The explosive growth in the derivatives market has spurred unprecedented cooperation between international banking and securities regulators, who this week teamed up to issue supervision and risk management guidelines.
The Basel Committee on Banking Supervision and the technical committee of the International Organization of Securities Commissions issued separate papers that drew. the same conclusion: Sound internal risk management is essential for both banks and securities dealers in promoting the stability of the financial markets worldwide.
While the suggestions contained in the regulators' guidelines have been standard operating procedure in the United States for many years, the joint announcement is significant because it brings the market another step closer to global standardization.
A Different Kind of Risk
The risks associated with trading derivatives are no more severe than other risks faced by banks, but they are different, said Erik Musch, secretary general of the Basel committee.
"We've adopted a risk-based capital requirement to handle off-balance-sheet credit risk. But derivatives need another approach" because they are subject to more than just credit risk, he said Wednesday at an annual meeting of the International Swaps and Derivatives Association in New York.
Separately, attendees at the conference heard reports from U.S. regulators that new rules are not imminent. (See story on back page.)
Mr. Musch explained that it is not the cost of the derivatives contract that causes problems, but rather the potential replacement costs, should one of the parties involved fail to hold up its end of an agreement.
"Adequate risk management has been a concern of the Basel committee for some time," Mr. Musch said. "Derivatives and the risks inherent in them are not new, but the growing diversity and complexity of derivatives is."
Potential Trouble Spots
The joint guidelines were issued in the expectation that they "will facilitate the further development of a prudent supervisory approach to the risk management of derivatives," the organizations said in a statement.
They focus on potential trouble spots in the areas of credit risk, market risk, and liquidity risk, as well as settlement, operations, and legal risk.
"A comprehensive risk management approach should be integrated into the institution's overall risk management process as much as possible," Mr. Musch said. "A routine and rigorous policy of stress testing is important. Stress testing now is done in some casual ways. It shouldn't be something a senior manager does on the back of an envelope."
The regulators emphasized that the new guidelines are not intended as a hard-and-fast risk management policy, but as prudent suggestions.
"These guidelines do not substitute for adequate capital standards," the regulators pointed out. "The committee has already introduced minimum capital requirements for credit risk in derivatives products .... However, capital requirements are not on their own sufficient safeguards against risks from derivatives activities."