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Banks' inability to price and measure risk on complex financial products is alarming and needs to be improved to avoid another market meltdown.

CHALLENGE: As structured products get more complex, financial firms are desperate to find ways to model and price these instruments accurately across the organization.

Where the Industry Is Now: Still licking its wounds. Two high-profile CEOs have been axed (Citi's Chuck Prince and Merrill's Stan O'Neal) after their institutions announced almost unimaginable losses due to the CDO mess. If they haven't already, other banks also will announce additional write-downs. In some cases, risk management technology wasn't up to snuff because CDO data was difficult to analyze and risk managers could not quantify the total risk to the firm. In other cases, risk management practices broke down when warnings from risk officers were ignored, as institutions salivated at the higher returns that CDOs offered (until summer 2007).

Moreover, financial institutions relied too heavily on ratings agencies to determine the value of CDOs, says Daniel Chait, managing director, Lab49, a consulting firm that builds advanced applications for financial institutions. "As CDOs are sliced and repackaged, the underlying data -- the data that gives you a good insight into what you are actually buying -- is very hard to come by. Most banks don't have the data or don't know how to get to it." Ironically, rating agencies based their ratings off of data from the banks, which turned out to be flawed.

Focus in 2008: Improving risk management technology and data access. "There are hundreds of risk management technology systems on the market, and most are very good," says Neil Edelstein, senior director, business solutions, GoldenSource. Most financial institutions use many different risk systems, but the systems are only as good as the data they crunch. "Unfortunately, there is still a lot of siloed risk management technology and associated data that reside with different business units. When you are looking at complex financial products across an organization, a centralized risk management structure that accesses broad data sets is required."

For instance, JPMorgan Chase has long recognized that quality data is vital to the firm and its risk management practices, relates John Galante, SVP and CIO, JPMorgan Worldwide Securities Services. "We have fortunately been investing a great deal in [data] ... and our pricing engines," he says. "We have been well-positioned in the way we price assets and extend the data to compliance and risk management practices." Galante also notes that JPMorgan was the second financial institution to name a chief data officer (Peter Serenita, SVP & CDO). [Ed. Note: JPMorgan took a $2 billion Q3 write-down. Morgan Stanley's totaled $3.7 billion. Merrill Lynch's write-down was $8.3 billion. Citigroup's total amounted to $11 billion.]

Industry Leaders: Before the credit crisis, most observers thought the bulge-bracket brokers had good risk management practices. Ironically, Bear Stearns -- which saw two of its hedge funds implode because of bad subprime bets -- was thought to have one of the best risk management cultures on Wall Street. Today, many aren't so sure. The Street's top-drawer institution, Goldman Sachs, had not announced any subprime mortgage write-downs at press time -- but it still could.

Technology Providers: There are hundreds of risk management systems on the market. But when it comes to pricing and evaluating complex structured products, the right financial data is just as critical as the risk management technology itself.

Price Tag: Integrating data and risk practices across a financial institution is pricey and difficult, especially in "Wall Street" time, where things are measured quarter to quarter. However, the price tag for even the most complex data and risk management integration at the largest financial institution will pale in comparison to the billions that have been lost due to inaccurate CDO calculations.

Greg MacSweeney is editorial director of InformationWeek Financial Services, whose brands include Wall Street & Technology, Bank Systems & Technology, Advanced Trading, and Insurance & Technology. View Full Bio

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