Nout Wellink: Recent market turmoil - implications for supervisors and
risk managers
Remarks by Dr Nout Wellink, President of the Netherlands Bank and Chairman of the Basel
Committee on Banking Supervision, at the GARP 2008 9th Annual Risk Management
Convention & Exhibition, New York, 27 February 2008.
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Introduction
I am pleased to join you today to speak about the recent financial market turmoil and the
concrete responses of the Basel Committee. The mission of the Basel Committee is to
improve the quality of banking supervision worldwide and to promote strong risk
management practices at banks. This morning I would like to discuss some of our recent
initiatives with you.
Issues and lessons for risk managers and bank supervisors
Let me begin by first focusing on some of the key issues that were identified during this
recent turmoil and the lessons - in some cases painful ones - experienced by risk managers
and supervisors. Quite frankly, some of the lessons learnt from the turmoil point to the
importance of risk management fundamentals. While the triggers and transmission of risk
always take on new faces, it is the basics that remain the same - complex structured
products provide a stark example of this.
From the perspective of bank supervisors, I believe there were three fundamental
shortcomings that contributed to and amplified the turmoil. These fundamentals can be found
in all parts of the credit intermediation process. The first of these relates to the origination of
credits. Here, the industry failed to consistently employ sound underwriting standards. In
many cases, firms also neglected to define prudent firm-wide risk limits on these exposures.
Second, risk management and measurement capabilities did not keep pace with rapid
financial innovation and the evolution to market-based credit intermediation. Third, certain
aspects of regulation, supervision and market transparency failed to reflect financial market
developments and therefore contributed to weak practices at banks. These are areas where
future practical improvements must be made.
Underwriting standards
As you know, the trigger for the turbulence was subprime mortgage lending, much of which
took place outside the regulated banking sector. A large part of this lending was based on
weak underwriting standards. Weak underwriting has long been the bane of banks and
banking systems; the difference in this case was the rapid and global transmission of risk
through the use of securitisation. Problems at banks are all too often caused by the failure to
adhere to basic risk management principles, especially when new products and markets
come into play. In many cases, this is due to the pressures that firms face to increase market
share, combined with unrealistic expectations about growth and performance prospects. But
no matter how much risk exposures get sliced, diced and distributed among financial market
participants, financial innovation cannot mask poor underwriting. At the same time, the
additional complexity, opacity and leverage resulting from certain structured products and
offbalance sheet vehicles further magnified the problem, as it has not been sufficiently clear
where the ultimate risk lies. This brings me to my second point.
Risk management infrastructure and financial innovation
Indeed, the second fundamental shortcoming is the wide disparity between the rapid pace of
financial innovation and the risk management infrastructure on which this innovation was
built. When I spoke at last year's GARP conference, I noted that the linkages between the
various segments of the credit markets and financial institutions had been fundamentally
altered. This is mainly due to increased market-based credit intermediation, or the
originateto-distribute model.
Historic or statistical measures of risk and exposure, such as value-at-risk, past loss
experiences and name concentration in the traditional banking book have proved inadequate
when assessing relationships in the originate-to-distribute model and how they may perform
under stress. In fact, the use of these and other historic measures resulted in a massive
understatement of stressed losses, which were far below the actual losses experienced to
date.
As I suggested at last year's conference, the greater reliance on securitisation and other risk
transfer mechanisms means that banks are more vulnerable to exposures building up or
returning to the balance sheet when market liquidity seizes up. In addition, increased reliance
on market liquidity means that problems in financial markets can adversely - and very
quickly - affect banks' funding liquidity. However, for those institutions that stress test
funding capabilities, many only assumed a firm-specific event.
The problems arising from poor underwriting were compounded by failures to manage
firmwide concentrations. Many firms were unaware of their overall exposure to subprime
mortgages and related structured products, such as CDOs, whose repayment depend on
such mortgages. These concentrations went far beyond traditional loan portfolio exposures
and included CDOs and mortgage-backed securities held in the trading book; liquidity
facilities extended to conduits; reputational exposures to sponsored SIVs; and counterparty
exposures to the monoline sector. In addition to failing to understand their firm-wide
concentrations, many institutions could not readily nor easily aggregate their subprime
exposure sector when the crisis arose. This points to the need for greater investment in firm
wide risk management and measurement capabilities.
Sound regulation, supervision and transparency
Finally, there were shortcomings in regulation, supervision and market transparency. It is
important to point out that this crisis has played out under Basel I, which was instrumental in
raising the level of bank capital in the late 1980s and through the 90s. However, the
framework became outdated and could not adequately capture the types of risks that banks
face in today's increasingly market-based credit intermediation environment. As a result,
offbalance sheet exposures as well as operational, legal and reputational risks were not
appropriately identified and measured. Moreover, liquidity supervision and regulation have
failed to keep up with banks' changing risk profiles and growing vulnerability to market-based
shocks. All in all, these issues underscore the need for Basel II and the necessity to
continuously improve the framework.
Recent difficulties also highlighted the lack of transparency due to insufficient disclosure.
CDOs of asset-backed securities are a particularly striking example. I must add, however,
the turmoil also made clear that investors did not make full use of available information and
placed excessive reliance on external ratings. Taken together, these factors resulted in
banks and investors assuming excessive risk and concentration to the subprime sector -
either directly or indirectly through structured products based on subprime mortgages.
Work programme of the Basel Committee
From the Basel Committee's perspective, the previous analysis points to a number of
concrete measures that banks and supervisors must take. These measures should improve
firms' resilience to market-based shocks and help strengthen confidence in core financial
institutions. I will address three of these initiatives the Committee is working to complete,
which are:
1) implementation of and further improvements to Basel II;
2) enhancing global standards for liquidity risk management and supervision; and
3) strengthening other risk management practices, particularly with respect to stress
testing and valuations.
1) Basel II
Let me now say a few words about each of these initiatives, and I will start by underscoring
the importance of Basel II. In developing the Framework, the Committee sought to provide
better incentives for banks to capture exposures to structured credit activities, both on- and
off-balance sheet, including ABCP conduits. The three pillars of the framework were
designed to better reflect banks' evolving risk profiles, while building in cushions for
uncertainty and forward looking risks. The implementation of the Basel II framework hence
remains a high priority.
At the same time however, we have identified some areas within the improved Basel II
framework that need to be strengthened to reflect the lessons of recent events. These relate
to the Pillar 1 capital treatment of certain securitisations of complex products where the vast
majority of losses in the banking sector have occurred. In Pillar 2 of the framework, we need
to make sure that banks perform adequate stress tests and hold capital for uncertainties
related to exposures coming back to the balance sheet for legal, reputational or liquidity
reasons. And we need to build on the Pillar 3 disclosure requirements of the framework to
strengthen banks' transparency around exposures to structured credit products and
securitised assets, including banks' involvement as sponsors.
I also want to emphasise the importance of strong capital supporting trading book exposures.
For the largest global banks, balance sheet assets have more than doubled between 2000
and 2006. Much of this growth relates to trading assets. Indeed, the vast majority of bank
losses have been on retained trading exposures, particularly highly rated CDOs and
leveraged lending. As supervisors, we need to make sure that the capital underpinning the
trading book is commensurate with the risks that firms face. We therefore are supplementing
the current VAR-based framework with a capital charge for credit default risk in the trading
book. Moreover, to address the shortcomings of VAR, it is critical that banks have rigorous
stress testing and scenario analysis that translate into prudent risk taking and limits along
with strong capital.
2) Liquidity risk
Our second initiative relates to liquidity risk management and liquidity risk supervision. It
goes without saying that over the past months, national supervisors have been closely
monitoring the liquidity situation of their banking sectors and individual banking institutions to
ensure that they enhance their resiliency to stress. The Committee is engaged in a major
effort to strengthen global standards for liquidity risk management and supervision. We have
identified a range of common weaknesses in liquidity risk management, including stress
testing, contingency funding plans, disclosure and the management of off-balance sheet
exposures. We are working to translate these lessons into robust global standards for risk
management and supervision. Practically, this involves a fundamental review of the Sound
practices for managing liquidity in banking organisations, which the Committee developed in
2000. We plan to issue the enhanced sound practices for public comment this summer.
Issuing sound guidance and standards is only the first step; implementation and follow-up is
the second. After the Committee issues the updated sound practices later this year, it will be
incumbent upon banks to properly implement them and for supervisors to follow up to ensure
proper implementation and adherence.
3) Strengthening other risk management practices
The third area to which the Basel Committee attaches high priority is the strengthening of
other risk management practises. As I have indicated, there is a need to strengthen various
aspects of firm-wide risk governance and management practices. Let me mention two
specific areas, namely valuations and stress testing.
Valuation practices for complex trading assets have been a destabilising factor over the
course of the crisis. When markets for financial instruments do not function properly, it is
difficult to determine a fair value. Also, market participants have had a notable lack of
confidence in firms' disclosure of exposures to structured products, processes for valuing
positions, and the timely and accurate recognition of losses. This translated in a marked
decline in financial firms' share prices. Recent financial disclosures are helping improve the
situation but more needs to be done. With close cooperation from risk managers and other
professionals, the Committee is carefully analysing how to help put valuation practices on a
sounder long term footing. This is a topic the Committee is deeply concerned with, given the
growing share of exposures that have been subject to mark-to-market valuations and which
then flow through to earnings and capital. Disciplined fair valuation practices and clear sound
practices can help make firms more resilient to stress. But poor practices can create major
vulnerabilities for individual banks and for the financial system.
Furthermore, it also is critical that banks improve their firm wide stress testing practices. The
turbulence has made clear that firms need to aggregate all exposures to a particular risk
driver or related drivers and subject them to stress, also taking into account second round
effects and the response of other market participants. This is particularly relevant since
funding and market liquidity are increasingly linked. In addition, additional forward looking
measures of risk must be applied when we see rapid growth in new products or markets,
which have not been subject to an economic or financial market downturn. Firms must
develop the governance and infrastructure to carry out rigorous stress tests that identify
where the major vulnerabilities and firm-wide concentrations lie. And there needs to be a
clear impact on risk taking and appetite. The Committee will be taking a close look at the
lessons of the turmoil, how the current range of bank stress testing practices stacks up, and
where we can strengthen the supervision around stress testing going forward.
Conclusion
In conclusion, the Basel Committee is focusing on practical and concrete efforts that will help
strengthen risk management, regulation, supervision, market transparency for banking
institutions. We have embarked on a focused and ambitious work agenda with clear
deliverables. We also are contributing to the broader initiative of the Financial Stability Forum
to address the issues resulting from the recent turmoil. Some of the Committee's efforts will
take time, but having a clear road map should improve market confidence even in the shorter
term.
The banking sector needs to have sufficient capital and liquidity buffers to absorb financial
shocks and the uncertainties around how such shocks could play out in the future as the
process of financial innovation continues. Risk managers need to continuously translate the
basics of sound risk governance and management to rapidly changing environments. And
importantly, regulators need to make sure that the infrastructure of supervision, regulation
and transparency keeps pace with innovation and promotes appropriate incentives for sound
risk management. There are no simple, quick fix measures that will prevent the next crisis.
But I believe that the steps I have outlined will make the banking sector more resilient to the
next set of shocks, whatever their source. Thank you.