Regulations, Risk Management, and a Cure for Financial Sector Ailments

by: Promod Radhakrishnan

It's difficult to write anything on the economy or the market in the midst of such a horrendous week! However the very fact that 3 of the top 5 stand-alone investment banks ceased to exist independently (and probably one more in the offing) - all with in a span of 3 months - shows how ridiculously leveraged and reckless most of these shops would have been. And seeing an insurer the stature of AIG in such massive trouble makes it even more dreadful.

Everyone's now talking about regulation and the need for supervisory oversight - including the 2 presidential candidates - though more in populist terms! When the credit crisis unravelled (the early Citi (NYSE:C) and Merill (MER) write-offs), I had written about the need to regulate the credit rating agencies, to avoid conflict of interest situations and also to ensure a robust methodology for ensuring forward-looking ratings. This week proves beyond a doubt that we need this and much more to lend some credibility back to the financial services sector.

I completely agree with experts who blame the Alan Greenspan era of deregulation and laissez-fare culture for creating this mess. Free market culture breeds unbridled capitalism, which in turn creates a business culture driven by short-term profit-taking...which leads to corporate decision-making power completely skewed to favor profit-generating functions. This is against the basic principle of risk management - a strong independent risk organization which mandates a firm-wide risk management policy, monitors and controls risk limits and promotes risk management-aligned business and compensation practices. It is apparent that none of this was happenning in most (if not all) of the broker dealers and investment banks. Financial innovation driven by exotic structured products and complex derivatives fueled an artificial boom whereby firms resorted to excessive leverage and focused on generating maximum returns on capital and thus maximum bonuses for revenue generating functions.

What is needed for financial services firms, especially investment banks, to win back the credibility that they have lost? Advanced modeling skills to price and value exotic products (like the so-called Level-3 'classified' assets)? Even more efficient straight-through processing engines to avoid settlement risk and operational risk? Multi-factor risk models to churn tons of data and help facilitate stress testing and scenario analysis?

All of the above would probably help - but the root of the malaise is some thing more fundamental. Lack of corporate accountability and supervisory regulation are two very important factors; however the absence of a culture driven by risk-management principles is even more important.

Look at some basic tenets - a) Independent and powerful risk management reporting to senior management, b) complete separation of duties between say, traders and back office folks, c) Defined risk exposure limits for lines of business and enforcement of the same. All of these were probably followed in letter, but not in spirit. There's absolutely no use having a compensation structure driven by risk-adjusted profits or for that matter trading policies controlled by VaR/Conditional VaR-driven exposure limits, if fundamental principles on classifying assets by risk weights, defining sectoral or instrument-level exposure limits, etc., are not followed. For once, the focus has to shift away from unbridled financial 'innovation' to enforcement of basic risk management principles.

But, having said all that, it's difficult to blame the investment banks completely for the same - since a regulatory environment which promotes extreme free-market culture does not incentivize executive management to take any long-term decisions sacrificing short-term profits. The very fact that regulatory authorities gave a short-shrift to the level of enforcement/coverage and deadlines associated with applying Basel II norms shows how callous they have been!

As Basel II norms clearly stipulate, one pillar (capital adequacy norms - driven partly/wholly by internal risk models and subsequent capital allocation) cannot hold on its own without the other two - supervisory review and market discipline. There's a lot to be done - solve the issue of overlapping supervisory roles (SEC, FDIC, OCC etc), creation of regulatory bodies to monitor systemic risk and excessive risk concentration, formation of a regulatory body/SRO to supervise the risk monitoring and rating agencies, etc.

However, none of these would solve the problem in itself - we probably need strong compliance mandates for corporate accountability and oversight to ensure that internal management of firms are driven with a balanced risk-reward mindset. Because, without it, we have enough ingenuity and brilliance in the system to thwart any regulatory oversight and exploit compliance loopholes!

Stock position: None.