Both art and science - risk management in the 21st century

At a seminar hosted by the City University of Hong Kong and Riskmetrics Group, Riskmetrics' CEO Ethan Berman outlined his vision of what risk management was in today's volatile market, with a special focus on banks and their changing regulatory concerns.

Berman, an alumnus of JPMorgan's groundbreaking risk management group, began by saying what most in the financial market already knew – that finance these days is all about managing risk. And in Asia, the main risks that banks face are credit risks and operational risks. "The real challenge [for Asian banks] is not about creating the mathematical models, but rather to put in place a credit culture that moves away from relationship banking to economically-based banking," he says.

This is a refrain known to most in the Asian banking fraternity, but it is a movement that will become more important when the dictates of the BIS's recent Basle Accord become enforced. Under this accord, banks will have to risk-weight their lending according to new criteria such as credit ratings, rather than follow the strict ratios that the BIS set down back in 1988.

Berman points out that many banks are already managing their credit risks through the use of credit derivatives and models because, "there is already a significant discrepancy between regulatory capital requirements and economic capital requirements these days". As the requirements shift, there will be a big need for banks to manage their risks – market, credit and operational – in a much more fundamental way than they have done before.

To this end, risk management will become much more than just the mathematical models devised by PhD's. It will involve more fundamental credit analysis as well as a deeper understanding of banks' operational risks – or how they interact with clients. To provide a road map for this change, Berman told the seminar about the nine principles of risk management that Riskmetrics Group has devised and which he urged all banks to adopt:

1. There is no return without risk;

2. Be transparent – all risks need to be known to be understood;

3. Seek experience to manage risks;

4. Know what you don't know as no model is perfect;

5. Communicate – share risks and knowledge of them across your organization;

6. Diversify – don't put all your eggs in one basket;

7. Show discipline in risk management and you will outperform over time;

8. Use common sense as it is better to be approximately right than precisely wrong;

9. Get a risk rate to measure your risks.

In Berman's view it is not enough to have all the best software and cleverest derivatives structures on the market. If bankers do not have that sense of the intangible, risks can never be fully understood and hence never properly managed. While these principles are obviously very worthwhile, it is surprising that Riskmetrics should choose to outline them rather than its own mathematical models.

The company was set up by JPMorgan's risk management team in the mid 1990s to firstly monitor the bank's own internal risk positions. It was then spun off from the bank in 1998, so that it could serve other clients as well. Now it runs sophisticated software tools for its clients, which include half the world's central banks as well as companies, banks, investors.

Of its 500 institutional clients, 50% are non-US and 15% of the total are from Asia. It has recently signed up its first corporate client in Hong Kong - Hong Kong Exchanges and Clearing - and last year quadrupled its business in Asia.

Berman puts the success of the company in Asia down to the increasing understanding of risk management as a concept as well as the ever-improving sophistication of Asia's banks. He also thinks that the creativity shown by the software programmers in companies such as Riskmetrics is where the true art lies in the modern financial world. He should know – before being a risk manager, Berman was a playwright.