Emphasis on Linkages

The Challenge

Banking relies heavily on confidence; without it, customers withdraw their money. One significant source of risk is the perception that a bank's capital is insufficient to sustain losses, leading to a run on liquidity, which becomes unsustainable. Leverage plays a major role because risk-taking weakens capital, prompting cash outflow. These elements are interconnected and should be managed as a whole. The best people to see the emergent exposures are those at the coal face, often dealers, and the flow of information from them to management needs to be encouraged. Metrics like limits and RAG reporting do not cover this well. The challenge is to create a flexible approach to risk management by acting on this information.

First, let’s look at connectivity.

Micro Case: Hedging Fixed-Rate Mortgages

Hedging fixed-rate mortgages with swaps removes a large portion of interest rate risk but simultaneously increases credit, basis, prepayment, and liquidity risks. This is why some firms get caught out—they focus on the rate risk and ignore other mismatches, which over time can become disproportionate. A broader oversight of the entire risk picture is necessary.

Macro Perspective: Lessons from the 2008 Crisis

Numerous cases from the 2008 crisis illustrate a similar problem. Northern Rock, for example, funded its mortgage business growth by creating mortgage-linked bonds, which were sold to investors to raise more liquidity for lending. When the funding dried up, the reliance on this source became evident. The message is clear: undiversified businesses feel the full force of market disruption. It is crucial to appreciate that doing things in isolation, whether concentrating on gap exposures or following a mono-line business model, heightens risk. We need to understand the linkages.

Further examples include:

• Counterparty Risk: Lending to a counterparty might seem safe initially, but changing market conditions can put your cash at risk if the counterparty fails.

• Collateral Management: Using collateral to secure trades appears sensible until market volatility strikes and you need cash to facilitate a margin call.

• Trade Dependencies: Entering trades with one or two counterparties might be expedient, but it increases reliance on them. Finding substitutes at short notice is a challenge.

This delicate balance of risks and linkages isn't limited to individual institutions—it goes much deeper. This systemic fragility means that in the event of a bank failure, central banks often need to bail out multiple commercial banks to prevent lasting economic damage. No wonder regulators now focus on reducing systemic risk, where the failure of one financial institution triggers a domino effect.

Let’s look at what steps you can take to improve things.

Insights from Traders

Although the Treasury isn't responsible for overall risk control, it's vital to communicate concerns as they arise. Therefore, ongoing dialogue with risk management is one way to improve what's happening and this is all about culture.

When front-office staff are encouraged to engage and share their observations with people outside the treasury, it fosters a flow of information and debate about what’s going on, helping the firm adapt to changes in the market.

In all the market crises I’ve seen, the front office detects changes in markets first, sometimes months before things go seriously wrong. Such is the nuance of information that flows minute by minute. Recognising and acting on this to create a learning business model is a senior management responsibility and goes beyond traditional risk reporting.

How you do this is not fixed, but having the right channels and forum that encourages discussion improves things.

Painful Surprise

Linkages are second-order problems that do not fit traditional limit and traffic light (red, amber, green) reporting.

For instance, a simple gap report may show interest rate exposure within guidelines, giving a sense of security. However, large risks can build up at short maturities, and because short-duration risk is seen as benign, it’s not perceived as a point of pain. But occasionally, particularly when there are changes to macroeconomic policy, severe market disruptions can arise, and short-term interest rates can shift dramatically, leading to substantial costs.

The best people to understand these risks are those dealing with them daily. It's essential to capture and disseminate their knowledge within the firm to prepare for what may arise. If you don’t encourage this, every once in a while you will be in for a surprise.

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