The Technology Behind Wall Street's Meltdown - InformationWeek

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9/23/2008
11:14 AM
Doug Henschen
Doug Henschen
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The Technology Behind Wall Street's Meltdown

Could technology have saved Wall Street from its current financial crisis? From my perspective, the Fannies, Freddies, Lehmans and AIGs of this world no doubt had plenty of risk analysis, predictive analytics, and business rules technology to see and avoid the risk. They just ignored the danger signs or, worse, used the technology to paper over the dangers.

Could technology have saved Wall Street from its current financial crisis? That's something I've been thinking about over the last few days as I've scramble to move at least some of my money into FDIC-insured accounts at multiple institutions. From my perspective, the Fannies, Freddies, Lehmans and AIGs of this world no doubt had plenty of risk analysis, predictive analytics, and business rules technology to see and avoid the risk. They just ignored the danger signs or, worse, used the technology to paper over the risks.Last September, I attended an event in New York (also attended by at least a dozen representatives of major financial institutions) at which the Managing Director, Global Risk, Compliance and Technology at a major bank boasted that predictive analytics had actually helped the bank reduce its reserves against lending risk. A decade ago, regulators imposed much simpler, cut-and-dried requirements, such as setting aside 8 percent of loan portfolios to offset risk, but Basel II has required more rigorous processes to minimize operational risk and much more detailed analyses to uncover unobserved market risk and better understand credit risk. The financial institutions have responded with much more complex formulas and predictive models to forecast risk more accurately and satisfy regulators without needlessly tying up capital.

"Over a six year period, we reduced our regulatory capital requirements by about $6 billion, which translates into about $2 billion in extra revenue recurring every year," the executive explained. "To do that, we had to go from examining about 1,000 market risk variables and 200,000 market risk movements up to about 30,000 market risk variables and 24 million market risk movements and a huge co-variance matrix."

Despite all that sophistication, regulators know that analytics are only as good as the data, so financial institutions are required to prove that their models work. At the bank in question, that's done with a separate "profit attribution analysis" system that regularly compares the predictive models for value at risk against actual profits and losses. Essentially, the predictions are compared to reality once that comes to pass.

Prophetically, the executive at one point asked for a show of hands, asking "how many of you think this subprime lending crisis is going to be a big problem?" About half of those attending raised their hands, and he said, "the risk is so spread around in the financial system, this crisis is bound to blow over fairly quickly."

Within weeks of that event, that very same bank announced major write downs. Soon after, a major capital infusion was needed and the CEO was forced out. Now that we have the benefit of hindsight, it's very clear that the subprime risks were so spread around and so extensive that few financial institutions have been spared.

So what can you say about technology's role in the sorry state of our financial systems? As one colleague shared with a group of editors this week, "Yep, plenty of risk technology... just using it for the wrong reasons! A risk manager at Merrill told me you can make the risk systems tell you whatever you want. If you ignore the bad (risky) data, the system will tell you that the investment is a slam-dunk winner!"Could technology have saved Wall Street from its current financial crisis? From my perspective, the Fannies, Freddies, Lehmans and AIGs of this world no doubt had plenty of risk analysis, predictive analytics, and business rules technology to see and avoid the risk. They just ignored the danger signs or, worse, used the technology to paper over the dangers.

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