24 October 2014

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It's Risk Jim, But Not As We Know It

04 March 2014  |  723 views  |  0

On 27th February 2014, the National Aeronautics and Space Association (NASA), in a joint mission with the Japan Aerospace Exploration Agency (JAXA) , launched the Global Precipitation Measurement Core, a satellite based observatory designed to provide next generation observations of global snow and rainfall.

 The parallels between space exploration and risk management are many and varied, and a mission designed to track precipitation and increase the predictability of global weather patterns is especially apt in this regard. What may be most interesting is how the changing role of NASA and that of its astronauts mirror the changing roles of risk and risk managers, as both find themselves in times of flux and uncertainty. 

Today NASA finds itself in an unusual situation, with the end of the Space Shuttle program (2011), characterized by low orbit missions to the International Space Station or the Hubble telescope, and the development of the Space Launch System (2017), intended to send manned missions to the moon and Mars.

In the meantime, NASA astronauts are ferried to the space station, when required, aboard the Russian Soyuz ships. What this highlights is the changing skill set of a successful NASA astronaut: from the test pilots of the 1960s to the engineers of the 1970s, scientists of the last 30 years to the survival specialist pioneers of the near future. These changes are consequential of the known capability versus the immediate ambition of the space agency. In short, they reflect NASA’s risk management strategy.

The role of the risk manager within a financial firm, particularly around derivatives, has evolved in a very similar fashion. From quantitatively modelling risks, monitoring systems, and interpretation and execution of regulatory requirements, to a future state of active risk management in a very different context than what has traditionally been the case.  In the recent past, there have been some significant market changes that have forced a re-evaluation of which risks are monitored and how they are managed.

First is the blurring of the distinction between the buy and sell sides of the capital markets. The credit/liquidity crisis challenged the concept that the traditional buy-side, made up of pension funds, hedge funds and institutional asset managers, represented the bulk of the credit risk. It is commonplace to find sophisticated approaches to credit and counterparty risk management within these funds, as concentration risk, systemic credit risk and potential future exposure of market counterparties now represent a very real risk to businesses.

At the same time, larger U.S. banks are under pressure to limit risk taking activities, driven by the Volcker rule, the increased cost of collateral and central clearing and counterparty concentration limit rules. Therefore more emphasis is being placed on de-risking their overall operations as they return to core banking businesses. This switch in risk focus is seeing some risk managers move from the sell side to the buy side, and a dramatic increase in the systems and approaches to credit risk that presents a short-term challenge for portfolio managers, risk departments and senior management alike.  This trend is further complicated by market conditions that have left many pension funds under-funded, with increased derivative use seeming a viable option to solve that problem.

Risk management in banks has moved from a front-office support function to a capital calculation of market risk, achieved increased sophistication on the credit risk side, become a C-suite influencer of risk appetite, and gained a regulatory compliance role in today’s new world where regulatory readiness is paramount. At the same time, buy-side risk management has moved from benchmarking and P&L attribution to more active risk management using VaR modelling of portfolios versus benchmarks, with an increasing appetite for counterparty credit risk. The skill set of risk managers in these institutions has evolved within this shifting context.

A modern risk manager, particularly on the buy side, is as different from their recent predecessors as is a modern astronaut, training to survive long-term in an environment where assistance from mission control is just not an option.

One of the chief reasons for change is available technology. In both cases, technical advancement in turn leads to greater technological ambition, forcing a need for ever more technical operatives. In the case of NASA, the shuttle allowed for a greater utilization of the International Space Station, which in turn ran more elaborate science experiments. Now that rockets are being developed that can take greater payloads, Mars missions are again on the agenda, leading to a need for risk mitigation on a huge scale.

In financial firms, technology leaps have allowed for complex derivatives to be priced and run through internal systems, leading to a rapid increase in complexity. Risk managers have had to evolve into IT-savvy operatives with a full understanding of quantitative methods and trading strategies.

Finally, but perhaps most importantly, both financial organizations and NASA have learned that data quality underlies all else. Subpar data leads to unreliable results and, at best, a false sense of security where the firm may be underfunded from a capital buffer standpoint. Similarly, quality data, from soil make up to atmospheric weather conditions, are the essential start points of any NASA mission.

So, as NASA and JAXA launch from the Tanegashima Space Center, we should keep an eye open to a future where technology and solid risk management could fuel a derivative trading operation on the Red Planet.

TagsRisk & regulation

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