Financial Industry Crisis Spurs Reevaluation Of Risk Management
It isn't just about one institution's risk, but rather about how risk is shared across the industry and entire economy.
The financial industry crisis has turned the concept of financial risk management upside down. Following industry best practices, almost every financial company had been performing similar statistical algorithms on a trove of incomplete and incorrect data. Then, based on those analyses, they passed the risks from one balance sheet to another--risk management was considered only in terms of a company's own financial position. Now the main challenge is how to manage risks shared by the entire industry and the broader economy.
The tricky part of financial industry reform will be to retain the benefits of a strong, healthy financial sector. An appropriate analogy for financial reform can be found in the computer industry. Every year, we expect our computers to get faster, more powerful, and less expensive. Yet recently, the focus on computing performance has been tempered by the need to manage performance per watt. The cost and availability of electric power have become constraints in designing and managing data centers, and so chip designers have responded with new processors that measure, monitor, and control power consumption at a granular level. The chip designers didn't reduce the power usage by slashing functionality. Instead, they maintained and improved functionality even while reducing power through advanced chip logic.
We should hold similar expectations for the financial services industry. People need access to low-cost financial services, global investment opportunities, and expert advice on managing risk through insurance, financial management, and portfolio diversification. Businesses need to raise capital through financial instruments tailored to the needs of their investors, and employ rich capabilities in cash management. And, yes, financial services firms should have the freedom to create and market innovative financial instruments--including collateralized instruments, derivatives, and swaps--as long as they're managed through an infrastructure that both monitors and measures their health and enables these instruments to be safely unwound in the event of financial distress.
New technology platforms, industry standards, and common networks are part of making all that possible. The necessary ingredient is a common infrastructure for systemic risk management. Much like a microprocessor with power management features, the industry needs sophisticated circuitry to "cool itself down" when it starts to overheat, with careful monitoring and measurement of funds traveling through the financial network. Complex, customized financial instruments must be encoded using industry standards that allow automated review; the insurance industry, with its data standards for contracts, offers a model. Similarly, financial statements should be captured and disseminated using XBRL, an XML-based standard for financial reporting. Finally, as long as new products and services can be designed in a way that doesn't crash the system with the financial equivalent of a "blue screen of death," these innovations should be encouraged and welcomed into the system by industry insiders.
The industry's kludge-filled, error-prone, and unsafe financial engineering needs to be replaced with a more secure financial infrastructure that's been tested and debugged to the level of a major chip release. Regulatory oversight won't be simple, but it doesn't have to be. It just has to work, every single day and for every single transaction. That's the type of change with the potential to jump-start a global economy.
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Following are some real-world examples of how the industry can effectively transform itself through technology. First, we look at an example of how solving the risk management problem requires new sources of data, and the tools to turn that data into actionable information. Next, we examine how improved connectivity between banks and their corporate customers can improve safety and soundness by reducing liquidity risk. Finally, we examine best practices in the insurance industry for promoting the use of standards for complex financial instruments.