The Sub-prime Market and Spreadsheet Dependence
With the US sub-prime mortgage debt hidden within complex structured credit products, questions remain as to how accurately credit derivatives are priced, what is the real level of risk and who owns it. As with any market crisis, the whole model – in this case the ‘originate and distribute’ model of modern banking where loans are repackaged and sold on to investors – will come under scrutiny. Regulators and policymakers are already requesting more transparency. The call for transparency is twofold: financial institutions firstly need to determine where the risk lies and how the derivatives are being priced and, secondly, to report and explain what’s going on.
The UK’s Financial Services Authority (FSA) has repeatedly warned investment banks and hedge funds, which one could argue have become excessively complacent, that they will face penalties if they do not better manage operational efficiencies in the credit derivatives markets and improve the handling of corporate data. The FSA’s concerns were that banks didn’t have a clear understanding of their exposures because their settlements were outlined with their commitments. Long before the credit crunch, the FSA urged for controls to be implemented. In my experience, it is difficult for financial institutions to control processes and, going forward, it will become even more complex as more regulations come into effect.
The credit crunch has effectively exposed behaviours that have long been in existence and yet the industry has turned a blind eye, because they were making enough profits not to care. But now, financial institutions, particularly banks, will need to provide information on how their risks are managed and valued, especially when regulatory conventions show risk to the off-balance sheet. Financial institutions will have to become more transparent and, ironically, in moving forward they will require additional technical controls to compensate for recent restructurings that have decreased resources in the middle office that controlled processes.
It is becoming widely acknowledged that, to a large extent, credit risk management is dependent on the humble spreadsheet. Traders use spreadsheets to price and model credit derivatives (including CDOs), as these are flexible and user friendly tools that enable innovation and productivity. Spreadsheets can be used to capture, price and manage a structured trade for its entire life cycle, for the next 20 years. Even if financial institutions have trading systems to book the components of a structured trade, they use spreadsheets to value it. In fact, we have observed that the more structured the markets become, the less likely banks are to use their existing systems to manage structured trades and resort to spreadsheets instead. It is unlikely that financial institutions would have ever been able to develop the markets and achieve growth and innovation, if it wasn’t for spreadsheets.
Spreadsheets need to be managed and controlled. The credit crunch revealed that the task of presenting and explaining all business critical information could become even more arduous, if financial institutions haven’t got spreadsheets under control.
To achieve transparency, financial institutions can use manual controls or apply technology solutions. Manual controls seem to be less of an option now, as many control departments have been culled back. Spreadsheet management software, on the other hand, can help financial institutions meet their compliance obligations while providing the safety net for the use of business-critical spreadsheets.
By managing spreadsheets, the accuracy of all vital strategic and competitive data is ensured. End users can confidently hold a wider range of profitable positions and focus on the core business of making money. Effectively, technology can enable financial institutions to trust in the output of their spreadsheets and use them like any other system application to provide business innovation and competitive advantage.