Risk Management

When Risk Meets Reality

New risk-management techniques are credited with transforming the banking system. But there may be less to their success than meets the eye.
Ronald FinkOctober 18, 2005

At its simplest, banking comes down to this: borrow short, lend long, and pocket the spread. But ever since the banking crisis of the late 1980s and early 1990s, bankers have sought more sophisticated ways of making money. As some learned to their sorrow, being so tightly linked to interest rates makes the industry extremely vulnerable to the vicissitudes of the business cycle.

Thus, banks have tried to supplement interest income with fee income whenever possible. That effort has involved everything from nickel-and-diming retail customers for ATM use to underwriting corporate securities and arranging as many mergers and acquisitions as federal law and regulation would allow.

This widening of bank activities sets the stage for the magazine you have in your hands.

CFO Banking & Finance examines corporate banking issues ranging from regulation, underwriting, and insolvency to risk management and globalization. In so doing, it seeks to illuminate the ever more complicated dealings between bankers and finance executives, and how the two sides seek to turn what has often been a love-hate relationship into something more mutually profitable (see, in particular, Tim Reason’s article “Inside Your Banker’s Head“).

Passing the Bucks

At the same time, this special issue looks critically at how banks manage risk. Some observers give risk management a great deal of credit for the industry’s turnaround since the early 1990s. On its most basic level, the practice involves the use of such tools as value at risk (VAR) models — computer-driven systems for stress-testing how a bank’s profits would be affected by every conceivable interest-rate scenario.

Seen from another perspective, banks’ risk management amounts to moving loan exposure off their balance sheets and onto those of investors, through the use of everything from securitization to derivative instruments (see “Who’s Holding the Bag?“). The assets in question thus find their way into the portfolios of mutual funds, hedge funds, insurance companies, and other “stuffees,” a telling bit of industry slang. And banks surely have employed at least as much time and energy developing new techniques for transferring risk to said stuffees as they have creating the VAR models that say if and when such risk should be transferred in the first place.

Is this handing off of risk a good thing? The late, great Financial Times columnist Peter Martin considered it the very basis of modern capitalism. That was why he praised Federal Reserve chairman Alan Greenspan for letting the Internet bubble grow larger and larger until it burst. In so doing, Martin explained, the Fed chief helped banks shift rising risk to the public at minimal cost.

Minimal? Well, yes, relatively speaking. This argument sounds ridiculous only until you realize that the public has a greater stake in the banking system than in the stock market (see “The Banker’s Protection Act“). Martin argued, in effect, that capitalism requires the public to be the one left standing when the financial music stops.

Greenspan Shrugged

Not everyone, of course, shares Martin’s opinion. Critics contend that Greenspan has merely substituted a credit bubble for the stock-market bubble, and that the latest bubble cannot be sustained given the global financial imbalances stemming from the gaping U.S. budget and current-account deficits. And if the public ends up holding the bad assets that banks no longer do, what ultimately will have been accomplished? Suffice it to say that the issue raises questions about the Federal Reserve’s dual roles of bank guardian and economic steward.

To its credit, the Fed has changed its tune recently and now worries that the banks may not have insulated themselves from risk but instead merely reconcentrated it elsewhere in the financial system. If so, that means that notwithstanding all of its maneuvers, the banking industry will still need regulators to help see it through. Yet as Randy Myers explains in his article on new international banking rules (see “Basel Faulty?“), regulators themselves are allowing banks to decide how much capital they need to keep on hand.

And if, in the end, all this risk-shifting comes to naught, the industry may remain dependent for its survival on a sufficiently wide spread between short- and long-term interest rates. Ironically, that would leave banks’ ultimate fate in the hands of the aforementioned stuffees — otherwise known as investors. And those investors seem intent on depriving the industry of such salvation: as this issue went to press, short- and long-term rates were converging instead of widening.

But if we thus can’t help but worry that the financial system is operating on borrowed time, our readers will be better prepared than most to cope with the fallout.

Ronald Fink is editor of CFO Banking & Finance and a deputy editor of CFO.