Missed Opportunity on Stress Tests?

When the Federal Reserve Bank (“FRB” or “Fed”) conducted stress tests of the 19 largest financial institutions back in 2009, many viewed it primarily as an exercise to restore the public’s faith in the financial system. Now that the FRB has requested the financial institutions to perform the same tests again, some are wondering if the tests should be redesigned to be more realistic.  One of those raising questions is Sim Segal, an ERM expert who wrote an article on the subject this week in Forbes magazine. Here’s his view:

….to be meaningful, the Fed stress tests must be changed to include (1) multiple simultaneous risks events, to capture the biggest potential threats, (2) all sources of risk, particularly strategic and operational ones, which represent the bulk of risks, (3) a full quantification of risk exposures, measuring the impact on value rather than on capital, (4) examination of the largest companies in all sectors that can threaten the economy, not just banks, and (5) worst-case scenarios provided by company insiders, to test each firm’s most vulnerable spots.

Mr. Segal raises some very good points that should be considered by not only the FRB and the Financial Stability Oversight Council, but also the individual financial institutions.  For those financial institutions and other companies that are not performing stress tests in the manner suggested by Mr. Segal, it could represent a missed opportunity that could prove fatal.

Assessing Systemic Risk

New York University’s Stern School of Business hosted a conference yesterday to discuss how systemic risk should be addressed under the Dodd-Frank Act.  One of the presenters at the conference, Stanford Finance Professor Darrell Duffie, proposed a new approach for identifying systemic risk.  Here’s some detail on his proposal as reported by Bloomberg.

The world’s largest banks and investment firms should undergo quarterly stress tests to identify risks that could sink the financial system, according to a proposal by Stanford University finance professor Darrell Duffie. “I’m not talking about the ordinary, matter-of-course, risk management of institutions. We’re looking at what are the sources of risk and how are they flowing through the system. We want to connect the dots.”

Duffie calls his plan “10-by-10-by-10” because it’s based on 10 financial firms undergoing 10 stress tests that expose the banks’ 10 largest trading partners. For example, institutions would be tested on their ability to withstand the default of a single firm that they do business with, an idea replicating the 2008 Lehman bankruptcy.

“The objective is to alert regulators and the public to potential sources of financial instability before they reach dangerous levels,” Duffie wrote in a paper outlining the proposal. The tests, which would be adjusted over time to cover different scenarios, could flush out new systemically important firms as they arise, Duffie said. Central bankers could opt to conduct some of the stress tests using average financial numbers over a given timeframe “to mitigate period-end ‘window dressing,’” Duffie said. Regulators should also audit the way the banks measure the data they present, he said.

More specifics about the Duffie proposal are contained in his working paper, “Systemic Risk Exposures: A 10-by-10-by-10 Approach.” By his own admission, Duffie notes that this proposal merely represents a first step for regulators to begin to analyze systemic risk. There are shortcomings to the proposal such as the current lack of data as well as the potential to exclude other entities that may pose risks to the system. However, the regulators must begin somewhere and this approach is a practical method for assessing systemic risk.

Just Keep Swimming

Children and parents familiar with the movie “Finding Nemo” may remember the lovable character Dory who possessed an enduring level of optimism, but a bad case of short-term memory loss.  As we continue to emerge from the financial crisis, many people are developing this “Dory Syndrome” in anticipation of good economic times ahead. However, the risks that we faced last year have not yet been fully resolved.  Here is what was reported in today’s Wall Street Journal.

While policy makers breathe a collective sigh of relief, they’re making little progress in addressing deeper flaws that the crisis laid bare: an unwieldy banking system, unreliable financial plumbing and a global economy that encourages and depends on heavy borrowing by the U.S.

Bankers and regulators say that fixes require careful consideration. But as the darkest days of the crisis fade from memory and the world’s biggest banks get back on their feet, political impetus for reform may be waning. “We’re wasting the crisis,” said economist Richard Portes of the London Business School.

Our collective short-term memory seems to be failing us as we heed Dory’s advice from the movie – “Just keep swimming!”  While certainly good advice to those looking to simply survive a crisis, we cannot deny the looming risks that remain ever-present.

Devil is in the Details

This week the U.S. Senate Committee on Homeland Security and Governmental Affairs conducted a hearing on how systemic risk needs to be governed by our financial regulatory agencies.  All agreed for the need of a single regulator, but there was not unanimous agreement on who should serve in the role.  Most point to the Federal Reserve given their role as the lender of last resort.  However, a few fear the increased level of political influence on the Federal Reserve given that they are the central bank for the United States.   Here is the view of Robert Pozen, Chairman of MFS Investment Management and Senior Lecturer at Harvard University.

1. The United States needs one federal agency to play the role of systemic risk regulator because of the increasing frequency of global financial crises and higher correlations among different investment markets.

2. Congress should give this role to the Federal Reserve Board because it has the job of bailing out financial institutions whose failure would threaten the whole financial system.

3. The Federal Reserve Board should focus on five areas that are likely potential sources of systemic risk – inflated prices of real estate, institutions with high levels of leverage, new products falling into regulatory gaps, rapid growth in an asset class or intermediary and mismatches of assets and liabilities.

4. The Federal Reserve Board should monitor closely the activities of all types of financial institutions with very large or otherwise very risky assets since they are the ones most likely to impact the whole financial system.

5. If the Federal Reserve believes that actions need to be taken to reduce systemic risks, it should work closely with the regulatory agency with primary jurisdiction over the relevant institution, product or market.

Senator Joe Lieberman, chairman of the committee holding the hearing, said lawmakers have a large task in redesigning financial regulation, which is now broken. “We cannot expect the creation of a systemic risk regulator to be a universal remedy for all that ails our financial services industry today,” Lieberman said. “As always, the devil is in the details.” 

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Risk Waits For No One

Back in September, one of the first posts to this blog focused on the systemic risk failure that led to the current financial crisis.  The systemic risk discussed was related to the use of derivative instruments such as credit default swaps (“CDS”) to mitigate credit risk associated with corporate debt.  The rapid increase in use of these CDS instruments combined with the lack of regulatory oversight led to a dramatic increase in systemic risk that has not been well managed.  A recent article by Institutional Risk Analytics provides a great example.

The basic tension over CDS starts with the fact that these instruments actually increase overall systemic risk. 

Consider a real world example: When the auto parts make for General Motors, Delphi, filed bankruptcy in October 2005, there were between $20 and $30 billion in CDS outstanding and deliverable against the $2 billion in debt outstanding and another $2 billion in bank loans that were also deliverable against the CDS.  Whereas the maximum cash loss to investors in the Delphi default might have been limited to the $4 billion of extant debt without CDS, the existence of CDS actually multiplied the potential opportunities for gain and loss on the Delphi default nearly 10 fold. 

While proponents of the CDS market will and do argue that the “net” exposure from the Delphi default was quite small, the fact remains that the “innovation” of CDS actually created a multiplicity of new risks around the existing cash default of Delphi, risks whose sole benefits seem to be a) providing speculative opportunities for a certain class of market participants – I won’t call them investors, because often they are not — and b) generating commission for CDS dealer banks.

A great deal of work must begin immediately to address this situation that is at the core of our economic meltdown.  While potential solutions have been discussed, no real steps have yet been taken by the public or private sector.  However, as we all know too well, risk waits for no one.

No Time for Complacency

In a speech last week to the Banque Centrale du Luxembourg, Vice Chairman of the Federal Reserve Donald Kohn provided a thorough analysis of events leading to the current financial crisis.  A major portion of his remarks focused on the inadequate investment in risk management by many financial institutions.  In his view, the long period of relative stability in financial markets bred a high level of complacency and inattention to the growing risks.  As he stated,

“Complacency contributed to the unwillingness of many financial market participants to enhance their risk-management systems sufficiently to take full account of the new (perhaps unknown) risks they were taking on.”

Risk management should be a primary focus of all companies, financial and non-financial, at all times.  It is precisely the moment when profits are at their peak and economic times are good that companies should be most vigilent.  Now, we are in catch-up mode and must make greater investment in risk management to ensure complacency does not become part of the risk equation again.

A Return of Systemic Risk?

The sudden about-face in the direction of the US Treasury’s Troubled Asset Relief Program (“TARP”) has brought on new fears of increasing systemic risk in the financial markets.  TARP was originally intended to lower systemic risk by ridding the markets of the toxic securities that currently plague the balance sheets of numerous financial institutions.  By leaving those securities on the balance sheets, many believe that a crisis in confidence will re-emerge.  Bloomberg.com noted the following comments yesterday from a credit strategist at BNP Paribas,

“Substantial risk still remains within the U.S. financial system,” said Rajeev Shah, a London-based credit strategist at BNP Paribas.  “Uncertainty about existing troubled assets could lead to increasing systemic risk.”

Where do we go from here?  Who knows?  However, one thing is certain.  Changing plans in mid-stream is certainly no way to reduce uncertainty in the financial markets.