World finances: what should happen now?

Yet banks will always seek new ways to increase their profits in world of finances. So new, unregulated and (probably) misunderstood markets, like the CDO market, will still be created.Very often, the demand for and supply of derivatives arises from differences in accounting rules. For instance, the swaps market, which is the largest of all derivatives markets, is driven by differences between cost and market-to-market accounting. As long as we have no unified accounting framework for all market participants, new derivatives markets will be created. However, given the time it has taken to agree on accounting world finances standards in IAS39, we should not expect much change in the near future.

 This huge casino, in which many times world GDP is bet every year, has proved impossible to regulate. Regulators always respond to crises by tightening rules and increasing the mini­mum level of risk capital to be held by banks. But this exacerbates the problem, since the only way out of the current crisis is to create liquidity. Injecting taxpayers' money into the capital markets is only a temporary solution; what is needed now is a complete reform of financial regulations. This does not necessarily mean tighter control on world finances market operations, or increases in the minimum level of risk capital held by banks. Indeed, there may be government pressure to loosen regulation in order to establish a leading financial centre.The new Basel Accord, which took eleven years to develop, failed to control the sys­temic risk in world financial markets. And the reason it has failed is that regulators are too fixed on detailed calculations of value at risk in their 'bottom-up' regulatory capital framework.

That is, they have been focusing on micro-managing the banks in their jurisdiction, and not onmacro-financial decision making under uncertainty. What may be needed now, in addition to curtailing the proprietary trading by banks, is a top-down, differential system of capital charges, with the major banks that pose the greatest systemic threat holding proportionally higher capital reserves than minor banks. This last spectacular failure in financial markets calls for a revision of the global banking system. This does not necessarily mean the wholesale nationalisation of banks, or even a return to socialist principles. That would indeed be an admission of failure, especially for Russia and the Eastern European countries that have only recently embraced capitalism. Free capital markets are essential to globalisation, and globalisation is essential for the health of the world's economy.

To prevent the next crisis being even more critical that this one, an urgent reform of the accounting, regulation and risk management principles that underpin financial markets is required. After each  world finaces  market crash - e.g. following the burst of the technology bubble in the early part of this decade, and following the Russian debt default in 1998 - governments try to promote growth by cutting interest rates and by injecting capital into the financial system. And, to be effective, each time they have to injectmore capital and introducemore drastic cuts in interest rates than before. This is because the banking system is unstable, and markets have recovered only by sowing even deeper seeds for the next crisis. Unless drastic reforms of the system are made in the near future, even more drastic action will be required to resolve the next crisis, when it comes. And what about financial risk management, and market risk management in particular - what reforms are needed now? A fundamental distinction must be drawn between riskman­agers and riskanalysts. A good risk manager should be adept at making decisions under uncertainty, and for this he needs to be well-informed about the basiceconomic principles that underpin price formation in capital markets.

And risk managers, like all managers, should be held accountable for their actions. Unfortunately, the opposite is usually the case. If a bank encounters problems due to bad management, then senior executives and directors can leave to join another firm, often with guaranteed bonuses on top of a six-figure salary.Risk analysts and financial engineers - for whom these books are designed - usemathe­matical models to measure risk, and to price illiquid products using arbitrage pricing theory. The assumptions made by these models need constant testing and refining, so that superior models can be developed. With greater confidence in mark to model prices, and in portfolio risk assessment, it may be easier to stem the panic when the next crisis comes. Clearly, bet­ter education in quantitative risk analysis is the key to developing effective risk models and accurate pricing models for world financial institutions.Each crisis of world finances has a disastrous effect on the global economy, so the lives of ordinary people are adversely affected. I believe these crises can and will be avoided, but only when financial risk managers acquire the knowledge, skills and framework they really need to oper­ate effectively in their profession. The recent crisis has shown that there is an urgent need for growth and change in the entire financial industry and in the financial risk management profession in particular.An important and fundamental change must be to start educating risk analysts properly, so that their managers really understand the risks that banks and other financial institutions are taking, as far as this is possible. Risk is a mathematical concept: it is a measure of uncertainty.

So risk managers or, at least, their trusted analysts, need to understand mathematics first, before they can even begin to understand risk.There are two world financial risk management associations, the Professional Risk Managers'International Association(PRMIA) and theGlobal Association of Risk Pro­fessionals (GARP). These associations provide entry-level qualifications for financial risk management. The PRM qualification is at a higher level than the FRM or the Associate PRM, but even the four exams for the full PRM qualification can be passed with only one year of part-time study.In the UK medical doctors must undergo a minimum of 5 years' full-time study, and to rise to senior positions they must take tough examinations every few years. Health risk man­agement is so important to the economy that our National Health Service offers a regular programme of free vaccinations and free screenings for cancer, heart disease, and so forth. Why, then, have banks been treating financial risk management so casually, placing inap­propriately qualified people in senior positions and taking less than adequate care over the education of their junior staff? Financial risk management is such a vast subject that to learn what we need to provide effective risk management in today's complex and volatile markets should take many years of full-time study, just as it does for medical doctors.