Thursday, May 30, 2013

Is It Time to Rethink the Nature and Management of Financial Risks?

For the most part, regulators and policy makers around the globe have "bought in" to the global regulatory reform agenda brought about by the financial crisis. But, there are differences of opinion on whether the reforms that are underway are up to the task of enhancing the resilience and robustness of the global financial system. Mr. Norman T L Chan, Chief Executive of the Hong Kong Monetary Authority, raises some interesting and serious questions about our understanding of global financial risk, and some of the assumptions underlying our reform efforts. In his May 28, 2013 speech before the Hong Kong Monetary Authority-Global Association of Risk Professionals, Mr. Chan raised thoughtful questions, the answers to which would have fundamental relevance to the nature and shape of the global financial system going forward.

  • To what extent is the mainstream thinking, that financial or systemic risks can be assessed and forecast through the use of the financial models that have been developed in the last two decades, still valid?
  • The financial markets have become very complex and, as we now know, have generated huge risks for the global financial system. Is the current international effort on regulatory reform adequate in addressing the risks arising from this complexity? and
  • The Basel Committee on Banking Supervision is undertaking major reform in upgrading global standards on the quality and quantity of the capital, and introducing global standards on the liquidity that banks have to hold in order to improve their resilience to risks and shocks. Some countries have already implemented these standards but some advanced economies have not yet done so. Does this create an unlevel playing field that might compromise fair competition as well as the soundness of the banking system?

Mr. Chan believes that we may need to rethink the nature and management of financial risks.  He posits that it may be a mistake to continue to view risk in terms of probabilities of events that can be quantitatively expressed and forecast with statistical models.  This reliance on modeling, in his view, may be folly, because, if we did not know before the financial crisis, we certainly are aware now that these models make broad assumptions that do not represent reality.

[S]ome of these models make strong assumptions, such as “normally distributed returns” or other not sufficiently fat-tailed distribution assumptions, which are usually not supported by empirical evidence. These quantitative models underestimate the likelihood of the “tail events” and the amount of losses that would occur in such events. As we now know, the highly improbable event, or the “tail risk”, has occurred all too frequently and with highly disruptive, if not devastating, impact on financial as well as macroeconomic stability.

Relying modeling as a way of assessing and understanding risk creates the same weaknesses in new efforts to regulate it.  Chan believes there is every reason to reexamine reliance on models, or at the very least, temper purely statistical modeling methods with actual market conditions and behavioral responses to market events.

All of this prompts the question of how far we should reflect on the efficacy of our methods for assessing, measuring and managing risks in the financial system. How can we avoid the temptation to see model output as the only crystal ball for the future? How can we equip management, board members and regulators and supervisors to overlay model output with informed expert judgement which can look to surrounding circumstances, be more forwardlooking and take into account possible behavioural responses to events?
Not only does Chan urge the rethinking of use of models in understanding and controlling risk, but he also suggests that combating the ever increasing complexity of global financial markets with even more complex regulations may have reached a tipping point of effectiveness.  That is, Chen believes that there may be diminishing returns on ever more complex regulatory measures.

Haven’t we hit the limit here of what might be considered optimal or indeed sensible? Should we rethink whether adding complexity to the regulatory system is the only effective way of reducing the risks of complexity in the financial system? Is there any room to inject an element of a more principle based, common sense, approach in bank regulation and supervision?
Mr. Chan plainly admits he does not have the answers to the questions he poses. Rather, he is teeing these questions up for the members of the members of the Hong Kong Monetary Authority-Global Association of Risk Professionals, the Basel Committee, and others throughout the globe to think about.    Indeed, these are serious questions, and there is no better time to address them then when we are in the process of rethinking the role of regulation and supervision in the wake of the financial crisis.