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Although the benefits of a consolidated, or firmwide, system of risk management are widely recognized, financial firms have traditionally taken a more segmented approach to risk measurement and control.
The cost of integrating information across business lines and the existence of regulatory barriers to moving capital and liquidity within a financial organization appear to have discouraged firms from adopting consolidated risk management.
In addition, there are substantial conceptual and technical challenges to be overcome in developing risk management systems that can assess and quantify different types of risk across a wide range of business activities.
However, recent advances in information technology, changes in regulation, and breakthroughs in risk management methodology suggest that the barriers to consolidated risk management will fall during the coming months and years.
In recent years, financial institutions and their supervisors have placed increased emphasis on the importance of consolidated risk management. Consolidated risk management-sometimes also called integrated or enterprisewide risk management-can have many specific meanings, but in general it refers to a coordinated process for measuring and managing risk on a firmwide basis. Interest in consolidated risk management has arisen for a variety of reasons. Advances in information technology and financial engineering have made it possible to quantify risks more precisely. The wave of mergers-both in the United States and overseas-has resulted in significant consolidation in the financial services industry as well as in larger, more complex financial institutions. The recently enacted Gramm-Leach-- Bliley Act seems likely to heighten interest in consolidated risk management, as the legislation opens the door to combinations of financial activities that had previously been prohibited.
This article examines the economic rationale for managing risk on a firmwide, consolidated basis. Our goal is to lay out some of the key issues that supervisors and risk management practitioners have confronted in assessing and developing consolidated risk management systems. In doing so, we hope to clarify for a wider audience why the ideal of consolidated risk management-which may seem uncontroversial or even obvious-involves significant conceptual and practical issues. We also hope to suggest areas where research by practitioners and academics could help resolve some of these issues.
The approach we take is to review the arguments made by supervisors and the financial industry in favor...