At the World Economic Forum in Davos, Switzerland, many financial experts spoke about what is needed to unleash the lenders, keep the books simple, and bring on more rules to improve the financial markets and avoid another global financial crisis. Is nationalizing global banks the answer, as some experts have proposed? Whether you are for or against the nationalization of the banking industry, one point is clear: There is a lack of confidence around the globe in our current lending practices. Of particular concern is the risk associated with various financial instruments and how much of that risk gets passed on to us taxpayers.
Many of us still don’t understand all the historical and economic conditions that have led us to this point. But, if you are like me, you just want to see our financial world settle down and our personal finances start to grow again. Since we all have different circumstances that affect how we invest our money and how we borrow money, I personally don’t think a “one size fits all" approach to solving the crisis and measuring risk is the way to go.
In hindsight, it is clear that our financial institutions did not really know how to weigh risk and price accordingly, so collateral was being packaged together with risky mortgages and other complex instruments, or collateralized debt obligations (CDOs). And why should they needlessly worry about what might lay ahead? With rising housing prices and assurances from Alan Greenspan, Ben Bernanke and Henry Paulson that there was not a housing bubble, credit rating agencies continued to give high investment ratings to CDOs without really understanding the underlying risk associated with each individual instrument or the bundle as a whole. As a result, risks were also disguised from investors.
The issue of risk brings me back to another key point that was raised in Davos with respect to keeping assets simple and transparent. Others can debate the rules and regulations part; it’s a debate worth having. In the meantime, I propose that banks and other financial institutions start doing a better job of analyzing the risk associated with each lending instrument, being more transparent with the risk that is being passed on to the investors, and better analyzing the potential risk the borrower is bringing to the table. Clark Abrahams, Chief Financial Architect at SAS, has outlined a new way of assessing credit-worthiness and weighing those risks. He discusses his Comprehensive Credit Assessment Framework (CCAF) in his newly updated blog. He and Mingyuan Zhang have also written, Credit Risk Assessment: The New Lending System for Borrowers, Lenders, and Investors. In it, they reveal their research into the underlying causes for the financial breakdown, reasons the CCAF is the most logical next step and how the CCAF can be implemented.
As I mentioned before, this is not a situation where the risk will always be the same for everyone. People behave differently, companies behave differently and the lending and potential capital raised needs to be assessed and priced accordingly. Keeping the assets simple is not necessarily the answer, but having good analytics and risk practices in place to effectively weigh risk and reward might be the most intelligent approach. Risk-based pricing can favor both the lender and the borrower, bringing mutual rewards. Customers are happier and feel safer. And financial institutions are rewarded by having more good capital on hand, increased deposits and less defaults.