mr backstrom reports on the significance of risk management speech given by mr urban backstrom, 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

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