Lessons Learned From The Credit Crisis For Financial Institutions

Eddie M. Chen, CFA, FRMEntie Commeical Bank

11 Dec. 2010

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The Chronicle Events of the Credit Crisis…

Feb 2007 U.S. Sub-Prime Mortgage losses were published

Jun 2007 Bank losses due to U.S. mortgage engagement

Sep 2007 Northern Rock bank-run

Mar 2008 Bear Stearns collapse

Aug 2008 Fannie Mae and Freddie Mac Prices Tumbled by 90% Sep 2008 Lehman Brothers collapse

Merrill Lynch bought over AIG liquidity crisis

Mar 2009 Stock market losses

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What went wrong that result in the crisis?

Unrealistic Market Liquidity Assumption - it is not always available at all levels, in all time periods, for all maturities…

Ineffective Capital Management - comprehensive capital management program which adequately links to stress testing is critically needed…

Under-estimation On the Correlated Impact of Counterparty Risk to Liquidity Risk and Market Risk

Investors’ Over Reliance On Rating Agencies – should not merely look at the assessment by rating agencies who employed traditional methodologies…

Static Stress Test only – Dynamic and comprehensive stress testing with adequate magnitude of shocks on risk parameters for stressed scenarios is essential…

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What went wrong that result in the crisis? Lack of Understanding the Complexity of Products - accurate valuation of mortgage security products requires a solid understanding on the underlying assumptions and attached collaterals …

Mal-functioning of Risk Measurement – inappropriate risk factors identification, inaccurate valuation of mortgage securities, and incorrect risk parameters distribution were accountable to non-reflective VaR computation

Insufficient Oversight by the Authorities – particularly over the so-called “innovative” product dealings of the investment banks…

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What the practitioners leaned from the Crisis? Capital adequacy and liquidity is the king – leverage level must be effectively managed. Basel III furtherly requires Capital Conservation Buffer and Countercyclical Buffer as well as Gross Leverage Ratio …

Liquidity would dry out very soon when asset bubbles burst – isn’t this what we are facing shortly as well?

Again, no free lunch in the world – experience from investing in the AAA-rated MBS as well as other high rated CDOs…

Manage the peer pressure to take on risks – When most of others are forced to pursue the riskier returns, will we do the same?

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What the practitioners leaned from the Crisis?

Loss of Confidence could be the trigger of Systemic Risk – counterparty credit risk management must be well managed

Comprehensiveness of Stress Testing need to be enhanced – to be able to dynamically cover all possible stressed scenarios that can produce meaningful risk information

The importance of cultivation of risk awareness and culture – Risk is everyone’s business!

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What’re the challenges for regulators? Essentiality of open, timely, and effective dialogue and communication between the regulators and financial institutions. Oversee not only the individual bank, but also the macro supervision including the systemic risk prevention.

In response to the regionalization of banking industry, the regulators shall collaborate/synchronize across the borders to create a sound marketplace in terms of consistent and transparent regulatory framework and accounting standards.

Harmonization of the pace of “robustly” complying with Basel requirements (I, II, and III) among financial institutions given the various adoption progressiveness.

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Conclusion Lessons learnt from the crisis turn to be a catalyst for financial institutions and regulators to expedite the endeavors enhancing the risk management and regulatory framework of banking industry.

Integration of various type of risks (credit, market, liquidity, operation, reputation, etc) to accomplish an enterprise-wide risk management is the over-arching goal.

Sound integrated management of risk, return, and capital is the basis for sustainable growth and going concern!

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THANK YOU

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