Better risk management "is a cultural thing"

With the theme of "Complexity, Compliance & Cost," SunGard Europa, the annual customer conference of financial software provider, SunGard, conducted a rather rigorous post-mortem of what had gone wrong in the lead up to the subprime crisis.

The guest speaker at SunGard Europa, which was held in Prague, was former Czech president Vaclav Havel, who spoke about the complexities of spearheading the "Velvet Revolution" in 1989, which eventually brought multi-party democracy to the country.

While the complexities Havel encountered seem far removed from those that investment banks now find themselves in as new and more complex instruments test risk models, one thing both events share is the need for clear and transparent information as to what is going on.

In the case of the recent sub-prime crisis, however, that information seems to have been compromised by an overemphasis on profits and growth.

Eager to deflect the blame from the automated risk management systems themselves, Value at Risk(VAR) as a measure of risk exposure and ratings agencies' modeling techniques, received a lot of flak from risk specialists for the sub-prime meltdown.

Commenting on the ratings agencies' models for structured investments, one leading chief credit officer said that, "you begin to wonder what they smoked". "How good is the work that ratings agencies do?" he asked.

With so much focus on growth and profitability, it appears risk management discipline within banks went out the window. "The risk function may have measured these risks, but at CEO level, you have to question whether these risks were accepted," said the credit officer.

The banks were also criticised for their overemphasis on VaR, which speakers concluded did not seem to tell us much, particularly when it comes to more complex instruments, such as derivatives.

Risk specialists at the conference stressed the need for more regular stress testing of risk models. "You can re-run the stock market crash of 1997," said a SunGard spokesman, "but the next catastrophe is not the same as the previous one. Firms need to look at their investment portfolios and say what is the worst that could happen, and take a view as to whether that is reasonable or not."

While a number of firms have broken down traditional silos between market and credit risk, the SunGard spokesman said that credit risk departments tended to say 'no' more often to the business than market risk. "Market risk says no less often to a trade. It is a cultural thing," which may have something to do with the fact that trading, historically, has been one of the most profitable parts of a banks' business.

Complex risk modeling techniques aside, it seems that managing risk sometimes can be as simple as just saying 'no'.