Reengineering the Risk Management Function: A Public Sector View Credit and Risk Management Conferen

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Reengineering the Risk Management Function
A Public Sector View Credit and Risk
Management Conference of theBond Market
Association Christine M. CummingExecutive
Vice President and Director of ResearchFederal
Reserve Bank of New York

October 16, 2001
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Disclaimer

• The Views Expressed are Those of the Speaker and
  not of the Federal Reserve System or the Federal
  Reserve Bank of New York

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What are the Goals of Risk Management?The Goals
Have Evolved and Grown

• Initially, information management
• But also, contribution to the control
  environment
• Support to business decision makers
• Support to senior management and board
• Recently, refinement of performance measures
• Capital and other resource allocation
• Evolving, enhancement of public disclosure

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Risk Management Needs to Workfor the Firm and
its Decisionmakers

• Evolution driven by needs of management (at
  several levels)
• Learning from stress experiences
• Trend is toward more sophistication, more
  integration of risk measurement across risk
  types, because institutions, business lines more
  complex
• Harnessing theory to solve very pragmatic
  problems, including aligning incentives within
  complex organizations

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Risk Management Is Increasingly Interdisciplinary

• Many firms are combining or linking their market,
  liquidity, credit and operational risk management
  staffs
• New frontier incorporating insurance risks
• New product approval process--also
  interdisciplinary, focused as much on new
  processes as new products
• Driven by the recognition of interactions across
  risk dimensions

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How Risk Interactions Have Become Understood

• 1980s and again in first half 1990s credit
  risk concentrations market, operational,
  liquidity risks
• Mid to late 1990s links between credit and
  market risk, especially for derivatives, trading
• 1998 The combination of leverage, liquidity
  and market/credit risks
• Very recently, liquidity risk at the market
  level and the links between operational risk and
  credit and liquidity risks
• Emerging optionality in credit risk transfer

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Liquidity Risks

• Recurring theme in stress situations
• Liquidity perils have evolved and become more
  complex e.g., derivatives, securitization
• Equally important scenarios for firms to study
  
• Problems arising from deterioration in a firms
  own credit standing
• Problems arising from market strains in
  liquidity occurs in episodes of deleveraging,
  flight to quality, or market breaks

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Marketwide Strains on Liquidity

• Classic cases flight to quality, runs on
  market
• Also, legal uncertainty and different
  conventions across markets--e.g., different
  margining practices
• Valuable role of standardization within
  markets--e.g., standard legal agreements
• Current efforts to look at cross-product,
  cross-market differences in agreements and
  conventions
• But, diversity across markets has been a great
  strength of U.S. financial system
• Balancing diversity against harmonization

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Operational Risk

• Analytically tough problem
• In bottom-up approach, many control points to
  account for need to measure financial exposure
• Industry has made dramatic progress on the
  intellectual front, but still important questions
  
• Dimensioning operational risk is essential to
  understanding certain credit risks, particularly
  settlement risks, the amount of effective credit
  protection in collateral arrangements
• Supervisors seeks to foster more development

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The Growing Role of Stress Testing

• Large advances since early 1990s
• Development reflects recognition of limitations
  of VAR, but important to note that VAR
  information framework enables sophisticated
  stress testing
• Stress testing not unidimensional, but seeks to
  replicate how markets, risks interact under
  stress
• Stress testing based on historical events used
  to explore those interactions
• Stress tests have important role in identifying
  and managing concentrations

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Risk Management Striving for Continuous
Improvement

• Evolution of risk management has been driven by
  managements recognition of the needs of firms in
  a globalized, complex financial system
• Supplemented importantly by the work of industry
  associations such as the BMA, and increasingly,
  cross-industry working groups addressing
  cross-market issues
• Role of supervisors to prod to ratify sound,
  as opposed to best, practices to create
  incentives to meet sound standards in all,
  working with industry