The Future of Risk Management

Ever since the global financial crisis, we at Axioma have been working together with a core group of our clients to address the following critical question: What is the next step in the evolution of risk management?

We began by framing both the situation and the challenge. In the aftermath of the crisis, financial institutions said “never again.” Risk management leaped to prominence. Chief risk officers assumed central roles. Risk departments and processes were beefed up. Oversight was strengthened. Indeed, looking back, it was almost a police-like response: Put more cops on the street, increase surveillance, and let nothing escape the gaze of the risk department.

In the six years since the crisis, however, it has become increasingly clear to our clients and to us that a stronger “policing” function, while enhancing risk oversight, does not necessarily beget better risk management.

One of the obstacles to gaining better control of risk management is the gap that exists between risk departments in their now-strengthened oversight role, and the portfolio managers and traders on the front lines of the investment side. Portfolio managers naturally focus on managing portfolio-level risk. Risk departments, on the other hand, focus on understanding risk across portfolios and reporting a firm’s potential financial vulnerability to regulators, clients, and asset holders, as well as the company itself.

However, to accomplish their respective goals, the risk measurement tools they use are different. Portfolio managers typically use factor-based risk models for measuring and controlling the risk of the portfolios they construct, while risk departments tend to use simulation-based systems to measure risk. These systems are more suited to a broad range of asset types, market scenarios for stress testing, and complex portfolios. Indeed, for portfolios with securities having features such as optionality or path dependency, simulation with full repricing is necessary to truly measure the risk for these non-linear instruments. And herein lies the problem. Because the front office and middle office use different tools for risk assessment, portfolio managers and risk departments do not “speak the same language” when it comes to risk, making it difficult to take an integrated and more constructive approach to risk management.

Yet, there is another even deeper issue here. While the methods used by risk departments can be effective at detecting problems, there may be little they can do about changing the way risk is actually managed. To put it another way, risk management, from the perspective of the risk department, is mainly a diagnostic tool. What it needs to become is preventive medicine.

Finally, there is the proliferation of multi-asset class investing. Asset owners and their managers are increasingly concerned about risk in all asset classes, as well as the interactions of those risks. And that is driving increased demand for more sophisticated risk-management solutions that can measure risk across the full spectrum of assets in a portfolio.

For these main reasons, we, along with our clients, came to the conclusion some time ago that two main things are needed to take risk management to the next level. The first requirement is an integrated approach to risk management that enables risk departments and portfolio managers to work collaboratively in ways that will enhance the effectiveness of the risk-management process itself. Second, in order to achieve that goal, this integrated platform must leverage the best and most sophisticated risk-management tools currently available in both the front and middle office.

Axioma Risk, the next-generation market-risk management platform that we launched in October of 2013, is the product of our efforts and the focus of this issue of Axioma Advisor.

At this point, we can say at least two things with absolute certainty. First, that Axioma Risk is now being put to the test by its initial users — and the response has been positive. Second, that when the next crisis comes, the firms with the most robust risk-management capabilities will be the best positioned to meet the challenge.

Sebastian Ceria