Risk management has taken on a whole new meaning after the crazy behavior of markets during the past 18 months.
No one predicted the extent of the devastation to equities in nearly every category, and even though firms had robust risk management plans in place, unless they were flexible, they were pretty much useless.
Fund industry leaders are still trying to figure out what happened as they develop risk management solutions that will hopefully help them be better prepared next time. Firms realize that they should enhance their risk management departments, but thatís not all.
Capital and accounting rules need to be updated, compensation models should be reviewed to reduce or eliminate conflicts of interest, and the markets in general should reassess their scrutiny of ratings agencies, industry leaders say.
Calculated risk taking can open the doors for competition, but if financial instruments become too complicated and opaque for anyone to understand, risk taking becomes reckless, not calculated.
"There should be improved transparency across all markets," said Bennett Golub, vice chairman and chief risk officer at BlackRock, during a webcast last week titled "New Paradigms in Risk Management," hosted by the Professional Risk Managersí International Association. "It does not have to be as obtuse as it is."
"The complexity of these products became too much. They were over-engineered," said Paul Shotton, managing director and deputy head of group portfolio risk control and head of group risk methodology at UBS AG.
As products became increasingly complicated, investors assumed that there were experts somewhere who could use fancy new analytical tools to understand it all. With little fanfare, increasing numbers of people began participating in investments they didnít understand. Extremely risky products got combined with safe and reliable products, and ratings agencies labeled everything with their highest, safest rating.
"There was a consensus that the credit rating process could distinguish the good from the risky," Golub said.
In the aftermath of the meltdown, it was learned that ratings agencies were highly compensated when they gave their top, AAA ratings. If the ratings agency refused, the company could take their business somewhere else.
"It should be absolutely inappropriate that you can shop around for your ratings," Golub said.
Risks were thought to be well-understood, and all the documentation was thought to be robust, but this transfer of risk turned out to have a dark side. Before the crash, it was thought that greater risk sharing would lead to reduced systemic risk, but the opposite occurred.
"When the flaws were exposed at ratings agencies, it led to a massive loss of confidence," Shotton said.
The general consensus seems to support the need for a systemic risk regulator that can take a broad view of risk across different financial instruments and regulatory agencies.
"We need some sort of entity that has visibility across the financial system and that can take a holistic view on risk," said Paul Glasserman, a professor of business at the Columbia University Graduate School of Business. Also, a better understanding is needed of contagion effects between financial institutions.
"People assumed liquidity was there," Golub said, and they thought they understood liquidity risk, but not enough attention was being paid to how liquidity responded to these complex financial products and particularly how it responded under stress conditions.
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