Throughout the financial crisis, one of the risks that has been revealed to have been consistently overlooked by investment banks and other financial firms is the costs of their own failure. While they hedged against the failure of other firms, they typically failed to include in their models the risks posed by the perception that they might fail. AIG, for instance, failed to take into account the fact that it might have to post additional collateral on its trades when its financial health came into doubt.
Even worse, financial firms seem to have not put in place any contingency plabs for failure. This meant that when failure occured, as it did at Lehman Brothers, chaos ensued and trades could not be easily unwound. AIG, for instance, is spending millions to keep on staff the very people who created its suicidal CDS portfolio. A cynic might even wonder if this was part of the strategy of traders at AIG and Lehman–make themselves indispensible in the event of a meltdown.
Now the UK is taking steps to address the situation. The idea is to require firms to plan for their own demise.
The Treasury has begun consultation into the insolvency regime for investment banks to plug one of the holes in Britain’s regulatory regime. “The failure of Lehman highlighted two areas of difficulty: first, around trading, clearing and settlement; and second, around the return of client assets,” the consultation document says. “Each needs to be addressed to maintain financial stability and protect the reputation of London as a world-class venue for investment banking.”
This is not only a great idea, it’s one that needs to be adopted as one of the earliest reforms of the financial sector. Risk management should immediately begin to include “failure management.” Let’s hope this one catches on.