International regulators release risk management report

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NEW YORK – International regulators have released risk management guidelines in an attempt to promote higher industry standards and reduce market reliance on the credit rating agencies. The report was triggered by a request from the Financial Stability Forum.

The seven participating supervisory agencies are the US Federal Reserve, Office of the Comptroller of the Currency, Securities and Exchange Commission, the UK Financial Services Authority, the French Banking Commission, the German Federal Financial Supervisory Authority and the Swiss Federal Banking Commission.

The report, Observations on Risk Management Practices during the Recent Market Turbulence, is based on a joint review of current risk management practices held by regulators last autumn and a round table held between supervisors and industry representatives in February.The report’s key observations and proposed supervisory responses were summarised in a transmittal letter to the chairman of the Financial Stability Forum, Mario Draghi, which stated that the predominant source of losses for firms in the survey through year-end 2007 was the firms’ concentrated exposure to securitisations of US subprime mortgage-related credit that was exacerbated by the fact that some firms made strategic decisions to retain large exposures to super-senior tranches of collateralised debt obligations that far exceeded their understanding of the inherent risks, which they then failed to mitigate or control.

Firms also underestimated their liquidity needs and control over their balance sheets, as some were found to have failed to price properly the risk that exposures to certain off-balance-sheet vehicles might need to be funded on the balance sheet at the same time that it became difficult or expensive to raise such funds externally.

Firms that avoided these problems, says the letter, did so due to having a comprehensive approach to viewing firm-wide exposures and risk, and had more adaptive risk measurement processes and systems that were flexible enough to adapt to a rapidly altering market. These firms, says the letter, “also relied on a wide range of risk measures to gather more information and different perspectives on the same risk exposures and employed more effective stress testing with more use of scenario analysis”.