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 r