Allan Grody, president of strategic advisory firm Financial InterGroup Advisors, has published two new papers aimed at shedding some light on the areas of risk management and data in the current market environment.
The first paper, Infrastructure Issues in the Financial Services Industry: A Case for a Central Counterparty for Data Management, explores the potential issues surrounding the establishment of a central counterparty (CCP) for reference data. The second, Risk Accounting: a Next Generation Risk Management System for Financial Institutions, examines whether a more comprehensive and timely measurement framework for risk exposure is now needed by the industry as a result of the crisis.
In the reference data counterparty paper, Grody contends that collaboration and risk sharing through industry sponsored centralised facilities has been a popular method of risk mitigation in the past and this could be applied to the area of reference data. Thus far, this approach has only been applied to the variable value portion of transactions, including quantities, transaction prices and monetary values, says the paper. However, the paper proposes the same techniques be applied, separately and earlier in a financial transaction’s life cycle, to the matching and settling of the non-valued referential data components of these transactions.
“These data components comprise upwards of 70% of a financial transaction’s assembled parts,” says the paper. “Faults in properly identifying this data, as well as mismatches that occur in separately sourced and assembled financial transactions that counterparties attempt to match prior to payment, are a large source of matching errors. The result is significant imbedded industry-wide operational costs, individual firm monetary loss and counterparty risk, and global systemic risk.”
To combat this problem, the paper advises that a new facility, a central counterparty for data management (CCDM), be established to first access and match multiple incoming sources of referential data at the pre-trade financial transaction assembly point. The CCDM would then clear this data through best of breed computer analysis, and settle, or distribute, industry accepted, CCDM assured data sets to participants, making it available to be attached to the variable value portion of the transaction at transaction assembly time, says the paper.
“By doing so at the immediate front end of a financial transaction’s life cycle, significant improvements can be made in lowering operational costs, reducing transaction failure rates, and reducing operational losses resulting from data failures in the post trade matching, clearing, settlement and reporting environment,” it contends.
The second paper claims that the financial crisis has awoken financial service organisations to the importance of risk management. They are now aware that when financial transactions enter their operating environments they trigger real time risk exposures that can go well beyond nominal transaction values, capital charges and other measures deemed appropriate for preventing unexpected losses, says Grody.
“Traditional risk accounting approaches have caused lagging measures of risk to be recorded in much of managements’ traditional performance and risk reporting systems. Conventional financial and risk management systems are failing management and their boards due to their inability to measure, aggregate and report risk exposures as they accumulate. In reaction to the current financial crisis the boards of many firms are assigning the additional task of oversight of management’s risk policies and guidelines to audit committees. Accountants are also being asked to discuss the enterprise’s key risk exposures with management including those that are beyond financial reporting related risks,” says the paper.
The paper links the current financial crisis to an inability to record and account for risk exposures in a timely manner. “Indeed, recent failures of financial institutions provide some measure of the degree to which accumulating risk exposures escaped the exercising of business judgment simply because executive management, investors, auditors and regulators were unaware of their existence on such a scale,” it claims.
Grody also considers whether a more “comprehensive and timely” measurement framework for risk exposure is now needed and examines one possible approach. The paper introduces a common unit of exposure measurement for a diverse set of business risk indicators and demonstrates how nominal transaction values and relevant quantitative and qualitative risk metrics can be coded into each transaction and used to calculate a risk adjusted transaction value. The combination of conventional risk measures derived from the capital conventions mandated by the Basel Committee on Banking Supervision and this proposed risk exposure measurement framework provides the basis for the system of risk accounting described in the paper.
Both papers can be purchased from the Social Science Research Network website here.