Climbing Out of the Credit Crunch

Risk Identification and Management

Banks have highly sophisticated risk management functions yet recent events have tested them and found many wanting. A report from UBS in April 2008 to its shareholders explaining the reasons for its write–downs provides a very clear example of risk management failings, with a clear disconnect between incentives to senior staff and risk management.

In early 2007, few senior managers thought they were betting on the viability of their banks. It appears they did not understand the risks and were using risk assessment with tools which were inappropriate. Boards may not have expended the necessary time and energy, and/or lacked the expertise to ask the right questions.

There seems to have been widespread misunderstanding about credit ratings. Some investors may have believed that an AAA–rating meant ‘safe’. Others were allowed by their employers to buy AAA–rated instruments with little or no further diligence or consideration of risk. As referred to above, the risks of such an activity were not matched to the incentive system. This meant that traders were able to buy large volumes of mortgage backed security and receive a bonus based on the difference between the yield on the security and the bank’s internally charged cost of funds. There was no downside risk for them individually. The inherent risk to the bank from such a trade was enormous yet was either ignored or not recognised.

Such activity generated a huge demand for AAA–rated securities. Selling derivatives of securities became akin to selling betting slips. Products were created, packaged and marketed which were a ‘bet’ on the performance of the reference assets. Collateralized Debt Obligations (CDOs) were created, in part, because there was an insufficient volume of underlying Mortgage–Backed Security (MBS) origination to meet investor demand. These products relied for their existence on credit grades as there was no claim on the underlying assets in difficult circumstances as there was in an MBS.

In a low inflation environment, banks’ search for increased yield has encouraged derivative trading. Derivative traders are, however, very different from traditional retail bankers, and the chief executives of banks may have lacked the necessary training in these new products. This, accompanied by complexity and volume of transactions in turn facilitated by the continuing increase in computing capacity, meant that traders were effectively allowed to ‘get on with it’ with minimal control from the board. The yields which seemed to be created, aided by AAA ratings, mesmerised top management of many of the major financial institutions. There was not enough questioning about what AAA actually meant.

The way risk is accounted for is a primary driver of capital value. Present prices, showing points (rather than ranges) in time are not a good indicator of future asset values. Many of the risk management tools such as VaR (value at risk) assume that ‘efficient market theory’ works. Efficient market theory in turn assumes a normal distribution around a mean, and does not take proper account of the huge risks posed by derivative market variables which may not move in line with normal distributions.

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