Yandraduth Googoolye: Credit risk and market risk - the journey ahead
Opening and closing remarks by Mr Yandraduth Googoolye, First Deputy Governor of the
Bank of Mauritius, at the working session on "Credit risk and market risk - the journey
ahead" at the Federation of Indian Chambers of Commerce and Industry and Indian Bank's
Association Conference on "Global Banking: Paradigm Shift" Theme: "Navigating
successfully in an uncertain world" Mumbai, 7 November 2008.
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Ladies and Gentlemen
It is a pleasure for me to chair this afternoon session on Credit risk and Market risk, a subject
whose importance is gaining momentum among policymakers these days.
Economic theory tells us that Credit risk and Market risk are intrinsically related to each other
and are not separable (Jarrow and Turnbull: 2008). With financial innovation, the interaction
between Credit risk and Market risk has itself become even more complex today. The recent
financial crisis has indeed showed us how a credit risk event can trigger other market related
and liquidity related risk events.
The sub-prime crisis in the United States, which has its origin in protracted low interest rate
policy, has shown us how our interest rates setting decisions impact on credit risk - a linkage
that has been somehow neglected over recent times. As we coordinate our efforts to ease
monetary conditions to curb the growing risk that our economies would dip into recession; we
need to be vigilant on the long term consequence of our decisions today, to avoid another
financial turmoil in future.
Financial innovation has spurred the development of risk management tools but it has also
brought together various other forms of risk into financial products, making the art of risk
management even more sophisticated. The rapid growth of derivative instruments blurs the
dividing line between the established concepts of Credit risk and Market risk. The trading of
credit derivatives and other exotic securities has transformed credit risk into market risk.
When the credit conflagration morphed into a fully-fledged panic in financial markets over the
last few weeks, the major stock markets plunged.
A decade or so ago, technological innovation produced securitized and other credit
derivatives to help financial institutions to manage risks (credit or liquidity). Those
instruments quickly gained popularity among practitioners as they promised to transfer credit
risk to those who were supposedly in a better position to bear those risks while contributing
to financial stability. As these instruments grew in complexity, existing risks were transformed
into other risks and new risks emerged. Those risks were typically measured and managed
in isolation from one another, whereas in reality, they are closely linked. A credit event that
drives down the value of a particular asset is likely to reduce the liquidity and price of that
asset as well, at least in the short term. Therefore, as trading in those credit instruments
grew, new portfolio models were developed to take on board the interaction between Credit
risk and Market risk.
Traditionally, regulation has distinguished between Credit risk and Market risk, and has
treated both risks independently. The Basel II Accord requires banks to keep capital for
Credit risk for banking book exposures and Market risk for trading book exposures. However,
it does not provide an implicit capital cushion for correlation between the two risks, other than
a capital charge for counterparty credit risk for certain trading book exposures. However,
emphasis is put on stress testing credit portfolio for these types of events.
The recent events in financial markets have brought Central Bankers, Regulators and risk
managers to rethink and question the reliability of these new risk management systems for
Credit risk and Market risk; and the diversification effects and the relevance of risk
aggregation embedded in these instruments.
Having said this, it may also be opportune to reflect over the future of regulatory practices for
Credit risk and Market risk.
Ladies and Gentlemen, as my time is almost over, let me take the next few minutes to tell
you more on our distinguished speakers for this session. We welcome today, experts from
McKinsey & Company.
(Presentations by the speakers)
Concluding remarks
I thank you all gentlemen for your fruitful presentations on such an interesting topic. This
session has indeed been very informative for all of us present today and I hope that we may
all draw lessons from your presentation on Credit risk and Market risk, particular on part of
the presentation that was focused on the experience of Indian banks in managing those
risks.
I now wish to quote a few sentences from the report: "Towards Superior Risk Management in
Indian Banking."
"Banks will need to continuously refine today's practices. It is important to
constantly revisit the risk architecture through the on going refinement of
models, stress testing scenarios, revalidating limits, redesigning customer
facing processes and restructuring of the organization. This also implies
broadening the traditional purview of risk management to include newer
practices such as reputational risk, business process re-engineering and
concurrent audit improvement."
To conclude, as banking gets more sophisticated, risk management systems should be able
to size up the newer risks the operations expose a bank to. Therefore, while the banking
sector has grown rapidly and displayed high resilience, the need for continuous vigil on the
part of bank managements and the regulator can hardly be overemphasized. For me
therefore, it is the systems and processes for being able to anticipate risk events in time in a
complex financial world that should be the focus area for banks the world over including the
banks in India.
Thank you all for you attention.