Thoughts on Risk Management Deficiencies CAIB November 2008

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

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

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

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

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.

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

Macro Policies • Market oriented – Regulation – Monetary policy: liquidity

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

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.

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

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

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