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1、The Financial Crisis and the Future of Risk Management Paul Ingram-Global Head of Market Risk,RBSThe views expressed in this presentation are the views of the author and do not necessarily reflect the views or policies of RBS GroupUniversity of Essex26 March 2010The Financial Crisis|2Who do you blam

2、e for the recent market crisis?The Banks?The Regulators?The Government?Risk Managers?The Financial Crisis|3BackgroundIn this presentation I will highlight some of the contributory factors that led to the recent market crisis,and promote discussion regarding what could be done to reduce the severity

3、of any future crises.The Financial Crisis|4Sowing the seedsA very low interest rate environment persisted throughout the early 2000s.This was Chairman Greenspans response to the bursting of technology bubble and 9/11The Financial Crisis|5Sowing the seedsDuring the 2000s,Global financial imbalances i

4、ncreased,China became a more significant exporter and a more significant influence in global financial markets,as it sought to invest its current account surplus.The Financial Crisis|6Sowing the seedsSurplus nations(e.g.China)sought to invest their excess funds into liquid marketable securities.This

5、 permitted the US to issue a significant amount of debt at historically low spreads.The Financial Crisis|7Sowing the seedsThe demand for US Treasuries from surplus nations,the low Federal Funds rate and low inflation meant that the real yield on highly-rated securities was low.Investors demanded sec

6、urities that provided enhanced yields but had high external credit ratingsBanks were therefore keen to provide new securities which had the same ratings as Treasuries,but provided an enhanced yield.The Financial Crisis|8Sowing the seeds-Asset Backed Securities(ABS)Agency(Fannie Mae/Freddie Mac)mortg

7、ages in the US had long been structured into ABS in order to facilitate the growth in home ownership.Packaging mortgages into bonds with an implicit US government credit protection proved very popular with investors.As the agencies had fairly strict lending criteria,the demand for these securities w

8、as strong and hence yields were not significantly above Treasuries.The Financial Crisis|9Motivation for non agency RMBSAs investors continued to chase yield there was a demand for ABS collateralised upon mortgages to riskier borrowers.This increased the supply of mortgages to portions of the US econ

9、omy that had never previously been homeowners(often at artificially low“teaser”rates)Banks who facilitated the original mortgage loans were less concerned about the ability of the borrower to repay,as they were transferring the credit risk onto the investors.Furthermore,the perception was that house

10、 prices would continue to rise,permitting homeowners to refinance with the increased equity in their homes.The Financial Crisis|10Boom and BustThis was mirrored by a perception that the UK economy had reached a stable equilibrium “As I have said before Mr Deputy Speaker:No return to boom and bust.”G

11、ordon Brown,Chancellor of the Exchequer-March 2006The Financial Crisis|11A move toward sub prime“Sub prime”(and Alt-A)mortgages had previously constituted a reasonably small proportion of total mortgage issuance,however with the demand from investment banks,this issuance grew significantly through t

12、he middle of the 2000s The Financial Crisis|12Sowing the seeds-Bank RegulationRegulation of banks and other financial institutions had moved away from an intrusive assessment of risk,to a principles-based approach where regulators placed more trust in institutions internal controlsDetermination of t

13、he required levels of capital became increasingly calculated based on models which were calibrated to current market conditions(which were benign)and did not cover all sources and nuances of risk that banks were exposed toCapital ratios across the banking industry were permitted to reduce over time

14、to a level at which the whole banking industry was at risk in the event of a systemic event.The Financial Crisis|13Sowing the seeds-LeverageThe amount of capital issued by banks(especially the investment banks)did not grow in line with their balance sheets.i.e.they became more highly leveraged over

15、timeThe Financial Crisis|14Sowing the seeds-off balance sheet assetsMany banks also set up special purpose companies whose role it was to facilitate the creation of highly rated assets for investors.Examples of this included Securitisation vehicles Structured Investment Vehicles(SIVs)Conduits/Asset

16、Backed CP vehiclesThe size of these off balance sheet vehicles were significant,more significantly many of the structures funded illiquid assets with short-term debt that needed to be rolled over regularly SIVs reached a peak of$425bn,The ABCP market peaked at$1.2trnThe Financial Crisis|15Sowing the

17、 seeds-off balance sheet assetsDerivative Product Companies were set up to be AAA rated derivative counterparties-the motivation was that banks would reduce their capital requirements through entering into derivatives with a AAA rated entityAdditionally AAA rated firms(monolines,insurers etc)that we

18、re not regulated in the same manner as banks were able to sell credit protection to banks in very large volumes.The Financial Crisis|16Growth in lending to riskier counterpartiesIn order to continue to meet very high Return on Equity targets,banks increased their leverage,and also extended credit to

19、 riskier counterparties than previously often with very thin spreads These loans were often secured against collateral that had escalated in value significantly(Commercial Real Estate,Residential property)or had mechanics that made full repayment contingent upon ever increasing asset values(e.g.leve

20、raged loans,payable in kind(PIK)notes)Banks also warehoused significant volumes of assets on their balance sheet for onward securitisation into ABS and retained the economic risk of the most senior portions of securitisations(often through derivative transactions)This could be seen as the start of t

21、he breakdown of the“originate to distribute”banking model.The Financial Crisis|17So what were the warning signs?Low interest ratesHigh risk appetiteBelief that“boom and bust”was overConsistent asset growthPerception that property was a“safe”investmentIncrease in product complexity without an increas

22、e in investor sophisticationThe Financial Crisis|18So what were the warning signs?Capital was highly model drivenOverall levels of capital were historically lowLack of proactivity in risk managementHigh level of herd-behaviourIncrease in liquidity mismatches Regulatory and risk management practices

23、accorded with the view that risk was lowThe Financial Crisis|19What happened next?In late 06 several research notes were published regarding the US sub prime market.Several market participants became more active in the CDS markets,betting on the failure of sub prime bonds(ABX).Through to the middle

24、of 07 these doubts continued and the lack of confidence spread to the funding markets,where funding spreads started to riseLiquidity popped in Aug 07,this caused significant issues for institutions that relied on wholesale fundingGeneral mistrust in the valuation of illiquid structured assets,and th

25、e liquidity of counterparties continued to raise the costs of fundingThe Financial Crisis|20The scale of the market movementsThe Financial Crisis|21The scale of the market movementsTED spread,i.e.the spread between US 3m T-bills and US 3m LIBOR rose significantlyThe Financial Crisis|22What happened

26、next?Doubts over valuation and liquidity continued to mount in early 2008 and the market turned its attention to banks that were most affected.Northern Rock had to turn to the UK government for liquidity in Sep 07 and was nationalised in Feb 08In March 08 JP Morgan rescued Bear Stearns from bankrupt

27、cy with the assistance of the US governmentThroughout the summer of 2008 banks rushed to issue capital to shore up their balance sheets,losses continued to mount as Alt-A borrowers,commercial real estate and leveraged loans started to show weaknessThe Financial Crisis|23Panic and the rescueLehman Br

28、others was the next most vulnerable institution and after rescue talks with the Korean Development Bank,then BoA and lastly Barclays fell,it was forced into bankruptcy on 15 Sep 08The house of cards started to tumble with Merrills selling itself to BoA,Wachovia to Wells Fargo,HBOS to Lloyds.Morgan S

29、tanley and Goldman Sachs came very close to losing their independenceGovernments had to step in to rescue RBS,AIG and the Icelandic banks and then provide capital for many major financial institutions.The Financial Crisis|24Pre-crisis characteristicsCrises share similar factors,a fundamental mis-pri

30、cing of risk driven by a combination of:A new“paradigm”Disconnect with the underlying economics Greed and hubrisThe Financial Crisis|25Pre-crisis characteristicsThe Financial Crisis|26Current regulatory responseMore capitalMore conservative modellingMore transparencyMore independent challengeThe Fin

31、ancial Crisis|27Crisis interventionMoral hazardLoss of confidenceLoss of legitimacyThe Financial Crisis|28Ideas for improvementCountercyclical capital measures-ensure banks hold more capital when markets are benignPenalise excessive leverage or funding mismatchesFocus on bespoke risk management-ensu

32、ring that practices are fit for the institutionTake action on systemic liquidity riskIntervene in markets to control macro-economic risk?The Financial Crisis|29Thoughts for investorsThere is no such thing as a free lunchUnderstand the investment propositionConsider what could happen in a stress even

33、tWho will provide you with liquidity?The Financial Crisis|30Key learning from all crisesDONT:believe in new paradigms buy or sell anything you dont understand rely entirely on models,ratings or market prices assume you can sell at the market price,or at all assume anything will remain the same forever get carried away-think about the underlying economics!