Weaving an integrated solution

A treacherous credit environment and growing awareness of the danger of credit and market risk correlation have convinced financial institutions that they need to evaluate these exposures together. To get a unified view, will they need to adopt unified risk technology?

The need to integrate credit and market risk analytics has become widely accepted since the financial shocks of the late 1990s. The Asian, Brazilian and Russian, crises taught dealers and investors that looking at market risk in isolation could prove disastrous. In many cases, credit and market risks turned out to be correlated. More recently, the decline in corporate (and some sovereign) credit quality and the increase in the complexity of credit instruments and credit risk mitigation tools have reinforced this view.

To get an effective unified view of market and credit risk; ideally institutions need something more than two systems working alongside one another. They need a methodology and technology infrastructure that can calculate and integrate market and credit exposures. Suppliers of risk management systems want to provide the building blocks for such an infrastructure - the tools necessary to measure individual risk factors, and the methodologies and applications to consolidate the measures into a unified view.

"It's easier to add on credit risk analytics to a market risk analytics engine than it is to bring market risk analytics into a traditional credit risk system." says Alex Tsigutkin, president of New York-based Axiom Software Laboratories. But the market risk system must collect data at a sufficient granular level to include counter party information.

"Because pure market risk systems don't need counter party information, early systems tended to not collect this data and used consolidated position-level information, rather than transaction- or contract-level information, in the interest of efficiency. Unless the data management elements of such systems can be amended to incorporate counter party details, it will not be possible to extend them to incorporate credit. The first requirement of a system that aims to integrate market and credit risk is a data platform that collects all relevant information - transaction or contract details and market, reference, credit ratings, etc." Axiom's Tsigutkin says.

A consensus is emerging among suppliers that the only way to properly integrate market and credit risk is to have unified technology architecture with a common data platform and a single risk engine. The data platform must be able to collect, standardize and consolidate all transaction or contract data, plus market and reference information, in order to provide consistent source information for all calculations. At the same time, the risk engine must provide consistent calculations (with consistent assumptions on things such as interest rate movements), including valuations and risk measures, for all analysis.

But such an approach can present a considerable technological challenge. To begin with, the underlying architecture must be right, and several suppliers have had to fundamentally redesign their systems as they have attempted to integrate market and credit risk. Furthermore, the calculations can require enormous computer resources because of factors such as the complexity of instruments in the trading book, the size of commercial and retail portfolios, and the multiple repetitive calculations so that certain factors, such as the values of individual instruments, can be calculated once but used many times across portfolios and scenarios.

Several risk management software specialists have formed alliances with suppliers of large-scale hardware and operating environments, such as IBM and Sun Microsystems, to optimize their software to run on the top-of-the-range systems.

"Our customers are looking to integrate market and credit risk, but have not yet achieved that, which is not unusual in the industry," says Tsigutkin. "Market and credit risk departments are traditionally separate, and first the institution must establish a common responsibility for them."

With the integration of market and credit risk frequently referred to as the holy grail of risk management, and with institutions beginning to create the required organizational structures while technology suppliers build the frameworks and tools for combined risk analysis, it might look like the end is in sight. However, a growing number of people are looking beyond the present horizon, and suggest that the integration effort is only just beginning.

- By Clive Davidson

Reprinted with the permission from Risk Publications • Risk • June 2002