OK – bit of a sensationalist headline, but the point I would like to make here is a valid one. The current drops in the markets can easily (and correctly) be put down to a big failure in risk management – in one or more of credit risk (for the institutions originating the loans), market risk (for companies buying the dodgy paper) and operational risk – where the institution’s systems simply miss the risks involved.
Each of these can, and have, resulted in poor management or trading decisions, resulting in losses.
The point I would like to make here, though, is that these errors in risk management should become less likely over the next few years as the larger banks increasingly use their advanced risk management systems to genuinely allocate capital based on risk across their groups. A large bank here or there may get it wrong, but these sorts of systemic frights should become less likely.
Current Position
The problem at the moment (under Basel I) is simple – a housing loan is a housing loan is a housing loan. There is no difference in treatment between a loan secured by residential real estate where the loan to valuation ratio (LVR) is 20% and the borrower has many times the income to pay the mortgage off and one with an LVR of 80% and the borrower has bearly enough income to cover the repayments and feed the kids. Given the risks in the second one the bank has to price it higher than the first.
The incentives for banks chasing high returns, therefore, is to load up on poor quality, but high-paying, debt. The costs before you consider credit losses are the same. If you consider credit losses unlikely then you can load up on these – and even start dropping the price to sell more.
Effects of Basel II
Why do I consider that this will be less likely in the future? The answer is simple. Basel II forces the banks going advanced to consider, and price, capital for credit losses explicitly. The models being used to do this need to have at least seven, more normally as much as ten, years worth of data, covering at least one credit cycle.
The smaller ones, going standardised (or, in the US, staying with Basel I) will be in the same space they were before – so they will still be originating the loans – but most of them rely on funding from the bigger banks through securitisations, so the funding should cut off before the number gets too large. A few of them may go due to poor lending practices, but the big ones should not be at risk.
So – this should be the last great risk management failure.
Note the use of “should be” – rather than “will”. I need to manage my own risks.
4 comments
13 August, 2007 at 16:13
Saso
I’ve been wondering the same myself, and the more I think about it, the more I get the feeling that this may just be the signs of things to come. I have a feeling that the ‘sub-prime’ market fallout is a result of risk management techniques becoming too sophisticated for us to keep a track of.
After all, ‘sub-prime’ bottom fell off a few months before first hedge funds reported problems, and we’re still unsure of the total exposure to it. I think with all the smart risk exposure ‘slicing and dicing’ that is going on right now, we have lost track of who is actually exposed to the risk, and how much of it. Banks have created smart risk management tools to – supposedly – minimise their exposure, but have forgotten that all this sophistication inevitably brings complexity. And complexity is hard to manage.
As you already said, what Basel II brings is clarity of vision. Banks have been too busy devising new financial tools and risk management approaches with similarly sophisticated tools to miss the most basic of all risks – what you don’t see coming is what is going to bite you in the end.
13 August, 2007 at 20:50
Penguin
My contrary view (at least to your headline): many if not most major financial services risk management failures (eg HIH, Barings, NAB’s FX scandal, etc) seem to be operational risk. While holding capital against op risk under AMA will hopefully encourage better risk management behaviour (not cutting costs in a way that increase op risk, for example), the calculations are manipulatable enough that I’m reserving judgement until I’ve seen the behaviour in action.
Last great credit risk management failure – possibly. I’m not sure that I know enough about it, yet.
13 August, 2007 at 21:35
Andrew
Penguin,
This is at least a little bit of stirring. In this instance, though, and unusually, I think that it is mostly credit or market risk. Ops risk will bring down one small to medium institution – as you noted. It is wide-spread credit and market risk that will cause this sort of wave.
That’s why I think the disclosures have to be improved. Institutions still try to get away with the regulatory minimum – to me, beating that minimum by a wide margin is behavior to be encouraged.
15 August, 2007 at 11:00
Steve Edney
Andrew,
I think you are overly optimistic. While Basel II may well shut the gate on these particular practices inevitably the industry will find new structures instruments and investments that it won’t cover well and there will be yet another such crisis. I think its just part and parcel of doing business. I don’t think any codified system of regulation is going to stop that, only active individuals in Risk management actually engaging with trading practices and critically examining what is going on can keep it in check in a timely fashion. Those without it will get caught up eventually.
Not that I think Basel II is worthless, but its hardly a panacea for risk management.