March 2012

RISK MANAGEMENT: Take charge of risks in-house

MousetrapThere are cases when it may be better to build risk systems inhouse, but problems can arise when various systems have to be integrated, finds Nicholas Pratt.

This 2012 Funds Europe risk survey varies from previous years in that we have asked system providers to highlight the risk-based issues that they feel present the greatest challenge for investment managers. These include counterparty risk and liquidity risk, but by far the most commonly cited challenge was the need to provide more transparent risk reporting.

Most risk system providers canvassed have enhanced their reporting capabilities as well as providing more sophisticated analytics to enable risk managers to conduct value-at-risk (Var)tracking, cash-value-added (CVA) calculations, scenario analysis and more intra-day market risk checks that are so necessary. However, ensuring that all of these activities can be done in an integrated fashion across all portfolios does create technical challenges that many firms must solve from within rather than off-the-shelf.

According to Mark Israel, head of the buy-side practice at consultant Sapient Global Markets, it is really a question of architecture. The traditional risk engines are able to provide the foundation of firms’ risk management infrastructures but many of the newer platforms and modules are not meeting managers’ demands. “Where these providers fall down is the ability to integrate their products with the investment management tools used by each portfolio manager. They want to see how the risk breaks down across a portfolio and how they view stress tests and what-if scenarios across a portfolio.”

Consequently, many firms are taking a hybrid approach where they develop their own risk tools and then add some off-the-shelf products.

Israel accepts that such an approach can sometimes get out of hand. Firms can build up a mass of separate systems and this can end up very expensive rather than buying a single source system or enterprise-wide platform as are offered by many risk vendors these days.

But, he says, the key is having the appropriate approach depending on the level of granularity needed. “When it comes to modelling specific risk measures of a single portfolio, this is better done in-house.

However, you can use off-the-shelf products for the less granular functions. For example, you could buy a valuation library off-the-shelf for some linear products but then build a valuation tool in-house for non-linear products.”

As for the cost issue, building in-house is not always more expensive than buying off-the-shelf, especially in the long-term, says Israel.

“Many of the third-party risk systems are priced on a per- transaction basis so the build option becomes less expensive over time. So many are taking a hybrid approach. But, over time, we do expect the vendors to bring their pricing down and be closer to the cost of in-house builds.”

Number crunching
Risk vendors will also get better at providing systems that can be easily integrated with existing in-house systems, but the investment management world does present some extra challenges.

Whereas many sell-side institutions are simply too big and disorganised to get a truly enterprise-wide view of risk, the buy-side has the issue of portfolio managers and the many different ways they work – even within the same firm.

Some will keep everything in their head, some will use an Excel spreadsheet and some will use a team of quantitative analysts – and then there are those that believe no risk system in the world can possibly understand the complexity of their investment strategy.

But this is changing, as can be seen by the example of Franklin Templeton Investments (see page 24) where a deliberate effort has been made to assign risk managers to work closely with their portfolio managers in both a physical as well as a processing sense.

This also reflects the recognition that risk managers will work better if they are embedded into the heart of the organisation rather than siphoned off in an underground bunker crunching numbers, and the same can be said for risk systems. For the vendors, the challenge is to provide systems powerful enough to provide the complex calculations needed that are affordable and easy enough to integrate with core in-house systems.

©2012 funds europe