A few days ago I criticized the effectiveness of the bank managers integrity watch as implemented by the De Nederlandsche Bank and worded by Mr. Nout Wellink.  Yesterday I stumbled upon the latest speech from Mr. Wellink and this time I’m much more positive.  In his speech Mr. Wellink more or less acknowledges the total failure of supervision and how this contributed to the current crisis.

I’m tracking the crisis since the beginning and one of the things I found unbelievable was the fact that supervision was in the US on a voluntary basis, at least for the big investment banks. It is clear that supervision was considered unnecessary by politicians who believe in the self cleansing capabilities of the free market and forgot that greed is also an important risk factor.   The recent billion dollar fraud scandals (Kerviel, Madoff, Stanford)  showed that the supervision can be fooled easily and questions the expertise of the people working for the governmental institutions. The risk manager of HBOS demonstrated another flaw in the governance of control functions within and around financial institutions. Supervisors simply cannot rely on the independence of internal control functions like Audit and Compliance although sound practice policies prescribe independence.  Independence requires much more and being on the payroll of a company certainly doesn’t make it easy to overrule a CEO. A similar statement can be made about the independence of rating agencies and their risk assessments of companies and products.

So, what is there to bring me in a positive mood? Well, it is simply the fact that supervision practices are under review as well. I partly agree with the analysis of Mr. Wellink. At the same time I think there is too little focus on how to ensure independent and knowledgeable supervision. Supervision which has the power and the professional background to be able to challenge a board of directors and their experts.

There are more fundamental questions to be answered like are the risk management systems up to par with the trading systems? Most trading platforms are build upon state of the art real time technology which present trading opportunities in a rich graphical variety. Now compare that to most manual and excel based risk ‘platforms’. In many cases risk management is trailing trade weeks or months and why are supervisors accepting this?

Even more fundamental is why supervisors until now have ignored Basel II Pillar III,  which is about transparency.  Although some companies are trying to become risk transparent the reality is different.  The way risk is measured and expressed is often way too complex and difficult to comprehend for investors and consumers. How to value off balance sheet S.I.V.’s in relation to a companies value and risk exposure? The assumption, also in theory, is that markets are efficient meaning that the pricing reflects expectations including risk adequately. Given the lack of transparency I doubt if this is true. Looking at how banks are priced should be enough to substantiate this point of view. Another good example is the American auto industry. How well was the risk of rising energy costs (a reasonably easy to predict event even before the crisis)  incorporated in the stock price of these companies?

Mitigation of systemic risks is the core responsibility of supervisors. Questions like how large the exposure of  a single company may grow, also in the context of the global financial system, need to be answered. Banks are used to managing concentration risk. On a world scale AIG and Lehman (but also Citigroup, ING etc.) can initiate a collapse of the financial system. Perhaps supervisors should manage systemic risks like credit risk managers are used to manage concentration risk in their portfolios.

Probably the most difficult challenge is to overcome the lack of cross-boundary supervisory alignment, policies, methodologies and tooling. Financial and technological innovation are developing at a speed that require innovation at supervisory level as well. It is likely that the first reaction will be to slow down financial innovation via regulation.  This approach will definitely fail simply because nobody ever succeeded in halting human creativity. Even when the approach to slow down financial innovation works for a while, it certainly will not halt technological innovation.  Financial, economical, political and environmental news travel with the speed of Internet around the world. How to create intelligent buffers to protect the financial systems against the impact of panic waves?

Hmm, what is there that makes me more positive? Well it is the acknowledgement that supervision failed and that there is need for improvement in a globalised environment.  It is a starting point for progress and therefore Mr. Wellink’s speech deserves some credit.

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