Private sector proposes rethink on risk

Tuesday, August 12

The Counterparty Risk Management Policy Group III (CRMPG III) on August 6 proposed sweeping changes in several areas -- including accounting, risk management, and clearing and settlement -- to rectify weaknesses that led to the current credit crisis. The group, formed in April, is the latest private sector response to the current credit market crisis.

If implemented, the measures could strengthen both financial institutions and the resiliency of financial markets. However, some key issues, involving appropriate compensation policies and fair value accounting procedures, have been deferred.

CRMPG III recognises that the US Financial Accounting Standards Board will soon issue new guidance concerning reporting of off-balance sheet structures under US Generally Accepted Accounting Principles. Its report endorses the expected direction of these changes if they are:

principles based;
convergent with IFRS; and
accompanied by suitable disclosure and transition rules regarding regulatory capital, so as to provide flexibility in implementing new accounting rules over a reasonable period of time.

The group says that market participants must undertake efforts to understand and manage credit risk inherent in high-risk complex financial instruments. It suggested that financial institutions evaluate leverage, liquidity, and price transparency for trading such instruments, to determine themselves what instruments qualify for such treatment.

The credit market crisis revealed shortcomings in risk monitoring and management that apply across many institutions and classes of institutions. In order to address this failure, the report recommends spotlighting four areas, and outlined detailed recommendations to apply to each, namely:

improving corporate governance;
enhancing tools and techniques in risk monitoring and management;
using techniques to upgrade liquidity management; and
linking together conceptual frameworks for analysing capital adequacy, leverage and liquidity.

Recent events spotlighted flaws and deficiencies in the foundation that support credit markets, and credit derivatives markets in particular. The report highlights weaknesses and recommends ambitious reforms, namely:

enhancing the daily valuation and collateral management process;
endorsing an industry initiative to compress outstanding trade populations, and by so doing, easing the task of unwinding transactions in future crises;
adopting formally the auction-based, net physical settlement procedure for credit events as part of standard documentation; and
most significantly, creating a central clearing mechanism, as this would address many apparent systemic deficiencies.

Two other key areas are noted as requiring further attention:

Compensation practices -- especially annual bonuses that are largely allocated on the basis of individual performance -- encouraged excessive risk-taking. The report recommends shifting to compensation systems based on overall firm performance, payable in stock and with benefits vested over a longer period.
Fair value accounting was significant in contributing to the credit crisis. The report recognises the need for an alternative accounting treatment to fair value that does not further undermine the already damaged credibility of the financial sector.

If widely adopted, these recommendations could significantly improve systemic stability. Yet much depends on whether firms themselves, and their regulators, will get behind these reform initiatives