Current approaches to risk management: The 31 points, challenges and developments Pascual O’Dogherty Banco de México

Overview I.- Background II.- Regulatory versus Supervisory approach III.- Banco de Mexico´s “31 points” IV.- CNBV and risk management V.- Current challenges

I.- Background SAFETY NETS PRUDENTIAL REGULATION Financial Stability Efficiency

I.- Background Establishment of regulations to reduce risk taking.Establishment of regulations to reduce risk taking. Monitoring to assure compliance.Monitoring to assure compliance. Prudential Regulation and Supervision:

Regulatory approach: Regulatory approach: Focus on the assesment of the quality of a bank´s balance sheet at a particular point of time. II.- Regulatory versus Supervisory approach

Breakdown of geographic barriers to the provision of financial services.Breakdown of geographic barriers to the provision of financial services. Users of financial services as well as intermediaries are global corporations. National linkages are replaced by corporate structures.Users of financial services as well as intermediaries are global corporations. National linkages are replaced by corporate structures. The wave of trade liberalization and deregulation of the 1980´s is now followed by a revolution in the financial sector Globalization Innovation New and more complex financial productsNew and more complex financial products New forms of financing, hedging and savings appear everyday with remarkable speedNew forms of financing, hedging and savings appear everyday with remarkable speed Financial Sector Revolution

Some limits might increase overall risk rather than decrease it.Some limits might increase overall risk rather than decrease it. Limited ways for conducting risk management. Limited ways for conducting risk management. Opportunities for regulatory arbitrage.Opportunities for regulatory arbitrage. 1 Does not promote financial innovation 2 It is the result of “ad hoc” adjustments from particular needs, It lacks an integral vision. 3 It uses a “bucket” approach. 4 It is fragmented among different institutions. Problems of traditional current regulation Current regulation lacks a rational, coordinated, and integral framework Principal problems Increase of risk

Supervisory approach: Supervisory approach: Focus on the soundness of bank´s management practices regarding risk and adequate disclosure of information to market participants. II.- Regulatory versus Supervisory approach

Criteria for a new regulation The two basic building blocks for a regulatory framework for the next generation are the development of a culture for effective risk management and a set of basic rules conducive to the self-regulation of participants and markets Self-regulation Increasing role of markets Developing a culture for risk management within the institutions Risk Management

Banco de México’s 31 requirements in derivative management Among others, institutions have to comply with: 1. Requirements of administration Creation of risk units independent from trading areas in charge of measuring and evaluating credit and market risk. 2. Requirements of operation have systems to measure and evaluate risk in real time. 3. Requirements for internal control Risk management committee; Efficient internal oversight mechanisms; Periodical reports. Evaluation by an independent firm. 1995: Banco de Mexico issued first risk management regulation. III.-The “31 points”

IV.- The CNBV´s : CNBV publish regulation (1423) for banks establishing conditions regarding risk management.1999: CNBV publish regulation (1423) for banks establishing conditions regarding risk management. –Sets more detailed internal procedures for risk management than those mentioned in the “31 points” –Distinguishes between credit, market, liquidity, legal and operational risk. –Covers all banks operations

To establish adequate disclosure of timely and relevant information to market participants and authorities.To establish adequate disclosure of timely and relevant information to market participants and authorities. To ensure the smooth and accurate functioning of internal risk management units and oversight mechanisms.To ensure the smooth and accurate functioning of internal risk management units and oversight mechanisms. Implementing risk management at financial group levelImplementing risk management at financial group level V.- Current challenges

31 points 1423 Covers derivative operations Covers all operations V.- Current challenges

31 points V.- Current challenges Pending issues to be defined: Who will be in charge of assessing compliance. Who will be in charge of assessing compliance. Who will be in charge of authorizing institutions to operate derivatives. Who will be in charge of authorizing institutions to operate derivatives. Integral Risk Management oriented regulation

CNBVCNBV –Enact prudential regulation for risk management. –Supervise compliance of individual institutions. Banco de MéxicoBanco de México –Measure and monitor risk level of the financial system. –Evaluate impact of current and proposed regulation on risk levels. –Monitor financial threats to financial stability arising from: exposure to system-wide shocksexposure to system-wide shocks V.- Current challenges

Current approaches to risk management: The 31 points, challenges and developments