Come Together - The Benefits of an Integrated Risk Management Solution

In these times of unprecedented change, a bank’s treasury unit has grown from being a liquidity management unit to a trading and profit-generating unit. Treasury business has focused on many new and complex financial products like derivatives and options, while monitoring closely how their business environment is evolving.

However, when trading in new financial products, banks are exposed to various risks and they have three basic choices:

• Avoid certain business strategies or customers to reduce risk
• Accept and retain the risk, but use internal controls and risk capital to manage this risk
• Accept the risk and transfer all or part of it to others, either within or outside the organization

Risk Management is the process of attempting to manage risks at an acceptable level. The objective of risk managers is to continuously evaluate the risk levels and make an attempt to bring it to the targeted level.

From a risk management point of view, risk can be subsumed under the following different categories

Credit risk:

Credit risk is the risk of loss due to counterparty’s failure to perform on an obligation to the institution.

Market risk:

Market risk is the risk of loss due to adverse changes in the market value (the price) of an instrument or portfolio of instruments.  Such exposure occurs with respect to derivative instruments when changes occur in market factors such as underlying interest rates, exchange rates, equity prices and commodity prices or in the volatility of these factors.

Liquidity risk:

Liquidity risk is the risk of loss due to failure of an institution to meet its funding requirements or to execute a transaction at a reasonable price.

Operational Risk:

Operational risk is the risk of loss occurring as a result of inadequate systems and control, deficiencies in information systems, human error, or management failure. Derivatives can pose challenging operational risk issues because of the complexity of certain products and their continual evolution.

Legal Risk:

Legal risk is the risk of loss arising from contracts which are not legally enforceable (e.g. the counterparty does not have the power or authority to enter into a particular type of derivatives transaction) or ones that are documented incorrectly.

Challenges in Risk Management:

Due to the nature, scale and complexity of treasury operations, risk managers face the following challenges:

1) Complex MIS and information requirement:

Users of different sub-units of treasury have different requirements from the same risk management system, these may include:

• Real-time updates on positions, risk, limits, and P/L
• Real-time mark-to-market
• Managing risk with dummy benchmark portfolios
• Real Time update on % usage of limits at granular level
• Real time alerts of market movement and impact of these movements on their portfolios
• Real-time Value at Risk
• Simulating FX and IR movements
• Advanced real-time Limit Management for various risk
• Generating various MIS reports
• Start of day risk numbers to dealers and top managers
• Flexiblity of defining new limit measures
• Flexiblity of analysing historical data

2) Disintegrated Trading Systems:

Risk managers face the following limitations when systems are not integrated properly:

• Aggregation of various types of risk across trading products
• Inability to collect and consolidate data for generating risk numbers
• Intra-day and real-time valuation across products are almost impossible
• Reconciliation of risk numbers across the system is very difficult

Future Approach to Treasury Risk Management:

Current trends require a solution where actions are consistent with business strategies. This is a ‘one firm, one view’ approach, which also recognizes the specific risk dynamics of each business. By taking an integrated approach to risk, companies will benefit from the following advantages:

1) The total risk-enabled bank

Technology will allow risk management information to be integrated into overall management reporting – including intra-day risk reporting. The Internet and intranet will become the delivery vehicles of choice for risk analyses.

There need only be one official risk measure from a fully integrated risk system. Independent risk calculators will exist for offline use. Real-time access will be provided via Web-based technologies. For example, independent risk calculators will be able to use the exact same analytics as those used in the official reporting process via the intranet.

Integrated risk management will be the ‘nerve center’ for trading and provide the impetus for new marketing initiatives, pricing and integrated profit and loss reporting.

2) Measuring Complex Mathematical Risk Models

Banking is moving into an era in which complex mathematical models, programmed into risk engines, will provide the foundation of integrated portfolio management. An integrated risk management system (IRMS) will be able to measure the risk of sophisticated products, compute and implement hedging strategies and understand the relative risk-adjusted return almost instantaneously. Given the trend towards consolidation and vast organizations` demand to provide key decisions quickly and consistently, IRMS will provide the ability to support tools for comparing profitability measures and risk tolerances for diverse businesses.

The risk management system should be tightly integrated with profit and loss reporting. Risk numbers to a business unit will be computed not only according to the volatility of the business line’s revenues but also according to its contribution to the total risk of the firm.

3) Universal Risk Limits

It is essential that limits should be rigorously enforced and that significant and persistent breaches of limits should be reported to senior management and fully investigated. An IRMS will put the limits in place to control the market, credit and liquidity risk of the institution at various granular levels. These will be integrated with the overall institution-wide limits for these risks. For example, the credit exposure for a particular counterparty arising from derivatives would be aggregated with all other credit exposures for that counterparty and compared with the credit limit for that counterparty. The aggregate limits can then be allocated and sub-allocated by management. Finally, the  system of limits should include procedures for the reporting and approval of exceptions to limits.

IRMS will establish the limits taking into account the following factors:

• Past performance of the trading unit
• Level of sophistication of the pricing, valuation and measurement systems
• Quality of internal controls
• The projected level of trading activity in regard to the liquidity of particular products and markets

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