Banks Must Rely On Their Own Risk Models in Future

There doesn't seem to be light at the end of the credit crisis tunnel just yet for banks. The rates of new foreclosures and delinquent payments have surged to their highest levels in nearly 30 years, affecting homeowners with prime as well as subprime credit. Federal bank regulators are warning of a new wave of losses in some sectors, particularly residential construction loans.

Bankers, understandably, are focusing on getting through the short term. But longer-term, it's clear that banks will have to provide more transparency into their credit and risk decisions -- and do a lot more of the work themselves.

Even though the worst of the credit quagmire may be behind us, it will undoubtedly trigger regulatory changes. Already, regulators are prodding lenders to raise capital, build up loss reserves and improve risk management practices. Regulators are demanding credit-driven lending practices that put a premium on borrower credit-worthiness, and accurate property valuations and exposures.

Data transparency will be a key focus, as both regulators and the investment community insist on understanding banks' rationale and ability to manage lending risks for all types of loans from both a portfolio and secondary investment market perspective. For example, it is expected that banks will have to disclose the underlying data that supports their valuations of illiquid securities and other assets.

The major credit rating agencies recently agreed with the New York attorney general to improve the independence and transparency of their ratings in the mortgage-backed securities market. Further, with regard to data transparency, the ratings firms will now require that investment banks provide their due diligence data for the loan pools to be rated. The SEC also is pushing tighter oversight of credit rating agencies.

In fact, transparency is going to be needed throughout the information chain, so banks must become more sophisticated about conducting due diligence on loan originations. Banks also are going to have to provide evidence of robust credit underwriting to satisfy regulators and the secondary market. This will probably mean declines in some of the more exotic types of loans offered.

Clearly, the era of relying on others, such as rating agency analysts, to make your judgments is over. These capabilities will need to exist within the bank, with a new emphasis on improving internal counterparty credit assessments, analysis of bankwide credit concentrations and new liquidity risk models. These capabilities will be crucial to understanding and managing the exposures with the greatest potential for damaging the bank.

Of course, the devil is in the details, and banks must focus on developing complete and consistent views of assets with common models for valuing them. A major problem leading up to the credit crisis was that models used for valuation in the absence of reliable market prices were not adequately developed for complex securities. Banks must start improving their pricing models for complex instruments such as collateralized debt obligations (CDOs) and credit default swaps. Other risk management practices, such as stress testing, should be strengthened to ensure that liquidity and capital cushions are robust enough to absorb acute adverse market events.

Ensuring that financial statements reflect a consistent view of banks' holdings, valuations and outlooks completes the transparency picture. The risk and finance units must share common and complete transaction and position information, valuation models, and data to ensure consistency. This makes it clear to the investor community that the bank has improved its management control and compliance capabilities.

Banks that emerge from the current environment with transparency and superior analytic capabilities are positioning themselves to deliver what regulators, investors and shareholders will demand in the coming years.

Chris Thompson is a senior executive in the financial services practice at Accenture, and Tom Mataconis is a senior executive in Accenture's credit services practice.