Bies, Susan Schmidt and Board of Governors of the Federal Reserve System (U.S.), 1935- "It's Not Just About the Models: Recognizing the Importance of Qualitative Factors in an Effective Risk-management Process." Remarks to the International Center for Business Information's Risk Management 2004 Conference, Geneva, Switzerland, December 7, 2004, https://fraser.stlouisfed.org/title/955/item/37202, accessed on January 9, 2025.

Title: It's Not Just About the Models: Recognizing the Importance of Qualitative Factors in an Effective Risk-management Process : Remarks to the International Center for Business Information's Risk Management 2004 Conference, Geneva, Switzerland

Date: December 7, 2004
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image-container-0 At the International Center for Business Information’s Risk Management 2004 Conference Geneva, Switzerland December 7, 2004 It’s Not Just about the Models: Recognizing the Importance of Qualitative Factors in an Effective Risk-Management Process Good afternoon. I am delighted to join you today. I have spent much of my career in the field of risk management, and of course the Federal Reserve has a keen interest in this topic. For those of us who have spent more than a few years in the business, it is easy to see the recent progress in the quantitative or scientific aspects of risk management brought about by improved databases and technological advances. These increased capabilities have opened doors and minds to new ways of measuring and managing risk. These advances have made possible the development of new markets and products that are widely relied upon by both financial and nonfinancial firms, and that in turn have helped to promote the adoption of the best risk measurement and management practices. They have also made the practice of risk management far more sophisticated and complex. These changes have come about because of better risk-measurement techniques and have the potential, I believe, to substantially improve the efficiency of U.S. and world financial markets. Although the importance of the quantitative aspects of risk measurement may be quite apparent--at least to practitioners of the art--the importance of the qualitative aspects may be less so. In practice, though, these qualitative aspects are no less important to the successful operation of a business--as events continue to demonstrate. Some qualitative factors--such as experience and judgment--affect what one does with model results. It is important that we not let models make the decisions, that we keep in mind that they are just tools, because in many cases it is management experience--aided by models to be sure--that helps to limit losses. Some qualitative factors affect what the models and risk measures say, including the parameters and modeling assumptions used as well as choices that relate to the characteristics of the underlying data and the historical period from which the data are drawn. In my comments today, I will address three topics. First, sound risk management is more than technical skill in building internal models. Models of risk need to be integrated into a robust enterprise-wide program that encompasses even line management's routine business practices. Second, regular testing of "data integrity" in its broadest sense as it relates to these risk measurement and management processes is essential to the effectiveness of these processes. Finally, I want to raise some issues around accounting and disclosure of risk. If there is a single theme to my remarks today, it is simply this: Keep improving, refining, and innovating in risk management. Although Basel II is a remarkable achievement, and the subject of this conference, don't let your best practices be limited by what Basel II does or
image-container-1 requires. Indeed, one of the more desirable aspects of Basel II is that it anticipates that it can evolve with best industry practices without creating a new framework. The designers have not intended to build a straitjacket, and the policymakers have insisted on this characteristic, which my colleague Vice Chairman Ferguson has referred to as Basel II's "evergreen" aspect. Enterprise-wide risk management Within financial institutions, the better and greater focus on risk measurement has helped to bridge the gap between the perspective of the traditional credit risk officer and that of the "quant." This is no small accomplishment, and a significant advance in credit culture. If you will pardon my use of stereotypes, historically the credit risk officer has been the fellow who always says "no" because it is the conservative thing to do, while the financial modeler has been the proponent of active-trading strategies that fulfill the promise of a data-mined efficient frontier that has been estimated to several decimal places of precision. The logic of risk and return in a competitive marketplace, as measured by return on economic capital that is founded in empirical analysis, has provided both sides with a common language and set of standards. It is not unusual anymore to hear chief credit officers describe their appetite for risk in terms of risk-adjusted return on capital (RAROC) or monitor current spreads on credit default swaps to look for market signals on borrower credit quality. With better credit cultures and improved tools, institutions can also measure and evaluate more objectively the results of their business strategies and use that information to enhance future performance. They can decide how much risk to take, rather than letting their risk profile be the consequence of other decisions. The evolution of interest rate risk management in the United States is a great illustration of how an enterprise-wide approach can help institutions customize products that better serve customers, set prices to reflect risk exposures and attain profit targets, and ensure that corporate earnings contributions are met. Thirty years ago, bankers who were used to taking fixed-rate deposits--capped under the old Regulation Q ceilings--and making fixed-rate term loans, found the cost of their deposits rising with the market after short-term rates rose dramatically late in 1979. Financial institutions found that, to meet market interest rates, they had to pay higher rates of interest on deposits than they were receiving on loans. As a banker, I went through that period in 1980 when the popular new six-month CDs that were booked in March, at annualized interest rates of around 15 percent, were funding loans at a negative carry when the prime rate fell to 11 percent by August. The roller coaster continued as lower CD rates in the second half of 1980 were funding loans at a prime rate of more than 20 percent by January 1981. One of the first challenges bankers faced in this environment was developing the information and analytical systems needed to manage the institution's overall interest rate sensitivity. So, in the early 1980s, taking advantage of the newly emerging computer technology and software, they developed asset-liability management models that integrated information on deposit and loan repricing. Further, the management committees responsible for interest rate risk changed. Instead of committees that included only management from the funding-desk and investment-portfolio management, a new group was created--the Asset/Liability Committee, or ALCO. This committee included the old finance committee members and new ALCO staff but also, most important, added business-line managers responsible for major corporate and retail banking activities. For the first time, pricing of loans and deposits was moved from the silos of business-line management, recognizing that the enterprise as a whole had to coordinate balance sheet usage in order to maintain the net interest margin around a targeted level. While this enterprise-wide approach to market risk evolved at
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