Bringing Back Best Practices in Risk Management

Banks' Three Lines of Defense

Executive Summary

Many financial institutions have had horrific losses over the past 18 months. A variety of largely exogenous factors have been blamed for the losses, such as ownership structures and incentives, rating agencies, and the absence of effective market pricing for some products. However, we contend that at a small number of banks, a focus on basics actually prevented many losses. Iin particular, they benefited from a strong risk culture combined with a sharp focus on three effective lines of defense: top management and the front office, the risk management function, and audit. These lines of defense, staffed with capable individuals imbued with a strong sense of risk awareness, are at the heart of effective risk management.

The Root of the Problem
The current downturn originated largely in the U.S. financial markets. Cheap credit from the Federal Reserve fueled an extraordinary leveraging of the U.S. economy—with a particular focus on consumer debt, especially mortgage debt. The original sin was not in the lack of regulation but in the expansion of credit to the non-creditworthy on outrageous terms—as in the case of 105 percent loan-to-value loans being given without credit checks. Underwriting banks, large and small, packaged and resold this debt to investors, including other banks, as collateralized debt obligations and mortgage- or asset-backed securities; this freed up their balance sheets and allowed them to go at it again. The latter step was predicated on the notion that the purchase of the debt would bring a perpetual stream of repayment income against “secure” collateral—and, of course, this notion depended on the idea that the real estate market would keep rising. Globally, many institutions, assured by ratings, believed this to be the case.

Cheap debt also contributed to the explosive growth in banks’ balance sheets. These purchases of assets resulted in irresponsible leverage, rising at some banks to debt-equity ratios of 30:1, 40:1, and even 100:1.

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