You Can’t Manage What You Can’t Measure!!

GREEDY bankers, poor risk managers, weak top management, sloppy regulators and confused governments have created a right royal mess in the global economy. There are increasing calls from policy makers to establish systemic-risk regulators.

By P V Ramanathan

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Published: Tue 28 Jul 2009, 12:57 AM

Last updated: Sun 5 Apr 2015, 10:30 PM

The G-20 nations have embraced this concept. Some have gone to the extent of calling for a supra-national body to oversee this on a global basis.

The first question — can it be done? The simple answer is YES. Will it be easy — the simple answer is ‘no’. In the aftermath of the 9/11, central banks round the world moved quickly to tighten money laundering regulations, making KYC mandatory for all bank accounts and transactions. These were cumbersome in the beginning but the world quickly got used to it. The world will get used to this systemic-risk regulation proposal as well. After all, it only involves institutions many of whom have gone to the government with a begging bowl not so long ago.

The bulk of the problem facing the financial world today has occurred because of leverage and the inability to unwind positions (often illiquid) in a market going down rapidly and inexorably. The downward momentum is just the beginning of the problem. When a market is under stress, it is difficult for an institution to sell what it wants to sell to reduce leverage. If they cant sell what they want to sell, they sell what they can sell which leads to a general downward spiral. A similar thing happened during the famous Hunt Brothers induced silver market scandal in the early eightees. In a rapidly deteriorating silver market, the Hunt Brothers could not unwind their silver positions and so what did they do – they unwound their cattle positions and the cattle market came under pressure.

There is a problem with managing systemic risk. Managing systemic risk requires knowledge about:

a) Systemic leverage;

b) Aggregated position holdings; and

c) Crowding – too many people chasing the same deals/positions/strategies.

However good their risk controls, individual institutions do not have this broader data. And neither do the regulators and even regulators cannot track investor concentration by assets or strategies nor can they assess the overall risk inherent in the huge swaps and derivatives markets. Therefore there is no way they can say what will happen to one market when another goes down. Let us now turn to look at what is needed to make this systemic risk regulator concept a success. There are four things needed to make this concept a success:

1) Beef up risk control departments in all institutions;

2) Make risk managers more accountable — much in the same way as compliance managers are more accountable post 9/11;

3) Make top management more accountable — most of the problems with the financial world today is not the failure of risk control models. Instead it was organisational — it had to with incentives, lack of communication and plain old fashioned pig-headedness of the top management; and

4) Ensure systemic risk regulators have direct access to the Chief Risk Officers of the institutions — an “external ombudsman” concept will work well.

To this, Richard Bookstaber, writing a wonderful article in the June 09 issue of the Institutional Investor, adds three more wonderful ideas:

a) Monitor financial products the same way that you would monitor food and drugs. He cites the example of salmonella discovered in a peanut factory in Georgia. As soon as the discovery was made, the FDA was able to track the problem product all the way to store shelves thanks to an elaborate tagging system. He says, if necessary, financial products could also be tagged so that the regulator can know which bank or hedge fund owns how much of these products.

b) Ensure that the regulator learns from every market crisis. He likens this to the National Transportation Safety Board’s investigation of each and every air crash site. He says regulators must “eyeball new financial products for their systemic risk potential”; and finally

c) Change the mindset behind regulation — hire the best brains in the business and pay them well.

You cant manage what you cant measure and it is difficult to measure what you cant see. It will be interesting to see how this idea develops around the world and how much lobbyists with vested interests are able to water these down. Stay tuned.

Views expressed by the author are his own and do not reflect the newspaper’s policy.

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