Alert May 20, 2008

FRB Discusses Bank Risk Management Concerns and Responses

At different conferences, FRB Chairman Bernanke and Federal Reserve Bank of Boston President Rosengren spoke about risk management concerns and responses by US banking institutions and US federal bank regulators.  Although Mr. Rosengren focused more on operational risk while Chairman Bernanke spoke more about risk management generally, both provided background as to the current turmoil, particularly the “originate to distribute model” of mortgage lending, and then focused attention on similar specific areas.

Risk Management Approaches.  Perceived breakdowns in risk management approaches of financial institutions was an extended focus of both speakers.  Chairman Bernanke noted “significant deficiencies” by banking institutions in identifying and measuring risks.  He cited underestimation of the risk of subprime mortgages and structured finance products, as well as failing to recognize the linkages between credit and market risk, as prime examples.  Chairman Bernanke also criticized an overreliance on quantitative models (like Value at Risk), rather than a more multi-faceted approach to calculating risk.  Mr. Rosengren highlighted that many of the problems in the current turmoil are attributable, in part, to institutions developing and applying risk models based on insufficient data regarding the originate to distribute model and larger economic changes, and failing to take a conservative approach (e.g., holding more capital) in light of that limited data.

Both speakers also highlighted the inadequate stress testing done by many institutions with respect to their credit models.  Mr. Rosengren noted that “none of the major stress tests I am aware of – done by a variety of financial institutions – came close to capturing the depth of problems that we are experiencing today.”  He stated that most models missed many of the linkages – between lowered housing prices and default incentives, the inability of a household to pay all its debts if it could not pay its mortgage, and the liquidity concerns that would result – that are evident today.  He further noted that legal risks particularly involving litigation, are among the higher risks today.  Chairman Bernanke focused more on the need for organization-wide stress testing to determine risk concentrations that cut across the banking book, the securities portfolio, and counterparty exposures.

Liquidity Risk.  Both speakers also focused on liquidity risk.  Chairman Bernanke stated that “institutions must understand their liquidity needs at an enterprise-wide level and be prepared for the possibility that market liquidity may erode quickly and unexpectedly”.  He noted that many institution treasury functions did not have sufficient data to gauge the liquidity impact of the liquidity needs of several business lines concurrently, or off balance sheet assets coming on balance sheet.  Mr. Rosengren focused on how banks did not adequately evaluate the liquidity of facilities such as auction rate securities, and also did not take sufficient precautions to protect against the illiquidity created by the need to quickly unwind positions of a rogue trader.

Supervisory Responses.  Chairman Bernanke also discussed the supervisory response to these issues.  He stated that it is “clear that supervisors must redouble their efforts to help organizations improve their risk management practices.”  Moreover, the FRB also is considering issuing further guidance on the need for an enterprise-wide perspective when assessing risk.  The FRB also is working with the Basel Committee on Banking Supervision to develop enhanced guidance on management of liquidity risks and better disclosures to strengthen market discipline.