As the boom persisted, investors grew more confident in the relative stability of macro and financial conditions and in the high levels of liquidity of the recent past, and projected that stability into the future. That confidence in a more stable future led to greater leverage and a larger exposure to the risk of a less benign world. The interaction of these forces made the financial system as a whole more vulnerable to a range of different weaknesses. The models used by issuers to structure these products and by credit rating agencies to assess risk and assign ratings turned out to be much more sensitive to macroeconomic assumptions than was apparent to investors at the time. Assumptions about home price appreciation and the correlation of defaults within the underlying collateral pool were particularly critical in this context. The proliferation of credit risk transfer instruments was driven in part by an assumption of frictionless, uninterrupted liquidity. This left credit and funding markets more vulnerable when liquidity receded. Banks and other financial institutions lent substantial amounts of money on the assumption that they would be able to distribute that risk easily into liquid markets. A sizable fraction of long-term assets – assets with exposure to different forms of credit risk – ended up in vehicles financed with very short-term liabilities and was placed with investors and funds that were also exposed to liquidity risk. As is often the case during periods of rapid change, more significant concentrations of risk were present than was apparent at the time.
Banks and investment banks sold insurance against what seemed like low probability events, but did so at what even at the time seemed like low prices. And on the assets they retained, these same institutions purchased insurance from financial guarantors and other firms that were exposed to the same risks. The crisis exposed a range of weaknesses in risk management practices within financial institutions in the United States and throughout the world. Today, a group of the primary supervisors of the largest banks and investment banks in the world released a comprehensive assessment of risk management practices in these institutions. This assessment will help lay the foundation for consensus on changes to supervision going forward in the major financial centers. The report examines a range of practices that helped determine relative performance during this crisis. Banks and investment banks with stronger risk management practices and cultures did substantially better. The most common failures were in how firms dealt with uncertainty about the scale of losses they would face in a less benign economic and financial environment; the scale of the cushion they built up against that uncertainty; how well they managed the internal tension between risk and reward; and how quickly they moved to mitigate risk as conditions deteriorated. The typical arsenal of risk management tools relies, by necessity, on history and experience, and as a result has only limited value in assessing the scale of potential future losses.