Models are playing greater role in senior management actions. While arguably all the models in a firm influence management process, in certain cases the senior management is essentially a direct user, utilizing model generated results to make high-level decisions or developing policies formulated in the form of mathematical models. The role of models in valuation, in particular those involving complex products, has been well discussed. Theory and assumptions underlying the models greatly influence valuation and subsequently items such as net income and asset size. This in turn influences management's assessment of a business. Faulty models or their incorrect usage can skew management's view and ultimately their decision making.
This article highlights other instances in which the models play an important role in organizational management. The increasing role of models in management process also pose challenges to the functions such as risk analysts within audit that examine the models. These are discussed later in the article.
Model Usage By Senior Management
i) Assessing risk profile
Senior management examines risk numbers to determine if the organization's risk profile is in sync with the broad business strategy, or if the current exposure is within the organizational risk appetite. Depending on the purpose, management may review portfolio risk measures, such as Value at Risk or product specific risk measures including option Greeks and credit spread sensitivity. As is well known, the risk measurement process often involves sophisticated models.
An incorrect management understanding of the risks can lead to poor decision making. For instance, if management erroneously believes that the exposure to a particular country has exceeded the threshold, they could decide to pull back when in reality there may still be room for further business.
The risk reporting process for senior management should highlight the major areas in which the potential loss is large enough to adversely effect the items senior management is typically concerned about: earnings; liquidity; credit ratings; etc. Whenever applicable the risk measurement should also take into account corporation's standards--for instance, one firm may calculate VaR at 99% confidence level while another firm may choose 97.5%. Additionally, the reporting process should convey the limitations of risk numbers especially in the circumstances under which the numbers cease to be reliable.
ii) Capital management
Senior management is constantly monitoring how the capital of an organization is used, what returns are generated, or how the individual businesses are faring on a return of capital basis. This often creates the need to allocate capital to the individual businesses or to assess the adequacy of financial capital. Economic capital process is one of the tools utilized to accomplish these purposes.
The economic capital may be viewed as the amount of capital required to adequately cover the risk exposures and is typically determined through risk models. Usually it is assessed for various forms of risks, such as market risk, credit risk and operational risk. Total economic capital is the aggregation of these different forms of capital. If there is no explicit allocation of financial capital to a business, economic capital may be used as a proxy for the equity being utilized. When there is explicit allocation, the adequacy of allocated capital may be assessed by comparing it with the level of economic capital.
The economic capital models may be viewed as consisting of two components: conceptual and organizational. The conceptual component comprises the underlying risks and the theoretical framework used to assess the amount of capital. The organizational component includes any management goals or objectives particular to a firm. For instance, a firm seeking to accomplish a particular rating may choose to allocate credit risk capital at a level where probability of loss exceeding the capital is equal to the default rate associated with the rating. For an economic capital methodology to succeed, both components should be addressed.
iii) Developing levers to influence behaviors
Senior management is always looking to influence businesses behavior in the interest of shareholders and in accordance with the company's strategy. Some of these ways could involve mathematical models.
With the growing emphasis on risk discipline, firms could incorporate risk in the performance measures of its businesses. For instance, they may use aggregate economic capital for the equity component in measures such as return on equity or economic value added with the intended purpose to motivate businesses to utilize risk and by extension firm's capital optimally. Also, the net income portion itself may include charges or credits designed to influence business behavior. For instance, management may choose to assign reserves against illiquid trading positions in order to persuade the traders to be more vigilant.
The senior management may also influence behavior through control measures of a quantitative nature. An example is establishing limits. The limits are typically used as a control measure against excessive risk exposure and their implementation could involve sophisticated models since risk measurement involves the use of models. The limits, however, may also be used as a strategic tool to check or encourage business activities. If the management wishes to reduce its involvement in a certain business, it may set narrow limits and vice-versa.
For a quantitative parameter to serve the purpose of directing behavior, the items that go into its calculation should be under business control so the business can influence the value of the parameters through its actions. Also, the quantitative measure should be well understood by the affected groups. Whenever applicable, the measure should not conflict with the industry measures that external parties, such as investors, use to assess a business.
iv) Others
There are other instances in which the management may use models, for example a one-off analysis of a potential acquisition. These one-off models should also take into consideration the firm's strategic criteria. In the example of an acquisition model, if the firm uses EVA as one of its performance measures, the model should assess the EVA implication of the possible purchase.
In some cases, the use of a model may not be so evident. For example, a merger transaction may include an option to modify the terms of a transaction if the stock price of the acquirer falls below a certain value. Such clauses have derivative-like features and consequently lend themselves to analysis through derivative models.
Challenges To The Model Examination Functions
The increasing model use by senior management poses additional challenges to the functions, such as risk analysts within audit that study the models and explore ways to improve their efficacy. A previous article (DW 9/15) discussed risk analysts function in detail and also outlined items that should be in place for a particular model to be effective. In the case of 'management models,' there is an additional strategic dimension and the functions examining the model need to be aware of that.
These functions should combine a big-picture view with detailed technical concepts, understand the broad organizational strategy and the criteria management uses in its decision making. They should be able to comprehend the role of a model in the strategic process and identify the elements within the model as well as in the overall implementation setup essential to filling the intended purpose.
The role of models in the management process is likely to continue growing. The increasing use of models has been driven by ongoing innovations in financial products and advances in modeling of different kinds of processes (most recently operational processes). The trend is likely to continue for foreseeable future.
This week's Learning Curve is written by Udayan Srivastava, v.p. risk analysis & audit at JP Morgan Chase in New York. The author thanks Alexander Hatzopoulos, managing director general audit, for his comments.
