Credit risk is a critical factor for capital markets firms as it directly affects their ability to manage potential financial losses stemming from defaults or failure to meet obligations. However, complexity within these organizations often hampers the assessment and communication of credit risk. In this blog post, we will explore the significance of understanding credit risk, examine two key drivers influencing it, and highlight how the Risk Cockpit can help firms achieve cohesive risk management.
Understanding the Drivers of Credit Risk
Capital markets firms often face challenges in comprehending the two distinct drivers influencing credit risk and how they interact with each other. This lack of clarity makes it difficult for firms to accurately assess and communicate their credit risk levels while aligning them with their risk appetite. These two drivers are:
1. Variation in Credit Risk Profiles
The credit risk profiles of different desks within an organization significantly impact the overall risk faced by the firm. Inadequate visibility of this relationship impedes effective control as firms are not able to identify the source of their credit risk and so do not make conscious decisions to operate at a given level of risk. By unknowingly operating outside of their risk appetite, firms can suffer from unexpected losses.
2. Control Failures
Three examples of potential control failures that we see firms actively managing are:
a) Inability to calculate margin requirements due to system issues:
Flaws or limitations in the systems used can compromise the firm’s ability to assess and manage credit risk effectively. Alternatively cyber-attacks can result in systems not being available leaving firms flying blind if adequate controls are not in place.
b) Trading limits misalignment with client capital:
Inconsistent or inadequate alignment between trading limits and client capital can lead to situations where positions are not adequately covered, increasing the potential for financial losses. In the most extreme situations, this can even lead to harm to the market
c) Ineffective management of intraday margin changes:
Changes in intraday margin requirements by counterparties can result in exposures that are not promptly communicated or passed on to clients. Failure to manage these changes effectively not only contributes to credit risk but also increases liquidity risk within organizations, as highlighted by the Financial Conduct Authority (FCA).
Understanding Credit Risk through the Risk Cockpit
To address the complexities associated with credit risk assessment, capital markets firms can leverage the Risk Cockpit. The Risk Cockpit allows organizations to track credit risk both at the corporate level and individual desks. By leveraging heatmap functionality, risk management teams can identify and understand the key drivers of credit risk. This enables them to communicate the current credit risk level and associated drivers to the board with confidence, facilitating informed decision-making.
Mitigating Credit Risk | A Case in Point
Consider a firm that identifies high credit risk due to ineffective trading limit controls. Recognizing the potential harm this risk poses to the market, the firm decides to invest in enhancing its trading limit controls. This strategic decision reduces the potential harm associated with this specific credit risk. The firm needs to track the implementation of this control, understanding the cost, quality and time associated with implementation to ensure that it is effective. Once implemented the firm needs to track the effectiveness of this control to ensure that they continue to operate at their desired level of credit risk. The Risk Cockpit supports this workflow from the identification of an issue through to the mitigation.
The Power of Cohesive Risk Management
Credit risk is a critical factor that capital markets firms must diligently address. Recognizing and comprehending the complexity inherent in these organizations is essential for accurately assessing and managing credit risk. By leveraging the Risk Cockpit and adopting a cohesive risk management approach, firms can effectively monitor and communicate their credit risk levels, align risk appetite, and make informed decisions to mitigate potential harm. Ultimately, understanding credit risk empowers capital markets firms to navigate the intricate landscape of the financial industry with confidence.
Contact us to find out more about how we can help you manage your credit risk