Fed Governor: Risk Management Can Be Better

Federal Reserve Board Governor Susan M. Phillips said Thursday that bank risk-management systems worked well during the Asia crisis, but she urged bankers not to become complacent.

"The record, while reassuring, should not imply that areas in need of improvement were not also exposed," Ms. Phillips said in remarks prepared for the International Swaps and Derivatives Association meeting in Rome.

Ms. Phillips said many banks had trouble valuing less liquid securities during the Asia crisis. The solution is to better incorporate liquidity risk into risk-management computer models, she said.

Also, some of the risk-management models used by banks were not sophisticated enough to accurately value some of the more innovative and complex instruments being traded, she said.

Banks also need to alter the way they stress test their risk-management models, she said.

"Events unfolded over much longer periods of time than the typical one- day horizon of a stress test and that contagion across markets was faster than anticipated," she said. "This argues for assumptions of multiday events in some stress scenarios, particularly when dealing with less liquid instruments."

Ms. Phillips also said banks need to be able to hedge all of the risk in their investment portfolios. Some institutions ran into trouble when securities they were using to hedge became illiquid. This forced the banks to use other, less ideal hedging instruments.

"Events of the last year ... have highlighted the fact that some dealers are not thinking carefully and critically enough about the ways they are going to hedge the risks assumed in various lines of business," she said.

Finally, she said the Asian crisis reinforces the need for banks to diversify their businesses. Those that concentrated too heavily in Asia suffered the most, she said.

"Despite the fact that there are numerous improvements dealers could make to their risk-management systems, I do not want to end with the impression that derivatives dealers and their systems somehow failed this test of market volatility," she said. "Systems generally performed well."

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