Official Says Risk Management Is Now a Separate Discipline

By James Hamilton, J.D., LL.M., Senior Writer Analyst, CCH Federal Securities Law Reporter; Co-Author, CCH Federal Privacy Rules for Financial Institutions.

The Reserve Bank official went on to note that the practice of risk management has finally evolved as its own separate and distinct discipline. As this evolution has taken place, the financial industry has worked to improve risk management techniques, and regulators have indicated an increased commitment to risk focused examinations. But as the industry evolves, he cautioned, risk management systems will need to improve even further and become a greater part of an institution’s decision-making process.

In recent years, risk management has become an increasingly prevalent and accepted industry discipline, observed Santomero. Institutions have rushed to develop systems and install processes to manage the risks that are an inevitable part of the financial landscape. Institutions now understand that risks of various types, embedded throughout their portfolios, must be managed both carefully and rigorously. Collectively, they impose an aggregate level of risk that can threaten the very solvency of the institution.

These developments have not been lost on regulators, said the Reserve Bank president, and they have embraced the new discipline of risk management. Regulators have made the very practical move to risk-based examinations rather than just looking at point-in-time balance sheets and financial ratios.

In addition, as the financial system has became more complex, regulators have encouraged more private sector innovation in the belief that markets are quite efficient at sorting out their own best practices. According to Santomero, the Fed’s own philosophy is that flexible yet watchful supervision, complemented by market discipline, is the best approach to ensure a safe and stable financial system.

ADVANCED RISK MANAGEMENT TECHNIQUES

Finally, Santomero emphasized that the new Basel II Accord should be seen as quite distinct from predecessor regulations in at least one important respect—it is an effort to engage both the industry and the regulators in using advanced risk management techniques. This shows through in two important ways. First, whereas Basel I focused only on regulatory capital adequacy, Basel II gives equal consideration to minimum capital ratios, supervisory review, and market discipline. Second, substantial effort has been made to incorporate the risk management practices that institutions actually use into the process and to increase the risk sensitivity of the minimum capital requirements.

Basel II is complex, he admitted, but hastened to add that its complexity reflects the underlying complexity of risk and risk management in modern financial institutions. Yet, it is “doable,” in his opinion. By proposing the use of a bank’s own risk management system in the advanced internal risk based (or IRB) approach, Basel II engages the industry’s risk management community in the determination of appropriate bank risk levels and regulatory capital ratios.

In its present form, explained the central banker, the advanced IRB approach is designed to employ the advanced risk management systems that banks have in place for day-to-day operations in the determination of capital adequacy. Regulators will need to certify that the bank’s systems are up to the task, and in many cases, this may require substantial improvement of the systems. However, the approach is one requiring banking institutions and regulators to work together to improve the existing best practices in the industry.

According to Santomero, it is important to recognize that just as Basel I became obsolete, Basel II will not be the final word on risk management regulation. But it is a step forward in that its structure works to encourage the industry and regulators toward better risk management practices. In this way, he foresees the industry itself leading in the evolution of risk management.