Current approaches to risk management: The 31 points, challenges and developments

1. Current approaches to risk management:The 31 points, challenges and developments Pascual O’Dogherty Banco de México

2. Overview I.- Background II.- Regulatory versus Supervisory approach III.- Banco de Mexico´s “31 points” IV.- CNBV and risk management V.- Current challenges

3. PRUDENTIAL REGULATION Financial Stability Efficiency I.- Background SAFETY NETS

4. I.- Background Prudential Regulation and Supervision: • Establishment of regulations to reduce risk taking. • Monitoring to assure compliance.

5. II.- Regulatory versus Supervisory approach Regulatory approach: Focus on the assesment of the quality of a bank´s balance sheet at a particular point of time.

6. Financial Sector Revolution Innovation Globalization • Breakdown of geographic barriers to the provision of financial services. • Users of financial services as well as intermediaries are global corporations. National linkages are replaced by corporate structures. • New and more complex financial products • New forms of financing, hedging and savings appear everyday with remarkable speed The wave of trade liberalization and deregulation of the 1980´s is now followed by a revolution in the financial sector Change can not be avoided. The responsibility of the authorities is to set an environment for an orderly transition

7. Principal problems Increase of risk Problems of traditional current regulation Current regulation lacks a rational, coordinated, and integral framework • Does not promote financial innovation • It is the result of “ad hoc” adjustments from particular needs, It lacks an integral vision. • It uses a “bucket” approach. • It is fragmented among different institutions. • Some limits might increase overall risk rather than decrease it. • Limited ways for conducting risk management. • Opportunities for regulatory arbitrage.

8. II.- Regulatory versus Supervisory approach Supervisory approach: Focus on the soundness of bank´s management practices regarding risk and adequate disclosure of information to market participants.

9. Risk Management Criteria for a new regulation The two basic building blocks for a regulatory framework for the next generation are the development of a culture for effective risk management and a set of basic rules conducive to the self-regulation of participants and markets Self-regulation Developing a culture for risk management within the institutions Increasing role of markets

10. III.-The “31 points” 1995: Banco de Mexico issued first risk management regulation. • Among others, institutions have to comply with: • 1. Requirements of administration • Creation of risk units independent from trading areas in charge of measuring and evaluating credit and market risk. • 2. Requirements of operation • have systems to measure and evaluate risk in real time. • 3. Requirements for internal control • Risk management committee; • Efficient internal oversight mechanisms; • Periodical reports. Banco de México’s 31 requirements in derivative management • Evaluation by an independent firm.

11. IV.- The CNBV´s 1423 • 1999: CNBV publish regulation (1423) for banks establishing conditions regarding risk management. • Sets more detailed internal procedures for risk management than those mentioned in the “31 points” • Distinguishes between credit, market, liquidity, legal and operational risk. • Covers all banks operations

12. V.- Current challenges • To establish adequate disclosure of timely and relevant information to market participants and authorities. • To ensure the smooth and accurate functioning of internal risk management units and oversight mechanisms. • Implementing risk management at financial group level

13. 31 points 1423 V.- Current challenges Covers derivative operations Covers all operations

14. 31 points 31 points 31 points 31 points 31 points 31 points 31 points 31 points 1423 1423 1423 1423 1423 1423 1423 Integral Risk Management oriented regulation V.- Current challenges • Pending issues to be defined: • Who will be in charge of assessing compliance. • Who will be in charge of authorizing institutions to operate derivatives.

15. V.- Current challenges • CNBV • Enact prudential regulation for risk management. • Supervise compliance of individual institutions. • Banco de México • Measure and monitor risk level of the financial system. • Evaluate impact of current and proposed regulation on risk levels. • Monitor financial threats to financial stability arising from: • exposure to system-wide shocks

16. Current approaches to risk management:The 31 points, challenges and developments