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Risk Management; a whole new ball game

We all thought we knew everything about risk and wow has that assumption been shot to pieces in the credit crunch. Virtually every bank in the world has spent an incalculable amount of money on their risk systems but when it came to the crunch they were proved to be almost worthless.

It makes you wonder how could we have got this so wrong and how can the markets put better systems in place to prevent any reoccurrence?

Risk systems are all built on measuring current situations against similar occasions in the past. The risk models indicate more than dictate actions that can be taken. It is hoped that no bank operated purely on their risk models but it is certain that many were confused by the reality of what was happening in the markets, impacts on the economy and the subsequent reactions of governments. For example no system or model would have included worldwide government intervention in financial markets and part nationalisation of banks. You would not have dreamt this, let alone foreseen it.

Based on recent knowledge the banking risk systems now all need recalibration to a new benchmark and although this will do nothing in today's environment, it will be the start of building a more resilient risk model for the future.

What's also clear is the risk models have not gone deep enough into derivative and OTC products, based on a broad industry perspective. The absence of central banks in taking early action in the crisis can be forgiven as the situation was confusing and the depth of the disaster unknown. However, this will not be the case in the future.

The rebuilding of the global financial markets must include a collaboration of central banks getting much closer to the investment banks and their products. New assessments of collateral valuations have to be included in the risk model. The banks must not be prevented from innovating new products but possibly a higher margin could be required to cover any short positions. Naked shorts by banks should be banned and left to companies that have the ability to manage this position. A vital new risk measurement should be created to ensure liquidity is maintained within markets and also within various different market verticals. After all, markets dry up fast without liquidity and this is clearly a lesson to be learned from the credit crunch.

The banking system is currently in a perilous state but will recover providing we fully understand what went wrong and actively put in place risk models that are deep rooted and cover all areas of markets and products. Risk today is a completely new ball game and we must start again and hopefully, this time, get it right!     

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Comments: (2)

A Finextra member
A Finextra member 30 October, 2008, 09:55Be the first to give this comment the thumbs up 0 likes

An interesting insight which has made me return to a theory I held strongly at the turn of the Century. Risk management systems are designed to disguise, not illuminate. The more complex the instrument being tracked, the more complex the system pricing and revaluing the instrument seems to be. Such systems should inform, not hide, otherwise the more senior the management, the less they know, instead of the other way round.

The cost of those systems, and the bonus paid to those buying them, was directly porportional to that complexity. The effect of this 'law' was to drive the innovators into inventing more and more complex instruments until we arrived at off-balance sheet instruments which had no hope of ever generating, or even represent, a real cash flow - except that generated when they were bought and sold.

The marketeers of systems to this environment went along with the myth that complexity means profitability for obvious reasons. but then the music stopped and we can look back and ask "who fooled who?".

A Finextra member
A Finextra member 30 October, 2008, 11:02Be the first to give this comment the thumbs up 0 likes

Thanks for the comment Hal and your spot on

Gary Wright

Gary Wright

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BISS Research

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