|
By Mel Duvall
Senior executives of the nation's banks and investment firms were blindsided by the subprime mortgage crisis in part because of a failure of their risk management technology, a report released this week by Diamond Management & Technology Consultants concludes.
The report by the Chicago-based firm, which includes a number of high-profile banks and investment firms in its client base, says that executives were shrouded to the aggregate risks they were taking on. Had these executives received and acted upon aggregated risk reports, particularly reports that simulated market stresses across each asset class, there would have been a far greater awareness of how deeply their fortunes were tied to the mortgage business.
Instead, major U.S. banks and securities firms are expected to take cumulative write-downs in excess of $100 billion as the credit crisis unfolds.
"The majority, but notably not all, of decision-makers at the top banks and investment houses simply lacked the depth of information required to appropriately assess the risk of their many investments," says Aamer Baig, managing partner of Diamond's financial services industry practice.
"The growth of complex products directly contributed to the challenges of managing risk exposure."
Diamond concludes that systems and processes at many firms are geared toward older styles of investments, focusing on the collection and management of risk information based on the risk profile of individual investment classes or asset types. As a result, mortgage instruments and equity risks were evaluated very differently, and in a manner that effectively resulted in "silos" of risk information.
Rachel Parker, a partner in Diamond's financial services practice, notes that most banks and investment firms have invested in sophisticated risk management systems. Does that mean the technology failed on a massive scale?
"That's a difficult question. The models themselves ran - the technology behind those models ran the numbers," says Parker. "But was the data that went into the models robust enough to provide the appropriate insight? I'm not at all confident in that. Did they model what was easy to model, or did they model the complex underlying structures?"
In other words, firms should have been re-evaluating how they collected, managed, and analyzed risk information in light of the explosive growth of financially-engineered debt instruments and securities such as residential mortgage-backed securities and collateralized debt obligations.
advertisement
Goldman Sachs is among the few Wall Street firms that seems to have weathered the crisis. It was revealed in December that the firm made a $4 billion profit by essentially betting on the collapse of the sub-prime market. The bet was placed after an analysis of the market showed that a jump in mortgage defaults on high-risk home loans was inevitable, and that in turn would drag down the value of bonds tied to the loans.
On Thursday, TD Bank, which also limited its exposure to the subprime market based on its risk assessment, reported a $1 billion quarterly profit.
Diamond points to five specific characteristics of the firms who are best weathering the current crisis:
- Policies that elevated risk management responsibilities to the highest ranks within the organization, generally on par with CFO-level positions.
- Comprehensive data collection and risk assessment processes that reached beyond individual business lines and asset classes to assess the combined or "aggregated" risk to the firm of all of its investments.
- Strategies that aligned aggregated risk with corporate investment policies and objectives, changing, in a very real way, individual investment decisions.
- A long-term, iterative view of infrastructure improvements that addressed not only the consistency and timeliness of risk information, but also the breadth and comprehensiveness of the information.
- A corporate culture that viewed risk assessment as a core strategic value, delivering significant competitive advantages to the firm.
Firms looking to avoid a repeat of the current crisis will need to shore up their risk management capabilities on two fronts—culture and information architecture, says Parker.
Based on its experience working with banks and investment firms, Diamond estimates the cost of addressing governance, modeling consistency, data transparency, and risk control issues to head off another crisis, could require individual investments by the big institutions of between $200 million and $250 million.
"It is a very large amount of money," says Parker, "but if you put it in terms of the losses that they're seeing and the deterioration of their market caps...it's not."
Only registered users can write comments.
Please login or register. |
