In the wake of the credit crisis of 2006-2010, it is more obvious to the management, boards, and shareholders of major financial institutions that the legacy silo approach to risk management systems and risk management organization was simply ineffective in preventing the failure of some of the world’s most prominent financial institutions. A fully integrated enterprise risk management capability, which combines credit risk, market risk, asset and liability management, liquidity risk, performance management, and capital allocation, exists today. This integrated enterprise risk management technology operates at the individual transaction level to assess risk accurately from the bottom up for every organizational unit and for the firm as a whole. This blog presents a simple 10 point quiz that indicates whether your firm’s primary risk system is capable of playing this role.
1. Is your primary risk system capable of simulating default/no default for every reference name on the balance sheet at the transaction level for all types of reference names (consumer, non-public firm, public firms, sub-sovereigns and sovereigns)?
Yes
No
2. Is your primary risk system capable of simulating random movements in default probabilities for every reference name as a function of time and any user-defined macro-economic factors, like home prices, stock index levels, interest rates, unemployment, growth in gross-domestic product, foreign exchange rates, gasoline prices and oil prices?
Yes
No
3. Is your primary risk management system capable of calculating a default-adjusted market value for every asset and liability, on balance sheet or off balance sheet, at the transaction level, regardless of whether that transaction is traded (i.e. has an ISIN or CUSIP number) or non-traded?
Yes
No
4. Is your primary risk system capable of calculating these market values at a large (up to 99,999 for example) user-defined set of future dates in a random interest rate environment where interest rates are driven by 6 or more risk factors (the minimum number of interest rate risk factors required by the Basel market risk rules)?
Yes
No
5. Is your primary risk system capable of calculating cash flows produced by every transaction in every scenario for every one of the user-defined cash flow periods for liquidity risk assessment?
Yes
No
6. Is your primary risk system capable of calculating GAAP interest income, interest expense and amortization (if any) for every transaction in every scenario for every one of the user-defined accounting periods?
Yes
No
7. Is your primary risk system capable of a dynamic Monte Carlo simulation of alternative value-at-risk measures, recognizing that the balance sheet is constantly evolving instead of being static (the legacy VAR assumption)?
Yes
No
8. Is your primary risk system capable of aggregating these calculations to produce (for every user-defined business unit, portfolio subset, and for the institution as a whole) the mark to market value of the organization, its GAAP net income, its GAAP balance sheet, its dynamic value at risk, and its aggregate net cash flow? (Note: These calculations should be available in every scenario in every user-defined period)
Yes
No
9. Is your primary risk system capable of predicting the probability that the institution will fail to meet its target capital levels (whether on a regulatory or mark to market basis) in every one of the user defined calculation periods?
Yes
No
10. Is your primary risk system capable of calculating the probability of default of the institution in any one of the user defined calculation periods?
Yes
No
Rating Your Primary Risk System
A firm’s primary risk system can be ranked by how many of the ten questions above were answered with a “yes.” The ranks are as follows:
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5 or Less
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Unacceptable. The primary risk system is not capable of meeting even a limited number of the objectives now demanded as part of regulatory capital guidelines and stress tests, and it would not meet the basic corporate governance standards at a sophisticated organization.
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6-7
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Good. The primary risk system being used is not bad, but substantial improvements to the risk system are necessary and these improvements are likely to be time consuming and costly with no guarantee of success.
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8-9
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Very good. The primary risk system being used is close to the state of the art.
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10
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Congratulations. You are using a state of the art risk management system, most likely Kamakura Risk Manager. Stay tuned for even more dramatic advances in the years ahead.
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This ranking of risk systems cuts to the heart of what distinguishes integrated enterprise risk management best practice from legacy silo risk applications. There are hundreds of other questions that can be added to this list. For assistance in preparing a request for proposal that will clearly identify a state of the art risk system, please contact my colleagues at info@kamakuraco.com.
Donald R. van Deventer
Kamakura Corporation
Honolulu, April 10, 2012
© Copyright 2012 by Donald R. van Deventer. All rights reserved.