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Market Risk - The Detrimental Nature of the Herd Mentality


Author: Lenny Broytman

August 20, 2007


Sophisticated technology aimed at properly assessing risk associated with trading asset-backed securities are essential for any of today’s large banks but according to experts, this much-needed technology could also be backfiring all the same.


Sophisticated technology aimed at properly assessing risk associated with trading asset-backed securities are essential for any of today’s large banks but according to experts, this much-needed technology could also be backfiring.


According to reuters.cok.uk., some of these systems have added fuel to the fire that is the liquidity crisis surrounding the subprime situation when investors hurried to sell at the very first sign of trouble. When the mortgage collapse in the US spread across numerous asset classes, banks quickly ceased lending to one another in a move that Reuters says, no risk management model ever saw coming.



"These risk management systems create risk," Avinash Persaud, Chairman of Intelligence Capital Ltd, a risk consultancy. "If you give investors the same set of data they end up with a similar portfolio, so when volatility rises they all end up having to sell the portfolio," Persaud added.


According to one Frankfurt-based analyst close to the investment banking sector, one-day Value at Risk valuations, which are used by both banks and investors alike to measure how far the value of a portfolio may and/or can fall in a single day, just don’t work in these kinds of situations.


Risk management models are essential. They assess risk as they should. They monitor future situations with a fair amount of accuracy investors value. But all of these things can only go so far. According to many, these risk models can also spark a herd mentality that can lead to market patterns that are unnecessary and oftentimes, stem from fear.


Many financial experts agree that these tools can only be utilized properly if and when the data they are fed into is accurate. Furthermore, investor follow-thru has to be a little bit more than just the natural, one-size-fits-all solution that everyone else in the market is going to resort to.


"Trading models have been calibrated for stable market conditions and cheap money," said a consultant at a financial audit firm in London. "The game was: 'let's not get caught when the music stops.'"


Experts note that the ailing credit market is not the only source of fear for investors.


"Models have correlation elements built in and in theory certain assets should not be correlated," said the consultant. "When there is a general panic, everything gets correlated," said the London-based consultant.


It is for many of these reasons that the larger banks are not relying as much on these risk management models as their less-experienced counterparts are. A lot of these experienced banks understand the concept of fear-driven short-term investors ruining portfolios by dumping assets in a wild stampede.


"You have a mentality that the (risk management) model gives you some sort of control but you also have banks that combine these models with the experience of analysts and a distinct risk management culture," said Michael Dawson-Kropf at credit risk agency DBRS.



"I would suspect that more people saw this (crisis) coming than are prepared to admit it, but the nature of the beast is you don't know when it is coming and if you quit too early you may be fired for it," the Frankfurt-based analyst added.


"People must ask not what happens to a portfolio if there is a repeat of the Asian crisis but what happens to a portfolio if I am part of a herd," said Persaud.



Source:   www.riskcenter.com


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