Enterprise-wide risk management and collateral management strategies are the way forward
Budgets may be dwindling by the day for financial institutions but many DerivSource members report the little budget left is allocated for improving risk management. The events of the past year or so, with the collapse or near collapse of household-name financial institutions resulting from the credit crisis, have revealed that previously relied upon procedures for managing counterparty risk are simply not good enough. Few firms however, have yet made the dramatic changes re-build a risk management structures in a significant way. Simply stated, changing CSAs or broker agreements, or checking risk profiles of counterparties more frequently is not enough – not now and certainly not for the long-haul.
In a Webinar hosted by Financial Technologies Forum on this very topic, two industry experts explained what they believe to be the best risk management strategy that will withstand the existing market turmoil and ongoing counterparty risk mitigation needs. And both Stephen Bruel, an analyst at TowerGroup and Darren Measures, of JP Morgan shared the same advice and ideas – think bigger, think integrated and enterprise-wide.
Stephen emphasized the need to adopt an enterprise-wide risk management strategy early on in the Web event. When dealing with OTC derivatives, risk comes in multiple guises and increasingly, these individual risks are becoming more intertwined. And the risk associated with relationship with a prime broker (sometimes also a firm’s executing broker) can quickly snowball as some of you may have already experienced or heard about.
What if your prime broker goes bankrupt, for example? Many firms have experienced this problem and were suddenly dealing with their counterparty’s inability to meet its collateral obligations, but there are many other risks involved in this event. If your prime broker goes bankrupt you have to assess the diversification of your portfolio to see just your exposures to this bankruptcy and also assess which trades executed have not yet settled or have not settled correctly. And of course following the bankruptcy your unsettled business (and monies) with this prime broker are subject to regulatory risk as you wait to see how the regulators will respond. You must also wait to see what the ultimate effect of this chaos will have on your own reputation as a company. Oh, and if you rely on the execution management system provided by this broker, then you can start looking for a new system since this one will likely not be supported much longer. I’ve counted these risks so far: credit risk, portfolio risk, settlement risk, sovereign risk, regulatory risk, reputation risk, technology risk.
In addition to risks types converging, risk is also becoming more global. More specifically, firms are trading with a greater number of counterparties and products reaching markets all around the globe. Risk is not localized as we’ve seen by the U.S. – led subprime crisis spilling into other country financial markets and economies.
Similarly, an effective risk management strategy requires the involvement and collaboration of multiple internal departments (compliance, operations, IT just to name a few), and a strategy also requires change in controls, procedures and systems in many areas of the processing chain. Most financial institutions, I assume, already realize the collaboration required because many Webinar participants had multiple department heads listening in.
Today information is located in silos segregated mainly by asset class. This means the operations and other functions such as collateral management are also dealt with in a segregated environment. The intermingling of risk types however, debunks the old or current method of managing these risks separately.
Though Stephen suggests enterprise risk management should be a strategy rather than viewed as a simple operational change, he suggests firms can support this new theory with technology. He says implementing a layer of processes and technology which encompasses all silos used and will analyze the data of each, but also do so in a collective manner. The result will be better and consistent management of the data of all silos while applying consistent risk analysis and providing the firm with a view of its risks on a holistic basis.
Collateral management is an integral function of risk management, and is becoming an increasingly important as the value of collateral playing in the markets increases as does the number of products and markets included in collateralization. More efficient management of collateral is essential, especially for buy-side institutions that now face a greater likelihood of their sell side counterparties going under.
Darren re-emphasized the need to think bigger in management of collateral. There are a greater number of products/asset classes being included in collateralization but often existing systems and procedures do not track all of these products equally or in a collective manner. The result is many gaps and holes in the overall collateral management process which amplify counterparty risks.
Darren explained to participants that there are three main components needing adoption to best mitigate counterparty risk: know your client, know your market appetite per client and ensure full and accurate collateralization at all times. How many firms can say they can satisfy each of these requirements easily (meaning retrieving the relevant data today, not next week) and do so with efficiency?
To be able to do this, Darren explains collateral really needs to be managed holistically and across all traded products, regardless of the credit risk category they fall into. And today, again this is how many firms manage collateral – in a silos segregated by product type. This is especially true for securities lending and repo activity which often is not integrated in collateral management procedures and thus creates massive gaps in controls and also increases exposures to counterparty and credit risk. So, adoption of this broader reach of collateral management is also the key to better collateral management.
With these ideas in mind, hopefully firms have a better hold on how to build a better risk management plan and know what to do with the budgets you have for ’09.
*Blog written by DerivSource founder and editor, Julia Schieffer