Time to keep a cool head

EDITOR'S LETTER

Recent events have been breathtaking in both the range of operational risks they've highlighted and the uncertainties those losses have created as knock-on effects.

Rogue trading, faulty models, internal control loopholes, market abuse, poor new product evaluations ... The lessons that can be learned from the contortions the financial industry has gone through over the past few months are many.

But it is how we learn these lessons that is so very important. Sarbanes-Oxley (and indeed the Glass-Steagall Act that came out of the 1930s banking crisis before it) shows the danger that lurks in knee-jerk legislation. One can't blame legislators - their constituents are on their backs to do something. The regulators are in the same boat - they too will be under pressure to produce change, irregardless of the form it takes.

The process that created Basel II, however, is a model of how regulators, legislators and the financial services industry can work together. Except in the US, these three parties communicated with each other at a level not seen before. This dialogue must continue - it must be enhanced - if we are to have any hope of improving the framework the financial services industry operates within after this crisis.

Former Federal Reserve chairman Alan Greenspan, and others, have called for Basel II to be rewritten. This might be the best way to tackle the issues that arise from this global credit crisis - and its spin-off mini-events. A global, co-ordinated response is required. Cool heads must prevail.

Greenspan, and others, have also remarked on the fact that our current crop of risk models seem to not work when negative correlations disappear in times of financial market stress. He suggests in a recent article that the problem might be resolved by modelling each phase of the economic cycle separately for credit and market risk. I wonder if this logic should be applied to operational risk loss analysis as well - that instead of focusing on modelling losses over a long period of time, there might be knowledge gained from modelling types of events (for example, rogue trading or market abuse) against specific key risk indicators or broader market conditions.

Greenspan also says that behavioural responses to market conditions should be taken into account in credit and market risk models. Again, I ask what the experiences of the operational risk discipline could bring to this, and what can be incorporated back into improving operational risk modelling.

Have a good month!