Banks relied too much on ratings, supervisors say

Regulators from France, Germany, Switzerland, the UK and the US say banks that suffered serious losses during the credit crisis often did so because of avoidable failures in risk monitoring and management.

The Senior Supervisors' Group, set up shortly after the start of the crisis, released its findings yesterday. It highlighted over-reliance on credit rating agencies as one of the main causes of problems.

"Firms that performed better in late 2007... were sceptical of rating agencies’ assessments of complex structured credit securities and consequently had developed in-house expertise to conduct independent assessments of the credit quality of assets underlying the complex securities... these firms were also more likely to test their valuation estimates by selling a small percentage of relevant assets" the report said. "In contrast, firms that faced more significant challenges... generally lacked relevant internal valuation models and sometimes relied too passively on external views of credit risk from rating agencies."

This was surprising, as these firms tended to have perfectly adequate internal credit assessment processes in place elsewhere in the organisation, but simply did not apply them to the securities at risk, the report said.

Firms that suffered during the crisis also "tended to have weaker controls over their potential balance sheet growth and liquidity," the report's authors said.

In particular, the group said, banks' use of risk measures such as value at risk (VAR) and stress tests had been undermined by poor methodology, which produced unrealistically optimistic predictions of correlation and basis risk.

The report cited "the failure to treat appropriately the basis risk between cash bonds and derivatives instruments such as credit default swaps", adding: "Another issue was the use of proxy volatility data as a substitute for risk assessments of instruments that did not have a long price history of their own. For example, some firms that encountered more substantial challenges tended to assume that they could apply the low historical return volatility of corporate credits rated Aaa3 to super-senior tranches of CDOs, a more novel instrument that rating agencies had likewise rated Aaa. That assumption turned out to be wrong."

The group included representatives from the French Banking Commission, the German Federal Financial Supervisory Authority, the Swiss Federal Banking Commission, the UK Financial Services Authority and the US Federal Reserve Board, Securities and Exchange Commission and the Office of the Comptroller of the Currency.

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