Fears of the next Chernobyl
Derek Wanless, group chief executive of Britain's NatWest Bank, is concerned about environmental risk
What is the biggest risk for your bank?
Credit risk is still the most significant risk to NatWest, alongside systemic risk. Credit risk is about looking after NatWest. Systemic risk is about the ability to do business with all the major financial institutions in the world, conscious that our exposures to some of these would massively outweigh our exposure to any corporate. If one of the world's major banks went down, that would have unpredictable, knock-on effects right through the system. If there was any hint of systemic risk, you couldn't be sure how counterparties would be affected.
Do you have a contingency plan for a failure of a major world bank?
We've been through a number of the "what ifs" and how we would cope. A lot would depend on the actions of the regulators in the home jurisdiction. The regulators have avoided systemic risk so far. But still we must consider the worst outcomes. What if a major bank went down? What knock-on effects would that have, first of all on the home country's banking system, then on the world system? Or if one of the Japanese banks went down who knows in western accounting terms what the balance sheets would have looked like.
You quickly get into the debate about whether any banks are too big too fail. What the regulators are attempting to do is get the structures in place to contain systemic risks so that if a major bank went bust there are watertight systems in place. But as bankers, the primary guard we have against systemic risk is the strength of our counterparties.
Has your attitude to risk changed over the past few years?
There can't be a bank CEO who is not thinking more than ever about risk. Our response to the problems of the late 1980s and early 1990s [arising out of the UK recession] was to make a main board director, John Melbourn, responsible for risk, especially credit risk because that's where the problems surfaced so badly. This has been widened out to an overall risk function. We're not saying we shouldn't take risks after all, we're in the risk business but we want to measure and price risks as best as possible.
We also do scenario planning as part of our annual strategic review. One of the things that went wrong in banking in the late 1980s was having a one-scenario view of the future especially with credit risk. I recently looked back at our 1989 plan to see what happened. The UK part of the plan said that times were going to get a bit harder, and growth was going to slow down to 2%, or even as low as 1.5% at the outside. There was just that one picture. Lending money into that picture wouldn't have been too difficult. Many of the policies we put in place could have coped, but clearly they couldn't cope with what actually happened.
What is your worst case outlook on the European Union?
The very worst would be a break-up of the single market. If the EU fragmented over the single currency if some countries couldn't take their people along and that put the single market in danger that would be a real step backwards. Our customers would be damaged and so would we be. Or a squabble between the ins [countries in the single currency] and the outs that would be damaging, as would an overnight reform of the Common Agricultural Policy that hurt farmers.
NatWest is known to be concerned about environmental risks. What are your worst nightmares there?
There's a massive number of things that could happen, some of which have few implications, some of which could be catastrophic for both the bank and the world. The one-off disaster is extremely difficult to do anything about. With long-running issues like climatic change, we are doing work on what the impact will be on the agricultural sector.
One of the potential big risks is massive environmental problems in eastern Europe that spill over into western Europe. Given the lack of environmental protection over the last 20 or 30 years of industrial growth, there is a risk of some kind of Chernobyl-type accident. Something like that could affect both our physical resources and our business.
What are the shortcomings of scenario planning and risk-modelling?
There is a spurious accuracy about a lot of the systems. Almost too much comfort is being taken from information collection and risk-modelling. By definition a big risk will be something unexpected. This isn't an excuse for not thinking, but it is a reason for putting the output from models into perspective. In any case, you can't run a business on the downside risk picture; it would mean doing almost nothing.
How do you deal with the risks of fraud?
The thing that makes banks very nervous is the speed at which technology can move money; the invisibility of so much of what we do to the naked eye. Most of the underlying techniques of fraud have been there for a long time, but it's the size and scale of what can be done in a new technological environment that causes concern.
Like most banks, we have a security section where we try to employ the best people with knowledge of what has been tried and what can be tried. At some stage, the money has to leave the banking system, or disappear in the banking system. A lot of traditional techniques, of knowing who your customers are and what they are doing, remain the best defence against fraud.
What new issues are thrown up by electronic banking?
We invented Mondex [a smart-card technology] so that we could be at the forefront of this. Attempting to ensure new electronic systems are as rigorous as possible in preventing fraud is what we are all about.
One issue is how will it be regulated. Regulators have to decide how they are going to cope with smart cards and payments through the Internet. If I plug in a PC and start making payments in different parts of the world, who is the regulator? The danger of regulatory arbitrage developing is quite serious. If you look at the difficulties of getting Gatt or the WTO to agree about trade issues, you realize the significant difficulties of getting banking regulators around the world to come to a common agreement. The situation would be even more difficult if non-banks were allowed into the system.
Risk premiums must rise
Felix Fischer, chief financial officer of Union Bank of Switzerland, on his bank's biggest risk concerns
What are the most serious risks facing UBS?
In the short term, our biggest concern is domestic credit risk due to structural change in Switzerland. We are mainly in the market for medium-sized corporates which don't have credit ratings with a portfolio that is impossible to change. The only way out is to raise the risk premiums. Current credit prices are inadequate for the level of risk and we are trying to raise them even if we do lose some business.
In the longer term, measuring operational risks is where we will be making an effort, mainly because it is most difficult to quantify. Fraud is an issue against which we protect ourselves internally through a strict separation of front-office and back-office duties, extensive product controls and internal auditors. Externally, we have made sure that no access is possible into our computer systems. Customers that communicate with us electronically have only access to certain kinds of segregated data. We have been amazed by the revelations in other banks of how many signs there were of fraud and how long it took for the case even to be discussed. It's astonishing. We are determined to see it doesn't happen here.
How do you deal with the risks arising from derivatives?
For derivatives we use analogue market and counterparty risk measurement systems as for other trading or lending products. In addition, the valuation model of every derivative product is checked twice, once on the front line, for example in London, and then centrally in Zurich. We also defer a portion of our earnings to take account of long-term derivative positions such as 10-year options or swaps.
Is European monetary union a threat?
I am confident Emu is going to happen but really the worst thing for us is the long-term appreciation of the Swiss franc that it could bring about. It's not likely to appreciate by 5% or 10% overnight, which means it's not a market risk. The risk would be on the credit side but it's impossible to judge how severe it would be.
Why has the bank introduced a new risk-control system?
We wanted to have a consistent overview of all risks. In the past, we have had a clear separation between credit and market risk, but there are connections between credit, market and operational risks. So mid-year, as part of a general reorganization, we created a risk-management group with a day-to-day watching brief on risk, together with a new executive group called the risk council which meets once a month to review the situation. The president, the heads of credit and market divisions, the head of the new risk-management unit, and myself all sit on the council.
How does the new unit track risk?
We have mathematical models that we use on a continuous basis. In addition, we take a major event, such as the 1987 stock market crash or the breakdown of the European exchange rate mechanism, and run it through our models to determine what the effects would be if it were to happen now. We want to test whether the bank could withstand these types of crises.
But what about unforeseen events?
Well, there isn't much that could have a higher impact than a stock market crash, unless it was total system failure. That is something different. You are not then talking about one instrument becoming illiquid. You are dealing with creditworthiness and counterparty risk that runs across the total banking community. This would be a meltdown of the financial system that would be beyond the control of any risk manager.
In the end, of how much use are models?
I take no absolute comfort from mathematical calculations, but this is the best we can do in terms of modelling risk. Bankers must always be alert to changes that fall outside their models.
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