Posts Tagged ‘Credit Risk Management’
Rude Lesson in Risk Management
A leading risk management expert and chief risk officer at a major U.S. financial institution offered his insight on risk management practices last week in the Columbus Business First Journal. His views are candid and becoming more common as the dust begins to settle from the recent financial crisis. Here is what he had to say.
Kevin Blakely, senior executive vice president of Huntington Bancshares Inc. in Columbus and its chief risk officer said years ago, things were relatively simple. “Most of our risk was centered in credit risk – lending to individuals and companies, and gauging our ability to get that money back,” he said. Until this past summer, Blakely had been president of the Philadelphia-based Risk Management Association. But as companies got bigger and financial products got more complex, financial institutions developed mathematical models to measure risk. They worked well, he said, but by the mid-1990s banks were depending on them too much. “We began to view them as the answer, rather than as one more input before you get to the answer,” Blakely said. “That was one of the rude lessons we learned over the last couple of years. As an industry, we weren’t as smart in the business of risk management as we thought we were.”
The false sense of security placed in risk management was certainly a rude lesson for many companies as they focused on quantitative models that told them what they wanted to believe. A balanced view of both quantitative and qualitative factors is critical to an effective enterprise risk management program.
The Credit Risk Paradox
In this month’s issue of Treasury & Risk Magazine, the dramatic increase in credit risk at financial and non-financial companies is examined. As strategies to mitigate credit risk become more sophisticated, a paradox ensues. Rather than lowering the amount of credit risk, the strategies can have the opposite effect because they provide a false sense of security. Here is what the article concludes.
On a macroeconomic level, the dramatic rise in credit risk is partly a result of the very success of credit risk mitigation tools and strategies, argues Jerry Flum, CEO of CreditRiskMonitor in Valley Cottage, N.Y. “We’ve done a lot to promote stability and off-load risk, but the more risk companies transfer, the more they leverage up. When you hedge credit risk with derivatives, you feel confident in taking on more debt.”
The illusion of safety achieved by theoretically reducing risk has encouraged companies to take steps that increase the consequences of negative developments. “Because the foundation seems stable, you build a skyscraper,” Flum says. “It’s rewarding but catastrophic when it falls.” Whether and how the skyscraper will be rebuilt will be a big issue for treasuries of the future.
The big question is how many skyscrapers with weak foundations are looming out there? Periodic credit stress tests can help provide a better view of the skyscraper and how their foundations can be strengthened.
Haunting Words from the Federal Reserve
For all that has been leveled at former Federal Reserve Chairman Alan Greenspan’s contribution to the current financial crisis, very little has been noted about the current Federal Reserve Chairman’s contribution. Mr. Greenspan has been vilified for his comments in 2004 supporting the use of adjustable rate mortgages. Here is what Mr. Bernanke had to say in a 2006 speech about the use of credit default swaps and asset backed securities.
To an important degree, banks can be more active in their management of credit risks and other portfolio risks because of the increased availability of financial instruments and activities such as loan syndications, loan trading, credit derivatives, and securitization. For example, trading in credit derivatives has grown rapidly over the last decade, reaching $18 trillion (in notional terms) in 2005. The notional value of trading in credit default swaps on many well-known corporate names now exceeds the value of trading in the primary debt securities of the same obligors. Asset-backed securitization has also provided a vehicle for decreasing concentrations and credit risk in bank portfolios by permitting the sale of loans in the capital markets, particularly loans on homes and commercial real estate.
Given the implosion of the credit default swap and mortgage backed securities markets, Mr. Bernanke’s comments seem to be equal if not more impactful than Mr. Greenspan’s comments in 2004. As we now know, the use of these vehicles actually increased risk on a systemic basis rather than lowering it.
