Thoughts on Risk Management Deficiencies

1. Thoughts on Risk Management Deficiencies CAIB November 2008

2. Outline • Background • What went wrong? • What is needed? • What are some international institutions doing?

3. Background • International Regulations: Basel 1 to Basel 2 • Economic capital / return on capital models • Arbitrage and innovation: securitisation,CDS • Accounting: • Standards on off-balance sheet vehicles • Mark to market and fair value; rules on reserves • “Shadow banking” system • Organization and Behaviors: • Separation of Risk Management Function form Risk Takers • Performance Incentives • Macro Policy • Market oriented • Globalization • IT revolution; flow of information • Trade • Financial flows and integration of developing economies in financial system

4. What went wrong? • Capital Models: • Quantitative techniques • Data driven by history even for new products • Increasing complexity; implicit assumptions • Many users may not have understood • Due to good environment, players believed models • Regulation vs. internal economic capital arbitrage: structured credit products

5. Accounting Standards • Off-balance sheet and structured products; • Fair value /Mark-to-market • Reserves: Incurred losses vs. expected losses Rules vs. principles Accounting purposes vs. risk management purposes

6. Shadow banking system • Non bank-regulated participants • Insurance; hedge funds • Risk was being shifted but was still in system • Counterparty risk: risk not necessarily with the entity best able to bear that risk. • Rating agencies • Investors delegated analysis to them • They had their own conflicts of interest because of incentive and fee structure.

7. Organization and Behaviors • Separation of risk management function • Risk Managers less close to information and knowledge; less real power • Conflict vs. co-operation • Incentives: • Volume, short-term returns • Benchmarking against industry vs. absolute performance relative to risk • Senior Management/Board engagement

8. Macro Policies • Market oriented • Regulation • Monetary policy: liquidity

9. Globalization • Information revolution • Rapid spread of money, ideas, techniques • Regulation and policy • Trend toward convergence Contagion

10. What is needed? • Regulation and Policy: • More principles vs. rules • Less procyclical ; need for buffers • Broader and more integrated coverage of institutions and instruments. • Balance between innovation and stability • Recognize purposes of risk standards and accounting standards • Information aggregation: institution-specific vs.system.

11. Corporate Governance • Business units responsible for risk and return • Closer interaction between risk and business • Long-term incentives vs. short-term market benchmarks • Balance between volume/revenue growth /innovation and stability • More Senior Management/Board engagement • More disclosure: accounting vs. “risk” income statements and balance sheets

12. Responses of International Financial Institutions • Environment • Spread to developing countries; direct financial effects but also growth, trade, commodity prices, remittances falling, • Poverty alleviation and development focus to be maintained • More inclusive responses, global partnerships • IMF • Funding; Financial Stability Forum • IBRD/IDA • Funding not only for financial crisis but also food, climate change; poorer countries, fragile and conflict states

13. Responses • IFC • Expanded trade finance program • Bank recapitalization fund • Infrastructure crisis facility • Refocused advisory services • Risk management, banking for MSME, housing, regulation