Article
September 1997: Futures and Options World
A Buy and Hold Approach: Risk management veteran FHLB's coo tells Andrew Webb about future front and back office plans, and of the bank's final withdrawal from third-party risk.
Much of the airtime that risk management receives is lavished on
the activities of a select few investment banks and their innovative techniques.
Far less prominence is given to developments in the less glamorous world
of commercial banking, which nevertheless boasts some risk management
veterans of its own.
For example, Terry Smith, chief operating officer of the Federal Home Loan Bank (FHLB) in Dallas, has seen risk management from both ends of the spectrum over the last ten years.
"In the late 80s and early 90s, we offered a risk management service to our clients. Our experience from that has certainly stood us in good stead during the current over haul of our own risk systems. One of the most important lessons we learnt was that unless you are dealing with very highly leveraged transactions, the quality of your pricing models is not nearly as important as the quality of your data. If, for example, you are doing very highly exotic derivative transactions with multiple layers of embedded options in them, you need high-powered models that are technically and analytically precise. We are a $21bn bank with $30bn with national principal off balance sheet in swaps and caps.
The bank is what you might call something of a buy and hold investor, with a $4.5bn investment portfolio of US government / agency securities and mortgages. We swap everything back into Libor to detoxify it. To run that sort of bank balance sheet you don't need proprietary models and analytical power equivalent to a Wall Street firm – you need really clean, timely data."
Consequently, the early stages of FHLB's development project have focused on the back office and database structure. Back office integration is already complete, with all loan, derivative & debt data in a common Progress database, which is also the accounting database. The bank is currently working on getting the Principia modelling system online, with the back office datafeeds directly plugged into it, so that transactions do not have to be re-keyed. This phase of the operation should be completed in the next 2-3 months.
"The longer-term objective is the implementation of Cats Carma," says Smith. "In the future (probably a year or so) we want the ability to run Monte Carlo simulations on the whole organization. Rather than just a 'time zero' mark-to
market, we want the ability to obtain an expected mark-to-market a year ahead based on 10,000 runs of the whole portfolio. While we will also have the capability to monitor risk in real time, it does not really make sense for us to do so. We do not have as volatile a set of assets and liabilities as a large investment bank."
Prior to the recent changes, the bank was using BankMaster, which Smith rated highly for income forecasts, but which was not designed to mark to market complex transactions – hence the implementation of Principia. In the front office, trade captures are currently handled by SunGard's Intrader, with some customized additions for swaps and advances / capital stock. (The recent interest rate swaps release of Intrader was based on FHLB's customization.) Mortgages are dealt with by EJV (recently acquired by Bridge), with Principia covering everything else.
One advantage of the bank's "build from the ground up" approach has been the lack of any need for middleware. "We don't have twelve old systems that need to talk to three new ones," says Smith. "The transaction database is also the system of record for the bank, and all applications link directly into that, so for us the issue of middleware does not arise."
Apart from the sort of commercial activities that its name implies, the bank is also prominent as a custodian, acting as a volume concentrator for many smaller financial institutions. It was on the back of client contact from this business that FHLB started to offer a third-party risk service in 1989. Though the bank has clearly amassed considerable commercial risk management expertise, it has since withdrawn from this market.
"When we approached clients about the service, their responses fell broadly into one of the three categories: 1. 'Go away – we don't need it', 2. 'Go away – we've already got it', or 3. 'Yeah we'd really like to have you come do it, but we don't know where our data is!'" FHLB started working with the third group and found that providing clients with enough analysis to provide their mark to market, rate movement exposure etcetera. was relatively simple for most institutions. The problem was in obtaining the data. Typical clients were Savings & Loans and commercial banks, with $100-500m in assets, and the aggravation was all in getting the data in one place and scrubbed clean.
A common problem for Smith's team was that while a client might how that it held $100m in mortgages, this could be spread across ten totally different mortgage types. Finding the various details such as rates, maturities and resets on all these proved problematic – to say the least. Most of the client back office systems were simply not readily structured to provide access to that kind of data. "In the end what we did was say: 'Give us what you've got and we'll figure it out'," says Smith. "We would build the database and regularly badger the client for more information. What we found was that by the time you completed the process, everything was working fine, but it simply was not cost-effective for us. We couldn't charge enough to cover the work, which was all manual and very labor intensive. We couldn't offload the work to the institution either, because all the staff were doing other things or simply lacked the technical skill."
"FHLB Finally withdrew from the business in 1991," says Smith. "It's something you can not do half way, and we could not see it being an effective revenue earner. I think third-party risk managers now split into two groups. The larger by far (perhaps 95% of the market) are the sort of operators such as the Big Six, who provide you with a report on how to create a risk management process. A further much smaller sliver do one of two things; build models (like Principia) or provide specific problem solutions for the esoteric such as the Blackstone Group do. We didn't see ourselves as fitting any of these categories and in the end decided that if we were going to spend the money, we should spend it on ourselves."