Fed Gov. Kroszner Gleans Lessons
from Risk Management Report

In the view of Federal Reserve Board Governor Randall S. Kroszner, the recent report on risk management by global regulators, including the Fed and the SEC, contains many valuable lessons for all levels of risk management. Although the analysis of the Senior Supervisors Group (SSG) report covered the largest banking and securities firms, he noted, the lessons learned actually have relevance for financial institutions of all sizes and scope, even those that have thus far not suffered from recent financial turbulence. Other regulators involved in the report were the UK Financial Services Authority and the German Federal Financial Supervisory Authority.

The report highlights the critical role that sound corporate governance plays in effective risk management. The report states that solid senior management oversight and engagement is a key factor that differentiated performance during recent events. Senior management must take on a very active and involved role in risk management. Senior managers must also ensure that they have proper understanding of the risks assumed by their firm.

Disturbingly, there is evidence that information was kept in silos within some firms and not adequately distributed, he noted, which prevented senior managers from developing enterprise-wide risk management. In turn, this meant that managers were not fully aware of the extent to which the risks of the different activities undertaken by the firm could become correlated in times of stress and result in high concentrations of risk exposures. Specifically, in particular cases, senior management was not fully aware of the firm's latent concentrations in U.S. sub prime mortgages, because they did not realize that in addition to the sub prime mortgages on their books, they had exposure to the claims on counterparties exposed to sub prime and complex securities.

According to the Fed official, effective risk management remains sturdy and durable only if supported by strong and independent risk functions that produce unbiased information. Since timely and accurate information is the lifeblood of sound risk management, he observed, a good risk-management structure must encompass risks across the entire firm, gathering and processing information on an enterprise-wide basis in real time.

The report noted that some firms could not easily integrate market and counterparty risk positions across risks types, making it difficult for their executives to identify concentrations across the entire firm. Understanding a firm's true risk exposures requires examining not just risks on the balance sheet, but also off-balance-sheet risks that are sometimes more difficult to identify and often not so easy to quantify. Latent risks from complex products and risky activities should be properly recognized, he pointed out, because they can manifest themselves when market turbulence sets in.

As the SSG report indicates, some firms had a poor understanding of the risks inherent in complex products or failed to recognize that certain activities contained latent risks that could be manifest in unexpected concentrations of risk exposures when market turbulence arose. For example, there were lapses in credit risk identification and measurement when certain institutions underestimated the actual credit risk of sub prime mortgages and the secondary effects brought on by disruptions in sub prime markets for their broader set of activities.

He also emphasized that the proper valuation of securitized products is part of sound risk management, particularly with regard to new products. The core of these practices is the ability to make appropriate judgments about the quality of information being used for valuations. The process usually starts with an initial experimentation phase in which market participants learn a great deal about the product's expected performance and risk characteristics, preferably under different market conditions.

Due diligence in the valuation process is very important, he noted, especially with regard to new and complex products. Unfortunately, in some recent cases new products were developed very quickly and not properly road-tested. He urged market participants to ensure that valuation decisions are not based solely on excessive reliance of external ratings or evaluations, but also reflects their own assessment.

Gov. Kroszner’s advice echoes the finding of the SSG report that firms that fared better in the crisis had in place rigorous internal processes requiring critical judgment and discipline in the valuation of holdings of complex or potentially illiquid securities. Skeptical of rating agencies’ assessments of complex structured credit securities, these firms developed in-house expertise to conduct independent assessments of the credit quality of assets underlying the complex securities to help value their exposures appropriately.

Stress testing and scenario analysis are of paramount importance, the Fed official emphasized, since they can reveal potential concentrations of risk that may not be apparent from using information gleaned from normal times. The SSG report stressed this point, but the federal banking agencies have also highlighted its importance for smaller- and medium-sized institutions.

The governor urged financial institutions to re-check the robustness of their stress testing in light of recent events. For example, banking organizations might benefit from expanding tests to include a wider set of variables to stress and to consider shocks they might have considered much less probable one or two years ago. He reminded that past experience is not always predictive of future events, meaning that firms should be creative in designing potential shocks.