Improving financial service risk management tools and practices are among the top priorities of institutional investors. There are many types of risk and they constantly change. Investors have the responsibility to take full charge of measuring, managing and monitoring risk. These tasks cannot be simply outsourced without understanding the context of the current environment. It requires thoughtful analysis by portfolio managers in collaboration with risk management professionals who are familiar with the strengths and weaknesses of risk models.
In order to create a robust investment financial service risk management framework, follow the key principles of investment in risk management.
Balance quantitative with qualitative assessment. Combine broad portfolio level controls, most of which are quantitative, with a deep qualitative understanding of the distinctive risks at the security level. Do not blindly follow expert opinion or statistical models.
Understand risk systems and measures limitations. Determine the strengths and weakness of financial service risk management models. Understand the environmental influences along with its potential risks. Be open in adapting and reacting when models break down.
Employ various risk measures and perspectives. Scenario analysis and stress testing are a great component to more traditional financial service risk management. Utilize these features to explore both known and unknown risks. Consider preparing for dealing with future shocks, and not merely anticipate future shocks. Force portfolio managers to think through low probability or highly adverse effects.
Incentivize long-term performance. Align compensation with incentives in financial service risk management. Also, create proper balance between risk controls and risk appetite, long term and short term performance, and firm-wide and individual objectives.
Integrate financial service risk management into investment. Create a detailed understanding of the investment process, build trust, get buy-in and make financial service risk management a part of the culture with the oversight of the senior management. Portfolio manager are more receptive to a team that is considered as risk management resource, risk budgeting, performance analysis, portfolio construction and providing input to investment strategy, than they are to a team considered to be risk enforcers. Disciplined internal control processes should also aid integrate risk management into the daily activities of money management.