When financial systems fail: Key lessons for risk leaders
Credit risk – the potential loss due to an obligor failing to settle amounts due for payment – is the largest risk type to which most banks are exposed and is generally the major source of bank earnings.
To manage credit risk effectively, a bank needs to have a clear credit risk appetite, a robust risk management framework, or RMF, and a strong credit culture, the responsibility for which lies with the bank’s board.
In making decisions about what credit risks to accept, and how they are to be managed, the board needs to draw on the lessons learned from its own experience as well as that of others.
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Lessons learned from the GFC
During 2007-9, banks faced increasing funding and solvency issues that threatened the wider financial system, which led to coordinated government and central bank intervention on a global basis. Though the specifics varied from country to country, commonalities included government guarantees, equity injections, arranged bank takeovers, and central banks providing liquidity support.
In the aftermath, it soon became clear that in the lead-up to the global financial crisis (GFC), many banks had sought to increase earnings by adopting aggressive growth strategies. A consequence of this was that bank management – and indeed their regulators – were not aware of the size and nature of the credit risks they were exposed to or they ignored warning signs.
In pursuing such growth strategies, bank management failed to heed the lessons from past failures including:
- Rapid expansion of credit exposures
- Lowering credit risk acceptance standards
- Failing to manage concentration risks
But there were also new dimensions, including:
- New and complex financial instruments – securitizations and derivatives
- Increased interconnectedness – banks bought securitizations from other banks
These dimensions/risks were not fully understood and a lack of transparency did not help.
GFC: rapid expansion of credit exposures
Common features of the growth phase of an economic cycle include:
- An increase in demand for credit products
- Heightened competition
- A lowering of credit standards
This occurs because unemployment rates fall, business performance improves, house prices rise, and consumers feel confident taking on debt. At some point the economy faces a downturn, defaults increase and credit losses rise.
Despite these cyclical effects being well known, the build-up to the GFC in the early 2000s followed a similar pattern which saw a rapid increase in consumer debt and residential mortgages as well as rising corporate credit exposures.
Factors that underpinned the rise in residential mortgages included rising prices and low interest rates reducing the cost of mortgages. Other factors that affected retail and corporate customer demands for credit included product innovations and lower credit standards.
New dimensions
An issue that caught many banks out was a failure to appreciate how things were changing, which meant that some of the lessons learned from previous crises were overlooked. In the lead-up to the GFC, these included:
- The development of new and complex financial instruments – two examples were securitizations and the use of derivatives for hedging and portfolio management purposes.
- Increased interconnectedness – the degree to which financial institutions and markets became connected increased substantially in the late 1990s and early 2000s. The upside was improved efficiency but the downside was increased volatility and contagion.
The result of such developments was the size and nature of the risks that banks were exposed to – including the build-up of concentration risks – were not always understood nor were warning signs heeded. Some examples are shown below.
Warehoused assets
Market dislocations meant that banks that were holding assets prior to launching a securitization (known as “warehousing”) were unable to sell those assets to investors. As a result, banks were forced to fund these assets for much longer periods than expected.
Implied support for securitizations
As securitizations sponsored by banks got into trouble, management often felt obliged to provide liquidity or other support even though the banks were not legally obliged to do so.
Derivatives settlement risks
Over-the-counter (OTC) derivatives trades were largely conducted on a bilateral basis with only a few market players, which resulted in very large settlement risks on just a small number of banks.
Credit migration
Unexpected downgrades of external credit ratings resulted in margin calls under collateral arrangements, which some banks struggled to meet. Collateral receivers also ended up with risk concentrations on some debt issuers.
Asset price movements
Actions to liquidate assets in order to address liquidity needs led to asset price falls, crystallizing losses for sellers and creating mark-to-market losses for asset holders. This in turn resulted in more asset sales and further losses.
These examples show how the increased use of securitizations and derivatives combined with increased connectivity resulted in not only credit issues but liquidity problems alongside large and unexpected losses.
Risk isn’t a checklist: 10 insights on enterprise risk
Ultimately, the lessons from past systemic events point to a simple truth. Risk rarely becomes a crisis without warning. When banks lose sight of governance, transparency, and disciplined decision making, small misjudgments compound into systemic problems. Strengthening culture, understanding emerging risks, and staying alert to complexity remain essential for avoiding the mistakes that defined previous crises.
The content for this article is taken directly from the Intuition Know-How tutorial, ‘Credit Risk – Lessons from Mismanaging Risk’.
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