A survey conducted by the Risk Management Association (RMA) in conjunction with Deloitte, the business advisory firm, highlights many banks are making progress managing wrong way risk (WWR) – but nearly a third make no effort to monitor it.
The RMA and Deloitte surveyed 56 of the association’s largest members including banks, brokers and investment firms and found:
• About two-thirds of the institutions surveyed had encountered substantial difficulties improving the measurement, monitoring and management of wrong way risk. These challenges were not limited to smaller institutions, and the survey highlighted that a number of sophisticated, top-tier financial institutions still had a long-way to go developing their WWR management capability;
• One-third of surveyed institutions said no effort was made internally to monitor or measure WWR as it was not considered important to their operations;
• Two-thirds of surveyed institutions said the management and measurement of WWR remains a manual task that is heavily reliant on scenario analysis and expert judgement;
• Management attitudes to WWR vary widely across the industry and, despite widespread acknowledgement of the importance of the issue, the survey found that the sophistication of approaches towards WWR varied significantly.
Wrong way risk is defined as the risk that exposure is adversely correlated with the credit quality of a counterparty. It is becoming more important to risk managers and regulators following high-profile defaults that have occurred since 2007, and increased volatility in investment markets.
Vishal Vedi, Capital Markets Partner at Deloitte, said:
“While many banks have made substantial progress improving their management and measurement of wrong way risk since the beginning of the financial crisis, the survey shows that this masks large differences across the industry. Those institutions that were quickest to react tended to be those who had advanced model approval for counterparty risk, and were under pressure from regulators to make near-term improvements to their management and measurement of WWR.
“A small number of institutions prioritised competing risk management and other pressing regulatory issues over WWR remediation efforts. A substantial minority of surveyed institutions simply do not recognise it as a material risk to their operations, and have made no effort to develop their capability. This divergence of attitudes towards WWR across the industry is symptomatic of the complex and institutional-specific nature of WWR, which does not lend itself to a one size fits all approach.”
Fran Garritt, Associate Director of Market Risk at RMA, said:
“The latest Basel III framework introduces a series of changes to better address wrong way risk. This includes a requirement to calculate future exposure under stressed market conditions, and a conservative measure of ‘exposure at default’ where specific wrong way risk has been identified. Against this backdrop of regulatory change, we expect a sharper focus in future on how banks measure, monitor and manage wrong way risk."
RMA made available a full report of the survey results to participating institutions and an executive summary will appear in the October 2012 issue of The RMA Journal.