November 29, 2004

Risk Factors

When The Bank of New York created its risk management data warehouse, it did so around the three main types of risk: market, credit and operational. Although the underlying risks are quite different, the measurement techniques have commonalities that have allowed for the transfer of risk management practices. "We have applied the portfolio management techniques that have been fairly common in market risk activities to the credit portfolio as well," BoNY's Gibbons says. "That led us to develop a credit risk data warehouse, to make the data that much more accessible to us in an electronic format."

By way of comprehensive evaluation of risk in the credit market, banks can gain better intelligence on whether or not to extend credit, or in detecting when creditors are at risk of entering financial distress. "The mathematical approaches that the market risk side has pioneered are now spilling over to the credit risk side as well," Accenture's Wilson says. "The evolution of the securitization market and the credit derivatives market has further driven the sophistication."

Another driver behind credit risk management has been the embarrassing inability of major banks to figure out their exposures to scandal-plagued companies. "Some of the largest institutions, when asked, 'What's your exposure to Enron? What's your exposure to Parmalat? What's your exposure to the telecommunications industry as a whole?' really struggled just to provide that information in a timely and accurate fashion," Wilson relates.

Furthermore, if a financial institution can't even figure out its exposure to a given company, it's hardly in a position to establish an "early detection system" to get an idea if something's going wrong. "There are obviously a significant number of other things that they can do around monitoring the cash flows and monitoring the balance sheet," Wilson adds.

Although initiatives such as eXtensible Business Reporting Language, or XBRL (see story, page 28), may have a role in helping banks monitor the financial statements of their borrowers, such efforts are only a part of the big picture. "XBRL is a great way to enable faster reporting and getting that information electronically exchanged," Wilson says. "But, if the [accounting] rules are not being consistently applied, or if the rules are out of sync with market reality, then it's 'Garbage-In, Garbage-Out.'"

Thus, strengthened accounting standards could do more for the ability of banks to achieve automated credit risk management than any technical innovation. "What you're seeing from the audit profession is a much more conservative and considered approach at signing off on the accounts," Wilson notes.