The stereotype of a bank risk manager is a geek scrawling Greek letters on a whiteboard. But mathematical errors by the pocket-protector crowd aren’t to blame for Wall Street’s woes. Regulators from five countries just published a report analysing 11 banks’ risk management practices. From their conclusions, it appears the losses were due to amateurish management blunders.
First, the big losers didn’t have effective firmwide systems for collecting data on, and evaluating, their risks. They allowed business heads too much leeway in setting and enforcing risk limits, and didn’t work to break down bureaucratic barriers that kept bad news from flowing upwards. The result was a profusion of disparate businesses indulging their own short-term appetites for profits, largely immune from having their performance evaluated on a risk-adjusted basis.
When these businesses—mainly leveraged finance, structured finance and conduits and structured investment vehicles (SIV)— started to go south, senior managers at the big losers didn’t hear about it early enough.
When they did, it was usually too late to hedge or sell the declining positions. This isn’t a new phenomenon—it happens regularly, most recently during the junk bond and dotcom routs. The study says that banks that learned from earlier episodes were able to identify the looming perils of this crisis as early as mid-2006.
Bankers also like to blame malfunctioning credit risk models. But the regulators found that the biggest losers used simple, static models such as Value at Risk and often relied on the ratings agencies to evaluate the complex securities they held. Those that dodged bullets were constantly updating and tweaking their models and used them to supplement, rather than replace, their market judgement.
Another massive blunder was banks’ failure to account for liquidity risk, particularly contingent liquidity risks inherent in products such as SIVs. This looks especially dumb, since liquidity crises are the bane of Wall Street—think Drexel Burnham in 1990, or Lehman Brothers in 1998.
It might have been more comforting if the regulators had been able to blame the mess on some poor quant’s slide-rule mishap. Such a mistake could be easily corrected. The periodic recurrence of banker stupidity is less tractable.