Risk Management Lessons from the Global Banking Crisis

The following post comes to us from William L. Rutledge, executive vice president in charge of the Bank Supervision Group at the Federal Reserve Bank of New York, and Chairman of the Senior Supervisors Group.

The events of 2008 clearly exposed the vulnerabilities of financial firms whose business models depended too heavily on uninterrupted access to secured financing markets, often at excessively high leverage levels. This dependence reflected an unrealistic assessment of liquidity risks of concentrated positions and an inability to anticipate a dramatic reduction in the availability of secured funding to support these assets under stressed conditions. A major failure that contributed to the development of these business models was weakness in funds transfer pricing practices for assets that were illiquid or significantly concentrated when the firm took on the exposure. Some improvements have been made, but instituting further necessary improvements in liquidity risk management must remain a key priority for financial services firms.

The Senior Supervisors Group (SSG), a group of senior financial supervisors from seven countries of which I am Chairman, recently forwarded a report to the Financial Stability Board entitled Risk Management Lessons from the Global Banking Crisis of 2008. The report reviews in depth the funding and liquidity issues central to the recent crisis and explores critical areas of risk management practice warranting improvement across the financial services industry. The report is a companion and successor to the SSG’s first report, Observations on Risk Management Practices during the Recent Market Turbulence, issued in March 2008.

In the report, we identify various other deficiencies in the governance, firm management, risk management, and internal control programs that contributed to, or were revealed by, the financial and banking crisis of 2008. Our report highlights a number of areas of weakness that require further work by the firms to address, including the following (in addition to the liquidity risk management issues described above):

  • the failure of some boards of directors and senior managers to establish, measure, and adhere to a level of risk acceptable to the firm;
  • compensation programs that conflicted with the control objectives of the firm;
  • inadequate and often fragmented technological infrastructures that hindered effective risk identification and measurement; and
  • institutional arrangements that conferred status and influence on risk takers at the expense of independent risk managers and control personnel.

In highlighting the areas where firms must make further progress, we seek to raise awareness of the continuing weaknesses in risk management practice across the industry and to evaluate critically firms’ efforts to address these weaknesses. Moreover, the observations in this report support the ongoing efforts of supervisory agencies to define policies that enhance financial institution resilience and promote global financial stability.

This analysis builds upon the first SSG report, which identified a number of risk management practices that enabled some global financial services organizations to withstand market stresses better than others through the end of 2007. The extraordinary market developments that transpired following the release of the first report prompted the SSG to launch two new initiatives. First, the group conducted interviews with thirteen firms at the end of 2008 to review specific funding and liquidity risk management challenges faced, and lessons learned, during the year. Second, in our supervisory capacities, we asked twenty global financial institutions in our respective jurisdictions to assess during the first quarter of 2009 their risk management practices against a compilation of recommendations and observations drawn from several industry and supervisory studies published in 2008. During the spring of 2009, SSG members reviewed the assessments and held follow-up interviews with fifteen of these firms to explore areas of continued weakness, as well as changes to practice undertaken recently. This report presents the SSG’s primary findings from these initiatives.

In their self-assessments, firms generally indicated that they had either fully or partially complied with most of the recommendations. SSG members, however, found that the assessments were, in aggregate, too positive and that firms still had substantial work to do before they could achieve complete alignment with the recommendations and observations of the studies. In particular, supervisors believe that a full and ongoing commitment to risk control by management, as well as the dedication of considerable resources toward developing the necessary information technology infrastructure, will be required to ensure that the gaps between actual and recommended practice are closed in a manner that is robust and, especially important, sustainable.

We hope the report will call attention to critical areas of risk management in which further effort is warranted.

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