Risk management consultant Halbert Lindquist says the chances of a fatal securities crash are small in the U.S. banking industry.
But that doesn't mean bankers can rest easy.
The industry still has insufficient expertise in evaluating and monitoring complex securities, which means profitability is more at risk than many portfolio managers realize, Mr. Lindquist warns.
"The pace at which increasingly complex instruments have entered the market has been much more rapid than the ability of systems people to measure and monitor their risks," he says.
Mr. Lindquist is a principal at Lindquist, Stephenson & White Inc., a consultancy based in Tucson, Ariz.
The firm recently made a presentation at an American Bankers Association bank investments forum in New Orleans, and it counts several district Federal Home Loan Banks among its clients.
The point portfolio managers should not overlook, Mr. Lindquist contends, is that financial leverage can magnify seemingly modest securities losses into painful episodes.
"I don't think a Barings PLC situation is going to happen to a typical commercial bank," Mr. Lindquist said in a telephone interview. "On the other hand, a typical bank might have an amount equaling 100% of its capital in a securities portfolio. A 15% loss in that can mean a 15% loss on capital, which could impede a growth plan."
Bankers can minimize the risks of securities investments, Mr. Lindquist says, by avoiding a reliance on brokers' valuation models, either building or availing themselves of technical expertise, measuring risk, and developing contingency plans for interest rate changes.
A big problem with complex investment products, says principal Charles E. White, is independently assessing their values.
Often the consulting firm interjects itself between clients and brokers, questioning the valuation techniques used by the purveyors of exotic instruments.
The same brokers who sell a security often determine its price for buyers, Mr. White warns, and that's not healthy.
"The more complicated the security, the more likely it is to be mispriced," says Mr. White.
Potential exposure cuts two ways: Investors risk overpaying when they can't perform an independent assessment, and they risk being stuck with an unsalable instrument if the market turns against them.
"Independent pricing allows problems to be noticed before securities rot and fester in portfolio," says Mr. Lindquist, who holds an MBA from the University of Arizona.
In addition to providing independent prices on securities, Lindquist, Stephenson & White also measures risk by looking at what hypothetically would happen to securities and portfolios under extreme circumstances.
The value of such simulation exercises largely hinges on how well practitioners estimate the probability of each possible outcome. "We never put the probability of a particular event at zero," says Mr. Lindquist.
From that perspective, Mr. White says one of the most commonly misunderstood structured notes is the so-called range floater. This investment provides a coupon as long as some variable measure, such as the London interbank offered rate, stays within a specified band.
As an example, Mr. White pointed to a note with a range of 3% to 7%, issued when the Fed funds rate was 3%.
"As long as Libor stayed within that range, the bond provided a coupon," he says.
Bankers underestimated the probability of Libor's going outside that range - and were stuck with a zero coupon bond when it did.
"The dealer community did not emphasize what happens when Libor strays outside that range," says Mr. White.
But even when broker disclosure is robust and internal expertise is high, banks should not rest until they develop contingency plans, Mr. Lindquist says.