The Trouble with Banks' Risk Models: Q&A with the Chief of SAS

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Jim Goodnight, who co-founded Cary, N.C., analytics software company SAS Institute in 1976 and has been its CEO ever since, came to New York Wednesday to tell journalists about the company's high-performance and visual analytics software. Goodnight's conversation with Bank Technology News veered toward the efficacy of risk models.

BTN: What's the state of the art in analytics right now?
Goodnight
: High performance analytics. That's a very big push right now in banking. If you can make the modelers much more productive, running 10 to 100 more models to make the very best investment they can find, instead of running 4-5 times in a week, that can make a big difference in banks.

BTN: Wall Street firms use high-performance computing to run pricing and risk models. Are you seeing this used a lot in more traditional banks?
In retail banking, it's all about making sure you're gaining new customers. The emphasis is on customer intelligence and marketing, to know who you should be marketing to. We're seeing a lot of that.

BTN: When you say "high-performance computing," are you talking about in-memory computing [in which calculations and queries are performed on data stored in local memory, rather than on a separate storage device]?
Yes. It's not only in-memory computing, but also using hundreds of processors rather than a single processor. Almost everything we do today is one processor beating itself to death trying to compute billions of operations. We've found it's much better on some larger problems to enlist hundreds of processors. They've gotten so darn cheap, for $10,000 you can buy a blade with 256 gigs of memory and 32 processors running in parallel, so you ought to take advantage of the hardware. Companies like us need to suck it up and get it done. That's what we've been doing for the past three years, trying to get all of our software running in parallel so that we can solve much bigger problems.

BTN: Have you accomplished that?
Yes. It's all done, we'll come out with another major release in June or July of high-performance analytics.

BTN: What has adoption of high-performance analytics been like in banking?
It's been very high. Right now, we have quite a few situations where people are taking another look at risk. After the London Whale did its job over there, everybody's concerned about risk. We have high-performance risk analytics where we can do 100,000 market simulations in a matter of 15-20 minutes, where it used to take 15-16 hours.

BTN: What do you think of the state of banks' risk models? The Fed recently conducted stress tests of the largest U.S. banks. The banks' own stress tests had much rosier results than the Fed's.
The only difference would be the pricing algorithms, because if you define the factors that are to be stressed, it's just a mere computation of what that market value will be, plus or minus 20% of that risk factor. Only the pricing models would be different.

BTN: Do you think some of the pricing models need to be tweaked?
Every bank thinks they have the best pricing models in the world. I'm not sure they'd tweak them.

BTN: There was a lot of debate after the financial crisis about how good banks' risk models are, a lot of risk managers never thought housing prices would drop. They made adjustments later, in hindsight.
In risk simulation, you're simulating the state the market has been in the last two years. If it makes a dramatic move that hasn't occurred in two years, your risk model is not going to be accurate.

BTN: So it's the assumptions plugged into the models rather than the models themselves that were at fault.
Since you're simulating market states around the average of the past couple of years, the mean is still the same for all the risk factors. If you do 100,000 simulations, you're still going to have the same mean. That bothers me because in fact, in the Black Swan events, that mean is going to change. It gives you, at the upper end of the distribution, some idea of how much danger you're in.

BTN: So you still need people around who have some sense of change coming.
If a lot of structured investment vehicles had been properly priced, the risk would have shown up, but we were pricing these housing bonds as if they were AAA government bonds. The risk is not going to show up. There were a lot of people at fault who were not pricing right.

BTN: What do you think the next big bubble will be?
Probably housing again.

BTN: Can it happen again?
Prices are going up rapidly in our area and we're building all over Wake county, it's the number-one growth county in the country. A lot of houses are going up, the prices of existing houses are rising. There's always been a housing bubble every 10 years, hasn't there?

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Comments (2)
Regulators will never have trouble when Bank´s Risk Models yield reasonable results, or credit ratings are correct, it is only when these give the wrong information that big troubles can surge.

And so the real trouble with Bank´s Risk Models, and credit ratings, is regulators believing in them too much, as they do now... authorizing some mindboggling bank equity leverage for holding some "absolutely safe" assets.

And using Bank´s Risk Models, and credit ratings to set different capital requirements while the information therein contained is already being cleared for in so many ways, is lunacy, as it introduces extremely dangerous distortions in the market.

Like now, when in the land of the brave, banks are allowed to make much higher risk-adjusted return on their equity when lending to the "absolutely safe" than when lending to the "risky", like to small businesses and entrepreneurs.

http://subprimeregulations.blogspot.com/2013/03/there-is-plentiful-of-vested-interest.html
Posted by Per Kurowski | Monday, April 01 2013 at 10:35AM ET
It will be interesting to see the factors that drive the most robust risk models, and if they take into account the rapid changes in consumer channel preferences. The risk may be less a rogue "whale" as pointed out in the article, but come in the form of a new bank operator that uses mobile technology to drive costs down further than the "price tolerance" of a more traditional bank. As outlined in the PwC retail banking study, 62% of consumers indicate that mobile/internet is their preferred banking channel.
Posted by J Grill | Wednesday, July 17 2013 at 1:57PM ET
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