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Risk Assessment and Management in Financial Market Turmoil

Jane Diplock AO
Chairman, Securities Commission

4^th National Conference on Risk Management
Wellington

6 November 2008

Risk Assessment and Management in Financial Market Turmoil

Introduction

Thank you for inviting me to speak at this conference. The current global market turbulence that has given rise to devastating consequences, I believe is a salutary reminder of the need for reliable risk management and assessment practices and it is certainly pertinent to be discussing it at this time. I therefore welcome the opportunity to talk to you today.

In recent weeks we have witnessed new heights of the turmoil as events have unfolded into what can only be described as a market meltdown. World leaders have rushed to settle and curb the free-fall in the capital markets. We have seen:

• approval of a US$700 billion financial rescue package by the US Treasury.
• the British government pouring 37 billion pounds into three major banks in a part nationalization programme that set the standard for similar schemes in Europe and the US.
• agreement to implement a range of measures to shore up their financial institutions including public lending for banks by leaders of the 15 Euro-zone economies plus in their own countries.
• 900 billion euro plan from Germany, Spain and France to rescue their banks
• Australian and New Zealand governments' announcements of a blanket guarantee for bank deposits which in our case also extended to deposits in non-bank deposit-taking entities, and
• stock markets on a roller coaster ride.

The first signs of the fact that all was not well with the global financial system was the unveiling of sub-prime mortgage crisis in the United States. Sub-prime lending is the practice of making loans to borrowers with poor credit ratings. The crisis began with the bursting of the US housing bubble and high default rates on mortgages. The downturn in the US housing market, risky lending and borrowing practices, and excessive individual and corporate debt levels have had multiple adverse effects that have reverberated around the world.

Traditionally, banks lent money to homeowners and retained the risk of default or credit risk. However with financial innovations banks began to sell rights to the mortgage payments and related credit risk to investors, through a process called securitization. These securities were then packaged and sold to investors as residential mortgage backed securities (RMBSs) and collateralised debt obligations (CDOs). From mid June 2007 onwards, it became apparent that many institutional investors were exposed to potentially large losses through their investment in these and other forms of securitized and structured financial products linked to US sub-prime mortgages.

The initial consequences included the nationalization of the UK's largest mortgage bank lender, Northern Rock late last year and the near failure of Bear, Sterns & Co this March amid concerns about the liquidity of that major investment bank and its concentration of exposure in certain markets.

The demise of investment bank Lehman Brothers had a profound affect on the financial market by triggering other collapses. Lehman Brothers faced unprecedented losses due to its heavy reliance on sub-prime mortgage products. When it declared bankruptcy this resulted in a massive liability for its counterparties. The counterparties were unable to pay their own creditors, forcing them to sell their assets and ultimately into bankruptcy.

What followed was a number high profile banks and financial institutions needing government intervention and rescue.

As these events have unfolded and the repercussions affected our markets, the failures in four key risk areas are evident. They are: credit risk, liquidity risk, market risk and operational risk. It is the management of these risks that ensures an organisation's existence and well-being and indirectly contribute to its success. I'd like to develop these risks as a theme to my discussion.

Credit risk
Credit risk is the risk that a loan or other line of credit will not be paid back, as evidenced in the sub-prime crisis. Analysis by IOSCO, the International Organisation of Securities Commissions, makes it clear that the market turmoil stems, in part, from widespread use of new forms of asset-backed securities and CDOs, CDSs and of sub-prime mortgage derivatives, which were used to transfer credit risk. Institutions failed to ensure that they were diversifying risk as intended through their investment in these instruments. IOSCO found that this was due to inadequate internal controls and risk modelling capability and an inability to really understand their exposure from these types of investment vehicles.

Liquidity risk
Looking at liquidity risk - an institution might lose liquidity if its credit rating falls, it experiences sudden unexpected cash flows, or some other event causes counterparties to avoid trading with or lending to the institution. A firm is also exposed to liquidity risk if markets on which it depends are subject to loss of liquidity. The liquidity crisis that has led to the current financial crisis is due to losses sustained on the complex structured securities, reduced leverage and increased demand for liquid assets which institutions had not provisioned for.

Securitised products and other structured finance instruments were originally designed to lessen investor risk through diversification in that an investor is not overly harmed by a default on a particular mortgage. However in some circumstances they have tended to concentrate investor risk in certain areas. By late 2007 this is exactly the situation that appears to have occurred - changes in expected default rates created considerable uncertainty about the cash flow prospects of mortgage backed structured products. This uncertainty caused credit markets to tighten and in August 2007 actually led to a liquidity crisis for some investors with significant positions in these securities. The liquidity crisis itself had ramifications far beyond the US sub-prime markets.

Another means institutions used to mitigate the risk of default on mortgages was through the use of Credit Default Swaps (CDSs). CDSs are insurance-like contracts that promise to cover losses on agreed securities in the event of a default. Financial institutions and banks use CDSs widely to cover the risk of default mortgages and other debt securities they hold.

As these contracts are not regulated they can be traded or swapped without assurance that the buyer has the resources to cover the loss if the security defaults.

As the terms of the contract are highly specific and therefore not interchangeable with other contracts, they can be highly illiquid. Therefore, with the unfolding of the sub-prime mortgage defaults the rush to claim on CDSs, a downgrading in their rating and the lack of equivalent reserves led to massive losses. What's more the institutions that invested in these products also directly or indirectly invested in the sub-prime market, further compounding their losses. The most remarkable example of this was the write-down by AIG, the world's largest insurer, of $11 billion on its CDS holdings necessitating a government bailout.

Multi-billion dollar losses were also sustained by monoline insurers. Traditionally these insurers simply covered municipal bonds, which rarely defaulted and had relatively predictable risks. Hence they almost always enjoyed a triple-A credit rating and this automatically applied to any products they chose to insure. With the property market lending boom they diversified into mortgage-backed securities without properly understanding and valuing the underlying asset and associated risks. This meant that they did not charge adequate premiums nor maintain adequate reserves, ultimately leading to massive unrecoverable losses.

Market risk
Market risk is the risk of the loss in value of an investment due to moves in market factors. So, what effect did the lack of a control on market risk have? The answer is the complex nature of CDOs and other securitized products made it complicated to value them and institutions and lenders relied heavily on credit ratings. Inadequate or poor control on managing market risk inevitably led to continued selling and investing in complex financial products that were poorly valued and poor investment decisions.

Talking about credit ratings brings me to discuss the role that credit rating agencies played in the crisis. The credit rating agencies played their part in the market turmoil by effectively propping up misconceived financial instruments. Recent downgrades of formerly ‘investment-grade' ratings of highly complex products have called into question the integrity of the processes used by of credit rating agencies and the reliability of ratings for complex financial instruments. A report by SEC (the United States Securities and Exchange Commission) on the role of credit rating agencies identifies eight major areas of deficiencies in processes, procedures and conflicts of interests. What is most controversial and unacceptable is the fact that CRAs helped design these financial instruments and then rated them.

A March report by the President's Working Group on Financial Markets found that there were faulty assumptions in the underlying rating methodologies of the agencies involved in rating the complex financial instruments. The Working Group recommended that the rating agencies reform their process and practices regarding structured financial products. The SEC reports that as a result of the questions that have been asked about the process of credit rating, agencies have significantly improved their risk management and ratings processes.

Operational risk
Moving on to operational risk, the Basel Committee on Banking Supervision defines this as "the risk resulting from inadequate or failed internal processes, people and systems or from external events". In my view failure in managing operational risk played an important part in the creation of this crisis. If institutions had procedures and systems in place which were adhered to diligently this crisis may not have happened at all or at least may have been far less pervasive.

The reliance on credit ratings provides a good example of how operational risk played out. In many cases the ratings for complex financial products were used as a proxy by investors rather than analysis of the underlying risks.

Corporate governance
As the world regulators grapple with understanding the underlying facts that led to the crisis more and more fingers point towards the lack of risk assessment and control. Managing risks is, and should be, a key part of the governance of an organisation. Here in New Zealand, you may recall, in April 2004 the Commission, after extensive consultation, published a handbook for directors and advisers giving guidance on principles of governance. Corporate governance is important because it goes to the heart of investor confidence in our capital markets. Investors are likely to have more confidence in markets when companies have high standards of corporate governance.

Principle 6 of the guide identifies the need for risk management. It says - The board should regularly verify that the entity has appropriate processes that identify and mange potential and relevant risks.

Boards can only be effective if they know of, and can properly assess, the nature and magnitude of risks faced by the entity. Effective risk management can enable an entity to take the risks appropriate to its business.

This Principle recognises that processes to identify, monitor and manage risks are needed so that the board and managers can be properly informed and can implement systems of internal control that are responsive to the identified risks. Effective processes will accommodate the types of risks that an entity is likely to face, including legal compliance, financial, operational, technological and environmental risks. What's more, an internal audit function can assist effective risk management and internal control in entities that face significant financial, operating and compliance risks.

International response
I have already mentioned earlier about the urgent rescue arrangements various governments and authorities have very hastily introduced in their jurisdictions to curb this crisis. Almost all major international organisations such as the IMF, the Financial Stability Forum, the World Bank and the Basel Committee have also jointly or individually undertaken research to carefully examine and understand the issues that led to full blown crisis.

As the Chairman of the Executive Committee of International Organization of Securities Commissions, IOSCO, I have been closely involved with the work that it has undertaken to better understand the issue and to come up with effective measures. Before I launch into the work I would like to familiarise you with IOSCO.

IOSCO is the unchallenged standards setter for securities regulation. It is recognised as such by the wider international financial community. Its focus is securities and derivatives regulation, but it also maintains close relationships with the other major international regulatory bodies, the Basel Committee on Banking Supervision and the International Association of Insurance Supervisors (IAIS) - which are the global standard setters for the banking and insurance sectors respectively. IOSCO's 109 member jurisdictions regulate some 95% of the world's securities markets: It promotes the implementation of its 30 Principles of securities regulation in all member states and facilitates cross border exchange of information and cooperation.

The Commission has been a member of IOSCO for over 20 years and has had a significant input into its policies and practices. At the same time our presence at IOSCO has significantly raised New Zealand's profile in the international community and provided the opportunity for us to promote New Zealand as a well regulated capital market to international business audiences.

In response to the sub-prime crisis IOSCO set up a Technical Committee Task Force to analyse the implications for international capital markets and make recommendations to address the issues facing securities regulators.

Its report published in May focussed on four key areas:

• issuer transparency and investor due diligence
• firm risk management and prudential supervision
• valuation and accounting issues, and
• credit rating agencies.

A key finding was that many institutional investors and investment banking firms had inadequate risk modelling and internal controls in place to understand and address the risks they were assuming when buying many types of structured finance products. They also relied heavily, or even exclusively, on external credit ratings for their risk analysis and had inadequate balance sheet liquidity even when adequately capitalised. Although the types of problems that financial firms encountered as a result of the turmoil varied considerably, all were directly affected by issues related to risk management.

IOSCO also addressed issues relating to credit rating agencies. As already mentioned, structured finance products backed by US sub-prime mortgages featured prominently in the global market turmoil. The quality of the credit ratings of these products - and the rating agencies' policies and methodologies that resulted in these ratings - have been questioned by many securities regulators and market observers. IOSCO amended its Code of Conduct Fundamentals for Credit Rating Agencies to assist rating agencies in strengthening their processes and procedures to protect the integrity of the ratings processes ensure that investors and issuers are treated fairly. The Code of Conduct aims to improve investor protection, improve the fairness, efficiency and transparency of securities markets and to reduce systemic risk.

It is time now for world leaders to take the lessons learnt from this crisis to set standards and put in place mechanisms that will ensure that this situation is not repeated. The global nature of business means leaders will not only have to work in their jurisdictions but also cooperate closely with other jurisdictions to align their procedures and processes.

After every crisis there tends to be a call for tough, and even prescriptive rules to be put in place. The Sarbanes-Oxley Act introduced in the US in the aftermath of Enron is an example of this. It is important that leaders find the correct balance between over- and under- regulation. Regulation should not only protect the interests of citizens but also foster economic growth and innovation. It is also the correct time for regulators to move from short-term crisis resolving mode to finding long-term sustainable solutions.

New Zealand scene
New Zealand, I believe, has a regulatory regime that is fast approaching international best practice. Here, we firmly believe that regulation should not exist for regulation sake. While formulating regulations we keep the interests of investors and businesses in mind. With new technologies supporting the globalisation of securities markets, New Zealand needs to have legislation aligned with similar jurisdictions overseas in order to attract investment and be accepted in the international financial community.

In the interest of benchmarking, New Zealand's financial sector, including regulatory framework, was assessed by international experts in 2003. This was a part of the Financial Stability Assessment Programme (FSAP) conducted by the IMF and World Bank. In general New Zealand was given a good report. It identified some shortcomings that have now been largely been addressed by subsequent reforms. One area of particular interest was the lack of regulation of financial intermediaries. Given the recent events in New Zealand, which I'll come back to in a moment, this reform has become even more relevant.

The Financial Advisers Act, passed in September, is an important reform for retail investors and consumers. It aims to ensure quality financial information and advice is provided to the public and also to assist New Zealanders to make the most of their investments. The new law will require financial advisers to meet standards for competence, professional conduct, and disclosure and make them accountable for the quality of advice they give to clients.

It enables investors to manage their own risks through the advice of competent and educated professionals.

This legislation is part of the broader review of financial products and providers. You may be aware that in the interest of consumers and retail investors, legislation requiring upfront detailed disclosure by investment advisers also came into force in February this year.

Returning to the financial situation in New Zealand, I can say that the credit constrictions which accompanied the sub-prime mortgage crisis are affecting companies here as credit becomes more difficult to source. After August 2007 when the sub-prime effects were being felt in the US and UK, credit to all banks began to be constrained. Inter bank lending was reduced. While few New Zealanders are directly exposed to the securitized products which caused turmoil in other parts of the world, it is the reduction in liquidity that more generally affected this market. This, combined with declining economic conditions and a falling New Zealand property market, began to influence the New Zealand capital market.

In one segment of the capital market we have suffered our own crisis if you like, with the collapse of a number of finance companies over the last year from early 2007. This represents in dollar terms, even in a New Zealand domestic context, a limited part of the capital market, but the failures in this sector were damaging to confidence of the investors affected and had an impact on investor confidence more broadly. The Reserve Bank, in its financial stability report, observes that the failures in this sector are unlikely to have widespread negative effects on the financial system or broader economy, although particular pressures are evident in certain industries such as property development. Nevertheless these events have raised important issues for domestic regulation.

Looking at the finance companies we can see operational risk was at the heart of many of the failures. The common thread across many of these collapses was the lack of good governance in a range of areas. As you will appreciate with investigations underway I cannot be specific, but I would like to share with you some general themes evident in the troubled finance companies. These have included the failure to ensure that disclosure and financial reporting were accurate.

We have seen situations of companies which were poorly capitalised, which were facing liquidity risk in a downturn. We have seen some fairly heroic valuations in a declining market. While directors are entitled to receive and rely on expert advice, I don't believe they should do so blindly. They need to be tuned in to careful risk management and assessment practices - to critically assess valuations and other external reports and exercise common sense and good judgement.

There have been instances of too few directors, even sole directors, and times when there were no independent directors on the Boards of these companies. In some cases where there were independent directors these directors failed to ensure they were adequately informed or took insufficient interest in the business. Some directors failed to address or even understand the underlying risks and the business model of their operation.

Sometimes we have seen an ineffective (or no) audit committee. We have seen the poor handling of growth or expansion of the business. There has been an evident failure to recognise or act on warning signs in a timely manner.

We are not saying that finance company failures have been solely due to poor corporate governance. But in our view, this has been a contributing factor in many cases. Clearly where there is poor corporate governance, poor risk assessment, poor capital and liquidity management or poor business models, businesses will fail.

I would like to mention here that the Commission has been extremely energetic in pursuing those who appear to have breached the law in relation to these companies and has cooperated with other regulators to an unprecedented degree. We are determined to ensure that those whose actions have led to investor losses and to the ensuing loss of confidence in the market are brought to account.

Conclusion

The success of any business is of course dependent on a wide range of factors including the external environment. An economic downturn, decrease in demand and risks associated with particular products can all contribute to business failures.

I would like to stress here that risk is inherent in business and in investment and regulation cannot prevent it. If there is one lesson that we can take away from the current turmoil, it is that good governance, and in particular proper management and assessment of the nature and magnitude of risks faced by an entity, that makes any business sound.

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