Last week, I wrote about my first visit on this journey through the financial crisis where I met two Federal Reserve Banks in the United States to discuss the financial crisis.

This week, I will discuss my second visit in this journey where I sought to understand the cause of the financial crisis, role played by investment banks and lessons learnt.

I was fortunate to get an opportunity to visit an investment bank on Wall Street in Manhattan, New York. It was an interesting visit and as I walked through Wall Street to my appointment, I could not help but marvel at the magnificent skyscrapers, each with a tale to tell on the financial crisis.  With the collapse of two investment banks, Wall Street seemed less busy and very serene.

Today Wall Street looks very different with the current "Occupy Wall Street” protests that have been featuring in the news in the last three weeks.

Similar to the meetings I had last week, the genesis of the financial crisis was the strong global economic growth, excess liquidity and low interest rates which resulted in the need to find new investment opportunities.

The best opportunities were seen in the housing market as the government supported home ownership and mortgage assets were considered safe investments.

Furthermore, flexible and varied mortgage products attracted more capital. This led to the complex financial innovations that were developed by the investment banks for the commercial banks.

Over time, it emerged that some of these innovations were so complex that they were little understood by both the banks and regulators. In addition, the complexity of these new instruments outstripped the operational capacity to manage them.

One would then ask what investment banks and other organisations could have done to better detect the crisis. The answer to this question is an area that is key to each organisation but often forgotten.

It also provides a key lesson from the financial crisis and is the reason why some organisations survived the crisis while others collapsed overnight. The answer can be summed up in two words – risk management!

Hence, the main lesson was that financial innovations should not exceed the capacity of an organisation to manage risks. Risks and control functions should be independent of other business units and the reporting lines should be clear.

In addition, the risk management function should have the same stature as core business functions.

In many organisations, risk management is often seen as a back office function that adds to the number of already existing onerous procedures.

For instance, in investment banks, some professionals in the organisation such as the traders are highly regarded because their day to day work is tied directly to business revenues while risk managers are seen as impediments to revenues due to the requirements they add to the business process.

It came out clearly that risk managers are important to the business and their decisions should prevail where there are disagreements on risk limits. Risk managers within investment banks should also be capacitated to effectively monitor financial innovations.

It was also recognised that regulators at both country and global level should be strengthened to better monitor the financial system and related complex financial innovations.

This calls for a dynamic regulation system that can identify and constrain market excesses while recognising the limitations of the regulation system that was in place before the financial crisis.

In addition, all significant components of the financial system, outside the normal banking system should be regulated.

Senior Manager, PwC Rwanda.
florence.w.gatome@rw.pwc.com