Risk management has significantly improved in the past decade, an evolution that was further accelerated by the 2008 global financial crisis.
The types of risks present in financial markets have also changed and the professionals who focus on risk management are now asked to do much more. More importantly, investors have come to realize that enhanced risk management has become an inherent part of their strategies.
"Risk management was bolted on, but that's changed," said Arvind Rajan, Managing Director and Head of Quantitative Research and Risk Management at Prudential Fixed Income. "In many shops that take risk seriously, it's in-house and built into the investment process." Rajan added that risk management has gone from being "a nice thing to have" to "indispensable."
Additionally, the old focus on how to calculate risk needs to be supplemented by paying close attention to messages sent by financial markets. "The feedback loop was inadequate," he noted. "Risk management was poorly responsive to new information." Rajan said that some risk management models failed to properly address risk, especially when they relied on insufficient historical data.
The types of risks have also changed. While credit risk used to be the main risk in emerging markets and interest rate risk used to be the main risk in the developed world, developed nations are now plagued by credit problems, especially sovereign credit, while interest rate risk is now a major focus in emerging markets. "Emerging markets and developed markets have basically switched places," Rajan said, adding that it has prompted a greater emphasis on sovereign and credit risk in Europe and even in the U.S.
Other growing risks in the wake of the 2008 financial crisis have been coming from the regulatory and political arenas. In the wake of every crisis, there's an effort to make sure problems encountered during a crisis don't recur, usually in the form of new regulations and legislative changes concerning the structure of financial markets. But new regulations can increase other risks, impact transparency, and spur unforeseen consequences on asset values. These effects are especially visible today in securitized markets as well as with the valuation of financial institutions, which are being forced to make significant changes to their business models and balance sheets. These types of risk aren't amenable to quantitative models. Instead, managers need to pay close attention to changes in the legal and regulatory landscape.
As a result of this changed profile of risk management, risk management professionals have also had to adapt. The quality and the number of risk managers has increased as crises have occurred more frequently during the past two decades, according to Rajan. He explains that in the past, the typical risk manager was someone smart at modeling, implementing technology and monitoring risk. Nowadays, experts in risk management are market professionals, often from the front office. "The quality and the type of professionals needed has changed," he said.