Friday, December 11, 2009

Risk management is not a petit committee issue! Regulators and credit rating agencies should not preempt the markets!

The report by the Institute of International Finance, IIF, “Reforms in the Financial Services Industry” states not surprisingly that “Strengthening risk management is a top priority, and risk functions are being reconfigured and upgraded to give firms a more integrated approach to risk management."

The report, making many good and valid observations in reference to risk management, also warns about the risk of it "becoming too prescriptive, inducing many firms to adopt the same risk management approach. That would detract from the important competitive benefits resulting from each firm being free to make its own choices regarding risk appetite. More important, it would create significant “model risk.” If all firms were required to use similar approaches and models in managing risk, they could tend increasingly to behave in the same way, reinforcing procyclicality."

For someone who in 2000 warned of new regulatory risks arising in Basel writing “In the past there were many countries and many forms of regulation. Today, norms and regulation are haughtily put into place that transcend borders and are applicable worldwide without considering that the after effects of any mistake could be explosive.”, those comments are pure music.

I have also argued that the only valid regulatory response that fosters market diversity in risk management is the establishment of some very simple rules that do not introduce more distortions and complications than those already abundant in the real world.

In this respect, the regulator, instead of permitting different capital requirements for different assets depending on perceived risks should require equal capital requirements for any type of assets and let the risk appraisal process to unhindered fully take place in the market, between bankers, shareholders and creditors… instead of, as currently is the case, between bankers, regulators and credit rating agencies.

The IIF report though understandably not totally clear on the issue, acknowledges it when it makes a sort of veiled leave-us-alone pleading stating among its “leading points”:

Communication and disclosure of risk appetite: Firms should improve their disclosure practices regarding their risk appetite determination (e.g., what metrics they use, their level of tolerance, their decision-making processes). These disclosures display to stakeholders, analysts, and creditors —in short to the market—how rigorous and robust the risk management framework is at an individual firm, hence contributing to effective market discipline.

Regulators and risk appetite: Some supervisors’ reports have called for authorities to monitor and regulate banks’ risk appetite. While it is legitimate for macroprudential regulation to gather information on firms’ risk appetites, and it is legitimate for supervisors to challenge the firm’s risk appetite and the means by which this is identified and transmitted, firms should be able to define their own risk appetites with the interests of their direct stakeholders in mind.”