Markets and institutions: Managing the evolving financial risk

Speech by Malcolm D Knight, General Manager of the BIS, at the 25th SUERF Colloquium, Madrid, 14 October 2004.

I am very pleased to address this Colloquium. The relationship between the BIS and SUERF goes far back in time and has been a very fruitful one. For many years now SUERF has promoted research in money and finance, topics that - not surprisingly - are close to our hearts at the BIS. Moreover SUERF, inspired by its pan-European charter, has adopted an international point of view in approaching these issues - one that is attentive to both the similarities and the differences in national experiences. This has made SUERF’s contribution particularly appealing to an organisation such as the BIS, because our mandate is to promote international cooperation and mutual understanding among national policymakers, especially within the central banking and supervisory communities.

The theme of this Colloquium is competition in financial services. Sometimes this is interpreted narrowly, as having to do with the interactions of players within a single sector of the financial industry. Today, I would like to take a broader perspective and explore the implications of changes in the financial industry as a whole for the nature of financial risk and for how to deal with it. My focus will be very much on the interactions between the various segments of the industry in general, and between markets and financial institutions in particular.

I will argue that the fundamental transformation of the financial industry over the past three decades, of which we are all keenly aware, has driven a significant transformation in the nature of financial risk. I will stress, in particular, how this transformation has resulted in a tighter interaction between different types of risk and the increased prominence of what has been called the “endogenous” component of financial risk, namely the component that is associated with the impact of the collective actions of market participants on the underlying determinants of risk itself. And although market participants and prudential authorities have been adjusting admirably to these fundamental changes, there is still considerable scope for improvement, and a number of questions remain unanswered.

The structure of my remarks is the following. First, I will briefly recall the main features of the transformation of the financial industry and explore in more detail the associated profound transformation that has been occurring in the nature of financial risk itself. I will then consider the implications of these deep changes in the financial system for market participants and for prudential authorities, tracing the progress made and the areas that call for greater attention.

1. A transformed financial landscape alters the nature of risk

By now it is well known that the financial system has undergone a profound transformation over the past three decades, driven by the combined impact of liberalisation and technological innovation. The result has been what might be termed the “let-a-thousand-flowers-bloom” phenomenon. Long gone is the excessive segmentation of different compartments of the financial system that was induced by extensive regulation. And the industry has gained enormously in richness, depth and variety. Just think of the myriad of new financial instruments that has developed, partly in the wake of breakthroughs in pricing theory and advances in computing technologies.

The impact of these trends on the financial landscape has been profound and multifaceted. For present purposes, however, let me focus on just two aspects: size and interconnectedness.

First, the size of the financial sphere of our economies has increased tremendously along different dimensions. Financial activity now represents a much larger share of aggregate economic activity than it did 20 or 30 years ago, regardless of how it is measured. This is true in terms of inputs, such as employment and capital, in terms of outputs, such as the ratio of credit to GDP, and above all in terms of turnover. As you know, monthly global turnover in the main asset classes far exceeds yearly global GDP. Within financial services, traded instruments have greatly outgrown traditional non-traded ones, such as loans or deposits. This is sometimes described, somewhat misleadingly, as financial markets having grown at the expense of financial institutions. Think, for instance, of the extraordinary expansion of derivatives, including more recently credit derivatives, and of asset-backed securities. Furthermore, individual financial institutions have also grown impressively in size. In the industrial countries, successive waves of consolidation have been creating a small group of dominant firms domestically and, more importantly, at a global level.

My second observation is that the different facets of financial activity have become much more tightly interconnected, as evident in two complementary trends. On the one hand, we have witnessed a broadening of the range of players engaged in the same type of financial activity. And on the other hand, the surge in cross-border activity has heightened the role of non-residents in domestic markets in many countries. With securitisation and the development of secondary markets, portfolio investors, such as insurance companies and pension funds, have diversified into areas that used to be the exclusive domain of credit originators, notably banks. Likewise, there are few substantive differences between the activities of the proprietary desks of the larger commercial and investment banks and those of smaller, independent institutional investors such as hedge funds and private equity financiers. We have also witnessed a broadening of the range of activities performed by any given player. Think, for instance, of the growth of conglomerates, or of the much more diversified investment portfolios of some institutional investors and, via mutual funds, of households themselves.

Another way of describing some of these changes is to say that, somewhat paradoxically, even as the financial system has become more diverse, we have witnessed greater convergence: between financial institutions and capital markets; among different types of financial institutions; and among different national jurisdictions.

What are the implications of these structural trends for the transformation of financial risk? Let me focus on four of them: the nexus with the real economy, the interaction between different types of risk, the relative roles of markets and institutions, and the link between the measurement of value and the measurement of risk.

First, uncontroversially, the management of financial risk has become a more important aspect of economic activity. This also means that problems in the financial system, if and when they emerge, can have larger consequences for the real economy than they did in the past. The message has been hammered home by the costs of the financial crises that have occurred in both industrial and emerging market countries over the past two decades. Not surprisingly, addressing financial instability has become a major policy concern, both nationally and internationally.

Second, more subtly, there is a sense in which the nature of financial risk has become at once purer and more complex. Financial risk has become purer because the myriad of new financial instruments, tailored to the needs of a broader set of investors, has enhanced our ability to dissect a complex risk into its simpler components. Derivatives, for instance, target specific forms of risk; first market risk and, more recently, credit risk. Likewise, collateralised debt obligations (CDOs) slice and dice the risks in the underlying portfolios so as to make them more attractive to particular investors. As a result, more efficient risk transfer mechanisms allow a closer matching between the risk-bearing capacity of players and the types of risk they take on. By the same token, the old analysis of risk that was structured around traditional business lines has become increasingly irrelevant. In other words, the similarities in underlying risks are becoming more apparent, regardless of the type of financial firm incurring them.

In this changed environment, financial risk has become more complex, for several reasons. For one, the deconstruction process does not eliminate risk, it simply transforms it and transfers it to economic agents. Risk is deconstructed to be reassembled in different packages and distributed among different holders. For instance, derivative instruments that originally targeted market risk resulted, as a by-product, in a pyramiding of counterparty risk that required separate management. More fundamentally, we now realise that as the management of risk increasingly comes to depend on mitigation techniques based on instruments that are traded in markets, elements that are extraneous to the parties directly involved in a transaction have a stronger influence on the risks incurred through it. For example, in an ordinary bank loan, credit risk depends exclusively on the financial standing of the borrower. By contrast, counterparty risk in a market transaction depends fundamentally on market conditions, such as liquidity and volatility, which are well beyond the control of the two parties to the contract. In this way, the vast development of risk transfer markets in recent years has strengthened the nexus between the different types of risk and the prices charged for bearing these risks. But the opaque layering of direct and indirect links through the markets also profoundly complicates the assessment of the true underlying risks.

Third, for much the same reasons and contrary to conventional wisdom, the roles of financial markets and financial institutions have become more complementary. At first sight this may appear counterintuitive. After all, the conventional classification of financial systems distinguishes between those where intermediation takes place mostly on the balance sheet of institutions and those where financing through capital market transactions is more pervasive. Institution-based systems put more emphasis on the ability of intermediaries to extract and utilise information about borrowers by leveraging close and long-term relationships. Transactions-based systems are founded on the ability of the market mechanism to distil the diversity in investors’ views into a single price; they emphasise transparency of information and arm’s-length relationships. Clearly, there are large benefits for economies that combine effectively both intermediation channels. The ability to switch smoothly between balance sheet financing and market-based financing contributes to the robustness of a financial system and improves its ability to deal with strain. Think, for instance, of the resilience exhibited by the US financial system in the early 1990s as one of the two channels of finance - commercial banks - experienced difficulties.

At the same time, the greater complementarity between these two forms of intermediation should not be overlooked. On the one hand, institutions rely more and more on markets for their funding, for their investments and, crucially, for the management of risks. Continued market liquidity is essential in this context. On the other hand, markets rely more and more on institutions for their liquidity, drawing on market-making services and backstop credit lines. Globally, the ongoing consolidation in the financial sector has created a smaller number of very large financial firms that are engaged in both types of intermediation. But financial conglomerates that combine commercial and investment banking operations, insurance and brokering services raise potential concentration risks for the financial system, despite apparent diversification of intermediation channels. In these large, internationally active financial institutions, a common capital base underpins on-balance sheet intermediation, capital market services and market-making functions. By the same token, losses in one activity can put pressure on the entire firm, affecting its activities in other areas.

Fourth, arguably the interaction between the determination of value and the drivers of risk has become tighter, or at least more clearly visible. This is not simply because market participants, in determining valuations, have become more operationally aware of the importance of risk assessments and the willingness to take on risk. Think, for instance, of the growing use of risk-adjusted returns as a basis for evaluating performance and allocating capital. More fundamentally, what is sometimes referred to as the “endogenous” component of risk has become more prominent. This is the component that reflects the impact of the collective actions of market participants on the ultimate drivers of risk themselves, such as asset prices and system-wide leverage. While this endogenous component of risk has always existed, it has arguably become more visible as a result of several factors. One is the relaxation of aggregate financing constraints associated with financial liberalisation. Another is the much larger role played by markets, with prices telescoping the impact of the changing collective assessments and attitudes towards risk. A third is the increasing common component of asset prices that results from the greater interconnectedness of the financial system, as exemplified by the closer co-movement of returns across different asset classes, especially in times of stress.

This endogeneity is natural - it is part of the physiology of the financial system. At times, though, it may have undesirable side effects and result in financial distress. For example, lending booms can boost economic activity and asset prices to unsustainable levels, sowing the seeds of subsequent instability. Likewise, if a large number of financial market participants assume that markets will remain liquid even under collective selling pressure, they could be induced to overextend their position-taking, thus generating the very pressures that would cause markets to become illiquid. From this perspective, financial distress reflects the unwinding of financial imbalances that have gradually built up over time.

This type of behaviour can be collectively dysfunctional. And it is especially hard to address because it can be fully consistent with individually rational behaviour. It is, for instance, consistent with the short horizons that are inherent in contractual arrangements designed to address informational asymmetries between providers and users of funds, such as arrangements for the frequent and regular assessment of third-party asset managers’ performance. Concerns with underperformance in the short term may numb the contrarian instincts of investors and push them to seek safety in numbers. Likewise, the impact of the rational retrenchment of individual investors and market-makers in reaction to spikes in market volatility or losses can trigger a self-propelling spiral of selling, market price declines and evaporating liquidity. Tighter financing constraints at those times can exacerbate distress further. These mechanisms were quite prominent, for instance, in the market turbulence following the Russian default and the LTCM crisis of 1998.

2. Implications for market participants

The structural changes I have just discussed have had a profound impact on the way market participants measure and manage financial risk. Risk management has now become a core activity for financial firms, with much more resources devoted to it at all levels of an enterprise. More specifically, its transformation has largely mirrored that of the broader environment. Let me briefly review three changes and highlight areas where further work is desirable.

First, companies have increasingly focused on the management of risk on a firm-wide basis. The general principle is that similar risks should be measured and managed in a similar way across the firm, irrespective of their location. This process has been encouraged by the gradual emergence of a “common risk language”, cutting across traditional distinctions along functional lines. In the process, the financial industry is reconciling differences in methods and frameworks reflecting historical and institutional factors. After all, the value-at-risk measures that are common in banking and the stochastic asset-liability techniques that are common in insurance are, conceptually, the same sort of tool; they differ primarily with respect to the instruments that are included in the analysis and the horizon used for assessing risk. As a recent Joint Forum report has concluded, this natural and welcome trend is unmistakable, although it still has a long way to go.

Second, firms have adopted a more holistic approach to risk management, taking into account the interactions between different types of risk. The long-term ideal would be a fully integrated treatment of risk, based on a common metric. Here again, the trend is unmistakable but the challenge is truly daunting. Current measurement technology is just not sufficiently advanced. In line with trends in the development of markets, the process has advanced furthest in the integration of market risk and credit risk; it is at best incipient for other categories of risk, not least for liquidity risk. Arguably, stress testing is the only concrete tool available that allows firms to analyse the joint impact of the broader set of risks in a meaningful way. This practice should be encouraged and developed further. Indeed, investors should be demanding more information about the outcomes of firms’ stress tests as part of their due diligence analysis.

Third, the area that remains largely unexplored is the treatment of the “endogenous” component of risk. This raises questions with regard to both risk measurement and risk management.

As regards measurement, stress tests can of course help here too: they are a way of describing scenarios where the interaction between market participants’ responses to risk and the evolution of that risk can be mapped out, however crudely. I would argue, nevertheless, that firms should devote more resources to two additional tasks. One is developing techniques that uncover vulnerabilities which emerge from the endogeneity of risk. Of course here I am referring to the signs of overextension that can herald subsequent distress. Work in this area, including at the BIS, has met with some success in identifying leading indicators of banking crises at business cycle frequencies, on the basis of simple proxies for “excessive” credit and asset price expansion. One may wonder whether similar indicators might also be possible for signs of pending market distress, as occurred during autumn 1998. Perhaps such indicators could be based on measures of excessive compression of spreads and some indirect measures of market leverage. Another task is to seek to disentangle more purposefully the impact of changes in risk assessments from that of changes in the market’s risk appetite when evaluating risk using the information embedded in asset prices. Many commonly used measures of risk, such as those derived from equity prices and credit spreads, are likely to be contaminated by time-varying risk appetite. This introduces an extraneous element that can lull participants into a false sense of security, because it is precisely high risk appetite that can sow the seeds of subsequent problems.

As regards risk management, the challenge is even more daunting. Addressing it clashes with the incentive structures that are at the root of the problem. Admittedly, even here some progress seems to have been made. For instance, a recent survey conducted by the BIS-based Committee on the Global Financial System (CGFS) suggests that, since the events of autumn 1998, some key market participants have become less inclined to respond automatically to risk limit violations because they now have a better awareness and understanding of the strategic interdependencies among players, and the impacts on market prices. This is an area that, by its very nature, falls naturally within the remit of prudential authorities, whose task is precisely that of internalising such externalities.

3. Implications for prudential authorities and standard setters

To a considerable extent, the implications of the changing nature of financial risk for prudential authorities mirror those for the private sector. In the limited time that remains, let me briefly highlight four points: the need for consistency in the treatment of risk across sectors; the need to strengthen the macroprudential orientation of prudential frameworks; the need to improve their incentive compatibility; and the need to promote a financial reporting framework that is fully consistent with best practice in risk management.

First, the wide-ranging convergence process in the financial industry naturally calls for greater consistency in the supervisory treatment of financial risk across sectors, be they geographical jurisdictions or functional segments of the industry. Greater consistency of prudential rules enhances the efficiency of the financial system by removing any distortions embedded in the policy framework, notably by promoting a level playing field and reducing the scope for regulatory arbitrage. As you are well aware, substantial progress has been made here.

Across geographical jurisdictions, progress is most advanced in banking, less so in insurance. Across functional lines, it has clearly proceeded much further within national jurisdictions, not least helped by the increasingly common practice of consolidating financial sector supervision into a single agency. At the same time, some steps have also been taken internationally. Witness the work of the Joint Forum, which brings together representatives of the international regulatory authorities in banking, securities and insurance. Increasingly, the benefits to prudential authorities from developing a common view are becoming evident.

Second, improving the safeguards against instability for a financial system that is larger and more interconnected, and where the endogenous component of risk is more prominent, naturally calls for a strengthening of the macroprudential orientation of prudential frameworks. After all, it is now well accepted that a system-wide perspective and a focus on the endogenous component of risk are precisely the distinguishing features of such an approach. This “macro” orientation requires a shift away from the notion that the stability of the system is simply a consequence of the soundness of its individual components. It involves the same shift in focus that a stock analyst is required to make in order to become a portfolio manager. In evaluating financial system vulnerabilities, a macroprudential approach would focus on the commonality in the risk exposures of the different segments of the financial system. In calibrating policy instruments, it would stress the need to establish cushions as financial imbalances build up, in order to give more scope to run them down as the imbalances unwind. This would act as a kind of self-equilibrating mechanism. The logic is analogous to that of calling for fiscal consolidation in good times to allow an effective countercyclical fiscal policy in bad times.

By now, the importance of the macroprudential perspective as a complement to the more traditional microprudential focus is widely recognised. As a result, steps have been taken to put it into practice. For instance, as regards the task of identifying vulnerabilities, macroprudential analysis is now routinely carried out in various forums, including the IMF and the World Bank, the Financial Stability Forum, and the CGFS; and, of course, in many national jurisdictions. As regards the calibration of policy instruments, too, there are signs of a keener awareness. In banking, for instance, one such illustration is the various adjustments that were made to Basel II, at least partly with a view to addressing concerns about procyclicality. And banking supervisors here in Spain have gone one step further, by adopting statistical provisioning in loan accounting. This provides a long-term anchor to loan provisioning that is independent of the state of the business cycle. Efforts to strengthen the macroprudential perspective should be pursued further, but they may well need to await the development of additional analytical tools to help measurement and calibration.

Third, in a highly interconnected and innovative financial system the prudential framework should work as far as possible with private incentives. This means empowering, rather than numbing, the natural incentive of market participants to instil discipline. And it means avoiding the imposition of rules that do not meet the “use test” by firms. An excessively prescriptive approach is an invitation for regulatory arbitrage and for practices that respect the letter of the standards but violate their spirit. Hence the major efforts by regulators to develop standards in close cooperation and consultation with the regulated communities in the private sector, to stress the adequacy of risk management processes and to strengthen disclosures. These are all welcome trends that should be encouraged further.

Fourth, the financial convergence process has put a premium on a common set of financial reporting standards; hence the current efforts of international accounting standard setters to put one in place. This is a worthy goal that has profound implications for the financial system and for financial risk. The measurement of value for accounting purposes has a first-order effect on the behaviour of financial institutions and their risk management, given the intimate link between valuations and risk. The stakes are high. At the same time, the process of establishing such standards has brought to the fore significant differences of views between accounting standard setters on the one hand, and prudential authorities on the other. It is important that these differences be reconciled.

I wanted to flag this issue because of its importance, although I know full well that I cannot do it justice in my remarks today. In a recent speech to the International Conference of Banking Supervisors, I have discussed the key ingredients of the debate and offered a sketch of a possible solution. Here, let me simply make three points. First, it seems desirable to think of the ultimate goal of any such reconciliation as establishing a set of accounting rules that seek to portray the best approximation to an “unbiased” and comprehensive picture of the financial condition of firms while prudential regulators seek to instil the desired degree of prudence in their behaviour on the basis of that portrayal. This would mean avoiding reliance on deliberately conservative estimates of value as a means of establishing safety cushions. Second, the portrayal of the financial condition of a firm should cover not just its profitability, cash flows and balance sheet, as it does today, but also its risk profile, including some indication of the margin of error surrounding point estimates. This is an area where prudential authorities have taken the lead, by encouraging greater risk disclosure by regulated firms. Finally, it is essential that at all stages during the transition towards this long-run goal, the prudential authorities are in a position to redress any adverse implications which changes in accounting standards that are desirable in the long term may have for the safety and soundness of regulated financial intermediaries over the near to medium term. In other words, the transition should be properly coordinated. It is my hope, and my expectation, that the dialogue between prudential supervisors and accounting authorities will intensify and become more institutionalised.

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In closing, let me summarise the key message. I have argued that the trends in the financial system have brought about a transformation in the nature of financial risk. These trends have put a premium on the links and interactions between different types of risk, largely reflecting a tighter relationship between financial institutions and financial markets. This transformation requires adapting risk management both at the level of individual firms and in the financial system as a whole. Essential dimensions of this adaptation are greater consistency in the treatment of similar types of risk, greater analysis of the interaction between different types of risk and a keener recognition of the endogenous component of risk. Progress has been made in many of these dimensions, but there is clearly scope for further improvements.

The academic community can play an important role in supporting and shaping this adaptation. More research is needed in understanding the interactions between different types of risk and the way they, in turn, are shaped by the structure of markets and institutions. The same is true for the analysis of the mechanisms that underpin the endogeneity of financial risk. And ways need to be found to turn this greater understanding into operational solutions. These are not easy questions and they often require skills that transcend disciplinary boundaries. Policymakers are eagerly awaiting the answers. I certainly hope that researchers’ inquiring and agile minds will seek to provide them.

Thank you