Portfolio Risk Challenges
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Portfolio Risk Challenges

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Portfolio Risk Challenges Portfolio Risk Challenges Document Transcript

  •  The  raft  of  post-­‐crash  capital  adequacy  regulations  and  demands  for  increased  transparency  mean  that  banks,  pension  funds  and  trading  desks  -­‐  some  in-­‐house  at  large  treasuries  -­‐  are  having  to  carry  out  extensive  de-­‐risking  exercises.  The  increased  reporting  requirements  should  theoretically  make  it  easier  for  treasurers  to  assess  bank  and  counterparty  exposure  risk,  pension  exposures  and  other  risks,  but  is  this  happening  in  reality?  A  risk  management  protocol  is  essential  to  be  able  to  tell  and  to  ensure  best  practice.  With  the  majority  of  financial  institutions  and  regulated  pension  funds  undertaking  extensive  de-­‐risking  of  their  respective  trading  portfolios,  it  is  imperative  that  robust  risk  frameworks  are  in  place  to  ensure  that  all  aspects  of  the  portfolio  are  managed  in  a  transparent  and  efficient  way,  particularly  in  terms  of  asset  diversification.  Financial  institutions  balance  sheets  are  currently  undergoing  major  asset  reductions  in  order  to  achieve  their  regulatory  capital  requirements,  without  compromising  their  core  business  revenue  targets.  Given  these  regulatory  demands,  it  is  now  more  crucial  than  ever  to  ensure  that  adequate  investment  in  process,  controls  and  systems  is  maintained  in  order  to  achieve  the  accuracy,  timely  risk,  position  reporting  and  benchmarking  for  both  management  and  regulatory  disclosure.  Trading  desks  are  being  assessed  not  only  on  the  revenue  that  they  produce  but  also  on  the  capital  utilisation  being  used  to  achieve  this  income.  This  requires  risk  managers  within  their  respective  organisations  to  work  closely  with  the  business  across  all  risk  functions  and  asset  classes.  They  need  to  analyse  the  specific  concentrations  and  diversifications  in  order  to  determine  the  most  appropriate  de-­‐risking  and  hedging  strategies  to  be  implemented.  This  can  only  be  effectively  achieved  with  the  existence  of  a  comprehensive  risk  framework  that  empowers  policies  to  incorporate  updated  regulatory  requirements  and  the  risk  appetite  of  the  institution.  Risk  Framework  Objectives  The  overall  objective  of  any  risk  framework  is  to  ensure  that  all  regulatory  requirements  are  maintained,  without  impinging  on  the  commercial  needs  of  the  business.  At  the  same  time,  it  needs  to  be  scaled  appropriately  against  the  risk  appetite  of  the  organisations  board  of  directors.  With  this  in  mind  it  is  important  to  ensure  that  a  best-­‐in-­‐class  risk  framework  is  used  and  to  be  confident  that  this  framework  has  the  ability  to  produce  transparency  and  accurate  reporting  of  the  risk  portfolio.  That  way  an  analysis  of  de-­‐risking  strategies  can  be  accurately  carried  out  for  management  consumption.   1  
  • An  organisations  risk  framework  has  to  be  reviewed  periodically  across  both  policies  and  procedures  in  order  to  ensure  that  all  aspects  of  the  business  are  clear  on  the  ownership  of  risk,  along  with  the  governance  structure  and  standards  of  measuring,  monitoring  and  reporting  on  an  accurate  and  timely  basis.  The  delivery  of  an  appropriate  risk  framework  essentially  enables  an  organisation  to  meet  its  regulatory  requirements  while  facilitating  the  business  needs  of  its  trading  desks,  in-­‐line  with  the  risk-­‐reward  appetite  in  order  to  achieve  defined  revenue  targets.  The  risk  strategies  and  the  risk-­‐bearing  capacity  of  an  organisation  for  the  individual  business  divisions  needs  to  be  consistent  and  continually  developed  as  part  of  an  interactive  process.  The  regulatory  environment  has  matured  considerably  in  recent  years  in  this  regard,  with  organisations  now  required  to  articulate  and  report  on  their  risk-­‐bearing  capacity,  risk  strategy  and  risk  appetite  as  part  of  the  Basel  II  requirement  of  the  Internal  Capital  Adequacy  Assessment  Process  (ICAAP).  Basel  III  is  on  the  way  as  well.  The  Core  Principles  of  Risk  Management  The  management  of  risk  can  be  defined  through  the  following  core  principles:   • Ownership.   • Integration.   • Alignment.   • Transparency.   • Engagement  and  approval  authority.  Incorporating  these  principles  into  a  robust  risk  framework  enables  an  organisation  to  de-­‐risk  and  manage  its  capital  requirements  across  all  asset  classes  effectively  and  efficiently.  Within  the  risk  framework,  it  is  the  responsibility  of  each  trading  desk,  fund  manager  or  business  area,  which  may  include  some  treasurers  at  advanced  multinationals  that  look  to  profit  from  their  hedging  activities,  to  manage  their  risk  exposures.  Both  the  hedging/de-­‐risking  strategies  and  positions  that  they  implement  are  a  fundamental  component  of  ownership  and  responsibility,  providing  the  framework  on  which  a  trading  portfolio  can  be  hedged  or  positions  closed  for  de-­‐risking,  on  either  a  micro  or  a  more  high-­‐level  management  of  exposures  across  a  business  line.  Ultimately,  the  responsibility  for  implementing  any  de-­‐risking  strategy  lies  with  the  individual  business  line  manager  or  fund  manager  on  a  daily  basis,  and  with  central  management  or  the  board  at  the  very  top  level.  The  Fundamentals  of  the  Review  Process  As  part  of  their  primary  function,  risk  managers  should  undertake  a  review  of  the  de-­‐risking  strategies  that  are  being  undertaken,  at  either  a  macro  level  or  business  line,  or  on  a  daily  basis  within  the  trading  group  in  order  to  determine  both  concentration   2  
  • and  diversification  effects.  When  performing  such  reviews  of  de-­‐risking  strategies,  a  number  of  considerations  need  to  be  taken  into  consideration;  such  as  the  choice  of  instrument,  the  size  of  the  hedging  position,  market  liquidity  and  concentration,  and  the  degree  of  basis  risk  between  the  underlying  and  hedging  instrument,  along  with  timing  factors  for  implementation  of  the  de-­‐risking  strategy.  This  is  even  more  relevant  to  fund  managers  where  concentration  risk  in  industry  sectors,  countries  and  counterparties  can  make  de-­‐risking  difficult  to  achieve  in  a  short  period  due  to  market  conditions  and  liquidity.  Where  de-­‐risking  is  being  performed,  risk  managers  also  need  to  weigh  up  the  individual  capital  impacts  on  credit,  market,  liquidity  and  operational  charges,  along  with  the  diversification  and  concentration  effects  across  the  portfolio  in  respect  of  the  asset  classes.  Where  concentration  risks  arise,  either  as  holding  positions  with  similar  characteristics  to  a  significant  size,  or  an  adverse  development  of  a  limited  number  of  risk  factors,  this  could  lead  to  both  a  significant  loss  and  major  capital  requirement  under  current  regulatory  rules.  Defining  Risk  Appetite  and  Strategy  Given  these  potentially  dangerous  and  unwanted  outcomes,  it  is  important  that  the  appropriate  governance  and  supervision  that  the  risk  framework  provides  is  matched  to  the  overall  risk  appetite  and  strategy  set  by  senior  management.  By  establishing  limits  and  monitoring,  an  organisation  is  guaranteed  the  key  control  and  transparency  needed  to  manage  both  the  portfolio  and  capital  requirements  effectively.  The  use  of  key  metrics,  such  as  economic  capital,  value-­‐at-­‐risk  (VaR),  stress  testing,  sensitivity  and  position  limits,  credit  and  default  limits  and  concentration  risk,  combined  with  robust,  accurate  and  timely  reporting,  effectively  allows  an  organisation  to  de-­‐risk  appropriately.  On  the  reporting  of  de-­‐risking  strategies,  such  as  the  implementation  of  hedge  positions,  it  is  important  that  the  calculations  used  in  determining  the  risk  are  easily  decomposed  at  each  stage  of  the  risk  reporting  process  to  give  transparency  and  validation.  Risk  managers  often  request  macro  hedges  to  be  segregated,  to  enable  more  accurate  monitoring  of  the  de-­‐risking  strategy  as  well  as  standalone  analysis  to  be  undertaken.  Within  a  robust  risk  framework,  reporting  principles  such  as  standardised  reporting  platform,  materiality  and  relevance  of  reports,  production  scalability  and  flexibility  along  with  infrastructure  enhancement  are  required  to  enable  efficient  risk  management  to  undertake  both  de-­‐risking  and  hedging  strategies.  This  has  become  paramount  over  recent  years  with  the  regulatory  requirements  of  both  Basel  II  and  III,  and  the  Capital  Requirement  Directive  (CRD3),  coupled  with  every  organisation  attempting  to  rebalance  their  respective  balance  sheets  by  focusing  on  their  core  businesses.  Dont  forget  either  that  the  final  CRD4  proposals,  associated  with  the  incoming  Basel  III  changes,  are  due  to  be  unveiled  in  Europe  next  year.   3   View slide
  • Senior  management  is  now  more  focused  on  analysing  the  drivers  and  diversification  affect  that  macro  hedges  have  across  the  portfolio,  on  the  basis  of  managing  the  risk  weighted  assets  (RWA)  for  capital  efficiency  effectively.  This  has  created  an  operational  strain  on  risk  infrastructures,  in  order  to  produce  and  maintain  transparent  and  accurate  reporting,  especially  for  regulatory  requirements.  This  puts  further  emphasis  on  the  need  for  an  infrastructure  that  provides  timely,  transparent  and  accurate  reporting  of  the  risk  portfolio,  to  support  de-­‐risking  decisions  in  an  effective  and  efficient  manner  by  senior  management.  The  steep  demands  of  the  CRD3  changes,  such  as  stressed  VaR  and  incremental  risk  charge  (IRC)  on  a  timely  basis  for  regulatory  reporting,  have  impacted  the  vast  majority  of  institutions.  Their  ability  to  leverage  their  current  risk  framework  is  no  longer  feasible  due  to  capacity  constraints  on  the  systems  infrastructure.  In  turn,  this  has  dictated  the  need  for  a  greater  integration  of  risk  reporting  within  the  organisations  hierarchy,  combined  with  the  flexibility  to  undertake  scenario  analysis  to  determine  the  diversification  impact  of  macro  hedging.  Robust  processes  and  systems  are  essential  for  accurate  and  timely  risk  reports,  combined  with  the  ability  for  increased  capacity  of  usage  at  all  levels  of  the  business.  This  requirement  has  necessitated  further  investment  in  the  current  infrastructure,  together  with  ensuring  transparency  of  the  risk  factors  being  used  in  both  VaR  and  economic  capital  calculations,  if  the  de-­‐risking  and  capital  management  strategies  are  to  be  effective.  Overall,  it  is  important  that  institutions  have  a  robust  risk  framework  in  place  to  provide  management  and  the  business  with  the  transparency  needed  to  enable  efficient  de-­‐risking  to  be  performed.  That  being  said,  the  significance  of  a  robust  systems  infrastructure  cannot  be  underestimated,  complete  with  the  appropriate  controls  and  capacity  to  facilitate  these  requirements.  Only  then  can  it  be  managed  efficiently  with  timely  and  accurate  reporting  in  place.     4   View slide