Risk Management Technology in Financial Services

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4 Integrating risk management

through an enterprise architecture

4.1 Choosing a risk-based architecture

Chapter 1 brought to the reader’s attention that innovation in financial instruments

is welcome, provided management is in control of risk; Chapter 2 presented the aims

of a risk management policy, as well as its means; and Chapter 3 has shown why

exposure associated with derivatives calls for an enterprise-wide risk control system.

A key feature of a solution which is in charge of corporate exposure is that it takes

the risks of every operating unit, down to the level of each individual deal, and rolls

them up through:

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Instruments,

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Counterparties,

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Branches and affiliates,

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Risk factors, and

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Profit targets.

A sound solution will be able to consolidate ad hoc all exposures, new and inven-

toried, according to the way (or ways) in which the bank wants to monitor its risks.

This strategy requires critical top management decisions. One is the limits system

which puts tolerances onto dealings and provides the metrics for risk measurement

in every business line and instrument. The other relates to high technology.

The transition to next generation networks (NGN) is only just beginning. Some

telecommunications industry analysts think that telecoms operators, suppliers and

big user organizations could be redesigning, revamping and restructuring network

infrastructures for the next twenty years.

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Embedding into them pre-qualification criteria for broadband, knowledge-enriched

fault recovery and other advances, and

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Capitalizing on all-optical end-to-end IP systems; a policy that will change the

economics of telecoms and of networks.

For a financial institution, an integral part of the infrastructure will be an enterprise

architecture providing real-time support to all executives, professionals and other

staff. This architecture must incorporate eigenmodels (in-house artifacts specifically

designed for each application; more on this in Part 2), distributed computer power,

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Integrating risk management through an enterprise architecture 61

interactive access to in-house and public databases, and any-to-any communications

linkages.

This enterprise architecture must be designed in-house. It cannot be bought off-

the-shelf. Effective risk control systems are custom-made. An integrated view to risk

exposure should integrate the bank’s strategic plan. This means a solution going well

beyond those classically available:

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Covering every corner of operations, and

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Providing a pattern of exposure which is both holistic and detailed, at any time

anywhere in the world.

Because this pattern of exposure must be kept dynamic, enterprise risk man-

agement means more than a simple corporate-wide summing up of risks. It inte-

grates into it portfolio management, matches assets and liabilities with risks being

assumed, and incorporate tools for prognostication of plausible extreme events. It also

includes tools for experimentation needed to review and re-evaluate strategic priorities

such as:



The choice of business activities to steer the portfolio in a given direction, and

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The development of novel financial instruments able to reshape and rebalance the

company’s risk profile.

Eigenmodels must calculate the change in value of all positions, as a result of new

transactions and market movements. This concept was set out in the 1996 framework

for voluntary oversight by the Derivatives Policy Group, in the US, but the majority

of institutions have not yet implemented it, in spite of the fact that modern technology

offers the tools for doing so.

The concept advanced by this chapter is that eigenmodels should estimate profits

and losses by position in real time; an advance over the 1996 solution of Derivatives

Policy Group for brokerage firms. (The latter had asked for losses to be calculated

over twenty-four-hour and two-week holding periods with a 99 per cent confidence

level.) At the foundation of this method is the establishment of specific core risk

factors, whose notion was introduced in Chapter 2.

An architectural solution for enterprise risk management should integrate all major

classes of risk, targeting limits, evaluating current exposure, incorporating expected

risk events and, most particularly, outliers, targeting wherever and whenever they

happen and indicating where they may show up. As Figure 4.1 suggests, no major

class of exposure should be left out. To accomplish this objective, the system archi-

tecture must be flexible and adaptable to the risk control methodology adopted by

management (Chapter 6).

At the kernel of architectural design targeting a holistic approach to risk control

are simulation and ad hoc experimentation (Chapters 7 and 8). There are plenty

of reasons why the eigenmodels of this architecture must be knowledge enriched

(Chapters 9 and 10). The knowledge content of financial instruments and operations

is steadily increasing, derivatives being an example:

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Software that does not match intelligence embedded in the instruments is worse

than useless, because it is narrow sighted and misleading.