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Credit Risk Management Looks to the Future

Asset management firms are working to create an entire culture of risk management that discounts historical trends and tools, embraces even the most outlandish outlying possibilities and includes counterparty risk.

That was the message of speakers at NICSA's recent panel, "Industry Trends in Credit, Liquidity and Market Risk" at its Enterprise Risk Management Seminar in Boston last month.

Risk management systems need to be more comprehensive today because, in fact, "extreme events that seem to happen only once every 100 or 500 years actually occur all of the time," said Benton Brown, editor in chief of "Whether it's five hurricanes in one location, the global financial meltdown or terrorist attacks, extreme events are happening all of the time. So, as we think of risk management, it must not just be about expected losses but extreme events."

That is why having a culture that proactively searches for and reports risk is so critical, Brown said. "Enterprise risk management is a process that supports decision-making in uncertain conditions and tests the strength of your organization as a whole to prove how resilient it is, how risk intelligent it is," Brown said.

Fidelity handles credit, liquidity and market risk by looking at all of the elements that make up the whole, including portfolio, information, technology, notional and collateral risk management, said Brian Conroy, senior vice president and head of global equity trading at Fidelity Management & Research Co.

Across the industry, asset managers' risk outlook is "dramatically different" than it was three years ago directly because of the credit crisis, Conroy said. But five years ago, even before the crisis hit in 2008, Fidelity began "digging down at a detailed level" and improving its risk management processes, he said.

And that has meant imagining the unimaginable. "The most important thing we have focused on in managing our risk across that spectrum is focusing on a process. Are we asking the right questions? Are we taking it to the nth degree? Are we looking at risk potentials where we didn't look last year? That is the key to preparing your organization to make the right choices," Conroy said.

In light of the financial regulatory reform bill, asset managers must continue with their out-of-the-box risk management programs, and not "turn backwards to focus on what the regulators want in the Dodd/Frank bill," warned Lawrence "Hank" Prybylski, a partner and financial services advisory services leader at Ernst & Young.

"Prior to the financial crisis, it was commonplace for business leaders to view the risk management function as a compliance role," Prybylski said. "Risk management must continue to be viewed as an integral part of decision-making throughout an organization."

Giving risk management this clout starts by involving chief risk officers in key, strategic decisions, he said. And invest the capital in scalable, flexible risk management technology, he added.

Credit risk officers at asset management and other industries with significant risk exposures, such as energy, will continue to become prevalent, said James Lam, president, James Lam & Associates. And audit committees will evolve into risk committees, he added.

"When I look at the organizations that survived the credit crisis, there is no correlation between the amount of money spent on independent risk management and survival," Prybylski said. "It's the depth of reporting and having the culture that, at the end of the day, matter."

And just as asset management firms diversify their portfolios, they should diversify their risk management tools, as well, the E&Y partner said. "Use a panoply of risk forecasting management tools and know the limitations of each," he said. "Value at risk (VaR), stress testing and scenario analysis all have important roles, but should always be used in combination."

Lam said that managers and external stakeholders are beginning to reject VaR in favor of a standard unit of risk measurement for all types of risk based on Basel's RAROC (risk-adjusted return on capital) model and that data resources on risk management are becoming available.

Further, Prybylski continued, it is critical for asset management firms to consider the unexpected, even the unbelievable. "All volatility and correlation assumptions should be forward-looking, incorporate severe outcomes and recognize tail correlations," he said. "For many institutions, stress testing leading up to the current crisis was not severe enough, and [due to] the absence of a risk-aware culture, was viewed as a mere regulatory-compliance exercise that bore little relation to actual business activity. Use a variety of extreme stresses; historical, risk manager-defined, rules-based, correlated, random and arbitrary shocks should all be considered."

"A 'risk intelligent enterprise challenges accepted convention, and is predictive rather than historic,'" Lam added.

A 2010 E&Y survey on global bank risk found that, indeed, 70% of banks have adjusted their risk models to rely less on historical data and assumptions, and 74% have incorporated forward-looking scenario planning and stress testing that considers outcomes with extremely low probability but potentially high impact.

In light of all of the M&As taking place in the asset management industry, the pool of creditworthy trading counterparties is shrinking, warned Vincent Starck, VP, credit risk, at State Street Global Markets. Add to that the questionable validity of credit ratings, and asset managers today are faced with heightened counterparty due diligence, he said. Some asset managers are now requesting documentation and collateral from counterparties, even on a daily basis, Starck said.