Risk Management: One Institution's Experience

Abstract

I am very pleased to be part of this forward-looking conference on developments in capital regulation. Because the purpose of capital is to support risk, I decided to approach this session from the viewpoint of someone leading an institution that depends, for its success or failure, on how well it manages risk. My plan is to take you through my experiences at Chase Manhattan Corporation and to close with some thoughts on the implications of these experiences for capital regulation in the twenty-first century. What I am going to describe to you is a dynamic approach to risk management, though not a perfect one. We continually make improvements, and we need to. Nevertheless, if I look back on the last six months--and the Asian crisis that has dominated this period--I would argue that never during this time did I feel that we had failed to understand the risks we were facing. In addition, I feel fairly confident that our regulators have a reasonably good understanding of the systems we use, and that, in the event of a crisis, these regulators would have access to daily information if they needed it. Let me speak for a minute about market risk. There has been considerable discussion at this conference about the limitations of the value-at-risk approach to risk measurement. This approach is, of course, imperfect: it is built on the same kinds of assumptions that we all use routinely in our work. In my view, value at risk is important, but it cannot stand alone. At Chase, we calculate our exposure to market risk by using both a value-at-risk system and a stress-test system. These systems apply to both the mark-to-market portfolio and the accrual portfolios. We use this combination of approaches to set limits on the risks we undertake and to assign capital to cover our exposures. We came into 1997 with five stress-test scenarios built into our systems: the October 1987 stock market crash, the 1992 exchange rate mechanism crisis, the March 1994 bond market sell-off, the December 1994 peso crisis, and a hypothetical flight-to-quality scenario. We are currently expanding this set of scenarios to include four new prospective scenarios. In developing at least three of these four, we will have to use our judgment to predict how currencies, interest rates, and markets would be affected. By contrast, in the case of four of the five scenarios now in use, we already know the outcome. Our risk limits in 1997, and certainly into early 1998, have been set by assessing our risks against these stress scenarios and the value-at-risk system. In fact, in the last year, the balance between the two approaches to risk management has probably moved more to the center. In any case, this combination of approaches has enabled us to manage market risk successfully. Now, turning briefly to credit risk, let me review how our institution handles it. First, at Chase, we monitor individual transactions from several angles. We examine not only how the transaction is structured but also how it measures up against our lending standards. In this regard, an independent risk-rating process for applying and verifying risk ratings--one that is entirely independent of the units that actually carry out the bank's business--is an essential part of the credit review process at Chase. We also decide, at the time of the transaction, which credits we plan to hold in our portfolio and which we plan to sell into the market. Finally, we determine the contribution that each transaction makes to the overall risk of the portfolio because that contribution forms the basis of the capital allocation process. Second, we identify and control credit risk by looking carefully at portfolio concentrations. Many of the crises of the 1980s--the real estate crisis, the savings and loan failures, the debt buildup in developing countries--can be traced to a failure to monitor portfolio concentrations. Recognizing these concentrations--for instance, by industry or by country--is a key element of understanding the true risks of the credit portfolio. …