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Friday, March 07, 2008

Risk Management During Recent Financial Market Turbulence

Via email:

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.

    Posted by on Friday, March 7, 2008 at 12:15 AM in Economics, Financial System | Permalink  TrackBack (0)  Comments (12)


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