"The Challenges of Risk Management in Volatile Financial Markets"

Introduction

Prof Tan Chorh Chuan,
Prof Duan Jin-Chuan,
Prof Robert Engle,
Other distinguished speakers,

Ladies and Gentlemen

1   It is a great pleasure to join you today for the Second Annual Risk Management Conference organised by the Risk Management Institute.

Sub-Prime Crisis

2   The focus of this year’s Conference, on "The challenges of risk management in volatile financial markets" is important and timely. The recent events triggered by the sub-prime crisis are a reminder to us firstly that financial markets are inherently volatile. While we may go through prolonged periods of subdued volatility and low risk premia, things can change quite sharply and a broad-based reappraisal and repricing of risk can ensue. Secondly, and no less problematically, financial markets are also inherently pro-cyclical. Consequently, financial institutions seeking not just to ride the upswing, but also to ride through a downturn will need to give sufficient attention to their tail risks.

3   The crisis has also made clear the importance of good risk management practices, and the potential difference it can make to the sustainable growth and resilience of financial institutions. A report issued by the Senior Supervisors Group to the Financial Stability Forum in relation to the crisis has noted, for example, that "institutions with better risk management practices have weathered the financial market turmoil better than others. These institutions were able to recognise emerging additional risks and adjust their business strategies, risk management practices and the level and type of their exposures promptly and proactively in response to changing market conditions."

4   There are many learning points arising from extensive review and analysis of the crisis itself. Among them, we see the importance of adopting a disciplined approach to risk management and asking fundamental questions about risk. Questions such as: Have risks really been transferred away through conduits or SIVs or have they been re-constituted or re-concentrated in a different form? Does risk premia adequately reflect market, credit and liquidity risk characteristics for assets? Beyond credit ratings, what are the underlying risks? Will wholesale funding continue to be available in times of stress?

Developing a firm-wide culture

5   Financial institutions should see this as an opportunity to identify and make improvements to their existing risk management frameworks. Coming up with a checklist of "dos" and "don’ts" may be necessary to deal with shortcomings in certain areas. However, in view of the nature and complexity of risk, and the limitations of resource, adopting a static approach to risk management is neither realistic nor adequate. Let me give you two examples.

6   First, in relation to the use of models. It is important for financial institutions to adopt quantitative risk management techniques and models appropriate to the complexity of their business. At the same time, it is equally important to recognise that models are predicated on simplifying assumptions, and these assumptions may vary across products and will change over time as business models, risk factors and financial markets evolve. As such, institutions need to fully understand the limitations and assumptions behind these models.

7   Using value-at-risk (or VAR) as an example, VAR-based measures that are derived using historical data from a prolonged period of subdued volatility will understate risk. In addition, VAR only captures how bad things can get 99% of the time, but it does not give a sense of the losses that might arise at the outlying 1%. In view of the inherent limitations, in this case with the use of VAR, institutions cannot simply accept estimates of primary risk systems without challenges based on other tools, which in this example, might take the form of tail VAR or P/L reporting.

8   But as we go further along, guidance can at best be principles-based and institutions need to decide for themselves what is effective and appropriate given their own circumstances. For example, we expect senior management to be kept informed of material risks on a timely basis. To meet this expectation, institutions will have to decide which of these "other tools" it should use. Using all of them may be technically possible, but what if it increases the current 20-page monthly risk report to say 150 pages? And how should the various results be interpreted side-by-side? More is not necessarily better; it could well just be more.

9   My second example is in relation to stress testing. In recent times especially, the industry as a whole has acknowledged the importance of developing and using forward-looking scenarios and stress tests to explore known and unknown risks. This should include an assessment of how exposures, relationships and behavior may change in light of unexpected changes or shocks to the business environment. As to how stress testing should be implemented, there are no straightforward answers. As a general principle, stress testing should be a thoughtful forward-looking exploration of adverse events which are outside the range of an institution’s normal expectations. This should cover a range of scenarios, including high-impact distress scenarios. In addition to historical macro scenarios, this could include the failure of a key or new business line. Reverse stress testing techniques are also being explored, and these require an institution to think through scenarios that could cause it to become insolvent. In practice, institutions will have to decide on appropriate downturn scenarios. What severity of stress should be applied? What is the impact of these scenarios on the business practices of the institution? How should the output of stress testing be incorporated into the decision making process? Will it provoke thought, discussion and action or will it just be a theoretical exercise?

10   The types of tools and scenarios that will be appropriate for an institution at any point in time is unlikely to remain constant in a dynamic market environment. In view of the need for financial institutions to exercise judgment on an ongoing basis, beyond the "dos" and "don’ts", institutions need to work toward developing a firm-wide culture that is focused on identifying, measuring and managing risks. What might this look like? The Senior Supervisors Report sums it up quite nicely in its observation that institutions who did better "demonstrated a comprehensive approach to viewing firm-wide exposures and risk, shared information more effectively across the institution and engaged in more effective dialogue. These institutions had more adaptive risk measurement processes and systems that could rapidly alter underlying assumptions to reflect current circumstances."

11   As for how we can get there, let me suggest three critical first steps. First, Board and senior management must take the lead and be actively involved. Risk taking must be aligned with the risk appetite set by the Board and enforced through appropriate controls. Senior management must be kept informed of emerging risks on a timely basis and be involved in decisions that may have significant implications on the institution.

12   Secondly, institutions must work toward having a firm-wide integrated process of risk identification, analysis and management. Risk must be seen as the responsibility of everyone, from Board and senior management to the business line risk owners and control functions, and not just the responsibility of risk managers. Furthermore, this process of managing risk must tie in with the firm’s risk appetite and capital and liquidity planning processes.

13   Third, there must be effective challenge. For example, middle office expertise should not lag behind the innovations of front office. Senior management should comprise people with experience in a broad range of risks. Indeed this is easier said than done with risk management expertise being a scarce commodity, especially so here in Asia. However, we must start the process of getting there by taking definitive steps toward building up such expertise. In this regard, MAS has also been working closely with industry and academia through initiatives such as the setting up of RMI and the Doctorate Scholarship Programme in Finance to build up risk management expertise here in Singapore.

14   This development of a firm-wide culture should reinforce ownership and complement the use of traditional methods of risk management such as notional exposure limits, internal controls, adequate levels of provisions and liquidity reserves, and contingency funding plans.

Role of supervisors

15   Moving on to our role as supervisors. Arising from the crisis, it is inevitable that there will have to be some adjustments to our rules to address weaknesses that have been identified, for example, in relation to stress testing processes. MAS will do this in a proportionate manner to ensure that there are no unintended consequences. At the same time, I must reiterate that our rules are not meant to be a comprehensive textbook for the management of risk, and Board and senior management must be responsible and continue to take the lead in ensuring that an institution’s risk management framework is robust.

16   MAS will continue to engage financial institutions on their risk management practices, and to ensure that capital and liquidity buffers and estimates of potential losses are appropriately forward looking. During this phase where the industry as a whole is seeking to internalise the lessons learnt from the crisis, institutions can expect more in-depth supervisory challenge by MAS on the appropriateness of their risk management frameworks, especially in areas relating to stress testing and contingency planning.

17  Finally, MAS will continue to adopt a macro-prudential orientation over and above our day-to-day supervision of financial institutions. In this regard, our existing supervisory structure where MAS is both the central bank and financial regulator has helped in our efforts to monitor potential vulnerabilities which may be linked to particular features of business or credit cycles. In particular, having regular and timely access to market-related information is critical for MAS to be able to respond quickly and appropriately to financial imbalances in the economy, whether it is through the calibration of prudential tools or the intensity of our supervisory review.

Conclusion

18   To sum up, financial institutions should see this as an opportunity to address weaknesses in their risk management frameworks. The silver lining in any crisis cloud is that those who survive should emerge wiser and therefore stronger. In this regard, there are many opportunities for academia to partner the industry in its endeavour to integrate and enhance its risk management approach. At the same time, institutions need to work toward developing a culture that is risk-focused. Success in this area, to a large extent, will depend on the commitment of Board and senior management. MAS on its part will continue to strengthen its policies and oversight of individual financial institutions and the financial system as a whole.

19   With that, I wish all of you a fruitful discussion at this year’s conference. For those of you who have come from overseas, I also wish you a pleasant stay in Singapore.

20   Thank you.