When to Practice Risk Management

The contrast between the REMIC and the commercial bank is stark. The debt and equity claims that both the REMIC and the commercial bank issue are risky in almost any sense. Yet, in the case of the REMIC, investors buy the instruments and seldom hold the intermediary accountable for their performance. The trustee monitors the service and foreclosure firm for a fee but is not held liable for market performance. Theoretically, the REMIC is the ultimate passive intermediary. Conversely, active management is critical to the commercial bank’s activity. The bank originates and manages illiquid assets whose values in the open market are imprecise and over time. Unlike the REMIC, the bank has no predetermined life span or constraints on asset replacement.

Differences between Institutions

The difference between a REMIC and a bank is the transparency or permanency of each organization’s investor interests. An investor in a REMIC can obtain a very detailed description of its assets, contracts, and payment schemes for regular interests. The rules for operation are quite clear. Thus the many unexpected events that severely affect the REMIC’s value do not lead to questions of confidence or competence on the part of the trust.

In a typical, actively managed financial firm, however, such information is only available to managers because of the uncertainty concerning the economic value of financial claims. Either because of product tieins, as in insurance products, or because of ambiguity in underlying asset value, pricing these assets and therefore shareholder value is problematic for the intermediary. In addition, the extent of dynamic asset change and the rules followed for such portfolio adjustment are rarely communicated or subject to monitoring, due to the features of the assets held.

We can generalize from the distinctions between these two institutional types by imagining principal financial institutions arrayed in a two-dimensional space in which one axis measures how transparent its actions are to investors and the other axis measures how actively its investments are managed . For simplicity, institutions are either transparent, translucent, or opaque in information and either active or passive in operation. Discretionary risk management activity is concentrated in the actively managed, opaque institutions, clustered in the top right corner. On the other hand, transparent institutions with rather passive investment strategies are in the lower left. In these institutions, rules substitute for management.

There are also institutions at the other extremes. In the upper left are the actively managed institutions such as open-end mutual funds, which are fully transparent but actively managed in a manner clearly defined by their prospectus. These institutions limit risk management to eliminating unnecessary risk. They shed nonessential risk at the same time that they seek those risks essential to the value-added activity. At the other extreme are agency mortgage pools, which flourish only with implicit government guarantees. The opaqueness of these portfolios makes the institutions’ asset value uncertain, and only through credit enhancements can the investor be convinced of the timeliness of future cash flows.

Institutions can also flourish inside this two-dimensional space, labeled translucent, because some information is available, but it is often not timely or wholly credible. At institutions in the vertical, intermediate range, a substantial amount of energy is spent communicating with stakeholders and presenting clear statements of investments or investment policy. These actions are attempts to clarify the institutions’ positions and perhaps move them into the transparent area.

Fees associated with intermediation services tend to correlate with the extent of active management. For example, index funds generally carry lower management fees than either actively managed investment funds or depository institutions. In part, this is because the latter have higher operating costs associated with more portfolio transactions and a higher turnover rate. However, this is also due to the presumed greater value added that the managers provide. They have discretion because of their expertise in the chosen market and their associated reputation for above-average performance and skill in active risk management. In essence, one value-added activity that managers perform is to control risk at the firm level in order to increase portfolio value to stakeholders.

Written by Dr. Chao Yuang Shiang (趙永祥 博士)