THE FIVE CHANGING FACES OF RISK

As the liquidity crisis of the last year shakes the very foundations of the financial industry, most agree that managing risk is part of the problem and key to a solution. Significant changes are expected, but little is known about what they could actually consist of.

Thomson Reuters has identified five key areas of changes that are naturally derived from the ongoing analysis of the crisis and of its roots. Risks, such as market or credit risk, do not change in nature but evolve with the instruments and the purposes that they are used for. The way we manage these risks, however, will be entirely different in the future. Risks are interrelated to one another. In most cases, it is the value of the firm - through the validation of its balance sheet - which is at stake. Liquidity is the ultimate reward or punishment for the sound management of the other risks combined. Therefore, liquidity risk emerges as the ultimate operational risk across departments, firms, sectors and even across borders by the regulators themselves.

These five changing faces will elevate risk policies to strategic priority, executed as a corporate culture hinging on risk management techniques dynamically implemented throughout the enterprise. For clarity, we define the key areas of risk as follows:

1. Valuation risk stands for managing market and credit risk as a whole after it appears a firm's credit exposure depends on the assessment and transparency of the market risks carried by its counterparties and, reciprocally, that cross-asset strategies have turned credit risk exposure into direct market risk for others. Whether it is about measuring collateral value, reporting portfolios' net asset value (NAV), assessing counterparty exposure or allocating capital, the risks related to data management, models and valuation processes are the true drivers of both market and credit risk exposures.
2. Liquidity risks have become a key factor of concern. Volatility, liquidity and correlations define the backdrop for valuations, sensitivity and tail risks. It's comparable to trying to experiment a chemical reaction in an unstable environment. The three can no longer be seen as standalone sensitivities to be managed: volatility, liquidity and correlations impact each other in a three-dimensional fashion, with highly non-linear and rather unpredictable interdependencies.
3. Settlement risks are being revisited after the crisis highlighted that risks can no longer be seen or managed in isolation at any link of the financial system chain. Failures or even delays in settlement or payments are credit events and have direct implications on credit spread, ratings, valuations, reputation and shareholder value. With 50% of trades going over-the-counter (OTC) combined with the multiplication of cross-asset, absolute return and arbitrage strategies, it has become essential that brokers, prime brokers, custodians, market-makers and administrators share the same definitions of instruments, events, data, protocols and remain able to settle trades independently of the legal frameworks they originate from.
4. Regulatory risks have been pointed out as some systemic risks have arisen from leading entire industrial sectors towards a narrow choice of models and uniform hedging tactics.
5. Risk policies will now be defined and implemented by all firms as part of their business strategy. To be sustainable and truly protect shareholder value, these strategies need to be aligned with each firm's culture, capabilities and true appetite for risks. Firms may choose to expose themselves to risks they cannot really manage or embark on inappropriate hedging strategies or risk diversification they cannot fully control.