1. Before (June 12, 2006):
in the area of market risk, advances in data processing have enabled more analytically advanced and more comprehensive evaluations of the interest rate risks associated with individual transactions, portfolios, and even entire organizations. Institutions of all sizes now regularly apply concepts such as duration, convexity, and option-adjusted spreads in the context of analyses that ten years ago would have taxed the processing capabilities of all but a handful of large institutions. From the perspective of bank management and stockholders, the availability of advanced methods for managing interest rate risk leads to a more favorable risk-return tradeoff. For supervisors, the benefit is a greater resilience of the banking system…
Today, credit-risk management encompasses both loan reviews and portfolio analysis. Moreover, the development of new technologies for buying and selling risks has allowed many banks to move away from the traditional book-and-hold lending practice in favor of a more active strategy that seeks the best mix of assets in light of the prevailing credit environment, market conditions, and business opportunities. Much more so than in the past, banks today are able to manage and control obligor and portfolio concentrations, maturities, and loan sizes, and to address and even eliminate problem assets before they create losses. Many banks also stress-test their portfolios on a business-line basis to help inform their overall risk management.
2. After (March 22, 2012):
A second, very important problem was that during this period, financial transactions were becoming more and more complex but the ability of banks and other financial institutions to monitor and measure those risks was not keeping up. That is, their IT systems and resources they devoted to risk management were insufficient…So if in 2006 you asked a bank about the effect if house prices fell 20 percent, it probably would have greatly underestimated the impact on its balance sheet because it did not have the capacity to measure accurately or completely the risks that it was facing.
For (2) I am quoting from the version of Bernanke’s lectures that is printed in The Federal Reserve and the Financial Crisis, sent to me Princeton University Press. Perhaps someone can find a written transcript on line.
Given (1), I find (2) to be disingenuous. Also, in the lecture “Response to the financial crisis,” Bernanke says
when the mortgage-backed securities started going bad, it became evident that AIG was in big trouble and its counterparties began demanding cash or refusing to fund AIG, and it came under tremendous pressure.
In our estimation, the failure of AIG would have been basically the end. It was interacting with so many different firms. It was so interconnected with both the U.S. and the European financial systems and global banks.
This is also disingenous. The problem at AIG was the demands for collateral coming from Goldman Sachs and a number of foreign banks. It was those institutions that needed bailing out, not AIG. I still like what I wrote back in October of 2008.
It is highly unlikely that the buoyancy of the U.S. economy depends on the liveliness of the Liar’s Poker game of mortgage securities trading. We should resist panic reactions and emergency bailouts.
My alternative to bailouts was what I termed the stern sheriff approach. I wrote,
I think that the people who insist on Treasuries as collateral should have to pay a financial penalty, just as someone who has a CD at a bank can be assessed a penalty for early withdrawal. By punishing liquidity preference, we could stop the liquidity squeeze.
The government could have made it difficult for Goldman Sachs and other counterparties to grab low-risk assets from AIG. Staying within the law, simply requiring those counterparties to go to court would have done the trick. Instead, the government essentially seized AIG, paid off the counterparties, and then sold off huge chunks of AIG to avoid taking a loss. If the government was going to exercise arbitrary power that way, it could just as easily have exercised that power to keep AIG liquid and force Goldman and the others to raise short-term funds through other means.