Fed Chair Details Regulatory Response to Risk Management Failures

Federal Reserve Board Chair Ben Bernanke has concluded that a failure of effective enterprise-wide risk management was a major cause of the recent subprime market turmoil. A regulatory response is demanded, he noted, and the Fed is planning one involving additional guidance and joint international efforts. In remarks at a recent Chicago Fed seminar, the chair also discussed individual core components of risk management, including risk identification and liquidity risk.

Given the central role of effective, firmwide risk management in maintaining strong financial institutions, emphasized the Fed chair, regulators must redouble their efforts to help organizations improve their risk management practices. Thus, the Fed is giving increased attention to financial institutions that are in most need of improvement, but will also continue to remind the stronger institutions of the need to remain vigilant, particularly in light of the ongoing fragility of market conditions.
The Fed is considering the issuance of revised guidance regarding various aspects of risk management, including further emphasis on the need for an enterprise-wide perspective when assessing risk. The Fed is also working through the Basel Committee on Banking Supervision to develop enhanced guidance on the management of liquidity risks. At the same tine, the Fed is promoting better disclosures by financial institutions with the goal of increasing transparency.
Implementation of the Basel II Accord will also be of help, said the chair, since Basel II enhances the quality of risk management by tying regulatory capital more closely to institutions' underlying risks and by requiring strong internal systems for evaluating credit and other risks. Although Basel II will by no means eliminate future episodes of financial turbulence, reminded the chair, it should help to make financial institutions more resilient to shocks and thus enhance overall financial stability.
At the same time, the Fed will ensure that the Basel II framework reflects the lessons of recent events. The Basel Committee has been evaluating how the framework might be strengthened in areas such as the capital treatment of off-balance-sheet vehicles and the use of credit ratings. The relatively lengthy transition to Basel II will allow more opportunity to absorb the lessons of the financial turmoil and make necessary adjustments to the framework.
For risks to be successfully managed, reasoned the Fed chair, they must first be identified and measured. Unfortunately, recent events revealed significant deficiencies in these areas, with a notable example being the underestimation of the credit risk of subprime mortgages and tranches of securitized products. Other firms did not fully consider the linkages between credit risk and market risk, leading to mismeasurement of their overall exposure.
Stress tests can provide a valuable perspective on risks falling outside those typically captured by statistical models, noted the official, such as risks associated with extreme price movements. Stress testing forces practitioners to step back from daily concerns to think through the implications of scenarios that may seem relatively unlikely but could pose serious risks to the firm if they materialized. For stress tests to be useful, they should be relevant to the business at hand, change with market and risk positions, and, have an impact on management's decisionmaking. Applying stress tests to several business lines at the same time is operationally challenging, he acknowledged, but exercises of this type can reveal previously undetected firmwide risk concentrations that cut across the banking book, the securities portfolio, and counterparty exposures.
In his view, another crucial lesson from recent events is that financial institutions must understand their liquidity needs at an enterprise-wide level and be prepared for the possibility that market liquidity may erode quickly and unexpectedly. Weak liquidity risk controls were a common source of the problems many firms faced. He urged financial institutions to develop firmwide strategies for liquidity risk management that incorporate information from all business lines. A best practice is to develop firmwide strategies that include consideration of the liquidity risks associated with structured investment vehicles.