Regulatory Risk Management

There are at least two fundamental problems with risk management that is driven by regulators:

  1. All risk management activities that would go beyond what the regulator requires usually cease.  Firms will not do the chaotic process of making their own decisions about how risky their activities are.  They will know because the regulator tells them.
  2. Everyone will work under the same exact view of risk measurement and risk management.  If there are flaws, those flaws will have systemic ripples.  Where the regulators set the capital requirements too high, then businesses will either cease that activity or will engage in regulatory arbitrage.  Where the regulators set the risk capital requirements too low, businesses will over leverage their risks and some businesses will participate in risks that they might not have were the risks properly assessed.

And if the regulators take the step of creating a world wide system where there is no place to go to get regulatory relief, or arbitrage of risks with excessive capital requirements, then the entire world will fall all at once when what ever risk they have set the requirement too low is over used by the firms to get the profits that they believe that they need.

So there are no happy endings for a regulatory driven risk management regime.  None unless the regulators are absolutely perfect in their work.

One of the many roots of the financial crisis was a regulatory driven risk management system used by banks, Basel 2.  The system was so wrong headed that the two largest banks that were stricken by the crisis, Bear Stearns and Lehman both were in fine health according to the Basel measures of risk taking capacity, right up until the time that they failed (or were taken over).

In the June 24, 2010 WSJ, an article entitled BP Relied on Faulty U.S. Data, it says that the regulators REQUIRED the oil drillers to use a specified model of risk of oil spill damage.  According to the article, the model set the risk very close to zero, making it not sensible to spend any money on safety of the rigs or on preparation for a spill.  So that was the way that the drillers leveraged up their risk.  By taking fewer and fewer precautions against a problem, until one did occur.  And the wrong model from the regulators resulted in the situation where none of the firms were prepared for a spill, and furthermore, it probably led to much of the complacency the immediately followed the rig exploding.

So if you find yourself in a business where the regulators are specifying the risk management floor, beware.  It is quite likely that sooner or later that floor will collapse from under all who are standing on it.

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2 Comments on “Regulatory Risk Management”

  1. […] Regulatory Risk Management (June 2010) The extreme pitfalls of a high degree of regulatory involvement in risk management. […]

  2. Max Rudolph Says:

    This revelation is like a Black Swan risk, as readers will say “of course this is true” but only after they read the article. I would argue that the argument can be generalized to all external stakeholders and not just regulators. Pseudo regulators like rating agencies also have the ability to consolidate practices. A better practice is for stakeholders to require a benchmark process along with the firm’s internal model. Transparency will provide peer pressure for the models to address exposure risks.

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