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Financial Crisis: Where Did Risk Management Fail?

Published: 2009
International Review of Applied Financial Issues and Economics
By Gabriele Sabato
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Abstract

The real estate market bubble and the subprime mortgages have been often identified as the causes of the current financial crisis, but this is not entirely true or, at least, they cannot be considered as the main cause. A poor regulatory framework based on the belief that banks could be trusted to regulate themselves is among the main sources of the crisis. At the same time, risk management at most banking institutions has failed to enforce the basic rules for a safe business: i.e., avoid strong concentrations and minimize volatility of returns. The purpose of this study is to identify the reasons behind the risk management failure and offer a view on how they can be solved or improved going forward if we want to ensure a sounder financial system than today’s one. In particular, I examine the following issues: 1) lack of a defined capital allocation strategy, 2) disaggregated vision of risks and 3) inappropriate risk governance structure.

"The real estate market bubble and the subprime mortgages have been often identified as the causes of the current financial crisis, but this is not entirely true or, at least, they cannot be considered as the main cause."

Introduction

When examining the causes for the financial crisis, most people start directly with the real estate market focusing on the subprime mortgages and unscrupulous lenders and casting the blame on the unsustainable real estate bubble which began to collapse in 2006. Whereas this is true, it is not the whole story. A poor regulatory framework based on the belief that banks could be trusted to regulate themselves is, in my opinion, among the main sources of the crisis. It is quite obvious that regulators across the world have not efficiently monitored the risk management functions of most banks.

At the same time, risk management at most banking institutions has failed to enforce the basic rules for a safe business: i.e., avoid strong concentrations and minimize volatility of returns. Several excuses have been presented to hide this failure (e.g. limited role of risk management, inability to influence business decisions, incapacity of forecasting such a severe crisis, etc). Although some of these excuses may be partially true for some institutions, however I am convinced that the risk management function has clearly shown its significant weaknesses and failures.

The purpose of this study is to identify the reasons behind the failure of risk management and offer a view on how they can be solved or improved going forward if we want to ensure a sounder financial system than today’s one. In particular, I examine the following issues: 1) lack of a defined capital allocation strategy, 2) disaggregated vision of risks and 3) inappropriate risk governance structure.

Most banks used to grow their lending portfolios driven by market demand without a clear capital allocation strategy. Regulatory pressures, such as Basel II and a greater focus on corporate governance, have been a stimulus for many changes in the industry. One of these has been the recognition of the need to articulate risk appetite more clearly. Risk appetite translates risk metrics and methods into business decisions, reporting and day-to-day business discussions. It sets the boundaries which form a dynamic link between strategy, target setting and risk management.

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