1. Thoughts on Risk Management Deficiencies CAIB November 2008

2. Outline Background What went wrong? What is needed? What are some international institutions doing?

3. Background International Regulations: Basel 1 to Basel 2 –Economic capital / return on capital models –Arbitrage and innovation: securitisation,CDS Accounting: –Standards on off-balance sheet vehicles –Mark to market and fair value; rules on reserves “Shadow banking” system Organization and Behaviors: –Separation of Risk Management Function form Risk Takers –Performance Incentives Macro Policy –Market oriented Globalization –IT revolution; flow of information –Trade –Financial flows and integration of developing economies in financial system

4. What went wrong? Capital Models: –Quantitative techniques –Data driven by history even for new products –Increasing complexity; implicit assumptions –Many users may not have understood –Due to good environment, players believed models –Regulation vs. internal economic capital arbitrage: structured credit products

5. Accounting Standards Off-balance sheet and structured products; Fair value /Mark-to-market Reserves: Incurred losses vs. expected losses Rules vs. principles Accounting purposes vs. risk management purposes

6. Shadow banking system Non bank-regulated participants –Insurance; hedge funds Risk was being shifted but was still in system –Counterparty risk: risk not necessarily with the entity best able to bear that risk. –Rating agencies Investors delegated analysis to them They had their own conflicts of interest because of incentive and fee structure.

7. Organization and Behaviors Separation of risk management function –Risk Managers less close to information and knowledge; less real power –Conflict vs. co-operation –Incentives: Volume, short-term returns Benchmarking against industry vs. absolute performance relative to risk –Senior Management/Board engagement

8. Macro Policies Market oriented –Regulation –Monetary policy: liquidity

9. Globalization Information revolution –Rapid spread of money, ideas, techniques Regulation and policy –Trend toward convergence Contagion

10. What is needed? Regulation and Policy: –More principles vs. rules –Less procyclical ; need for buffers –Broader and more integrated coverage of institutions and instruments. –Balance between innovation and stability –Recognize purposes of risk standards and accounting standards –Information aggregation: institution-specific vs.system.

11. Corporate Governance Business units responsible for risk and return Closer interaction between risk and business Long-term incentives vs. short-term market benchmarks Balance between volume/revenue growth /innovation and stability More Senior Management/Board engagement More disclosure: accounting vs. “risk” income statements and balance sheets

12. Responses of International Financial Institutions Environment –Spread to developing countries; direct financial effects but also growth, trade, commodity prices, remittances falling, –Poverty alleviation and development focus to be maintained –More inclusive responses, global partnerships IMF –Funding; Financial Stability Forum IBRD/IDA –Funding not only for financial crisis but also food, climate change; poorer countries, fragile and conflict states

13. Responses IFC –Expanded trade finance program –Bank recapitalization fund –Infrastructure crisis facility –Refocused advisory services Risk management, banking for MSME, housing, regulation