CLSA's Michel airs concerns about concentration risk

Many observers are worried about how much market participants have really learned from the past 18 months, with some -- such as commentator Marc Faber -- suggesting we are potentially more at risk of another crisis than before.

Senior risk executives aired their concerns on the matter on a panel chaired by Alan Taylor of Hong Kong-based consultancy AT Associates at AsianInvestor's Southeast Asia Investor Forum last week in Bangkok.

There had been a perception in the market that the increasing complexity of financial products was matched by increasingly sophisticated techniques for measuring and controlling risks, says Chris Michel, Hong Kong-based chief risk officer at equity brokerage CLSA Asia-Pacific Markets. In reality, he says, an over-reliance on such mathematical risk models may have contributed to the financial crisis.

For example, the risk numbers for toxic assets -- such as securitised credit products -- calculated by risk departments may have been far too low for the risks these products carried. As a result, says Michel, complex mathematical methods may have provided a false sense of security.

Another factor contributing to the inadequacy of risk management controls was the pressure from research analysts and peers to meet revenue targets, he adds. Combined with compensation arrangements that created incentives to maximise revenues and undervalue risks, this created a culture of excessive risk-taking in many financial institutions.

Michel also raised the issue of concentration risk. Fewer and larger players in the financial markets are now increasingly interconnected, which creates a concentration risk and increasing external costs, he says. In other words, the failure of one bank will have ever higher costs for the entire economy.

Ultimately, there is a risk that -- due to booming stock markets, strong financial results at banks and hedge funds and lobbying efforts from banks -- the world is going back to business as usual without addressing the fundamental weaknesses of the financial system, he says.

However, while regulatory action is clearly needed, the more intrusive and widespread regulations become, the greater the uniformity of models, structures and strategies, thus further increasing concentration risk, says Michel.

He quotes the Turner Review*, published by the UK's Financial Services Authority (FSA), which says the new FSA approach will be "more intrusive and more systemic" than previous rules.

The approach of many regulators, including the FSA, seems to assume that the regulators are both in a privileged position to recognise and correctly interpret the risks in the financial industry, and at the same time, are able to react in time with the correct countermeasures to prevent a major crisis, argues Michel. He suggests these assumptions may need to be challenged.

As for approaching risk management in future, he says the fundamental approach has not changed. The size of a trader's 'bet' on the markets is the only variable that is known with certainty in the risk assessment, and therefore it is key to plan for the exit. The bigger the 'bet' is, he adds, the more important it is to plan how to get out of the trade when everybody else is running for the exit.

Another panellist made the point that risk governance and enterprise risk management has been propelled to the forefront in light of the financial crisis. Risk management needs to be embedded as part of "business as usual", and not relegated to a compartmentalised function performed by a few, says Dennis Lee, chief risk officer at the National University of Singapore.

Hence, he argues, oversight by regulators and independent boards is even more important than before. It is even more crucial now to have independent risk functions -- such as the CRO or entire risk department -- to help management embed a risk culture.

Certainly, asset managers need to focus more on risk management, if recent studies and surveys are anything to go by.

*A Regulatory Response to the Banking Crisis, published in March 2009.