Investment banks and other large financial institutions need to work together and share risk information to prevent future financial crises having the same impact as the recent sub-prime mortgage problems, according to Philippe Carrel, executive vice president of risk management for Thomson Reuters.
Carrel thinks investment concentration, even in mortgage-backed assets, is not necessarily risky because investments by their very nature continually move from one liquidity pool to another. He believes concentrated investment strategies can be effectively managed as long as firms have the means to identify the need for and execute a swift exit strategy. This means that underlying risk factors need to be effectively and constantly measured and monitored.
Therefore, adopting a fixed mindset on which assets might be risky is not suitable. “What is liquid today may be completely illiquid tomorrow,” comments Carrel. “In addition, if you just allocate capital to try and mitigate risk, you will just move your liquidity hole from one area to another and potentially make it worse.”
The potential solution proposed by Carrel is the sharing of data between investment banks and other major financial institutions relating to exposure concentrations and correlations, as well as news and data that can anticipate particular areas of vulnerabilities or potential changes in funding conditions. This can then be aggregated and categorised into national or sectoral data, for example, thus creating a series of tangible benchmarks for firms to use.
“The only way you can figure out whether your risk concentration is a good move is if you benchmark your concentration with other like-minded firms,” he says. “With this kind of information you will have a clear view of where risk is concentrated.”
Thomson Reuters has taken the lead in the creation of an industry-wide liquidity data workgroup by approaching regulators with a consultation paper.
“If I identify that my firm is 75% exposed to oil prices and a number of securities related to oil, for example, by using the data you can measure this investment concentration against other firms’ exposure,” says Carrel. “If you figure out that everyone else is in a similar position to you are, you will sense what you have to do.”
Currently, Thomson Reuters is awaiting responses to the paper from investment banks and regulators. Carrel admits that the fall-out from the current crisis means establishing the data workgroup may not be a priority for these firms and considers that a final solution could take a few years. However, he remains adamant that this kind of data solution is the most effective way of handling risk. “I don’t think there is a smarter way of managing risk effectively,” asserts Carrel. “There is a massive common interest for everyone to contribute to improve their day-to-day jobs.”