"The majority, but notably not all, of decision-makers at the top banks and investment houses simply lacked the depth of information required to appropriately assess the risk of their many investments," said Aamer Baig, managing partner of Diamond financial services industry practice. "The growth of complex products directly contributed to the challenges of managing risk exposure. Since information is deal-specific and usually captured on paper and manually managed, it is virtually impossible for many risk managers to maintain timely and accurate information."
In a new report, "Investing in Risk: The Enduring Legacy of the Subprime Meltdown," Diamond notes that the systems and processes at many firms are geared toward older styles of investments and simpler times, focusing on the collection and management of risk information based on the risk profile of individual investment classes or asset types. Mortgage instruments and equity risks were evaluated very differently, and in a manner that effectively resulted in "silos" of risk information. But as financial markets grew exponentially more complex and interdependent, huge decision-making gaps emerged.
"Firms should have been re-evaluating how they collected, managed, and analyzed risk information in light of the explosive growth of financially-engineered debt instruments and securities such as residential mortgage-backed securities and collateralized debt obligations," said Michelle Wilkes, a Diamond financial services partner who has worked with several major Wall Street firms.
"The few winners of today's subprime meltdown have been addressing the need for more robust data collection and risk assessment processes for more than 10 years. Rather than taking a reactionary 'meet-the-regulations' approach to risk management, these organizations view risk management as a core strategic principle and source of enduring competitive advantage."
Wilkes points to five specific characteristics of the firms who are best weathering the current crisis, including:
- Policies that elevated risk management responsibilities to the highest ranks within the organization, generally on par with CFO-level positions;
- Comprehensive data collection and risk assessment processes that reached beyond individual business lines and asset classes to assess the combined or "aggregated" risk to the firm of all of its investments:
- Strategies that aligned aggregated risk with corporate investment policies and objectives, changing, in a very real way, individual investment decisions;
- A long-term, iterative view of infrastructure improvements that addressed not only the consistency and timeliness of risk information, but also the breadth and comprehensiveness of this information; and
- A corporate culture that viewed risk assessment as a core strategic value delivering significant competitive advantages to the firm.
"In our experience, the critical difference between the victors and victims of market dislocations is the consistent investment in a risk assessment infrastructure and the institutionalization of aggregated risk management across the firm," said Wilkes.
New Culture, New 'Architecture' Required
Financial services firms looking to avoid a repeat of the current crisis need to shore up their firmwide risk management capability on two fronts-culture and information architecture, said Baig.
"Firms need to readjust their culture by promoting a broad understanding and accountability for risk across all levels of the organization. For example, employees should be regularly rotated between business operations and risk control, and awarded equivalent status across divisions," said Baig. "Incentives for both risk managers and front-office traders should take into account risk-adjusted return measures.
"In addition, they should establish dedicated and independent firmwide risk functions that reach across all information silos to aggregate, measure and manage risk at the broadest level. Senior level management committees should be responsible for evaluating all aspects of risk to avoid independent decision-making that may affect the entire firm," he added.
Diamond finds the firms that are successfully navigating today's crisis also are investing in technology to meet what Wilkes calls, "the staggeringly complex computational demands of complex pricing and simulation models." "The ultimate goal should be organization-wide roll-ups of risk assessment data," said Wilkes. "Leading firms can produce aggregate, firmwide risk reporting that can be decomposed to the business unit, account, and position level. End-of-day trading positions in each region are directly sourced from the front office, which means that the front office is held accountable for the accuracy of their end-of-day positions. And the technology is in place to guarantee all accounts and positions are sourced and processed in a timely manner in every region."
Investing in the Fundamentals
Baig notes that CEOs at firms that are weathering the subprime crisis are the champions of their firm's technology direction. Their chief information officers (CIOs) have peer status with the leaders of other functional groups and are expected to provide strong direction regarding risk management practices and tools, as opposed to functioning as mere order-takers. Instead of focusing on quick fixes and managing IT costs, CIOs at the leading companies are look for ways to improve their firms' risk infrastructure.
"We continue to see significant investment in projects that provide incremental improvements rather than attacking the fundamental issues associated with today's information environment," cautions Baig. "This is a mistake, as the infrastructure required to support this level of integration is complex and requires constant investment."
Diamond's experience suggests that the cost of appropriately addressing today's governance, modeling consistency, data transparency, and risk control issues could require an investment between $200 million and $250 million. The outcome, however, is an organization with risk controls, transparency, and accountability that reaches all the way from a firm's trading positions to the board level.
