Some financial institutions in developed markets may have fallen short in managing their risks.
Continuing with this series of Viewpoint articles on the underlying causes of the current financial crisis in developed markets, another specific weakness that has played a role is a number of shortcomings in risk management by financial institutions. There are many risk areas where the experience in the US suggests that assessment and management of risk were less than adequate. The first area is market risk. Experience is often a useful reference for the future, but not always. Low (and decreasing) market volatility over a sustained, benign period misled market participants into thinking that future market volatility would continue to be low. This, as it turned out, was far from reality. Risk parameters calculated on the basis of past market volatility and risk-management tools (including the maintenance of adequate capital) designed to support the taking of market risks turned out to be inadequate, with market participants incurring much greater losses than those thrown up by the risk-management models, even under the most stressful assumptions.
Second is liquidity risk. Financial institutions typically fund their holdings of long-term and high-yield assets by borrowing short-term money – by taking deposits, issuing short-term paper or borrowing from the interbank market. Because the stability of these funding sources varies, financial institutions should have clear strategies to manage the liquidity risk associated with the possibility that one or more of these funding sources may suddenly dry up, particularly if the markets for their long-term and high-yield assets are not deep and liquid enough to allow them to sell them quickly at fair market prices if they need to. In many jurisdictions, including Hong Kong, there are supervisory requirements in the form of minimum liquidity ratios for deposit-taking institutions. The HKMA requires banks to submit information about their policies and processes as well as their position, cash-flow and stressed-scenario analysis to give both the banks and us a better understanding of the liquidity risk they are taking on. If these submissions cause us any concern, remedial action will be taken.
Third is concentration risk. This refers both to the risks arising from the assets of financial institutions being overly concentrated in a particular type of financial instrument, risking the viability of the institutions should there be a major disappointment in the market for those financial instruments, and the risk of financial institutions maintaining positions that are too large for the market to absorb, if the institutions need to unload their positions in times of stress. Managing concentration risk is never easy, particularly for exposures to over-the-counter markets because there is less market information than there is for exchange-traded financial instruments, even for the very purpose of establishing the precise degree of concentration risk involved. This is the flip side of being a market leader.
Fourth is reputation risk. This comes in many forms. In the current context of events in the developed markets, it takes the form of financial institutions sponsoring, through the provision of back-up liquidity, conduits, SIVs and other forms of Variable Interest Entities whose activities turn bad or whose funding dries up. The potential damage to the reputation, and therefore the market standing, of the sponsoring financial institutions, if they were to walk away from their moral or contractual responsibilities, might be so large that they have no alternative but to come up with the back-up funding, even while facing capital constraints and knowing that they would also have to take a hit on the underlying assets acquired back from the conduits.
Fifth is re-intermediation risk. Items that were thought to be off the balance sheet may turn out not to be because incomplete credit-risk transfer, through, for example, securitisation and the use of conduits, may mean the institution has to re-assume assets at much impaired values and liabilities at higher costs.
Sixth are tail risks of varying types. Low-probability events – those at the tail end of the distribution of occurrences built into risk-management models – can have large, perhaps disproportionate, impacts on key regulatory and business parameters such as capital adequacy, liquidity and profitability. These tail risks, because of the low probability assigned to them based on historical experience, are usually not given much attention by those assuming them.
Seventh is the interaction of these risks in times of stress when there is a tendency for them to be correlated and to reinforce and even amplify each other.
While it is for the financial institutions to assess and manage the risks associated with their activities – and judging from recent events it seems they have not done as well as they might have in some jurisdictions outside Hong Kong – the authorities also have a facilitating role to play, by making available analytical and data resources, particularly at the macro and industry levels. There is also a need for the authorities, in the interest of maintaining financial stability, to satisfy themselves that this essential task is being done properly and up to a level that justifies the continued approval of the licenses of the financial institutions. If necessary, supervisory remedies should be promptly introduced, although a market solution is always preferred.
Joseph Yam
20 March 2008
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