## Mr McDonough focuses on the importance of risk management techniques and the enhancement of market discipline
Remarks by the President of the Federal Reserve Bank of New York, Mr William J McDonoug before the Bond Market Association in New York on 21/1/99.
Good morning. It is a pleasure to be here today and I thank the Bond Market Associat giving me this opportunity to share some of my thoughts about supporting the resilie liquidity of our capital markets.
As you recall, last August the Russian government announced an effective devaluation ruble and declared a debt moratorium, shocking investor confidence all over the world. the backdrop of weakened economies and financial markets in many developing countries, equity and debt markets became increasingly volatile. In the U.S., a number of market o had anticipated a correction in stock prices. However, the simultaneous and abrupt wid credit spreads went far beyond the expectations of investors and financial intermediari
We are all familiar with the immediate consequences of these dramatic events. What i important, it seems to me, is to try to understand what public and private entities ca do to prevent, mitigate, and manage financial uncertainty in the future.
In the face of the recent events in Brazil, the launch of the euro, the countdown to Y extraordinary market volatility of the last 18 months, all of us are obliged to think c our responsibility to support the functioning of liquid and efficient financial ma conclusion seems clear: prudent risk management by a critical mass of firms will not on ensure a safe and sound financial system, but also will reward individual institutions term profitability.
In my view, market discipline, enhanced by appropriate regulation and supervision, of only realistic path for us to achieve our goals of a strong and stable marketplace. Tod like to focus my comments on the importance of risk management techniques and how mar discipline can be enhanced to the benefit of public and private sector participants ali
A series of market events over the past year and a half, beginning with the devaluat Thai baht in July 1997, had a major impact on many lenders and investors, revealing process several shortcomings in risk management techniques. One lesson financial inst learned from these events was the need to continuously reassess both counterparty cr management techniques and assumptions about market liquidity. Broadly, financial insti learned that reliable estimates of the size and portfolio composition of major counterp lacking and that improved credit risk management techniques were needed in two key credit and market exposure measurement, and counterparty due diligence.
Let me be a bit more specific about some of the weaknesses found in credit risk mana techniques. For example, some institutions routinely performed credit assessments usin often unaudited financial information from valued customers, some of which had rec substantial profits in previous years. Moreover, institutions that received intermitt statements and had infrequent contacts with these counterparties were left to make peri assessments using stale information in a rapidly changing market. This insufficient in impeded the setting of prudent credit limits and terms, including collateral requir contract covenants.
Many risk managers also failed to account fully for the risks involved in new financial Non-traditional products, such as equity repos and credit derivatives, challenged exis
analysis systems and methodologies. In addition, relatively few financial institutions stress test credit exposures and even fewer anticipated a market environment as advers we experienced in the third quarter.
For these and most other institutions, the rush to mitigate and reduce their exposures, to highly leveraged institutions such as hedge funds, quickly resulted in the w withdrawal of all lending activity to some troubled sectors, regardless of an counterparty's financial condition. While these decisions undoubtedly were intended t risk and avert losses, they also served to exacerbate already extraordinary financ fragility.
Given that the task of assessing and managing risk is not going to get any easier as we the 21st century, let me now turn to some of the issues that I believe will challen institution managers in the coming year and beyond. One issue is the increasing integ banking, securities and insurance services; a second is the increasing pace at which ca across international borders; a third, the Year 2000 problem; and a fourth, the ch bringing improved risk management techniques to business operations as a whole, includ trading rooms. This is particularly important for participants in the rapidly chan income markets.
First, the integration of previously separate financial services means that institut prepared to manage risks across a far wider range of products, business units, and cou than they have been accustomed to doing. In the securities lending markets, for exa increasing number of firms are accepting equities as collateral for financing arrang structuring securities lending transactions off-balance-sheet through total return swap derivative structures. Thus, corporate treasurers must develop greater expertise in derivatives markets.
More broadly, the potential economies of scale and scope, as well as the potential b reducing risk through sectoral and geographic diversification, have fueled the tren consolidation in varied financial industry sectors. As this trend continues, we mus challenge of merging the risk management practices of previously separate financial fir readjustments are likely to be far more complex for firms consolidating across the sp financial service providers.
A second issue that has an important bearing on risk management techniques is the inc pace at which capital moves across international borders. The proliferation of electro and banking may not only improve the efficiency with which transactions are executed, may accelerate the rate at which capital flows through global financial markets. The r increasingly open financial markets may be great, but the punishment for poor inv decisions and lapses in public policies may be comparably severe. Thus, global financia are likely to place a greater premium on robust risk management practices.
The Year 2000 computer problem is a third issue that needs to be a top priority managers. One need only look at the price action in interest-rate futures markets to no degree of uncertainty surrounding this issue. While an organization may have prepa internal systems, it still may be exposed to credit risk from less-prepared counterpar the public and private sector. Thus, I fully support the contingency plans a number of are putting in place.
I think it is important to make clear that it is the boards of directors and senior m financial institutions - not the regulators - who must be responsible for ensuring
companies provide seamless and high-quality service through the year end. The Federal R System has completed the internal testing of almost all of its applications. In ad governments of various industrialized nations stepped up their internal Y2K remediatio last summer. At the official level, international cooperation is intensifying through as the Joint Year 2000 Council, chaired by my Federal Reserve colleague, Governor Fer However, it is plausible that time will simply run out for some countries and some in While I certainly don't expect a financial system breakdown, the potential for some dis international trade and capital flows exists and that puts a premium on maximizing ou now.
Finally, the practice of risk management must permeate all levels of your institution executive offices to the trading rooms. The senior management of most large fi institutions now have a variety of sophisticated measures and reports on their firms' making it possible for them to track credit and market risks on a daily basis. But if gleaned from these risk management tools are not incorporated into the operations of line, where both trading and credit decisions are made, they will be of little help w needed most.
This is especially true for this audience because of the constant and rapid evolution income markets. Against the backdrop of the budget surplus in the United States, t expectations for a continued reduction in the supply of U.S. Treasury securities. Borr variety of markets - including corporate, agency, and, to a lesser extent, emerging m mortgage-backed securities - have taken this opportunity to meet investor demand with a volume of new issues and larger offering sizes.
In addition, expectations for increased investor demand for euro-denominated inves together with the possibility of reduced participation by speculative and arbitra accounts, are likely to have an effect on spreads of fixed-income securities to Treasur in various fixed-income markets already have begun to note increased levels of spread and expectations for higher absolute spreads relative to historical levels in respon market dynamics.
In this environment, managing market risk will become more difficult as the nature o income spread products changes. As we recently have learned, spread relationships t endured for many years can break down suddenly, thereby increasing the already complex t hedging positions. The increase in the liquidity premium for on-the-run Treasury secur fall resulted in increased hedge-related activity in both the interest-rate swap a futures markets. Traders have continued to explore the usefulness of non-Treasury fixe securities as hedging vehicles. Risk managers must, therefore, be especially rigorous i their firms' positions and hedging strategies, particularly when historical experience as predictive a guide as it once seemed to be.
I am encouraged by some recent market efforts to improve risk management practice lending, the risk-return discipline has been greatly enhanced at some international ba institutions have introduced measures to compare credit spreads with historical loss ra defined categories of credit. They also have enhanced the methods they use to assign in ratings to individual credit exposures. The development of credit models by a number o has led to a deeper understanding and analysis of the relationship between risk and credit activities at the portfolio level. In addition, some banks are exploring the validating their internal ratings using information from the equities markets.
With respect to securities financing, several institutions have discussed and, in ce already have implemented instrument specific collateral haircuts. Many institutions acted to ensure the adequacy of their current collateral holdings and developed proce accessing additional collateral when necessary. Finally, I applaud recent efforts by t lending community in the U.S. to begin publishing aggregated cash-collateral reinvestm that reflect reinvestment return, interest-rate sensitivity, and liquidity and credit t all positive developments.
However, along with many of my colleagues in the private sector, I believe there still for the market to develop and implement additional risk management techniques. Let me you some examples of what I am thinking about.
First, financial institutions must have the discipline to consistently apply robust ris techniques through all phases of the business cycle. A concern for supervisors is the t credit markets to steadily bid down spreads in the optimistic phase of the cycle, often where returns no longer seem commensurate with risk. Then, as problems emerge, lenders credit markets pull back, causing spreads to reverse sharply.
In addition to the most recent cycle, examples of such behavior include high-yield leveraged buyout lending in the 1980s, and Latin American investment and lending in th 1980s. Too often, management edicts to reduce risk occur during the latter phase of cycle, after substantial losses have already occurred.
Second, I would argue that targeting returns commensurate with risk over an appropriat time horizon probably is the single most important defense against violent swings in cycle. Individual banks can protect themselves if they recognize when margins become t to cover risk by restraining their credit activities at those rates. They can benefit their credit activities when returns have risen enough to cover risk once again. To cycle volatility, appropriate risk and return analysis must be practiced widely and throughout the financial system.
Third, more attention must be directed at stress testing, the leading technique in a direct and indirect effects of unusual market and economic events. Stress test fundamentally qualitative and judgmental process, typically used in conjunction wit formal, statistical approaches to risk measurement, such as risk modeling. The primar stress testing is to identify scenarios, usually low probability, high-stress event jeopardize the health of a financial institution.
Stress testing of market risk exposures is not a recent development. However, the an distinct classes of fixed-income securities all too often occurs in isolation. What we the crisis last fall is that markets that previously did not move together can sudd reversing trends that had been under way for several years. Moreover, we became awar liquidity in even the most widely traded securities can be interrupted, primarily w traders attempt to enter or exit positions at the same time. Thus, simultaneous str across diverse fixed-income portfolios may help to identify high-risk market scenarios.
Finally, I am convinced that there is a need for improved disclosure. In my vi transparency derived from more open disclosure of risk management practices, risk profi risk management performance cannot help but facilitate market discipline. Timely discl such information would enable market participants to better assess how much risk participants are taking, how well they manage it, and how much capital and liquidity need to survive adverse markets.
The desirability of improved disclosure is made clear in a report issued by the Basle on Banking Supervision in September on enhancing bank transparency. This report set framework for the disclosure of key risks and performance measures for banks. In my vi availability of more detailed data on international exposures would enhance the abili supervisors and counterparties to assess the vulnerability of domestic banks and bankin to financial shocks from abroad. Better information about the credit risk profiles of internationally active banks, including the composition of their portfolio by inter would also be useful.
A commitment to the use of advanced analytical tools, stress testing, and improved di comes under the widely discussed rubric of seeking out and adopting industry-wide practices. It is, perhaps, most important to note that the development of best pra dynamic, not a static, process that can only be enhanced by consistent risk managemen over a long time horizon.
In sum, I am led to conclude that diligent market discipline using techniques such suggest here is in the long run the essential element needed to achieve both public a goals. All market participants bear the difficult responsibility of determining an adequate compensation for risk. While the public sector has a responsibility to inc effectiveness of its overall regulatory and supervisory framework, it is the priva continuous reassessment of risk and advancement of risk management techniques that ulti will serve to preserve a safe and sound financial system while simultaneously re individual institutions with long-term profitability.
In the public sector, we can help markets work more effectively by ensuring that r financial institutions support the trading process by making sound credit decisions. W work to improve bank supervision by our ongoing examinations of bank risk measurement management processes, a major focus of the examination process.
On the international level, we are working hard at rethinking the Basle Capital Ac international agreement on minimum capital standards, developed by the Basle Committe Banking Supervision, first put in place in 1988. The Committee, which I have chaired si 1998, is attempting to make certain that banks hold an optimal level of capital based o appetite and their demonstrated ability to manage risk. Also, with the help of many of room, central bankers and security regulators from around the world are working t through the International Organization of Securities Commissions and the G-10 centra Committee on Payment and Settlement Systems to develop a clearer understanding of gl securities lending markets.
At the end of the day, however, it is market discipline that will make the crucial diffe view, market discipline involves three key elements, each of which is equally import continuous questioning of market assumptions regarding adequate compensation for ris relentless pursuit of more advanced risk management techniques, and the conviction to business decisions over an appropriately long time horizon. My experience with fi markets and institutions has convinced me that diligent market discipline - rather than regulation - is the essential variable in ensuring the future health and efficiency capital markets. I believe that it is in the mutual interest of private and public sec alike to support this effort.