Speech by Mr Ong Chong TeeDeputy Managing Director, Monetary Authority of Singapore,at the NUS Risk Management Institute Fourth Annual Risk Management Conference
1 Ladies and gentlemen, good morning.
It gives me great pleasure to join you today at the Risk Management Institute’s fourth Annual Risk management conference. This year’s theme “The Risk Management Paradigm in the Post-Crisis Era” is apt. The worst of the global financial crisis appears to be over but the financial landscape in this post-crisis period appears no less challenging for investors and financial regulators alike.
2 Let me first touch on the implications for investment and risk management from the perspective of an investor. As you all know, MAS has within our central banking functions, a reserve management role.
3 The risk-return trade-off has become more acute in a post-crisis world. This is partly because expected returns for asset classes have been adjusted downwards as the world undergoes a phase of structural deleveraging. But this more demanding trade off is also because the risk half of the equation has risen and become, arguably, harder to manage. Let me highlight three key challenges to investment risk-management.
4 Firstly, the fundamental tenets on which much of our risk management tools and methodologies are built have been severely challenged by the recent crisis. One relates to the benefits of diversification. During the crisis, asset class correlations went towards one and portfolio diversification as we know them appear to fail in its risk mitigating role. In the immediate aftermath of Lehman, only sovereign bonds of developed countries rallied. All other asset classes were hurt across the board. But as events in the last six months showed, even developed market sovereign bonds may not be fully insulated. The instability of correlations undermines the mean-variance approach to portfolio optimization. Some new approaches have been mooted. For example, the “risk parity approach” has gained popularity and may provide new insights on portfolio construction. Risk parity looks at assets on a risk-equivalent basis to assemble an optimal portfolio. Instead of looking to allocate capital to various asset classes, risk parity seeks to allocate risk. Some studies have shown that portfolios constructed in such a manner have proven to be more efficient and resilient than through the mean-variance approach.
5 Another fundamental investment tenet under challenge is the assumption of rational markets. John Maynard Keynes once said that “markets can remain irrational longer than one can remain solvent”. This was indeed the case during the crisis. A sharp liquidity crunch triggered massive dumping of balance sheet intensive assets. As a result, for long periods, we witnessed pricing anomalies like TIPS with very negative real interest rates, 30-year negative swap spreads and very depressed prices even on supposed high quality asset-backed securities. Thus, models assuming market rationality may need to be augmented with some dose of behavioural finance.
6 Yet another investment tenet under siege during the financial crisis is the normality of asset returns especially at the tail of the distribution. The bell-curve has tended to underestimate the frequency and severity of tail events. This means that Value-at-Risk, which is based on curve, may not be adequate for us to manage extreme risk events. To clarify, mathematical models are useful approximations of the real world. We should continue using them as a starting point for understanding our portfolio’s risk exposures. However, we should not rely on them exclusively to direct our risk-taking activities. To augment the use of VAR models, we will need to carry out stress tests or scenario analysis to determine how the investment portfolio will perform under extreme events. This will help us ascertain the maximum loss that we can tolerate and allow us to make contingency plans. In addition, we may also use downside risk measures such as conditional VAR, downside deviation, as well as risk factor profiling and dynamic correlation modelling to get a clearer picture of the loss expected in tail events. These will help ameliorate the shortcomings of VAR models. Just as how we buy insurance to cover catastrophic outcomes, we should adopt a “just in case” mentality and hedge against tail risks that will result in losses beyond what we can tolerate. But an investor will also need to manage his hedging costs, which means not just buying the insurance when everyone else is doing the same.
7 A second challenge for investors in this post-crisis era, is the management of what I would term as “indirect or attendant risks”. The crisis has reinforced the importance of managing and mitigating a whole host of non-price risks - including counterparty credit risk, legal risk, modelling risks and operational risk.
8 Relative to market price risk, the body of knowledge in managing attendant risks is relatively sparse. Take counterparty risk for example. Pre-crisis, most investors will manage counterparty risk in broadly two ways: through the use of counterparty lines or limits, which are typically a function of a counterparty’s credit rating, and through ISDA agreements which will limit our exposure to the counterparty in case of insolvency. The crisis showed that this approach is inadequate. Are credit ratings responsive enough to changing realities? The credit downgrades of an entity can be swift, and may occur not because of factors inherent to the entity but to severe disruptions to its operating environment. Other questions that the recent crisis has brought to the fore - how do we account for trading counterparties’ exposures to each other, where the failure of one may set of a whole chain of defaults? Are standard ISDA documentations fool-proof enough to withstand local bankruptcy laws and comprehensive enough to cover very complex transactions? These are questions easier asked than answered but I am sure the investing and trading community in the financial marketplace will seek to address these issues.
9 A third challenge for investors is one of managing in an environment that is still evolving and fluid, and it is difficult to be definitive about what that steady state – if there can be one – will be. Professor Raghuram Rajan of the University of Chicago and former chief economist at the IMF pointed out in his recent book, interestingly titled “Fault Lines”, that the fault lines that underlie the crisis have not gone away. The worst of the crisis may be over but the crisis has damaged the developed world whilst the emerging world in particular Asia has largely been spared. Meanwhile, the global landscape will be dramatically different, both economically and financially in the post-crisis world, as we are unlikely to revert to the previous norms. But whatever that “new normal” may be, one thing is certain. Financial markets by its very nature of innovation and risk intermediation will dynamic and changing, and one may argue that the ongoing regulatory reforms are but long overdue adjustments to evolving risks.
10 Reforms to the global financial system will mean changes to the way market participants like banks, other financial institutions and investors interact. The trend of financial de-regulation of past decades has reverted to re-regulation. Discussions are ongoing at national and international levels to strengthen financial institutions and financial systems, and many governments in the developed economies are also putting in place fiscal reform measures to ensure the sustainability of public finances.
11 It remains to be seen whether and how the financial fault lines can be fixed to create that much desired safer marketplace. Carmen Reinhart and Kenneth Rogoff in a recent book argue against any notion that “this time is different” from their review of eight centuries of financial crises. For the financial and investing community, risk management techniques have to keep adapting and evolving, alongside product innovation; and managing evolving downside risks remain very much the name of the game of managing prospective returns.
12 Let me now offer some thoughts from the perspectives of a regulator and central bank.
13 While there is the move towards expanding the roles and responsibilities of regulators and central bankers following the crisis, the additional toolkits to enable them to carry out the new mandates are less clear. The crisis has shown that sound monetary policy alone may not be sufficient for maintaining financial stability. Monetary policy needs to be supplemented with other policies, including prudential ones. As the global financial crisis threatened the integrity of the financial system as a whole, the ongoing global reform agenda has included a greater focus on addressing the build-up and mitigation of systemic risks via greater macrosurveillance and the use of macroprudential policy tools. This will equip regulators and central bankers to address vulnerabilities within financial institutions, as well as across the financial system as a whole.
14 Macroprudential tools seek to promote the stability of the financial system as a whole, for example, by targeting systemic risks that might not be addressed by other policies that promote the stability of individual institutions. It is evident, on hindsight, that systemic risks went unchecked in the years leading up to the crisis in certain economies. These risks could arguably have been better spotted and addressed with more comprehensive surveillance and targeted macroprudential measures. They might also have provided authorities with the motivation and the means to lean against the wind during the years of high credit growth.
15 Even as we acknowledge the need to develop the macroprudential arsenal, it would be unwise to overlook the importance of old-fashioned robust microprudential supervision and regulation.
16 But there are limitations to macroprudential tools. The use of macroprudential measures has been relatively dispersed, and has been guided frequently by discretion or judgement, taking into account domestic and perhaps regional idiosyncrasies and circumstances. As a result, macroprudential policy tools, the mechanisms by which they work and their comparative effectiveness remain neither as well-understood nor as deeply researched as they are for say, monetary policy.
17 There are other aspects of macroprudential policy which need further exploration. For example, while there are several instances of how macroprudential policies have been tightened in response to emerging risks, there are far fewer examples of how it has been used successfully on the other side of the cycle, that is, when it is loosened to avoid constraining risk-taking activity excessively. So in the same way that we commonly acknowledge the limitations of monetary policy instruments, we need to be realistic about how much or what macro-prudential policies can do. International coordination is another challenge, and can pose concerns if policies are seen as creating an unlevel playing field, or leads to unintended cross-border spillovers.
18 Ultimately, both macro- and micro-prudential policies will be essential components of the new post-crisis regulatory framework, working alongside other instruments and policies in a calibrated and mutually enforcing manner. I encourage the risk management professionals in the financial community to take an active role in helping to shape the new tools of financial regulation.
19 Let me mention briefly about central banking practices in this post-crisis period. Reinhart and Rogoff (whose book I referenced earlier) characterised financial combustions as universal rites of passage that occur with surprisingly consistent frequency, duration and ferocity. This is why central bankers and regulators are always a paranoid bunch that takes away the punch bowl just when the party gets going.
20 An important new theme is to create and provide stronger financial safety nets for the banking system, rather than believing that future crises can be prevented. Walter Bagehot, whose name titles an eponymous opinion page in The Economist, summarised the central bank’s role with the dictum "lend freely at a high rate, on good collateral." This maxim has served central banks well for many years. However, with the globalisation of capital flows through global financial institutions, there has been a philosophical shift in how central banks think about our roles as liquidity providers. As capital flows become more globalised, central banks, especially those in international financial centres like Singapore, have recognised the need to be able to provide liquidity not just in the local currencies but in global currencies. At the same time, as more global financial institutions participate in domestic financial systems, central banks have also responded by recognising a broader set of good collateral from global capital markets in their liquidity facilities.
21 This has led to two important developments among central banks in the crisis. First, foreign exchange swap lines that allow central banks to provide liquidity to local markets in global currencies, such as the US dollar and Euro. This has helped to prevent stresses in global funding markets from cascading down to local markets. This is why the MAS entered into a US$30 billion swap arrangement with the US Federal Reserve in October 2008. Even though we did not need to draw on the swap eventually, the availability of the Fed's safety net via key global nodes have helped to improve US Dollar liquidity conditions in global financial markets. Second, cross-border collateral arrangements can allow central banks to provide local currency liquidity to foreign financial institutions in their jurisdictions, as these banks may hold the bulk of their quality collateral in the global markets of their parent or head office. Accordingly, MAS concluded a Memorandum of Understanding with De Nederlandsche Bank N.V., the Dutch central bank, as part of establishing a network of cross-border collateral arrangements (CBCAs) to accept well-rated foreign currencies and government debt securities as collateral to tap our Standing Facility. And we are proactively expanding on this network of CBCAs.
22 Asian finance authorities of the Asean+3 countries have also set up a multilateral liquidity facility under the Chiang Mai Initiative. In the longer term, Asia will also need to step up our collective efforts to distribute risks away from the banking system through deeper and broader capital markets. There has been considerable progress on developing local currency bond markets since the Asian financial crisis, including regional co-operation on such initiatives as the Asian Bond Funds by regional central banks. However, local currency bond markets remain largely domestic, while savings from surplus economies to those that need capital for long term development such as infrastructure tend to flow through the banking system. The next phase of market development will require Asia to not just continue to develop our local currency bond markets, but also look at improving cross-market access including harmonising of standards and documentations.
23 In conclusion, the financial crisis has provided all financial market stakeholders with a reason for reflection and an opportunity for reform. We may never be able to prevent the next big crisis but hopefully, the global community will be able to better manage that next crisis and the ensuing cost from the fallout. A silver lining perhaps, from the painful experiences of the recent failings, is a humbled sense from all quarters over how little was understood of the pre-crisis market exuberance; and accompanying that, a heightened desire now to review old assumptions and paradigms. The future evolution of investment strategy formulation, risk management techniques and regulatory reforms will be manifestations of this.
24 I commend the Risk Management Institute for once again arranging an interesting agenda at this Annual Conference with a line up of impressive expert speakers.
25 Will Rogers once said that a conference is held “for one reason only; to give everybody a chance to get sore at everybody else”. So on that provocative note, I trust you will all see much lively debates and spirited exchanges over the course of this forum. Thank you.