Randall S Kroszner: Strategic risk management in an interconnected
world
Speech by Mr Randall S Kroszner, Member of the Board of Governors of the US Federal
Reserve System, at the Risk Management Association Annual Risk Management
Conference, Baltimore, Maryland, 20 October 2008.
* * *
It is not an overstatement to say that we are in the midst of a fundamental transformation in
financial services, with market-wide ramifications. At the heart of that transformation lies a
much more intense emphasis on funding and liquidity. Additionally, we are all witnessing the
extent to which banking and financial markets are interconnected.
The current environment certainly presents some fundamental challenges for banking
institutions of all types and sizes.1 Their boards of directors and senior management, who
bear the responsibility to set strategy and develop and maintain risk management practices,
must not only address current difficulties, but must also establish a framework for the
inevitable uncertainty that lies ahead. Notably, the ongoing fundamental transformation in
financial services offers great potential opportunities for those institutions able to integrate
strategy and risk management successfully, and I will argue that survival will hinge upon
such an integration in what I will call a "strategic risk management framework."
In the remainder of my remarks, I plan to discuss the necessity for institutions to improve the
linkage between overall corporate strategy and risk management, and how they can develop
concrete strategic risk management frameworks. I will argue that in the highly interconnected
financial world, funding and liquidity need to be at the center of such frameworks. But before
doing so, I will briefly review recent events.
Recent events in financial markets
We are indeed witnessing dramatic shifts in the structure of financial markets. These are
quite extraordinary times that have required extraordinary responses from the Federal
Reserve, the Treasury, and other governmental bodies in the United States and around the
world. Since last summer, there had been a continuous deterioration of conditions in financial
markets, becoming much more acute since March of this year. For instance, we have seen
significant disruption in several key sectors of our financial system, such as normally
creditworthy companies having difficulty issuing commercial paper, dramatic increases in
interbank lending rates, and significant concerns about money market funds "breaking the
buck." These are sectors usually considered to be relatively low risk and quite liquid, so
disruptions here have signaled the extent and depth of this turmoil and the lack of confidence
among financial market participants.
The Federal Reserve has responded to these developments in two broad ways. First,
following classic tenets of central banking, the Federal Reserve has provided large amounts
of liquidity to the financial system to cushion the effects of tight conditions in short-term
funding markets. Second, to reduce the downside risks to growth emanating from the
tightening of credit, the Fed, in a series of moves that began last September, has significantly
lowered its target for the federal funds rate. Indeed, earlier this month, in an unprecedented
joint action with five other major central banks and in response to the adverse implications of
the deepening crisis for the economic outlook, the Federal Reserve again eased the stance
of monetary policy. We will continue to use all the tools at our disposal to improve market
functioning and liquidity, to reduce pressures in key credit and funding markets, and to
complement the steps the Treasury and foreign governments will be taking to strengthen the
financial system.
As a result of these ongoing upheavals, we are witnessing substantial institutional changes,
in which some long-standing financial institutions have either failed, sought government
assistance, or were forced to merge with other institutions. What were the major U.S.
investment banks have essentially disappeared, such as by merging with bank holding
companies or becoming bank holding companies themselves. Other major banks and thrifts
have been absorbed into other banking organizations. Financial institutions and investors
have placed much more emphasis on the banking charter, likely driven by banks' more stable
funding and deposit insurance, even before the recently announced government support of
the banking system.
Over the past year, there has been increasing concern among financial institutions and other
counterparties about the health of some financial institutions. Uncertainty about the value of
assets and other exposures, as well as uncertainty about the ability of institutions to sustain
continued access to funding, has caused financial institutions to operate with great caution
and hoard funds. What was once a healthy, active interbank market has become frozen from
time to time, as some institutions feel that conditions are so uncertain that they cannot even
lend to long-standing clients or counterparties. In quite a dramatic shift from just 18 months
ago, there is much more scrutiny being placed on capital adequacy, with financial institutions
trying to retain as much capital as they can, raise as much as possible, and demonstrate that
their capital positions are not impaired. The Capital Purchase Plan by the U.S. Treasury
Department under the Emergency Economic Stabilization Act is focused on improving capital
adequacy and, hence, improving confidence in the interbank market.
Perhaps one of the most pressing issues, as I mentioned briefly earlier, is the intense
emphasis on funding. This dramatic shift in concerns about a financial institution's funding
base results in much more focus on the stability of funding sources - one of the reasons that
the bank charter has become so attractive. Indeed, we are seeing the emphasis on funding
driving many other factors that affect financial institutions, including the viability of various
aspects of firms' business models. And problems with liquidity have affected capital levels,
which in turn have further exacerbated liquidity concerns. It is indeed quite remarkable how
this "flight to liquidity" has brought about so many institutional and structural changes, and
become essentially the most important factor (at least now) for the viability of a financial
institution.
Over the past year there have been a number of studies analyzing the causes of the current
turmoil, which include shortcomings in the risk management practices of financial
institutions.2 It is absolutely clear that many financial institutions need to undertake a
fundamental review of risk management. They now realize that ignoring risk management in
any aspect of the banking business usually creates problems later on. Risk management
shortcomings need to be addressed not only to improve the health and viability of individual
institutions, but also to maintain stability for the financial system as a whole.
Framework for strategic risk management
At this time, I would like to explain a bit more about what I mean by a "strategic risk
management framework." In my view, an effective overall corporate strategy combines a set
of activities a firm plans to undertake with an adequate assessment of the risks included in
those activities. Unfortunately, many firms have forgotten the second part of that definition. In
other words, there can be no real strategic management in financial services without risk
management, hence my use of the term "strategic risk management." Risk management
needs to be interwoven into all aspects of the firm's business and should be part of the
calculus for all decision-making. Strategic decisions about what activities to undertake should
not be made unless senior management understands the risks involved; assessing potential
returns without fully assessing the corresponding risks to the organization is incomplete, and
potentially hazardous, strategic analysis.
Ensuring that risk management permeates an entire organization may require some
fundamental changes for certain firms. And this lesson applies not just to the prominent
organizations mentioned in the headlines of late, but also to smaller firms. Even if smaller
firms have been less affected by the recent turmoil (and perhaps have even won back some
market share as customers seek more "traditional" places to put their money), their
managements must understand that the financial landscape has changed and needs to be
surveyed anew because events outside of their control in market-wide flight to liquidity, for
example, can have direct impacts on them. Of vital importance will be incorporating into
strategic risk management the lesson that funding and liquidity will be a major determinant of
institutions' success going forward.
Building a rigorous strategic risk management framework requires an institution to reexamine
both its internal practices and its external environment, and to understand how closely the
two are connected. In other words, external factors have an impact on internal practices, but
those internal practices, because financial markets are so interconnected, can in turn have
an impact on how the institution is viewed externally - and even have an impact on the
marketplace more broadly. We have witnessed several such examples of late, in which an
institution encountered severe liquidity needs, which then affected funding for other
institutions. Institutions need to understand better that a number of factors affecting their
business are beyond their control, and that events can have secondary or tertiary "knock-on"
effects. The real art is to realize that while all institutions may be affected by external factors,
each is affected in its own way.
Now that I have laid out a general framework for strategic risk management, I would like to
offer a few examples of its application.
Funding and liquidity
As I noted, the clear driver of the fundamental transformation in financial services is the
increased importance of funding and liquidity. The ability to secure funding is a fundamental
task in banking, and banks have been managing expected liquidity demands since the
beginning of banking itself. In times of stress, such as now, having a solid and reliable
funding structure becomes much more important, in some cases so much so that it affects
most other banking activities.
The current turmoil has brought about substantial deleveraging in financial services.
Managing this process is an immediate challenge for banking institutions, as they must
consider the need to reduce leverage at their own institution as well as understand the
consequences of deleveraging at other firms. This is clearly an example of external factors
affecting internal practices, and vice versa. From a strategic perspective, bank directors must
examine their current and future funding situation in light of recent deleveraging, its
nearterm prospects, and the state of overall liquidity in financial markets.
Financial institutions rely on external funding in some fashion - either through retail deposits,
interbank lending, or debt offerings. Therefore, they must understand that their funding can
be subject to the vagaries of the market, such as sudden shortages of market liquidity or
rapid swings in investor sentiment. For example, banks may benefit in the near term in
attracting deposits and thereby improve their funding positions, but they also may experience
more difficulty securing other sources of funds and find that situation persisting for some
time. Additionally, counterparty reactions to changes in the business mix or risk profile of an
perceived
institution (or even the change in its risk profile) could suddenly hamper the ability
to find funding.
In recognizing the inherent leverage in the business of banking, institutions must examine
longer-term implications of funding and liquidity, and begin to build those into the overall
strategic plan for their organizations. The market for external funding is an international one,
so liquidity troubles in one market can have repercussions in others. Accordingly, banks
should be prepared for a range of adverse situations related to funding and market liquidity
that can be precipitated by a range of sources.
Bank directors and senior management need to anticipate potential difficulties in funding the
bank, and demand that solid contingency plans are in place - and are regularly updated - for
a variety of funding and liquidity problems. Such plans should include the potential for
external factors to generate a funding squeeze for the institution, even if its own positions
and risk profile have not materially changed. Preparing for sudden changes in the pricing and
availability at any price of funding sources is something that, leading up to the current
turmoil, most banks did not fully consider. Instead, their managements focused mostly on
building market share, growing revenues, and realizing the short-term profitability of their
activities - a telling example of banks not properly including risk management in their overall
corporate strategy. As the Senior Supervisors Group Survey of major financial institutions
pointed out, there have been numerous examples of failures of strategic risk management
and these must be rectified going forward.
Finally, strategic risk management for funding and liquidity needs to consider potential
liquidity problems on both sides of the balance sheet. We saw such examples recently when
there were draws on liquidity commitments to structured investment vehicles and commercial
paper conduits, and when banks faced difficulty selling exposures in illiquid markets. When
there is a marketwide scramble for liquidity, a bank must be prepared to manage funding
challenges and unplanned asset expansions simultaneously. Developing a strong strategic
risk management framework that recognizes the vital importance of funding and liquidity to
both sides of the balance sheet is one way in which directors and senior management can
help ensure that their institutions are ready for such outcomes. They should also ensure that
they fully understand that funding and liquidity issues will drive many of the activities in which
they will be able to engage, something to which I will now turn.
Choice of financial services activities
While the financial landscape is by no means settled, certain emerging trends will affect
which activities make sense, which exposures should be assumed, and which risks should
be undertaken. One immediate trend is that much of the future of business activities of
banking organizations will be driven by the increased focus on funding and liquidity.
Accordingly, this trend must be integrated into a strategic risk management framework. For
instance, there may be less opportunity to pursue activities that were quite prolific under the
previous "originate-to-distribute" model, such as securitizations, given current disruptions or
longer-term uncertainties about the reliability of market liquidity. For similar reasons, other
activities, such as investing in collateralized debt obligations or structured investment
vehicles - which typically relied on relatively easy maturity transformation - may not be as
viable in this new environment.
Whether transactions take place on an organized exchange or in the so-called over the
counter market is another important aspect of the strategic risk management choices
undertaken by an organization. When contracts are traded on an exchange, clearing and
settlement, for example, may have less uncertainty associated with them. In addition, an
exchange that has a centralized counterparty - perhaps the clearinghouse of the exchange -
can reduce uncertainty about counterparty risk and help to avoid market dislocations that can
arise from such uncertainty, not only for an individual firm but, potentially, more broadly in
that market. Thus, market infrastructure and its impact on how organizations are connected
to each other can have a large impact on market confidence in times of stress.
Of course, we have seen that uncertainty, fear, and lack of trust among key counterparties
can dramatically affect trading in some products across markets in many countries, again an
example of the impact of interconnectedness. These days, institutions are seeking more
assurance that their counterparties will not default from one day to the next. Whether there is
a shift to more trading on clearinghouses will be driven by firms' analysis of counterparty
credit risk and the extent to which they are comfortable doing business with leveraged
counterparties about which they have limited information. Firm managers should take these
infrastructure and interconnectedness issues into account in undertaking their own strategic
risk management choice about what activities to undertake and the risks posed by each. This
is a clear example of how external structures should be taken into account in a firm's
strategic planning.
In their strategic risk management frameworks, institutions should also understand the
broader issue of potential gravitation to a model in which most or all types of financial
services are brought together in single institutions. That is, institutions have to prepare for the
possibility that they could lose customers and/or be less competitive if they are unable to
provide the full set of financial products. Importantly, however, bank directors and senior
management, in assembling their strategic risk management framework, should fully
understand the complications associated with offering multiple products and engaging in a
wide array of activities - such as reputational risk. And they should not automatically assume
that engaging in multiple activities in multiple geographic markets will provide so-called
"natural diversification." As I just noted, different financial markets and different types of
financial services are quite interconnected, and during times of stress all can experience
losses concurrently.
Of course, there may also be an opportunity for some institutions to benefit from more
traditional, "bread-and-butter banking," with exposures and risks tied more closely to bank
balance sheets. This potential opportunity for niche banking could have certain benefits, as
clients and investors, because of the fear of contagion, seek institutions that are specifically
not involved in multiple markets and activities. And local banks can often provide more
personalized service and have a better understanding of their clients' needs. In such cases,
however, institutions conducting specialized or local business must understand the inherent
risks, such as potential risk concentrations.
Compensation
As many of you know, as an economist I am particularly interested in the impact that
compensation has on incentives for bank management.3 I am pleased that the industry has
also begun to address this issue, as reflected in a recent report by the Institute of
International Finance.4 Clearly, the industry needs to better understand the link between
compensation and risk management, as in the past those two areas have usually been
addressed in isolation.
Generally, investors analyze financial institutions on a risk-adjusted basis, interpreting profits
based on the amount of risk taken. Management at financial firms should do the same thing
with regard to their business units and their employees. A risk-sensitive compensation
framework will help provide the right incentives for employees, and establish a better link
between the actions of those employees and the firm's overall risk profile. Institutions should
be particularly sensitive to employee activities that could either directly or indirectly impair
access to funding or disrupt liquidity.
Clearly, bank directors have an influential role to play in setting compensation, and they
should exercise their authority to establish a more risk-sensitive compensation framework
while embedding it in the broader strategic risk management framework of the institution.
Directors should understand the consequences of providing too many short-term and
onesided incentives. There are many ways that this risk sensitivity could be accomplished, and it
is up to the firms themselves to arrive at solutions. One possibility, for example, is to include
more types of deferred compensation, since the risks of certain investments or trades may
not manifest themselves in the near term. It makes sense to try to match the tenor of
compensation with the tenor of the risk profile and, thus explicitly, take into account the
longer-run performance of the portfolio or division in which the employee operates. A good
risk-sensitive compensation regime, properly embedded in a strong strategic risk
management framework, can bring about changes in behavior so that the firm's employees
refrain from taking on risk beyond the firm's stated risk appetite. Perhaps most importantly,
such a compensation regime must give the appropriate incentives to take risks fully into
account during good times, when many often underestimate longer-term risks.
Conclusion
I have tried to lay out the importance for banking institutions to develop and maintain a
strategic risk management framework that fully incorporates all the risks they face - both
internal and external - when making choices about what activities and markets in which they
will operate. Indeed, having a corporate strategy that does not include risk management at its
core is not really a strategy at all. Market infrastructure, which affects not only the ways in
which firms are connected to each other but also the types of shocks to confidence that they
may encounter, is an important external factor that should be taken into account in strategic
risk management.
As a concluding point, I will offer a few comments on one additional area to which banking
institutions must pay particular attention: the regulatory and supervisory structure in which
banks operate. Banking is an industry that is subject both to market competition and
considerable regulation. Therefore, banking institutions must not only evaluate potential
changes in the competitive financial landscape (as I noted earlier), but must also pay
attention to potential changes on the regulatory side.
Over the past year, there have been a number of suggestions for possible statutory changes
in U.S. financial services regulation, so bank directors must be prepared for whichever
outcomes such changes might imply for the regulatory structure in the United States. For
example, the Congress may wish to undertake legislative action to effect regulatory changes,
or there may be changes to the existing authority and responsibility of certain regulatory
bodies. In any event, there will likely be some type of adjustments in regulatory structure
simply given the changes in the financial services landscape. Given the fluid situation in
which we find ourselves today, bank directors and senior management in their strategic
planning have to anticipate a range of potential outcomes in the regulatory sphere in both the
short and long term.
Since banking and financial markets are so interconnected, the fundamental transformation
in financial services is affecting all types of financial institutions, even those less directly
affected by recent events. Importantly, in developing strategic risk management frameworks,
institutions must not only understand the direct consequences to their own firms of such
shifts, but must also recognize that consequences to other firms can have effects on the
broader market. The heightened importance of funding and liquidity is a clear example of a
major change that has far-reaching ramifications and, thus, has to be appropriately
addressed in assembling any credible strategic risk management framework in an
interconnected world.