The Paradox of a Predictable Failure in Risk Management

Olivier Raison

Swiss Management Center

27th April 2011

Electronic copy available at: http://ssrn.com/abstract=1857382

The Paradox of a Predictable Failure in Risk Management

Author Note
Olivier Raison (olivier.raison@student.swissmc.ch) is a graduate from the Swiss Management Centre in Zurich, Switzerland, with a Doctorate of Finance. He has an extensive experience in the fields of business finance and accounting with a worldwide exposure as a senior executive. His research interests include modern economies and geostrategic issues in the Gulf countries as well as global finance markets. He also holds a Master in Business Administration degree from the IAE - Universit de la Sorbonne in Paris, France.

Electronic copy available at: http://ssrn.com/abstract=1857382

The Paradox of a Predictable Failure in Risk Management

Abstract
The global economic crisis that appeared in 2008, outside the consideration for its tremendous effects on markets and people, has shed light on various issues. Most notably, the lack of transparency and honesty amongst actors of the finance sector played a critical role in the demise of well-known institutions such as Lehman Brothers and others that did not survive this financial quake. Despite what seems to be cyclical phenomena, the successive economic crises that have shaken the world over the last century have not served their true purpose: being a lesson for improvement of risk management tools as well as audit and control mechanisms. This paper highlights some of the reasons why recurring failures in risk management and transparency have led to the recent crisis and why it is very likely that the very same failures will eventually trigger another potential crisis of far greater extent. The appetite of the finance community and unscrupulous investors for fast returns is still prevailing today. And this is done with the discreet consent or the simple lack of responsibility and ownership of governments and regulating bodies. The risks of permanently and irreversibly damaging the financial and economic balance of the world today are far from being properly managed and controlled. This can only be the beginning of something worse, unless immediate remedial action is taken. Keywords: crisis, CDO, risk management, markets, credit

The Paradox of a Predictable Failure in Risk Management

The Paradox of a Predictable Failure in Risk Management

The current crisis the world fell into two years ago had certainly the widest range of qualifying attributes: financial, economic, social, industrial, and maybe lethal as it dramatically affected and eventually destroyed lives beyond the point of no return. Described by contemporary economists as the worst ever crisi experienced by America for a hundred years,1 it was however another repetition of what seems to be a cyclical phenomenon: the 1929 crisis, the energy crisis in 1973, that of 1997, and more recently the internet bubble. And despite the lessons learnt from the past, with the technology evolving exponentially and the refined risk management, societies, corporations, institutions, and governments failed yet again by not having the right controls at the right time, substantially creating spiraling consequences that took investors and the wider public by surprise. The causes of the 2008 crisis raised numerous questions, some of them leading to the foundations of todays capitalism and one of the common sins of humans: greed. Nevertheless, one could have hoped that, with the dynamic of industrial countries and the norms of audit and compliance such as those of Basel II and III,2 in which operational risk and credit risk are separated, the international financial system would be protected against the collapse of the bank sector. But this was without counting on the intrinsic failures of these very norms, standards and risk management tools. As a matter of fact, the crisis finds its roots in a simplified scheme: the lack of accountability, mortgages and default on large amounts of money against little income, and finally the liquidity for which the same institutions failed to have sufficient capitalization to cover immediate large needs when the whole system started to present default cracks. The problem of sufficient capitalization became a recent issue with the rise in the prices of commodities, whereas speculators can highly leverage their buying power without offering a real financial counterpart in exchange. And thats certainly why French President Sarkozy recently called for more regulations on commodity markets. 3 However, progresses in that sense are yet to be commonly agreed or applied by governments and leaders of industrial countries. Overall, today it is the review or maybe the prosecution of an entire system that is taking place. Questions and concerns from governments, investors, officials, and ultimately the public have found few relevant answers so far. The lack of accountability and transparency from the protagonists directly or
1

Mark Gertler, a New York University economist who worked with fellow academic Ben Bernanke, current Chairman of the Federal Reserve, was cited by The Wall Street Journal saying that this has been the worst financial crisis since the Great Depression. There is no question about it. Although his optimism regarding the mechanisms in place to fight the crisis, and which were not in place in 1929 according to him, may have boosted the hope for a quick recovery amongst politicians and leaders in the USA, the story that has unfolded two years later is quite different and reveals a far more complicated financial nebula with worldwide intricacies. 2 Basel II principles intend to preserve economic stability by ensuring that banking institutions are exposed to risks in relation with their own capital, thus avoiding potential insolvency on large scale. Basel III principles aim at responding to the problems posed by the recent global crisis by increasing capital requirements and introducing new regulations on bank liquidity and leverage. 3 Sarkozy conspicuously asked his follow G20 members: Does it make sense that you can buy considerable stocks of commodities without running any risk, without blocking any sum, without committing to any cargo delivery? as reported by Bloomberg in its 24 Jan 2011 edition.

The Paradox of a Predictable Failure in Risk Management

indirectly involved in the crisis has raised anger and consternation worldwide. The cynicism displayed by bankers and financial institutions who announced remarkable profits for the last quarter of 2010 may be perceived as a new alarm bell ringing for another major financial crisis yet to come.4 This paper presents some of the key issues the financial crisis brought into light in terms of risk management and lack of control from corporations, banks, auditors, credit agencies, and governments. It does not aim to provide a solution but rather gives the reader a fair understanding of what could have been avoided or improved and what may come again should the global financial modus operandi not be drastically changed.

Analysis of the Financial Crisis

An article published in the International Business Time, Financial Risk Management: Lessons from the Current Crisis ... So Far, ideally summarizes the substantial work that has been done to date to analyze the recent economic crisis and cites examples such as: Enhancing market and institutional resilience (Financial Stability Forum); Credit risk transfer (Working Group on Risk Assessment and Capital); Observations on risk management practices during the recent market turbulence (Senior Supervisors Group); Supervisory lessons from the sub-prime mortgage crisis (Basel Committee on Bank Supervision); Study of market best practices (International Institute of Finance), and; Risk management practices including the identification of risk management challenges and failures, lessons learned and policy considerations (International Monetary Financial Committee). Todd Groome, adviser in the monetary and capital markets department of the International Monetary Fund (IMF) interviewed by the same magazine, asserted that the epicenter of the market crisis was subprime mortgages and structured credit products. With them came innovative financing, such as asset backed security CDOs (Collateralized Deposit Obligations) which were followed by more potent variations such as CDO-squares (baskets of CDOs), and synthetic CDOs (CDOs combined with credit default swaps). Risks were often under-estimated partly due to product complexity and over-reliance on quantitative analysis, including that done by rating agencies which produced reports that were either wrong or purposely misleading. As Groome pointed out, taking write-downs in illiquid markets will amplify the loss. The downfall in housing prices impacted market downfalls. As such, creation or destruction of wealth often relates to consumer spending and as such may be uncertain. Meanwhile, the direction is quite similar. If one goes down, the other tends to follow. Negative trend implies negative trend. Nevertheless, weak risk management isnt the only reason. Banks and financial institutions regularly rely on data related to a
4

JP Morgan, once a moribund financial institution on the eve of the 2008 crisis, proudly announced US$ 4.8 billion in profits in 2010 last quarter.

The Paradox of a Predictable Failure in Risk Management

particular period. However, economies can also experience a non-recurring event when the economy moves into unknown or grey areas. It makes the risk managers job very difficult, concluded Groome. On another plane, bad risk management still played a role. According to Groome again, there may have been over-reliance on models and, in many cases, too similar risk management and mitigation strategies. The problem is that despite the fact the models given in a particular circumstance may have been correct pretty much everyone who has them will use them, all at the same time. This phenomenon tends to increase systemic risk and as such it relates to technical market analysis. Indeed, if there is a consensus amongst users over a specific event, say a bullish trend, everyone is likely to follow that trend and buy at the same time, thus creating a momentum. But for how long will this last?

Cracks in Risk Management and Regulation Opacity

The recent crisis also highlighted a failure in risk management on a large scale, due to a failure of the techniques employed, and the fact that some of the risk managers were not well informed. The home market in the U.S. was the nest in which everything began. Low interest rates and government promoting home ownership by with no or little regulations played a role in the increasing demand for home purchases. Underwriters passed questionable loans over highly leveraged investors in order to create even more loans, fueling a spiral of non-recoverable dirty assets. What is flagrant today, looking back at the whole process, is the fact that the risk assessment tools used by some investors, despite their sophistication, did not give a realistic picture of what was happening. In other words, although they were certainly giving sufficient information on the potential risks that lending huge amounts of money to low income individuals would create, the likelihood of such risk spreading to a rather large population was totally dismissed by the whole chain of command. Modeling rare events is certainly what the error is all about and not taking them into consideration was the effect that catapulted the system towards a major failure. Nassim Taleb in his best seller The Black Swan: The Impact of the Highly Improbable confirms this statement and argues that most of the really big events in our world are rare and unpredictable, and thus trying to extract generalizable stories to explain them may be emotionally satisfying, but it's practically useless. Nevertheless, numerous risk managers and experts rang the bell for potential upcoming issues several years ago5 and whilst greed and arrogance are the common denominators, the irrationality of the markets also comes into light. Clinging desperately to what was an announced disaster seemed to have been the

Amongst others Chris Wood, Managing Director and Chief Strategist with broking company CLSA, invited investors in 2005 to sell their existing exposure to American mortgage securities market.

The Paradox of a Predictable Failure in Risk Management

pattern of behavior that inflated the bubble until explosion. As such, the economist John Meynard Keynes confirms that the market can stay irrational longer than you can stay solvent. Another root of todays financial debacle are the regulations applied to some of the instruments used in financial markets. CDOs for instance, often containing a non-negligible part of subprime risk, were heavily exchanged without proper scrutiny from the rating agencies. Transparency becomes a crucial element in the markets sustainability. And this is when the accounting standards play a key role for liability valuation and, hence, transparency. The snow ball effect is obvious: no regulations lead to poor transparency, which equally leads to disaster. The financial accounting has proven to be relevant to convey useful and accurate information to markets. Nevertheless, the concept of fair value, for example introduced by the International Accounting Standard Board (IASB) and Financial Accounting Standard Board (FASB), is to record values for assets and liabilities which are as close as possible to the values these instruments would have in an open market. As confirmed by Heckman in his essay Transparency and Liability Valuation, the IASB and FASB dont recognize any difference between methods for valuation of assets and liabilities, which has proven to have perverse consequences as some companies can use the process to turn losses into profits, since liabilities can be valuated at current market price. This has led to the misreading of the balance sheets and profit and loss statements of unscrupulous companies, providing the wrong information to investors and to some extent regulators themselves.

Impact of Liquidity and Failure of the Bank System

The current crisis has shed a light on the fact that the enterprise risk management should not only emphasize the risks to asset and liability values but also the liquidity risk. Liquidity risk is the probability of not having sufficient financial means to cover up liabilities. To some extent, posting collateral poses a liquidity threat as well. In fact, selling off an immature asset engages a loss. As the markets fall into problems, liquidity issues can be drastically worsened as liquid assets become non-liquid. Liquidity management works pretty much like capital management. As such, the liquidity protection comes with sufficient liquid assets. On the other hand, consistency between cash flows of assets and liabilities can reduce risks pertaining to liquidity. Nevertheless, these strategies may show some limitations during conditions of heavily disrupted markets when credits are unavailable or unsecured. G. Venter in Modeling and Managing Liquidity Risk confirms that modeling liquidity risk can start with stress tests. As such, the current market is an example of situations intimately involving assets, liabilities, and credit facilities when cash flow adequacy becomes preponderant. The idea behind the scene is to take into account in the models the different factors which dramatically impact markets. The correlation between price and

The Paradox of a Predictable Failure in Risk Management

liquidity comes into the picture and adequately modeling these possibilities can certainly be worth further research. In 2006, a couple of years before the eruption of the financial crisis, Iyer and Peydro-Acalde discussed the potential risks of an interbank contagion in their research paper Interbank Contagion: Evidence from Real Transactions. They exposed and tested the impact of interbank dependencies over a fraud cause. Interbank markets are crucial to provide liquidity into the overall financial system and actively play a role in monetary policies worldwide as well. The research of Iyer and Peydro-Acalde came to the conclusion that as the exposure to the failed bank increases, the runs stemming from the higher fraction of deposits held by other banks drastically increase. These results lend support to the theories of financial contagion due to interbank markets. This is indeed the exact phenomenon observed in 2008 when major banks reached the potential bankruptcy threat. The interbank markets dried up, obliging governments to first inject cash through loans, capital sharing or even nationalization. As such, the Iceland bank system is now a school case of its own. The three main Icelandic banks, namely Glitnir, Landsbanki, and Kaupthing, were tightly interconnected. With a high reliance on similar macroeconomic models and business partners, they appeared to be dangerously related to one another already on paper. The chain reaction triggered by the difficulties of one bank would mean diminished confidence in other banks, thus shrunk liquidity available from potential resources and financial partners. The worst part of the picture lies in the fact that these three banks encompassed the vast majority of Icelands financial system. 6 Hence, one would have conspicuously assumed that a possible failure would have a dramatic impact on the Icelandic economy. However, the reality was often disguised by biased official reports about the financial health of the Iceland bank system, 7 which certainly contributed to further deepen the crisis as investors would be grossly misled. Eventually, the arrogance of the system ended up in a painful stake. Borrowing in wholesale markets became an issue and banks chose to open high interest savings accounts pretty much everywhere in Europe. As such, Icelandic banks, with government permission, used these savers accounts to provide the liquidity they could not obtain elsewhere. At the end of the story, deregulation and uncontrolled privatization of the financial system in Iceland led to its demise. Lack of ownership from supervisory regulators and governmental bodies and failure to recognize a systemic risk in an artificial economic growth widely contributed to the fall-out of the Iceland financial institutions and overall system.

The Financial Stability reports from the Central Bank of Iceland from 2006 to 2008 compelling enough to be regarded as a masquerade of the reality. See http://www.sedlabanki.is/?PageID=677 7 The lack of impartiality and independence from names in the field of business sciences such as R. Glenn Hubbard, Dean of the Columbia University, who co-wrote a report called How Capital Markets Enhance Economic Performance and Facilitate Job Creation with William C. Dudley from Goldman Sachs, raising concerns over a potential conflict of interest.

The Paradox of a Predictable Failure in Risk Management

Ultimately, when the banks were heading for failure the Icelandic government opted for a gamble on resurrection rather than closing the banks down. The governments bet failed and Iceland suffered a systemic crisis in return. As reported by the Telegraph in its 10 March 2009 edition, it was now a matter of twenty billion dollars here, $20bn there, and a lush half-trillion from the European Central Bank at give-away rates for Christmas. Buckets of liquidity are being splashed over the North Atlantic banking system, so far with meager or fleeting effects. A very alarming situation, quite unreal as one may have observed. Numerous economists are now warning the worlds central banks to focus on the right issue now rather than later. Creating further liquidity without proper backup means such as gold or a strong economy is likely to fuel the disaster. York professor Peter Spencer, chief economist for the ITEM Club, 8 said at some point that the global authorities had just weeks to get this right: The central banks are rapidly losing control. By not cutting interest rates nearly far enough or fast enough, they are allowing the money markets to dictate policy. We are long past worrying about moral hazard. For instance, in Europe, the European Central Bank (ECB) was facing a dilemma with a record high inflation forecast at 4.1 per cent in July 2008, the highest since the monetary union advent.9 Meanwhile, the worse is probably yet to come as fragile countries such Iceland, and now Spain, Italy and Greece, which are sharply falling into recession, may be running out of liquidity and may have to be backed up by other European members. The question at the end is: Will the European tax payers accept to pay this bill when their own country is at risk? Hence, this may show the true reality of the Eurozone: the weak solidarity of a supposedly mature organization, in fact not quite yet ready for the real thrill. Finally, major banks like Citigroup, Merrill Lynch, UBS, HSBC and others have recently stepped forward to reveal their losses. As reported by the Telegraph in December 2007, Goldman Sachs caused shock when it predicted that total crunch losses would reach $500bn, leading to a $2 trillion contraction in lending as bank multiples kick into reverse. Two years later, the IMF (International Monetary Fund) estimated the total losses to reach $2.28 trillion. But it seemed to have been just a beginning.

Passing the Risk: Who is Next?

As described above, financial crises appear to be repetitions of History. Working cyclically, they differ from their inherent nature though. For instance, the current crisis rose from the weakening of the U.S. home market and became a global crunch. Furthermore, the fact that the problem spread from financial and
8

The ITEM (Independent Treasury Economic Model) Club is a group of forecast experts in economic matters founded in 1977 and sponsored by Ernst & Young. 9 http://www.nytimes.com/2008/07/31/business/worldbusiness/31iht-31inflation.14906518.html

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banking sectors to the entire economy at a global scale in such a short time made it a quite unique momentum. Increased speed, advanced communications and information technologies evolving exponentially have created a greater risk with deeper and long lasting consequences as ever before. Global markets with stronger interdependence and high complexity are paradoxically more prone to correlated risks.

Most people are driven by the simple desire to succeed and do well financially. This means they work harder, enhancing productivity, creativity and innovation. But where and when does this legitimate feeling get overtaken by greed and unscrupulous envy? Why does a minority change the principles of innovation into a gambling leverage for immediate profits? If one considers some of the past economic crises such as the London Market Excess (LMX) 10 fall out in the late 80s and the equivalent substitutes during the following two decades, they all started at some point from promising innovations. These initiatives were all new and seen as very profitable during the early stages. And they all implied a promise on huge benefits, fast and furious. However, the promise turned hopes into ruin and despair. Out of the multiple questions this series of dramatic and unfortunate events can raise, some of them could pose the problem of the impact of risk management that is meant to promote innovations that work and praise individuals for their will to succeed.

Two important factors can shed some light: the fact that new communication means have propelled the finance community to another level of instant profits driven by frenetic greed. Rumors, news whether good or bad instantaneously drive markets to their best or worse. Data signification is amplified far beyond comprehension in a momentum that magnifies exponentially in spiral dive fallout when not controlled adequately. And on another plane, looking at the amplitude of the issue, there is no doubt that financial markets, industries and economies are now fully interdependent. The impact economic and financial shocks can create are far beyond the spectrum of a region or even a nation and can be wide-spread on a global scale instead. While the LMX fall out was limited to the reinsurance market in U.K., the Internet bubble at the beginning of the past decade had a wider range globally but yet remained restricted to investors who had placed financial interests in the sector. From a weakening home market in the U.S., the 2008 crisis shortly developed into a global financial issue bringing down economies, industries and sometimes governments worldwide.

A parallel can be made between the LMX spiral and the subprime fiasco that ignited the global crisis. CDOs and similar financial products were created to temper the risks generated by unscrupulous
10

http://www.clydeco.com/attachments/published/5644/LMX%20Spirals%20update.pdf

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investments by diluting them into cleaner credits. However, the plan did not work as expected and spread all over the credit system. In fact, Schwartzman (2008) confirmed that the LMX spiral and subprime debacles share similar roots by saying: an attempt to mitigate risk by spreading it to market participants, a series of new and complicated instruments not understood by most people and not even well understood by market professionals, a pool of unsophisticated investors not adequately advised of the risk they were taking on, a collection of unscrupulous brokers who took advantage of the situation to increase commissions by encouraging as many deals as possible with no concern as to how they might play out in the future, and huge profits that continued as long as nothing happened to change the situation on the ground.

Conclusion: Towards a New Order?

Following the debacle of the financial and banking systems in 2008, one could have hoped that executive managers would be taking a more serious insight of what risk management is all about. Indeed, their priority has always been to successfully run corporations in which investors had shares and interests. As such, incentives based on performance should have sent a clear message to these top executives who should have then adjusted the risks they were willing to take for their company and somehow as well as for themselves as professionals. But this is the theory of should have happened and not what happened at the bottom of the chain. Indeed, the fiduciary responsibility of many was not met. Meanwhile, the vast nebula created around financial markets has, until recently, hidden the fact that the credit crisis was in the end caused by unscrupulous people who were seeking short term profits rather than long term growth. Lenders with few scruples did take advantage of credulous borrowers, and fortunately or unfortunately these lending businesses disappeared killed by their own counterproductive strategies. Borrowers lied about their incomes to live in homes they could not afford in reality and were given full consent by lenient banking institutions. This spiral of controversial and ineffective stubbornness towards failure could have been stopped or maybe controlled if a relevant structure of regulations had been put in place. Improved and stricter regulations on loans policies could have avoided a large chunk of the crisis dramatic effects, but will those rules, if ever truly and transparently implemented, ever prevent futures crises? Unfortunately, history reminds us that for each regulation or procedure created there is a loophole that can be exploited. Hence, the whole issue lies in the effective design of regulating systems, taking into account the various risks inherent to the relation between economies and private investments. Better focus on the matter would certain reduce systemic problems in the future and it is becoming now a serious concern in Europe and the U.S. who are looking at introducing enhanced reforms on the regulatory system and the quality of rating agencies. Improved risk management is now a definite requirement. The systems in place

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today are too limited to encompass the numerous issues they are intended to address. Hence, weak risk management systems imply more risk. The role statistical and probabilistic models play in the equation is far from being negligible. However, they often tend to focus on the wrong perspectives such as the occurrence of a major loss in a year rather than the likelihood of a Black Swan event for instance. As such, models must not be considered as finite and should evolve and adapt in correlation with their environment. The key to prevent markets from dramatically failing beyond control may also simply lie in the capability of predicting these rare events, a concept that is yet to be fully understood and mastered.

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