Sophisticated systems used by banks to help weigh risks in trading asset-backed securities may have helped fuel a liquidity crisis as investors rushed for the exit at the first sign of trouble, say analysts and consultant.
An implosion in the US subprime mortgage market set off a prairie fire, sweeping across asset classes and sparking a liquidity crunch as banks stopped lending to each other in a scenario that no risk management model saw coming.
"These risk management systems create risk," Avinash Persaud, Chairman of Intelligence Capital Ltd, a risk consultancy, who says most financial institutions use much the same programs which lead to similar investment decisions.
"If you give investors the same set of data they end up with a similar portfolio, so when volatility rises they all end up having to sell the portfolio," said Persaud.
One-day Value at Risk valuations (VAR), which investors and investment banks use to measure how far the value of a portfolio may fall in a single day, have been made worthless as markets for some assets dried for lack of buyers.
"A one-day Value at Risk valuation assumes you can close a position when you want. That clearly does not work in this situation," said a Frankfurt-based analyst who follows investment banks.
The stampede by investors, which knocked over markets for securities, linked to subprime mortagage and asset-backed commercial paper programmes is seen as evidence that risk management models merely encourage a herd mentality.
Risk management and trading programs are only as sound as the data that are fed into them and the assumptions about interest rates and market volatility on which they are based, say financial analysts.
"Trading models have been calibrated for stable market conditions and cheap money," said a consultant at a financial audit firm in London. "The game was: 'let's not get caught when the music stops.'"
Investors have also been caught out by the speed of contagion as panic spread beyond subprime and rippled across global money, credit and equity markets.
"Models have correlation elements built in and in theory certain assets should not be correlated," said the consultant. "When there is a general panic, everything gets correlated," said the London-based consultant.
Others say that larger banks with experienced investment banking teams do not rely solely on the risk models to take investment decisions.
"You have a mentality that the risk management model gives you some sort of control but you also have banks that combine these models with the experience of analysts and a distinct risk management culture," said Michael Dawson-Kropf at credit risk agency DBRS.
Some investors believe that even if banks operated flawless trading and risk-management systems it may be hard for brokers to sell when the lights are flashing red, because of the penalties for getting out of a rising market too early. "I would suspect that more people saw the crisis coming than are prepared to admit it, but the nature of the beast is you don't know when it is coming and if you quit too early you may be fired for it," said the Frankfurt-based analyst.
What risk management systems need to take more account of is how panic-stricken short-term investors can quickly devastate the value of a portfolio by dumping assets in a wild stampede.
"People must ask not what happens to a portfolio if there is a repeat of the Asian crisis but what happens to a portfolio if I am part of a herd," said Persaud.
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