Financial Risks, Stability, and Globalization
Chapter

Comment

Author(s):
Omotunde Johnson
Published Date:
April 2002
Share
  • ShareShare
Show Summary Details
Author(s)
BARBARA BALDWIN

Having spent a fair amount of time over the past year and a half working on bank restructuring in Asia, I read the Nakaso paper with particular interest. The Japanese experience during the recent financial crisis is a valuable case study, with important lessons on crisis management and bank restructuring. Given the magnitude of the Asian crisis and its effects on the global economy, the paper asks a very important and timely question—namely, whether early warning of a financial crisis is possible.

Importance of Monitoring Changes in Bank Behavior

A major premise of the paper is that banks’ financial behavior changes during a financial crisis; empirical evidence on Japanese bank risk profiles during and immediately following the asset bubble phenomenon supports this assertion. Therefore, significant changes in banks’ behavior and risk appetite, if properly monitored, should provide the authorities with useful insights on the changing condition of the banking system and could serve as a component of an early warning system.

The author notes that there is no one, unique early warning indicator for the development of a financial crisis; rather, relevant indicators will depend on a bank’s particular balance sheet structure and risk profile. In addition, the importance of analyzing aggregate quantitative data on the financial sector (or a particular component thereof) as a whole to assess the potential for development of a systemic problem is highlighted. If it is determined that an emerging financial problem has the potential for significant impact on the financial system as a whole or on the real economy, the authorities can respond with comprehensive measures to limit the ultimate effect.

With the critical importance of a robust risk assessment and risk management framework—both within institutions and from an overall sectoral perspective—duly acknowledged, a logical follow-on would be to explore how implementation of a comprehensive risk assessment program by the supervisory authorities might be incorporated as a core component of an effective early warning system.

Mechanisms for Detecting Potentially Significant Changes in Bank Behavior

The author notes that there are various mechanisms for detecting potentially significant changes in bank behavior that, in the appropriate context, may be indicators of developing preconditions for financial crisis. These supervisory mechanisms include off-site monitoring, on-site examinations, stress testing of bank performance, and implementation of timely and effective policy measures addressing identified issues. Both individual institutions and aggregated sectoral data must be monitored to form opinions not only about the condition of particular institutions, but also about the potential for systemic risk.

However, the manner in which these individual supervisory tools are used, as well as the ability of the authorities to implement a continuous supervisory cycle that employs these tools effectively, is critical to the ultimate success of the early warning system. It is vital that the supervisory authorities know the kinds and magnitudes of risks being accumulated within the financial system. By understanding the risk profiles of individual financial institutions, and aggregating this information to formulate an assessment of the overall condition of the financial sector, the authorities will be in a better position to limit the impact of any problems that emerge within the sector.

The author notes that Japanese banks developed a greater risk appetite without commensurate increases in risk management skills and procedures. The acceptance by banks of greater amounts of credit and market risk, without an adequate understanding of how those risks should be appropriately monitored and controlled, had a direct bearing on the depth of the crisis. In addition, an underestimation by the authorities about the extent of risk associated with the banks’ credit portfolios kept them from taking more aggressive supervisory action at an earlier stage. Thus, when the asset bubble burst, the risk profile of many banks—and thus the resultant level of nonperforming assets—was actually well beyond what either bank management or the supervisory authorities had envisioned. The importance of effective risk assessment and management cannot be overemphasized.

A useful expansion on the paper would be to offer some practical observations on how a comprehensive early warning framework might be made operational. An important step is the implementation of a risk-focused supervisory approach that optimizes the use of supervisory resources by identifying the risk profiles of individual institutions within the financial sector and allocating supervisory resources to the areas of greatest need.

Risk-Focused Supervisory Approach to an Early Warning System

We are witnessing a cultural revolution in financial institution supervision, and with it the development of a new breed of financial sector supervisor. The financial services industry is rapidly evolving, and the supervisory authorities must make sure that their approach to regulation and supervision remains effective. This is no small challenge, and requires a fundamental shift in supervisory practices and techniques.

Historically, many supervisory authorities have practiced “compliance-based” or “rules-based” supervision, which essentially focuses on compliance with applicable laws and regulations. However, risk-focused supervision goes a step further, requiring the supervisor to make qualitative assessments and develop a thorough understanding of a bank’s risk profile and risk management capabilities. It is more forward-looking and proactive, and requires flexibility for the authorities in supervisory program design.

Design of a risk-focused supervisory approach involves identifying different categories of banks, such as (for example only) those that are systemically significant, are identified problem institutions, or are small and well-rated. Supervisory programs are then developed for each category, which are tailored to each group’s specific needs. Statutory supervisory requirements must be sufficiently flexible to accommodate such an approach.

A risk-focused framework allows the supervisor to design individualized supervisory programs for different banks based on their risk profiles. Specific supervisory strategies are developed for each institution, outlining the annual examination and surveillance program and allocating sufficient resources to carry it out. Specific information requirements (i.e., information that must be submitted by the bank to the authorities) must be defined, which will likely vary widely between categories of banks. Communication must be enhanced with those institutions that present the greatest potential risk. Supervisors will need timely access to internal risk management reports, which likely goes well beyond standard bank reporting requirements and may require specific outreach efforts with the affected banks when initially introduced. Supervising systemically significant or problem institutions must be recognized as a resource-intensive effort, with necessary accommodations made. This may require an assessment and enhancement of existing supervisory resources and skills.

In carrying out the supervisory strategy, the authorities will focus on understanding both a bank’s risk profile and the risk management systems in place to monitor and control those risks. It is not so much the absolute level of risk that matters, but rather whether the risk management program is commensurately robust. An effective risk management program requires an informed supervisory board that sets the strategic direction and risk tolerances for the financial institution, a capable management team that works effectively within the guidance set by the supervisory board, and appropriate staffing levels in both front and back office activities to allow adequate segregation of duties and the establishment of an effective internal audit and control program. The level of sophistication in risk management systems will likely vary widely between institutions; those with a larger risk appetite or more complex products and activities should have more formal and sophisticated risk management tools and techniques. A risk management program that must address a complex portfolio may incorporate sophisticated models for managing market and interest rate risk that are factored into the relevant policies and procedures. On the other hand, for institutions with a less complex scope of activity, an effective program can be as basic as well-designed policies and procedures for controlling credit and other risks that are consistently and effectively applied. Supervisors will need to assess if the system is adequate in relation to the amount of risk perceived.

The categories of risk with which banks and supervisors should be concerned may be defined in different ways, but generally include credit, market, liquidity, operational, legal, and reputation risk. Supervisors must learn to evaluate these risks the way banks do. In addition to categories of risk, it is necessary to identify the direction of risk assumed (e.g., is it decreasing or increasing). These analyses are then synthesized into an overall composite risk assessment for the institution, which evaluates the quantity of all risks against the quality of relevant risk management tools and techniques.

Implementation of a risk-focused supervisory approach essentially requires an evolution of supervisory programs and practices. This is only natural considering the evolution already acknowledged in the financial services industry. Goals for supervisors in dispatching their responsibilities should include

  • tailoring supervisory efforts to each institution’s risk profile;

  • preventing supervisory processes from imposing unnecessary burdens;

  • making the best use of scarce supervisory resources; and

  • applying a consistent framework for supervisory activities across all banks.

The primary objective in supervising banks and other financial institutions—the maintenance of a stable financial sector that promotes economic development—is achieved only when the supervisory program keeps pace with developments in the industry. The supervisors must be able to determine the condition of each bank and the risks associated with current and planned activities. Based on the risk profile identified, an evaluation of the overall integrity and effectiveness of a bank’s risk management systems can be made. Within this process, the supervisor can determine whether the bank is in compliance with applicable laws and regulations and can implement corrective programs as necessary. Throughout the process it is necessary to maintain communication with bank management, not only to obtain information critical to the analysis, but also to effectively communicate supervisory findings and recommendations or requirements. It is also necessary to maintain contact in order to confirm the effectiveness of any corrective action programs initiated. Implementation of a risk-focused supervisory program should enhance the authorities’ ability to closely monitor changes in the condition of institutions—at least those designated as posing the greatest risk—by allocating resources necessary to implement a surveillance program that keeps supervisors in close contact with the relevant institutions.

Operational and administrative considerations in the adoption of a risk-focused supervisory program include an assessment of procedural or other changes that may be required in the existing supervisory program to accommodate incorporation of “supervision by risk” and the assessment of risk management processes into the examination and surveillance processes. Among other things, this may involve recognition of the need for additional training for staff and the possible amendment of policies or guidelines. Management must more explicitly define the minimum conclusions that examiners must reach in each examination, but still preserve flexibility in the design of tailored examination programs. It will be necessary to provide more explicit direction for less experienced examiners by developing detailed procedural guidance, including an overview of the conditions under which it is appropriate to broaden the scope of an examination based on preliminary findings. It must also be recognized that this approach involves more qualitative assessment on the part of examiners, which may be the source of some discomfort for staff in the early stages.

Conclusions

In summary, the financial services industry is rapidly evolving. Supervisory authorities must be able to understand the nature of various risks faced by banks, and how bank management is responding to these risks. The technological advances recently experienced bring opportunity, but not without substantial risk. Usually a new product or technology arrives and is in use well before adequate legislation and prudential regulations are in place, perhaps even before the full extent of associated risks are realized. Supervisors must strive for timely development of an appropriate regulatory and supervisory framework that promotes advancement while mitigating risks.

Effective supervision is one of the cornerstones of a stable financial sector. In many crisis countries, weaknesses in supervision have been cited as contributing factors to the depth of the financial crisis.

Supervisory authorities facing similar challenges may wish to review more specific available guidance on practical measures, including risk-focused supervision, that can be taken to enhance the early warning components of their supervisory programs.

    Other Resources Citing This Publication