The proliferation of computerized market risk models may be creating a false sense of security at banks and could lead to more disasters like those that struck Barings Bank, Bankers Trust New York Corp., and Orange County.
That was the warning from several experts at a recent risk management conference sponsored by the Fifth Annual World Economic Development Congress.
"There is a risk your model will tell you that something will happen, or that you have a risk level of 12 when your risk isn't anywhere near 12," said Tanya Styblo Beder, principal at Capital Markets Risk Advisors in New York.
The experts said inaccurate risk data can wreak havoc on a bank's investment strategy, turning seemingly safe projects into risky gambles.
The warning came just as banks are increasingly using computerized models to predict how fluctuations in stock and bond prices would affect their securities portfolios. Also, regulators in 1998 will require the largest trading banks to base part of their capital charge on the predictions of market risk models.
The experts, however, said trouble is ahead because of a lack of computer expertise among senior executives, an unwillingness to question underlying assumptions in models, and a refusal to accept early signs of trouble.
Ms. Beder said junior-level executives often are the only bank employees with the skills to create these complex computer models. However, new employees lack the seasoning to make the hundreds of assumptions about the performance of the economy and the institution that the model requires, she said.
Senior managers must constantly question underlings about the assumptions used. "The best philosophy to remember is that you have to ask yourself, 'What if I am wrong about my assumptions?'" Ms. Beder said.
Models also don't account for traders, who may not share the bank's investment objectives. Till Guldimann, executive vice president at Infinity Financial Technology in New York, said traders - looking for bonuses - want their portfolios to have the highest return possible, even if that means taking a lot of risk. The bank, however, often wants a less risky, stable return, he said.
Senior management also should shun instruments they don't understand, said Ezra Zask, president of Ezra Zask Associates in Connecticut. For example, he said, Gibson Greetings lost a small fortune because its derivatives portfolio at Bankers Trust was so complex that the card company's executives had no clue what was in it.
Bankers also must look up from their computerized models and search for early signs of impending doom, Mr. Zask said. Barings' management failed to act on reports of a dangerous lack of separation between front- and back- office staffs in Singapore, and Orange County never questioned how it could continuously receive abnormally high returns on its investments, he said.