony supplied by Lepus contacts, that the risk function is involved, at least to a certain extent at majority of the firms. Authorisation to go out of and not adhere to policy, providing oversight and advice, chairing committees, advising, communicating and interacting are just a selection of responsibilities that fall within the remit of the risk team.

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The use of models within the financial industry has become prolific to the degree that their deployment has become responsible for a risk factor in and of itself: that of model risk. Although the benefits financial models can offer are considerable, a model that is ill-fitted to its task, applied improperly, poorly understood by its users or not subject to rigorous checks can potentially cause massive damage to a business.

Key findings

• Why validate ALM models? – Validation of ALM models is vital for a number of reasons. The most obvious of these is regulatory requirement. In the US, the law is laid down in the OCC Bulletin 2000-16: Risk Modelling, Description: Model Validation document, while European countries are subject to the regulations of Basel II and Solvency II.
• Current industry practice – In addition to the guidance provided by the regulators, ALM departments must decide what model validation procedures to follow, both during and after the implementation of an ALM model, and how often these procedures should be followed in the future. In addition, they must decide whether internal or external validation is more appropriate at any given time.
• What should be included in the validation process? – The elements included in a typical validation vary between institutions depending on their size, business lines and other factors: there is no ‘one size fits all’ process that can be used across the board. However, common processes include looking at data integrity, cash flow definitions and back-testing of model predictions versus actual results.
• Quantitative versus qualitative approach – It is important that validation should not be viewed as a purely quantitative exercise, although this approach by necessity provides much of the data necessary for a successful model validation. The Basel II validation subgroup has been at pains to stress that qualitative elements must stand beside the necessary mathematical exercises.

Conclusion

Most participants in this survey feel – and this is backed up by the regulators themselves – that the onus for a thorough and successful validation approach falls directly on the banks and insurance firms, which results in the need for a clear set of rules for best practice approach. While this varies between firms, often relating directly to their size, the need for both internal and external validation seems to be well-recognised.

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