An additional concern is that many of the transactions suffering from this risk may have been entered into for portfolio management reasons (such as the pension fund example) or regulatory capital relief and other “window dressing” purposes rather than genuinely to protect against default. Net exposure numbers quoted on earnings calls, or stress losses reported to regulators, can all be made to look more palatable if the insurance is apparently in place, while the true risks in the event of default may not have changed much. These issues raise general questions for market structure with tradeoffs that are far from trivial. Is it beneficial for, say, banks to lay off sovereign risk with other banks and other leveraged financial institutions such as hedge funds, or does the ensuing web of contingent exposures across leveraged institutions increase the systemic risks? It seems that many of these arrangements increase diversification in the case of small and medium size stress scenarios, but may actually exacerbate the systemic implications in the case of very large shocks7. These arrangements also highlight the delicacy of the appropriate regulatory structure. In many instances, subject to sufficient diversification, these tail risks might be better borne by so-called “real money” investors, i.e. insurance companies, pension funds and traditional long-only bond and equity funds, as these investor categories operate with little or no leverage.
Just as the application of information technology revolutionised the business of banking and risk management in the second half of the twentieth century, I expect that the increasing quantification of risk will drive tremendous advances in the first half of the twenty-first century. But, as prudent risk professionals and bank supervisors, you and I know that quantifying risk involves making assumptions. And no model, and no software package, no matter how sophisticated, can ever replace the skills of a trained, experienced, and conscientious risk manager. Banking, finance, and insurance are, at least in part, an art, not a science. We can and should supplement and enhance our judgement with the best technical tools available. Yet - against the backdrop of unpredictable markets and times it would be folly to derive business strategies purely from the projections of a mathematical model. And that is why the work of an organisation like GARP matters so much. GARP creates a forum for its 30,000 members to share ideas on new ways to approach risk or to share suggestions on ways to improve current practices. Furthermore, GARP and similar professional organisations encourage all of us to improve our own skills constantly and to probe and understand emerging issues in the market. So it is a particular pleasure for me to share some thoughts on the Basel Committee’s progress to develop regulatory capital standards that reflect the best practices in risk management today - and that recognise the importance of exercising prudence and sound judgement when taking on risk in banking.