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RISK GOVERNANCE IMPLICATIONS FOR

FINANCIAL STABILITY

A Risk Manager’s Perspective Presented by:Eneni Oduwole

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CONTENT

Risk, Risk Management and Risk Governance 3

Risk Universe of Financial Systems 9

Governance Nexus 19

Responsibilities for Risk Governance 24

Conclusion 30

References 32

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RISK, RISK MANAGEMENT

AND RISK GOVERNANCE

Brief Introductions

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WHAT IS A RISK?

It is the possibility that a decision or action could lead to a positive or negative event in future

It implies future uncertainty

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WHAT IS RISK MANAGEMENT?

It is a discipline that deals with the possibility that decisions and actions taken by the organization may cause unexpected results

It trains us to deal with uncertainties and ensure that suitable controls are implemented to mitigate likely exposures for losses

It raises the awareness that all decisions made and business activities engaged in may result in consequences that are positive, negative or both

It makes organizations ascertain and agree on the level of risk to take in achieving its goals

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WHAT IS RISK GOVERNANCE?It refers to the institutions, rules conventions, processes and mechanisms by which decisions about risks are taken and implemented

It analyses and formulates risk management strategies to avoid and/or reduce the human and economic costs caused by disasters (Wikipedia)

It is implemented through defined structures

It enables institutions minimize the negative consequences of inherent risk exposures

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FEATURES

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GOVERNANCE RESPONSIBILITIES

• Risk appetite and toleranceBoard

• Ownership and accountabilityProcess Owners (All Staff)

• Business requirementMgt Staff / Dept

Heads / Line Managers

• Risk standards and benchmarksERM

• Independent reviewInternal Audit

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RISK UNIVERSE OF FINANCIAL SYSTEMS

The Typical Risk Landscape of Financial Institutions

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COMPONENTS OF A FINANCIAL SYSTEM

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LIKELY BUSINESS ACTIVITIES

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TYPICAL RISK UNIVERSE

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FINANCIAL SYSTEM STABILITYApproach 1:

i. Takes a systematic view of the entire financial system and emphasizes its resilience as a key component of its stability

ii. With this approach, it is assumed that financial stability stems from a financial system that is durable, that does not experience major disruptions and offers an efficient basis for allocation of savings to investment opportunities, Mishkin (1991 and 1997)

iii. The ability of the system to act as a shock absorber when an entity within the system fails attests to how stable the system is

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FINANCIAL SYSTEM STABILITY (CONT’D)Approach 2:

i. Financial stability is likened to situations without banking crises and with asset price stability

ii. With this approach, rates and product offerings are relatively predictable and consistent

iii. It is however weaker than Approach 1 because the strength of its resilience is hardly tested; this approach does not provide confidence on the relative strength of the financial system

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FINANCIAL SYSTEM STABILITY (CONT’D)Approach 3:

i. A hybrid of Approaches 1 and 2 that was promoted by Crockett (1997)

ii. Stability requires that key institutions (too big to fail) are stable, are able to meet their obligations consistently without interruption or external support

iii. This approach requires that key markets are also stable to allow players confidently consummate transactions at prices driven by demand and supply consistently where there are no changes in the macro-economic fundamentals; Financial stability is therefore likened to situations without banking crises and with asset price stability

iv. With this approach, rates and product offerings are relatively predictable and consistent

v. It is however weaker than Approach 1 because the strength of its resilience is hardly tested; this approach does not provide confidence on the relative strength of the financial system

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STABILITY → SOUNDNESSStability

• Based on state of financial system components

• Not easily measurable

• Test of resilience is usually known after the fact

• May be wishful thinking

Soundness

• Constitutes a major component of overall stability

• Is measurable

• Reflects the element(s) of resilience

• Is more robust

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Capability of regulators to

build and sustain an efficient system

Sustainable macroeconomic

policies

Effective

management of counterparty risks

DRIVERS OF STABILITY IN FINANCIAL SYSTEMS

Robustness of payment

systems (esp. in major financial centers)

Credible exchange rate regime

Trustworthy

payment systems

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RECOMMENDED RISK GOVERNANCE STRUCTURE

Layered Governance Practices

Subsequent layers are modeled by the output of the previous layer

Previous layers are defined to demonstrate the required practice of the next

This structure should govern the activities and practices of all components in the system

This layered practice of Risk Governance in Financial Systems is commonly known as “The Governance Nexus”

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GOVERNANCE NEXUS Required Interrelationships

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COMPOSITION

Regulatory Agencies

Financial Institutions

Corporate Sector / The Public

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KEY DRIVERS

Regulatory Governance

=

Financial Liberalization + Advanced Risk Management

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FOCUS

Managing the rise in competitive pressures within the system

Increase in liquidity crisis and leverage

Financial soundness of institutions

Efficiency of the market infrastructure

Managing the spread of cross-market and cross-sector financial distress

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BASIS FOR GOOD GOVERNANCE Independence: Regulatory agencies should be insulated from improper influence from the political sphere and other supervised entities

Accountability: It is crucial that regulatory agencies are able to willfully justify their actions against the context of the mandate given to it by the Government or Legislature

Transparency: Regulatory Agencies should create an environment in which their objectives, frameworks, decisions and modus operandi are made available to the public in a comprehensive, accessible and timely manner

Integrity: Regulators as enforcers must pursue institutional goals without compromises or unethical behaviours

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RESPONSIBILITIES FOR RISK

GOVERNANCEKey Priorities for All layers in a Financial System

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RESPONSIBILITIES

Government

Promote good public sector governance

Demonstrate transparency and anti-corruption across all levels of government

Maintain an effective legal and judicial system

Does not promote government ownership

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RESPONSIBILITIES (CONT’D)

Regulatory Agencies

Promote and oversee the implementation of sound practices in financial intermediaries

Maintain sound governance practices internally

Establish credibility amongst players in the financial system

Promulgate good practices in the institutions being monitored

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RESPONSIBILITIES (CONT’D)

Financial Institutions

Responsible for establishing good governance practices that would gain and keep the confidence of customers and the markets

Ensure that their customers in turn implement good corporate governance practices in their organizations (Caprio and Levine, 2002)

Stimulate the efficient allocation of resources in the economy which in turn assures the soundness of the financial system.

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PILLARS FOR FINANCIAL SYSTEM STABILITY (FSS)

FSS

Macroeconomic Conditions

1. Monetary Policy2. Debt Structure

3. Exchange Rate Policies4. Economic Growth

Regulatory & Supervisory Conditions

1. Regulatory Framework2. Supervisory Efficacy

3. Safety Net Management4. Contingency Planning

Market Infrastructure

1. Money & Exchange Markets

2. Payments & Settlements3. Financial Accountability

Responsibility for Regulatory Governance

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RECOMMENDED RISK GOVERNANCE STRUCTURE FOR FINANCIAL INSTITUTIONS

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CONCLUSION

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Eneni Oduwole enenioduwole@gmail.com

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REFERENCES

www.ecb.europa.eu

www.investmenttodayer.blogspot.com

www.nomuraholdings.com

www.sec.gov

www.imf.org

www.bis.org