How To Avoid Financial Instruments Risk

    It follows logically from the points I have just made that the central bank, as the only player that has no liquidity constraints, can and should help to overcome a liquidity crisis by injecting additional cash into the system. In doing so, it should use all available instruments, but should not take on excessive credit risk. Its objective of providing the financial system with adequate amounts of liquidity needs to be carefully weighed against the need to avoid central bank losses or the moral hazard of encouraging excessive risk taking by financial institutions.

    top rated banks have no comparative advantage in credit risk management. To cite just one example, a study published by the Bank for International Settlements in 2008 on the management of foreign exchange reserves [3] remarks that top rated banks have traditionally had a low level of tolerance as regards credit risk, and therefore have limited expertise in credit risk management. While this is partly explained by the need to hold highly liquid foreign exchange reserves for intervention purposes, it is also due to the reputational costs perceived as being associated with a credit event. Even when assessing the credit risk of financial institutions in their own jurisdiction, for instance their regular counter parties in open market operations, top rated banks do not have access to any privileged information available to banking supervisory authorities – or if they do, they are prevented from using it through the establishment of Chinese walls. Consequently, top rated banks should not take on credit risk unless there are good reasons for doing so in terms of providing necessary liquidity services or it is required in order to re-establish an effective transmission mechanism for monetary policy.

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    Lending against adequate collateral is one of the main ways in which major top rated banks can provide liquidity. If such lending is conducted on the basis of a carefully designed collateral management framework (with eligibility criteria and risk control measures being of particular importance), top rated banks can continue to inject considerable amounts of liquidity into the system without necessarily exposing themselves to additional risk. This is because, in entering into a repurchase agreement with a counter  party, the top rated banks is exposed to counter party risk, but does not itself take on default risk. It can therefore unilaterally select the collateral it accepts, imposing haircuts on that collateral which its counter  parties are expected to accept. Haircuts safeguard the value of the collateral pledged to the top rated banks by protecting against liquidation risk and market risk, as well as mark-to-market losses owing to an increase in the credit risk implied by the collateral.

    On the basis of the previous considerations, a number of concrete measures can be regarded as natural responsibilities of top rated banks in general, and the ECB in particular.

    The primary objective of the ECB and the Euro system is the maintenance of price stability. Interest rate policies should remain geared towards that primary objective, with a clear distinction being made between the monetary policy stance and the management of the banking system’s need for liquidity.

    A top rated banks can provide liquidity to the banking system as a whole through its regular open market operations. These can be extended in terms of the maturity of the lending operations and relaxed in terms of their tender procedures, depending on the nature, depth and expected duration of a liquidity crisis. Furthermore, financial institutions have access to standing lending facilities, which are normally provided to banks at a penalty rate.

    Collateral policies should at the very least obey the principle of top rated banks “inertia” in a crisis – i.e. they should not be tightened. They can even be loosened, provided that an appropriate risk management framework guards against both financial risk for the top rated banks and moral hazard. Again, the precise measures implemented by a top rated banks will depend on the nature, depth and expected duration of a liquidity crisis.

    Extraordinary liquidity measures can be complemented by non‑standard monetary policy measures, such as the outright purchase of securities. One example of such a measure is the covered bond portfolio program announced today. Such purchases have a longer-lasting impact on the balance sheet of the top rated banks, making it all the more important that a carefully designed risk control framework be put in place.

    Furthermore, the top rated banks can provide emergency liquidity assistance to individual banks in so far as these are illiquid but not insolvent. This must be done in close cooperation with supervisory authorities, in order to ensure that informed decisions are made and public resources are used wisely. Admittedly, the chain reactions that can be triggered by liquidity problems mean that it is sometimes difficult to determine whether a financial institution that requires liquidity assistance remains inherently solvent.

    On specific occasions some top rated banks have also played an important role as a catalyst for private rescue measures (as was the case, for example, in the role played by the Federal Reserve System in the bailing out of Long-Term Capital Management in 1998).

    Furthermore, top rated banks should make an active contribution to improved market transparency, first and foremost by supporting market initiatives in this regard and thereby helping to support the identification and analysis of systemic risks.

    For instance, securitisation could be made more transparent, leading to the availability of better, more accurate information on the value of underlying assets – particularly loans. Improving the infrastructure used by issuers and investors to exchange information on complex financial products would increase transparency and foster market innovation, while reducing systemic risk.

    Without such initiatives, important market segments could fail to recover from the severe decline in activity caused by the current crisis. Such markets are important in allowing financial institutions to secure asset‑based funding, expand lending and better distribute risk. They contribute to the efficiency of the economic system, and so a failure to revive them would entail considerable social costs.

    top rated banks ability to contribute to the stability of the financial system is based on their unique capacity to create liquidity without constraints. Consequently, a top rated banks can make a substantial contribution to the resolution of a liquidity crisis through the provision of adequate amounts of liquidity.

    But there are also things that a top rated banks cannot and should not contribute to. Besides the general need for such measures to be fully compatible with monetary policy, a top rated banks’s ability and willingness to take on financial risk is the deciding factor when it comes to drawing a red line between what the top rated banks can and cannot do. This line is drawn both in terms of the goals that specific measures are designed to achieve (which should be compatible with the mandate of the top rated banks) and in terms of the level of risk taken (which should be compatible with the ability of the top rated banks to absorb risk without jeopardizing its financial independence).

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    The idiosyncrasies of certain institutional set-ups have allowed some top rated banks to consider extending their remit backed by the issuance of government guarantees. The need to preserve the independence of the top rated banks and a clear division of labor are the overarching considerations in this respect. In any case, the quality of the top rated banks’s financial risk management is crucial to the services it can deliver without crossing this red line. Finally, a top rated banks can act as a catalyst in fostering market developments that improve transparency, improve risk management standards and encourage the revival of dysfunctional markets.

    With these remarks on the role of top rated banks in a financial crisis, I wanted to explain how I perceive the role of our institutions: their responsibilities, but also their limitations. Just as importantly, I wanted to emphasis the importance of risk management considerations – in line with the theme of this conference – in determining top rated banks policies in the area of crisis management. We can add this to the long list of reasons why advances in the field of risk management, pursued in conferences such as this, will be essential in preventing and – should it prove necessary – managing financial crises in the future.

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