As the new presidential administration and regulators continue to try to pick up the pieces of the shattered U.S. economy, the heat is on financial institutions to make sure their risk management practices are fully aligned with rapidly changing economic and market conditions. For most Wall Street firms, this means a growing demand for real-time systems, particularly for the valuation of securities, and increased automation, according to experts.
"Whether you're a business or a regulator, I wouldn't be surprised if in the near term more real-time systems are brought into play," says John Jay, a senior analyst with Boston-based Aite Group. "People before weren't paying attention. Now, knowing implosions have occurred, they're moving forward, and the trend is toward real time."
And with so much information flowing so quickly, automation is a key component of any risk management strategy. "If firms have significant assets, they would be foolish to still be using spreadsheets," Jay asserts.
"Size is an issue," he continues. "Over the past few years values have come down, but maybe the line items are still there. So for a lot of sell-side companies that are buying and selling all day long, particularly with over-the-counter derivatives, they might have tens of thousands of line items. And that's just a small portion of their business. So to have a spreadsheet would be rather dangerous."
As recently as a year ago, with the credit crunch and financial crisis looming, many firms relied on reactive and manual processes, confirms Dave Stewart, director of risk solutions for Misys and global solutions manager for the vendor's Misys Opics Plus front-to-back-office multi-asset-class processing platform. "They needed to put data in a spreadsheet, do analysis, get information to be aware of their positions of risk and have a bunch of metrics to enable them to make decisions for business," he says. "That type of practice has not been very effective. That practice doesn't give them the level of transparency or visibility to make the right decisions."
To avoid the kind of systemic meltdown that caused the financial crisis in the first place, companies need much better access to information in real time, Stewart stresses. "A lot of how they monitor their business can be improved dramatically if they have the ability to be aware of what's going on in a more holistic and real-time manner," he comments.
Finding a Good Value
One of the main issues financial firms are facing today is valuing their over-the-counter derivatives, according to Robert Park, CEO of FINCAD, a Surrey, British Columbia-based provider of derivatives analytics tools, who says firms increasingly are interested in getting independent valuations of derivatives positions. "Most of the assets being traded are Level 2 instruments for which there is no market quote available," Park explains. "So getting an independent valuation is one of the key concerns in the marketplace today."
Reliance on valuation models also is greater than in the past, adds Jason Hahn, SVP of market risk management for the mortgage lending division at BB&T Corp., a Winston-Salem, N.C.-based financial holding company with $137 billion in assets. But the models face their own challenges, he notes.
"A lot of people have taken the stance that fair-value accounting has been detrimental to the financial system's stability," Hahn relates, referring to the mark-to-market practice of valuing financial instruments using available market prices. "To do that in cases where the instruments are really easily tracked is good, but for more-esoteric instruments, some market value might be available for a benchmark, but you also need to have financial models that allow you to translate the benchmark to your simple calculation."
Further, many valuation models do not consider counterparty risk, points out Tom Driscoll, VP, sales and marketing, Charles River Development. "Institutions once deemed quite solid are not," he observes. "That puts pressure on flexibility and the models to make assumptions that a year or two ago would have been quite outrageous but, given the current situation, are likely a much greater risk now. That counterparty risk and how valuations are done need to be more flexible." He adds, "There's a lot of pressure for firms to not use a standard model to look at risk and valuation."
Ultimately, however, the financial analytics software itself shouldn't change all that much, suggests BB&T's Hahn. Rather, it is how the software is used -- what kinds of numbers are fed into it -- that will change. "Do you feed market data that is current, or a historical-average number?" Hahn poses. "Perhaps how you use the model might change -- the role that a model value has compared to market value, and how you go about reporting that."
Adapting Models to New Regulations
Another variable in Wall Street's risk models is emerging regulations, notes Aite's Jay. "Change is upon firms whether they like it or not -- not only internally but with regulations, too," he points out.
As a result, stress-testing systems -- not just for extreme market conditions but also for regulatory scenarios -- are becoming increasingly important. "In more-robust systems, we will see some of these compliance tools incorporate randomly generated scenarios subjected to constraints," Jay predicts.
"But what some systems may or may not capture is ... the effect of compliance if such a scenario came into play," he continues. "So if you're just looking at economics over a scenario, the economics might work and come up with a number. But you may also be violating liquidity constraints."
The bottom line, then, is that executives need to understand their own risk systems and what those systems are trying to say, Jay asserts. This is crucial when faced, for example, with rogue traders who have a lot to gain if they are successful and stand to lose little if they are caught, such as Jerome Kerviel, the former Societe Generale trader who was responsible for a $7 billion loss at the French bank by circumventing the risk management system.
"As far as risk managers are concerned and very senior guys, they need to understand from a compliance perspective the little loopholes but also the analytics, and understand what those risk management systems are telling them, and what they're not telling them," says Jay. "A senior officer ... now has to go beyond [trading volume] and see what his concentration and exposure is, [trades] on the books, those that are about to settle or will in the future, who the counterparties are, and whether some have incorporated regulatory requirements."
No Escaping Accountability
Overall, the key issue for everyone -- right up to a company's senior officials -- is to truly understand the instruments that are being traded, asserts Aite's Jay. "[Madoff whistle-blower] Harry Markopolos said the SEC was asleep at the wheel," Jay notes. "He said regulators don't understand the financial instruments. But that could be said for a lot of executives at buy-side and sell-side firms."
That lack of understanding, Misys' Stewart adds, contributed to organizations extending their risk exposure. Too often, he suggests, those who should have been accountable for their firms' positions weren't aware of the level of risk involved in certain holdings.
"It's one thing to be in business and make your assets under management grow, but another to not be held accountable to what they are," says Aite's Jay. "There has to be an increased knowledge base from senior folks. You can't get a free pass anymore by saying, 'Our risk people are dealing with that.' "
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