Taking Some Of The Risk Out Of Risk Management

Two providers of risk-management software, J.P. Morgan Chase and SunGard, are turbocharging their offerings to tackle the increasingly sophisticated computational tasks of analyzing risk.

J.P. Morgan Chase this month introduced MorganRisk, a portfolio risk product that enables buy-side firms, such as asset managers, pension fund managers, insurance companies, and broker-dealers, to employ the same risk-measurement methodology that J.P. Morgan uses internally. It's scheduled to be available in July. SunGard unveiled plans for an integrated suite of trading and risk-management solutions employing state-of-the-art technology.

MorganRisk provides libraries of historical pricing data that, combined with J.P. Morgan's risk-modeling system, provide businesses with a statistical measure of risk. The libraries were compiled by J.P. Morgan Chase's predecessors, J.P. Morgan and Co. and Chase Manhattan Bank, and combined when the two merged in 2000.

The data are reflective in quality of a $755 billion-asset money center institution, says Ann Hitchman, product manager of MorganRisk. Unlike other products, which tend to be on "the academic side," MorganRisk "was developed by traders for traders," she says.

MorganRisk tracks risk for a cornucopia of financial instruments: equities, equity derivatives, fixed income, vanilla interest-rate and foreign exchange derivatives, commodity derivatives, and mortgage-backed securities. The coverage will be expanded later to include non-vanilla derivatives.

J.P. Morgan Chase's Investment Banking and Investor Services divisions developed the product jointly. "Both of those groups were getting requests from clients, so they got together and developed MorganRisk," Hitchman says.

The product addresses two major components of risk management: value-at-risk and stress testing. Value-at-risk (VaR), is a measure of exposure to fluctuations in interest rates and other forces, expressed as the maximum amount of losses that a portfolio can sustain over a given time period within a given statistical level of confidence. For example, a one-day VaR of $2 million at a 99% level of confidence means that there's less than a 1% chance that a portfolio could lose more than $2 million to market forces in a single day.

Stress testing is a method for measuring a portfolio's ability to withstand abnormal market shocks, such as the Sept. 11 terrorist attacks. Financial institutions are required to maintain high quality in both the data and statistical methods used in VaR and stress testing.

VaR calculations typically employ one of two methods: variance-covariance and historical simulation (a third method, Monte Carlo simulation, is also sometimes used). Historical simulation, the method used by MorganRisk, incorporates historical swings in prices to arrive at a likely value for the portfolio. The MorganRisk VaR "is a historical simulation that we've developed over the last five years," Hitchman says. "It keeps the numbers fairly stable."

RiskMetrics, a New York firm that was part of J.P. Morgan before being spun off five years ago, employs the variance-covariance method, in which correlations in prices of various asset classes, such as stocks and bonds, are used to predict portfolio values, as well as the Monte Carlo and historical-simulation methods.

The RiskMetrics spin-off provided the impetus for J.P. Morgan to switch to historical simulation, says Rich del Mastro, technology manager for MorganRisk.

J.P. Morgan will deploy the MorganRisk product on WebLogic, an application server product from BEA Systems Inc. Clients will feed information on their positions electronically to MorganRisk, which will perform all the necessary analysis.

The increasing sophistication of risk analytics calls for greater processing capacity, notes del Mastro. "We're now using the same pricing models used by the front-office traders, and that's where you see the need for high-performance computing."

Meanwhile, SunGard has announced that it's moving all of its risk products onto a single platform composed of Intel-based processors and Microsoft's .Net software environment. The new platform enables customers to carry out risk management and trading tasks more efficiently, according to Don Wood, chief technology officer of SunGard Trading and Risk Systems, New York. The platform also employs XML, a standard method for defining data elements within documents. "The use of XML means that selected components will interoperate seamlessly," Wood says.

The computer-intensive nature of risk analytics was captured in a benchmarking test performed by SunGard last year at Microsoft's UK Center in Reading, England. Using three single-processor machines, SunGard processed approximately 12,000 new deals per hour and completed end-of-day processing in 2-1/2 hours. For each deal, the processing involves updating approximately 50 portfolio credit exposures and performing limit checks against them. Test designers constructed a 500,000-deal portfolio spanning 2,000 counter-parties, 24 primary currencies, 16 countries, 27 cities, and five industries.

The J.P. Morgan and SunGard announcements come as financial institutions prepare for Basel II, a set of regulatory proposals due to go into effect in about two years. The proposals, from the Basel Committee on Banking Supervision, cover three broad categories or "pillars"--capitalization, supervisory methods, and disclosures. Together, they form the biggest overhaul in bank regulations since 1988.

The Federal Reserve, which is responsible for implementing Basel II in the United States, has recommended that it be limited initially to the largest banks. "Our best guess is that 10 or so banks will choose Basel II capital requirements in this country in the first round," Roger Ferguson, vice chairman of the Federal Reserve Board, said in a June 10 speech to the Institute of International Bankers. "As time passes, additional larger banks, responding to market pressures, will opt for Basel II."

In deciding whether to adopt Basel II, Ferguson noted, banks will be influenced by two factors: the bottom line and their reputations. "The decisions of these banks will reflect their perceptions of self-interest," he said, "from either their implied new capital charges under Basel II, or the message they want to send about their risk-management techniques."