The IFMR Financial Systems Design Conference 2011 was organised into three main sessions for discussions – Origination, Risk Transmission and Risk Aggregation. Our earlier post summarised the deliberations that took place on Origination. This post summarises the deliberations on the theme of Risk Aggregation.
In a financial system, risk can be mitigated either through diversification or transfer. The former involves a portfolio-based strategy designed to reduce overall risk by combining a variety of assets which are highly unlikely to behave in an identical manner. The latter involves the movement of risk to external counterparties that are better positioned to hold those risks, on account of being well capitalised and well diversified entities.
Entities ultimately bearing such risks may be termed “aggregators”. Any well-functioning financial system should have robust risk aggregation capacity with a range of institutions, such as commercial banks, insurance companies and mutual funds, having the appetite and the ability to play the role of aggregators.
Characterising the present state of risk aggregation in India
In discussing the current risk aggregation landscape in India, following features stand out:
- The size of the Indian financial system is not adequate to meet the needs of the real economy.
- The landscape is dominated by government owned institutions or directly by the government.
- There exist multiple regulators governing the field with absence of effective mechanisms for inter-regulatory exchange of information. Different substantive rules lead to a skewed playing field for different types of risk aggregators.
- Senior management compensation structures dominated by stocks and options are potentially faulty as they do not incentivise risk management.
- Mechanisms for dispute resolution are not sufficiently well developed.
- Positive regulatory developments are underway, including the setting up of the Financial Stability and Development Council to prevent inter-regulatory conflict, RBI guidelines permitting credit derivatives for corporate bonds, SEBI guidelines allowing exchanges to list securitised paper, and the setting up of a Financial Sector Legislative Reforms Commission to comprehensively rewrite the existing set of laws pertaining to the financial sector.
Ideas that emerged on aggregation from participant discussions at the Financial Systems Design Conference may be organised along the following themes:
Role of the government as a large risk aggregator
The first line of thinking advocated a neutral role for the government in this space, with it playing the role of an arbiter who sets the ground rules and not being involved in the capacities of owner, provider or interested party. The contrarian view took the stance that activities that have a “public character” can be achieved only if the government has ownership.
Regulation and management of systemically important risk aggregators
Participants stressed the need for effective regulation and management to ensure that risk aggregators are able to deal with plausible stress events, especially for “systemically important” entities. The need for norms stressing levels of capital adequacy was particularly emphasised.
Risk management capability within the financial system
In this context participants discussed effective risk management mechanisms. The participants debated outsourcing risk management to third party experts like rating agencies versus building internal risk management capabilities.
Following the discussions along these key themes, participants formulated the following vision statement for Aggregation:
“Our vision for risk aggregation in the Indian financial system is one where aggregators are numerous enough, large enough, and have the risk management capabilities to evaluate, price, hold and manage the diversity of risk originated from the real economy.”
A more detailed summary of the deliberations on Aggregation is available here.