Mr Bäckström reports on the significance of risk management
Speech given by Mr Urban Bäckström, Governor of Sveriges Riksbank and Chairman of the Board of
Directors and President of the Bank for International Settlements, at the Risk Management Forum,
organised by Ernst & Young, in Stockholm on 3 February 2000.
* * *
First a word of thanks for the invitation to attend this forum and discuss future risk management. I
shall be talking about the socioeconomic aspects of financial risks and what the authorities are doing
in this field.
Why is the financial sector so important?
What makes the authorities so concerned about the financial sector? Why don't they focus to the same
extent on, say, the forest industries, car manufacturing or even on other service industries? The reason,
of course, is that the financial sector - banks in particular - performs such special and central functions
in a modern economy.
It is not the case that parliaments, governments, supervisors and central banks around the world are
particularly concerned about individual banks. What matters is the part that financial institutions play
in sophisticated modern systems for credit and payments. Virtually every economic transaction
involves a payment service of some kind; it can take the form of banknotes, payments on account or
the provision of credit. It follows that if the facilities for payments by households and firms are
seriously disrupted, the consequences for the real economy may be disastrous. So disturbances in
credit and payment systems can be costly for society and the costs are not primarily the direct
consequences that measures of support will have for government finances. The essential consideration
instead is the costs that a collapse of credit and payment systems may entail indirectly in the form of
decreased production and higher unemployment. When payments and the supply of credit do not
function efficiently, the rest of the economy also suffers. That is the main reason why governments are
more concerned about the bank sector than they are about other service industries.
To appreciate what happens when credit and payment systems are disrupted, one can just take a look
at what happened as a result of the financial crises that occurred around the world in the last two
decades. There are, unfortunately, numerous examples that can serve as illustrations. The International
Monetary Fund has estimated that since 1980, serious problems in the bank sector have arisen in three
out of four of its 180 or so members. This has been case in the industrialised world, where one
example is Sweden in the early-1990s, as well as in emerging markets.
Bank capital bases relatively small
There is a variety of factors that could be cited as possible causes of these disturbances. They include
shortcomings in economic policy, inadequate supervision and, in many instances, poor risk
management by the players themselves. But the roots of the problem go deeper than this.
The basic issue is the financial system's vulnerability to unforeseen events. Take, for example, the
bank sector's solvency, measured as the ratio of equity capital to the balance sheet total. This amounts
to only a few per cent, whereas the level in non-financial firms is 20, 30 or even 40%. So a simple way
of solving the bank sector's vulnerability would be to raise the capital base to what is customary in
other companies. Banks would then be in a better position to cope with unexpected disturbances in the
financial markets.
Maintaining a large reserve of equity capital for unexpected events is, however, costly and someone
would have to pay for this. The solution would therefore lead to expensive credit and low interest on
deposits. Projects that are not exceptionally profitable would not obtain finance and the level of saving
in the economy would be low. With little investment and low saving, growth would ultimately falter
and prosperity would suffer. From this it will be readily understood that unduly tight capital adequacy
requirements for the bank sector can be very costly for the entire economy.
So if the whole economy would be liable to suffer because the banking system opts for or is coerced
into holding a sizeable capital reserve, one can say that this is not a viable remedy for ensuring the
financial system's stability. But how, then, are financial crises to be prevented?
After the global crisis in the 1930s, the path that was chosen up to around the 1970s (its duration
varied from country to country) was regulation. Credit and exchange controls were reintroduced. In
Sweden, the credit system had been liberalised in the middle of the 19th century but after the 1930s it
was regulated once more. The risk of serious financial crises was countered by controlling the
domestic credit supply in detail and more or less prohibiting cross-border capital movements that were
not directly connected with trade in goods and services. But these controls also had the effect of
hampering the financial system's development. If the costs of this period of regulation could be
identified and estimated, we would probably find that they were considerable.
What this amounts to is that high capital requirements for banks are costly, not just for the banks but
for the entire economy, and the same applies to controls on credit and foreign exchange.
As this was recognised by more and more countries, national policies in this field were realigned in the
course of the 1970s and 1980s. Controls were abolished and domestic capital markets were opened up
for cross-border capital flows.
But in many instances the financial system was unprepared for a freer environment. The era of
regulation had lulled many banks into a false sense of security. Moreover, supervision concentrated on
the wrong issues and was by no means appropriate. Neither did economic policy observe the discipline
that a deregulated financial system requires. And the gold standard, which had functioned as a highly
disciplined system for monetary policy, was a thing of the past. New, costly problems were
encountered, as is clear from the numerous bank crises that occurred around the world in the 1980s
and 1990s.
It is in the light of these experiences that we are now engaged in erecting, step by step, a new financial
architecture that will work in a world where capital adequacy requirements for banks are relatively
limited at the same time as the financial system is rather free and open.
Increased importance of risk management
One function of a bank's capital base is to act as a buffer for absorbing various types of disruption and
risk. The greater the difficulty a bank has in identifying the numerous types of risk involved in
financial activities, the larger its capital base needs to be. Otherwise, a sudden increase in risk may
quickly render the bank insolvent. By the same token, the lower the stipulated capital requirement for
financial operations, the more important it is to have efficient systems for risk management.
The capital base in banking has, in fact, been strengthened to some extent in the past decade. When
minimum capital adequacy standards for banks were specified in the Basel regulations in the
late-1980s, they were met by protests from banks in Sweden as well as elsewhere. One of the
criticisms was that the regulations would be costly. Today, all the Swedish banks have voluntarily
strengthened their capital bases by more than the Basel regulations require. Banks in many other
countries have done the same.
At the same time, the concept of bank sector solvency has been increasingly undermined. Many risks
are not on the balance sheet. It is therefore more relevant to consider the ratio between total risk
exposure and the capital base.
With the expansion and growing complexity of financial market operations, it has become increasingly
important that banks are capable of managing the risks in their business. The financial turbulence in
recent years has underscored this and banks are also more determined to have such a capability. The
capacity to understand, monitor and control internal risks is thus featuring more and more prominently
in the organisation of financial enterprises.
A major aspect of this work has been the development of more advanced methods for the quantitative
measurement of risks. As one might expect, most progress has been made in the measurement of
market risk; the extensive trading in financial instruments provides a good supply of price statistics
and this is a considerable help when it comes to estimating market risks.
Much work is now being done in many places to construct models for a better management of credit
risks, which are still by far the largest risk category for banks. The difficulties here, however, are far
greater than in the case of market risks. The estimation of key parameters for models is obstructed by a
lack of statistics. And even if individual default probabilities can be estimated reasonably accurately, it
is still rather difficult to combine them into portfolio assessments, partly because not enough is known
about the interaction between variables. The models therefore tend to rest on a large number of
simplified assumptions based on subjective judgements.
Still, sector players are displaying a strong determination and creativity in their efforts to surmount the
obstacles. The rapid progress in this field was evident from the discussions last June in Stockholm at
the conference on credit risk modelling that was arranged jointly by the Riksbank and the Swedish
Financial Supervisory Authority.
Recently, moreover, some advances have been made in the estimation of operational risks (the risk of
losses arising from technical problems or inadequate internal controls). Previously, operational risks
had attracted less attention than, for example, credit and market risks. It is changes in the nature of
banking operations that have brought them more to the fore. The significance of operational risks for
an individual institution is evident, not least, from the case of Barings Bank.
The development of quantitative risk measurement is an interesting and important matter and many
speakers today will no doubt be talking about these methods' technical aspects. I therefore want to
draw attention to the need for a holistic approach; instead of relying solely on statistical models, it is
necessary to combine them with sound judgement and common sense.
It must be borne in mind that models are no more than a highly simplified and limited image of the
real world. While their simplicity does make them very useful in the work of identifying risks, it is
also perhaps their chief disadvantage. Models fail to catch a great deal of what is happening in a
dynamic and complex environment.
Events in the autumn of 1998 and the problems at that time in connection with the American hedge
fund LTCM are a telling example of the limitations of risk models, or perhaps rather of errors in the
ways they are used.
Firstly, there was the evident difficulty in separating the management of market risks from credit risks.
As a result of major shifts in market prices, the credit risks, which had seemed to be negligible
initially, suddenly became considerable.
Loans are often provided against collateral in the form of securities; the securities are not pledged for
their full value, which leaves a margin for unforeseen events. This buffer, however, is often relatively
small. Additional collateral, it is said, can always be called for if market prices make this necessary.
Alternatively, the existing collateral can be realised.
There has been a tendency to disregard both the potential credit risk in arrangements of this type and
the possible refinancing and liquidity risks. What happened with LTCM in the autumn of 1998 showed
that market value can deteriorate so rapidly that there is not enough time for calling in and receiving
additional collateral. Neither could the securities be sold without further ado in order to realise the
existing collateral. Under these circumstances, the market risk was transformed into credit risk. In the
case of LTCM, the banks had made a proper credit assessment and scrutiny of their counterparties.
The end result, as we know, was that the banks were obliged to take over the fund and contribute
additional capital.
Secondly, we were reminded that Value-at-Risk and similar assessments must be used prudently.
Looking back, it can be said that too much faith was put in estimates that had been made while the sun
was shining and which proved less watertight when it suddenly started to rain. The parameters on
which risk calculations are based - standard deviations and correlations, for example - are usually
estimated on the market's historical performance together with some simple assumption - for instance
a normal distribution - about the underlying pattern of probabilities. Shocks of the kind that occurred
in the autumn of 1998 pulverise the conditions behind such calculations and make Value-at-Risk less
meaningful as an indicator of the risks that actually apply.
As with any innovative activity, there is an element of trial and error here that we must aim to tackle
by developing new methods at the same time as we try to learn from mistakes.
The hard-earned lesson for the authorities as well as for market players - not least the executive
managements of financial institutions - has been that, to make them functional, statistical
measurements require additional techniques.
An important component for risk assessment is provided by analysing sensitivity, using what are often
referred to as stress tests. This involves assessing the consequences that a more dramatic course of
events would have for a particular exposure. Instead of considering the scenarios that are most
probable, these tests refer to the worst possible cases. The information is very valuable for those who
ultimately have to decide about the risks that are to be taken.
The work of the authorities
Developments in the financial system obviously affect the work of the authorities that are responsible
for the system's stability. This applies to rules as well as supervision.
Financial legislation and regulation need to be sufficiently flexible to accommodate the rapid pace of
developments in the financial sector. It tends to take considerably longer to amend rules than it does to
create new financial products. But there has to be a foundation of minimum requirements for such
matters as capital bases and risk management.
In addition, the authorities must be increasingly involved in ensuring that institutions themselves
possess a basic competence in and understanding of the risks that have to be managed, as well as
adequate systems for their management, rather than issuing detailed risk management instructions.
In other words, it has become more important to inspect systems, defined in a wide sense, than to
scrutinise particular commitments or market risks. Some supervision, moreover, can be carried out
with the market's assistance. By this I mean that authorities can prescribe as well as encourage a more
open presentation of the institutions' risks and profitability in different operations. Such a transparency
accentuates the banks' demands on each other as well as what customers require of their banks.
These developments do, of course, call for new forms of competence and resources for the authorities.
The transition from an administrative organisation to one that inspects sophisticated risk management
systems in a wide sense is something of a cultural revolution. That is what central banks and financial
supervisors around the world are working on intensively at present. Some have come a good way,
others have more to do.
Basic minimum standards for solvency and risk management, more active supervision with a stronger
focus on risk, and increased transparency are also the foundations of proposals that have been
presented both by the Basel Committee on Banking Supervision and by the Swedish Committee on
Bank Legislation.
In this context I want to draw attention in particular to the international work that the Director General
of the Swedish Financial Supervisory Authority, Claes Norgren, is doing as chairman of the Basel
Committee's Capital Task Force, as a part of the cooperation in the Bank for International Settlements,
and in the Banking Advisory Committee of the European Commission.
Claes Norgren will be talking later on about the proposals for new rules. I should like to acknowledge
that the task of achieving such a far-reaching reform of the international capital adequacy standards is
by no means easy. Quite apart from the exceptional technical complexity of the substantive issues, it is
not always evident how the political and cultural differences that nevertheless exist can be reconciled.
I know that Claes Norgren's international efforts have been most valuable and appreciated around the
world. Permit me to conclude by congratulating the Director General of Sweden's supervisory body
on his successful work.