Regulators expect banks to learn from subprime

Regulators from five countries have issued a report calling on financial services firms to address weaknesses in risk management practices that emerged during the US subprime crisis.

The regulators said they would work to ensure 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.

The project was undertaken to evaluate the effectiveness of current risk management practices and followed calls to improve the functioning of markets and reduce systemic risk.

The regulatory agencies participating in the project—called the Senior Supervisors Group—came from France, Germany, Switzerland, the UK and the US.

The report’s key observations were outlined by the Senior Supervisors Group. The findings are highlighted below:

• The predominant source of losses for firms in the survey was their concentrated exposure to securitizations of US subprime mortgage-related credit.

• In particular, some firms made strategic decisions to retain large exposures that far exceeded the firms’ understanding of the risks inherent in the new instruments, and failed to take appropriate steps to control or mitigate those risks.

• Another risk management challenge concerned firms’ understanding and control over their potential balance sheet growth and liquidity needs.

“The project was undertaken to evaluate the effectiveness of current risk management practices and followed calls to improve the functioning of markets and reduce systemic risk.

• 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.

• In addition, management of better performing firms typically enforced more active controls over the consolidated organisation’s balance sheet, liquidity, and capital, often aligning treasury functions more closely with risk management processes.

The Federal Reserve Bank of New York said the observations made in the report would define an agenda for regulatory oversight. In particular, in the following areas:

• To support the efforts of the Basel Committee on Banking Supervision to strengthen the efficacy and robustness of the Basel II capital framework.

• To strengthen the management of liquidity risk.

• To strengthen existing guidance on risk management practices, valuation practices, and the controls over both.

• To address issues that may benefit from discussion among market participants, supervisors, and other key players. 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.

The report—Observations on Risk Management Practices during the Recent Market Turbulence—is available for download.