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Convergence of Regulatory Objectives and Institutional Interests
14
CHAPTER
Convergence of Regulatory Objectives and Institutional Interests Alignment of Goals to Enhance Sustainability and Reduce Systemic Risk Contents 14.1. Apparent Conflict 14.2. The Challenge 14.3. Convergence towards Common Goals 14.4. Reduction of Systemic Risk
105 106 107 108
There is significant common ground between institutions and regulators. An explicit focus on sustainability management can turn this common ground into a convergence of interests.
On the surface, it may be easy to conclude that there is a conflict, and the pursuit of institutional interests beyond some undefined boundary is at odds with regulatory objectives.A regulatory attempt to draw such a boundary is often opposed vigorously by the industry, as seen recently in relation to the Volcker rule.
14.1. APPARENT CONFLICT Regulators maintain their supervisory role through reviews and monitoring of operations and performance of institutions. They do so by looking at each institution and its modus operandi. This includes a review of its business model, plans, policies, governance and management of risks, client and customer base, financial and analytical models, financial statements, audit reports, etc., as well as an assessment of intangibles, such as management experience and strength, managerial and decision-making processes, Managing Extreme Financial Risk http://dx.doi.org/10.1016/B978-0-12-417221-0.00014-9
© 2014 Elsevier Inc. All rights reserved.
105
106
Managing Extreme Financial Risk
reporting and controls, marketplace reputation, etc. In other words, they use objective observations and subjective assessment of many tangible and intangible factors that may have a bearing on an institution’s going-concern sustainability. In the end regulators turn this review, as well as output from their black box, into opinions about the institution’s strengths, vulnerabilities, and likelihood to sustain a going concern in extreme events. Despite extensive analyses, because they do not include objective and transparent input about extreme tail risk, such reviews often result in opinions that are viewed by institutions as subjective. Institutions may look at the same variables and draw conclusions that may be at odds with the regulatory view. This often gives rise to a disagreement, particularly if key opinions are not favorable to the institution, which starts a chain of arguments that create the conflict.
14.2. THE CHALLENGE As discussed earlier, institutions today do not have an explicit focus on going-concern sustainability management, making it difficult if not impossible to gauge objectively how an institution may fare in an extreme situation. Now imagine an institution that prides itself on effective sustainability management. • Its board has an explicit statement of sustainability objective, with defined quantitative targets and limits. • It has clearly formulated sustainability corporate policies to provide guidance to the management of the institution. • It has a distinct management process to proactively address the goingconcern sustainability of the institution, with all senior managers well versed in sustainability management issues. • It has PML limits assigned to each of its business segments, who in turn have implemented a mechanism to assign similar limits to all of their portfolios and to discriminate among transactions using a complete 3-D view of the risk-reward relationship. • As a part of the managerial process, it has strong control mechanisms to report, monitor, and manage limits. • Each of its business segments has specific credible plans and programs with clearly pre-defined triggers, coordinated through corporate criteria, to protect the institutional capital in the event of a crisis. The readiness of these plans is documented and tested regularly.
Convergence of Regulatory Objectives and Institutional Interests
107
• E ach senior manager’s performance evaluation metrics includes at least one meaningful sustainability-management goal. • In other words, it has a sustainability-management process that qualifies as outstanding.
14.3. CONVERGENCE TOWARDS COMMON GOALS In this scenario, the focus of regulatory review would be quite different from the current approach. Regulators would still review all the items and factors they have been monitoring, but their primary focus will be on critical issues, such as the following. • Is the corporate objective clearly stated to indicate the institution’s going-concern-sustainability priority? Is it a prudent and realistic objective? Is the objective and goal-setting exercise backed up by sound analyses? Is there a mechanism to report PML exposure from major business segments? • Are business segment limits reasonably developed, with objective tradeoffs between financial return, risk-management measures, and PML measures? • Are there sound policies that establish management’s approach to PML and sustainability exposure throughout the organization? Have they been communicated clearly? • Are there sound governance guidelines that encourage risk taking consistent with the institution’s financial and sustainability objectives? • Do individuals in key management roles have a good understanding of what it takes to supervise and ensure adherence to sustainability management policies and balance risk-reward tradeoff by using the 3-D matrix? • Is the audit committee of the board fully engaged in reviewing reports and ensuring proper governance that includes sustainability management? These are all proactive steps that an institution can and should implement to add shareholder value. It so happens that these steps also advance the regulatory objective of protecting the institution and, thus, the financial system. Therefore, the primary regulatory focus will shift from understanding the risks in what institutions are doing to achieve their profits goals to evaluating how effective is the sustainability-management process. A review specifically focused on such issues will give regulators a much more objective basis for addressing going-concern issues with the senior
108
Managing Extreme Financial Risk
management and the board than a subjective view of selected transactions. Under this scenario if there is a disagreement, it is about a specific item that points out a weakness, rather than regulatory objections to certain transactions for reasons that may appear to be arbitrary and subjective opinions. For example, under this scenario, the issue in relation to the Volcker rule is not whether the activity in question is or is not in the best interest of institutions, but rather how does an institution justify the resulting extreme exposures in relation to sound institutional objectives and policies driving sustainability management. Such a regulatory review, focused on the institution’s sustainability management process, will also help the board of an institution obtain an independent perspective on its effectiveness. This will lead to a convergence of objectives and interests, providing right incentives to the managers of financial institutions.
14.4. REDUCTION OF SYSTEMIC RISK As discussed earlier, the institutional threshold for going-concern sustainability is higher than the regulatory threshold for protecting the financial system. In addition, effective sustainability management programs enhance the going-concern integrity of an institution. Therefore, an effective sustainability management process at each institution actually reduces systemic risk and the need for regulatory intervention in a crisis to protect the system. Because of sound and credible sustainability management programs, it creates a bigger cushion in front of an institution’s capital, reducing the amount of assistance needed in case of regulatory intervention in a crisis. This will advance public interest significantly. Along the same lines, can effective sustainability management—along with the use of a PML-based approach to communicate with stakeholders— reduce marketplace anxiety and thus add further shareholder value? An effective sustainability management process can turn the sometimes adversarial relationship between regulators and financial institutions into a productive and effective partnership that adds shareholder value and reduces systemic risk.
CHAPTER
Convergence of Regulatory Objectives and Institutional Interests Alignment of Goals to Enhance Sustainability and Reduce Systemic Risk Contents 14.1. Apparent Conflict 14.2. The Challenge 14.3. Convergence towards Common Goals 14.4. Reduction of Systemic Risk
105 106 107 108
There is significant common ground between institutions and regulators. An explicit focus on sustainability management can turn this common ground into a convergence of interests.
On the surface, it may be easy to conclude that there is a conflict, and the pursuit of institutional interests beyond some undefined boundary is at odds with regulatory objectives.A regulatory attempt to draw such a boundary is often opposed vigorously by the industry, as seen recently in relation to the Volcker rule.
14.1. APPARENT CONFLICT Regulators maintain their supervisory role through reviews and monitoring of operations and performance of institutions. They do so by looking at each institution and its modus operandi. This includes a review of its business model, plans, policies, governance and management of risks, client and customer base, financial and analytical models, financial statements, audit reports, etc., as well as an assessment of intangibles, such as management experience and strength, managerial and decision-making processes, Managing Extreme Financial Risk http://dx.doi.org/10.1016/B978-0-12-417221-0.00014-9
© 2014 Elsevier Inc. All rights reserved.
105
106
Managing Extreme Financial Risk
reporting and controls, marketplace reputation, etc. In other words, they use objective observations and subjective assessment of many tangible and intangible factors that may have a bearing on an institution’s going-concern sustainability. In the end regulators turn this review, as well as output from their black box, into opinions about the institution’s strengths, vulnerabilities, and likelihood to sustain a going concern in extreme events. Despite extensive analyses, because they do not include objective and transparent input about extreme tail risk, such reviews often result in opinions that are viewed by institutions as subjective. Institutions may look at the same variables and draw conclusions that may be at odds with the regulatory view. This often gives rise to a disagreement, particularly if key opinions are not favorable to the institution, which starts a chain of arguments that create the conflict.
14.2. THE CHALLENGE As discussed earlier, institutions today do not have an explicit focus on going-concern sustainability management, making it difficult if not impossible to gauge objectively how an institution may fare in an extreme situation. Now imagine an institution that prides itself on effective sustainability management. • Its board has an explicit statement of sustainability objective, with defined quantitative targets and limits. • It has clearly formulated sustainability corporate policies to provide guidance to the management of the institution. • It has a distinct management process to proactively address the goingconcern sustainability of the institution, with all senior managers well versed in sustainability management issues. • It has PML limits assigned to each of its business segments, who in turn have implemented a mechanism to assign similar limits to all of their portfolios and to discriminate among transactions using a complete 3-D view of the risk-reward relationship. • As a part of the managerial process, it has strong control mechanisms to report, monitor, and manage limits. • Each of its business segments has specific credible plans and programs with clearly pre-defined triggers, coordinated through corporate criteria, to protect the institutional capital in the event of a crisis. The readiness of these plans is documented and tested regularly.
Convergence of Regulatory Objectives and Institutional Interests
107
• E ach senior manager’s performance evaluation metrics includes at least one meaningful sustainability-management goal. • In other words, it has a sustainability-management process that qualifies as outstanding.
14.3. CONVERGENCE TOWARDS COMMON GOALS In this scenario, the focus of regulatory review would be quite different from the current approach. Regulators would still review all the items and factors they have been monitoring, but their primary focus will be on critical issues, such as the following. • Is the corporate objective clearly stated to indicate the institution’s going-concern-sustainability priority? Is it a prudent and realistic objective? Is the objective and goal-setting exercise backed up by sound analyses? Is there a mechanism to report PML exposure from major business segments? • Are business segment limits reasonably developed, with objective tradeoffs between financial return, risk-management measures, and PML measures? • Are there sound policies that establish management’s approach to PML and sustainability exposure throughout the organization? Have they been communicated clearly? • Are there sound governance guidelines that encourage risk taking consistent with the institution’s financial and sustainability objectives? • Do individuals in key management roles have a good understanding of what it takes to supervise and ensure adherence to sustainability management policies and balance risk-reward tradeoff by using the 3-D matrix? • Is the audit committee of the board fully engaged in reviewing reports and ensuring proper governance that includes sustainability management? These are all proactive steps that an institution can and should implement to add shareholder value. It so happens that these steps also advance the regulatory objective of protecting the institution and, thus, the financial system. Therefore, the primary regulatory focus will shift from understanding the risks in what institutions are doing to achieve their profits goals to evaluating how effective is the sustainability-management process. A review specifically focused on such issues will give regulators a much more objective basis for addressing going-concern issues with the senior
108
Managing Extreme Financial Risk
management and the board than a subjective view of selected transactions. Under this scenario if there is a disagreement, it is about a specific item that points out a weakness, rather than regulatory objections to certain transactions for reasons that may appear to be arbitrary and subjective opinions. For example, under this scenario, the issue in relation to the Volcker rule is not whether the activity in question is or is not in the best interest of institutions, but rather how does an institution justify the resulting extreme exposures in relation to sound institutional objectives and policies driving sustainability management. Such a regulatory review, focused on the institution’s sustainability management process, will also help the board of an institution obtain an independent perspective on its effectiveness. This will lead to a convergence of objectives and interests, providing right incentives to the managers of financial institutions.
14.4. REDUCTION OF SYSTEMIC RISK As discussed earlier, the institutional threshold for going-concern sustainability is higher than the regulatory threshold for protecting the financial system. In addition, effective sustainability management programs enhance the going-concern integrity of an institution. Therefore, an effective sustainability management process at each institution actually reduces systemic risk and the need for regulatory intervention in a crisis to protect the system. Because of sound and credible sustainability management programs, it creates a bigger cushion in front of an institution’s capital, reducing the amount of assistance needed in case of regulatory intervention in a crisis. This will advance public interest significantly. Along the same lines, can effective sustainability management—along with the use of a PML-based approach to communicate with stakeholders— reduce marketplace anxiety and thus add further shareholder value? An effective sustainability management process can turn the sometimes adversarial relationship between regulators and financial institutions into a productive and effective partnership that adds shareholder value and reduces systemic risk.