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Unraveling Best Practices in Risk Management
In collaboration with the NUS, Risk Management Institute (RMI), The Institute of Banking and Finance (IBF) held its inaugural risk management seminar as part of RMI's 3rd Annual Risk Management Conference on Thursday, 16 July 2009.
With an exciting line up of speakers from the industry, the event was attended by a good mix of over 200 participants comprising researchers, regulators, academics and industry practitioners from various banking and financial institutions, who were there to hear the insights of four distinguished senior executives, namely:
• Mr David Dredge, Distinguished FICP and Managing Director, Artradis Fund Management
• Mr Elbert Pattijn, Chief Risk Officer, DBS Bank Ltd
• Mr Tham Ming Soong, Executive Vice President, Group Head, Risk Management, United Overseas Bank
• Dr Mark Lawrence, Director Mark Lawrence Group, Senior Advisor Mckinsey & Co.
Systemic Risk, Liquidity Shocks and Market Collapse – Lessons Learned Since 2008 |
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Mr David Dredge defined the issue of systemic risk as risks imposed by interlinkage and interdependencies in a system or market, where the failure of a single entity or cluster of entities can cause a cascading failure. Mr Dredge felt that the cause of such risk can be summed up by two factors. |
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Firstly, factor of moral hazard. “The prospect that a party insulated from risk may behave differently from the way it would behave if it were fully exposed to the risk”, said Mr Dredge, emphasizing that this could be evident from the ability, and the willingness, of large “too big to fail” banks to maintain clearly unsafe, unsustainable levels of leverage on their balance sheet courtesy of their implicit (now explicit) government guarantee.
Mr Dredge highlighted that the next cause of the systemic risk are the flaws in the original Basel Accord (Basel I) which focused primarily on credit risk requires a bank to classify its assets into five risk buckets carrying risk weights of zero, ten, twenty, fifty and one hundred per cent based on the parameters of counter-party (sovereign, banks, public sector enterprises or others), collateral (e.g. mortgages of residential property) and maturity.
One of the two approaches is the standardized approach, which makes use of external credit ratings for attaching risk weights of 20%/50%/100%/150%. While a bank must maintain capital equal to at least 8% of the value of its risk-weighted asset, the risk of an inaccurate value assigned by credit rating agencies defeat the very purpose of better risk mitigation and aggravate the issue of over-leveraging.
Financial Innovation – Risk Sharing and Systemic Risk |
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Mr Elbert Pattijin felt that the current crisis commenced with financial innovations, which resulted in:
• Securitization as a process to reduce liquidity premium by transforming illiquid assets (mortgages, corporate loans, credit cards, auto leases etc) into tradable assets; |
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• Divergence between the originators and holders of debt; and
• Rating agencies using classical rating techniques for securitization (structured finance) assets. There were discrepancies between rating and returns, e.g. AAA rated tranche of CDO can have a much higher yield than a AAA corporate bond.
In Mr Pattijn's opinion, the current crisis yields many lessons for the various players in the financial services industry. Investment banks need to revert to the basics of liquidity management, and rating agencies need to review the framework and rating methodologies which have proved erroneous.
For Investors, including commercial banks, Mr Pattijn felts that there are hidden pools of toxic assets still in the books and that sources of funding (retail vs wholesale) need to be reviewed and re-evaluated and regulators including accounting standard boards need to implement “more hawkish policies to force de-leveraging”.
The Value of an Integrated Risk Management Approach for Financial Institutions |
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Mr Tham Ming Soong highlighted multiple points of failure in the financial landscape that resulted in the current credit crisis. Firstly, the long period of benign interest rate environment encouraged the chase for higher yields, and hence the manner in which businesses and products were being structured. Second was the failure of the regulatory framework and how Basel II was interpreted and implemented. Finally, the failures that resulted from the over-reliance on quantitative models, and a breakdown in model assumptions. |
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In terms of ownership of risk management within the organisation, Mr Tham felt that there is a need to differentiate between the risk management function and the risk management process. While the function is owned by the Risk Management Department, the process however should be owned by the entire organization.
Mr Tham encouraged more organizational participation in the risk management process. This would include functions such as the economists, and strategic planning units to inculcate a wider ownership of risk management. Over and above these, there should also be a good understanding of the business environment and how organisational objectives are aligned both tactically and strategically.
Risk Management: Where to From Here? Important Industry Lessons Learned from the Global Financial Crisis |
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Dr Mark Lawrence highlighted the key challenges for risk management effectiveness , which included:
• Seeing how the external environment is changing & perceiving the drivers of these changes (e.g., US house price declines, diminishing market liquidity); |
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• Understanding the current and potential impacts of these changes across all businesses, portfolios and geographies; and
• Acting quickly to reduce risk when necessary.
Dr Lawrence emphasized that all three of the above tasks are challenging in practice. In particular, the aggregate, integrated risk profile of the firm and the way this profile is changing is fundamentally opaque to insiders as well as to outsiders.
“Establishing a robust risk culture is of paramount importance in ensuring effective risk management” said Dr Lawrence noting that it is “important to understand the sheer impossibility of knowing everything that you need to know about emerging risks & rapid changes to the risk profile of the firm through formal channels”.
Globally, banks need to first “fix the fundamentals” of risk management, and Dr Lawrence highlighted the importance of ensuring full transparency of important risks and developing an integrated view of risks across all businesses. Subsequently, Dr. Lawrence urged banks to benchmark their risk management capabilities against the newly created industry best-practice recommendations published by the Institute of International Finance in July 2008.
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