We also trusted the rating agencies. It is hard to imagine now but the reputation of outside bond ratings was so high that if the risk department had ever assigned a lower rating, our judgment would have been immediately questioned. It was assumed that the rating agencies simply knew best.
We were thus comfortable with investment-grade assets and were struggling with the huge volume of business. We were too slow to sell these better-rated assets. We needed little capital to support them; there was no liquidity charge, very little default risk and a small positive margin, or “carry”, between holding the assets and their financing in the liquid interbank and repo markets. Gradually the structures became more complicated. Since they were held in the trading book, many avoided the rigorous credit process applied to the banking-book assets which might have identified some of the weaknesses.
The pressure on the risk department to keep up and approve transactions was immense. Psychology played a big part. The risk department had a separate reporting line to the board to preserve its independence. This had been reinforced by the regulators who believed it was essential for objective risk analysis and assessment. However, this separation hurt our relationship with the bankers and traders we were supposed to monitor.
In their eyes, we were not earning money for the bank. Worse, we had the power to say no and therefore prevent business from being done. Traders saw us as obstructive and a hindrance to their ability to earn higher bonuses. They did not take kindly to this. Sometimes the relationship between the risk department and the business lines ended in arguments. I often had calls from my own risk managers forewarning me that a senior trader was about to call me to complain about a declined transaction. Most of the time the business line would simply not take no for an answer, especially if the profits were big enough. We, of course, were suspicious, because bigger margins usually meant higher risk. Criticisms that we were being “non-commercial”, “unconstructive” and “obstinate” were not uncommon. It has to be said that the risk department did not always help its cause. Our risk managers, although they had strong analytical skills, were not necessarily good communicators and salesmen. Tactfully explaining why we said no was not our forte. Traders were often exasperated as much by how they were told as by what they were told.
At the root of it all, however, was—and still is—a deeply ingrained flaw in the decision-making process. In contrast to the law, where two sides make an equal-and-opposite argument that is fairly judged, in banks there is always a bias towards one side of the argument. The business line was more focused on getting a transaction approved than on identifying the risks in what it was proposing. The risk factors were a small part of the presentation and always “mitigated”. This made it hard to discourage transactions. If a risk manager said no, he was immediately on a collision course with the business line. The risk thinking therefore leaned towards giving the benefit of the doubt to the risk-takers.