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The interactions between risk management and technology

Focus both on technology developments that can help improve risk management, but also on other aspects such as operational and potentially strategic risks caused by advances in technology

August 09, 2010

The Invisible Hand

I recently read a most instructive paper entitled "Slapped in the Face by the Invisible Hand: Banking and the Panic of 2007" by Gary Gorton from Yale. The paper is an attempt to explain the underlying causes of the 2008 market failure. I will do a short summary here, but the paper itself is very readable and I highly recommend it.

Basically, Gorton's premise is that the crash was caused by a run on the shadow banking system. He defines the shadow banking system as one in which wholesale financial market players - banks, securities dealers, asset managers etc. - deposit and borrow large sums of money. This situation is exactly parallel to the way in which individuals (that's you and me) in the real banking economy "lend" money to banks via deposits. The thrust of the article is to show that what happened in 2008 was nothing more than a "run-on-the-bank" that has been seen numerous times, but this time in the harder to understand shadow banking system.

The term "shadow banking system" has no sinister connotations. Banks lend money to each other all the time via what is known as the repo market. Basically what happens in this market is as follows: Bank A buys a $100 bond (usually the numbers are of course much larger) but does not have the cash for it. What it does instead is go to Bank B and gets into a short-term repurchase agreement (or repo) to get the cash. Essentially Bank A sells the bond to Bank B immediately for $100, and at the same time agrees to buy the bond back from Bank B the next day for a slightly higher amount (say $100.10). The 10 cents difference that is made by Bank B is the interest rate for what amounts to a 1-day loan. The net effect is of Bank B lending $100 to Bank A with collateral for safety. Bank B is said to engage in a Reverse Repo. This sort of lending is usually considered very safe. First, if Bank A were to go bankrupt in the evening, Bank B is not left holding the bag - it has $100 of collateral that it can liquidate to ensure that it has no losses. Second, the loan is for a very short term (usually 1-day or at most a few days long) to minimize the chances of the borrower failing during that time. Third, banks resort to a mechanism called haircuts - rather than give Bank A $100 for the bond, Bank B may haircut the bond by $5 and lend only $95. This would ensure that even if Bank A went bankrupt and Bank B was forced to sell the bond in a distressed market, there was a safety cushion.

The perceived safety of this market had an explosive effect on its growth. Continuing the above example, if Bank A started off with $100 of cash, it could use successive rounds of repo financing to hold up to $2000 of bonds in this way, or establish a leverage of 20. This limit is established due to the 5% haircut. What if the haircut were made smaller, or entirely eliminated? Bank A would essentially have the potential for unlimited leverage. The foundation of this market, as in any other, is trust. Banks trust one another to be solid, upstanding organizations. Even if that line of defense fails, banks trust that the collateral can be liquidated for a price that is close to that which the repo was contracted at. The violation of this trust was at the heart of crisis in mid-September. The prices of mortgage-backed collateral rated "Super-Senior" (i.e. supposedly safer than the very safe AAA-bonds), started plummeting for a variety of reasons. This combined with the perception of weakness among various players in the wholesale market ensured a panic where lenders did not know which borrower was good for the loan, and decided to figuratively stuff their mattresses instead.

So, according to Gorton, the last-ditch firewall is to prevent the panic at all costs. The key notion here is to make debt like deposits or reverse-repos "informationally-insensitive", i.e. there is no value in knowing information about the debtor's credit-worthiness. In the retail deposit market in the US this has been effectively done by insuring deposits via the Federal Deposit Insurance Corporation (FDIC). He suggests a similar approach in the institutional market. Just like retail depositors don't need to think twice about which bank they deposit savings into, institutional investors will likewise not have to hoard cash if they had a federal guarantee.

The paradoxical aspect of this is, of course, that the informational insensitivity - that is the state where creditors do not care about information about their counter-party - can only come about with extreme amounts of information being provided. The only way the FDIC can avoid losing money in the aggregate is to closely monitor bank performance and take strong, rapid steps to address any issues that may come up. This is evidenced by the large number of banks that have been taken over by the FDIC in the past 2 years. Clearly, real informational insensitivity can only come by increasing the information sensitivity of a particular, credible entity. Credibility is critical. This mechanism would not work if the FDIC were not backed by a reserve fund that was properly managed. Indeed, where the fund has dropped to dangerous levels the FDIC has had to take steps to boost funding.

However, one could well ask if simple transparency into the information is enough. In other words, without the punitive power of the FDIC to shut down banks, would the informational insensitivity work simply by ensuring that information about the repo market is available? Clearly this would not be sufficient - for the mechanism to work it's essential for an organization like the FDIC to be keenly interested in continuously analyzing the information. The current financial reform bill, that was signed into law on 21,July 2010 provides such a mechanism for this market. While imperfect in many ways (see here for a contrary opinion), it does provide the mechanism and the intent for closer and more flexible monitoring of the largest financial players, especially those considered systemically important. Add to this the concept of deep data collection and analysis through the Office of Financial Research, also provided for in the bill, and we have the makings of a system that can bring trust to the shadow banking system. While the extreme aspects Gorton's proposal - with the Federal government actually guaranteeing deposits in this system - have not taken root, the underlying premise will surely have a salutary effect on the health and strength of the system. 

Posted by Dilip Krishna at 03:42 AM | Comments (0)

February 12, 2010

Collaborating on Data

The year has well and truly started, and my other commitments (aka my real job!) are preventing me from devoting as much time to intellectual interests as I would like to spend. In spite of this, however, I did manage to read a couple of papers by Allan Grody where he lays out a compelling vision for a common reference data management utility dubbed the Central Counterparty for Data Management (CCDM) - you can read all about it here and here. Allan is a well-known figure in the industry and has been working on data issues for some time. His basic thesis is that while reference data is expensive to manage and difficult to maintain, hoarding it and specializing in its conformance brings no lasting competitive advantage to any specific financial institution. This is especially true where reference data is critical in enabling the connections between them such as in the settlements process. Therefore he advocates creating a central clearinghouse for reference data which is managed as a cooperative utility by the largest financial institutions.

Continue reading "Collaborating on Data"

Posted by Dilip Krishna at 01:57 AM | Comments (4)

January 20, 2010

Systemic Risk and Macro-prudential Regulation

On my recent holiday I took the opportunity to read a few very interesting papers on systemic risk that came out of UK (yes I admit this sounds geeky even to me!). Links to these can be found at the end of the blog, but I want to discuss one,  a discussion paper produced by the Bank of England entitled "The role of macroprudential policy", that I found particularly thought-provoking. The paper focuses on how systemic risk can be effectively managed in a global financial system.

Continue reading "Systemic Risk and Macro-prudential Regulation"

Posted by Dilip Krishna at 11:32 AM | Comments (1)

October 01, 2009

Lessons from the Current Crisis

Last week I attended a PRMIA lecture series where we were treated to a fascinating presentation by David Rowe, EVP for Risk Management at Sungard. Entitled "Lessons for Financial Risk Management from the Current Crisis",  he presented 5 crucial lessons that we must learn from the debacle of the past few years. Concise and well-presented, the presentation and subsequent panel discussion got me thinking about the technology implications of these lessons.

Continue reading "Lessons from the Current Crisis"

Posted by Dilip Krishna at 12:13 PM | Comments (1)

September 23, 2009

Utilizing Technology to improve TARP and Financial Oversight

Below is the written testimony that I gave last week for the hearing before the House House Financial Services Subcommittee on Oversight & Investigations regarding the role of technology in improving TARP and Financial Oversight. I focused on the idea that the absence of technology and analytics in financial oversight is more a function of awareness and will than of the suitability and maturity of technology itself. What's more, I argued that the very targets of oversight, the large financial institutions, are themselves enthusiastic users of such technology. Government has much to gain by learning from the private sector in this regard.

For transcripts of the other fascinating testimonials at the hearing, please see here.

Continue reading "Utilizing Technology to improve TARP and Financial Oversight"

Posted by Dilip Krishna at 01:50 PM | Comments (1)

September 09, 2009

Splendid Solitudes

It's been a while since I wrote a post on the blog - an omission that's as inexplicable as it is unforgivable. It will be my endeavor going forward to avoid  long absences.

Continue reading "Splendid Solitudes"

Posted by Dilip Krishna at 12:21 AM | Comments (3)

December 18, 2008

A ray of sunshine on TARP

"Sunshine", Justice Brandeis famously said, "is the best disinfectant". Last week I had the interesting experience of seeing this in action at the hearing of the House Financial Services Committee to consider a report by the Government Accountability Office (GAO) on the Treasury Department’s implementation of TARP (you can see the full hearing on C-SPAN's web-site).

Continue reading "A ray of sunshine on TARP"

Posted by Dilip Krishna at 09:44 PM | Comments (2)

November 05, 2008

Can Business Intelligence handle the stress?

I recently read an interesting article that asked a provocative question? Could business intelligence (BI) have provided advance notice to the meltdown in the markets (read the article)? The article mostly references two specific technologies: Analytic Tools and so-called Complex Event Processing (CEP) technologies.

Continue reading "Can Business Intelligence handle the stress?"

Posted by Dilip Krishna at 01:48 PM | Comments (3)

October 13, 2008

Risk Technology and Risk Culture

Since my last column the markets have gotten, if possible, only more interesting. This has naturally prompted some people to write me asking whether better risk management technology alone could really have saved us in this crisis. First let me say that I appreciate the feedback and dialog - keep it coming.

Continue reading "Risk Technology and Risk Culture"

Posted by Dilip Krishna at 02:18 AM | Comments (1)

September 20, 2008

What's tech got to do with it?

This has been an interesting week to say the least - two of the largest investment banks in the world felled by events by seemingly unforeseen circumstances, with a third being brought to the brink; the world's largest insurance company being felled with the same chilling efficiency by the markets. If you're like me, your head must be spinning with the questions.

Continue reading "What's tech got to do with it?"

Posted by Dilip Krishna at 12:18 PM | Comments (4)

May 09, 2008

Interactions between Risk Management and Technology

Dilip Krishna is the director of Teradata's Enterprise Risk Management and Capital Markets practice in the Americas. He and his team support Teradata's financial customers including banks, insurance companies and investment banks.

Krishna joined Teradata in 2004. Prior to Teradata, he had 15 years of experience in technology and business consulting, especially in the securities business. He also brings a significant experience in the successful management of large-scale projects.

At Teradata, he and his team have consulted on risk management initiatives with several large financial corporations in the Americas and Europe. In addition, they have been involved with numerous implementations of risk management programs to meet the Basel II Accord requirements for banks.

Immediately before joining Teradata, he held the role of chief architect of the Basel II program at Canadian Imperial Bank of Commerce. Krishna has been responsible for several implementations of risk management and trading solutions across a variety of banks, dealing with for diverse financial products including fixed income instruments, interest rate derivatives and funding products for major global institutions as well as internet-based trading platforms for fixed-income products.

Krishna has authored numerous articles and whitepapers on risk data architecture, implementations and information management. He is also a contributing author to Frontiers in Risk Management. He has also spoken on this topic in a range of professional associations dealing with risk management. Krishna has an extensive and varied educational background including Chartered Financial Analyst designations, as well as graduate and post-graduate engineering degrees from the Ohio State University and the Indian Institute of Technology.

Posted by Dilip Krishna at 10:25 AM | Comments (3)

Patrick McConnell


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