Risk Management During Recent Financial Market Turbulence

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What Went Wrong...and Right, by Athenian Abroad: The Federal Reserve Bank of New York released an extremely interesting report today. Written by the Senior Supervisors Group (comprised of financial regulators from France, Germany, Switzerland, Britain and the United States), "Observations on Risk Management Practices During the Recent Market Turbulence" (pdf) analyzes the performance of eleven major banking and securities firms in the period prior to and during the subprime crisis.

In the pleasingly genteel language common to bank regulators the world around, the report delivers an unfailingly polite, yet devastating, critique of the "everyone was doing it" defense. Simply put, some institutions implemented responsible and sophisticated risk-management practices and successfully avoided the worst of the crisis. Others...well...others [messed] up. The report examines what worked, what failed, and why.

The following particularly caught my eye:

At firms that performed better in late 2007, management had established, before the turmoil began, rigorous internal processes requiring critical judgment and discipline in the valuation of holdings of complex or potentially illiquid securities. These firms were skeptical of ratings agencies' assessments of complex structured credit securities and consequently had developed in-house expertise to conduct independent assessments of the credit quality of assets underlying the complex securities to help value their exposures appropriately. [...] Subsequent to the onset of the turmoil, these firms were also more likely to test their valuation estimates by selling a small percentage of relevant assets to observe a price or by looking for other clues, such as disputes over the value of collateral, to assess the accuracy of their valuations of the same or similar assets.

In contrast, firms that faced more significant challenges in late 2007 ... generally had not established or made rigorous use of internal processes to challenge valuations. They continued to price the super-senior tranches of CDOs at or close to par despite observable deterioration in the performance of the underlying RMBS collateral and declining market liquidity. Management did not exercise sufficient discipline over the valuation process: those firms generally lacked relevant internal valuation models and sometimes relied to passively on external views of credit risk from rating agencies and pricing services to determine values for their exposures. Given that the firms surveyed for this review are major participants in credit markets, some firms' dependence on external assessments such as rating agencies' views of the risk inherent in these securities contrasts with more sophisticated internal processes they already maintain to assess credit risk in other business lines. Furthermore, when considering how the value of their exposures would behave in the future, they often continued to rely on estimates of asset correlation that reflected more favorable market conditions.

In other words, all of these firms had sophisticated analytical capabilities, but only some actually chose to use them. Others didn't bother, preferring to rely on third-parties (like ratings agencies) and optimistic assumptions until it was too late.

It gets better:

An overarching difference is apparent in the balance that senior management achieved between expanding the firms' exposures in what turned out to be high-risk activities and fostering an appropriate risk management culture to administer those activities. [...] For example, firms that experienced material unexpected losses in relevant business lines typically appeared to have been under pressure over the short term either to expand the business aggressively, to a point beyond the capacity of the relevant control infrastructure, or to defend a market leadership position. In some cases, concerns about the firms reputation in the marketplace may have motivated aggressive managerial decisions in the months prior to the turmoil. [...]

[S]enior management at ... firms that recorded relatively large unexpected losses tended to champion the expansion of risk without commensurate focus on controls across the organization or at the business-line level. At these firms, senior management's drive to generate earnings was not accompanied by clear guidance on the tolerance for expanding exposures to risk. For example, balance sheet limits may have been freely exceeded rather than serving as a constraint to business lines. The focus on growth without an appropriate focus on controls resulted in a substantial accumulation of assets and contingent liquidity risk that was not well recognized.

So it wasn't just fecklessness that led firms to over-rely on ratings agencies, etc. It was a conscious decision at the executive level to ignore risk and pursue short-term profits.

There's more:

A second difference noted by our supervisory group concerns the role that firms' senior managers (including its chief executive officer, chief risk officer, and others) played in understanding the emerging risks and acting on that understanding to mitigate excessive risks.

The senior management teams at some of the firms that felt most comfortable with the risks they faced and that generally avoided significant unexpected losses ... had prior experience in capital markets. Consequently, the nature of market-related events over the summer of 2007 played to their experience and strength in assessing and responding to rapidly changing market developments and issues such as uncertainty in valuations. As risk issues were identified and brought to the attention of senior managers, executives in many of the firms that avoided significant losses championed robust and timely risk mitigation efforts, including executing hedges, deciding to write down exposures, and enhancing management information systems.

In contrast, some of the executive leaders at firms that recorded larger losses ... did not have the same degree of experience in capital markets and did not advocate quick, strong, and disciplined responses.

This is about as close as a multi-national panel of financial regulators will ever get to saying, "Bumbling rubes somehow got control of major banks...and lost billions!"

But the bottom line isn't simply that bumbling rubes lost billions; it is that some but not all of these institutions were mis-managed in this fashion. That is, there was nothing "inevitable" about the chain of events leading to the sub-prime meltdown, and the risks really were apparent to those who cared to look for them.

Comments

[blam]

"As risk issues were identified and brought to the attention of senior managers, executives in many of the firms that avoided significant losses championed robust and timely risk mitigation efforts, including executing hedges, deciding to write down exposures, and enhancing management information systems."

Many firms ? From my perch, the biggest of the many were and are playing both sides against the middle. Creating and selling toxic shit to customers and the market while simultaneously shorting the same is not risk management, it is criminal fraud. And where were the regulators ?

The reason this financial disease will damn near kill many markets before the cure is the level of absolute denial, even at this late date.

[Market Forces and Regulation]

Deregulation of FDIC insured banks appears to be a failure. Market forces cannot work to purge poor business plans in this industry. Widespread bank failure would be bad for the economy, so bad bank business plans are routinely bailed out. In private industry, bad business plans lead to bankruptcy, which efficiently removes bad business plans from the system.

FDIC insured banks should be tightly regulated as to what they can do. Under this plan, if someone wants to start a non insured private bank to market exotic products, feel free. It will have to raise money privately though, based on its sound business plan. The FDIC will not cover depositor losses. It will not be bailed out if it fails, because exotic products are not essential to the economy. Only the tightly regulated FDIC insured banks would be essential to normal functioning, so only they would be regulated and bailed out. No incomprehensible exotic products for them. Less potential profit, but that is the price for insurance and bailouts.

[Farrar]

Contrast Citigroup and JP Morgan. Strange that the cultures in these two haven't changed all that much in the last 40 years.

[Lafayette]

France reported today that the total loss of French banks in the sub-prime mess amounts to 11B euros, which is likely to be one of the lesser amounts in the matter.

French banking is typically conservative. So much so that the Miliken Institute ranked it 20th amongst countries worldwide in terms of ease of access to credit.

Guess who was tops in the list. Just one guess ...

[hari]

Mark -

The upshot of this dismal risk performance by established banks has given EU Financial Group the initiative to go further and officialy investigate how the securties (SIV/CDO) Ratings was actually done and reported to purchasing agents...who passed it on.

The objective is to est transparency of Rating Agencies.

Last few days Spiegal had a lengthy interview with Ackermann/Deutsche Bank in which he claims to reading about the stuff in Spiegal Magazine when on vacation in Ticino (Swiss/It boarder) and recognized anamolies and got ahead of the curve ---although he also reported loses in 2007.

[a]

"There was often a naive (or perhaps more accurately, an unduly optmistic) use of VAR."

Give me an effing break. It's the regulators who thrust VAR down our throat. There was nothing better to measure the risk in my department than a good ol' minus x% scenario on the markets, with 100% correlation. That gave a pretty good idea of the over-all riskiness of the position. But no, the regulators needed a magic number which was "the same" across all banks, to determine the amount of regulatory capital needed. And they fell upon VAR, with the connivance of certain American IBs, who had already instituted this measure.

The regulators have to face up to their responsibilities. Either they accept that they need to be able to understand a bank's books, or they don't. Up to now they have chosen the latter. So we have an incoherence in that there are some banks which are too big too fail. Yet their regulatory capital, which is meant to prevent failure, is based on a VAR system which apparently the regulators now realize is completely flawed and which was chosen so that regulators would not have to understand a banks' books.

If some banks are too big to fail, then surely it is up to the regulators to determine how much capital these banks need to hold. If the regulators have any job, then surely it is that. And if it is up to the regulators to determine this number, then surely it must be based on a sensible system, which would preclude VAR.

Let us see now how serious these hypocrites in the central banks are. Regulatory capital for credit and operational risks is about to be determined by Basel II, which uses essentially the same VAR system as for market risk. Will these regulators assume their responsibilities and junk Basel II? I don't think so.

[a]

To put it as simply as possible, since regulators use VAR to determine the amount of regulatory capital, who has been naive and overly optimistic?

[Lafayette]

anon: Will these regulators assume their responsibilities and junk Basel II?

And replace it with what?

Damn few people on this planet understand national accounts completely from country to country world-wide, and Basel 2 at least attempts to provide such a standard.

In its absence, you would suggest what? If you don't have a reasonable alternative, then what have you?

Just blather ...

[oops]

could everyone execute these hedges? maybe a few large banks got them off but i'd like to see what it did to prices of the hedeges. if every bank tries to buy the needed amount of default swaps wouldn't the cost shoot up like a rocket?

i'd like to see what DB's hedging did to the price of default hedges and just how deep the market for them was.

[a]

"In its absence, you would suggest what?"

Duh, we already have a system now, which generally requires more capital than Basel II.

[dancing fool]

“When the music stops, in terms of liquidity, things will be complicated. But as long as the music is playing, you’ve got to get up and dance. We’re still dancing,”

[Lafayette]

df: "But as long as the music is playing, you’ve got to get up and dance. We’re still dancing,"

Yes, but they shoot horses, don't they? ;^)