Ladies and gentlemen,
I am pleased to have the honour to co-chair with ISDA this distinguished Forum. In the past few years, opinion about derivatives has tended to oscillate quite widely. At one extreme, derivatives are associated with gamblers and big financial losses. Around all such publicity, there is a key word; "risk". Derivatives markets are widely perceived as risky territory where prudent investors should fear to tread.
At the other extreme, is the more comforting view that derivatives pose no new sources of risk. The fundamental risks of derivatives are the same types of risks - credit, market, operational, and legal risks - that many financial institutions and firms face in their traditional businesses. Derivatives actually enable these risks to be unbundled and shifted around the system. On this view, the problem is not derivatives but the people who used them.
The truth probably lies somewhere between these two extremes and I hope that this Forum will help to throw light on the matter. Without prejudging the issue, I think that we regulators are probably right to take a cautious view. The growing complexity, diversity and volume of derivative products especially the highly leveraged nature of some of them, do bring new opportunities for taking risks. If these risks are not properly understood, managed and controlled, the extent of losses can be such that the very existence of financial institutions can be endangered.
I believe that the goal of regulators should be to establish an approach that affords market participants flexibility in using derivatives to meet their financial needs, while simultaneously making sure that excessive risks are not taken. With this in mind, banking regulators, in their efforts to establish a workable and flexible approach to derivatives oversight, have focused primarily on capital adequacy standards, internal controls and disclosure. Therefore, the topics to be discussed in this Forum are highly relevant in the light of recent supervisory developments.
It is important that banks have sufficient capital to absorb losses arising from derivatives trading. The need is underlined by the Basle Committee's proposals for new capital requirements for market risk. The decision of the Basle Committee to allow the more sophisticated banks to use their own internal "value at risk" models to calculate the capital adequacy requirement reflects the modern supervisory approach of using market-based techniques for measuring risk. This should result in a more flexible approach towards risk measurement and gives a built-in incentive to institutions to lower their capital requirements by improving the accuracy of their models. It does however pose a challenge to regulators of how to build expertise in assessing the models and the controls surrounding them.
While adequate capital is vital to protect a bank against losses, it is clearly preferable if unexpected losses do not rise in the first place. This has led to the current focus on risk-based supervision, that is on identifying the quantity of the risk within a bank and assessing the quality of the bank's systems for managing the risk. These principles underlie a number of current supervisory developments, in particular the Basle Committee's guidelines to encourage improvements in the risk management of derivatives. I note that a number of participants in this Forum have incorporated the Basle Committee's recommendations into their own guidelines. It is easy to criticize some of the Basle recommendations as being statements of the obvious. But the Barings and Daiwa Bank cases have shown that even the most basic controls and proper management oversight cannot be taken for granted.
Effective supervision also relies on the integrity of information reported to regulators and to the market place. Given the rapid growth of derivatives in recent years in terms of volume and complexity, it is important that supervisors continuously improve their understanding of how these instruments affect the overall risk profile and profitability of banks and securities firms. The Basle Committee and the IOSCO have already taken initiatives to establish a framework for banking and securities supervisors to gather information about the derivatives activities of banks and securities firms. Regarding public disclosure, the two supervisory bodies have also strongly encouraged banks and securities firms to provide enhanced, meaningful public disclosure. This is necessary to enforce proper market discipline on trading activities.
With the increase in derivatives activities both domestically and globally, it is important for regulators to take active steps to keep themselves up to date with market and supervisory trends and to maintain a close dialogue with the industry. The Forum provides a means of achieving this and I hope that both sides represented here today will benefit from the discussion. Thank you.
