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Home > Blogs > Anthony Harrington > Rethinking risk management – the ECB takes stock

Rethinking risk management – the ECB takes stock

Global risk | Rethinking risk management – the ECB takes stock Anthony Harrington

At a recent speech to delegates at a conference on Risk and Return in South Africa, José Manuel González-Páramo, Member of the Executive Board of the ECB, talked about the lessons learned from the crisis as far as risk management is concerned, and about the way thinking about risk management has changed. The ECB, he told his audience, has always placed a great importance on the design, development and implementation of sound risk management policies. One might wonder, that being the case, why European banks were allowed to be quite as daft as they were, or to get themselves into as much trouble as they did, but that would be hindsight talking. In the build up to the crash, the ECB thought it was doing its job fairly competently.

González-Páramo lists five of the possible causes of the crash, or contributory causes, since they all clearly had some role. These are:

a)   excessive borrowing prompted by low interest rates

b)   the build up of asset bubbles

c)   biased incentives for bankers and others in the financial services sector

d)   the failure by regulators to adapt to the latest evolution of the financial system

e)   market failures related to the lack of transparency about risks and products

f)    conflicts of interest affecting key agents in the securitization process

g)   the failure of investors to carry out due diligence

Personally I find it extremely difficult to quarrel with any of these as a contributory cause, nor with his statement that the eventual underperformance of the sub-prime sector was the spark that triggered the crisis. His terse summary of how the crash unfolded is also admirable:

"In the summer of 2007, as highly leveraged investors were forced to unwind some positions to cover margin calls, liquidity in some fixed-income markets dried out completely. Investors found themselves trapped and were forced to sell assets at considerable discounts. In some cases further sales - particularly for subprime Mortgage Backed Securities - were forced by stop-losses and Value-at-Risk based risk budgets. Liquidity risk-related losses piled up over losses registered as a result of fair value accounting as risks in the real estate sector started to materialise on a scale unseen since the Great Depression."

As González-Páramo notes, only one or two elements in his catalogue of causes really call for new thinking. The rest all comes down to shoddy work by the financial services sector, which in effect punted risk management out the window and gave the sales desk its head. In his words, “Common sense risk management practices such as 'know your counterparties', 'invest only in products you understand', 'do not outsource credit risk management', 'do not rely exclusively on quantitative models'..." were all cast aside in the dash for cash.

The cure, one would have thought, given this analysis, would be blindingly simple. Reinstate proper risk management and give the poor old risk manager some clout and a voice that can make itself heard effectively at Board level. The debate should then move on to how this can be achieved.

Instead of really learning lessons, González-Páramo suggests that what has happened is that investors and institutions have simply become over-reactive. As he puts it, "… market reactions to recent rumours about the financial soundness of institutions and sovereigns have been in some cases 'off-the-charts'". Veering from being seemingly indifferent to risk, to being wildly risk averse, is not true learning, he notes. However, he also adds the interesting point that henceforth central bankers will need to take “behavioural factors” (the herd stupidity of investors?) into account rather more than they have hitherto. “It seems obvious that we need to incorporate into our decision-making process and in the models we use to support it, the notion that markets are driven by behavioural factors."

Where González-Páramo's analysis is weakest, it seems to me, is when he goes on to talk about the need to enhance “the global financial infrastructure to mitigate counterparty risks and to limit the channels of contagion of firm- or sector-specific shocks.” The point here is that you cannot have your cake and eat it. If you have cross-border financial institutions, which would seem to be a prerequisite for globalisation, then the interrelationships between organisations and sectors are going to get very complicated.

Glass-Steagall was an attempt to avoid over-complication by separating investment banking from deposit taking, commercial banking. A raft of other rules have been tried, such as forbidding banks to own insurance companies, but ultimately the risk of contagion goes hand in hand with the benefits of globalization. I would be astonished if it ultimately turns out to be possible to design a system which gives us one without the other. I will also be hugely impressed if the current regulatory flurry really does deliver a responsible regulator with an adequate overall view of all systemic risks as they form, so that bubbles are nipped in the bud. If this was really the aim we’d do away with fractional reserve banking and the right of central banks to inflate credit, but I don’t see that happening any time soon.

Further reading on global risk management:



Tags: contagion , ECB , European Central Bank , Glass-Steagall Act , globalisation , leverage , risk management
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