Former NY Fed President Describes Difference between Risk Monitoring and Risk Management

With Congress poised to pass legislation creating a federal systemic risk regulator for the financial markets, former NY Fed President Gerald Corrigan emphasized the critically important difference between risk management and risk monitoring. In testimony before the UK Treasury Committee, he noted that risk monitoring has to do with getting the right information to the right people at the right time, while risk management has to do with what you do with the information once you have it.

Mr. Corrigan, currently a Goldman Sachs Managing Director, was also Chair of the Counterparty Risk Management Policy Group, a creation of the President’s Working Group on Financial Markets, which filed a seminal report on containing systemic risk.
A central recommendation of the group is that a risk management function, with a Chief Risk Officer, must be positioned within all large integrated financial intermediaries in a way that ensures that their actions are independent of the firm’s income producing business units.

The former NY Fed chief said that leading to the financial crisis there were important failures in risk monitoring that by their nature suggested that risk management would suffer accordingly. If a financial firm does not do risk monitoring well, he reasoned, the firm will have a problem with risk management. They are interconnected and co-dependent. He also noted that a firm dealing in derivatives should have some idea about the effectiveness of risk management at its counterparties.

With regard to measuring risk using the Value at Risk measurement, Mr. Corrigan first stated that the framework within which his firm works, through a whole family of stress tests, has changed in a very material way over the past two years. While his firm was always among the most progressive firms in the industry in terms of the design and rigor of the stress test it employed before the crisis, he noted, over the past two years that effort has been taken ``many steps up the ladder.’’

For example, the firm developed sophisticated procedures through which it can obtain rigorous scenario and stress test results and take them on a thoroughly integrated basis through the P&L on a global basis within a matter of time. The firm has also substantially upgraded the speed with which it can compile counterparty exposures to any counterparty just about any place in the world across all legal entities and all product groups. The firm has also introduced the use of reverse stress tests as kind of overlay to the more aggressive stress tests that are used in the first place.

The primary use of reverse stress-testing is as a risk management tool to improve business planning and risk management rather than to inform decisions on appropriate levels of capital or liquidity specifically.

In reverse stress-testing, a firm identifies and assesses the scenarios most likely to render its business model unviable. Generally a firm’s business model would be unviable at the point when crystallizing risks cause the market to lose confidence in the firm. A consequence of this would be that counterparties would be unwilling to transact with or provide capital to the firm and, where relevant, that existing counterparties may seek to terminate their contracts. Such a point could be reached well before a firm’s regulatory capital is exhausted.

Using reverse stress testing, firms identify what could cause their business to fail and use this information to ensure that the relevant risks are sufficiently well-understood and appropriately managed to secure consumer protection and market confidence.

The Financial Services Authority views reverse stress testing as an important complement to the suite of stress tests that firms are required to carry out. The FSA’s new reverse stress testing mandate is designed to encourage firms to explore more fully the vulnerabilities of their current business plan, including milder adverse scenarios, and make decisions that better integrate business and capital planning, as well as to improve their contingency planning.

The design and results of a firm’s reverse stress test must be documented, reviewed and approved at least annually by the firm’s senior management or governing body. A firm is required to update its reverse stress test more frequently in light of substantial changes in the market or in macroeconomic conditions.

.