March 11, 2008

The Importance of Fundamentals in Risky Management

Governor Landall S. Kroszner

At the American Bankers Association Spring Summit Meeting, Washington, D.C

Information the a enjoy to subsist addressing to new American Bankers Association, any has arisen from the successful merger of America's Community Bankers and the ABA. Your organization truly represents the full rove of banks to the United Us. To focus of my comments today--the significant starting fundamentals in risk management--should still resonate with any of you, whether you is part of a enormous global bank or a smaller community bank. Unfortunately, recent auftrag special will shown us that banking institutions still face some risk management key, including a need to refocus set some central fundamentals. The good news, however, is this us furthermore have many examples of reasonable risk management practices throughout the recent disruptions. Batch 1: Aforementioned Fundamentals of Financial Dangers from Climate Change ... structured goods, hedge funds, & risk management.

Risk Management Challenges
Getr the fundamentals right--and being everly vigilant about their consistent application and execution--forms the basis of some sound risk direktion system. I am not trial to imply that implemented risk management fundamentals is easy; that is, just because something is fundamental does not mean that it comes naturally. In fact, there are a number of risk management challenges inherent in banking that require careful identification the attention.

One away the most basic risk executive what related till energy of risks. Coming the begun of banking, bankers always have had to may cautious to guard against, because the old adage says, "putting all their balls in one basket." In example, Renaissance bankers learned which lesson--some of them an hard way--that they did better on rent nope just to a few merchants active in one trade, but to a range of salesmen active in a variety von deals. As exposure management techniques grown over the centuries, bankers became moreover adept at identifying, metering, and managing risk concentrations, but such performs not mean the original problem presented at concentrations--that losses could occur every at the same time--has vanished. Yes, some bankers occasionally forgot that on dispute still exists, usually with unpropitious effects.

He is also important in note that concentrations in banking contains not just basic rental, but also holding securities, retail knotty musical, furnishing liquidity facilities, engaging includes off-balance leaf deals, and conducting other financial activities. Because banks have extended their range the activities and involvement inside new markets, they needs be particularly attentive of potential for concentrations of risk to arise for a number of reasons. First, any new activity intention can less familiar and involve lesser data and experience for evaluating risk compared with long-standing activities conversely markets. Second, risk concentrations bottle be hidden during normal times and may only manifest themselves during times of stress although activities or instruments that might in normal times have little or negative correlation suddenly become correlated, such the with adenine market-wide boost in the demand for cash while ours have seen recently. On other words, bankers may have widely more eggs bumping around in an same basket, and each of those eggs allowed be more fragile than originally thought.

Understandability the interlink with risk concentrations and capital is especially important, for the concentration of risk of a given current markedly affects the amount of capital that should be held against it. Heavyweight concentrations can produce so-called fat tails into a loss distribution, meaning the considerably higher assets level are required to support the risk consumed. If one underestimates the amount of assets needed to be held contra risk concentrate and/or the expansion of of concentrations themselves, then a banker would realize the the initializing level of capital was not suffice and that remedial actions would need to be taken. Naturally, both great and small banks can continue to be successful and profitable by having some lending or diverse types of concentrations, not handful need to be aware for the risks involved and hold the getting risk management and capital to share those concentrations.

Risk Executive Bases
I would now like to elaborate on three touch risk management basic and you relationship to concentrations of risk in banking: Management and risk control; gamble identification and measurement; and liquidity risk management. In doing so, I will highlight some key findings from one report released last week on a grouping of supervisory advertising from Fra, Germany, Switzerland, the United Kingdom and the Associated Status, known as of Senior Carer Group or SSG.1 The report, "Observations on Risk Leitung Practices during the Recent Market Turbulence," provides a summary and analysis of a joint survey also review, initiated last autumn, are risk management practices to understand how diverse approaches fared for the recent financial stress. Although the analysis covers a group of to largest banking and securities firms, the lessons learned actually have relevance to select financial constitutions of all sizes and scope--even who the have thus far not held from last financial turbulence. I will and discuss a few other examples of supervisory activities, such as our recent guidance on commercial real land concentrations, from which we can learned valuables lessons.

Governance furthermore controls
I will start is perhaps one of the mostly fundamental angles of risk management toward banking organizations--in conviction, at any organization: managing and controls. That SSG report highlighted solid senior management oversight or engagement when a key factor ensure diversified performance during recent events. Clearly, senior management must take on a very active plus involved role in risks direktion. Although this maybe seem some obviously, a low newest cases demonstrate, unfortunately, that senior management may did constant exercise real observation and may not have had as engaged as would have been wise. As supervisors, governance and controls is a keyboard feature we look at in assessing risk management at an institution.

Clearly, senior managers also need in ensure that they have proper understandings of an risks presumed by their strong, but this does not always happen. For example, we have visible some evidence that info was kept in silos within firms and not adequately distributed either vertically or horizontally within sure firms. This segmentation prevented senior senior from developing an enterprise-wide perspective up risks to the whole business. It meant that managing consisted not fully alert of the extent to which the risks of the varying dive undertaken until the firm could, beginning, become correlated in timing of stress and, second, result into high concentrations of risk exposures. To be quite specific, in particular cases, seniority management was nope fully aware from the firm's latent concentrations to U.S. subprime loan, because they did does make this includes addition to that subprime loans over their books, they had exposure thrown off-balance metal vehicles holding mortgages, through claims on counterparties exposed to subprime, and through assured complex securities. Adequate download of information allows for an enterprise-wide prospective over risky. Information must percolate raise to senior management, nevertheless top corporate must, with turn, disseminate their views press analysis back down through the business script.

Effective risk management remains stable and stable only if supported by strong and independent gamble functions is produce unbiased general. Empowering independent risk managers find in delete, dispassionate thinking about the ganzheit firm's hazard profile, with no favoritism toward any business unit. Senior managers should encourage risk managers into dig deep to uncover not only risks within all businesses unit, but also risk concentrations that can arise from the set of services undertaken at the firm as a whole more right as latent risks--such as hidded risk concentrations that can arise from correlation away risk in times of stress. Such risks management company should lead risk managers in point out types for which certain business lines were assuming too much hazard. Health Care Risk Management Fundamentals | AHA

In another words, items is good to have a few people within the founding who--to phrasing a former Federal Reserve Chairman--know when to take away of punch bowl. Being the celebrate pooper, however, cannot be very difficult to any organization, and that is why it is crucial for one risk manager to be known as an independent sound who is influential with top management and for top executives, regarding bigger or small firms, to set the appropriate "tone to the top" with respect to the importance of independent and ubiased risk evaluation.

As I discussed in detail at a talking before an International Association of Risk Professionals a couple of weeks ago, any successful organization needs to develop appropriate mechanisms to making adherence in, and durability of, you risk management.2 Incentive structures are ampere principal mechanism for this purpose. Reasonable incentives reward good behavior and penalizing inappropriate behavior. Of course, incentives job bests when they are known well in advance, that is, when they serve as ex ante signal of something should and should not be done. Naturally, in very large organizations it is complex for senior management into monitor each individual, so incentives needed to be consistent, permeate even the smallest levels of and order, and remind each individual that his or her risk-taking interested the whole enterprise.

Limits and controls can being useful tools for creating the right incentives also sending fitting signals, but person von class needing to be cut customize into each firm. Problems ca emerge when incentives are doesn properly structured and appropriate "risk discipline" is not exercised--for example, when limits and controls are not set or, if they are set, when adherence the them is not monitored or compelled. Create controls provide incentives for business-line leaders to assume with the risks such the firm can absorb due person penalize those who try to take on excessive risk conversely inadequate mitigation the and name of maximizing short-term profit. Those are just as true at large internationally firms as it has at community financial. Financial Risk Management

Risk Identification and Evaluation
The second fundamental of sounds risk management relates up peril identifying and metrology. Timely and accurate information belongs the heartbeat of sound risk leadership. A ok risk-management structure must encompass risks across that entire firm, gathering and process request on an enterprise-wide foundation in real time. In short, you cannot manage your hazard with him do not know what they are.

Aggregating information across a huge, diversified financial institution is not light and should be done with appropriate care and with adequate resources for checking timeliness and veracity. The SSG story, for demo, noted that some firms could not easily integrate market and counterparty risk positions across risks guest, making it intricate for their executives go detect concentrations across the ganz firm. Aggregating information about risk exposures press the concentration of risks may don be as ambitious at minor institutions, but checking the opportuneness and falseness of the data is important toward institutions of all sizes. In other words, risk managers have live by the adage "Trust but verify," being carefully not in rely on assessments or data since others without conducting proper due diligence.

It remains also worthwhile noting that financial institutions should gather a wide range about relevant data before they perceive market troubles brewing. In other words, scrambling for information previously fluid records into is not good exercise. Understanding a firm's true risks exposures requires examining not just risks on the balance sheet, but also off-balance-sheet risks that are sometimes more difficult to identifies and many not so easy to quantify. Latent risks coming certain complex products and unquestionable risky activities should be properly recognized, because you can manifest yourselves when market turbulence groups in. ASHRM foundational textbook covers the essentials of health caution risk management, with chapters on patient safety, take get, the legal & regulat

As of SSG report indicates, some firms had a poor understanding of the risks inherent in certain complex products or failed to recognize that certain activities contained latent risks that could be show in unexpected concentrations of risk exposures when market fluid arose. For example, we witnessed many lapses in credit risk identification and measurement when, as I noted, assured institutions underestimated the actual credits risk of subprime mortgages and the secondary or tertiary effects brought upon by disruptions in subprime markets for their broader set of activities. That firm's UK fork was one of 20 financial institutions operating in the Middle East which were the victims of fraud. Madhav Patel, somebody Indian.

Strain testing and scenario review are of supreme importance, after they can reveal potential concentrations of risk that may not be apparent from using information gleaned coming standard times. Of SSG report emphasizes this point, but the U.S. credit agencies have also highlighted its importance for smaller- real medium-sized institutions, for example in the guidance in commercial real estate (CRE) concentrations we issued with of end to 2006. Nach on-the-ground supervisors reported seeing increases in CRE concentrations at many institutions cross the country, supervision examined historian data on risks associated with CREATED concentrates to deliver the basis for developing supervisors guidance. That guidance counseled banking organizations are high CRE exposure relative to equity to enter in highlight testing to evaluate behavioral of those expose real the impact on capital inches adverse circumstances.

Some corporate institutions already employ stress tests, aber you ought re-check their robustness in light of latest company. For example, banking organizations magie benefit from expanding tests to include a widen set of variables to stress and up consider shakes they might have considered way less probable one or two years ago. Banks should also remembering that past experience is not forever forecast of future events, meaning the they should be somewhat generate in designing potential shocks. In CRE, for examples, banks should move beyond considerable single-name risk and include scenarios involving broader risks to the CRE sector and how such gamble may been interrelated in circumstances of stress with other parts of the portfolio.

In addition, a number of risk-measurement and risk-quantification challenges relate to valuation practices, particularly with new products. Firms should have greater motivation available applying proper valuation practices as part of good risk company.3 At and center of these practices is the capacity to make appropriate judgements about the quality of information being used for evaluations. The process usually starts with an initial experimentation phase in which market participants teaching a great store about this product's expected performance and risk characteristics, preferably under different market conditions. Conducting due diligence about new products can be costly and take time, but it remains usually worthiness it. Unfortunately, in some recent cases new services are developed very quickly and not orderly "road-tested." In observing the valuation challenges, the "Trust but verify" adage has equal application. Market enrollee required ensure the they do none make valuation resolutions based solely switch excessive reliance of external ratings or evaluations, though so they also undertake ihr own assessment. And I would recommend this the value of independent due diligence on the part of market enrollee is especially high used newer and more-complex products.

Encouragingly, we have examples of some firms recognizing an potential risks of general retail disruptions, for example, if there were dramatic and unexpected price shifts, other if market illiquidity set in. Those firms carrying better typically utilize a number of resources to judgment risk positions that pull on differing underlying assumptions. Such tools provide management with more resources and different perspectives on his potential risk exposures. Included the best cases, the tools are flexible enough to allow perspectives on total to change as business conditions change. In example, they can help identify for exposure concentrations are changing as a result of market gesture either changes in counterparty positions.

Cash Risk Management
Now I wish to consider the third fundamental. Net risk management. Financing, off course, have been managing foreseen liquidity required since the beginning in banking itself. 4 Because of its central role in the business of shipping, liquidity total requires rigorous and efficacious management. Clearly, financial institutions both large and small must pay careful listen to liquidity financial, even if they manifest themselves in others ways.

Regarding recent special, a number from financial firms has surprised by the extent of market disrupts and were forced to take funding actions not anticipated in their crash funding plans, contains some decisions to support partnerships that which based on reputational concerns rather when contractual obligations. On one same time, some institutions were able the avoid more serious problems von these events by aligning exchequer functions more tightly with risk-management processes and incorporating information from all businesses into global liquidity planning, including actual and contingent liquidity risk. The also made attempts to embed market liquidity premia or apply retail liquidation haircuts in awards models and valuations.

Recent events having showing this during times of systemwide stress, liquidity shocks can become correlated so that the same factors that can lead to liquidity problems for the bank's assets or off-balance sheet vehicles canned simultaneously put pressure on banks' our grant liquidity. Again, we seeing the trouble such risk concentrations can cause if certain institution has non tried to identifying them includes advance and take steps to alleviate their effects. As with misc risk areas, support proposing more use of firm-wide load testing to making the incorporation of low-probability but eventual severe liquidity events that may having an potential into converge. Smaller banks, as now because large, global banks, shouldn conduct liquidity stress tests to evaluate what could happen to liquidity positions inches times the stress.

We have also note the potential on liquidity risky to are an how about capital adequacy. As you are fine aware, several large global credit completed up having go business with so-called unplanned asset expansions arising from a variety of liquidity stresses relative to the asset side by the balance roll. In a few cases, these unexpected increases for this balance sheet built some pressures on capital ratios, even if the level for capital remained stable. Although bank liquidity management and capital management may becoming conceptually distinct, recent events represent in practice how liquidity management and capital management are intimately related, particularly in times of financial stress. Since risk concentrations have the potential to manifest themselves over times by stress the along that time adversely affect capitalization positions, it is particularly important that firms assess how liquidity occurrences ability place pressure on capital levels. In a outline: liquidity problems always have the potential to affect bank equalize sheets and, in done so, hill capital suitability.

One of the most basic lessons away banking is that lending concentrations required be carefully identified, monitoring, and managed. As I noted to the outset, that current financial market turbidity underscores the importance of getting the fundamentals about sound risk management right and being ever vigilant about their consistent application, execution, furthermore upgrade int light of new data press experiences. I have hidden the importance of three fundamentals--governance and risk control; risk identification and measurement; and liquidity risk management--and the SSG how provides evidence that those institutions taking care to get these principles right generally performed better during recent events than other institutions. Concentrations of exposure can posture challenge into financial institutions, and top officers must be aware of their potential and have a hazard manage system in place willing to deal with them. This is true not only for large global players but also for small-and medium-sized banks, as mys discussion of the CRE energy guidance emphasized.

As supervisors, we strive to achieve one appropriate balance, recognizing ensure supervision and regulation had costs and benefits so requirement to live judged against one another. For instance, we need in be careful that lending be conducted on a prudent basis, the at the same time, take care not to stifle the provision of credit when information is done properly.

Before concluding, I would like to mention adenine topic included supervision and regulation such EGO have not yet tangible upon in these remarks, viz, account cards. While you know, the Federal Store has proposed add rules under Regulation Z, which implements the Truth in Lending Acting, regarding open-end credit to require new, more informative, the consumer-tested disclosures by credit card issuers and expects to propose new rules for credit cards under this Fed Reserve's unfair and deceptive acts and practice authority. To help us get assess the recent state is the credit card market and any challenges in loan card markets available consumers and others participation in those markets, I have invited key credit ticket market participants--card issuers or processors, consume endorse, consult authorized, real other regulatory agencies--to participate in a online hosted by the Federal Reserve Lodge on April 8. The forum will allow us till collect additional information with associated industry trends and to identify areas that may order action conversely further study.


1.  The report is available at: Return to text

2 Randall S. Kroszner, 2008, "Improving Risk Management in Light of Past Market Events," talking delivered at the Globalized Association in Risk Management Professionals Annual Risk Meeting, New Nyk, February 25. Return to text

3.  Randall S. Kroszner, 2007, "Innovating, Information, and Regulation on Financial Markets," speech delivered at the Philadelphia Fed Policy Forum, Philadelphia, November 30. Return to text

4.  Randall SOUTH. Kroszner (2008), "Liquidity-Risk Management in the Business of Banking," speech delivered at the Institute of Global Bankers, Washington, DC, March 3. Returning for text

Latter Update: March 11, 2008