Risk groups produce tons of pertinent information that can be used by portfolio managers to generate superior returns, says a recent report from Woodbine Associates. Yet, because risk management is often viewed purely for control or regulatory purposes, a lot of great information that is produced is simply overlooked and wasted.
Risk management groups that calculate VaR for regulatory and/or control purposes also produce a host of timely information that could benefit groups charged with investment return generation, writes Jerry Waldron, director of risk and portfolio analytics at Woodbine. “But in firms that treat risk management as a control function, this information is walled off from the investment process. The result is missed opportunities – day after day after day.”
The risk management function aimed at regulation misses the upside opportunity in its focus on potential loss, he added.
“Return distributions need not be symmetric and due to sound portfolio construction frequently display positive asymmetry. In our example below, the return distribution displays positive asymmetry in that there is a 5 percent chance of a 22 percent return, compared to a 5 percent chance of a 19 percent capital loss.
“The 95th VaR loss of 19 percent enters the regulatory capital adequacy framework. However, the equally likely 22 percent return frequently does not enter into the investment process.”
Waldron said that improved organization and communication between the risk management group and the investment units could overcome this.
The question is also one of culture, Waldron said.
“What are you running the organization for — compensation schemes, mark to market, P&L or for the shareholders? The front office guy says I can put money on the table right now, and risk management said it is a long-term problem. The front office guy wins. You take the money upfront.”
It’s hard to change the culture of a bank, he added. “If they didn’t change after the chaos of 2008, it’s a long haul to get them to use all the information embedded in the risk management function.”
Investment firms are letting regulators drive the process and the focus is on when do firms need to inject capital.
“There’s a whole industry of models to minimize regulator capital rather than focus on good business.”
Indeed, at a risk panel I covered at SWIFT Sibos conference in Dubai a few weeks ago, a couple of risk managers from banks asked why they didn’t push back harder against regulators, or work together to make regulation more rational. One of the issues they complained about was zero tolerance rather than risk-based compliance which would admit that some errors would occur. Zero tolerance was driving banks out of some businesses, and the business was moving to less regulated firms or going underground, neither outcome exactly what regulators had in mind.
Waldron said that hedge funds have a mix of approaches. Some are becoming more like banks and do risk as a check-box for regulators, but others have skin in the game and use risk for economic gain.
“Giving regulators what they ask for, banks are also silo-ing risk management so it doesn’t overly constrain the business, but then it doesn’t improve the risk/return investment decision.”
VaR doesn’t address which business decisions help a firm generate capital more efficiently. Many banks, however, calculate VaR and report it to regulators, but the risk department isn’t looking at how to generate internal capital efficiently. ????IS THIS RIGHT?
“Risk management can be seen as the control panel of a race car,” Waldron added. “You can move aggressively and safely, but if you think of risk management as just brakes, you have a problem. Risk people contribute to the problem by focusing on the wrong issues for the business. They look at fat tail distribution, but that’s not what the front office needs to focus on. Although regulators are very interested in what the tail looks like, they aren’t interested in which distribution generates capital internally in the best manner.”
The information is there for the asking, added Waldron.
“The information can be developed by risk functions but it is not being requested and risk management doesn’t present it well. Risk management has been siloed into a control function, so the information isn’t designed to help decision-making.”
He blames the senior people at the banks, because they are the ones who have decided that the risk function is oriented toward regulation rather than business.
Banks are spending a lot on risk, and their exclusive focus on regulation is costing them.
“Financial institutions are not getting what they paid for from their risk management functions,” his report said. “This failure is largely a reflection of the perception that risk management is a control function more focused minimizing regulatory capital than providing investment value. This perspective is unfortunate and need not be the case. The analytical framework and infrastructure necessary to satisfy regulatory requirements also can be used to improve the investment decisions at no additional cost.