Financial institutions ill equipped to deal with credit risk developments, says D’Silva

The changing attitudes to credit risk among banks amounts to a "cultural revolution", Adrian D'Silva, director of capital markets supervision for the Federal Reserve Bank of Chicago, told delegates at a credit risk management conference in Vienna today. But many financial institutions are ill equipped to deal with the changes, he warned.

D'Silva said the changing focus on credit risk from the "underwrite and hold” to the “underwrite and distribute” approach (using credit derivatives to distribute risk) has produced a new level of risk management concern both for banks and other financial institutions. Many firms do not have the management information systems to support firm-wide risk assessment, D’Silva added. This was particularly apparent for banks that had evolved out of mergers and acquisitions.

The increase in the types of firms using credit derivatives over the past few years has also brought new risk management issues to the market, D’Silva told delegates at the conference, organised by Toronto-based risk management technology vendor Algorithmics.

"We spoke with two insurance companies that have been involved in credit derivatives," D'Silva said. "When they talked about the size of their exposure it came as a shock to us. They weren't doing too well handling this and that's why they came to us."

D’Silva’s remarks are a reminder that regulators have become worried about the ability of insurance companies to effectively manage credit derivatives. In a speech in January, Howard Davies, head of the UK’s Financial Services Authority, quoted an investment banker who had quipped that synthetic collateralised debt obligations and other derivatives used by insurers are “the most toxic element of the financial markets today”.