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A Decade After the Financial Crisis, These Lessons Can't Be Forgotten
Traders Magazine Online News, May 3, 2018
During the 2008 financial crisis, everyone in the business world, and many observers outside of it, were riveted to the news of the chaos unfolding daily in the markets. I viewed the crisis from a much different seat from the one I occupy now, having been effectively on the front row as the turmoil spread around the globe.
I had joined the Risk Management Division at Citigroup in April 2008 to help Vikram Pandit and Brian Leach rebuild what had been a failed function. Of course, that was just before a period in finance developed that was unlike anything we had ever seen. Only months later, I would find myself taking part in meetings at the Federal Reserve Bank of New York during the so-called Lehman Weekend in September 2008.
We're now approaching the 10-year anniversary of the events that combined to pose an extraordinary threat to the modern financial system. Clearly, we made it through, but not without making considerable changes to pre-crisis practices. Recently, I had the opportunity to reflect on the crisis and its aftermath as part of a panel called "The Role of Exchanges & Post Trade Infrastructures in Preserving Market Integrity - A Decade on from the Financial Crisis," which took place at the World Federation of Exchanges' IOMA Conference in Chicago. During the discussion, I covered six lessons I've drawn from the financial crisis, all of which I believe are relevant for central counterparties, such as OCC, as well as other types of financial intermediaries.
Fat tails can't be underestimated: The returns on the many over-the-counter products that caused issues during the financial crisis are characterized as having "fat tails," that is to say, extreme negative outcomes occur with significantly greater frequency than would be the case in the widely assumed "normal distribution."
Those unprepared for such outcomes, whether they were institutions, intermediaries or individuals, experienced significant and sometimes material losses during the crisis. This characteristic was manifest with respect to credit risk exposures, as well as liquidity risk exposures, particularly where liquidity step-in components had been built into certain complex products.
Aggregation is a must: In managing or supervising large complex financial institutions, aggregation is extremely demanding, but critical. At one institution, the risk management group brought the aggregate equity exposure to the attention of the institutional securities group management team, only to be told by the head of the equities business that the number was off by a couple of billion dollars - and had the opposite polarity of what the risk group was reporting. It turned out that, while the equity lead understood the exposure of the desks he managed, the equity hedges in the single-name credit default swaps business and elsewhere more than offset the exposure he thought he was managing.
Complex booking arrangements across various affiliates are also a challenge for aggregation: It took the firm three days to determine and aggregate all of the Lehman exposures. Many other firms faced similar predicaments.
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