Diffusing Balance Sheet Bombs

Diffusing Balance Sheet Bombs | Risk & Insurance | Ever since the ancient mariners set sail on the wine dark seas, we've tried to make sense out of information that could give us an advance warning of impending storms or other danger.

By Patricia Vowinkel

Without the technology we have today, people often had little warning of trouble on the horizon.

As recently as 1938, for instance, a hurricane known as the "Long Island Express" caught almost everyone unprepared as it raced up the East Coast, wreaking havoc on Long Island and much of New England.

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In the last year, an entirely different kind of storm has wreaked havoc on our global financial system. Stocks are down about 50 percent from their highs in 2007 after bubbles in the real estate and financial markets popped. Most major investment banks have either gone out of business or have been acquired by larger commercial banks. The federal government has had to bail out AIG, which has been on the brink of collapse.

While a few people were able to see the imbalances that were building and warn of a possible financial market meltdown, most people were caught by surprise by the magnitude and intensity of this crisis.

Here we are, awash in financial data and yet unable to make enough sense out of it to avoid a near systemic financial collapse.

That's where the idea of creating a standards-based approach to risk reporting comes in.

At the moment, institutions have inconsistent methods and vague language for disclosing operational, market, and credit risk. These inconsistencies make regulatory oversight difficult and complex.

The IBM Data Governance Council is exploring a new approach that would provide semantic clarity--a precise method for consistently describing and reporting risk across all financial service organizations.

The idea would be to use Extensible Business Reporting Language (XBRL), a software language for describing business terms in financial reports, for risk reporting. XBRL is already widely used for financial reports throughout Europe, Australia and Japan.

Although financial terms can be described in XBRL, so far there is no vocabulary, for risk in XBRL.

"Creating a risk taxonomy using XBRL will provide a vocabulary and a common language allowing everyone to understand what risk means, and that's the first step to making it easier to calculate and report," according to Steve Adler, chairman of the IBM Data Governance Council.

That would make it easier to aggregate loss information, analyze it with standard actuarial methods, compare past exposures to present conditions and forecast potential outcomes.

It could help warn risk managers and regulators about possible disasters that could be brewing on the balance sheets of major financial institutions. A common language and transparency about risk could help to make it easier to identify toxic assets, mitigate fraud, prevent wide-scale fiscal crisis and rebuild confidence in financial systems.

The idea is not without problems. Companies may resist having to implement new software when so many are looking to cut costs. Nor will it be easy to come up with common terms for the financial products and exposures.

And even with the best early-warning system, people can always close their eyes to avoid seeing what they don't want to see.

But a standardized approach to risk reporting could help financial institutions avoid getting blindsided by another balance sheet bomb.

The devil will be in the details.

PATRICIA VOWINKEL has worked for national media outlets for more than 20 years.

May 1, 2009

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