Risk, Baseball and a Brand New Year of Opportunity

This blog post was originally published on TabbFORUM.

It’s 2013. The days are lengthening again, and the risk world is facing an environment that is more concrete, while remaining every bit as challenging as it was before the millennium became a teenager.

The challenges faced by risk departments everywhere are well known, and include rafts of new regulations from Basel and Dodd-Frank, and data sets including the recent financial crisis, pointing to very likely high volatility in the months and years ahead, central clearing making calls to the risk management quant teams, and a low inflation/interest rate state continuing to cause anxiety in the pension world. With such a backdrop, it is easy to see risk management as an exercise in compliance at the lowest cost, but as Brad Pitt playing Billy Beane in the baseball movie “Moneyball,” demanded of his staffers: Are we asking the right question?

It is true that risk can be seen as simply calculation of “buffer capital” in the form of regulatory capital, margin, or collateral, depending on the underlying activity, but this crucially ignores the management aspect of “risk management.”

A couple areas in the financial markets illustrate this point well.

On the buy side there are the pension funds, where risk management has traditionally been based around performance and volatility tracking of fund managers against their benchmarks. Essentially, this meant that the risk management itself was really only addressing the risk of poor manager selection, rather than exploring the deeper risks of the fund as a whole. This view of risk is changing, however, as many funds face being under-funded against their liabilities as returns dry up and pensioners live longer than originally accounted for.

The question becomes one of calculated excess risk, often with derivatives being used to leverage the fund, and risk budgeting being used to allocate that excess. In a nutshell, risk budgeting involves:

• Understanding the risk, or possible loss profile, of the benchmark of the overall pension fund. VaR or conditional VaR (VaR shortfall) is most typically used as the risk metric
• Determining a level of risk, or increased level of possible loss, that the fund is willing to take on, to make up any underlying funding deficiencies
• Allocating the excess risk to the underlying managers who run the assets for the fund

So far so good, but the situation is complicated by the fact that many funds use external managers who operate against alternative benchmarks. This means that for the fund to be well managed, and the risks fully understood, the central risk managers also need to understand:

• The risk or potential loss profile of the fund benchmark (i.e. the fund assuming that it was invested exactly against its benchmark)
• The risk or loss profile of each external manager’s benchmark (again the amount of the fund allocated to that manager, assuming investment to be exactly in line with the benchmark)
• The basis or allocation risk between the aggregate external benchmarks and the fund’s official benchmark (this is the risk associated with the selection of the external managers themselves)
• The risk or potential loss profile created by the external manager’s investment choices, or the stock selection risk (this is measured between the actual external portfolio and the external manager’s benchmark)

The risk budgeting itself is a mix of selecting managers with riskier benchmarks and then allowing those managers the latitude to actively increase their risky positions against their own benchmarks.  The two elements have to be taken together, and once they are, the risk profile of the fund, using well tested risk methodologies, can be fully understood, and used to actively control the increase in overall fund riskiness, in search of higher returns to make up funding gaps.

This type of risk-based fine tuning transforms risk departments from performance measurement departments into active risk controllers, adding considerable value to the business at a time when it is desperately needed. In this instance, the right question is really about solving an under-funding issue, rather than a risk management one.

On the sell side, the adoption of VaR-based margining by central clearing venues opens up many opportunities for risk practitioners to actively add value to their firms. These would include:

• Ability to calculate the optimum venue, margin-wise, for any new trades to be cleared
• Full control of regulator-required “independent margin”
• Margin minimization using futures, where allowed, to offset cleared OTC trades

In both cases, on the sell side and on the buy side, risk is actively enabling informed decision making and empowering those who choose to use it in that way. Both are simply asking a different question to the original, “How do we cope with the latest requirement?”  In the case of pension funds, we are asking how best to solve the under-funding problem, and in the case of central clearing, we are asking how best to profit from the new environment. In both cases, the use of well understood risk management techniques is the answer.

In what should be an interesting year for risk managers across all sectors, the first step begins in looking afresh at the problem, seeing the opportunity and ‘getting on first base’ with the solution.

Happy New Year!

While you’re here…

• Explore SunGard’s Adaptiv solutions for enterprise risk management.
• Read more articles from Marcus Cree.