New York – RiskMetrics continues to execute a major roll-up in the research/risk management industry, with the announcement that it has reached agreement with Ed Altman to produce a state-of-the -art credit risk model. While RiskMetrics has a VAR-based Credit Risk service, the goal is to augment this with additional capabilities and more forward looking credit risk assessments.
RiskMetrics has developed services to address a large proportion of the risks facing investors, banks, market makers and corporations. They have three main practice groups, including Risk Management, Financial Research and Analysis and Governance Services. In total, the categories that fall within these practice areas are Accounting Risk, Regulatory Risk, Legal Risk, M&A Risk, Reputational Risk, Corporate Governance Risk, Environmental and Social Risk, Fiduciary Risk, Compliance Risk, Portfolio Risk, Credit Risk and Market Risk.
Credit risk is most simply defined as the risk of financial loss because of counterparty default (i.e. failure to live up to contractual obligations). It has a number of moving pieces. The first piece is called default risk and is measured by assessing the probability that the counterparty will default. The second is credit exposure risk, which is the risk of fluctuations in the market value of the claim on the counterparty (e.g. bond price) at default. This is also known as exposure at default. Third, is recovery risk, which is the uncertainty that is associated with the portion of the claim that could reasonably be recovered in a default.
Credit Risk has traditionally been the domain of the credit rating agencies, such as Standard and Poor’s, Moody’s and Fitch. These firms have traditionally looked only at the first element of the credit risk exposure that is the probability of default. After the recent credit crisis, these ratings agencies were criticized for being slow to react to the changing market conditions. Part of the problem was that the credit reviews took a substantial amount of time and energy by both the ratings agencies and the company’s management and were therefore backward looking assessments of the credit situation of the firm.
Altman is one of the leading lights in credit research, having published and lectured extensively on the subject as the Max L. Heine Professor of Finance at NYU’s Stern School of Business. One of his early findings was Altman’s Z-Score, which was a quantitative method to determine default status of a firm. The Z-score is estimated by regressing a variable, which takes a value of zero or one, on a number of financial ratios for individual firms. The findings were quite predictive and became a useful tool in determining the status of firms and their risk of default.
Recently, Ed Altman has developed scoring systems that work for small and medium sized enterprises, for emerging markets, estimate corporate default recovery rates and analyses of firms in Chapter 11, to name a few.
As stated above, Riskmetrics already has an extensive credit risk module which includes data and applications that clients can use to assess credit risk. The Altman alliance will add to this battery of weaponry specifically by trying to create a more forward looking or proactive credit monitoring system as compared to most current analysis which tends to be more reactive in nature.
It is clear that RiskMetrics is very serious in its quest to become the central source of analytics, education and applications covering all areas of financial risk management.