FROM THE OFFICE OF PUBLIC AFFAIRS

For most of the last twenty years, the rise of the science of risk management in banking has ironically coincided with a corresponding decline in attention to the basics of credit analysis. There are macro-economic reasons why this occurred and why these trends are now reversing themselves.

The volatility of our capital markets over the last five years, and over the last five weeks, should be serving as a wake up call to those who have paid too little attention to credit analysis – to assessing the particular probabilities that individual borrowers may not be able to sustain the cash flow necessary to meet their obligations.

Credit matters and it matters more now than it did just a few years ago. This is a natural consequence of the transition we have been experiencing from a world of more volatile output and inflation to a world of more stable output and more stable prices.

In a financial environment dominating by sharp swings in real output and in inflation expectations money is made (or lost) in debt markets by anticipating (or failing to anticipate) the corresponding changes in real and nominal interest rates. This is precisely the environment experienced by the financial markets from the late 1970s to the early 1990s.

In that setting, the big macro-economic events were relatively more important than the particular circumstances of individual borrowers. It was good enough for bankers and bond traders to form a consensus on credit by using rough rules of thumb for spreads and for credit rating categories, so long as they could hang on for the ride while the underlying interest rates gyrated.

In a period of more stable output and prices, by definition, it becomes relatively less important to anticipate the changes in underlying macro-economic conditions and relatively more important to assess accurately the credit standing of individual borrowers. In the recent downturn and recovery now underway, while we have seen some spectacular volatility in the financial markets, we have seen much less volatility in real output and prices than most observers expected.

In this environment we have all discovered that the risks of lending money (or, I would add, investing money) is a little bit less about macro-economics and a little bit more about micro-economics – about whether behind the balance sheet and the income statement, the borrower has the cash flow to meet its payment obligations.

The science of risk management, developed in response to the macro-volatility of the previous decades, has helped financial institutions control risks that were previously unidentified or incompletely understood. The models, the simulations, the statistical and probabilistic discipline that have been applied represent an extraordinary improvement in the management of financial risk. However, this process has coincided with the outsourcing of basic credit analysis either to the rating agencies or to the designers of the indexes used as benchmarks.

So as not to belabor the point, permit one anecdote to tell the story.

A money manager recently told one of my colleagues that duration shifts in his portfolio are quickly flagged by risk management controls and require him to explain himself to management up and down. However, if he were to fill a single credit category in his portfolio solely with the bonds of a single company, nobody in risk management would even notice.

Since the Asian crisis of 1997, credit spreads been repeatedly shocked to wider and wider levels and, most importantly, the "spread of spreads" has been widening as market participants have come to differentiate more carefully among borrowers. The events of ’97, ’98, and of the last two years have been mistakenly, in my view, seen through the prism of "market risk" as if they were exogenous shocks. I think they are better understood as a series of credit events in which the quality of certain borrowers came to be better understood.

Whether sovereigns, central banks, foreign banking systems, hedge funds, or seemingly blue chip companies, over the past five years we have been learning the importance of differentiating between those with real cash flows and those without, between those that have honestly and transparently disclosed their risks and those that have not.

The challenge for policymakers now is to help the banking industry retool itself to deal with an environment in which credit matters.