José Manuel González-Páramo: The challenges of credit risk
management - lessons learned from the crisis
Speech by Mr José Manuel González-Páramo, Member of the Executive Board of the
European Central Bank, at Risk Europe 2010, Frankfurt am Main, 26 May 2010.
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Ladies and gentlemen,
It is a great pleasure for me to address again this year, for the second time in a row, the
annual Risk Europe conference here in Frankfurt. I would have liked to say that this simply
shows the great importance that the ECB places in the development of sound and effective
risk management practices in the financial industry. However, I must admit that my
eagerness to address this forum is also a result of the great challenges that we, central
banks and private financial institutions alike, continue to face collectively in managing risk.
These challenges seem to persist, although they have been changing face. The high levels
of uncertainty manifested in unprecedented levels of asset volatility in the years 2007-2009
emanated originally from liquidity shortages in the off-balance sheet management of highly
complex assets. In late 2009 and 2010 we have seen again high levels of volatility, this time
associated with concerns about the large fiscal imbalances in some EU Member States.
In both phases of the crisis, financial markets have reacted to the increasing fear that some
market participants may fail to honour their obligations; they have in other words experienced
an increase in credit risk. Under the general concept of credit risk I would include both the
risk of default of issuers of securities held in portfolios as well the counterparty risk faced in
over-the-counter transactions. Today I would like to share with you some thoughts on the
management of such risks in general and in central banks in particular.
General principles in the management of credit risk
It is widely accepted (but not appropriately emphasised) that one of the causes of the deep
financial crisis witnessed since mid 2007 has been the deviation from well established
principles in the management of risk (in particular credit risk) by financial institutions.
Common sense risk management practices such as "know your counterparties", "invest only
in products you understand", "do not outsource credit risk management by relying exclusively
on external credit assessments", "do not rely exclusively on quantitative models, however
sophisticated" had been abandoned. It is interesting to recall at this stage the work of the
original Counterparty Risk Management Policy Group1 co-chaired by E. Gerald Corrigan and
Stephen G. Thieke which already in 1999 stressed that "better knowledge of one's
counterparty represents the foundation upon which the other pillars of risk management
rest". Re-establishing these principles in risk management practice is essential for the
resilience of the financial system.
I would like to highlight in particular the trend witnessed in recent years for many market
participants to exclusively rely on external assessments for the management of their credit
risk. These assessments have been often provided by only a small number of specialised
institutions (rating agencies). The critique on the role of rating agencies has become a
recurring theme in all analysis of the current crisis. In addition to potential conflicts of interest
embedded in their business models, rating agencies have faced questions on their
methodology, in particular in the area of structured finance, and the lack of transparency in
their activities. The ex-post assessment of the performance of their ratings in the last two
years has raised serious concerns. At the same time the use of credit rating in legislation,
regulations, and other supervisory policies is so widespread2 that I would agree with the
Financial Stability Forum which has questioned whether it is not these policies that
unintentionally give credit ratings an official seal of approval and discourage investors from
performing their own due diligence. This should certainly be one of the main concerns of
regulatory authorities in the immediate future.
How central banks address credit risk
Central banks are unique as market participants because they do not face liquidity risk in
their own currency. However, they are not immune to credit risk. Losses occurred because of
a default of one of their counterparties or an issuer of a security they hold in their portfolio
can deplete their financial buffers. Although their financial survival does not depend in any
vital way on such buffers, their perceived lack of financial resources could irrevocably
damage their credibility in the market and thus their ability to implement monetary policy and
safeguard financial stability. Furthermore, if a recapitalisation of the central bank by the
government becomes ultimately necessary, it could jeopardise the independence of the
monetary authority.
In general central bank risk management is considered conservative, so that overall it could
be perceived that the development of an elaborate risk management framework is not really
necessary. However, the central bank becomes an above average risk taker in a crisis
situation - first of all by showing inertia in its risk management framework. There is thus
some fundamental transformation taking place in the risk tolerance of the central as it
continues operating in a financial crisis when other market participants have long adopted a
very conservative approach. At a time when all risk measures (probabilities of default of
collateral issuers and counterparties, correlations, expected loss, VaR-measures) have gone
up dramatically and financial institutions are cutting credit lines and are increasing margin
requirements in the interbank market, the central bank becomes the lender of last resort. In
such a situation its risk taking increases considerably. This suggests that the management of
the central bank's risk exposures is even more important in a crisis and requires, at least
then, a very carefully designed risk management framework.
Credit assessment in the Eurosystem
The experience of the financial crisis has led the Eurosystem to solidify the already elaborate
credit risk assessment framework it uses in its credit operations. Let me now give you some
more information on the way the Eurosystem handles credit risk assessment in the context of
its own credit operations. As you are probably aware, Article 18.1 of the Statute of the ESCB
requires that all credit operations conducted by the ECB and the National Central Banks
(NCBs) should be based on adequate collateral. In particular all such collateral must meet
high credit standards.
The Eurosystem has defined an elaborate framework of credit assessment (the European
Credit Assessment Framework - ECAF) to ensure that such standards are met. In the
assessment of the credit standard of eligible assets, the Eurosystem takes into account
credit assessment information from credit assessment systems belonging to different
sources. Some of them are private, namely external credit assessment institutions (ECAIs),
counterparties' internal ratings based (IRB) systems and third-party providers' rating tools
(RTs). Others are public, namely the national central banks' in-house credit assessment
systems (ICASs), Additionally, in the assessment of the credit standard, the Eurosystem
takes into account institutional criteria and features guaranteeing similar protection for the
instrument holder such as guarantees.
The performance of all credit assessment systems that are accepted by the Eurosystem is
closely monitored. On an annual basis the observed default rate for the set of all eligible
debtors assessed by a particular system is compared to the credit quality threshold set by
the Eurosystem. This way, the results from credit assessments are comparable across
systems and sources.
With regard to the ECAI source, the Eurosystem does not automatically follow the
assessments provided by a rating agency. First, any such assessment must be based on a
public rating. Even then, the Eurosystem reserves the right to request any clarification that it
considers necessary. In particular when it comes to asset-backed securities, a number of
transparency requirements are imposed. Ratings must be explained in a publicly available
credit rating report, namely a detailed pre-sale or new issue report, including, inter alia, a
comprehensive analysis of structural and legal aspects, a detailed collateral pool
assessment, an analysis of the transaction participants, as well as an analysis of any other
relevant particularities of a transaction. Moreover ECAIs must publish regular surveillance
reports for asset-backed containing an update of the key transaction data (e.g. composition
of the collateral pool, transaction participants, capital structure), as well as performance data.
The need for better understanding of the underlying assets in securitised transactions was
emphasised by the ECB when it launched a public consultation on loan-by-loan information
requirements for asset-backed securities (ABSs) in the Eurosystem collateral framework.
With this initiative, the ECB strives to promote an improvement of disclosure standards in
securitisation markets from current levels. Such higher standards would contribute to
avoiding the inadequate assessment of risks in the underlying asset pools of ABSs by
investors and the exclusive dependence on third-party assessments that was at the core of
the current crisis.
Finally, I would like to emphasise one important element of our framework. Despite the fact
that the Eurosystem uses ECAI ratings as one of its credit assessments it still reserves the
right to determine whether an asset fulfils the requirement for high credit standards on the
basis of any information it may consider relevant from a risk management perspective.
Therefore it should not come as a surprise that on 3 May 2010 the ECB decided to suspend
the application of the minimum credit rating threshold in the collateral eligibility requirements
for the purposes of the Eurosystem's credit operations in the case of marketable debt
instruments issued or guaranteed by the Greek government. This suspension was based on
the positive assessment on the side of the Governing Council of the ECB, in liaison with the
European Commission and the International Monetary Fund of the Greek government's
economic and financial adjustment programme. The measure acknowledged therefore the
strong commitment of the Greek government to fully implement the programme and was an
example of the ability and will of the ECB to make an independent credit assessment.
The connection between credit and liquidity risk
While I have emphasised so far credit risk management, I would also like to touch upon the
more elusive concept of liquidity risk. The current financial crisis has been triggered by the
inability of some financial institutions to fund some complex assets. It has been traditionally
thought that while such a situation may put the institution at strain, it should be clearly
distinguished from that of an insolvency. However, the experience of the last three years has
showed that the distinction is far from simple. A prolonged period of liquidity difficulties may
easily leave no other choice to the institution than an emergency sale of assets at significant
losses and a subsequent depletion of its capital position. Therefore a liquidity problem, if it
cannot be properly addressed - possibly by the intervention of the central bank- can easily
lead to insolvency.
In recognising the importance of liquidity risk and the systemic implications of a liquidity
crisis, the Basel Committee issued a consultative document on an international framework
for liquidity risk management, standards and monitoring in December 2010. The document
put forward two liquidity risk standards and a set of tools for ongoing monitoring of liquidity
risk exposures and information exchange among supervisors. The two standards, namely (i)
a global minimum "liquidity coverage ratio" which aims at capturing liquidity risk in the short
term by ensuring that banks hold sufficient high quality liquid assets to withstand an acute
stress lasting one month; and (ii) the longer term "net stable funding ratio" which aims at
incentivising banks to fund themselves using more stable sources on a structural basis by
establishing a minimum acceptable amount of stable funding based on the liquidity
characteristics of the financial institution's assets and activities over a one year time horizon.
A discussion has been triggered and various concerns were voiced on the calibration of the
standards, which in the view of some could generate significant negative repercussions for
the real economy, for certain markets (such as the money market and interbank market) and
for the business models of some banks. Central in this discussion is the question on the set
of assets considered eligible for the short-term liquidity standard. It has been claimed that the
proposal is not in line with the severe stress scenario that is assumed and that it could lead
to concentration risk as well as higher cost for the assets that are not included. Furthermore,
the design of the longer-term standard was questioned, as it was argued that a higher level
of mismatch between assets and liabilities is necessary for banks to fulfil their intermediation
role in the economy.
The ECB has a particular interest on the Basel Committee proposal on liquidity risk as it
relates to the implementation of monetary policy, has an impact on the money market, as
well as possible consequences on the financial integration in the Euro area. Clearly the
proposed liquidity standards address the major shortcomings identified by the financial crisis
in the area of liquidity risk by requiring banks to increase their holdings of liquid assets and to
reduce their reliance on short-term volatile funding sources. Furthermore, enhancing the
liquidity risk management of banks could have a positive impact on market confidence,
reducing thus the volatility in money and capital markets.
Still the calibration of the proposed liquidity standards needs to be revisited to take into
account the comments received during the public consultation and their impact on the
banking sector, financial markets and the overall economy. Finally, the establishment of an
appropriate phase-in period that will allow banks to adjust their balance sheets without an
undue impact on their operations or an increase in their reliance on central bank funding is
warranted.
Conclusions
I would like to close my remarks by the rather pessimistic conclusion that, unfortunately, it
appears that periods of "irrational exuberance" can lead us to forget well established
practices on how to prudently manage risks. Financial crises like the current one remind us
of their importance. Also central banks have learned valuable lessons in their own risk
management and have made steps in solidifying their defences, while remaining faithful to
their objectives of ensuring price stability while also safeguarding financial stability.
Thank you very much for your attention.