The relationship between regulators and financial institutions can be described in many ways, but one would not be to call them allies. While it is not totally antagonistic, it is also not like a partnership.

Regulators have an objective to protect the financial system and minimize taxpayer costs. A very large part of their efforts, other than to prevent fraud, constitutes protecting institutions from extreme tail risk and drawing regulatory boundaries and limits. Tail risk refers to exposure from uncertainty that is so high that — if it materializes — it can turn into catastrophic losses and overwhelm institutions.

Financial institutions view such boundaries and limits as overly restrictive, even though institutions also have a fiduciary objective to protect themselves from extreme tail risk. Despite this common objective of protection, there is an apparent divergence of interests because of how each side goes about achieving this objective.

Limitations of Traditional Risk Management

Until recently, regulators monitored financial institutions by peering through the prism of traditional risk management. The crisis of 2008 highlighted a couple of problems with this approach.

First, risk management models are geared towards an objective to structure, preserve and protect profits from risk. Obviously, this is important, but maintaining a going concern or protecting the financial system goes far beyond this objective. In this regard, these models fall significantly short of preserving and protecting a going concern.

Second, employing traditional risk management models, driven by historical data to manage extreme tail risk, is analogous to steering a vehicle through a storm by looking in the rear-view mirror. A consequence of this is the potential to miss critical exposure from extreme tail risk. Risk management models have a limited, useful role in relation to the management of tail risk, but that role is in the context of a sustainability-management framework.

Positive Steps Fall Short

Since 2008, regulators have developed their own stress-testing mechanism. This is a step in the right direction but falls short of being an effective tool. It employs subjective assumptions, which may diverge from institutions’ own subjective assumptions. Also, its black-box approach makes it nearly impossible to use it as an effective management tool at institutions.

For this reason, stress testing and other, similar regulatory monitoring mechanisms become parallel systems rather than internalized mechanisms that add value to institutions beyond satisfying regulatory requirements.

Over the years, regulatory requirements have gotten progressively more complex, and it has become increasingly difficult to understand how they relate to a healthier industry. Given human nature, if people can’t perceive benefits from them, then they treat such requirements as a bureaucratic exercise.

The absence of any internalized benefits creates incentives for institutions to find ways around restrictive regulations, while appearing to meet the requirements. This often results in new, generally more complex and often riskier ways to pursue the institutional agenda around regulatory restrictions.

Common Interests, Diverging Views

Institutions have an implicit objective to protect their going concerns. However, there are very few, if any, explicit, objective and transparent links between a sustainability objective and an institution’s operations. Everyday operations are run to capture the full potential of the business model within stated policies and limits, without an explicit link to the implicit sustainability objective. The net result is that institutions end up managing extreme tail risk through implicit and subjective mechanisms.

So institutions and regulators each have their own subjective perspectives on extreme tail risk — perspectives that often diverge because of the subjectivity.

Institutions view regulations as unnecessarily onerous, while concluding that the actions of their own managers are important to achieve their profit goals. Regulators view their own actions as necessary to achieve their mandate, while concluding that the institutional perspective is overly optimistic and sometimes not in the best interest of institutions. Hence, a conflict results because extreme tail risk is viewed from two different subjective perspectives, even though both parties have a common interest to protect the sustainability of the institution.

Converging with Objectivity

This conflict can be resolved, but it requires viewing extreme tail risk through a distinct prism with objective parameters to protect institutions from becoming casualties in crises. An objective approach will narrow the gap through a convergence of interests and provide right incentives to institutions.

Such an approach will not only enhance the going-concern sustainability of institutions, but also lead to a stronger financial system and reduce the need for regulatory intervention in a crisis to protect the system.

About the Author

Karamjeet Paul, Managing Principal of Strategic Exposure Group, has developed expertise in extreme tail risk. His commentaries have been widely published. He is the author of Managing Extreme Financial Risk: Strategies and Tactics for Going available for purchase on the Elsevier Store. Use discount code “STC3014” to save 30%!

he has over 30 years of operating, finance, treasury, and exposure managment experience, giving him unique expertise in identifying and addressing critical risk-exposure-reward and other strategic issues at the highest levels in large organizations. Mr. Paul’s perspective has been gleaned from hands-on experience in large global organizations, startups in entrepreneurial settings, and consulting assignments.