The Hindu Business Line : ‘Better risk management to fight financial turmoil’

New Delhi, Feb. 9 In the wake of the recent major financial market turbulence across the world, central bankers need to sharpen incentives for regulated institutions to improve risk management and stress-testing practices, and the adequacy of their capital and liquidity buffers.

Interim Report

This is the broad conclusion of the Basel -based Financial Stability Forum (FSF)-appointed Working Group on Market and Institutional Resilience’s interim report.

The report was provided to the G-7 Finance Ministers and Central Bank Governors meeting in Tokyo (Japan) on Saturday, according to the central bankers’ central bank — the Bank for International Settlements (BIS).

Asset pricing

Stating that the most immediate task for market participants is to rebuild confidence in the creditworthiness and robustness of financial institutions, the Group said realistic asset pricing is critical to restore asset market liquidity and market-based credit intermediation.

Firms need to recognise the realistic market value of their assets and the uncertainties that exist around those values. It said unusually benign global macroeconomic, monetary and financial conditions over recent years bred high risk appetites, a reach for yield and rising leverage among financial institutions, investors and borrowers.

A wave of financial innovation fostered instruments and risk exposures so complex that risk management systems at a broad range of financial institutions, including many of the largest global banks, failed to control them effectively.

Among the specific weaknesses that the Working Group identified include poor underwriting and some fraudulent practices in the US sub-prime mortgage sector, shortcomings in firms’ risk management practices, poor performance by the credit rating agencies in evaluating risks of sub-prime residential mortgage backed securities, and CDOs (collaterised debt obligations) of asset-backed securities.

Identify Amplifiers

Referring to amplifiers that shaped the responses of market participants and public authorities to market shocks, it said these include bank-sponsored off-balance sheet vehicles (conduits and SIVs) that issued shorter-term liabilities against these complex products and lacked adequate capital and liquidity resources, actions by firms to build up liquidity to fund contingent commitments and shortcomings in modelling and valuation of complex instruments.

It called upon supervisors and central banks to work in concert to identify and address practices and mechanisms that have the effect of amplifying market turmoil once it breaks out. A significant element in the present turmoil was the re-concentration of liquidity and credit risks into banks’ balance sheets from off-balance sheet entities they had constructed.

The market shock was also amplified by uncertainty about the distribution of losses, the unforeseen linkages among certain types of risks, the uncertainty surrounding asset valuations and the size of exposures to underlying credit problems relative to banks’ capital base, it added.

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‘Better risk management to fight financial turmoil’