After an extended period of ample financial market liquidity and generally low credit spreads in many economies, the sharp loss in the value of subprime mortgages and related mortgage backed securities and the deterioration in investor appetite during the summer of 2007 led to broad and deep market distress. Because these and other innovative products had been created during the prior period of more benign market conditions, banks and securities firms had not observed how such products would behave during a significant market downturn and found their risk management practices tested to various degrees.
Asset backed securities (ABS) in general and mortgage backed securities (MBS) in particular experienced the greatest degree of stress in 2007. The loss in the value of subprime mortgages throughout the year led to growing uncertainty about the valuations of credit instruments such as collateralized debt obligations (CDOs) that often included such subprime mortgages in what investors and rating agencies had previously considered high-quality assets. Consequently, investors sought clarity about the quality of specific assets supporting investment securities and shunned those whose risk they could not easily assess. Their willingness to purchase similar securitized assets backed by mortgages waned as they realized the difficulties of assessing the quality of the underlying assets, as did their willingness to purchase other complex credit products, such as collateralized loan obligations (CLOs). Consequently, many types of credit instruments, such as MBS and other ABS, CDOs, CLOs, and asset backed commercial paper (ABCP), became illiquid during this time, causing steep decreases in many secondary market prices and requiring corresponding markdowns in the valuations of firms’ holdings of affected assets.
Early on in this period of market turbulence, our group senior supervisors of such major financial services firms from France, Germany, Switzerland, the United Kingdom, and the United States convened to assess whether shortcomings in risk management may have contributed to the losses. More specifically, we sought to identify risk management practices that may have tended to work well, and those that may no have, so that we could better evaluate whether changes in supervisory guidance and expectations are necessary.
To this end, we developed an extensive questionnaire covering senior management oversight and risk management performance across key dimensions. We shared the questionnaire with a sample of eleven global banking organizations and securities firms that are significant competitors in affected markets and that experienced a range of outcomes through the early months of the market turmoil.In November 2007, we met with senior management at the selected organizations to elicit their perspectives on how well or how poorly key elements of their corporate governance, business strategy, and risk management practices had worked up to that point in time. By analyzing the results of these systematic discussions and by using information otherwise available to principal supervisors, our senior supervisory group sought to determine the effectiveness of different risk management practices over the period of stress through the end of calendar year 2007. We then met with industry representatives on February 19, 2008, in New York to share our observations and seek comments on them.
Contents B. Three Business Lines Where Varying Practices Differentiated Performance C. Supervisory Response IV. LIQUIDITY RISK MANAGEMENT V. CREDIT AND MARKET RISK MANAGEMENT B. Use of a Range of Risk Measures C. Stress Testing and Scenario Analysis VI. CONCLUDING COMMENTS Download
I. INTRODUCTION
II. SUMMARY OF KEY OBSERVATIONS AND CONCLUSIONS
A. Four Firm Wide Risk Management Practices That Differentiated Performance
2. Consistent application of independent and rigorous valuation practices across the firm
3. Effective management of funding liquidity, capital, and the balance sheet
4. Informative and responsive risk measurement and management reporting and practices
1. CDO structuring, warehousing, and trading businesses
2. Syndication of leveraged financing loans
3. Conduit and SIV business
III. SENIOR MANAGEMENT OVERSIGHTA. The Balance between Risk Appetite and Risk Controls
B. Senior Management’s Role in Understanding and Acting on Emerging Risks
C. Timing and Quality of Information Flow up to Senior Management
D.Breadth and Depth of Internal Communication across the FirmA. Planning and Managing Internal Pricing for Contingent Events
B. Funding Liquidity Management during the Stress Event
C. Contingency Funding Plans
A. Valuation Practices Relevant to Risk Management1. Market liquidity premia embedded within pricing
2. Ongoing refinements to models
3. Uncertainty in the performance of subprime assets1. Use of multiple tools
2. Consideration of notional measures
3. Use of value-at-risk
4. Quality of price data sets and volatility estimates
5. Basis risk .
6. Design and integration of market risk measurement tools
7. Integration of exposures across risk types
8. Use of profit and loss reporting as a signal of emerging stress1. Risk identification and modeling issues
2. Senior management involvement in stress testing and scenario analysis Links between scenarios and business practicesD.Hedging of Market and Credit Risks
E. Credit Underwriting and Reporting
F. Counterparty Risk Measurement and Management
APPENDIX A: A BBREVIATIONS USED IN THIS REPORT
APPENDIX B: MEMBERS OF THE SENIOR SUPERVISORS GROUP
PDF Ebook Observations on Risk Management Practices during the Recent Market Turbulence
