It is widely recognized that the series of market events that led to the Great Financial Crisis of 2008 was as a result of poor risk management practices in the banking system. The worst financial crisis since the Great Depression of the 1920’s, this crisis resulted in the liquidation or bankruptcy of major investment banks and insurance companies,an exercise of the ‘moral hazard’ and severe consequences to the economy in terms of job losses, credit losses and a general loss of the public’s confidence in the working of the financial system as a whole.
Wikipedia defines Financial risk management as “the practice of economic value in a firm by using financial instruments to manage exposure to risk, particularly credit risk and market risk. Other types include Foreign exchange, Shape, Volatility, Sector, Liquidity,
Inflation risks, etc. Similar to general risk management, financial risk management requires identifying its sources, measuring it, and plans to address them.”
Improper and inadequate management of a major kind of financial risk –
liquidity risk, was a major factor in the series of events in 2007 and
2008 which resulted in the failure of major investment banks including
Lehman Brothers, Bear Stearns etc resulting in a full blown liquidity
crisis. These banks had taken highly leveraged positions in the
mortgage market, with massive debt to asset ratios & were unable to
liquidate assets to wind up these positions in order to make debt
payments to stay afloat as going concerns.
This in turn led to a triggering of counterparty risk i.e the hundreds of other firms they did business with counter-parties – who would otherwise have been willing to extend
credit to their trading partners – to begin refusing credit, which
resulted in the “credit crunch”.
Inadequate IT systems in terms of data management, reporting and agile
methodologies are widely blamed for this lack of transparency into
risk accounting – that critical function – which makes all the
difference between well & poorly managed banking conglomerates.
Indeed, Risk management is not just a defensive business imperative
but the best managed banks can understand their holistic risks much
better to deploy their capital to obtain the best possible business
outcomes.
Just in case you got the impression that risk management is a somewhat
dated business imperative,it is very topical that the potential Greek
exit from the European monetary union is being termed as a massive
liquidity risk crisis by Bloomberg View on June 29th, 2015 by the
influential analyst Matt Levine. To reproduce his quote – ” Three
Words Count in Bonds: Liquidity, Liquidity, Liquidity”. Here is a
Bloomberg News article finding that “there are three things that
matter in the bond market these days” and all of them are liquidity. I
was prepared for, like, two of them to be liquidity — liquidity,
liquidity and default risk, say — but, no, it’s “liquidity, liquidity
and liquidity.” One hundred percent liquidity! What were the odds?
http://www.bloombergview.com/
Need one say more?
Risk practices are very closely intertwined with IT and data
architectures. Indeed data is the currency of the banking business.
Current industry-wide risk practices span the spectrum from the
archaic to the prosaic.
Areas like Risk and Compliance however provide unique and compelling
opportunities for competitive advantage for those Banks that can
build agile data architectures that can help them navigate regulatory
changes faster and better than others.
Adopting fresh & new age approaches that leverage the best in Big Data, Analytics and Cloud Computing can result in –
1. Improved insight and a higher degree of transparency in business
operations and capital allocation
2. Better governance procedures and policies that can help track risks
down to the transaction level
3. Streamlined processes across the enterprise and across different
banking domains. Investment banking, Retail & Consumer, Private
banking etc.
Indeed, lines of businesses can drive more profitable products &
services once they understand their risk exposures better. Capital can
only be allocated more efficiently, better road-maps created in
support of business operations instead of constant fire-fights and
concomitant bad press.
In the next post in this three part series on Risk management, I would
like to examine the major regulatory regimes that Banks need to adhere
to post 2013. We will examine the Basel accords (Basel III and the
addendum BCBS 239), Dodd Frank and CCAR.
The downstream implications of all of the above will also be reviewed in that post.