In the quest for enterprise risk management, several banks have recently undertaken radical reorganisation efforts to integrate different risk teams into a more collaborative whole. However, any permutation of reporting lines and designation of roles can prove to be an expensive – and ultimately, desultory – exercise in the absence of a sound and communicable risk culture. Mitigating this situation requires a top-down approach to setting the risk appetite of the business, which can be mediated by risk factors collected through a bottom-up approach.

Key Findings

• Setting the Appetite – Banks generally follow a top-down approach that is mediated by the bottom-up perspective. Limits are initially prescribed by business heads in collaboration with senior risk officials, which are then assessed for their potential impact on the balance sheet before being presented to the board of directors.

• Methodology – As expected, stress testing and VaR are the primary methods through which limits are determined, with the confidence level generally set at 99%. The focus is on target debt ratings, future earnings and, most importantly, the capital ratio. As market risk is easily quantifiable, qualitative judgements are rare.

• Role of Stress Testing – Serving as the central measure for risk appetite, stress testing is typically conducted over an average of 10 days but varies by asset class. All risk variables, from volatilities to sensitivities, are stressed.

• Cascading the Appetite Downwards – Allocation of limits across desks are based on interdependencies. Uniquely, one bank has no specific market risk limits as it is moving towards enterprise risk management.

• Role of Past Performance – Past performance is mainly considered in terms of unutilised limits and earnings. While there are no capital penalty charges, limits are reassessed every year and may be lower if they had previously remained unused. Similarly, measures akin to the Sharpe Ratio are not key determinants, but past earnings do guide future projections for stress tests.

Conclusion

Transparency of the risk appetite setting process and seamless communication to lower levels of the organisation will be key criteria on which performance will be monitored by regulators. At the participating banks, even though the top-down perspective has gained ascendancy, the bottom-up perspective also holds considerable weight. Involvement from the C-suite is expected, but decisions are made in consultation with individual business heads and the Finance department for assessing the impact on the balance sheet. Increasingly, it is apparent that the importance of stressed quantitative measures is being appreciated throughout the organisation.

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Since the financial crisis, several banks have reorganised the Risk Management department so that it can effectively serve as a second line of defence against the excesses of business lines. Part of this goal is to ensure that information on key risk metrics is available to all stakeholders at all times so that damage from a potential tail event can be punctually forestalled. For effective management of such risks, dashboards have recently gained significant traction in the industry.

Key Findings

• Prevalence of Operational Risk Dashboards – 83% of banks in the survey acknowledged the existence of a Market Risk dashboard, with a figure of 100% for Credit Risk.

• Format – Although risk dashboards are prevalent, more than 70% of banks have introduced them in the form of written reports or spreadsheets for each risk category. A significant and rising number of banks, however, have developed interactive tools.

• Duration of Use – Banks that are using interactive tools for Market Risk have been doing so for at least three years in most cases. This differs markedly for interactive Credit Risk dashboards, nearly all of which have been introduced within the last one to three years.

• Frequency of Reporting – Market Risk metrics are monitored and reported weekly, daily or in real time. In contrast, owing to the lengthier holding periods for trades, Credit Risk measures are commonly monitored only monthly or, at best, daily. Real time access is only available when interactive tools are used.

• Drilling Down – At a significant number of banks, Credit Risk and Market Risk dashboards allow risk managers to drill down into any level of detail. At the same time, all remaining respondents from Credit Risk noted that this was not the case, although the level of detail provided at the outset was deemed to be sufficient.

Conclusion

A large majority of banks still rely on written reports and spreadsheets for management level dashboards in the Market Risk and Credit Risk space. While a notable, burgeoning proportion is also using interactive tools, it is dominated by smaller institutions, most of which have built these tools in-house. As progress in this area continues to be made, evident through the immense interest generated by this survey, it is expected that banks will soon converge upon best practice standards.

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Although the regulatory climate over monitoring frequency of market risk has been marked by relative ambiguity in recent years, the evolution, complexity and effervescence of financial markets renders intraday reports a sensible approach. However, several issues may yet inhibit its feasibility. The computational intensity involved can make it a prohibitively laborious undertaking. Further, intraday seasonality may require de-seasonalized models. Another complication is introduced by the necessity to ensure that observations are equidistant.

Key findings

• Demand for Intraday VaR – In an earlier study conducted over ten banks, enthusiasm for intraday VaR was miniscule. This report again confirms the aversion to intraday VaR.

• Instrument Coverage – Intraday Monitoring tends to be confined to very high activity desks, although coverage tends to be limited to a few asset classes. These include FX and Fixed Income.

• Monitoring Responsibilities – There is an emerging preference for monitoring to be performed within Risk, although responsibilities tend to be shared with the Front Office in some form at the moment.

• Technology – Systems for intraday monitoring are invariably integrated with the daily process. Banks are reluctant to commit large sums.

• Reporting Frequency and Time Management – Reporting occurs between two and four times a day. Complications posed by the lack of synchronicity are also combated through certain governance procedures

• Methodology – As traditional VaR models are deemed infeasible, banks tend to monitor notional values or sensitivities based measures.

Conclusion

While intraday VaR is quite understandably constrained by a plethora of technological limitations, even less sophisticated measures have apparently drawn negligible interest. This disappointing result owes largely to a lack of data synchronicity at nearly all levels. Barring these, some improvements in modelling sophistication may gain more currency with increases in technical prowess. At the moment however, practical experience at one bank has cast any potential benefits of this approach under a thoroughly despondent view. With future upgrades in IT infrastructure, these alternatives to full revaluation VaR modelling may gain higher appeal.

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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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