Daniel Hofmann says a more rigorous approach to insuring financial risks is needed.

The credit crisis shows that financial innovation and the emergence of large complex financial institutions have made our world much riskier. But the wheel of innovation cannot be turned back, and risks are a fact of life. What should be done to avoid a repeat of the past?

The wrong answer is to call for more regulation. Regulation always has unintended consequences and does not prevent a crisis, but there is room for improving the resilience of our financial system. To do so, we should adhere to the principles of good risk management: know our risks; assess and price them properly; and ensure that incentives encourage responsible behaviour and accountability.

Alas, all three principles were ignored in the run-up to the current crisis.

Admittedly, risks of opaque financial instruments are difficult to understand. But that should not have absolved buyers from conducting due diligence. The risk of complexity was also under-appreciated: while the probability of one small thing going wrong is negligible, the feedback mechanisms in complex markets ensure that even small risks will have large systemic impacts.

Stress testing may allow for a better understanding of risk. But the value-at-risk (VaR) models have created a false sense of security. The objection relates not only to the assumption that the future is an extension of the past, but also to the time horizons in VaR models. By the 100 to 2000-year standards applied for extreme events in the insurance industry, they appear short.

A couple of years ago, Nobel Prize laureate in economics Myron Scholes called for new methodologies and said that planning for crises is more important than VaR analysis. Today, planning is even more imperative.

“Regulation always has unintended consequences and does not prevent a crisis, but there is room for improving the resilience of our financial system.

Daniel Hofmann

Turning to the assessment of risks, we can accept that it was encumbered by off-balance sheet vehicles that may have been created to mask the true ownership of risk. Hence, reporting standards should be built on consolidated accounts, and regulators should apply consolidated supervision of entities. This is no small feat.

Even more difficult will be the work needed towards an agreement for better and timelier information sharing among national supervisors. Cross-border activities are part and parcel of our modern financial institutions. It should not mean that a problem in a small segment of one market creates collateral damage in another market.

Finally, and most importantly, there are incentives. Much has been said about bonus systems that royally compensate profitable trades, but do not apportion accountability for losses. Similarly, there are questions behind the incentives of rating decisions. And it appears that securitisation has weakened the screening incentives of mortgage lenders.

Correcting incentives will strengthen the market’s ability to identify and better value the risk of complex transactions. One should also hope that supervisors reduce incentives that encouraged regulatory arbitrage and the use of off-balance sheet vehicles. The challenge remains for regulation to enhance and not stifle the market activities.

This current crisis also provides an opportunity to reconsider monetary policy. While price stability is a necessary condition for market stability, the central banks’ focus on consumer prices, while neglecting asset prices, was too narrow.

Monetary policy must better reflect the cyclic nature of financial markets. There is little time to be lost if we are to find ourselves more resilient and better prepared for the next crisis.