Financial Risk Management in the 21st Century

Last week, an article in InformationWeek magazine profiled the current issues with the financial industry's risk management practices and offered some solutions.  The article compared the approaches to risk management in the financial industry to the design and production of computer chips.  Both are highly complex exercises.  However, risk management to date lacks the standardization and control found in chip manufacturing.  Here is what the article suggests as a solution.

The industry's kludge-filled, error-prone, and unsafe financial engineering needs to be replaced with a more secure financial infrastructure that's been tested and debugged to the level of a major chip release. Regulatory oversight won't be simple, but it doesn't have to be. It just has to work, every single day and for every single transaction. That's the type of change with the potential to jump-start a global economy.

Through stronger controls over data collection, improved networking among industry participants, and greater use of standards across a wider range of financial instruments, the future of the financial services industry can be assured in a way that enables a bright future for the rest of the economy. It's high time for the industry's circuits to get an upgrade.

The article provides a unique perspective on a major problem.  The solution is fairly obvious, but the task is massive and will require a significant investment to successfully implement.  However, our global economy and the financial services industry as a whole will suffer additional crisis situations in the 21st century without this sort of change.

Global Solutions for a Global Problem

Last week, the Wall Street Journal in the United Kingdom published an article featuring the views of Britain's Financial Services Authority Chairman Adair Turner.  Given the continued debate and relative inaction from the U.S. Congress, the thoughts from Lord Turner are particularly refreshing.  Here's what he had to say:

One, finance got too big. "We must be more willing to ask...whether the financial system is delivering its vital economic functions as efficiently as possible, or whether parts of it can, and before the crisis did, swell beyond their economically efficient size," he said in a recent speech.

Two, there was too much debt in the system. "There is a huge bias in the tax system towards debt," he said, largely because companies can deduct interest payments before computing taxable profits. "If we can't change that, then the regulatory approach needs to lean against that."

Three, regulators failed to curb excesses, but politicians hardly encouraged aggressive regulation. The cry for "better regulation" meant less regulation, both in the U.K. and U.S. The diagnosis of Britain's economic woes was that regulation was stifling entrepreneurship, he said.

Four, erecting a wall between ordinary deposit-taking and lending, on one hand, and trading on the other is impractical and unwise. Economies benefit when banks turn loans into securities or hedge their positions -- to a point. But by forcing banks to hold capital in the trading operations to provide thicker cushions to absorb losses -- he calls it "a bias towards conservatism" in trading beyond what is necessary for ordinary banking -- speculative trading will migrate away from banks toward hedge funds and the like, a change Lord Turner welcomes.

Five, for all the angst about the slow pace of post-crisis repair of the financial system, global regulators are making surprising progress toward consensus on a new regulatory regime. "We are attempting in 18 months to do changes far more radical than we did in Basel II that took between 12 and 15 years and dealt with some of the areas which proved to be less important," Lord Turner said, referring to the pact regulators reached in the Basel Committee on Banking Supervision that didn't avoid the crisis. Pushed by the newly empowered Financial Stability Board, the process, he said, "has worked better than I would have expected," he said.

Since the crisis was global in both cause and impact, it is encouraging that some are working towards global solutions to the problem.  As the regulatory reform effort unfolds, the U.S. must ensure that our reforms are aligned with our global partners.

Fair Warning to Improve Risk Management

This week, a report was published by the Senior Supervisors Group ("SSG") regarding risk management lessons learned from the 2008 financial crisis.  For those who do not know, the SSG is a group of central regulatory agencies from seven nations including the United States.  The report highlights the following deficiencies in risk management practices at major corporations across the globe.

Some of the highlighted areas of greatest need, such as board and management oversight, articulation of risk appetite, and compensation practices, are potentially a result of the aforementioned imbalance between the stature and resources allocated to firms’ revenue-generating businesses and those afforded to the reporting and control functions. Other areas, such as risk aggregation and concentration identification, stress testing, and credit and counterparty risk management, can also be attributed to the weak condition of many firms’ IT infrastructure. While considered central to sound firm governance and risk management, the areas of continued improvement addressed here are not exhaustive.

In highlighting the areas where firms must make further progress, we seek to raise awareness of the continuing weaknesses in risk management practice across the industry and to evaluate critically firms’ efforts to address these weaknesses. Moreover, the observations in this report support the ongoing efforts of supervisory agencies to define policies that enhance financial institution resilience and promote global financial stability.

This report serves as fair warning for financial institutions to proactively strengthen their own risk management practices before the regulatory authorities are compelled to force necessary changes.  If your company is looking for cost-effective solutions, Wheelhouse Advisors can help.  Visit www.WheelhouseAdvisors.com to learn more.