By Ed Blount, contributing editor, is executive director, ASTEC Consulting Group, New York City.

As the final shape of Basel II, the new capital solvency regime for large, complex banks, continues to emerge from the mist of negotiation and experimentation, it is becoming clear that there are many more parties-in-interest to the reform process than had been seen at first.

Customers will be affected as the very largest financial organizations redefine their markets and priorities in reaction to changing capital costs. Smaller banks and non-banks may gain opportunities, but they will also be expected to raise their own risk management capabilities. So will vendors, who will be asked to develop systems and procedures that help bankers adapt to the new, more risk-sensitive bank supervisory environment. And, ultimately, the counterparties and correspondents of large banks will have to understand the novel ways that bank managers will use to employ their capital, not least to draw timely conclusions about the relative efficiency of these huge financial organizations.

At the same time, bankers themselves can also look to some of their capital market partners as role models for managing the new risks of modern financial systems, since so many of the banks’ traditional credit risks have been relayed to counterparties and market systems, through syndications and securitizations.

In that light, ABA Banking Journal contributing editor Ed Blount has been speaking with executives from many of the players above—that is, bankers as well as other financiers—to search for role models that will be useful in the newly-emerging risk capital management environment. Indeed, bankers may be held to standards that are set well beyond their own traditional peer groups. Last month, Blount interviewed Bill Rutledge, chief of bank supervision at the New York Federal Reserve Bank. This month, Blount spoke with Mike Alix, chief credit officer and senior managing director of Bear Stearns.

With more than 10,000 employees and $30 billion in total capital, Bear Stearns & Co. is active in corporate finance, mergers and acquisitions, institutional equities and fixed income sales, trading and research, private client services, derivatives, foreign exchange and futures sales and trading, asset management and custody services. The importance of Bear Stearns’ risk management process is reflected in the fact that, for the last decade, the firm has been a party to trades involving nearly 20% of all stocks loaned through New York Stock Exchange firms!

Much of that activity is done with banks as partners so, clearly, Bear Stearns is not only a major counterparty to banks and their customers, but also a major consumer of banking services.

Alix began the interview by explaining that a broker-dealer manages credit risk in many ways, all of which are designed to assess the relative probability of a counterparty’s default. Bear Stearns begins with the reported financials of publicly-traded companies, in order to understand how the counterparty thinks about its business and its risks.

Risk Profiling

Blount: What would you say, from your perspective, is the most elusive aspect of a counterparty’s risk profile?

Alix: It’s very difficult to anticipate, for credit risk analysis, how a counterparty’s management would react to unanticipated changes in their markets—whether by reducing risk, shutting down the business, or whatever the case may be. We find it most difficult, but most important in managing our risks, to get an idea of how a counterparty is positioned.

For the counterparties that pose an important exposure for us, we talk to their managements at the time they are dealing with market changes. It’s very easy to gather lots of information from counterparties about how they manage risk. In normal times you tend to get a very good comfortable feeling, but it’s hard to understand how firms are positioned for problems, whether they will stick with their risk controls under stress, especially if they are facing serious losses for the first time.

Positioning

Blount: When you say “positioned,” do you mean the nature of their business strategies or their trading strategies?

Alix: I actually mean both. To use a simple example, if you have a hedge fund counterparty, one which is long and short in a market neutral strategy, you would expect that as markets go up and down the counterparty’s performance would not vary markedly. If you had a different customer, one which was directionally a short seller, you would expect that counterparty to have a problem with losses in a rising market. You need to know that’s how they generally would be positioned in order to know where to focus your attention as you are observing changes in the market place. If it turns out that a counterparty you expected to thrive in a particular environment is having a problem, then that tells you that your information about their strategy and management style was wrong. That’s what you need to focus on when you are dealing with your clients. You need to understand where their problems are, from observing your own positions and the direction of risk that you have bilaterally with that counterparty, as well as from applying your general understanding of what they should be doing based on your due diligence prior to that point.

Internal Rating

Blount: In the past few months, we’ve seen examples of Enron and other energy trading firms, which were so complex that many people said it was impossible to get an understanding of their strategies. Is that problem any different for securities trading firms?

Alix: When you are dealing with large, rated entities, counterparties have a temptation to rely on the opinions of the rating agencies. That’s because the rating agencies have access to information that most arms-length counterparties would not have. They process that information in a way that is comforting to the dealers. There is a reliance—proven in some cases to be over-reliance—on the opinion of the third party, where that opinion exists. As a creditor, I think in many cases it’s actually easier to deal with situations where you don’t have an external rating, because you can demand more information directly from a counterparty client.

Many, many of the counterparties we deal with in the securities markets (leveraged professional investors and so forth), do not have expert ratings that we can refer to. We have to apply our own judgment using our own due diligence and our own investigative techniques. We don’t want to rely solely on a third-party opinion, even if it’s available. We want to do the research, we want to read the financials, we want to understand the management, we want to understand how they deal with problems, and we want to understand how our firm is positioned vis-ŕ-vis that firm, in terms of the kind of transactions we’re doing, and what we can learn from those transactions about management’s relative aggressiveness. If you’ve gone through your process and still can’t get comfortable that you understand the strategies and risk profile of your counterparty, you should not be taking credit risk with them.

Market Signals

Blount: Is there anything that the market itself can contribute to you as a counterparty, that represents a signal about the continuing viability of your portfolio of counterparties or about any individual ones?

Alix: We—and I think this is a growing trend in the marketplace—rely heavily on market signals in evaluating our counterparty portfolio. For one thing, we have a reserving process which relies, not on a long-term rating, but rather on the market-implied probability of default, which is observed from counterparty-specific credit spreads. So, if the market’s credit spread for Enron begins to widen out well in advance of a downgrade, as it did last fall, we would observe that and begin to focus our attention on that portfolio.

I think that flows through the new [Basel] Accord to the capital requirements. An increase in market volatility or a widening in credit spreads will result, at least for trading portfolios, in an increase in capital required to be held against those trading positions.

Disclosure Firewalls

Blount: If the market is going to provide effective signals, it must be well informed. Where do you draw the line between confidential and proprietary information that an individual firm is entitled to protect, and information that should be given to a counterparty?

Alix: There is a spectrum. At one end is: “Show us every position that you have, so we can make our own assessment about the risk of your portfolio and your business, to extend credit accordingly.” The other is, “Show us no information about what you have, other than the high-level, basic, ‘know-your-customer’ stuff. Demand complete confidentiality … but provide sufficient collateral or other risk mitigants in your terms of trading with us, that we don’t have to worry about those positions being unduly risky.”

You either show us everything and we deal with you as aggressively as we can, or, you don’t disclose your strategy, and we deal on an extremely conservative, collateralized basis. The decision about how much information we need is a function of how much risk we are taking. At some point—and I don’t know if there is a bright-line test for this—we say,

“Well, I have enough discomfort with my lack of knowledge about this counterparty, that I will not continue to extend credit on favorable terms.”

But there are trade-offs along the way.

Peer Outliers

Blount: You said that, when looking at your customers’ strategies, you could correlate their results against those of your own trading desks. Does that give you an advantage in the marketplace, as opposed to other credit providers?

Alix: There are two sources of market information that can inform your counterparty risk management process. One, of course, is the result that you see in your proprietary activities on a day-to-day basis. In our situation, that takes a back seat to looking at results across the spectrum of clients who are following similar strategies. If we were to observe that one client’s performance was an outlier, relative to what we consider to be its peers, based on the way it described its strategy, we would focus on that client.

It’s important to know that it could be bad or good performance.

If somebody is doing particularly well, when we wouldn’t expect them to do well, we would ask questions about why they were so ‘fortunate.’ Very often, the answer is that their strategy, or the positioning of some portfolios, was somewhat different from what we expected. Or, the level of leverage in the aggregate was somewhat greater than what we expected.

Yes, we can learn from our proprietary trading results. We can get a sense of what is going on in the market. But that is where the information flow has to be one way. We can gather information from clients; we can gather information from our desks; we can understand what strategies are doing well and what strategies aren’t doing well. We can get a pretty good idea as to why. But we can’t then pass the information that we get about our clients to our proprietary trading desks. That’s not a part of the process.

Systemic Flashpoints

Blount: Does that then imply that certain supervisors in certain markets, because there is a range of sophistication, will have a better ability to manage systemic risks—because they understand strategies which create expectations about the results of their banks?

Alix: What is really important is the level of open communication between the supervisors and the banks, not only about what the banks are doing themselves, but also about what they see the clients doing,. That absolutely has to happen. We certainly see interest among supervisors, not only in the U.S., but elsewhere in what we are seeing generally in the marketplace. I know I personally meet with representatives from central banks from around the world from time to time. They ask, “What are the macro trends you see in credit, what are you worried about?”

I don’t believe it is particularly easy for a supervisor simply to monitor markets by looking at asset prices, trading and liquidity; to get a sense for whether there are problems or not. They have to understand the general trends via their institutions. We often get questions from the official sector that seem to belie a real understanding as to what’s going on, at least from our perspective. I think some people make guesses and develop hypotheses, but those are at odds with what practitioners see in the marketplace. Supervisors need to know that. They need to constantly reform their views based on that dialog with the marketplace.

Supervisory Premiums

Blount: Can I infer that there is a community of chief risk officers that is evaluating the supervisory machinery in each market, maybe not in a formal way, but informally, and is developing, as you are, a sense of certain markets and the sophistication of their supervisors, which might then actually work its way into their “degree of comfort” in dealing with counterparties in those markets?

Alix: Absolutely. In international markets in particular there is much discrimination among the various counterparties based on the quality and efficacy of the supervisory process they are subject to. It tends not to be a concern in the major markets. But in some of the emerging economies there are real concerns about how effective the supervisor can be, both in understanding what’s going on with their constituent institutions and then taking action to mitigate a systemic problem.

A distinction is made: If you have a decent counterparty, operating in a high-quality supervisory regime, that’s a positive. If the same counterparty were operating in a market without that kind of oversight, we would probably be less willing to take risks with them. BJ