Malcolm Knight, general manager of the Bank of International Settlements (BIS), observes that transformations within the financial industry have led to transformations in the risks faced by the industry, and that bankers and regulators have to develop better methods for measuring systemic risk.
Knight spoke at a conference sponsored by Société Universitaire Européenne de Recherches Financières (SUERF), a Vienna-based organization whose membership includes academics, central banking officials, commercial bankers and other members of the financial community.
The financial-services industry has gotten larger, more consolidated, more global and more important than ever before. "Financial activity now represents a much larger share of aggregate economic activity than it did 20 or 30 years ago, regardless of how it is measured," says Knight. "In the industrial countries, successive waves of consolidation have been creating a small group of dominant firms domestically and, more importantly, at a global level."
With the rise of the global bank has come the unprecedented use of sophisticated risk-management technology designed to mitigate financial losses. "Companies have increasingly focused on the management of risk on a firm-wide basis," says Knight. "This natural and welcome trend is unmistakable, although it still has a long way to go."
One positive step would be if investors demanded that companies perform stress tests upon their portfolios. "Arguably, stress testing is the only concrete tool available that allows firms to analyze the joint impact of the broader set of risks in a meaningful way," he says. "Investors should be demanding more information about the outcomes of firms' stress tests as part of their due diligence analysis.
Even as organizations make sweeping changes in their measurement and management of enterprise risk, the total risk inherent in the system has not gone away. Instead, the concentration of the financial system has changed the risk profile of the industry in perhaps unpredictable ways, which has serious implications for the economy, for market participants and for regulators.
To begin, the increased size and scope of financial activity makes the possibility of market failure that much harder to contemplate. "Management of financial risk has become a more important aspect of economic activity," says Knight. "Problems in the financial system, if and when they emerge, can have larger consequences for the real economy than they did in the past."
Knight recommends that banks develop methods to stay alert to the "endogenous" component of financial risk stemming from collective actions that impact the underlying drivers of risk. Examples would include lending booms that "boost economic activity and asset prices to unsustainable levels" prone to a sharp correction, or "if a large number of financial market participants assume that markets will remain liquid even under collective selling pressure...[and] overextend their position-taking, thus generating the very pressures that would cause markets to become illiquid," says Knight.
Measuring the risk of the global financial industry is more than a "sum of the parts" analysis, notes Knight. "This 'macro' orientation requires a shift away from the notion that the stability of the system is simply a consequence of the soundness of its individual components," he says. "It involves the same shift in focus that a stock analyst is required to make in order to become a portfolio manager."
The full text of Malcolm Knight's speech is available at: http://www.bis.org/speeches/sp041014.htm
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