Exchange Ideas

A weblog by Satchidananda Sogala

April 22, 2009

A New Paradigm for Financial Regulation

President Obama spoke of the mess in financial regulation and the need to clean up in his State of Union Address. With the banks and financial institutions and financial markets braving new odds everyday, of one thing there is consensus. Existing regulatory setup has not delivered and is passé. The regime of free market regulation characterized by the triad of supervision, audit and self regulation has come into question. It’s a sign of times that people are fighting shy of the most pervasive financial regulatory regime namely BASEL II International Standards for Capital Measurement and Capital Standards. There is, thus , a churning about the best way to regulate the markets. Against this background I would like to outline, according to my views, what the new regulatory regime should not be and more importantly what it should not be.
What should not be done?
When times are bad like now, it is easy for the pendulum to swing to the other extreme. Already shrill voices are being heard to put in place a comprehensive regulatory regime in which every micro aspect is controlled and directed by the statutory authorities. No doubt the current framework hasn’t had the strength to weather the storm, has wobbled under the stress but we need to guard against overdoing the regulation and establish micro level controls regime. Therefore the first danger to be avoided is the micro management of financial markets and players and instruments. Why? Don’t kill the market, the hen the lays the golden eggs. History has evidence that markets need to flourish and they do so through innovation.
Don’t throw away the quants. It’s only recently that quantitative measurement had emerged as the basis for market operations and market regulation. During a crisis like this, it is easy to malign the quants approach. We need to remember two things in this context : Financial markets are risk intermediation markets, their value lies in the way they facilitate the transformation, slicing and dicing of risks to cater to the varying profiles and appetites of the individual households, corporate and governments for raising resources and their optimal deployment. Its pretty obvious that this task is tough, complex and highly nuanced.
Secondly, risks are about the future uncertainty and there is no alternative to looking at the past data and making an attempt to abstract the patterns which could be recursive. While the total reliance on number crunching and their results as precise prognosis is certainly not correct, lets recognize that the quantitative estimates is all that we have. Numbers are not God, their patterns are not inviolable, but their the only peephole into the future. Lets improve the methods of analysis in modeling techniques and our estimations of various market events in the light of the experience of the current crisis but lets not castigate or abandon the work done over the years to provide an operational basis based on data and mathematical modeling. The rigor may not be irrefutable, but at least it can be used with good effect when we don’t regard it as the gospel.

Avoid the compliance mania : It is fashionable now to talk about compliance and corporate governance and ethics. They are no doubt important but they are not to be deified. They are all means for a purpose. The goal is growth and development through the medium of the financial markets invoking some vague ideas and establishing elaborate regimes for their implementation is counterproductive. Let’s not forget that the Enron corporation had been recognized for the best corporate governance standards. More recently in India, the Satyam Infotech had won the best corporate governance award successively for two years and ironically the peacock award had been conferred on it just a few months before the corporate fraud exploded.
We all like certainty in good behavior on the part of the corporate but it’s neither easy to command it nor useful to expect it. Of necessity, we need to have certain tentativeness about the corporate controls and the compliance requirements that we impose so that we can adapt them to the emerging scenarios as we move along.
Keep it simple and enforce with rigor.
Like in life, regulation needs to be clear, simple and unambiguous. Regulators have a knack of making things complex and confusing in an attempt to be comprehensive and correct. The regulatory arrogance must give way to conscious attempt to keep the regulation to the minimum and a continuous process to simplify it. I would suggest an annual review of all regulations and their relevance with a view to achieving targeted reductions a la the paper reduction requirements in the United States. The objectors will screen that it is not doable and involves very high costs. My answer to them is that the costs of the alternative of perpetuating confused and confusing regulatory matrix are several times more.
Given the natural tendency of a regulator to expand his turf and his power, there should be a rigorous regime to regulate the regulator and enforce inescapable discipline in the matter of regulation.
Make the regulation goal- oriented.
The goal of regulation has been and should be to support effective functioning of the markets. While this is a truism, somehow this tends to be missed often. In response to the changes in the financial markets from time to time, every country establishes statutory and other regulations to meet the specific demand of the market. However we forget to weed out the rules and regulations that have outlived their utility. The rescinding on existing control particularly in a democratic setup seldom happens unless there is a crisis as the vested interests develop in its perpetuation and the policy makers find it a safe option to do nothing. Our attempt should be to keep the regulation current and relevant through continuous review.
In summary, the new regulatory order should be simple, market -oriented and dynamic rather than elaborate, rigid and etched in stone. That is my view ! I would welcome your considered responses!

Posted by satchidananda s sogala at 09:05 AM | Comments (0)

January 17, 2009

The Serpent and the Rope: The Reality and the Myth of the Current Crisis

Let us get it straight. Current market crisis is the crisis of confidence , the crisis of credibility among the financial market participants . The heart of the crisis is the information failure. This should be pretty obvious. A truism not worth saying, were it not for the fact that very distinguished people are trying to find reasons "otherwhere". For instance, Mr. Christian Noyer, Governor of the Bank of France appears to think that the present problem is a liquidity crisis and a securitization crisis. , and goes on to say that"During the last few months, at no time have I felt that our organization was deficient or was preventing me from obtaining adequate information needed to make the necessary decisions. "
Not every one, certainly not me, can agree with this description that adequate information was and is always available to the regulators and to the market participants. Indeed , it is to the contrary. In fact, the lack of information and information distortions are at the root of the markets failures everywhere. Let us explain. It is not that the quarterly / monthly disclosures were not happening. Nor that the company boards were not getting their MIS. Of course, tons of numbers were doing rounds. Data were being collected and researched by a large number of people within and outside the financial markets in the US and elsewhere. Financial reengineering by smart guys had been happening on those numbers. Regulators were getting their Basel reports and feeling secure in them and in the the CRAR ratios. Then, where is the problem regarding the information? I hear you ask.

In fact, this perception is the problem. This feeling that we know ,the "information security" is the obfuscator. As Macbeth says, "the security is the mortal's chiefest enemy." We tend to believe that there is good information floating around everywhere. This, in fact, is not the case. Confidence comes from knowing and ignorance breeds fear and the markets now are in the grip of fear!

The anatomy of crisis is on. The “magi “have come up with different reasons. Let us examine some of these myths. Let us ask the real culprit to stand up!

Villain No 1: Poor liquidity?

Poor liquidity in the US and world markets is to blame, say some experts. For sure, the markets showed liquidity problems and this is a worst manifestation of the crisis, more a result than the cause, and more a symptom than the disease. If this were the real culprit, why has not the large-scale pump priming the world over not put the markets back in form?

Villain No 2: Greed ?

Others attribute the current market problem to the greed of the Wall Street. They say ethics should prevail over economics. By implication, this means that it is wrong to have purely economic incentives for performance. Coming from the IT czars of Bangalore, who benefited from the markets, this sounds unreal ! As a principle, no one can quarrel with it. In fact, the Hindu's deified the absence of greed as a way of life and the Rishi's were not supposed to pluck the fruits or grow the corn but live on what was available in nature in the natural form. Like King Dushyantha from the famous Indian play ( Abhijnana Shakunthala ), we can only pay obeisance to this ideal .
Like my Chicago Professor said once, the only workable basis for the modern economic life is to hold that the maximizing wealth is maximization of happiness and that individual self-interest is the basis of all economic activity. Just as it is not possible to say when the competition becomes unhealthy, in actual practice, it is not possible to differentiate "good greed "from
“bad greed". Unless one is an ancient Indian Rishi or an ascetic like Mahatma Gandhi, the wheel of business is moved by the self interest of the individual. While business ethics as compliance with laws is required and enforceable, it cannot work if it is a moral judgment.

Some communist friends have seen the end of capitalism I n this crisis. Let us wish them well in their daydreaming. The world has progressed and been sustained by capitalism and for all its imperfections, there is no alternative to it.

Villain No 3: Quants?

In any severe crisis, people will be desperately looking for some thing to attack. The global meltdown provided an occasion for the people to attack the quantitative approach and risk modeling as ineffective and even responsible for the current crisis. Think about it! Rejecting quants and models tantamount to shooting down the messenger for the bad news. Just because a model did not work, one cannot dismiss the science of modeling itself which is a but a method for abstracting the repeatable elements of the past events for estimating the uncertain future. Sooner than later, we shall have to return to the quants approach.


Villain No 4: Financial Engineering & Derivatives

The crisis is sometimes attributed to the exotic financial products created through securitization. In the context of the collapse of Lehman and the transformation of the investment banking giants like the Goldman Sachs and the Merrill Lynch, it is only natural to blame the crisis on the derivatives and the asset bubbles created by them. The question to ask here is whether the United States could have had the amount of housing stock it has but for the mortgage backed securities.

Therefore, the origins of the crisis lie in the information latency. It is well know that despite the postulate of the efficient market hypothesis EMH, the information asymmetries and uncertainties exist as between the market participants. And are the sources of risk. When these asymmetries are exaggerated, the markets give way. After all, “animal spirits” guide the markets. As such, the remediation for the current market failure, should also lie in building better estimates of the uncertainties, better information dissemination mechanism across the markets and better estimates of the uncertainties. In short, what we need is comprehensive risk based information system which would reflect and communicate the reality better.

Posted by satchidananda s sogala at 04:42 AM | Comments (0)

May 04, 2008

The Challenge of Choosing the Right Risk Technology

Selecting the right technology solution for risk business optimization is not a simple matter of choosing Hardware, Software, Storage and setting them up. It is about harnessing the computing and communication technology for achieving optimal results and this is a challenge.

Two things are clear in this context. Technology is an essential condition for effective risk management in financial services because the data gathering and its analysis on real time basis require effective data capturing and transmitting mechanisms across the organization as well as considerable computational power. Second, there is NO single solution that fits all. As a matter of fact, each case has some unique features and requires customized risk solution.

Selecting the right technology for risk management is a critical decision and should be addressed with due involvement of the top management .Typically, the consultants who are entrusted with this job end up putting the cart before the horse, put the technology before the business. Why? Because it is the simpler, often, grandiose option and gets them good mileage as experts and business in the industry. Also because the banks and other financial entities are not themselves clear about the business they want to pursue and not fully aware of their own requirements. Thus, the technology becomes the DRIVER and not the TOOL it is and should be! I can cite in evidence not an untypical experience I had recently while having to respond to a Request for Proposal for risk technology to a major bank in India. The RFP document, apparently constructed by a reputed consulting firm, was actually the imperfectly integrated reproduction of the table of contents from a couple of standard risk books. During the discussions, neither the bank nor the consultants could tell us how the disparate elements in the RFP were relevant to the bank’s current and future business .Worse still, how they were supposed to be integrated. The moral from this is that the business requirements rather than the fancy ideas should dictate the technology selection.

It is possible that the bank may lack clarity about its business and the ways of growing it. In such cases, first, they need to focus on the business strategizing, either by themselves or through external experts. Only thereafter, they should map their business plan to the technology solution. And this exercise is best done on case by case basis. Despite apparent similarities in size and business, often the risk appetite and the growth trajectories of each institution would vary and vary substantially. Second lesson, achieve clarity on business and its growth path first!

Third suggestion. Establish the risk management processes, right from data collection to analytics and modeling, before initiating the technology adoption. I am aware of the cases where the best technology systems are in place without much benefit because the requisite data and skill sets were not available.

Another point to consider is the approach towards risk technology costs. Traditionally, people ask for Return on Investments in Risk technology spending. What they forget is this spending is for the key enabling infrastructure without which the risk business cannot be carried on. The cost of good risk technology may be substantial. The cost of its absence is more : EXIT !

Cost savings are always important to any business. However, the common approach of economizing on the essentials or compromising on the performance in the technology selection exemplifies the penny-wise and pound foolish mentality. In fact, it entails much larger costs both in terms of business results and the cost of enhancing the technology infrastructure to measure up to the business demands.

Yet another thing to bear in mind is that the risk business and the technology are both dynamic .There is no point planning for a “permanent” technology solution. The recognition that the technology adoption is a continuous process would enable the banks to reduce if not overcome, the operational risks emanating from technology.

In sum, risk technology choice is too serious a matter to be delegated away and requires due involvement of the top management on a continuous basis. Further, there is a strong need for the board level executives to be aware of the contours and methods of risk management in sufficient depth so that they can drive their organizations to achieve constantly better business outcomes benefiting from the appropriate technology adoption.

Posted by satchidananda s sogala at 10:14 PM | Comments (2)

January 28, 2008

Implementation Challenges in Risk Management

“Intentions are nothing except as realized” said Frank Raymond Leavis, the famous Cambridge don. This applies to risk management in full measure. The execution, like in most other things, is the key to successful risk management. The execution measured not only in terms of actions taken, (like the establishment of processes or implementation of technology systems and operationalization of governance procedures), but in terms of effectiveness of the regime in achieving higher risk-adjusted-returns on capital; increase in market share on account of finer rates and customer delight ; and lowering of the non performing assets through more accurate risk differentiation. In other words, in terms of improved overall performance of the bank. All these assertions would have been trivial truisms if only the risk management in banks were achieving these obvious objectives at least substantially. The financial crises events in the recent past in different parts of the world evidence otherwise and provide some justification for looking at risk implementation issues again in some detail. Let me begin by narrating a real incident. The other day I was speaking at one of the Risk Management seminars in Mumbai. In the same event, one of the chief risk officers of an important state - owned bank also spoke on the status of the Basel II implementation in his bank. He asserted that their bank had completed the implementation process and there was nothing more to be done particularly, in credit risk management. I was very much impressed, surprised and a little uncomfortable by this claim as most banks in India do not practice risk based pricing of their assets even today. Soon after this, I was invited to conduct a session on credit risk modeling to the credit officers of the self-same bank in their training institution. My interactions on this occasion laid bare the hollowness of the CRO’s claims. It turned out the rating of loan accounts was perfunctory and the rating reports were done under duress with scant regard to reality, mostly in the absence of accurate data and / or proper application of mind. Sure, the Risk Management department had received all the reports it ‘wanted’ and submitted the reports to the management and the regulator regarding the Basel II implementation. I thanked my stars that I was not a board member of this bank which got all the ‘required’ reports and was taking credit decisions based on misplaced certainty and confidence. Is it not better to know that we don’t know than to think we know when in fact, we don’t? “The security is mortal’s chiefest enemy!” (Macbeth). This kind of experience is not solitary instance. Not long after this, the chief of Risk Management of another big Indian Bank mentioned to me that they have researched and implemented more than a dozen credit risk models in their bank. Needless to say, I was greatly impressed. However, on verification, I found that the bank, indeed, has a huge risk management department and sadly, their work was not resulting in the improvement of the performance to any measurable way. The bank was yet to differentiate between credit risks and was yet apply risk-based pricing them on the basis of tested and robust risk models. It seems to me, there is certain amount of vagueness and confusion and also hyping in the risk management implementation. As such, in risk management implementation, there is a need to constantly focus on results rather than processes alone. After all, REALITY is more important in this case as in others, than FORMALITY! The key question to ask in the context of risk solutions implementation is the difference between the ‘form’ and the ‘essence’. Between the implementation of this or that software systems and the perceptible increase in the revenues and earnings and net worth. What then are the implementation challenges? What are the possible resolutions? As I have been involved in the implementation in this part of the world, I will share some of my experiences. I propose to focus on some of the key implementation challenges in this area based on my own not inconsiderable experience in this regard. May I invite you all to contribute your insights and knowledge on this topic for common benefit of the risk community?

Posted by satchidananda s sogala at 09:15 PM | Comments (6)

June 20, 2007

About Satchidananda Sogala

Dr.S.S.Satchidananda is currently Head of Risk Solutions & Research at IBM India, and formerly Research Director, Center for Banking and Information Technology, International Institute of Information Technology, Bangalore (DEEMED UNIVERSITY), on deputation from the Reserve Bank of India. He was formerly Regional Director for Orissa and headed the Reserve Bank of India at Bhubaneswar. He has Master of Science Degree in Economics from University of Illinois at Urbana-Champaign, a Ph.D in Economics with specialization in Financial Markets; graduate degrees in Law, and Education and professional certification in banking and Quality Management Systems. He has published over 20 papers on banking and finance, particularly Risk Management and application of IT for banking. He has been a Ph.D guide in the area of Finance at the IIT, Chennai. He has also worked as Senior Faculty in the RBI Staff College and also the Bankers Training College in the area of Banking and Finance.
He has also worked in leading commercial banks on deputation from Reserve Bank of India besides being involved with the banking policy and regulation and supervision of banks and other financial entities in Reserve Bank for over two decades. During his long career with the central banking authority, he has had good exposure to all the segments of the financial markets from money markets to capital markets, both at policy and implementation levels. Having specialized in Risk Management both at Masters and doctoral level, he has published widely in this field and on the Basel II Implementation and is a known authority in this field. He is on advisory board of the International Institute of IT Law, Bangalore and nominated as Regional Director for South India Chapter of Professional Risk Managers International Association.

Posted by satchidananda s sogala at 05:39 AM | Comments (1)

Satchidananda Sogala


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