As part of the industry’s drive to contain systemic risk, financial institutions should receive daily end of day counterparty risk reports, according to the Counterparty Risk Management Policy Group’s (CRMPG) recent report.
The group was formed in April this year to examine the steps that must be taken by the private sector to reduce the frequency and severity of future financial shocks, following the events of the ongoing credit market crisis.
The report, which is entitled Containing Systemic Risk: The Road to Reform and was released last week, is aimed at defining industry best practices that will help mitigate systemic risk. In particular, it recommends standardisation of practices around dealing with high risk complex instruments including OTC derivatives and credit default swaps, as well as the introduction of substantial enhancements to risk monitoring and management.
It highlights what it describes as the “extraordinary complexity” being faced by firms when dealing with risk management and in their policies and practices related to valuation and price verification for some classes of financial instruments. The report recommends that rather than relying on quantitative risk metrics, risk management must rely heavily on “judgment, communication and coordination”. This should be across silos, the CRMPG states, and the teams charged with risk management must be “truly” independent from front line business unit personnel.
“At the end of the day, corporate governance reduces to behaviour and incentives, not the vagaries of organisational charts,” the report explains. This entails a regular review of corporate governance practices and the risk management staff.
According to the CRMPG, large integrated financial intermediaries should also have in place the systems to compile, within a matter of hours, estimates of comprehensive counterparty exposure information on a given day based on the prior day’s close of business. “Timely access to such information helps to ensure that risk metrics are providing the proper signals, but of greater importance, such timely information facilitates meaningful insights into concentrated positions and crowded trades,” the report states.
The group therefore recommends that all large integrated financial intermediaries must have, or be developing, the capacity to monitor risk concentrations to asset classes as well as estimated exposures, both gross and net, to all institutional counterparties in a matter of hours. Moreover, these institutions must also have the capacity to provide effective and coherent reports to senior management regarding such exposures to high risk counterparties, the report adds.
The report also recommends that the institutions should conduct comprehensive exercises aimed at estimating risk appetite and work together with other institutions to identify risk contagion “hot spots”.
Philippe Carrel, executive vice president of Risk Management at Thomson Reuters, comments on the findings of the report: “The new approach consists of identifying the key risk factors truly underlying a firm’s exposure and assessing their impact on the very positions of that firm. Firms need to drill through the underlying risks as the securities they hold are sensitive to and assess the potential impact on themselves, on their customers, and on their capacity to react or to fund their positions. Each individual firm would therefore have a different sensitivity to similar risk factors. This is a brand new, hands-on approach to risk based on know how, experience, expertise and deep knowledge of one’s market, products and clients, rather than an ivory tower, math intensive modelling exercise.”
Risk is now being elevated to a corporate priority, he adds, and risk managers have the power to qualify a balance sheet. Communicating and managing risk policies with appropriate transparency has therefore become a shareholder priority. “Risk managers need to come out of the audit departments and sit in between the CEO and the CFO of a firm,” he adds.
“Precepts and regulatory recommendations need to encourage the diversity of strategies, tactics and risk policies. Regulators are core to defining the spirit, and some boundaries, to keep the markets fair and efficient, but can let individual firms be free to define their own governance rules, control procedures and risk mitigation strategies. Regulators of the securities and banking industries, potentially supplemented by data providers, can then combine their efforts to gather everyone’s information and produce global views of exposures, chosen strategies and typical methodologies, so that each individual firm can benchmark their own undertakings against such a monograph,” Carrel suggests.