The financial services industry was rocked in 2008 by the beginning of an unprecedented global financial meltdown and recession. Billed as the worst such crisis since the Great Depression, it further spawned a level of interbank risk aversion that brought on extreme levels of capital rationing.
The global financial services industry was plunged into a crisis of both capital availability and confidence. The level of both firm-specific and systematic risk reached the extreme, bringing on a full-blown recession and the need for governments to infuse immense amounts of capital into the global banking system.
Global treasurers and regulators became obsessed with liquidity and building back a level of confidence and risk-taking increment by increment.
So, the old cliche of reality being stranger than fiction applies to the financial services system during the last year, and the events will be analyzed for years to come. Now let's put some of the year's events into a risk management context and see what the forward-looking implications are.
The financial services industry is working its way through a period where the level of unsystematic risk to the organization was raised substantially along with the global level of systematic risk. We are in a period where financial managers have to not only worry about the performance of their own assets, but also have grave concerns about how to fund them. The industry has been dealing with the double jeopardy of credit performance and capital rationing.
A good context to look at risk is through a framework that considers credit, market, operational and sovereign risk from 2008 into 2009. From a credit-risk perspective we can categorically state that consumers are maxed out, that they are laden with record-high of debt and traumatized by unemployment rates over 9%.
In earlier economic cycles, consumers were able to kick-start consumption and drive business demand and subsequently economic growth. This is not the case with a recovery from this recession. Consumer credit has been hammered by high levels of unemployment, producing payment stress and ultimately record levels of defaults across consumer loan products from mortgages to auto loans and credit cards.
Further, the financial services industry placed a big bet on subprime and emerging credit consumers successfully managing new debt for housing, transportation and personal consumption. As the economy faltered, these consumers fell first and farthest from a credit-quality standpoint. Analysis has shown that while subprime consumers may represent a minority of nonperforming loan assets, the majority of bad debt is with this population segment, by some estimates, as much as 90%.
This is important because as the industry recovers this is not a population that lenders are going to be looking toward to drive growth over the next few years. Time will tell how short or long the memory of the subprime lending experience is with lenders. The the industry faces a situation in which depending on the product, up to a third of the potential population is now out of bounds from a credit perspective.
The conundrum for growth is now who, where, and how. The answer in part will lie with institutions' ability to cross-sell their current customers additional products and to concentrate on issues such as service to improve customer retention. This will be a tall order given the evolution of mobile banking and payment technologies, which make it easier than ever for consumers to move swiftly from one lender to another or to rapidly shift their assets around the industry. In one sense a degree of customer loyalty has been lost forever.
Other areas of credit risk have also been hit hard over the last year. The counterparty risk being dealt with within the capital markets sector is real and severe as is the level of liquidity across the fixed-income space. Financial managers are also looking to innovation from FinTech solutions vendors to help them better match assets and liabilities.
Over the past year market risk has been immense as we have seen record spreads within the fixed-income markets and a near standstill in the issuance of new securitized debt. Two risk assessments stand out relative to systematic and market risk: the value at risk of the organization and the strategic risks that financial institutions are exposed to. Those firms that have invested in both human decisioning and advanced analytics to peg the value that is at risk are and will be the survivors. Those that are able to harness risk issues on an enterprise basis and move them through a strategic action process will be the long-term survivors. Such processes involve using organizational risk assessments to drive business decisions on hedges, as well as organization and technology investments.
The headlines for operational risk over the past year continue to be financial crimes and compliance. Financial crimes include various types of fraud but also identity and access management. Identity and access-management risk is growing with the proliferation of internal and external systems users and data assets of financial institutions. As the level of economic stress globally has increased, so has the number of data breaches, electronic security intrusions and identity theft cases.
Operational technology risk, while in the background, is a critical issue. The recession has created a high level of organizational capital rationing. The dream of replacing legacy systems has been put on the back burner. Institutions will struggle with the fact that innovation within the business model will be driven by core systems; there is forward-looking financial risk in not being competitive because of an outdated or inadequate technology infrastructure. The machine may not be broken, but is it positioned to compete two to three years from now, particularly as regulation and compliance become a global rave?
No discussion of organizational risk can leave out human capital or people risk. The recession has caused the financial services industry to shed thousands of jobs and many organizations report being extraordinarily lean, but with little or no ability to rebuild their work forces due to business-model pressures. The events of the past year have introduced a level of operational volatility that the industry has not seen in many years. Along with issues of default, liquidity, strategy, compliance and processes, senior managers of financial institutions have to be mindful of succession planning, loss of intellectual property, and the resilience of the organization to reductions in force, furloughs, wage freezes, wage cuts and general low morale. The risk to the people of an organization is a legitimate, tangible risk to be managed.
Over the past year we have seen numerous examples of global instability and specific economic decline due to terrorist events. The financial services industry is part-and-parcel of a globally interwoven economy with organizational competencies and activities being spread far and wide. With heightened international instability, senior managers need to weigh the financial and intellectual benefits of decentralized activities versus pulling back operations with a domestic focus. Analysis does show that the cost benefits of decentralized operations are real and meaningful, but also it is important to diversify — to the extent possible — concentrations in volatile parts of the world. However, diversifying offshore activities will create higher costs for reducing the chances of business interruption and at some point there is point of diminishing returns.
Without a doubt the last year has been one of the riskiest for the financial services industry in generations. While a grim picture has been painted thus far, there is a silver lining. The industry has had the benefit of years of data and analytical advancements. The same level of analytics that added fuel to the meltdown fire also has insulated many firms from crippling damage to their business models. The ability to harness huge amounts of data and to run mind-numbing levels of simulations has given senior managers guidance to navigate a very rough global-risk environment. Technology solutions available today to help the industry manage risk have been a natural hedge against a total financial collapse.
As one looks out over the next year it is clear that credit, market, operational and sovereign risk remain elevated. There are countless scenarios where any one of these risks could quickly migrate from an "orange" to a "red" alert level. The reason is that it's unclear right now what economic forces will conclusively bring the global economy around with forward momentum. Over time, asset bubbles have been the fuel of economic cycles. What will the next one be? The confluent issues of consumer consumption, credit availability, investor expectations, global instability, need for innovation, the velocity of electronic commerce and increased regulatory oversight will certainly keep the global community of risk management professionals busy in the coming year.
Dana Wilkund is risk management research director at Financial Insights.
