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August 2010

RMI hosts 4th Annual Risk Management Conference

The NUS Risk Management Institute (RMI) hosted its Fourth Annual Risk Management Conference from 15 - 17 July 2010 at the Shangri-La Hotel, Singapore. The topical theme of the conference was 'The Risk Management Paradigm in the Post-Crisis Era.' The event featured a one day policy forum, followed by a one and a half day scientific program which drew over 350 delegates from the financial sector, central banks, regulatory agencies, academia and think tanks.

In the inaugural session chaired by RMI Director Prof. Jin-Chuan Duan, NUS President Prof. Tan Chorh Chuan gave the opening remarks and welcomed the delegates. He pointed out RMI's rapid growth in four focus areas of education, training, research and industrial outreach. He stated that while its flagship Master of Financial Engineering Program remained popular, of particular significance was a major credit rating initiative that covered 12 major economies in the Asia Pacific region.

Implications for investment and risk management

The Guest of Honor, Mr. Ong Chong Tee, Deputy Managing Director at the Monetary Authority of Singapore (MAS) spoke of the implications of the post-crisis period for investors and financial regulators. He highlighted the challenges for investment and risk management from an investor's perspective. The fact that the risk-return trade-off has become more acute in a post-crisis world created three challenges for risk management. Firstly, the fundamental tenets on which much of risk management tools and methodologies were built have been severely challenged by the recent crisis. High asset correlations had undermined the benefits of portfolio diversification. The assumption of rational markets was also being questioned. The liquidity crunch resulted in a massive sell off in high risk weighted assets. Subsequently for long periods pricing anomalies like TIPS with negative interest rates were observed, along with 30-year negative swaps spreads and depressed prices on high quality asset-backed securities. "Thus, models assuming market rationality may need to be augmented with some dose of behavioral finance," he added. Moreover, the normality of asset returns especially at the tail of the distribution led to underestimation of the probability of extreme risk events. Stress tests were needed to ameliorate the shortcomings of VAR models. A second challenge for investors, according to Mr. Ong, was management of 'indirect and attendant risks', encompassing a whole host of non-price risks including counterparty credit risk, legal risk, modeling risks and operational risk. According to him, there was limited awareness of risk mitigation techniques in this area as compared to market price risk. A third challenge for investors was trying to grasp the shape a 'steady state' would assume in the current unsettled environment. Although Asia had been relatively unscathed from the crisis, there has been substantial structural change in financial markets and the nature of financial flows. Regulators were confronted with new challenges to maintain financial stability and risk management techniques had to evolve and adapt, along with product innovation. 

Mr. Ong spoke of moves towards expanding the role and responsibilities of regulators and central bankers in the aftermath of the crisis. It was apparent from the crisis that sound monetary policy alone was inadequate for maintaining financial stability. The crisis had reinforced the need to monitor the buildup of systemic risks and for sound macro surveillance and use of macroprudential policy tools. He called for more research and understanding of the development of macroprudential tools that incorporate local and regional idiosyncrasies. However, Mr. Ong cautioned against over-reliance on them, "Ultimately, both macro- and micro-prudential policies will be essential components of the new post-crisis regulatory framework, working alongside other instruments and policies in a calibrated and mutually enforcing manner," he added.

Mr. Ong highlighted two important developments among central banks during the crisis: the proliferation of foreign exchange swaps and cross-border collateral agreements. The next phase of market development would require Asia to not just continue to develop the local currency bond markets, but also look at improving cross-market access including harmonizing of standards and documentations.

Future directions for the credit rating industry

The second session focused on the future of the credit rating industry was moderated by Prof. Patricia Langohr of ESSEC Business School. Problems in the functioning of rating agencies were deemed to be one of the pivotal causes of the financial crisis. David Crammond, CEO of Crammond & Partners, believed that since investors have lost faith in credit rating agencies (CRAs), and governments thought they were best placed to determine rating policies rather than industry experts, the future of the credit rating industry could be characterized by more government oversight. Ratings xenophobia, the distrust of ratings by foreign ratings agencies, would also feature more prominently as governments believed that locals had a better understanding of the context of the domestic market. From a CRA's perspective, D. R. Dogra, Managing Director and CEO of India's Credit Analysis & Research noted that the debate on business model of CRAs should focus on 'how can the system encourage high quality ratings' rather than 'who should pay for ratings'. To strengthen analytical integrity, analysts should not be involved in designing the structure of an issue but do more rigorous stress testing of financial models, and be able to incorporate soft information, such as the integrity of the accounting information in the rating process.

A highlight of the session was Prof. Duan's presentation on RMI's credit rating initiative. The initiative operates on a unique approach whereby RMI builds and maintains the research infrastructure with 1) a comprehensive database of over 20,000 currently listed Asian firms from 12 Asian economies, and around 5,000 delisted firms which includes over 1,600 defaulted or bankrupt firms since 1990, and 2) an advanced IT system with both grid and parallel computing capability. He also mentioned that researchers have to compete to get their models adopted for the RMI ratings. This approach runs like a "selective Wikipedia", a timely amalgamation of the best research ideas, where the rating methodology is allowed to evolve organically. A global call for proposals has been conducted and the 11 winning research teams plus an RMI internal team have been working on their different rating models, he said. Despite the size of the major credit rating agencies and their access to proprietary data, he cited evidence to suggest that it is possible for a purely quantitative model to achieve better accuracy. The beta version of the RMI ratings system (available at http://www.rmi.nus.edu.sg/cri/) based on a forward intensity model was rolled out at the conference and, like Wikipedia, RMI welcomes any challenges and improvement to this methodology as part of its scientific pursuit of the best rating model. However, it was also noted that credit analysts may also have valuable soft information regarding the firms under their coverage. Hence, RMI has conceived the Credit Analyst Survey (http://www.rmi.nus.edu.sg/survey/) to assemble such information and help improve credit analysis. The survey's results will be made available only to survey participants for now to encourage greater industry participation.

Reforming the international financial system

The theme of the concluding morning session 'Reforming the International Financial System' reiterated the stress laid on macroprudential supervision. The session was chaired by Dr. Sung Cheng-Chih, Chief Risk Officer of Government of Singapore Investment Corporation. Dr. Sung provided an informative insight into the challenges that laid ahead for market participants and regulators. Mr. Tham Ming Soong, Chief Risk Officer of UOB Bank gave a useful overview of the origins of the crisis and the impact on different stakeholders. He struck a cautionary note, stating that the global economy was not entirely out of the woods. Several challenges remained, e.g. creating a global regulatory framework, disparities in economic structures across economies leading to an uneven recovery, and the surfeit of liquidity in the global economy following loose monetary policies and the fiscal stimulus. These could jeopardize prospects for a smooth recovery, he emphasized. The next speaker, Ms. Nell Cady-Kruse, Chief Risk Officer for Credit Suisse, Asia Pacific, focused on the reforms necessary within the Basel Accord, and shared with the audience insights on the Basel III. She noted that the Basel III laid considerable emphasis on capital, risk capture and leverage, and also on the new minimum quantitative liquidity standards. She pointed out that it was not a case of survival of the fittest, but organizations that were most responsive to changes were the ones that would survive the financial crisis.

Dr. Eli Remolona, Chief Representative for Asia and the Pacific at the Bank for International Settlements (BIS) further examined macroprudential reforms. He opined that a credit bubble that was five years in the making, coupled with unchecked reliance on short-term debt, enhanced the vulnerability in the financial system. The crisis reiterated the importance of checking banks' propensity to take on excessive risks during high growth periods, as regulators also run the risk of becoming caught up in the exuberance. Building up regulatory buffers and imposition of capital charges on institutions of systemic importance was essential for strengthening the global capital framework. He also stressed the importance of effective governance of financial institutions, developing countercyclical buffers, imposition of systemic surcharges, and guidelines for dealing with liquidity problems on a systemic basis.

The session's last speaker was Dr. Mangal Goswami, Deputy Director of IMF - Singapore Training Institute. After outlining the origins of systemic risk, he stated that the challenge was to understand and formulate a robust framework for assessing systemic risks of institutions, markets and instruments as these risks were linked to the moral hazard of being 'too-big-to-fail' (TBTF) and 'too-interconnected-to-fail' (TITF). He pointed out that the IMF, along with the Financial Stability Board and the BIS, was actively working towards producing guidelines for such an undertaking. In its analytical assessment, size measured by volume of financial transactions, substitutability, and interconnectedness, were considered to be the primary criteria, while vulnerabilities were deemed to be secondary. One of the broader policy considerations Dr. Goswami said was to limit the market advantages that intermediaries and institutions derived from being TBTF or TITF, and the related negative externalities they inflicted on the entire economy.

Best practices in risk management

Following an inspiring keynote address given by Prof. Myron S Scholes, Nobel Laureate and Frank E. Buck Professor of Finance, Emeritus, from Stanford University on "Risk Management: Lessons from the Crisis", the timely focus of the first afternoon session was on 'Best Practices in Risk Management - Managing the Evolving Risk Function'. In this session jointly-organized with the Institute of Banking and Finance, an informative and useful overview of the pre-crisis and the needs for a post-crisis risk management paradigm was provided by Mr. Chris Matten, Partner, PricewaterhouseCoopers Singapore. He elaborated on the dichotomy between the finance manager's and the risk manager's views of a bank's operations. Holistic balance sheet management was fast emerging as the 'best' paradigm. It was imperative for risk managers and accountants to understand each other's language. Risk managers needed to transcend the isolated silo approach to incorporate the interactions between different types of risks. As was the case with most other speakers, he emphasized the importance of stress tests as a complement to traditional risk assessment.

The importance of stress tests was reiterated by Mr. Gopalan Vedartham, Head of Market Risk, Asia Pacific at Barclays Capital. He explained the importance of the tests, which had been recently carried out throughout the European Union. Regulators in several other economies have embarked on stress testing financial institutions under their jurisdictions. Mr. Gopalan elaborated on the type of stress tests that were being carried out, and how they fitted into the risk management framework. He delineated the essential advantages and drawbacks of these tests as risk management tools. He shared his thoughts on what constituted a useful framework for stress testing, concluding with some observations on what had gone wrong during the subprime crisis and a possible way forward.

An overview of the regulatory initiatives undertaken in the U.S. as well as the basic tenets of Basel III was highlighted by Mr. Vincent Choo, Managing Director of Market Risk Management at Deutsche Bank. In agreement with other speakers, he highlighted the need for monitoring leverage and enhancing capital requirements. According to him, dealing with liquidity constraints would be a major challenge. He advocated an approach to risk management that would integrate different risks, concluding with a call for risk managers to be proactive - a theme that was emphasized by nearly all the speakers.

New approaches to measuring and managing credit risk

The concluding session of the policy forum on New Approaches to Measuring and Managing Credit Risk was co-sponsored by the International Association of Credit Portfolio Managers (IACPM). As chair of the first session, Dr. Jeffrey Bohn, Head of Portfolio Analytics and Economic Capital from Standard Chartered Bank, elaborated on the tension between regulatory capital and economic capital. He felt that regulatory capital arbitrage underpinned much of what went wrong during the subprime crisis. Mr. Noel D'Cruz, Head of Risk Portfolio Management from OCBC Bank, provided another perspective, noting that risk management was an evolving process and the aim of Basel II was to avoid the arbitrage that existed under the previous regime. However, subsequent experiences had raised serious questions about the adequacy of the framework. He further delineated the microeconomics from the macro causes of the crisis. While he acknowledged that Basel II and some of the proposed legislation addressed the problem, he expected the emphasis to be on higher levels of regulatory capital and improved disclosure. He went on to elaborate on the modeling challenges for risk managers, saying there was a need for improved measurement and development of better risk metrics within financial institutions.

Mr. Shaji Chandrasenan, Director of Financial Risk Supervision Division at MAS, outlined the range of practices for addressing the issue of aligning regulatory capital with economic capital. He cited the BIS Document published in March 2009 which spelt out the major concerns and issues that needed to be addressed by regulators. At the forefront were definitions of risk measures; the challenge of dealing with risk aggregation, and the development of model validation methodologies. Mr. Chandrasenan provided an informative taxonomy of the different risk measures deployed by banks. On the challenging question of risk aggregation, he proposed a framework that articulated the methodology and supervisors' concerns. He emphasized the importance for risk managers to recognize risk amplification when considering interaction between different types of risks, e.g., market and credit risks. For validation purposes, simulation in tandem with other tests is useful for highlighting the consequences of different scenarios. The organizational structure of the bank and the economic nature of risks were crucial for defining aggregate risk, he added.

The concluding session, chaired by Ms. Marcia Banks, IACPM's associate director, comprised of a panel with Mr. Oliver Parenty, Head of Resource and Portfolio Management, Asia Pacific, BNP Paribas, Mr. Andrew Rothery, Head of Loan Exposure Management Group, Asia Pacific, Deutsche Bank, and Mr. Benoit Strosser, Senior Credit Portfolio Manager from JP Morgan Chase. The panel presented results of an IACPM survey on the Principles and Practices of Managing Credit Risk in a Changing Environment. The survey revealed unanimity on the importance of reducing concentration risk and managing credit migration risk. On the issue of coverage, corporate loans were covered by all institutions, while there were significant differences in coverage of the trade finance book, trading counterparty exposure, and coverage of workouts and the SME/Middle Market sector.

According to the survey, European banks have been found to consider broader classes risks compared to the JP Morgan, the only American bank in the sample.

The survey also highlighted differences in emphasis on risk mitigation challenges and opportunities between European and American banks, and banks in Asia outside Japan.

A lively scientific program

The scientific program was organized along the lines of an academic conference following a competitive global call for papers. It comprised of 28 papers on cutting edge themes of risk management. The highlights were four plenary sessions featuring globally recognized researchers from academia. In his talk on 'From Maths to Alchemy and Magic', Dr. Damiano Brigo, Managing Director, Fitch Solutions, and visiting professor at the Department of Mathematics at Imperial College, London, provided a vigorous defense of quantitative modeling in risk management. He pointed out how years before the crisis, academicians and some practitioners had pointed out the limitations of excessive reliance on models. The models were essentially of a static nature, and as good as the underlying assumptions. 'Quants' had become a handy scapegoat for the ills that permeated the financial system. Dr. Brigo pointed towards lax lending practices; poor, tainted and even fraudulent data; poor liquidity; lack of uniformity in regulatory coverage; excessive leverage and concentration risk, and accounting rules and excessive reliance on credit rating agencies as the major causes of the crisis.

How should we construct and estimate dynamic term structure models? By how much do flexible multifactor term structure models overfit the data? What should we do to limit this flexibility? What properties of the term structure are robust to concerns about overfitting? Prof. Gregory Duffee, Carl Christ Professor of Economics from Johns Hopkins University sought to answer these questions by turning to conditional maximum Sharpe ratios as a measure of overfitting. He studied the ratios implied by discrete-time Gaussian models with two through five factors. Prof. Duffee's methodology entailed using a panel of bond yields across T periods, and estimating an unrestricted n-factor model. This was followed by a determination of sample mean, across T, of conditional maximum Sharpe ratios. He estimated a sequence of n-factor models, tightening a constraint on the estimated sample mean. The questions that arose were: which features of the term structure are robust to tightening this constraint? Which are not? He found that four or five factors could help turn these results into a model with parameter constraints.

Prof. Marti Subrahmanyam, Charles E Merrill Professor of Economics and Finance from New York University turned to an important question: Was it illiquidity or credit deterioration that had a larger impact on U.S. bond markets during the financial crisis? He opined that the crisis had shown that credit and liquidity risk were the key determinants of asset pricing. Thus, it was important to understand their relative effects and how these had changed during the crisis. However, this research became challenging as most markets are over-the-counter, posing data problems. Using a unique dataset on bond transaction he pointed that the U.S. corporate bond market was an ideal laboratory as detailed transaction data since 2004 are available. He then posed the following questions: To what degree is liquidity priced in the U.S. corporate bond market? Are liquidity effects stronger in times of financial crisis? How do liquidity and credit factors interact? How do different sub-segments of the bond market react on their liquidity effects? His study found that liquidity is an important risk factor for corporate bond pricing and liquidity effects explaining about one-tenth of the market-wide corporate yield spread variation. During periods of crises, the economic impact of the liquidity was found to increase significantly. These results are relevant for pricing, risk management, and regulatory policy.

In the concluding plenary session, Prof. Christian Wolff, the Director of the Luxembourg School of Finance, spoke on 'Leverage and risk in U.S. commercial banking in the light of the current financial crisis'. He suggested that the current crisis has revealed several systemic inadequacies linked to malfunctioning of the banking industry. These inadequacies are largely related to the degree of bank leverage in the years before the crisis. Prof. Wolff's research asked how different types of leverage at U.S. too-big-to-fail commercial banks affected the stability of the financial system prior and subsequent to the financial crisis. The study found that both on- and off-balance sheet leverage threatened the stability of the financial system. Short-term leverage impacted the stability of the financial system negatively, but only after the outbreak of the crisis. Banks based on traditional banking activities typically carry less risk than banking based on modern financial instruments. Prof. Wolff stated that these findings provided support for more stringent restrictions on off-balance sheet as well as short-term leverage, and were in line with the ongoing discussion on bank restructuring and the possible revival of the Glass-Steagall Act.

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Published quarterly by Risk Management Institute, NUS
Editor: Ivy Wang (rmiwy@nus.edu.sg)