'Monte Carlo' Software Is Applied to Risk Management

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|Monte Carlo' Software Is Applied to Risk Management

Banking and casino gambling should have little in common, but a Phoenix-based consulting firm has introduced PC-based forecasting software that uses "Monte Carlo" analysis techniques to better predict bank earnings.

"Most banks have a difficult time accurately forecasting interest rates. This in turn affects their income forecast," said Dennis Bennett, president of Bennett Management Services, a firm that specializes in helping financial institutions with interest-rate planning, also known as asset-liability management.

"The Monte Carlo technique simulates reality enough times to come up with a probability chart of how reality may come to be," Mr. Bennett said.

In Long Use Elsewhere

The Monte Carlo model has long been applied in other industries. Pioneered during World War II, "Monte Carlo" became a code name for a weapons-industry project that dealt with probability and chance - hence the gambling reference.

The early Monte Carlo simulation was so accurate that the British government has used it to predict traffic and toll patterns as a means of coming up with municipal bond prices. Scientists - particularly biochemists and engineers - regularly use the technique in their research.

Mortgage bankers also use Monte Carlo analysis to adjust prices of asset-backed securities and derivatives.

Technological Limitations

Because of software and hardware limitations, however, Monte Carlo analysis is new to asset-liability management in banking.

"Monte Carlo analysis takes a lot of number-crunching," Mr. Bennett said. "Banks which were using [the method] in the mortgage area typically ran the programs on a mainframe because the analysis required so much power. Up until now, it hasn't been feasible for other parts of a bank to use it."

The new software runs on International Business Machines Corp. …