Credit Crisis Caused by Clashing Risk Management Systems at Financial Institutions: C.D. Howe Institute

    TORONTO, July 22 /CNW/ - Clashing models of debt funding, and the risk
management systems associated with them, engendered the credit crisis,
according to a Commentary released today by the C.D. Howe Institute. Review
and reform of these systems and their regulation are required.
    In Anatomy of the Credit Crisis: The Role of Faulty Risk Management
Systems, Frank Milne, an economist at Queen's University and newly appointed
Special Advisor to the Bank of Canada, examines the roots of the credit crisis
that began in mid-2007. Milne identifies two competing models of risk
management. According to the first view, securitization in liquid credit
markets was making obsolete, or at least reducing, traditional banking
concerns about asymmetric information, uncertainty and illiquid markets. The
second model saw increasing securitization as merely obscuring traditional
banking problems, which remained important.
    To the degree that the first model prevailed, risk managers made false
assumptions about the liquidity and transparency of a new generation of credit
instruments. The result was the creation of a shadow credit-banking system.
Milne argues that the current crisis reflects not a liquidity problem, but a
massive de-levering of that shadow system as the credit market model
underlying it has been shown to be inadequate. There has been what amounts to
a massive run on an insolvent shadow banking system, whose reverberations are
far from over.
    The paper outlines possible policy reforms for risk management systems
and their regulation. However, the author cautions that, at this stage, one
should be cautious in adopting specific and major policy changes, either at
the national or international level, pending further analysis of what has been
a complex systemic failure.
    For the Commentary go to

For further information:

For further information: Frank Milne, BMO Professor of Economics and
Finance, Queen's University, (613) 545-0431

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