Post-crisis regulations have increased capital adequacy and transparency requirements, forcing financial institutions and pension funds to extensively de-risk their portfolios. Robust risk frameworks are needed to ensure risks are well-managed across all assets as balance sheets undergo reductions to meet capital rules, while maintaining revenue. Effective risk management requires frameworks incorporating ownership, integration, alignment, transparency and engagement to allow de-risking strategies to meet regulatory demands while facilitating business needs.
RISK-ACADEMY’s guide on risk appetite in non-financial companies. Free download
Portfolio Risk Challenges
1.
The
raft
of
post-‐crash
capital
adequacy
regulations
and
demands
for
increased
transparency
mean
that
banks,
pension
funds
and
trading
desks
-‐
some
in-‐house
at
large
treasuries
-‐
are
having
to
carry
out
extensive
de-‐risking
exercises.
The
increased
reporting
requirements
should
theoretically
make
it
easier
for
treasurers
to
assess
bank
and
counterparty
exposure
risk,
pension
exposures
and
other
risks,
but
is
this
happening
in
reality?
A
risk
management
protocol
is
essential
to
be
able
to
tell
and
to
ensure
best
practice.
With
the
majority
of
financial
institutions
and
regulated
pension
funds
undertaking
extensive
de-‐risking
of
their
respective
trading
portfolios,
it
is
imperative
that
robust
risk
frameworks
are
in
place
to
ensure
that
all
aspects
of
the
portfolio
are
managed
in
a
transparent
and
efficient
way,
particularly
in
terms
of
asset
diversification.
Financial
institutions'
balance
sheets
are
currently
undergoing
major
asset
reductions
in
order
to
achieve
their
regulatory
capital
requirements,
without
compromising
their
core
business
revenue
targets.
Given
these
regulatory
demands,
it
is
now
more
crucial
than
ever
to
ensure
that
adequate
investment
in
process,
controls
and
systems
is
maintained
in
order
to
achieve
the
accuracy,
timely
risk,
position
reporting
and
benchmarking
for
both
management
and
regulatory
disclosure.
Trading
desks
are
being
assessed
not
only
on
the
revenue
that
they
produce
but
also
on
the
capital
utilisation
being
used
to
achieve
this
income.
This
requires
risk
managers
within
their
respective
organisations
to
work
closely
with
the
business
across
all
risk
functions
and
asset
classes.
They
need
to
analyse
the
specific
concentrations
and
diversifications
in
order
to
determine
the
most
appropriate
de-‐
risking
and
hedging
strategies
to
be
implemented.
This
can
only
be
effectively
achieved
with
the
existence
of
a
comprehensive
risk
framework
that
empowers
policies
to
incorporate
updated
regulatory
requirements
and
the
risk
appetite
of
the
institution.
Risk
Framework
Objectives
The
overall
objective
of
any
risk
framework
is
to
ensure
that
all
regulatory
requirements
are
maintained,
without
impinging
on
the
commercial
needs
of
the
business.
At
the
same
time,
it
needs
to
be
scaled
appropriately
against
the
risk
appetite
of
the
organisation's
board
of
directors.
With
this
in
mind
it
is
important
to
ensure
that
a
'best-‐in-‐class'
risk
framework
is
used
and
to
be
confident
that
this
framework
has
the
ability
to
produce
transparency
and
accurate
reporting
of
the
risk
portfolio.
That
way
an
analysis
of
de-‐risking
strategies
can
be
accurately
carried
out
for
management
consumption.
1
2. An
organisation's
risk
framework
has
to
be
reviewed
periodically
across
both
policies
and
procedures
in
order
to
ensure
that
all
aspects
of
the
business
are
clear
on
the
ownership
of
risk,
along
with
the
governance
structure
and
standards
of
measuring,
monitoring
and
reporting
on
an
accurate
and
timely
basis.
The
delivery
of
an
appropriate
risk
framework
essentially
enables
an
organisation
to
meet
its
regulatory
requirements
while
facilitating
the
business
needs
of
its
trading
desks,
in-‐
line
with
the
risk-‐reward
appetite
in
order
to
achieve
defined
revenue
targets.
The
risk
strategies
and
the
risk-‐bearing
capacity
of
an
organisation
for
the
individual
business
divisions
needs
to
be
consistent
and
continually
developed
as
part
of
an
interactive
process.
The
regulatory
environment
has
matured
considerably
in
recent
years
in
this
regard,
with
organisations
now
required
to
articulate
and
report
on
their
risk-‐bearing
capacity,
risk
strategy
and
risk
appetite
as
part
of
the
Basel
II
requirement
of
the
Internal
Capital
Adequacy
Assessment
Process
(ICAAP).
Basel
III
is
on
the
way
as
well.
The
Core
Principles
of
Risk
Management
The
management
of
risk
can
be
defined
through
the
following
core
principles:
• Ownership.
• Integration.
• Alignment.
• Transparency.
• Engagement
and
approval
authority.
Incorporating
these
principles
into
a
robust
risk
framework
enables
an
organisation
to
de-‐risk
and
manage
its
capital
requirements
across
all
asset
classes
effectively
and
efficiently.
Within
the
risk
framework,
it
is
the
responsibility
of
each
trading
desk,
fund
manager
or
business
area,
which
may
include
some
treasurers
at
advanced
multinationals
that
look
to
profit
from
their
hedging
activities,
to
manage
their
risk
exposures.
Both
the
hedging/de-‐risking
strategies
and
positions
that
they
implement
are
a
fundamental
component
of
ownership
and
responsibility,
providing
the
framework
on
which
a
trading
portfolio
can
be
hedged
or
positions
closed
for
de-‐risking,
on
either
a
micro
or
a
more
high-‐level
management
of
exposures
across
a
business
line.
Ultimately,
the
responsibility
for
implementing
any
de-‐risking
strategy
lies
with
the
individual
business
line
manager
or
fund
manager
on
a
daily
basis,
and
with
central
management
or
the
board
at
the
very
top
level.
The
Fundamentals
of
the
Review
Process
As
part
of
their
primary
function,
risk
managers
should
undertake
a
review
of
the
de-‐
risking
strategies
that
are
being
undertaken,
at
either
a
macro
level
or
business
line,
or
on
a
daily
basis
within
the
trading
group
in
order
to
determine
both
concentration
2
3. and
diversification
effects.
When
performing
such
reviews
of
de-‐risking
strategies,
a
number
of
considerations
need
to
be
taken
into
consideration;
such
as
the
choice
of
instrument,
the
size
of
the
hedging
position,
market
liquidity
and
concentration,
and
the
degree
of
basis
risk
between
the
underlying
and
hedging
instrument,
along
with
timing
factors
for
implementation
of
the
de-‐risking
strategy.
This
is
even
more
relevant
to
fund
managers
where
concentration
risk
in
industry
sectors,
countries
and
counterparties
can
make
de-‐risking
difficult
to
achieve
in
a
short
period
due
to
market
conditions
and
liquidity.
Where
de-‐risking
is
being
performed,
risk
managers
also
need
to
weigh
up
the
individual
capital
impacts
on
credit,
market,
liquidity
and
operational
charges,
along
with
the
diversification
and
concentration
effects
across
the
portfolio
in
respect
of
the
asset
classes.
Where
concentration
risks
arise,
either
as
holding
positions
with
similar
characteristics
to
a
significant
size,
or
an
adverse
development
of
a
limited
number
of
risk
factors,
this
could
lead
to
both
a
significant
loss
and
major
capital
requirement
under
current
regulatory
rules.
Defining
Risk
Appetite
and
Strategy
Given
these
potentially
dangerous
and
unwanted
outcomes,
it
is
important
that
the
appropriate
governance
and
supervision
that
the
risk
framework
provides
is
matched
to
the
overall
risk
appetite
and
strategy
set
by
senior
management.
By
establishing
limits
and
monitoring,
an
organisation
is
guaranteed
the
key
control
and
transparency
needed
to
manage
both
the
portfolio
and
capital
requirements
effectively.
The
use
of
key
metrics,
such
as
economic
capital,
value-‐at-‐risk
(VaR),
stress
testing,
sensitivity
and
position
limits,
credit
and
default
limits
and
concentration
risk,
combined
with
robust,
accurate
and
timely
reporting,
effectively
allows
an
organisation
to
de-‐risk
appropriately.
On
the
reporting
of
de-‐risking
strategies,
such
as
the
implementation
of
hedge
positions,
it
is
important
that
the
calculations
used
in
determining
the
risk
are
easily
decomposed
at
each
stage
of
the
risk
reporting
process
to
give
transparency
and
validation.
Risk
managers
often
request
macro
hedges
to
be
segregated,
to
enable
more
accurate
monitoring
of
the
de-‐risking
strategy
as
well
as
standalone
analysis
to
be
undertaken.
Within
a
robust
risk
framework,
reporting
principles
such
as
standardised
reporting
platform,
materiality
and
relevance
of
reports,
production
scalability
and
flexibility
along
with
infrastructure
enhancement
are
required
to
enable
efficient
risk
management
to
undertake
both
de-‐risking
and
hedging
strategies.
This
has
become
paramount
over
recent
years
with
the
regulatory
requirements
of
both
Basel
II
and
III,
and
the
Capital
Requirement
Directive
(CRD3),
coupled
with
every
organisation
attempting
to
rebalance
their
respective
balance
sheets
by
focusing
on
their
core
businesses.
Don't
forget
either
that
the
final
CRD4
proposals,
associated
with
the
incoming
Basel
III
changes,
are
due
to
be
unveiled
in
Europe
next
year.
3
4. Senior
management
is
now
more
focused
on
analysing
the
drivers
and
diversification
affect
that
macro
hedges
have
across
the
portfolio,
on
the
basis
of
managing
the
risk
weighted
assets
(RWA)
for
capital
efficiency
effectively.
This
has
created
an
operational
strain
on
risk
infrastructures,
in
order
to
produce
and
maintain
transparent
and
accurate
reporting,
especially
for
regulatory
requirements.
This
puts
further
emphasis
on
the
need
for
an
infrastructure
that
provides
timely,
transparent
and
accurate
reporting
of
the
risk
portfolio,
to
support
de-‐risking
decisions
in
an
effective
and
efficient
manner
by
senior
management.
The
steep
demands
of
the
CRD3
changes,
such
as
stressed
VaR
and
incremental
risk
charge
(IRC)
on
a
timely
basis
for
regulatory
reporting,
have
impacted
the
vast
majority
of
institutions.
Their
ability
to
leverage
their
current
risk
framework
is
no
longer
feasible
due
to
capacity
constraints
on
the
systems'
infrastructure.
In
turn,
this
has
dictated
the
need
for
a
greater
integration
of
risk
reporting
within
the
organisation's
hierarchy,
combined
with
the
flexibility
to
undertake
scenario
analysis
to
determine
the
diversification
impact
of
macro
hedging.
Robust
processes
and
systems
are
essential
for
accurate
and
timely
risk
reports,
combined
with
the
ability
for
increased
capacity
of
usage
at
all
levels
of
the
business.
This
requirement
has
necessitated
further
investment
in
the
current
infrastructure,
together
with
ensuring
transparency
of
the
risk
factors
being
used
in
both
VaR
and
economic
capital
calculations,
if
the
de-‐risking
and
capital
management
strategies
are
to
be
effective.
Overall,
it
is
important
that
institutions
have
a
robust
risk
framework
in
place
to
provide
management
and
the
business
with
the
transparency
needed
to
enable
efficient
de-‐risking
to
be
performed.
That
being
said,
the
significance
of
a
robust
systems
infrastructure
cannot
be
underestimated,
complete
with
the
appropriate
controls
and
capacity
to
facilitate
these
requirements.
Only
then
can
it
be
managed
efficiently
with
timely
and
accurate
reporting
in
place.
4