spikegifted.net - Risk Management

Mitigation: Can we make these risks go away?

It is all very well that we have all kinds of risk specialists assessing and monitoring the various categories of risk an institution is exposed to, it is equally important for the business areas to actively practice risk mitigation in both their day-to-day operations as well as part of their longer-term strategic objectives. In effect, risk mitigation can be looked at as an institution goes to the market to buy insurance and spreading its risks to other buyers of risk in the short-term and looking at how an institution conducts its businesses in a longer term. With this understanding, it is, therefore, vital that in the effort to mitigate risk, an institution doesn't rid itself of one type of risk and taken on risks of another form.

1) Market Risk: The main weapon risk managers (and business areas) employ to mitigate market risk is hedging. Hedging has been around for a long time. Derivatives (futures, options and swaps) started out as hedging instruments for buyers to insure against specific risks they're exposed to - uncertainty in prices and uncertainty in their returns. For a modern financial institution, even traders (those who bet on the direction of the markets or arbitrage using small discrepancies in prices in different markets or products) use hedging techniques to eliminate unnecessary risks. While it is often the case that a 'perfect hedge' can be found, there are lots of situations where even a combination of hedges only manages to eliminate some of the risks. The key to hedging is to choose the hedging instrument carefully, to find one that truly reduces market exposure. Picking a wrong hedge can ended up increasing the firm's exposure, thanks to correlation risk. Additionally, even when a 'perfect hedge' is found, the quality of the 'insurer' should be carefully considered, otherwise, the market risk exposure simply transforms itself to become a counterparty risk exposure.

2) Credit Risk: While the assessment and monitoring of credit risk is partly quantitative, its mitigation is almost entirely qualitative. The key to reducing credit risk exposure is to carefully choose who you're dealing with. In case of lending money to borrowers, it is essential to have good knowledge of the borrower's ability to repay, under different market conditions. Qualitative assessment of not only the client, but the industry sector, geographical and political influences on its franchise and other factors (like suppliers, off-takers, outstanding debts, etc). Aside from loans, it is important to have a thorough understanding of the credit quality of the counterparties. Additionally, thorough understandings of the counterparty's business objectives and risk systems are essential. By allowing sensible levels of business activities, but not allowing exposures to run away, goes a long way in mitigating unnecessary exposures. The setting of conservative exposure limits, mark-to-market trigger levels and stringent documentations will allow close monitoring of exposure to counterparties of all credit qualities. In terms of mitigation of collateral risk, a qualitative and quantitative process of understanding the correlation between the collateral and the underlying transaction will reduce the chances of being doubly exposed to market fortunes.

3) Operational Risk: The most effective way of mitigating operational risk is a thorough set of policies and procedures setting out the process of operations across all business areas. These policies and procedures have to be relevant to the actual functioning of the business rather than some ideal dreamt up by audit teams. However, frequent audits are equally important to ensure that the quality of operations are achieved and operational failures are minimized. While insurance can be bought to reduce an institutions exposure to operational failure, it is vitally important this transfer of risk does not translate to transforming operational risk into counterparty risk or market risk.

4) Legal and Regulatory Risks: The legal and regulatory risks assumed by an institution are assess and monitored by the legal, compliance and audit teams. Therefore it is only natural for these teams to act as guardian angels, to protect the organization from unnecessary exposures. Training forms a key part in bring the troops up to date with current status of rules and regulations and highlight any changes in policies. Frequent audits of all parts of the business can be used to ensure that policies and procedures are followed. Senior managers have to be actively involved in the compliance process as they'll have to lead by example. On a transaction level, where third parties lawyers are involved, internal counsels have to ensure that the quality of the external lawyers are properly representing the interest of the organization and those of the clients.

5) Reputation and Underwriting Risks: In the cut-throat world of finance, it is all too easy to promise the clients all kinds of fantasies to win mandates. However, once mandates are won, the organization faces the difficulties of bringing the transaction to the market. To avoid the reputation risk in failure of a transaction or the underwriting risk of having a large portion of the issue stranded on the balance sheet, senior business and risk management have to be involved prior to the firm making the commitment to the client. Once the mandate has been won and the execution process runs toward the launch of the transaction, business and risk management have to be consulted again on the status of the terms of the transaction, market sentiment, the likelihood of demand, pricing range and institution's final take (if any). The entire decision process has to be controlled and the business area has to demonstrate that the clients expectation can be matched by those of the market.

6) Systemic Risk: So, just how do financial institutions guard themselves against something that has few historical precedents and is completely unpredictable? In essence, systemic risk mitigation is the capstone of risk management. It is like, if we take a snap shot of all the positions of an institution and apply some kind of market dislocation on these positions, would it be able to survive? This involves all areas of risk management and it also means that every risk area has to be fully under control. Any weakness in the risk management armor will translate to devastating risk losses. Having a comprehensive risk management policy and thoroughly implementing such policy broadly and consistently will ultimately mean survival.

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