Supervising the Quantitative and Qualitative Aspects of Derivatives
Meister, Edgar, The Journal of Lending & Credit Risk Management
The subject of derivatives has been dominating discussions among financial experts for some time. After initial difficulties of interpretation, and with the rapidly increasing volume of business, the understanding of derivative activities has grown.
Despite an enormous global growth in the volume of derivatives business,a more realistic assessment has replaced initial gloomy predictions. Is this development bound to worry us, or has the banks' handling of the risks arising from derivatives transactions normalized to such an extent that banking supervisors can now feel greater equanimity facing this "financial revolution"? To put it another way, Do banks have derivatives business under control - at least to the extent of control that cases like Barings cannot recur?
The Effect of Derivatives
It is an indisputable fact that derivatives have brought about a fundamental change in how banking supervision assesses financial transactions, market structures, and approaches to bank management. As far as banks, other financial market players, central banks, and banking supervisors are concerned, it has long become a matter of course that we think more in terms of risk categories than types of business. Derivatives not only make this concentration on risk categories possible, but also absolutely necessary: It is not possible to handle derivatives otherwise. As such, everyone has to adjust, both market participants and supervisory authorities.
As can be seen, the process of adjustment has made much headway. At the same time, however, it is also evident that there is still a difference among global market players in the intensity with which derivatives are being used. In addition to different market preferences and business requirements, this difference may also be attributable to the fact that resources in personnel and technical areas may be further advanced at one institution than at another More highly developed institutions can exploit the associated competitive advantages until the catching-up process is completed.
Once the transition period is over, market opportunities will decrease, but the security of the new products will increase in practice and with experience. Product innovation will then be the market solution to develop further business, which, in line with basic marketing ideas, will open up new opportunities for some time owing to the imperfection of the new market segments. However, this process often leads to new problems and risks. In the interests of micro- and macroeconomic risk prevention, and for the sake of the stability of the financial markets, a solution will have to be found by banks and banking supervisors. Robert Morris Associates makes a valuable contribution to this goal with its activities in the field of information, education, and training.
Supervision of Derivatives
Any discussion of the topic of derivatives and banking supervision should consider the following: Banking supervision is regulatory policy which, in a liberal and social economic system, should be designed in accordance with the principle "as much supervision and regimentation as necessary and as much freedom and private-law autonomy as possible."
It is useful if disciplining market forces are reinforced by appropriate government measures, such as an improvement in disclosure requirements. However, strong market partners often perform the function of providing guidance to other market participants by their own behavior, thus setting "standards" which cannot be ignored without suffering market disadvantages. For example, J.P. Morgan set standards for controlling risk by publishing its "Risk Metrics" but others, including some German institutions, have helped, to a large extent, shape standards by their disclosure practices in the field of derivatives.
Despite the numerous supervisory regulations issued recently, by and large there has not been a departure from the narrow path between regulation and liberalism, although some criticism of overly extensive and complicated regulations is frequently voiced. …