Balance Sheet

Risk management: the way forward

Derek Ross,
Article information:
To cite this document:
Derek Ross, (2000) "Risk management: the way forward", Balance Sheet, Vol. 8 Issue: 1, pp.7-10, https://
doi.org/10.1108/09657960010338409
Permanent link to this document:
https://doi.org/10.1108/09657960010338409
Downloaded on: 09 December 2018, At: 04:20 (PT)
References: this document contains references to 0 other documents.
To copy this document: permissions@emeraldinsight.com
The fulltext of this document has been downloaded 1698 times since 2006*
Downloaded by UNIVERSITAS TRISAKTI, User Trisakti At 04:20 09 December 2018 (PT)

Users who downloaded this article also downloaded:

(2000),"Risk management: the need to set standards", Balance Sheet, Vol. 8 Iss 4 pp. 9-10 <a href="https://
doi.org/10.1108/09657960010373400">https://doi.org/10.1108/09657960010373400</a>
(2000),"The challenges of enterprise risk management", Balance Sheet, Vol. 8 Iss 6 pp. 22-25 <a href="https://
doi.org/10.1108/EUM0000000005390">https://doi.org/10.1108/EUM0000000005390</a>

Access to this document was granted through an Emerald subscription provided by emerald-srm:551360 []
For Authors
If you would like to write for this, or any other Emerald publication, then please use our Emerald for Authors service
information about how to choose which publication to write for and submission guidelines are available for all. Please
visit www.emeraldinsight.com/authors for more information.
About Emerald www.emeraldinsight.com
Emerald is a global publisher linking research and practice to the benefit of society. The company manages a portfolio of
more than 290 journals and over 2,350 books and book series volumes, as well as providing an extensive range of online
products and additional customer resources and services.
Emerald is both COUNTER 4 and TRANSFER compliant. The organization is a partner of the Committee on Publication
Ethics (COPE) and also works with Portico and the LOCKSS initiative for digital archive preservation.

*Related content and download information correct at time of download.


Risk management: the way
forward
Deloitte & Touche has just published the results of research involving 70 international
investment banks on how they are introducing extra risk management techniques
after the losses incurred over last year’s financial upheaval. Derek Ross reports
Downloaded by UNIVERSITAS TRISAKTI, User Trisakti At 04:20 09 December 2018 (PT)
ANY LEADING global
M banks are having to
implement additional risk
management techniques
because existing models
failed to prevent losses which occurred as
a result of financial turbulence during the
past year. This is the main finding of
research recently released by chartered
accountants Deloitte & Touche, which
aimed to establish the new directions that
banks are taking, in terms of both risk
measurement methodology and systems
development.
The survey was designed to be a
comprehensive benchmark of risk man-
agement practice and the approaches
currently taken to systems development.
It found that, at present, both
traditional and more advanced
approaches to risk measurement are
widely used: 80% of respondents use
sensitivity analysis and 70% use sce-
nario analysis. Seventy-nine per cent use
some form of value-at-risk (VAR) mod-
elling and 50% of those respondents not
using this approach are planning to do
so. However, in spite of the recognised
strengths of VAR, most banks have
identified that more sophisticated tech-
niques are required to move forward.
As well as the need to survive an
increase in market volatility, this trend
towards greater sophistication in risk
management methodology is the direct
result of several forces:
■ The globalisation of financial mar-
kets has necessitated better control of
return on capital; this in turn has
increased the need for more accurate
measurement of risk.
■ Regulatory developments, particu-
larly the internal model approval
process, enable and encourage banks to
save on both regulatory and economic
capital by exploiting improved risk mea-
surement techniques.
■ The trend is that as risk management
is beginning to mature, so attention is
shifting towards greater fine tuning of
the main risk measurement methodolo-
gies, particularly for infrequent events.
■ Financial products have become
even more complex and have therefore
introduced a whole series of higher-
order risks, necessitating new risk mea-
sures. For example, retail demands have
resulted in major changes in the over-
the-counter equity derivatives market,
and banks increasingly hold significant
exposures to more complex risks such as
correlation, volatility skew and term
structure risks.
One particular area where more
sophisticated risk measurement tech-
niques can be expected is stress testing
of extreme events. It is generally accept-
ed that current risk measurement
techniques tend to underestimate
extreme values in both their size and
Table 1
‘How does your organisation perform stress tests?’
Type of test
Political and economic-based scenarios
Market-based scenarios
Historical shocks
Global stress tests
Micro stress tests
Extreme value theory (EVT)
BANKING
frequency. In reality, there tend to be
more extreme value events than are
forecast by these methods. As a result,
traditional parametric VAR delivers
increasingly unreliable results, as the
confidence level required is raised. This
is because the low frequency of extreme
events drawn from empirical samples
leads to a high standard error for
remote quantile estimates.
One solution is the Extreme Value
Theory (EVT), a portfolio of various
techniques for quantifying more
accurately the likelihood of extreme
events. This provides a solution to deal
with high systemic risk scenarios such as
those experienced during the market
turbulence of last year. Despite the
abilities of EVT, Table 1 shows that it is
currently used by only five per cent of
respondents, but that almost one
quarter plan to introduce it in the
future to improve the quality of stress
testing.
Another way in which banks intend
to increase the sophistication of their
risk measurement techniques is by
increasingly introducing liquidity stress
testing as well as stress testing on credit
Current Planned
40% 45%
70% 55%
65% 58%
30% 50%
44% 29%
5% 24%
VOL 8 NO 1 | BALANCE SHEET |7
 BANKING
spreads. This can be seen from the
responses shown in Table 2.
It is highly likely that half of those
that are planning to introduce liquidity
stresses are doing so because of the
experience and losses incurred during
last autumn’s financial crisis. This
demonstrated the difficulties VAR
techniques have when market liquidity
dries up. Poor liquidity has the potential
to disrupt markets and invalidate the
assumptions behind market and credit
risk models. The Counterparty Risk
Management Policy Group (co-chaired
by Gerald Corrigan) recommends in its
Downloaded by UNIVERSITAS TRISAKTI, User Trisakti At 04:20 09 December 2018 (PT)
June 1999 report: ‘Financial institutions
should deepen and strengthen the
ongoing monitoring of their own risk
and the risk posed by their large
counterparties by utilising an integrated
framework for evaluating the linkages
between leverage, liquidity and market
risk.’
While many banks attempt to
capture liquidity risk, there is no clear
consensus on how this should be
achieved. This difficulty is noted by the
March 1999 report of the Task Force on
Risk Assessment of the Institute of
International Finance (IIF) which states:
‘Few quantitative methodologies exist to
measure liquidity risk and its potential
impact on portfolio value.’
Techniques commonly employed
include extending holding periods used
in VAR calculations (as suggested by the
Corrigan Report), profit and loss provi-
Figure 1
‘Which areas are high priority for your risk
management systems?’
8 | BALANCE SHEET | VOL 8 NO 1
‘Which of the following is true of stress testing in your
organisation?’
How stress tests are used
Daily stress tests
Encompass liquidity stress tests
Encompass stresses to credit spreads
Limits placed on stress results
Stress tests only used to trigger further discussion
Table 2
sioning, and stress testing. However,
none of these provides an entirely satis-
factory solution. Extending the holding
period presents problems because it is
only appropriate for less liquid positions
in a given portfolio. It would be an exag-
geration to do this for all positions.
However, to impose different holding
periods for different products would be
difficult (although not impossible) to
implement from both a methodological
and systems perspective. Profit and loss
provisioning and liquidity stress testing
are subjective and also harder to
accommodate within a VAR limits
framework.
The fact that 50% of respondents
are planning to stress test credit spreads
shows that volatility of credit spreads
has become a more worrying feature of
credit markets. Stress testing credit
spreads is likely to form a key control of
this risk in the future.
As was demonstrated last year,
credit spreads can increase significantly
Current Planned
54% 56%
21% 50%
30% 50%
39% 36%
52% 26%
in a very short period of time. Spreads of
three to four times higher were not
unusual. In such scenarios, if a general
lack of liquidity forces a bank to close
out those positions that can be sold,
these increased spreads can make banks
prone to large unexpected losses. It
therefore becomes clear that under-
standing and modelling correlations
between the different risk categories is
key in developing a strong risk manage-
ment function.
Over one third of respondents take
into account correlation between all
market risk parameters. Only six per
cent extend this to credit risk, although
over one third are planning to do this
despite methodological and systems dif-
ficulties. The IIF Task Force found that
most firms were not using ‘portfolio
level correlation analytics’ when
evaluating credit risk in the time leading
up to the east Asia crisis. The Task
Force attributes this to methodologies
not being in place, unavailability of
data and ‘most importantly few
firms, if any, identified in advance
the degree of positive correlation
between market values and … credit
quality’.
Another key finding is that credit
risk has become the number one priority
in many organisations, especially for
information technology projects (see
Figure 1). Many banks are shifting the
emphasis both in systems and methodol-
ogy development from market risk
towards credit risk management. This
shift is not surprising – credit risk man-
agement is core to the traditional busi-
ness of banking, but it is only recently
that the risk management industry, par-
ticularly the quantitative and informa-
tion technology disciplines, has started
to apply its full expertise to
 BANKING
‘Do you intend to have any development projects in the
following areas?’
Downloaded by UNIVERSITAS TRISAKTI, User Trisakti At 04:20 09 December 2018 (PT)
Figure 2
Integration across financial product categories
Adequate
More than adequate
Inadequate
Table 3
credit risk management. Developments
in methodology, such as those of KMV
and CreditMetrics, have both responded
to and encouraged this shift in emphasis.
Another important reason for this
development has been the surge in
volatility in financial markets over the
past year. This volatility has affected
credit markets dramatically and has
highlighted the inextricable link between
credit and market risk. For example, the
experience of 1998 has shown how a
profitable strategy such as shorting the
rouble can be potentially eliminated if
the short positions are held against
Russian counterparties.
A third reason for the greater
emphasis on credit risk is the continu-
ously greater globalisation of financial
markets. This adds to the narrowing of
risk premiums in many markets: lower
returns demand a better understanding
of risks. This was illustrated by the sud-
den leap in the risk premiums in credit
spreads in the second half of last year.
Despite this dominance of credit risk
as a concern throughout the survey, it is
surprising that the majority of planned
development projects concern market
10 | BALANCE SHEET | VOL 8 NO 1
61%
14%
25%
risk management rather than counter-
party and credit risk management. It can
be seen from Figure 2 that, whereas
market risk is the main area of develop-
ment, counterparty risk, regulatory
reporting and credit derivatives all figure
prominently. This mix of different areas
of development is probably linked to the
desire in most banks for further integra-
tion of the different risk management
systems currently used. The increasing
demands of credit risk management and
the move towards greater sophistication
in risk measurement techniques are
placing pressure on existing risk
management systems.
Integration is key to credit risk man-
agement, as banks measure credit risk by
combining market exposure measures
with default probability and recovery
analysis. The integrity and accessibility
of data continue to be a major
constraint to enterprise-wide risk
management. Furthermore, performance
is also highlighted as a significant con-
cern that will get worse with the integra-
tion of credit risk.
To the question ‘How well-
integrated are your current risk
management systems?’, most respon-
dents indicated system integration at
least up to the departmental or product-
based level. However, only one third of
respondents have enterprise-wide inte-
gration of credit risk systems. Typically
banks allocate limits to counterparties
by region in order to circumvent the lack
of global systems integration across the
institution. However, this can lead to
lines being filled in some regions while
others have low limit utilisation.
Integration of risk management
systems across all product categories is
achieved by 75% of respondents (see
Table 3). However, only 23% currently
integrate across multiple risk categories
– 40% plan to do this within 12 months.
The IIR Task Force recommends greater
integration of risk measurement
systems, particularly when ‘devising
stress and scenario analyses and when
assessing potential correlations’. This
implicitly requires integration of credit
and market risk measurement systems,
because market shocks tend to be
regional or global and affect different
risk categories simultaneously.
Overall, the survey indicates that
although there is a general awareness
among most financial institutions about
the key elements of strong financial risk
management, there is still a fairly wide
discrepancy in the level of implementa-
tion. There are two reasons for this.
First, there is still a lack of well-
developed methodologies for measure-
ment of extreme market events and
related problems such as lack of
liquidity and volatility in credit spreads.
In addition, integration of methodolo-
gies and systems across different risk
groups, mainly market and credit risk,
still requires significant development. ■
For copies of the Financial Risk
Management Survey, contact Sarah
Welch at Deloitte & Touche on +44
(0)171 303 6405.
Derek A Ross is the
partner in charge of the
Global Treasury and
Capital Markets Group at
Deloitte & Touche. He is a
past chairman of the ACT
and the author of 16
books.