Credit Risk Management Sunk by Crisis? Market Stress Prompts Calls for Drastic Change, but Many Advise against Scrapping Everything

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In the days leading up to the presidential election, a punctured and weakening economy was still very much in the frame, and the post-mortem of dysfunctional world credit markets had cycled through denial, rage, and despair.

In the weeks following news of economic rescue, a more sober analysis was beginning to surface. Risk management systems and credit risk models, which didn't get mentioned all that much during the first, explosive phase of the crisis, were quietly being recalibrated at the offices on Wall Street--and off.

That's when ABABJ interviewed experts in the field to find out how, if at all, risk management let lenders and dealmakers down. What, if anything, could be done differently?

Paul Stark, senior vice-president of credit risk at $10. 4 billion assets FirstMerit, a Cleveland based supercommunity bank, says that his bank, like many others, stayed out of trouble by remembering fundamentals. "A lot of the deals that I was hearing about just didn't make sense to me," Stark says, adding that he was still trying to make sense of the National City scenario, which featured so prominently in Cleveland. "Some banks were making loans based on nebulous criteria for people they'd never met," Stark recalls. "And the derivatives based on subprime loans didn't make much sense to me either. The idea that you can subdivide risks sounds good, but how do you know which loans will actually go bad? Tranche making is a guessing game."

Protecting the enterprise

Not surprisingly, many indicated that risk management systems should be set up to "blanket" the entire bank environment from middle-to-front office, although models would have to be adjusted to better reflect liquidity risk and have broader application in managing derivatives. This makes sense because enterprise risk management (ERM) isn't new, having been called for since Basel II had been under development and has the virtue of being a thorough method. (Although Basel II's reliance on internal models and credit rating agencies has been questioned by groups such as the Financial Stability Forum's Working Group on Market and Institutional Resilience.) Still, many interviewed took educated guesses that improved credit management in the context of ERM would be called for with new urgency, and with louder voices after the government shifted out of emergency response mode.

Stark, for instance, says that his bank is interested in--and has begun to deploy tools to support--an enterprise approach, although FirstMerit doesn't need to meet Basel II requirements.

Yet, the reality on the ground at many banks--especially the spawn of new mega-mergers--is that they are burdened by a series of redundant data marts, missing support of models, and complex legacy systems, says Frank McKeon, financial services industry director, Cognos, Burlington, Mass. So bringing more effective measures and mitigations will be big projects. "The issue will be that a given bank, having spent millions on a project, will consider their risk program completed," says McKeon. "Beyond the infrastructure development to accommodate a better risk program, which can be a relatively short term project, actual risk monitoring and management is an ongoing process."

Extreme remedies called for

While extreme voices in the market were calling for everything from a ban on derivatives to a rollback on aggressive home ownership policy objectives, those in the middle acknowledged that individual practices of lending, packaging debt for liquidity, and trading complex instruments needed to be revised--and nothing scrapped.

"There is nothing wrong with trading derivatives or making loans to new segments of the market, but the risk needs to be evaluated from the start as part of strategy development," says Leo Tilman, president of L.M. Tilman & Co., a strategic advisory firm based in New York. "That is, the language of risk management--the delineating of new risk exposures and hedging strategies--has to happen among the senior officers and key business executives. …