I want to welcome you to the Federal Reserve Bank of New York, and to the risk forum we are sponsoring jointly with the Global Association of Risk Professionals. I want to thank Rich Apostolik and Rene Stulz for their work in organizing this forum with us.
Before I introduce tonight’s speaker, Pat Parkinson, I’d like to make some brief remarks.
The financial crisis underscores the importance of good risk management practices and systems. Some firms had a better understanding of the risks that they were exposed to and liquidated positions and bought protection as the housing boom turned bust. But others took too much comfort in credit ratings or felt too comfortable operating with very high risk concentrations. The desire to protect revenue streams also caused some firms to stick much too long with businesses that were much more exposed to risk than anticipated.
Value at risk measures proved inadequate—understating risk in numerous ways—first, by putting too much weight on historical volatilities, second, by understating tail risks, and third, overstating diversification benefits in adverse economic circumstances. Also, some firms had difficulty in assessing their exposures on a consolidated basis. Thus, while risks in particular business units might have looked manageable, there was a lack of understanding about how the risks aggregated up at the firm level and how adverse shocks could reverberate more broadly throughout the firm’s activities and business.
There has been considerable progress made since the crisis hit. Risk management practices have been bolstered, MIS systems improved, and scenario stress analyzes have become more commonplace. But there is still much to do. In particular, transparency into risk management practices remains poor. Investors have little information by which to assess the competencies of firms as risk managers or how well firms will likely do in adverse economic circumstances. Also, the ability to discern various basis risk exposures is poor. The large banks have huge books of business that net down to much more modest net exposures. Investors are uncertain about how to think about this as they cannot easily discern how solid the hedges, collateral, and guarantees will turn out to be under stress. Right now, investors are focused on exposures to European sovereigns and banks. The gross exposures are sometimes quite sizable, but the net positions are typically small. We need to figure out better ways to present these exposures and risks in the firm’s disclosures.
Two more points, I would like to make about risk management.
First, in thinking about risk management, we need to be cognizant that, at times, that risk management objectives for the firm may diverge from those of the regulator. In the spring of 2009, the largest U.S. banks did not want to raise more capital because in good states of the world they would not need it and raising that capital in order to have capital for bad states of the world would be very dilutive for shareholders.
The regulatory perspective was different. If banks did not prepare for a bad state of the world, this made the bad state of the world more likely. By forcing the banks to hold sufficient capital to withstand bad states of the world, the SCAP exercise made a bad state of the world less likely. This underscored an important externality—if an individual firm strengthens itself, this strengthens the financial system and makes everyone better off. I would argue that this issue is relevant right now with respect to the European bank and sovereign debt crisis.
Second, there are limits on the ability of good risk management practices to protect the financial system. We have to recognize that the feedback loops and contagion channels within our complex financial system are extraordinarily complex and that risk management modeling will often be inadequate in describing how such a complex system is likely to perform under stress. For example, I think we can take too much comfort by focusing on bilateral, direct exposures. As we have seen in the financial crisis, the lines of contagion can occur in unanticipated ways. Also, I may understand well my exposures to my counterparties, but what about my counterparties’ exposures to others in the financial system? I conclude that good risk management practices are essential, but not sufficient. Appropriate capital and liquidity buffers; fulsome transparency and disclosure, and incentives that are consistent with safety and soundness are all also important. Also, working towards a financial system structure in which shocks are attenuated rather than amplified is important.
I’m pleased tonight to introduce Pat Parkinson as our keynote speaker. Pat has been Director of the Federal Reserve Board’s Division of Banking Supervision and Regulation since October 2009. Prior to that, Pat was Deputy Director of the Board’s Division of Research and Statistics, with responsibility for oversight of the micro-financial policy. In addition, from 1993 until 2009 he was the principal staff advisor to the Board’s Chairman on issues considered by the President’s Working Group on Financial Markets. He first joined the Board’s staff in 1980. During the first half of 2009 Mr. Parkinson served as Counselor to Treasury Secretary Geithner and played a leading role in development of the Administration’s proposals for reforming financial institutions and markets, including the OTC derivatives markets.
Pat is one of our most experienced risk management experts. His international experience is extensive. From 1999 to 2004 he co-chaired the CPSS-IOSCO Joint Task Force on Securities Settlement Systems, which developed the international standards for securities settlement systems (including central counterparty arrangements for derivatives). This work has been the basis for the current effort to update these standards. Pat’s earlier contributions are an important reason why this work has been moving ahead smoothly.
Finally, let me underscore my own appreciation of Pat’s work. He and I worked very closely together during the worst days of the financial crisis in the fall of 2008 developing some of the special liquidity facilities such as the CPPF and the TALF. Those were very difficult and uncertain days. I have a great appreciation for his ability and insight.