Seeing Below the Surface: Lessons from Hidden Risks

How can we effectively manage treasury and risk if our information isn't clear and accessible?

Understanding this is crucial for ensuring we make informed decisions and avoid unexpected pitfalls. In this insight, we'll explore a real-world example that shows how important it is to recognise hidden risks—what we call the 'iceberg of risk.'

Whether you're just getting started or looking to expand your knowledge, this case offers practical advice on avoiding oversight problems that can happen even with the best intentions.

The Hidden Risk Emerges

I worked with a client who taught a vivid lesson about managing all kinds of risk, including the kind that often hides below the surface. The bank's treasury team had invested in a portfolio of long-term government bonds, known as gilts, and used swaps to protect against interest rate changes. They felt confident about their strategy because their reports suggested that all the risk was covered. But there was a problem they couldn't see.

Over time, the value of their gilts kept going up, while the value of the swaps they used for hedging stayed about the same. This happened because the gilts were exposed to changes in credit spreads, which increased their value, whereas the swaps only hedged against interest rate movements and not credit spread changes. Seeing this as a good opportunity, they decided to sell their positions and made a lot of money. They expected praise, but when the Board found out, the response wasn't as positive: how had they made money if there was supposedly no risk?

Credit Spread Risk—The Hidden Problem

This response exposed a big gap in the firm's oversight—a failure to monitor credit spread risk. The fact that gilts could increase in value compared to the swaps had been completely overlooked. The risk seemed covered, but a hidden exposure was there all along, reminding us that risk reports don't always show the full picture.

Credit spread risks like this are common. In a mark-to-market accounting setup, you can immediately see the effects. But in an accrual-based setup, these risks can stay hidden until it's too late to handle them properly. The broader risk here lies in hidden credit exposures—situations where changes in the creditworthiness of an asset impact its value, but those changes are not immediately visible. For example, if a company's credit rating is downgraded, the value of its bonds may decrease, but this impact might not be reflected in reports right away. Such hidden risks can accumulate over time, leading to significant financial surprises if not properly monitored.

Fixing Reporting Problems

The core issue was that the reporting tools didn't catch the mismatch in the hedge due to a combination of outdated technology, lack of data integration, and human oversight. The treasury team focused on the quick profits from selling the gilts, calling it a lucky gain, without thinking about the bigger picture. The firm was caught off guard by a risk that should have been obvious.

To prevent these kinds of oversights, it's important to include credit spread risk analysis in the overall risk assessment process. One simple approach is to use a credit delta measurement, which helps estimate how sensitive the portfolio is to changes in spreads. This means calculating how the value of both the assets and their hedges changes in different scenarios. It’s not a perfect solution, but it can show the size of the risk and prompt deeper investigation if needed.

For example, think about a scenario where credit spreads widen by 100 basis points. In this case, the value of the gilts would likely drop a lot, while the swaps wouldn’t provide enough protection, leading to significant losses. Running scenarios like this can help banks understand the potential effects of bad market conditions and take action before risks get out of control. This type of exposure is similar to what pension trustees faced during the Liability Driven Investment (LDI) crisis in September 2022.

Promoting Transparency

An important part of this story is how the business prided itself on open communication about risk. But even with that culture, the exposure stayed hidden, which suggests that traders might have known about it but didn’t raise the issue properly.

In this case, the Board rightly asked why these risks weren’t discussed earlier. Creating a culture of transparency and making sure there are no barriers between traders and senior management is crucial. Effective risk management relies on everyone being able to recognise and share information about risks as they appear.

The role of the second line of defence is also key here. In risk management frameworks, the second line of defence refers to the functions responsible for oversight, such as risk management and compliance, which provide independent monitoring and guidance to ensure risks are properly managed. The second line should actively review trading and hedging strategies and independently verify exposures. If this function doesn’t have enough expertise or capacity, problems like this are likely to happen. In this case, everyone had a role to play—the traders should have flagged concerns earlier, the second line should have identified the mismatch, and the Board should have asked for a detailed risk analysis before the positions were sold.

A Broader Lesson

The main lesson from this situation is clear: while risk can never be eliminated, it can be managed better by looking deeper. Addressing hidden risks takes vigilance, careful analysis, open communication, and sometimes admitting that there might be more beneath the surface than we realise.

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