Bankers hoping to escape the rigors of risk management ought to think again. Regulators are convinced the tool soon will become a must-have -- not just for the money-center banks but for almost all banks.
"I can tell you with some confidence that developing improved risk measurements will continue to be a priority for banks and regulators," Comptroller of the Currency John D. Hawke Jr. said in a recent speech. "The information revolution, technological advances, and intense competition that accompany any industry deregulation demand it.
"Banks are expected to know what risks they are taking, understand the implications of those risks, and be able to manage them."
Mr. Hawke's agency addressed the issue this month in a two-day conference titled "Measuring Financial Risk in the 21st Century." It drew several hundred people from around the world, including professional risk managers interested in cutting-edge practices and community bankers interested in keeping up with larger competitors.
Topics addressed by panelists ranged from the most basic ("What is Risk?") to the advanced ("What Future Risk Measurement Technologies Will Be Used by Banks?").
Of the several common themes, the dynamics of risk weres sounded again and again. New practices and theories are constantly emerging and being tested, as one speaker put it, "on the battlefield of the marketplace."
In addition to improving risk management, bankers seek more advanced techniques. The plan by the Basel Committee for Banking Supervision -- announced June 3 -- to revamp international capital standards suggests a framework that would let banks with sufficiently sophisticated risk management systems determine their own capital requirements.
The Basel committee's proposal recommends an interim step that bankers find so unpalatable it may hasten the development of risk management. This step would use credit rating agencies to assess the risk of certain assets and assign them to one of a handful of "buckets" for which capital levels are predetermined.
The banking industry has "a need for rationality in regulatory capital requirements," said Charles Monet, a managing director at J.P. Morgan & Co. "The current (Basel) proposal," he added, "is not that."
During the conference, three broad areas of concern emerged: assuring the quality of the data used to measure risk, problems with the models used to process this information, and the lack of understanding by top management of what risk measurements do and, more important, do not do.
Underlying every presentation was a fourth concern: measuring operational risk. As the field expands, it is becoming nearly impossible to quantify the risk posed by potential failures in correlated business lines, by computer hackers, by employee fraud, and by failures of internal controls. (See related story on this page.)
Needed to calculate the risk associated with an asset are its promised return, the probability of default or a downgrading, and expected loss in the event of default. "These are what we need to calculate risk," said Charles Smithson of Rutter Associates, "and right now we only have good data on one of the three -- promised return."
Representatives of large banks with established risk management systems, such as Mr. Monet of J.P. Morgan and Lesley Daniels Webster of Chase Manhattan Corp., emphasized the need to value assets in the context of current market prices -- known as "marking to market" -- in order to assess realistically how their portfolios would perform under stress.
Though common in the securities industry, marking to market has been resisted by bankers, who argue that because they hold many of their assets to a distant maturity, current market values are not representative of assets' long-term value.
Christine Cumming, executive vice president of the Federal Reserve Bank of New York, and Tanya Styblo Beder, managing director of Caxton Corp. in New York, said that data collection -- which currently relies on quarterly reporting by companies and annual reviews by loan committees -- has fallen far behind the speed of business and the needs of risk managers.
"An annual review is an absurd concept," said Brian J. Ranson, executive vice president of Bank of Montreal. "The world simply doesn't move at that pace, and credit risk does not change ... in time with annual reviews."
Numerous speakers, including Mr. Hawke, said the formulas risk managers use actually carry a measure of risk themselves. "Since risk measurement relies on models, we expect banks to be aware that they face model risk -- the imprecision associated with the use of any model," the comptroller said. "We expect banks to approach model risk in a prudent and systematic fashion, as they would approach any other risk that they face."
The most carefully constructed model, others said, is still only a model.
"Even models that are not fundamentally flawed are just approximations of reality," warned Jeffrey A. Brown, the OCC's director for risk analysis.
Speakers who addressed model risk, including Federal Reserve Board Chairman Alan Greenspan, advocated stress testing and model validation processes to confirm the models' underlying assumptions. Mr. Greenspan's comments on this subject were sufficiently pointed to contribute to a stock market plunge Oct. 15, the day after he spoke.
Finally, speakers said, various human elements can interfere with accurate and useful risk management. Simple internal controls -- such as making sure the portfolio manager is not a direct supervisor of the analyst -- are needed to avoid contamination of data.
Also vital is the careful explanation of what risk measurements are actually indicating. The commonly used value-at-risk formulation measures only the probability of potential losses under normal market conditions, said Robert J. Mackay, senior vice president of National Economic Research Associates. It does not give a worst-case, or near-worst-case scenario, and it completely fails to predict the amount of catastrophic loss possible under stressed market conditions, he said.
"It is incumbent on risk managers to make sure these things get heard," Mr. Mackay said. "It's not a flaw in VaR itself but a flaw in understanding of what it is capable of."
On the same subject, Mr. Hawke said, "Until we adjust expectations about what risk models can realistically deliver, some who use them will inevitably be disappointed."
