The proliferation of derivatives has bankers turning more and more of their attention to the technology of risk management.
According to experts in the field, computerized risk management tools are equal to the challenges reflected in the Barings PLC failure and other high-profile problems.
"With the advancements of risk assessment technology and the amount of information available on the subject, there is no reason for institutions to take unnecessary risk," said William Ferrell, president of Ferrell Capital Management in Greenwich, Conn.
Such comments reinforce advocates' position that derivatives, with risk controls, are important and useful financial instruments that don't have to be regulated into oblivion.
"Used properly, derivatives are an easy way for banks to put up a very little amount of money to make sure that their positions are protected against changes in interest rates," said Mr. Ferrell. "As long as the proper controls are in place, the instruments provide an efficient way to manage risk."
Derivatives are financial arrangements whose returns are linked to, or derived from, changes in the value of stocks, bonds, commodities, options, currencies, or other assets or indexes. For the most part, banks use derivatives as an asset and liability management tool.
David Vitale, a vice chairman of First Chicago Corp., said the nation's 10th-largest bank has been using derivatives as an efficient means of funding, and that without their use, it would have to look to other markets to provide the returns it needs.
"We have been using derivatives for a long time and we have been successful because we are able to manage risk effectively," he said. "If we did not use derivatives, we would have to be in cash markets and it would prove to be an inefficient way to meet our objectives."
Yigal Yankelevits, director of capital market products at ACT Financial Systems in New York, said technology plays an important role in managing risk and allows financial institutions to constantly evaluate the strengths and weaknesses of a portfolio.
"With these complex instruments, banks are realizing that the more information they have, the better they will be in making sure they do not exceed the risk limits set by management," he said.
"By installing various risk assessment systems, institutions are able to constantly measure the value of their derivatives and make the necessary moves to hedge risk when problems come up."
Hedging is used to ensure that a portfolio or security is protected from market swings.
For example, if an investor has a portfolio with a duration of five years and is afraid rates will go up, it can establish a short position in a derivative, such as a futures contract or an option, that offsets the risk of a rate increase.
"Banks can use technology to run a series of scenarios which allow them to forecast what will happen to a portfolio as certain changes occur in the market, so that they can make adjustments to avoid losses," said Mr. Yankelevits.
"They are able to determine from the 'what-if scenarios' what will happen to the portfolio when a certain change occurs, and in turn are able to react to the event before it happens."
Mr. Ferrell said risk assessment systems allow institutions to analyze thoroughly the various types of risk surrounding derivatives.
"One of the big problems with derivatives is that many people who do not know how to use them, use them," he said. "When they get hurt, it causes the public to view the instruments as evil.
"However, if the institution employs the proper controls, including making sure the person who is making the trade is not the person entering the item into the books, derivatives can be used with reasonable risk."
Mr. Ferrell said it is very hard to lose a lot of money without having been being exposed to serious risks, and in order to lose $1 billion, with a 5% market move, one must have an exposure of $20 billion.
"With the proper controls in place, the exposure can never get out of control," he said.
"In all of the explosions in the industry we have seen, all of the people were taking huge amounts of risk outside of the norm and none occurred when the proper risk management systems were in place."
