How Banks Should Manage Risk

They can't do it alone. What's needed is a regulator who can pull data firm-by-firm to better grasp systemwide exposure and identify hot spots

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By David Bogoslaw

Marking the one-year anniversary of the collapse of Lehman Brothers' , President Barack Obama urged Wall Street to mend its ways. "Instead of learning the lessons of Lehman and the crisis from which we are still recovering, they are choosing to ignore them," he said in a speech in New York on Sept. 14. Part of his ambitious plan to overhaul the financial system is a new Financial Oversight Council to identify emerging systemwide risk issues and improve coordination among agencies such as the Federal Reserve Board, the Securities & Exchange Commission, and the Federal Deposit Insurance Corp.

The collapse of Lehman and the global credit crisis it spawned made it clear that it's not enough to manage risk only within individual banks. Risk needs to be examined on a systemwide basis, taking into account the crowding of speculators from different firms into certain assets, which often leads to market bubbles. Banks need to determine their exposures to other markets that can easily come under pressure in a downward liquidity spiral once a bubble bursts.

In taking a more holistic approach to risk, financial firms are paying more attention to the kinds of risk they have, where it resides in their organizations, and how one kind can potentially affect others, says Rob Mochwart, a risk consultant and former chief risk and credit officer for a now-defunct subsidiary of Popular (BPOP).

Traditionally, retail brokers have confined their risk analysis to very large clients with margin accounts who raised concerns about their accounts blowing up if asset values collapsed, says Gregg Berman, who heads the risk-management business at RiskMetrics Group, a New York consultant. But after last year's turmoil, brokers have become more proactive, trying to look at the exposure that all of their clients have to a certain company or industry.

blame executive negligence, not models

"Having that level of detail across a huge volume of accounts, while quite daunting, is becoming part and parcel of operating, so they can see ahead of time what portion of their clients have exposure to a certain name or a certain category of risk factors, a certain portion of the yield curve, or a certain sector," Berman says. "If lots of clients have exposure to the short end of the [Treasury bond] yield curve and the yield curve were to steepen, all my accounts would get hit."

To deal with that possibility, RiskMetrics recommends that firms at least inform their clients of these concentrated positions and then suggest rebalancing their positions or hedging their existing exposure. "The first step to any risk-management program is understanding what can happen to your portfolio, not predicting what will happen," he says.

After watching their funding quickly dry up last year when investment banks stopped lending, hedge funds have learned to use multiple prime brokerages as funding sources rather than just one and are gravitating to trading activities that are less sensitive to financing, says Berman.

Risk expert Rick Bookstaber, whose 2007 book A Demon of Our Own Design anticipated the credit crisis, blames the market crash more on a failure of risk governance within banks than on faulty risk models. "If you don't have risk managers looking at positions and understanding risk and communicating it, or if you don't have CEOs willing to act [on data], it doesn't matter what you're doing as far as risk models," he says.

bonus "clawbacks" when warranted

There's not much individual firms can do to reduce their exposure to systemwide risk other than shore up their due diligence and be more careful in choosing the counterparties they trade with, says risk consultant Mochwart.

The culture of Wall Street also argues for a regulator dedicated to systemwide risk oversight. One reason for the time lag between innovation in financial products and implementation of countervailing risk strategies is traders' unwillingness to share what they see as proprietary information with others, even within the same comnpany, says Dr. C.H. Ted Hong, a mortgage securitization consultant and president of Beyondbond, a financial consulting firm in New York. And, he adds, because risk management is a cost center, not a profit center, for banks, it doesn't get the respect it deserves.

The most visible progress in managing risk is in the area of derivatives such as credit default swaps (CDS's). The concentration of risk that brought insurance giant AIG (AIG) to the brink of defaulting on its obligations and required a massive government bailout has provided a compelling argument for shifting CDS trades from an unregulated, over-the-counter environment to central clearinghouses that guarantee both sides of a transaction and greatly reduce the risk of counterparty default. On Sept. 10, J.P.MorganChase (JPM) and 14 other swap dealers agreed to send bigger portions of their trades to clearinghouses. The standardization of swaps required for them to trade on exchanges would also create more liquidity in the swaps market. CME Group (CME) and IntercontinentalExchange (ICE) are leading the way toward central clearing of these trades. There are also plans to impose greater capital costs on traders who insist on customized swaps that continue to trade over the counter.

There are also efforts under way to put constraints on compensation for bankers in order to rein in risk practices. Central bankers and finance ministers from the G20 countries are now calling for global standards that include bonus clawbacks if trading strategies cause a firm to lose money and longer-term performance measures. In his speech, Obama told Wall Street movers and shakers that executive bonuses should be put to a shareholder vote this year.

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