Mitigating systemic risk

The Counter party Risk Management Policy Group (CRMPG) is an influential self regulatory authority that is concerned with the identification, measurement and control of counterparty risk. The group’s August 2008 report provides valuable inputs on dealing with risk in an increasingly complex global financial system. The following summary outlines the approach suggested by the CRMPG.

It is difficult for the senior management of large banks to fully grasp the scale and complexity of these control and risk management challenges. But there are certain relatively simple, core precepts that can facilitate the management and supervision of large integrated financial intermediaries and ensure that risk controls are both robust and flexible over business and credit cycles.

Precept I: The Basics of Corporate Governance
The culture of corporate governance at individual financial institutions can have a very large bearing on how individual institutions respond to unstable periods/crisis.

Risk monitoring and risk management must not be based totally on backward looking quantitative risk metrics. Instead risk management must rely heavily on judgment, communication and coordination, spanning the organization and reaching to the highest levels of management.

Sound corporate governance can help to break down the silo mentality and ensure that critical information on risk profiles, institution-wide exposure and potential channels of contagion are regularly monitored at all levels.

Critical control personnel in such areas as risk monitoring, credit, operations, internal audit, compliance and controllers must be truly independent from front-line business unit personnel. Support and control functions must be equipped and empowered to impose necessary checks and balances across all risk- taking business units. High-potential individuals must be rotated between business units and support/control functions. Incentives must be designed to discourage short-run excesses in risk taking.

Precept II: The Basics of Risk Monitoring
Risk management models and metrics will be effective only if individual institutions are able to monitor all positions and risk exposures on a timely basis. All large integrated financial intermediaries must have the capacity to monitor risk concentrations and exposures, to all institutional counterparties in a matter of hours. The operating staff must provide effective and coherent reports to senior management regarding such exposures to high-risk counterparties.

Precept III: The Basics of Estimating Risk Appetite
Estimating risk appetite and finding an adequate risk-reward balance must be a dynamic process that takes into account both qualitative and quantitative factors. Stress tests and other quantitative tools are necessary, but not sufficient, tools for making judgments about risk appetite. Stress tests can never anticipate how future events will unfold unless such tests are so extreme as to postulate outcomes that no level of capital or liquidity will provide protection against potential failure. Risk appetite must also consider inherently judgmental factors such as compensation systems and the quality of the control environment.

In other words, estimating acceptable thresholds of risk appetite is more an art than a science. The challenge for senior management, boards and prudential supervisors is to exercise the necessary judgments as to how factors such as incentives, the quality of the control environment, the point in the business cycle and other qualitative inputs will influence the appetite for risk. All large banks must periodically conduct comprehensive exercises aimed at estimating risk appetite. The results of such exercises should be shared with the highest level of management, the board of directors and the institution’s primary supervisor.

Precept IV: Focusing on Contagion
The basic forces that give rise to contagion are reasonably well known and recognized. These include:
· credit concentrations;
· broad-based maturity mismatches;
· excessive leverage
· the illusion of market liquidity.

All large financial institutions must regularly brainstorm to identify “hot spots” and analyze how such “hot spots” might play out in the future. Even if the “hot spots” do not materialize or even if unanticipated “hot spots” do materialize, the insights gained in the brainstorming exercise will be of considerable value in managing future sources of contagion risk.

Precept V: Enhanced Oversight

The board must provide an appropriate degree of oversight of the company consistent with the goal of maximizing shareholder value over time. It is difficult for outside independent directors to fully grasp all the risks associated with the day-today activities of large banks. But they can ask the right questions and insist on necessary information – properly presented so that they can exercise their oversight responsibilities.

The highest-level officials from primary supervisory bodies should meet at least annually with the boards of directors of large integrated financial intermediaries. The supervisory authorities must share with the board and top management their views on the underlying stability of the institution and its capacity to absorb periods of adversity. The spokesperson from the supervisory body should be a true policy level executive or, preferably, a principal of the supervisory body. These high level exchanges of views should minimize the use of quantitative metrics and maximize the use of discussion and informed judgment.

The core precepts mentioned above are interrelated. No one institution can, by itself, accomplish all that needs to be done in restoring the credibility of the industry and limiting future financial stocks. There must be collective and concerted industrywide initiatives supported by progressive and enlightened prudential supervision.