Requiring banks to enhance the quality and quantity of their capital and liquidity reserves is one way to help make the financial system safer. But it's only part of the solution.
Regulators' short-term response to the global financial crisis has been to require banks to hold more capital with the aim of increasing their capacity to buffer unexpected losses. They have also introduced mechanisms to counter model risk and measurement error in capital adequacy calculations. These efforts have been primarily driven by the Basel Committee on Banking Supervision and the Financial Stability Board.
Banks dramatically increased their risk-taking in the run-up to the financial crisis for a number of reasons, including the complexity of financial products, de-regulation, and escalating business consolidations due to globalization. These changes occurred over the course of little more than a generation and at a pace that did not allow regulators, accountants, auditors, risk managers and technologists the time to design and implement sufficiently robust risk control, monitoring and reporting systems. This resulted in massive accumulations of exposures to risk in the global banking system that escaped timely identification and quantification.
The longer-term response by these same regulators gets at the root of the problem by placing emphasis on implementing more robust risk management frameworks and technology infrastructures.
Five such recently announced frameworks are worthy of particular mention. Basel's principles for effective risk data aggregation and risk reporting and regulatory framework for balancing risk sensitivity, simplicity and comparability are among them. The FSB has also issued principles for an effective risk appetite framework, guidance on supervisory interaction with financial institutions on risk culture and a report entitled "A Global Legal Entity Identifier for Financial Markets."
The above five initiatives are interdependent. For example, an effective risk appetite framework is dependent on a bank's ability to aggregate risk data. The ability to aggregate data is dependent on defining participants in transactions consistently through common identification standards. And the development of a positive risk culture is dependent on the implementation of an effective risk appetite framework. None of this will be possible if we do not achieve a greater degree of simplicity and comparability in the regulatory framework.
We highlight these mandates as we believe they provide the cornerstone for a future global banking system. Their implementation by industry members will be a proactive response to the financial crisis and its aftermath, not a reactive one where more capital is simply used to count down to failure.
We need a "firm-at-risk" risk management regime, not just the "capital-at-risk" one that we have now. The FSB is pointing the banking industry in the right direction. Banks simply need to take the bait.
Allan D. Grody is president of Financial InterGroup Holdings Ltd, editorial board member of the Journal of Risk Management in Financial Institutions and a member of the Blue Ribbon Advisory panel to the Professional Risk Managers International Association. Peter J. Hughes is executive director of Financial InterGroup (UK) and research fellow at Leeds University.