Magazine article The RMA Journal

RMA Book Looks at Advances in Risk Measurement

Magazine article The RMA Journal

RMA Book Looks at Advances in Risk Measurement

Article excerpt

Contemporary Perspectives on Credit Risk, Portfolio Management, and Capital compiles key RMA Journal articles from 2001-14 to highlight improvements in the industry's credit risk management.

THE RISK MANAGEMENT ASSOCIATION is set to publish a book entitled Contemporary Perspectives on Credit Risk, Portfolio Management, and Capital: Readings from The RMA Journal. The tome, compiled by longtime RMA Journal contributors Joe Breeden and Mich Araten, features several of their articles in addition to the work of other authors.

The articles center around the theme of advances in risk measurement since 2001 and examine topics and best practices related to effective credit-rating systems, estimating credit capital for credit risk, stress testing, risk grading, and much more. The excerpts below were taken from the book's introduction and chapter introductions.

Contemporary Perspectives on Credit Risk, Portfolio Management, and Capital is slated for publication later this year.

From the Introduction

For the last 25 years, banks have improved the quantification of the risks they assume when they extend credit or take market positions. Their objective in doing so is to better measure risk-return trade-offs, provide appropriate returns to their stakeholders, and meet the safety and stability concerns of their regulators.

Since risk has always been encountered in many different ways in retail and wholesale credit, trading activities, and investments, developing a common language for measuring risk is important. Based on the early work of Bankers Trust in the mid-1970s, economic capital became the lingua franca for measuring risk, and a risk-adjusted return on capital (RAROC) metric was introduced as a way to price and evaluate the relative attractiveness of banks' risk-taking activities.

On the regulatory side, Basel I was established in 1988 by the Basel Committee on Banking Supervision as a capital framework for international banks. It classified each asset or off-balance-sheet exposure into one of five risk buckets and assigned different levels of capital to each risk category. However, in the next decade, new products developed by banks, such as derivatives, securitizations, and subprime lending, did not fit neatly into these few risk assessment buckets, and the banks argued that this framework did not accurately measure risk. Since regulatory measures were substantially less risk-differentiated than internal assessments, regulators raised concerns that banks were beginning to practice regulatory capital arbitrage as they offloaded high-quality assets and retained poorer-quality, higher-returning assets as a way to reduce their capital requirements and increase near-term profits.

It was clear that Basel I needed replacement in the form of Basel II with its more risk-differentiated capital measures. In June 1999, the Basel Committee issued a proposal for a new capital adequacy framework to replace the 1988 Accord. The Basel II release document noted that "in developing the revised Framework, the Committee has sought to arrive at significantly more risk-sensitive capital requirements that are conceptually sound." At the same time, banks also argued that internal risk measures already in use for their own decision making should find a parallel in a regulatory framework.

It was thus no coincidence that Robert Morris Associates changed its name in 2000 to The Risk Management Association, and its flagship publication, now called The RMA Journal, began publishing articles on various aspects of risk measurement as well as risk management. Appealing to a broad constituency, the articles ranged from the practical to the more theoretical and were authored by both practitioners working in banks and consultants to the industry. Many of the articles written by bankers followed the delicate balance of describing important new technologies in assessing risk that could be shared with the banking community at large without diluting any of their competitive advantages. …

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