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22 Financial markets contain a great deal of credit information—monitoring the stock prices and credit spreads of counterparties can be helpful, especially on the downside

22 Financial markets contain a great deal of credit information—monitoring the stock prices and credit spreads of counterparties can be helpful, especially on the downside

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100



The Simple Rules of Risk



exposed to the performance of a weakening counterparty. Credit officers often view themselves as analysts of financial statements rather than “watchers” of markets; as a result, they

may miss important credit information embedded in market indexes such as stock prices and

credit spreads. The diligent credit officer should make use of all available market indexes to

monitor market perception of counterparty credit quality; these are powerful tools that can

make monitoring a far more effective process — allowing time to reduce exposures before it

is too late to take action. For instance, if a credit officer notices that Company ABC’s stock

price is falling and its bond credit spreads are widening, he may investigate the reasons for

the moves. If, after examining these variables, he determines that the market is concerned

about ABC’s liquidity and access to short-term funding, he may opt to perform further due

diligence by calling on the company to discuss its financial standing; alternatively, he may

simply curtail further credit or instruct the trading desk to purchase credit protection on ABC.

By simply waiting for the company to make a public statement about the performance of its

stock and bonds and its possible liquidity problems, or by waiting until the release of the next

financial statements, the credit officer might miss an opportunity to protect the firm’s credit

exposure. Monitoring information from the markets is thus an important part of the credit risk

management process.

Summarizing the simple rules related to reporting and monitoring we note the following:



r If risks cannot be monitored they cannot be managed — if this occurs, a firm cannot be said

to be in full control of its operations.



r Timeliness is important — reporting mechanisms that deliver 90% of a firm’s risk picture

r

r

r

r

r



efficiently can often be more effective than those that deliver 100% on a delayed basis;

equally, mechanisms that are flexible, and can provide risk information in a multitude of

formats to internal and external parties, are ideal.

Generally speaking, more, rather than less, risk information and disclosure is beneficial —

though it must be targeted at the correct audience and presented in a relevant fashion.

Any effective reporting mechanism should be able to deliver an appropriate level of detail

to the appropriate audience; senior managers should receive and review information that

depicts the firm’s risk without an excess of detail, while business, trading and risk managers

should focus on information that is granular enough to run, or risk-manage, a business.

Reporting on the source of profits and losses is a vital component of risk monitoring — if a

firm is unable to explain its P&L it will not be able to understand, and therefore manage, its

risks.

Sensitivity to regulatory reporting requirements is also important to bear in mind — such

reporting is important and will become more prominent over time; regulatory reports, however, are generally not sufficient to manage a business, meaning two reporting streams must

be produced.

Mechanisms to monitor top risks, collateral, counterparties, aged/illiquid inventories and

other special risks should form part of the process as well; these can help identify potential

risk problems before it is too late to take action.



7

Risk Management

Active management of risk is the core of trading/treasury, banking, business origination and

independent risk control. Once a firm has established a governance process, identified and

quantified its exposures and implemented monitoring and reporting mechanisms, it is ready

to actively manage its risk. Ongoing management is the responsibility of trading and business

unit managers, credit and market risk officers, and professionals from other control functions

(including auditors, controllers, operations specialists and lawyers); each must play an active

part in order to create an effective risk management culture. If business leaders introduce new

risk management techniques but risk officers fail to keep pace, or controllers and auditors

attempt to create a more secure environment but trading managers dismiss their efforts, a

robust process will not emerge. Communication, prudence, experience and awareness are all

central to the active management of exposure. While the management discipline makes use of

a host of tools, models, analytics and reports, it is perhaps most reliant on the common sense

and judgment of professionals charged with managing the risks; this is where the “art” of risk

management moves to the forefront.



7.1 RISK MANAGERS SHOULD BE VISIBLE AND AVAILABLE

The independent risk management group is responsible for enforcing the firm’s risk management directives on a daily basis. One of the most effective ways of accomplishing this task is

to ensure credit and market risk officers are visible and available. Risk officers should work

closely with traders, originators and business unit leaders, engage in regular communications

and discussions with them, and be readily available to resolve risk management issues or

queries. Active risk managers are typically consulted by business leaders for advice and counsel, while those that remain part of the “anonymous bureaucracy” of risk control are likely to

be regarded as a hurdle that needs to be “overcome” in order to proceed with business — this

does little to strengthen risk awareness. For example, a risk officer may make it part of her daily

routine to spend time on trading floors, speak to trading managers and participate in morning

origination and trading conference calls. Traders and originators will soon realize that the risk

officer is available for discussion and consultation and is an effective link in the management

and communication process. Market risk officers are often more “visible” than their control

counterparts, as they spend more time in business and deal-related settings; however, it is just

as important for credit, legal, financial and settlements specialists to be visible. Visibility and

availability permit communication; communication strengthens risk management.



7.2 RISK OFFICERS AND RISK TAKERS SHOULD DISCUSS RISK

ISSUES ON A REGULAR BASIS

Extending the rule above, it is useful for market and credit risk officers to communicate daily

with trading managers, originators and other business leaders in order to consider risk matters



102



The Simple Rules of Risk



of mutual interest and reinforce the governance process. Communication is often most effective

when it is informal; a quick review of a handful of relevant risk issues can be very useful. In

addition, communication should be “two-way” in nature in order to be constructive: business

managers should receive, not only provide, information. Risk officers, aware of events and

issues affecting the organization at large, can use daily meetings to provide information;

the reciprocity generates goodwill and strengthens communications. If a market risk officer

covering US corporate bond trading makes it a daily habit to review the top corporate bond

risks, hedges and spread movements with the head of bond trading, he may also wish to provide

an update on the firm’s progress in other areas or discuss any significant risk, operational or

systems issues/initiatives that are underway. This all forms part of the communication element

that is so important in the daily management of risk.



7.3 RISK MANAGERS SHOULD BE IN REGULAR CONTACT

WITH MARKET PARTICIPANTS — THE MARKET HAS A

GREAT DEAL OF INFORMATION THAT CAN BE

USED IN DAILY MANAGEMENT OF RISK

Since information is central to effective management of risks, it is essential for risk managers

to be in continuous communication with traders, salespeople, bankers, research analysts and

others with a view on markets, credits and events in the financial system; they should also

have a regular dialog with external parties that are involved with particular markets or credits.

Business leaders acting on the “front lines” are generally in an ideal position to learn about

events that can directly impact exposures, and should be encouraged to share “breaking news”

with risk officers. Having risk officers proximate to trading and banking floors can help in the

process — being close to the source of information fosters stronger communication ties. For

example, a trader, learning that a particular counterparty is having difficulty settling trades,

can forward the information to the credit officer, who may wish to investigate the veracity of

the information, the potential reasons for the settlement problems, and whether any protective

action is warranted.



7.4 RISK MANAGERS SHOULD STRIVE TO BE “VALUE ADDED”

BY SEARCHING FOR BENEFICIAL RISK SOLUTIONS

WHENEVER POSSIBLE

The function of the risk process is to protect the firm and its shareholders from unexpected

losses and other financial “surprises” by ensuring a sound operating environment. This means

guiding a firm towards good, properly-priced risk opportunities. A process that rejects all

risk may protect the firm from losses, but is unlikely to maximize shareholder value as the

firm will be unable to generate revenues from its risk-related activities. Accordingly, a risk

function that adds economic value while protecting the firm’s resources might be regarded

as benefiting the interests of the firm and the shareholder. Risk officers who have enough

experience and knowledge to help a business unit transform a bad risk — one that generates

too much risk for the profitability being offered — into a good risk can protect the firm while

permitting profitable business to occur. For instance, a credit officer who rejects a proposed

credit-sensitive transaction because it has “too much risk” is missing half of the risk/return



Risk Management



103



equation; an officer who examines the same risk and attempts to restructure it by lowering

the risk (to a level commensurate with the profitability being offered) helps transform bad

risk into good risk and optimizes use of the firm’s risk capital. Transforming the credit risk

may involve the use of collateral, netting agreements, margining arrangements, credit default

structures, and so on; while risk transformation may not always be possible, the diligent risk

officer will make every attempt to do so. Similar types of transformations can, of course, be

considered for market, liquidity and legal risks — risk managers should attempt to add value

in the management of any risk the firm assumes.



7.5 RISK DECISIONS SHOULD BE DOCUMENTED

CLEARLY IN ORDER TO AVOID ERRORS AND

MISINTERPRETATION; GOOD DOCUMENTATION

ESTABLISHES A PROPER AUDIT TRAIL

Clear documentation of all risk decisions is common sense and sound management. While

maintaining good records may seem obvious, poor record-keeping is often a recurring problem;

it may be attributable to lack of discipline, decisions taken higher up the management chain,

exceptional decisions made by those in regional offices, and so forth. For instance, a senior

risk manager, contacted for risk approval during “off hours” by a trader in another time zone,

may simply fail to document the decision the following day. This can result in wasted hours

trying to reconstruct what has, or has not, been approved, and by whom. A simple process of

requiring every risk management decision to be properly documented and filed — whether in

electronic or hardcopy form — helps eliminate misunderstandings and builds a strong audit

trail; both are essential for risk control purposes and preservation of the firm’s risk experience

and “memory.” There should be no exceptions to the documentation process.



7.6 WHEN A POTENTIAL RISK PROBLEM IS DISCOVERED,

IMMEDIATE ACTION MUST BE TAKEN; PROBLEMS

MUST NOT BE PERMITTED TO GROW

OUT OF CONTROL

Many large risk-related problems begin as very small problems. They often grow and intensify

because they are not managed early in the identification process, or because market events

move quickly and cause losses to grow before action is taken. When any type of risk problem

is encountered — credit, market, operational, legal, and so on — it is incumbent on the risk or

control officer to take immediate action. This may involve solving the problem in conjunction

with relevant business and control personnel, or elevating the issue to senior or executive

managers. Regardless of the process, it is imperative to act on risk problems as soon as they

are discovered. For instance, if a market risk officer responsible for coverage of yen interest

rate derivatives notices, during the course of her review, that new trades are appearing under

slightly different counterparty names — ABC Ltd., ABC Corp., ABC Intl. Corp. — she may

feel that trade tickets are being entered erroneously, or that the firm is actually dealing with a

variety of different counterparties under the ABC “umbrella.” While not strictly a market risk

issue, she determines that the matter should be investigated by operations and credit personnel,

as it may be indicative of a broader problem — lack of discipline by sales/trading personnel in



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