How are systemic risks mitigated?
Should central banks develop and apply a model (compare to Basel Risk Models) to manage systemic risk? part 1

Paul van Dam Project Manager / Business Consultant in Financial Services and (Financial and Management) Accounting

Which parameters must be included?
Is this a quantitative or qualitative model?

Please comment. Maybe we can bring the discussion further
Comments (18)
Boris Agranovich
Consultant, Project Manager, deal maker, helping clients successfully increase revenue, manage risk and enhance control.
Great question, Paul.
For my understanding the main reasons for regulation to exist is to reduce systemic risk or collapse of the current financial system. But the current situation allows regulation arbitrage, which brings systemic risk back.
Another measure of systemic risk is a number of Too Big to fail institutions. To be able to properly mitigate this situation such institutions should be downsized.
Interconnection between financial institutions is also a major factor (look at Lehman)
Jorge Iwaszkiewicz

Bank & International Management Adviser
I agree with the general comment, that arbitrage will always be there. The financial world is too interconnected today.
I am not too sure about "downsizing" large financial institutions may be the answer. I think the area where more regulation and control should be focused is on the "inter-connectivity" of these financial behemoths!
Reporting by these financial institutions should be "more transparent", adhere to stricter international guidelines from Basel(?), and, hopefully, some sort of "transaction fee" should be imposed on ALL financial institutions to contribute to a fund,"just in case".
Boris Agranovich 

Consultant, Project Manager, deal maker, helping clients successfully increase revenue, manage risk and enhance control.
There is an article in on this issue
IMF weighs in to too-big-to-fail debate
Report looks at current proposals to deal with systemic risk and bank failures
David Runk, CPA

Chief Risk Officer at First National Bank of Mifflintown
It is very rare that something happens that affects the entire system at one time. I think the great recession was started from fraud and compounded by a lack of confidence in the financial system. Until the Chief Risk Officers have a seat in the Board Room and afforded true independence, it's only matter of time until we get there again.
Steven Smallsman

Senior Manager, Financial Risk Management at KPMG
The BCBS has produced a consultative document on liquidity risk management in which there is recognition of (amongst other things) the risk of market-wide liquidity shocks - .

Solomon O. Omidiji
Student at University of Tampa - John H. Sykes College of Business
First, I absolutely agree with David Runk's comments and other contributors' thoughtful contributions.

Also, Central Bankers must as a matter of priority and in the interest of conforming with global initiatives on financial transparency and ethical governance, institutionalize country-specific risk management model that will best take care of each player's business risks (commercial and investment banking, mutual funds, insurance, mortgage, brokeraging institutions etc) within the financial system, without loosing the flavor of Basle I & II compliance requirements.

This is necessary to reflect the nature and depth of risk appetite peculiar to each country, financial market, and institutional player, while simultaneously ensuring stricter compliance with global norms.

Guided de-regulation and strategic reform/re-regulation of broader "rules of the roads or engagements" for the financial sector are inevitable if the GFC (global financial crisis) of recent years is to be fenced off from revisiting the markets and economies within a minimal time span from today.

Re-regulation in this context is to lay stronger risk management policy foundations and structures for a healthier financial system over the long haul, while ensuring systematic re-sanitization of the stained governance systems of recent past.
Nihar Mehta

MSc Finance Strathclyde University
This debate could take a look at another angle. Academics have criticized regulation itself as a cause of systemic risk. Having deposit insurance on banks for example causes moral hazard problems for the bankers. Also, having the central bank as the lender of last resort adds to the problem. Making "Big Banks" pay the additional insurance could perhaps also lead to big banks having moral hazard issues. Similar opinions are shared by academics - Benston and Kaufman (1996) in their article "The appropriate role of bank regulations". They concede weather we like it or not, regulation is here to stay so no point making a case against it. This is just one example of a paper that argues against regulation.

Perhaps having more transparency or information of information may be the key to solving this issue as Jorge has pointed out. This was a big problem in untangle Lehman. This would solve the inter-connectedness problem.

Another twist in the debate could be, is this really the role of a central bank? In the UK there is a separation between the Bank of England and the FSA. Bank of England is tasked with managing the debt office and keeping inflation on target. Regulation and supervision is handled by the FSA. Granted the FSA is answerable to the Bank and the public but they remain separate entities.
Guan Seng Khoo, PhD

Snr Director/Head, Quantitative Analytics, Risk Mgt
David is right. Until the CRO and risk mgrs are really "empowered", it will be financial crisis redux. Also, there's the element of turf control among the various regulatory agencies, e.g. NAIC, etc. and regulatory arbitrage with most banks in the US still on Basel 1 with antiquated securitization & derivatives regulations for the shadow banking system, while other banks around the world are on Basel 2, with Basel 3 evolving and the emerging fallout from today's SEC's charges against Goldman for misrepresentation & fraud!

Paul van Dam

Project Manager / Business Consultant in Financial Services and (Financial and Management) Accounting
Thanks all, for your contributions so far. I hope to see this discussion continued.This idea came to my mind, when I read that central banks are complaining over the banks restricting their support of businesses with credit. This while supervisors require higher solvency ratios for banks, separate investment and commercial banking, But, as concluded by Boris Agranovich, the supervision of the central banks traditionally used to be aiming at systemic risks (amongst others), but why weren't they capable to detect extreme tension wihtin the international financial system before the most recent GFC?
Some reflections triggered by the input, so far are:
- although models may be helpful, professional judgment always must precede substantial decisions
- country specific risk may facilitate regulation arbitrage
- Euro countries have a more complex regulatory situation, as the responsibilities are spread over ECB (price control), National Central Banks (national financial stability, monetary policy, payments system oversight), behavioural watchdogs (AFM, AMF etc.), where there is competition in tax regimes between the Euro-participating countries and there is a lack of economic convergence
- OTC trades tend to blur transparency (need they be cleared centrally, as is now underway)
- are CRO's employed by a specific bank allowed to get together and decide for their collective market behaviour (competing banks)?
- liquidity squeeze may inflict insolvency
- judgment of product risk can only made by individual banks
I will come back later on these issues.
Some parameters that I deem essential for a model supporting detection of systemic risk are:
- market interest rate (central banks)
- volume of derivatives traded
- ratio of risk compared to earnings
- intensity of regulation arbitrage
- size of financial industry in relation to Gross National Product

Thanks again so far guys, let's continue the discussion.

Eric Glaas

Risk Management Consultant
Some excellent discussion here on the nature of systemic risk. How we measure risk concentration at the supranational level seems critical here. I suspect that one would find all manner of latency and transparency challenges in estimating systemic risk across borders. We may find that money market funds and brokered deposits players serve as a "transmission mechanism", for lack of a better phrase, for measuring liquidity concentration. The BIS paper to which Steve referred above does distinguish between liquidity coverage (30 day window) and net stable funding (1 year window), with the latter addressing off-balance sheet exposures. So addressing systemic risk as a liquidity issue may yield more immediate benefits, with a longer-term view of identifying systemic risk in a predictive sense.
Ziya Eken

Senior Consultant at avantage
Certainly very relevant and up to date discussion,
Sharing the same thought about "interconnectedness" being a major concern, I think the institutions which innovate (like credit risk transfer or substitution products etc) should be treated differently from the institutions only using those. There should be much wider disclosure requirements on the innovative institutions and a centralized body should also follow the multiplier effect of these innovations since those are subject to many use over and over by chain of institutions.
Unless Innovations are monitored and managed properly, those do not always lead to progress and financial development.
Paul van Dam

Project Manager / Business Consultant in Financial Services and (Financial and Management) Accounting
@Ziya and others:
Should this imply that many products will be forbidden somehow?

Ziya Eken

Senior Consultant at avantage
Dear Paul,
Frankly speaking I support the reverse. While having ground for this much innovative academic and practical appetite, sooner or later the industry will face with these upcoming trend. So, understanding (especially from regulatory body side) and putting proper (but not restricting) regulation and supervision on those would lead more robust financial system I think.
Boris Agranovich

Consultant, Project Manager, deal maker, helping clients successfully increase revenue, manage risk and enhance control.
I certainly agree with Ziya that innovative institutions, like Goldman should be placed by more attentive regulatory regime. At the same time uncontrolled innovation and fancy product creation, (printing money) will certainly lead to bigger systemic risk and probably to crash of the capitalistic system as we know it. I will recommend you to watch some videos that I collected on Global Risk Community site:
Pay attention to "Money as debt" and "The Quants -alchemist of financial world"
To be able to watch the videos you have to sign up to the site, which takes only 1 minute.
Steve Folan

Versatile and Adaptable Programme Manager, Team Leader in Finance, Technology and Energy Sectors
Treat new financial products the way the pharmaceutical industry treats new drugs and don't bother working out systemic risk. These new products are rarely innovative but just complicated enough to fool the clients and the risk managers. Such an approach won't stop the problems but it will slow them down and they will be fewer.

Ideas like 'managing systemic risk' give risk managers a bad name - its the sort of idea that the European Commission would come up with.
Paul van Dam

Project Manager / Business Consultant in Financial Services and (Financial and Management) Accounting
But so many banking products (swaps, CDO's, CDS's) are based on differences in markets and therefore rely on interconnection. So, how can the interconnectedness of the international financial markets be reduced if these products are still traded? I guess this confirms Boris' comment.
Another comment I need to make is that in my opinion risk managers are not the ones that must be responsible or are able to manage systemic risk. Responibility lies with the central banks and oversight institutions like BCBS and IMF.
Ziya Eken

Senior Consultant at avantage
But I think we should be careful while drawing the boundaries of systemic risk. Risk managers will always be responsible for part of it while managing portfolio based credit risk. There are many adjacent issues like pricing, integrated risk management, counterparty rating and credit risk capital models for which you have to take systemic risk (asset and default correlations etc..) into account.
However I totally agree on having need for broader authorities to regulate disclosure and structures of innovations.
But this is coming soon I think. In C-EBS website it is quoted that "More recently CEBS has been involved in the expected changes in the institutional arrangements that anticipate a changeover from CEBS to the future European Banking Authority (EBA) by the end of 2010."
Aytekin Bilgili

Risk manager at Business Lease
If risks are improperly assessed and prioritized, time can be wasted in dealing with risk of losses that are not likely to occur. Spending too much time assessing and managing unlikely risks can divert resources that could be used more profitably. Unlikely events do occur but if the risk is unlikely enough to occur it may be better to simply retain the risk and deal with the result if the loss does in fact occur. Qualitative risk assessment is subjective and lacks consistency. The primary justification for a formal risk assessment process is legal and bureaucratic.

Prioritizing the risk management processes too highly could keep an organization from ever completing a project or even getting started. This is especially true if other work is suspended until the risk management process is considered complete.

It is also important to keep in mind the distinction between risk and uncertainty. Risk can be measured by impacts x probability.

to be continued...