The State of Market Risk Management
Zeltkevic, Michael, The RMA Journal
Market risk is often considered one of the more mature areas of risk management; the sophistication with which it is managed outstrips that of credit, legal, operational, and reputational risks. Rate risk has long been the stock-in-trade of commercial banks, while trading risks were the first to be put on a properly quantitative basis with the development of analytical models of volatility and portfolio risk.
However, the background against which market risk is taken and managed continues to evolve. Over the past few years, an increasing proportion of activity has revolved around complex and structured products, which frequently blur the lines between market and credit risks, and a shift has begun toward proprietary risk-taking. The resulting organizational, theoretical, and technological challenges have attracted scrutiny from regulatory authorities and internal watchdogs.
Oliver Wyman recently conducted two studies of market risk practice. The first covered major universal and investment banks, while the second focused more narrowly on the market risk issues associated with the hedge fund industry. This article presents the state of market risk management today as seen by the survey respondents and points out some potentially productive avenues for industry consideration.
The New World of Market Risk
Global capital markets have enjoyed a few strong years, as evidenced by a steady climb in revenues since 2002. Credit businesses have led the way, buoyed by the growth of high-yield and distressed debt, structured derivatives and collateralized debt obligations (CDOs), products for retail and high-net-worth investors, and alternative and hedge fund investments. Equity businesses also have done well, as profitability has been turned around by firms' increased appetite for risk--particularly in proprietary trading.
Rate businesses have fared less well, with the interest rate environment limiting the scope of potential risk taking and eroding some client-driven revenues. The pace of securitization has slowed in retail mortgages while accelerating in the commercial sector; "principal finance" models are catching on in both the asset- and mortgage-backed sectors. Derivatives have become more widely used--by both the buy and sell sides--for hedging, proprietary trading, yield enhancement, and other purposes.
A risk gravity shift. In terms of business mix, margin compression in flow businesses has been offset by growth in structured products across all asset classes.
The effect has been to shift risk management's center of gravity, as such products are becoming not only more common but also more complex--mixing risk types and often requiring considerable customization. CDOs and convertible equity products, for example, may integrate credit risk with several types of market risk, as well as legal and reputational risks.
Many firms have also become more reliant on proprietary risk taking. Leading investment banks have seen trading revenues across the board grow by approximately 10% since 2001; in some areas, including fixed income, the increase has been far more pronounced. The price paid for these returns is increased volatility: One-day value at risk (VaR) has risen by more than 60% across the industry.
A general trend toward risk taking is most evident in the rise of the hedge fund industry. Capital is still pouring in, creating an increasing number of funds big enough to demand favorable credit terms from dealers and build diversified businesses, including such comparatively stable, cash-flow-driven businesses as loan portfolio management and reinsurance. Dealers, for their part, are responding by investing in the talent and products needed to attract and retain lucrative hedge fund business.
A changed risk management environment. These trends--toward structured products, derivatives, risk taking, proprietary trading, and hedge funds--have substantially reshaped the environment for market risk management. …