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1. Senior Supervisors Group Observations on Risk Management Practices during the Recent Market Turbulence March 6, 2008 2. OBSERVATIONS ON RISK MANAGEMENT PRACTICES…
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  • 1. Senior Supervisors Group Observations on Risk Management Practices during the Recent Market Turbulence March 6, 2008
  • 2. OBSERVATIONS ON RISK MANAGEMENT PRACTICES DURING THE RECENT MARKET TURBULENCE FRANCE Banking Commission SENIOR SUPERVISORS GROUP Didier Elbaum Alain Laurin March 6, 2008 Guy Levy-Rueff Mr. Mario Draghi, Chairman Frederick Visnovsky Financial Stability Forum Bank for International Settlements GERMANY Centralbahnplatz 2 Federal Financial CH-4002 Basel Supervisory Authority Switzerland Sabine Lautenschläger-Peiter Peter Lutz SWITZERLAND Dear Mr. Draghi: Federal Banking Commission On behalf of the Senior Supervisors Group, I am writing to convey a report that assesses Tim Frech which risk management practices worked well, and which did not, at a sample of major global Roland Goetschmann financial services organizations during the recent period of market turmoil. This report, Thomas Hirschi Observations on Risk Management Practices during the Recent Market Turbulence, summarizes Daniel Sigrist the results of a review that we undertook this past autumn of firms’ practices. It also reflects UNITED KINGDOM the results of a roundtable discussion that participating supervisory agencies held with industry Financial Services Authority representatives on February 19 at the Federal Reserve Bank of New York. Stan Bereza A few caveats are necessary when reviewing this report. First, while the analysis covered Nicholas Newland eleven of the largest banking and securities firms (and the roundtable included representatives Andrea Pack of five additional firms), it did not cover the universe of all major firms active in the relevant UNITED STATES markets. Second, the observations reflect supervisory judgments based primarily on detailed Board of Governors of the discussions with these firms, supplemented with information drawn from ongoing supervisory Federal Reserve System work. Finally and most importantly, the analysis was completed prior to the conclusion of the Deborah P. Bailey period of market turmoil. Roger T. Cole Subject to these caveats, the report identifies a number of risk management practices that Jon D. Greenlee Steven M. Roberts may be associated with negative or positive performance to date. The predominant source of losses for firms in the survey through year-end 2007 was Federal Reserve Bank the firms’ concentrated exposure to securitizations of U.S. subprime mortgage-related credit. of New York In particular, some firms made strategic decisions to retain large exposures to super-senior Arthur G. Angulo Brian L. Peters tranches of collateralized debt obligations that far exceeded the firms’ understanding of the William L. Rutledge risks inherent in such instruments, and failed to take appropriate steps to control or mitigate (Chairman) those risks. Such firms have taken major losses on these holdings, with substantial implications for their earnings performance and capital positions. Office of the Comptroller of the Currency Another risk management challenge concerned firms’ understanding and control over their Kathryn E. Dick potential balance sheet growth and liquidity needs. For example, some firms failed to price Douglas W. Roeder properly the risk that exposures to certain off-balance-sheet vehicles might need to be funded Scott N. Waterhouse on the balance sheet precisely when it became difficult or expensive to raise such funds externally. Likewise, some firms found that they could not syndicate their holdings of leveraged Securities and Exchange loans because of reduced investor appetite for those assets and that they could not cancel their Commission commitments to fund those loans. The resulting effects on the balance sheets of major firms Matthew J. Eichner from these sources have been substantial, although the impact on capital ratios has been Denise Landers significantly less than the effect from the write-downs on their exposures to securitizations Michael A. Macchiaroli of subprime mortgage-related credit. Erik R. Sirri Firms that avoided such problems demonstrated a comprehensive approach to viewing firm-wide exposures and risk, sharing quantitative and qualitative information more effectively across the firm and engaging in more effective dialogue across the management team. Senior managers in such firms also exercised critical judgment and discipline in how they valued its holdings of complex or potentially illiquid securities both before and after the onset of the Transmittal letter
  • 3. OBSERVATIONS ON RISK MANAGEMENT PRACTICES DURING THE RECENT MARKET TURBULENCE market turmoil. They had more adaptive (rather than static) risk measurement processes and systems that could rapidly alter underlying assumptions to reflect current circumstances; management also relied on a wide range of risk measures to gather more information and different perspectives on the same risk exposures and employed more effective stress testing with more use of scenario analysis. In addition, management of better performing firms typically enforced more active controls over the consolidated organization’s balance sheet, liquidity, and capital, often aligning treasury functions more closely with risk management processes, incorporating information from all businesses into global liquidity planning, including actual and contingent liquidity risk. Using the observations of the report to set expectations, primary supervisors are critically evaluating the efforts of the individual firms they supervise to address weaknesses in risk management practices that emerged during the period of market turmoil. Each supervisor is ensuring that its firms are making appropriate changes in risk management practices, including addressing deficiencies in senior management oversight, in the use of risk measurement techniques, in stress testing, and in contingency funding planning. Finally, our observations help to define an agenda for strengthening supervisory oversight of relevant areas. In particular, we have identified the following areas relevant to this agenda. First, we will use the results of our review to support the efforts of the Basel Committee on Banking Supervision to strengthen the efficacy and robustness of the Basel II capital framework by: • reviewing the framework to enhance the incentives for firms to develop more forward-looking approaches to risk measures (beyond capital measures) that fully incorporate expert judgment on exposures, limits, reserves, and capital; and • ensuring that the framework sets sufficiently high standards for what constitutes risk transfer, increases capital charges for certain securitized assets and asset-backed commercial paper liquidity facilities, and provides sufficient scope for addressing implicit support and reputational risks. Second, our observations support the need to strengthen the management of liquidity risk, and we will continue to work directly through the appropriate international forums (for example, the Basel Committee, International Organization of Securities Commissions, and the Joint Forum) on both planned and ongoing work in this regard. Third, based on our shared observations from this review, individual national supervisors will review and strengthen, as appropriate, existing guidance on risk management practices, valuation practices, and the controls over both. Fourth and finally, we will support efforts in the appropriate forums to address issues that may benefit from discussion among market participants, supervisors, and other key players (such as accountants). One such issue relates to the quality and timeliness of public disclosures made by financial services firms and the question whether improving disclosure practices would reduce uncertainty about the scale of potential losses associated with problematic exposures. Another may be to discuss the appropriate accounting and disclosure treatments of exposures to off-balance-sheet vehicles. A third may be to consider the challenges in managing incentive problems created by compensation practices. We are simultaneously releasing the report publicly to inform the broader industry of the results of our review and to identify areas of practice where industry attention is necessary. Sincerely, William L. Rutledge Chairman Transmittal letter
  • 4. OBSERVATIONS ON RISK MANAGEMENT PRACTICES DURING THE RECENT MARKET TURBULENCE TABLE OF CONTENTS I. INTRODUCTION . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1 II. SUMMARY OF KEY OBSERVATIONS AND CONCLUSIONS. . . . . . . . . . . . . . . . . . . . . . . . . 2 A. Four Firm-Wide Risk Management Practices That Differentiated Performance . . . . . . . . . . . . . 3 1. Effective firm-wide risk identification and analysis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3 2. Consistent application of independent and rigorous valuation practices across the firm. . . . . . . . . . . . . 3 3. Effective management of funding liquidity, capital, and the balance sheet . . . . . . . . . . . . . . . . . . . . . 3 4. Informative and responsive risk measurement and management reporting and practices. . . . . . . . . . . . 4 B. Three Business Lines Where Varying Practices Differentiated Performance. . . . . . . . . . . . . . . . . 5 1. CDO structuring, warehousing, and trading businesses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5 2. Syndication of leveraged financing loans . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5 3. Conduit and SIV business . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5 C. Supervisory Response. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6 III. SENIOR MANAGEMENT OVERSIGHT . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6 A. The Balance between Risk Appetite and Risk Controls . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7 B. Senior Management’s Role in Understanding and Acting on Emerging Risks . . . . . . . . . . . . . . . 8 C. Timing and Quality of Information Flow up to Senior Management . . . . . . . . . . . . . . . . . . . . . 9 D. Breadth and Depth of Internal Communication across the Firm . . . . . . . . . . . . . . . . . . . . . . . . . 9 IV. LIQUIDITY RISK MANAGEMENT . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10 A. Planning and Managing Internal Pricing for Contingent Events . . . . . . . . . . . . . . . . . . . . . . . . 10 B. Funding Liquidity Management during the Stress Event . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11 C. Contingency Funding Plans . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11
  • 5. OBSERVATIONS ON RISK MANAGEMENT PRACTICES DURING THE RECENT MARKET TURBULENCE V. CREDIT AND MARKET RISK MANAGEMENT. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12 A. Valuation Practices Relevant to Risk Management. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12 1. Market liquidity premia embedded within pricing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13 2. Ongoing refinements to models . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13 3. Uncertainty in the performance of subprime assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13 B. Use of a Range of Risk Measures . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 14 1. Use of multiple tools . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 14 2. Consideration of notional measures . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 14 3. Use of value-at-risk . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 14 4. Quality of price data sets and volatility estimates. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15 5. Basis risk . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15 6. Design and integration of market risk measurement tools . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 16 7. Integration of exposures across risk types . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 16 8. Use of profit and loss reporting as a signal of emerging stress . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 16 C. Stress Testing and Scenario Analysis. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 16 1. Risk identification and modeling issues . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 16 2. Senior management involvement in stress testing and scenario analysis. . . . . . . . . . . . . . . . . . . . . . . 17 3. Links between scenarios and business practices . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 17 D. Hedging of Market and Credit Risks . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 17 E. Credit Underwriting and Reporting . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 18 F. Counterparty Risk Measurement and Management . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 19 VI. CONCLUDING COMMENTS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20 APPENDIX A: ABBREVIATIONS USED IN THIS REPORT . . . . . . . . . . . . . . . . . . . . . . . . . . . . 21 APPENDIX B: MEMBERS OF THE SENIOR SUPERVISORS GROUP . . . . . . . . . . . . . . . . . . . . 22 ii
  • 6. OBSERVATIONS ON RISK MANAGEMENT PRACTICES DURING THE RECENT MARKET TURBULENCE I. INTRODUCTION have, so that we could better evaluate whether changes in supervisory guidance and expectations are necessary. After an extended period of ample financial market liquidity To this end, we developed an extensive questionnaire and generally low credit spreads in many economies, the sharp covering senior management oversight and risk management loss in the value of subprime mortgages and related mortgage- performance across key dimensions. We shared the backed securities and the deterioration in investor appetite questionnaire with a sample of eleven global banking during the summer of 2007 led to broad and deep market organizations and securities firms that are significant distress. Because these and other innovative products had been competitors in affected markets and that experienced a range created during the prior period of more benign market of outcomes through the early months of the market turmoil. conditions, banks and securities firms had not observed how In November 2007, we met with senior management at the such products would behave during a significant market selected organizations to elicit their perspectives on how well downturn and found their risk management practices tested or how poorly key elements of their corporate governance, to various degrees. business strategy, and risk management practices had worked Asset-backed securities (ABS1) in general and mortgage- up to that point in time. By analyzing the results of these backed securities (MBS) in particular experienced the greatest systematic discussions and by using information otherwise degree of stress in 2007. The loss in the value of subprime available to principal supervisors, our senior supervisory group mortgages throughout the year led to growing uncertainty sought to determine the effectiveness of different risk about the valuations of credit instruments such as management practices over the period of stress through the collateralized debt obligations (CDOs) that often included end of calendar year 2007. We then met with industry such subprime mortgages in what investors and rating agencies representatives on February 19, 2008, in New York to share had previously considered high-quality assets. Consequently, our observations and seek comments on them. investors sought clarity about the quality of specific assets This report outlines supervisors’ observations on the risk supporting investment securities and shunned those whose management practices that may have enabled some firms risk they could not easily assess. Their willingness to purchase to weather the financial market turmoil better than others similar securitized assets backed by mortgages waned as they through year-end 2007. Specifically, supervisors focused on realized the difficulties of assessing the quality of the practices related to the following: underlying assets, as did their willingness to purchase other complex credit products, such as collateralized loan • the role of senior management oversight in assessing obligations (CLOs). Consequently, many types of credit and responding to the changing risk landscape; instruments, such as MBS and other ABS, CDOs, CLOs, • the effectiveness of market and credit risk management and asset-backed commercial paper (ABCP), became illiquid practices in understanding and managing the risks in during this time, causing steep decreases in many secondary retained or traded exposures as well as in counterparty market prices and requiring corresponding markdowns in the exposures, in valuing complex and increasingly illiquid valuations of firms’ holdings of affected assets. products, and in limiting or hedging exposures to credit Early on in this period of market turbulence, our group— and market risk, and senior supervisors of such major financial services firms from France, Germany, Switzerland, the United Kingdom, and the • the effectiveness of each firm’s liquidity risk United States2—convened to assess whether shortcomings in management practices in assessing its vulnerability to risk management may have contributed to the losses. More that risk in a stressed environment and taking specifically, we sought to identify risk management practices appropriate action. that may have tended to work well, and those that may no It should be emphasized that the observations in this report 1 A list of abbreviations used in this report appears in Appendix A. reflect our understanding of risk management practices at 2 The seven supervisory agencies participating in this project are the French eleven major firms through our year-end 2007 review period. Banking Commission, the German Federal Financial Supervisory Authority, Our work does not represent a comprehensive review of the the Swiss Federal Banking Commission, the U.K. Financial Services Authority, turmoil and all firms’ experiences. As market events progress, and, in the United States, the Office of the Comptroller of the Currency, the Securities and Exchange Commission, and the Federal Reserve. other weaknesses may emerge, and our observations may not The list of working group members appears in Appendix B. prove to be definitive or complete. Consequently, this report 1
  • 7. OBSERVATIONS ON RISK MANAGEMENT PRACTICES DURING THE RECENT MARKET TURBULENCE should be viewed as an interim assessment of the key risk surprised by the nature and length of the market disruption management practices that have affected major firms’ ability and were forced to fund exposures that they had not to weather the current market turbulence. anticipated in their contingency funding plans. This included retaining exposures in warehouse portfolios for significantly longer periods of time than expected when firms reali
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