Federal Reserve Chairman Ben Bernanke says he learned a few things from what he calls the “current turmoil” in the financial markets. Speaking at a Chicago Fed seminar on bank structure, He thinks these lessons would also benefit a wide array of market participants — including financial institutions of all types and sizes.

First, Bernanke blames our current problems largely on “the problematic implementation of the so-called originate-to-distribute approach to credit extension,” which created problems at every step of the process. At the point of origination, underwriting standards were increasingly compromised. Poor-quality loans were embedded in complex and opaque structured products, which spread losses throughout the system.

This problem extended beyond subprime mortgages, Bernanke declared. Credit standards eased elsewhere in the financial system as well, even as market-risk premiums contracted. Investors often took insufficient care in evaluating risks, in part because they relied too much on the credit rating agencies, whose methodologies, data, and assumptions were deficient. When the mortgage crisis arose, the agencies had to sharply downgrade a variety of products, causing investors to lose confidence in the agencies and the markets for structured credit products to seize up.

This experience should provide a number of lessons for risk management at financial institutions, the Chairman observed. These lessons include:

• Risk management: “For risks to be successfully managed, they must first be identified and measured,” Bernanke observed. This requires the use of a range of risk measures, including both quantitative and qualitative metrics. “Sophisticated quantitative tools and models play an important role in good risk management,” Bernanke said, “But no model, regardless of sophistication, can capture all of the risks that an institution might face.” Institutions must emphasize validation, independent review, and other controls for models and similar quantitative techniques.
• Valuation: Developing in-house expertise to conduct independent valuations enables institutions to avoid relying solely on third-party assessments. Testing valuations (by selling a small sample of the assets in question, for example) helps institutions derive appropriate market liquidity premiums in their pricing models and evaluations.
• Liquidity risk: In the current crisis, the more-successful institutions developed firm-wide strategies for liquidity risk management that incorporated information from all business lines, Bernanke observed. Firm-wide strategies that included consideration of the liquidity risks associated with structured investment vehicles led to less involvement in these activities.
• Senior management oversight: Senior managers should be actively engaged in risk management, which includes determining the firm's overall risk preferences and creating the incentives and controls to induce employees to abide by those preferences.

“Recent events have also demonstrated the importance of generous capital cushions for protecting against adverse conditions in financial and credit markets,” Bernanke concluded. “I strongly urge financial institutions to remain proactive in their capital-raising efforts. Doing so not only helps the broader economy but positions firms to take advantage of new profit opportunities as conditions in the financial markets and the economy improve.”