Crossroad of ERM

The ninth ERM Symposium in Chicago was the crossroads of ERM for a few days.

Heard there:

• The Financial crisis was not the failure of regulators, except perhaps the OTS.
• Compliance culture of risk management in banks contributed to the crisis
• 85% of bank losses were from the structured finance area.
• Securitization was 30 years old, but there was a quantum jump of complexity.
• Banks were supposed to have been sophisticated enough to control their risks.
• Discussion of subsidization of housing was broadly blamed.
• Riskviews suggests that only a tiny part of the fault is with housing policy.  Rest is simply finger pointing at best and deliberate misdirection at worst.  Losses and problems in banks were 400% or more higher than actual losses in mortgages, possibly 1000% or more higher.  Severe losses resulted from using housing as the basis for gambling.  They could have just as easily have bet on rainfall.  Then would they blame the weather for the losses?  Securities in play far exceeded the amount of mortgages.  And the multiple layers of bets concentrated on the worst stuff.
• Regulators need to keep up with innovation and excessive leverage from innovation.
• Riskviews:  No evidence that regulators have even started to deal with excessive leverage except in the crudest manner.  It is still possible to derivatives to skip right past leverage rules.  If you can replicated a highly levered position with a derivative position, then the derivative position IS A HIGHLY LEVERED POSITION.
• German regulator requires that banks have a Risk Controller who reports directly to the board.
• ERM is not an EASY button from Staples.
• Energy firms that had excessive trading losses were allowed to fail.
• Banking suffered from concentrated opacity.
• The board has to challenge management about risk.  Masters of the Universe approach or the smartest guys in the room tries to intimidate the board into feeling too stupid if they ask any questions.
• There will need to be major cultural changes for ICAAP/ORSA to be effective.
• Many banks and insurers should be failing the use test for ERM regulation to be effective.
• Stress testing is becoming a major tool for regulators.
• European regulators could not apply real stress tests because that would have meant publicly asking banks to look at a scenario of major sovereign defaults in Europe.
• Regulators need to be able to pay competitive market salaries
• Cross boarder collaboration among regulators has broken out.
• Difficult for risk managers to operate under multiple constraints of multiple regulators, accounting systems.
• Riskviews: It would be much faster to reach wrong conclusions if there were only one system to worry about.  That is not the way to go if there is really a concern about risk.  The multiple points of view encourage true understanding of the underlying risks.
• Banks are natural oligopolies
• Nice tree/forest story:  Small trees take resources from the forest.  Large trees shade smaller trees making it harder for them to get sunlight.  Old trees die and fall crashing through the forest taking out smaller trees.
• Riskviews:  This story illustrates to me that there is too much worry and manipulation to try to fix short term issues.  Natural processes work fairly well.  But interference has allowed a few trees to grow so large that little else can gro making the forest unhealthy.  Solution is to trim largest trees and plant/encourage new smaller trees.
• Things that people say will never go wrong will go wrong.
• Compliance should be the easy part of ERM, not the whole thing
• Asking dumb questions should be seen as good for firm.  10th dumb question might reveal something that no one else saw.
• There is a lack of imagination of adverse events.  US has cultural optimism.  Culture is risk seeking.
• Swiss approach to regulating banks is for their banks to hold the most capital.  Credit Swisse has signaled that they will seek lower return on capital.  Using that as marketing advantage – they are the most secure banks.
• 90% of Risk Management professionals believe that Dodd Frank will push the risks of the financial system out of regulated banks into unregulated financial enterprises. (Hedge Funds)
• Trade-off between liquidity and transparency is not true
• Requirements to post collateral may not increase costs at all for non-financial firms.  The dealers were changing them for the lack of collateral.  Prices may go down net of all costs.
• Bear Stearns was well capitalized.
• People understand and prefer principles based regulation.  But when trust is gone everything moves towards rules.
• Riskviews:  MTM should be adjusted for illiquidity.  Much larger adjustment than being contemplated for illiquid insurance liabilities.  Need to compare position size to trading volume.  If position is much larger than trading volume then liquidity adjustment needs to reflect possible price movements during the time needed to liquidate.
• Many CROs have been given the role of minimizing capital required for the firm.
• Insurers are moving rapidly to the bank model for this.
• The range of ERM practices are narrowing
• Riskviews: Narrow range of practices is only a good thing if the next large risk event is cooperative with practices that everyone is using.  Diversity is much, much healthier.
• Need to get rid of arb between trading and banking books in banks.
• FSA wants the whole world on one standard
• Riskviews: Solves one problem.  Creates another that is doubtless much, much larger.
• Difficult to explain decisions when there are multiple accounting and regulatory systems.
• Investors need to do their own due diligence
• Counterparties are not your friends.
• Supervisors need to learn to say no.
• Caveat Emptor
• Riskviews: Modern US society has moved in the opposite direction of Caveat Emptor.  It is always someone else’s fault.  Risk Management needs to overcome this tendency.
• Businesses need to learn to say no to non-core activities, no matter how good they look.  They usually do not have the expertise to really examine them, not to manage them.
• A risk metric that makes you more effective makes you special.
• Do we overtrade?
• Reduction of ROE target would take off pressure to take excessive risks.
• Regulators put 80% weight on model and 20% weight on judgment.  Should be the other way around.
• We have shifted to being too focused on risk, need to balance business need for returns.
• There will be unintended consequences from the major shifts in regulation.
• Must not freeze in a crisis.  Need to act and act approximately correctly.
• Moral Hazard was a major issue.  Some people should be put in jail because of the crisis.
• Riskviews: The losses to bank executives and employees were enormous.  People look at salaries of remaining bankers, forgetting that there are now 10% to 20% less of them.  Shareholders of Citi are still off 90% from the peak.  Execs whose net worth was largely in stock holdings and stock options are still out quite a large amount of money.  Riskviews has trouble understanding the moral hazard argument.  It does not match up well with any facts except the bail outs.  Moral hazard ONLY seems to have impact on creditors of banks.  Not unimportant but not the largest driver in bank activities.
• SIFI do get GSE level cost of borrowing.
• Riskviews: My question is why it is good public policy for monetary policy to transfer so much money to the shareholders and employees of banks?  They have been able operate at approximately zero cost of goods sold for four years now.  Their lending rates do not pass all of those savings along.  Why does it make sense for the banks to find themselves to be so smart and well paid when they are being totally supported by monetary policy.  In any other business you would have to be totally brain dead to not succeed if someone gave you your raw materials for free.
• More market discipline is needed.
• Riskviews:  AMEN

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