Financial Risk Management in Practice

Financial Risk Management in Practice: The Known, The Unknown and The Unknowable 13 2005 Mercer Oliver Wyman clinical studies.” She went on to note, “Typically we don’t … Contents 1. Opening Address…..1 2. Roundtable 1: The Known, the Unknown, and the Unknowable in Financial Policymaking….. 3 3. Roundtable 2: The Known, the Unknown, and the Unknowable in Banking….. 6

Michael Mussa of the Institute for International Economics opened this annual conference on financial risk management by offering a historical perspective on some of the forces that have intruded on risk management over the years. He argued that understanding the differences between what is known, unknown, and unknowable is critical so that “financial risks may be managed within tolerable limits.” Mussa, a former member of the President’s Council of Economic Advisors, emphasized the inevitability of risk: “To be alive is to be at risk,” he said, adding that “virtually very worthwhile endeavor entails some risk.” He said that simply minimizing or avoiding risk “is not what life is about,” nor is it necessarily an objective of financial management. Mussa argued that the proper goal for financial institutions and regulators is to “ensure that risks are not excessive and that they are efficiently allocated among those willing and able to bear them.” Achieving that, however, requires a “reasonable basis for assessing risk.” He noted that in the past some public policies seeking to reduce risks in financial markets went “too far,” and he cited as an example, the regulations restricting the range of activities open to commercial banks. But now he said, “There is a more important problem, and that is policies which encourage excessive risk-taking.” Mussa said it was appropriate that this conference was being held in Philadelphia because for the first third of the 19th century, it was “the most important financial center in the United States.” The First Bank of the United States, which was chartered in Philadelphia in 1790, functioned as a “relatively stern guardian of the sanctity of credit,” he said, and this was not universally applauded. Indeed, its 20-year charter was not renewed…. Financial Risk Management in Practice: The Known, The Unknown and The Unknowable 5 Copyright © 2005 Mercer Oliver Wyman derivatives have facilitated better risk management. In recent years, he said, financial markets have come through stressful periods with limited damage because of increased diversification of risk and improved risk management systems as well as stronger capital bases. He applauded institutions for managing risk on an increasingly integrated basis. But Kohn warned that “no institution can be too big to fail. ” While imposing the costs of failure on managers and shareholders may be difficult, he said this is something that regulators must be prepared to do for the good of the market. Nonetheless, the growing complexity of institutions” has “elevated” the goal of avoiding crises rather than simply managing them, he said. Anthony Santomero of the Federal Reserve Bank of Philadelphia said the dividing line between what is known and unknown “is not a static line - what is unknown can become known.” The real dilemmas, he said, had to do with things that have seemed unknowable. Santomero noted that imposing regulations on realms with many “unkowns” being with imposing underwriting standards, which eliminates known risks. But he warned that “sometimes we call things known that aren’t,” and this can create problems. For example, institutions may be regulated by structuring capital requirements based on loss rates. But this can lead to problems when the regulatory framework doesn’t fit the structure of the banks because there is an asymmetry of information. He explained that when regulators are building a model of risk for various assets, they don’t have all the necessary information, so they must ask institutions to provide the information needed to validate the models these institutions are using. “At the end of the day,” he added, the models an institution uses are theirs, not the regulators, “but regulators must feel comfortable with them.” Moving from the unknown to the unknowable, Santomero said the latter is often the realm of operational risks. The question for banking regulators is whether to require large amounts of capital to provide protection against these risks. He noted that insurance concepts “have a lot to say about this.” Insurance companies are familiar with short- and long-tailed risks, and for insurers some of these risks are desirable to retain and some are not. For banking, he went on, the response to unknowable variables has been to “add an extra layer of regulation,” but he warned that “there is a flip side” to this: Increasing the regulatory burden adds a “dead weight” to a financial institution’s operating costs, and “this can lead to inefficiencies and circumvention of underlying regulations.” Like Crockett, Kohn warned that excessive regulation can be counterproductive by driving activities to other jurisdictions. One member of the audience asked if understating risks leads institutions to hold less capital or to take on more risk with the same amount of capital. Santomero said that if an institution truly has “a better handle on risk,” it can “take on more risk yet be less risky.

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