Risk management’s failure in the credit crunch

“How did the last 20 years of progress in risk management fail so many institutions so spectacularly given the current financial turmoil?” Marsh & McLennan Companies asks in its latest issue of Viewpoints.
“While the industry at large was undoubtedly overconfident in its ability to quantify risk, the bigger problem lies in the way risks were governed and regulated at the top of the house,” writes Andrew Kuritzkes, a partner and senior member of Oliver Wyman’s finance and risk practice. “Institutions employed weak oversight processes that ignored the compounding effects of individual risk decisions on a firm’s overall risk profile and allowed business strategies to be divorced from basic risk principles.”
The Basel II capital framework compounded the failures of firm-level governance, he says, because Pillar I of the framework failed to impose an explicit capital charge for asset/liability risks, business risks and reputation effects, each of which played a role in the crisis.
Although it is impossible for a regulatory framework to operate with perfect foresight and anticipate the causes of the next financial crisis, “nevertheless,” Kuritzkes writes, “the enormous international effort to comply with Basel II arguably led to a ‘crowding out’ of scarce internal risk resources that were diverted from new problems or more pressing risk issues by the need to get over the Basel finish line.”
In addition, Kuritzkes says both the industry and regulators missed the overriding importance of funding and liquidity as contributors to the current crisis.
“The dependence on short-term funding created an inherently fragile business model that is leading to unprecedented changes in market structure,” he argues.
“While firms could not have been expected to protect themselves fully against the unprecedented disruptions of the current market, certain structures (such as structured investment vehicles and conduits) were inherently unstable and uniquely prone to funding crises.”