PrefBlog

The Financial Times reported on a paper by the Financial Stability Forum titled Observations on Risk Management Practices during the Recent Market Turbulence, with a related Options paper.

I haven’t read the paper yet, but I will tomorrow. Hat tip Naked Capitalism … but NC, when they’re talking about simultaneous disclosure, they do indeed mean simultaneous public disclosure. The regulators have that information, but it is currently considered confidential.

I’ll write more on this paper when I’ve read it properly. A quick skim is very encouraging.

Update, 2008-4-2: The paper begins by differentiating between those firms that are performing (relatively!) well during the crunch and those that are getting hit. There are details, of course, but the basic conclusion to be drawn is that the firms performing well have managers who talk to each other and think about what they’re doing.

Write that down, get an MBA. You read it on PrefBlog!

However, “Please don’t be dorks” is not a suitable supervisory injunction, so there are more details:

First, we will use the results of our review to support the
efforts of the Basel Committee on Banking Supervision to
strengthen the efficacy and robustness of the Basel II capital
framework by:
• reviewing the framework to enhance the incentives for firms to develop more forward-looking approaches to risk measures (beyond capital measures) that fully incorporate expert judgment on exposures, limits, reserves, and capital; and
• ensuring that the framework sets sufficiently high standards for what constitutes risk transfer, increases capital charges for certain securitized assets and ABCP
liquidity facilities, and provides sufficient scope for addressing implicit support and reputational risks.

This looks very good. The first step is extremely tricky … how does one determine whether expert judgment has been fully incorporated or not? There’s a big danger that this could turn into a box-ticking exercise.

I have been harping on the definition of risk transfer and ABCP liquidity facility capital charges for a long time. It seems quite clear, for instance, that Apex / Sitka were not quite far enough off BMO’s balance sheet for risk transfer to have been deemed complete; it also seems clear that the capital charges for liquidity lines on ABCP inter alia need to be increased to reflect the fact that when bad stuff happens, it happens all at once. Thus, as I have written previously:

If the risk weights applied to, for instance, the provision of a global liquidity line to a SIV have been shown to be inadequate (and this has not been documented, although I suspect that it is the case) … increase the risk weight of the line! Currently it’s at a flat 10% … I suggest that a tiering be considered, so that a bank with $10-billion of tier 1 capital can extend such a line for $10-billion at the 10% rate, but the next ten billion is charged at a 20% rate, etc.

The report continues:

Second, our observations support the need to strengthen
the management of liquidity risk, and we will continue to work directly through the appropriate international forums (for example, the Basel Committee, International Organization of Securities Commissions, and the Joint Forum) on both planned and ongoing initiatives in this regard.

Can’t say much more about this without detail!

Third, based on our shared observations from this review, individual national supervisors will review and strengthen, as appropriate, existing guidance on risk management practices, valuation practices, and the controls over both.

Motherhood.

Fourth and finally, we will support efforts in the appropriate forums to address issues that may benefit from discussion among market participants, supervisors, and other
key players (such as accountants). One such issue relates to the quality and timeliness of public disclosures made by financial services firms and the question whether improving disclosure
practices would reduce uncertainty about the scale of potential losses associated with problematic exposures. Another may be to discuss the appropriate accounting and disclosure
treatments of exposures to off-balance-sheet vehicles. A third may be to consider the challenges in managing incentive problems created by compensation practices.

More public disclosure would be appreciated, but I’m not sure how much good it will do. There’s more disclosure now than anybody reads. A review of off-balance-sheet vehicles is appropriate because, as noted above, a lot of them weren’t as far off the balance sheet as they should have been.

The last point in this section is a little troubling. First, it’s so carefully hedged it doesn’t actually say anything; but the fact that it is considered worthy of mention in such a document makes me a little fearful. If, for instance, I join a big bank as a pref trader, I don’t want my compensation to be influenced by whether some dork in government finance lent $20-billion to Argentina. I want my compensation determined by things I have control over – my own trading, or, should I become Head of Fixed Income, the trading of the guys working for, and accountable to, me.

Second, if in my role as pref trader, I strap on Nortel prefs with 20:1 leverage, surely the risk to the bank is due to the holdings of Nortel prefs with 20:1 leverage, not the timing of my bonus for the enormous profits such a position will surely bring.

Against this is the evaluation of risk and the up-front income. For instance, if I had sold a massive position of five-year credit default swaps then, while the profitability of this position is marked to market daily, the actual profit on the whole position is not known until they expire five years later. Regulators rely on the individual firms to make good judgements; they do not and should not second-guess every little thing. If that judgement is biased by a risk/reward profile for the decision maker / risk assessor that is different from the profile appropriate for a firm with continuing operations, this is in fact a regulatory concern.

I suggest that the most appropriate way to address this issue is to ensure that the risk management and accounting functions are independent, objective and senior to the traders. Trouble is, that’s a very, very hard thing to ensure when, for instance, so much of the risk depends on whether Joe Subprime will be able to refinance his mortgage in five years. Pick a number! Why is it better than another number?

More later.

Update, 2008-4-3: Well … not a lot more! Most of the paper is a simple review of the general types of actions taken by management of firms that are coming through this ordeal successfully, compared to … er … less successful companies.

There are many examples given, across all the business lines that the Large Complex Financial Institutions are involved in but, oddly enough, the situations boils down to the same thing. At successful companies, managers:

• think about what they’re doing
• talk to each other

This entry was posted on Wednesday, April 2nd, 2008 at 12:20 am and is filed under Interesting External Papers. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.