Banks need to take a much broader view of investment risk as they dig their way out of the current financial crisis, and mortgage-backed securities need to become simpler and much more transparent, a senior U.S. Federal Reserve official said on Monday.
"Not only do banks need to assess counterparty credit-worthiness and behavior on an individual basis, they also need to assess counterparties on a collective basis," Fed Governor Randall Kroszner said in remarks prepared for delivery at a conference on risk management in Geneva.
"They need to understand how their own actions to protect positions can put pressure on key counterparties, especially when other market participants are likely to be taking similar action to protect themselves," he said.
The financial turmoil of the last 18 months showed risk managers failed to anticipate how individual investments could be negatively affected by broader market stress, he said.
"Risk managers did not fully contemplate the possibility that many participants would need to unwind their positions at the same time, that such actions might present substantial losses for several key counterparties, and that collateral posted as protection for positions would fall in value at the same time," Kroszner said.
This highlights the need for banks to develop "stress tests and scenario analysis that … include the potential for key counterparties to fail or suffer difficulty at the same time, for market liquidity to erode and remain low for some time, and for market participants to view the bank itself as an impaired counterparty," he said.
Banks also should hold higher liquidity and capital buffers as additional protection against "future market distress that could cause correlated and cascading losses among market participants," Kroszner said.
"At the Federal Reserve, we have already begun to enhance our supervisory work in this area and are communicating expectations to banks," he said, adding that would be a major focus of U.S. and international regulators in 2009.
Kroszner steered clear of monetary policy, but again emphasized his view that the market for mortgage-backed securities will return to health only after the contracts and disclosure of those investments are standardized.
"A recovery in the market for mortgage-backed securities will require greater transparency and less complexity, and importantly, comprehensive and standardized loan-level data that will allow more independent credit analysis," he said.
Product complexity and a lack of transparency are at the root of many the financial market problems that have emerged, "especially in the markets for securitizations and structured credit products," Kroszner said.
