Refocusing Your Risk Models

Coverage of the 2010 Risk Management Conference.

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blurry road lightsAs pensions review their plans and positioning in the wake of the financial crisis of 2008/2009, risk management has gained in importance and now looks to become a more central element of their process in future work.

The crisis exposed unforeseen potential dislocations in portfolio construction and unexpected changes in risk characteristics that forced pension plan sponsors to broaden their focus from specific tools and metrics to seek a fuller understanding of all the risks they face in managing both assets and liabilities.

Limitations in many of the tools used by risk managers were highlighted and nimble managers were able to identify and exploit many of these limitations. Shared risks and crowded exposures in quant funds and beyond, hidden leverage and optionality in products and plans, these and similar risks were hard to identify and measure and risks that are difficult to measure are difficult to manage. Participants who were able to identify these risks as their importance grew were better able to neutralize exposures before material damage was done.

In light of this, plans and risk managers are focusing on a number of new fronts. Many institutional investors became somewhat complacent, neglecting to adequately stress test, and failing to anticipate the way risks could deviate from risk management models. The models aren’t broken, but they must be adjusted to absorb some of the key lessons of the past two years, such as the need to define short to medium-term liquidity needs and the fact that excess leverage can shorten time horizons. Similarly, sponsors must better recognize that risk budgets must be based on liquidity needs and liability structures and that it is unwise to follow the crowd and discount the downside of leverage, illiquidity and equity and credit risk.

This increased concern indicates that risk management will be handled differently in future. We clearly need to become more sophisticated at modelling so that we better understand the component parts of a portfolio both qualitatively and quantitatively. We must be prepared for much more nuanced conversations about risk management with our strategic partners. We need to hire smart and experienced risk managers, people who have grown up in the field, and we must develop scalable and flexible portfolio management structures that can adjust to multiple risk management models.

Equally, risk management structures must be characterized by transparency, partnership and communication. By definition, these are also essential qualities of managers. Above all, there must be sufficient oversight, partially to ensure proper compliance, but also to ensure that organizations are fluid and able to both recognize and reconcile different types of risk.

Ian Baker is vice-president, derivatives and risk management, Pyramis Global Advisors.

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