Regulation, Supervision, and Risk Management of Financial Institutions An OECD perspective Stephen A. Lumpkin Principal Administrator, OECD Financial Affairs Division February 2012 1 The interlinked components of risk management Market discipline Competition Haircuts In finance, discipline always has to be imposed: if not by governance or the market, then by regulators and supervisors 2 1
Risk is inherent to financial intermediation Banks Securities Insurers Purpose firms Lending Maturity transformation => credit risk, liquidity risk, market risk Mark-tomarket basis Short-term funding => Funding and liquidity risks Technical risks (under-pricing, underprovisioning) Investment risks Other risks Match surplus of capital with demand Facilitate real economic activity Through coverage and proper management of risks 3 What can go wrong? Own goals vs. collective rationality Take on risks as long as the cost of doing so makes sense from the institution s own point of view of its balance sheet (i.e. profit maximisation) There may be little economic incentive to internalise costs associated with the protection of third parties or the system as a whole Some institutions will err in the process Errors of judgment, flawed business models (risks to safety and soundness) Failures pose significant problems for customers and clients, especially individuals and SMEs (risks to clients) Asset quality problems can lead banks to become reluctant to extend new loans or refuse requests for rollovers Contagion (risks to the system) 4 2
Feedback loops among mismanaged risks Direct losses (funds, assets, collateral) Loss of access to financing Failures Loss of confidence Maintaining confidence is necessary if the financial system is to attract capital and function efficiently On deposits, CIS, repos, market liquidity Broader systemwide problems Runs Crisis episodes can have longer run effects 5 The evolving crisis is illustrative Crisis backdrop Imbalances on the macroeconomic front Flawed incentives across the range of market participants Some core features of the crisis A substantial build-up of leverage and accumulations of assets, with very low risk spreads and high concentrations of risk (risk management?) Evolutions in risk mgt. processes, wider acceptance of instruments for credit risk transfer and structured products, underestimation of required liquidity (market discipline?) Insufficient i pressure to adequately enforce proper underwriting and risk management criteria, allowing excess leverage to build-up in structured investment vehicles and conduits (supervision?) 6 3
Crisis outcomes are not so rare 1400 90 1200 October87 crash Asia/TCM Tech bust Worldcom/ accounting scandals Sep 08: GSE takeover, Lehman collapse 80 70 1000 S&L/LBO crisis Sep.11, 2001 Mar 08: Bear Sterns collapse April/May 2010: Start of EU sovereign 60 Spreads (bps) 800 600 Jul/Aug'07: severe subprime effects on money markets debt crisis 50 40 Volatility index 30 400 20 200 10 High yield US (BofA ML) EMBI global (JPM) VIX (r.h.s.) 0 0 7 and the effects can be significant Growth of SME business loans 1, 2008-10 Year-on-year growth rate, as a percentage Country 2008 2009 2010 Canada -0.1 3.7-0.9 Chile 11.3 6.9 8.8 Denmark -13.7-19.2 22.9 Finland 2.6-16.3-22.0 France 4.3 1.0 5.7 Hungary 4.9-6.8 1.3 Italy 2.1 1.2 6.6 Korea 14.1 5.5-1.0 The Netherlands -5.0-24.2 5.1 Portugal 9.2 1.8-2.0 Slovakia 34.1-0.3 Slovenia 16.7-0.9-8.8 Sweden 7.2 20.4 Switzerland 5.9 5.3 1.3 Thailand 9.5 7.4 7.2 United Kingdom 8.2 1.4-6.1 United States 3.6-2.3-6.2 Notes: 1. Definitions differ across countries. Financing SMEs and Entrepreneurs: An OECD Scoreboard, forthcoming in April 8 4
Enterprises by size class in 2007 1 9 10 19 20 49 50 249 250+ 9 8 7 6 5 4 3 2 1 OECD, Entrepreneurship at a Glance 2011 9 Employment by size class in 2007 1 9 10 19 20 49 50 249 250+ 9 8 7 6 5 4 3 2 1 OECD, Entrepreneurship at a Glance 2011 10 5
and the costs have sometimes been high Source: S. Schich and B. Kim (2010) Systemic Financial crises: how to fund resolution, OECD 11 What should be done? High costs of widespread distress Prevention is better than cure, but how best to do it? Limits of risk management: Boom-and-bust cycles are recurrent phenomena Systemic risks can hide in the interactions between institutions, products, and markets, and not necessarily with particular institutions Limits of market discipline: Only as effective as the broader governance framework Weak mgt. systems or ineffective or incompetent boards => cannot rely solely on firewalls and related control mechanisms to control or mitigate conflicts of interest or other risks Limits of supervision: Difficult in practice to directly control behaviour without sacrificing some measure of efficiency and innovation or creating adverse incentive effects 12 6
What about structure? 40 40 35 35 30 30 25 20 15 GBR CAN USA 25 20 15 CHN IND IDN 5 5 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 40 40 35 35 30 30 25 20 15 AUS JPN KOR 25 20 15 BRA MEX ARG 5 5 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 Total assets of largest 3 banks as share of GDP 13 Balance sheets of large financial groups More risky elements but more diversification Large, integrated institutions may not have a greater risk of failure than smaller institutions Might fare better because of the diversity of their activities or the diversity of their funding sources Increases in cross-sector, cross-border, or cross-risk type correlations limit diversification benefits But risk factors can interact If not properly managed, these risk exposures can precipitate institutional failures or have broader implications And given cross-sector and cross-border inter-linkages, once problems do erupt they tend to be transferred from one market segment or region to another 14 7
The structure-behaviour nexus Regulate Structure Some activities not compatible from a direct risk or moral hazard standpoint Should not be combined Regulate Behaviour Issue is not structure per se But implications of structure for risk management & internal controls 15 Would the separation of traditional and nontraditional bank business make the sector safer? Opaque universal banking model vs. Non-operating holding company structure, with firewalls Commercial Bank Investment Bank Insurance Invest. Banking, position taking, securities business Commercial Bank, external funding, trading etc. Broker/Dir. equity sales, IPS's etc. Broker/Dir. equity sales, IPS's etc. Wealth Management Broker Dealer Insurance, general, life, reinsurance Wealth management, private clients, etc. Source: The Financial Crisis: Reform and Exit Strategies, OECD, September 2009, Paris, available at www.oecd.org/dataoecd/55/47/43091457.pdf 16 8
Linked components of risk management Structure alone not sufficient Possible risk of contagion across group members from shared brand name and damage to group s reputation Entire governance framework must be appropriate for risk profile and business model Role of managers in risk mgt. Direct, but not sole, responsibility for ensuring a proper mix and mgt. of institution s assets and liabilities Effective market discipline Should provide an external constraint on managerial discretion External governance mechanisms are at a disadvantage in the case of complex structures Normal competitive mkt. function Some institution s asset-liability mix, risk mgt. techniques, or entire business model will prove to be deficient and result in losses or failure Implications Is the problem idiosyncratic, likely to spread to other institutions having a similar structure or business model, or further still? 17 Thanks very much for your attention ti Any questions? 18 9