EUROPEAN SHADOW FINANCIAL REGULATORY
Paris, 1 March 1999
TOWARDS SAFER DERIVATIVES MARKETS
The trading of derivatives contracts has grown tremendously in recent years.
Such instruments perform a valuable economic function in facilitating the efficient allocation of financial risks, and thereby
improve the performance of the economy. The rapid growth of derivatives markets nonetheless raises legitimate concerns among
regulators relating to the adequacy of bank risk control measures and the potential for significant trading losses at one
institution to spread illiquidity or insolvency much more widely. The Committee takes the view that public debate on such
matters has not focused sufficiently on technical aspects of market operation, which we deem to be of central importance.
Our statement addresses two such aspects: procedures for internal risk control, and the clearing and settlement of trades.
Risk Control Procedures
There are three levels at
which accountability for financial risk management can logically be lodged: bank management, independent auditors and government
regulatory bodies. Were it not for the putative existence of significant systemic risk deriving from bank failure, bank management
- acting on behalf of shareholders - could be expected to exercise undivided authority and bear full responsibility. However,
legitimate public concerns related to the mechanisms through which the illiquidity, or even insolvency, of large banks or
highly leveraged funds might spread default risks throughout the financial system justify regulatory intervention to ensure
prudent internal risk management and effective procedures for dealing with insolvent institutions. This issue we addressed
in our statement of 22 June 1998 on "Dealing with Problem Banks in Europe".
approach to the problem of ensuring effective internal risk management in international banks has been the 1988 and 1993 Basle
Committee model, and the 1993 EU Capital Adequacy Directive model, of setting specific bank capital to asset ratios on the
basis of risk weightings established by regulatory fiat. This approach has revealed several significant limitations in practice:
in particular, incentives to bank management simply to swap one form of (regulated) risk for another (unregulated) form of
risk, and insufficient credit risk discrimination among broad categories of counterparties.
limitations have long been recognized in the private sector, and encouraged the development of internal "Value at Risk"
models, based on more sophisticated portfolio approaches to risk management. The 1996 Basle amendment legitimized this approach
as a supplement to the capital-asset ratio approach.
Regulators now face the significant task
of determining principles for distinguishing between prudentially sufficient and insufficient risk modelling, delineating
procedures for effective internal implementation and operation, and delegating responsibility for the external evaluation
of internal risk management systems to appropriate private or public bodies.
In the context
of derivatives, reliance on internal models raises a number of concerns. First, market risk can be exceptionally difficult
to estimate, owing to such factors as a lack of reliable data to determine price parameter inputs on OTC products and insufficient
consideration of market liquidity constraints. Second, credit risk is not independent of market risk, but is in fact dynamically
linked to the performance of underlying cash instruments. Finally, the existence of estimation risk and dynamic credit risk
can exacerbate "implementation risk"; that is, the ever-present risk associated with the unreliability of internal
procedures for implementing control systems based on the output of market risk models.
proposes that regulators address these issues by:
1) establishing good practice guidelines for
validating internal risk models;
2) requiring clear line management responsibilities to board
level for ensuring compliance with such guidelines; and
3) extending the role of external auditors
to include responsibility for assessing compliance with these guidelines and reporting significant breaches to the regulatory
The above procedures would reduce the present unrealistically heavy burden on regulatory
authorities while preserving their responsibility for determining capital requirements.
and Settlement Procedures
Robust clearing and settlement procedures are a basic
precondition for financial stability, since any disruption in this area has the potential to trigger defaults throughout the
financial system. The Committee notes that in the derivatives markets the use of clearing houses offers significant advantages
in terms of transparency of risk exposures, standardized procedures and prudential safeguards. In contrast, without such systems,
OTC derivatives contracts expose market participants to counterparty, operational and greater legal risks. Furthermore, a
recent BIS study (September 1998) documented that market participants often fail adequately to address such risks.
In light of the systemic risks which inhere in large-scale international banking operations, the Committee
proposes that regulators encourage the use of central clearing systems via the imposition of capital requirements which reflect
the higher settlement risks encountered in OTC derivatives trading. Furthermore, regulation pertaining to the role of external
auditors should strengthen their role in identifying and addressing problems in the OTC settlement processes.
Recognizing the systemic concerns which would accompany the collapse of a major clearing house, the Committee
also proposes that all derivatives clearing and settlement systems should themselves be subject to minimum operational and
prudential standards, including in particular adequate margin requirements. Moreover, the facts relating to the recent collapse
of Griffin Trading, a clearing member of the London Clearing House, and the resulting freeze of margin assets of non-defaulting
customers, should be made public. This is essential to enable market participants and regulators to learn from the specifics
of the case, and adapt their expectations and practices in the future.