Risk Management
The single most critical element of risk management is good personnel. Risk management to some consists simply of a series of computer programs aimed at evaluating the risk of a particular transaction, portfolio or variety of portfolios. These quantitative techniques, however, are based upon historical patterns and may not account for the here and now.

Unfortunately, many events are non-linear in nature and history is not always the best predictor of future events. Standard deviations that seemed preposterous often become real. Experienced personnel can refine mere computer driven results with knowledge of not only what is probable, but also, what is possible. More important, risk management extends beyond the market risk management department. Every person involved in the transaction, from the trader and salesperson, to the operations clerk and documentation staffer, must be a risk manager; only through senior management’s commitment, can this goal be achieved. The same discipline holds true for major end-users, which often engage in financial market activities at a level of complexity and scope rivaling those of dealers.

In addition to experienced people, a firm needs the proper tools to manage risk. These tools are expensive. They involve technological systems that retrieve data and analyze it. Often, financial institutions’ technology infrastructure is composed of disparate systems developed to service individual businesses around the globe. The ability to extract and normalize data from different systems and align it along multiple dimensions of risk in a uniform errorless format is one of the greatest challenges of any risk management operation.

Given that significant risk arises from derivatives trading and other activities involving prices that depend upon computer models, proper validation of all models is crucial. Validation includes consistency with a third party’s analysis of the various assumptions reflected in the model, as well as with assumptions made in other models used by the firm.

It is necessary to emphasize that risk management must be independent of a firm’s businesses. In an ideal world, this department should report directly to the firm’s Chairman or Chief Executive Officer. Although risk management functions act as partners with the businesses for practical reasons of cooperation, such a partnership should not vitiate independence.

The risk management chapter of our mythical best practices book would borrow from existing best practices efforts, including the Derivatives Policy Group, the Group of Thirty, the Joint Forum and others, and would seek to create consensus among those sources. To maintain credibility, these best practices would need to be monitored from time to time by internal and external auditors to assure another layer of independent review.

Chapter Two

Credit Procedures
Although this separate chapter is devoted to credit procedures, to a great extent, credit is a component of risk management. The similarities shared by risk management techniques and credit procedures far outweigh the differences. Market risk seeks to measure the risk associated with market movements, while credit risk seeks to measure the ability of counterpart ies to pay during and after those movements. Market risk and credit risk personnel, therefore, should work hand-in-hand.

Just as with risk management, quality people are the cornerstone of good credit risk management. Credit is as much an art as a science. Consequently, as with market risk, credit risk requires experienced personnel with good judgement. Experience is necessary not only with respect to credit issues generally, but also, regarding specific industry and country matters.

Credit procedures should require the credit department to become involved at the early stages of a transaction. The credit department generally should be required to formally sign off on credit transactions to the extent that particular transactions are not subject to pre-existing approved credit limits. Additionally, recent volatility highlights the need for the credit department to remain current in its evaluation of counterparties, to ensure that credit decisions are based on today’s analysis, not yesterday’s news.

Technological systems must provide the credit department with the ability to sign off on documents before they are transmitted to counterparties. The documentation process at all firms should require a stop at the credit department.

Just as significant, systems should aggregate total credit exposure. Most major financial market participants maintain a presence throughout the world; an effective credit department, therefore, needs to aggregate exposures to counterparties regardless of where the business is conducted. Credit systems need to distinguish between exposures that can be legally netted (i.e., set off) against a firm’s exposure to a counterparty, and those that cannot. The ability to net can only be accomplished if the legal and documentation teams are closely coordinated with the operations and systems teams. Systems should also flag exposures that exceed certain limits, both in dollar terms and in tenor. Credit exception reports should be acted upon quickly. Coordination with the legal department and the businesses is critical, particularly in volatile times, to ensure that if the credit department is not satisfied with margin, collateral quality or counterparty behavior, positions may be appropriately liquidated or other action may be taken.

This chapter of our mythical book of best practices, as with the last chapter, would borrow from existing learning, including the recent book entitled, Managing Credit Risk—the Next Great Financial Challenge (by: Caouette, Altman, and Narayan) and similar publications to provide a consensus list of practices that would be subject to internal and external audit.

Chapter three

Sales Practices
Allegations of sales practice shortcomings arise in virtually every dispute that ripens into litigation. Sales practice problems involve not only oral misrepresentations, but also defective marketing materials. Proper sales practices become especially critical when new or complex products are introduced to counterparties or when transactions are negotiated over a long period of time. Although different sales practice rules apply to different financial instruments, basically all boil down to the principle of treating customers and counterparties fairly. Given that sales practices are not subject to comprehensive black and white standards, it can be difficult to police the relationship between a financial institution and its counterparty. Certain guidelines, however, could and should be established.

Marketing materials, for instance, should contain appropriate disclaimers and should be subject to regular review. Salespeople should be educated as to proper sales practices. Education should be both general as to all products and specific with respect to particular products, especially leveraged or derivatives trades. Salespeople who precipitate controversies with counterparties should be appropriately disciplined and held out as examples for others. Finally, it is important to codify the nature of the relationship between a financial institution and its counterparty. Often, when a trade loses money, non-dealer counterparties claim the dealer should bear the loss because it was acting as an advisor or fiduciary. Clarity in defining a relationship up front, including discussion of who bears what risks before a problem arises, avoids rolling the dice in costly litigation later. This process should be bilateral, with both dealers and major end-users cooperating to achieve the mutually beneficial goal of enhanced legal certainty. Again, transparency regarding the nature of the relationship should be the mantra in oral discussions and written documentation.

Chapter Four

Credit Information Availability
Regrettably, in the global financial market, there exists a lack of uniformity regarding the type and availability of information that is used as the basis of credit determinations. When a financial institution deals with a hedge fund, for example, many aspects of the risks of the hedge fund’s portfolio remain obscured. By contrast, rating agencies provide a degree of consistency for rated institutions but, even here, ratings may not be current. As a result, there should be a voluntary consensus regarding the type of information that should be made available generally by any institution conducting business in the financial markets. Senior officials from various sectors of the financial services market, including end-users, should agree upon the appropriate level of detail without divulging proprietary information. Such information ultimately will act as a natural regulator of the amount of credit extended. This consensus would create a template for a voluntary disclosure mechanism. Once again, the concept of "transparency" is the hallmark of credit information availability.

Chapter Five

Documentation Practices
As stated earlier, if transactions are not properly documented and key terms are not incorporated in the documentation, lengthy and expensive lawsuits may arise. I have often noted that when a little money is lost, banks get called to pay it, but when a lot of money is lost, lawyers get called to avoid it. During periods of market stress, every aspect of a transaction will be scrutinized and, often, non-payment will be based on controllable factors, such as documentation and sales practices, as opposed to non-controllable market and credit deterioration. An effective documentation policy should include elements of a credit approval process so that credit decisions are incorporated into documents. Evidence of proper authority by a signatory is critical, as counterparties sometimes claim that losing trades were ultra vires and, therefore, that no contract or obligation to pay exists. A documentation deficiency list that identifies counterparties without documents shou ld include specific time periods for obtaining fully executed documentation. This allows firms to take aggressive follow-up action, including a mandatory cessation of new business with deficient counterparties. A documentation policy, however, should establish more stringent standards for entities when a risk-based analysis reveals a greater likelihood of an adverse market or credit event, due to market, geographic, product type or other relevant factors. The greater the likelihood of such an event, the greater the need to require signed documents before any trade is executed.

Chapter Six

Role of Internal Audit External Audit and Compliance
As suggested previously, all of the practices in our mythical book must be subject to internal and external audit from time to time; they also must be reviewed by the compliance department. Compliance typically is considered the enforcer of the rules of regulatory and self-regulatory bodies. In our mythical world, where those entities do not exist, the compliance department would enforce best practices. Broadening the mandate of a compliance department and that of internal and external audit also could have the beneficial corollary effect of deflecting criticism that voluntary guidelines are not enforced. Enlightened surveillance tools, inspired by perceptions of risk rather than based solely upon requirements of regulators, could trigger independent reviews of adherence with voluntary guidelines when risk measures reach predetermined thresholds. Because these guidelines are designed to save money and maintain reputations, firms themselves have the best motivation to ensure that they are followed.

Role of Government
The important role of government in this voluntary endeavor cannot be understated. On a voluntary basis, credit and other risk reports could be sent to governments globally to facilitate judgments regarding systemic risk. The role of government here would differ from its usual role of regulator. Governments’ jurisdiction over specific aspects of financial institutions’ business provides a nexus for coordinating the risks of an entire company. More to the point, government generally focuses upon systemic risk that affects all players in the financial market. Government has the power to rectify potential problems and, therefore, needs to be armed with adequate data to make informed judgments. Once again, transparency is a motivating factor in providing adequate information to governments worldwide.

It is important to emphasize that real transparency can only be accomplished with the involvement of major end-users, such as pension funds, hedge funds and active corporate treasuries, which often operate in the markets outside of government’s regulatory ambit. These significant market players face many of the same challenges as dealers, such as managing market and credit risk effectively, obtaining proper documents for trades and minimizing legal uncertainty as to their trades and market relationships. They also could have the same potential to precipitate systemic risk, as the recent downfall of Long Term Capital vividly revealed. In that instance, credit instability in the end-user community gave rise to harmful market and credit repercussions that extended to the far corners of the global financial community. Accordingly, to create effective best practices worldwide, antiquated distinctions between dealers and end-users should be discarded while the commonalities of today are em phasized to ensure full participation and broad-based risk reduction. This groundbreaking proposition would obviate not only artificial legal and jurisdictional boundaries, but also, the inaccurate categorization of participants based on corporate labels instead of risk profiles.

It is particularly important to resist the temptation to regulate specific types of entities when they experience difficulties during volatile times, such as hedge funds have in recent months. History has taught us that perceived risk problems associated with a type of market player, e.g., hedge funds, cannot be resolved meaningfully by constructing a new structure tailored to fit that player; the inevitable result of such an approach is duplication, contradiction, inefficiency and enhanced risk. Targeting the essential elements that contribute to systemic risk on a global basis and without regard to entity typecasting, using the best practices discussed above, presents a far more workable solution than any new law or rule ever could.

Similarly, it is imperative to avoid superimposing any orthodoxy when searching for solutions. The "best practices" proposal contained in this speech reflects one perspective; alternative approaches to systemic risk reduction, such as the single regulator paradigm suggested by my friend Dr. Henry Kaufman, also have great potential and warrant serious debate.

Up to this point, we have established an outline of a mythical book of best practices in the global financial market. We have not yet addressed how to accomplish that goal. From my own experience with the Derivatives Policy Group, I believe government’s encouragement paves the best route to success. The Derivatives Policy Group, which was a voluntary effort by the leading U.S. investment banks, became a success because the chairmen of both the SEC and CFTC, Arthur Levitt and, at the time, Mary Schapiro, respectively, encouraged those participants to develop voluntary guidelines to govern their unregulated over-the-counter derivatives activities. Likewise, governments need to be principal players in encouraging voluntary best practices on a global basis, which transcend the securities, futures, banking and insurance industries, extend beyond any individual country’s borders and cover major end-users.