Strategic Risk Management: Driving Risk-Adjusted Return on Capital

Article excerpt

Aside from the Internet, few issues in the financial services industry have commanded as much attention in recent times as that of enterprisewide risk management. Fewer still are as significant to a financial institution's profit motive.

While the infamous collapse of Barings and several other trading- related losses of scandalous proportion sent shock waves around the financial services industry, the events did little more than scare most money center bank CEOs into eyeballing current op erational risk management controls in an attempt to ensure that their respective institutions didn't turn up on the evening news. Only a handful of risk pioneers-CIBC, Bankers Trust, J.P. Morgan, Commerzbank and DG Bank-have been focusing on the implicati ons, from a strategic risk management (SRM) point of view, of integrating market and credit risk.

Savvy financial industry players recognize that risk management is a continuum; what's sometimes lost in the evolution of risk initiatives is the real impetus for firmwide risk management: the ability to calculate risk- adjusted return on capital (RAROC).

In the past few years, firms have been moving from a tactical to a strategic approach to risk management. "The strategic (view) is in my mind a more board-level type thing. It's trying to decide how (one) wants to position the bank with regard to risk man agement. What are our goals? What is an acceptable level of risk? And what do we need to know about our exposures to better manage the bank or institution as a whole?" says Debbie Williams, founder and a principal of Needham, MA-based Meridien Research.

Banking the way it will be

In many ways, the lack of proactive, "big-picture" risk management among bankers is no surprise. Historically, it's been very difficult for the banking industry to match investment in technology in any way to increased profitability, according to Williams . "That's just as true for risk management technology as for any other technology," she says. "If it's unclear exactly how to match the investment to the bottom line-what the relationship is (between technology investment and profitability)-why are people going to do this?"

In the old banking paradigm, risk management really focused strictly on credit risk, which prompted many bankers to live by the 3-6-3 rule: lend money at six percent, borrow at three percent and be on the golf course by 3 p.m. The advent of asset liabilit y management changed all that, says CIBC's Bob Mark, executive vice president of corporate treasury and market risk management. "There was now a recognition of the fact that a bank's net interest income was very subject to the switching of highly volatile interest rates," he says.

Times have changed. As money center banks began to move into trading product, the industry began to consider creating groups-largely composed of ex-trader and quant types-to focus on market risk management. With the rise of derivatives, players began to s crutinize credit-related issues. Now, credit derivatives are blurring the line between market and credit risk. "The world is changing rapidly. Now throw on top of that securitization and liquification of the balance sheet," says Mark, who some industry pl ayers refer to as the "godfather of risk" (a recognition he shares with Till Guldimann, executive vice president of Mountain View, CA-based Infinity Financial Technology and formerly of J.P. Morgan fame). "The whole dynamics have changed; we have a very t ight integration between the worlds of trading market risk and trading credit."

These same principles that have been applied to trading room risk management are now applicable across the enterprise. The caveat: Bank CEOs must learn to view the enterprise as a portfolio of market and credit risks (see chart). CEOs are concerned about regulatory capital, economic capital and liquidity to fund growth in the balance sheet, says Mark, adding: "Risk management, I would argue, is becoming more and more a part of day-to-day thinking in institutions; it's on the table while business decisions are being made. …