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Central Bank of the Republic of China


The New Development on Risk Management

The New Development on Risk Management
Dr. Fa-Chin Liang, Deputy Governor
The Central Bank of China, Taipei

Inaugural Address

38thSEACEN/Federal Reserve System Course on Banking Supervision (Intermediate Level): Market Risk Analysis( Taipei, Taiwan, Republic of China, April 10, 2002)

Good morning dear Dr. Joyosumarto, Distinguished Guests, Participants, Ladies and

I am honored to be here to inaugurate the SEACEN and Federal Reserve System
Course on Banking Supervision: Market Risk Analysis.On behalf of the Central Bank of China, I would especially like to welcome our distinguished speakers and participants to Taipei, and to extend my compliments to the SEACEN Center and Federal Reserve System for the
remarkable contribution they have made in arranging this course.

The major topic of the course is market risk analysis.As everyone knows, taking and managing risks are fundamental to the operations of financial institutions.Following the liberalization and globalization of financial market, financial institutions face more dynamic and complex environment.Establishing an adequate risk management structure and process to control risks involved in various products and lines of business becomes an important and vital issue for a safe and sound institution.Risk management is a process for identifying, measuring, monitoring and controlling risks.In brief, a sound risk management includes active board and senior management oversight, adequate policies, procedures and limits, adequate risk measure, monitoring and
management information systems, and comprehensive internal controls.

For developing the sound practices of risk management, The Basel Committee on Banking Supervision has issued several relative sound principles and guidelines.Those principles
and guidelines focus on various risk management such as credit risk, interest rate risk, liquidity risk, settlement risk, operational risk, legal risk and reputational risk.It is necessary indeed that all financial institutions should review their own risk management practices whether they coincide with principles and guidelines issued by the Basel Committee.For the banking authorities, we also should encourage financial institutions to adopt these sound principles in order to enhance safer and sounder financial system in our jurisdictions.

In recent years, risk management skills have been revolutionized by advanced financial innovations and technology.Those improvements on risk management have helped financial institutions to better manage their risks associated with increasingly complex financial instruments and the growing volume of financial transactions.An increasing number of financial institutions have developed and applied several risk models such as ¡§value-at-risk¡¨ and credit risk model
to quantify market and credit risks for many years.The quantifying model of operational risk is also under development, even though there still are many arguments and difficulties on it.The new model-based approaches not only strengthen the financial institutions¡¦ ability of risk measurement and management, but also contribute to more efficient resource allocation through better evaluation of risk.In result, the financial institutions can more thoroughly understand their risk exposure and hedge unwanted risk.

Although risk models have been accepted by international banking industry and adopted by complex financial institutions for several years, there still are many criticisms on them.Some criticized that these models may understate the herding effect in financial market if most of financial institutions use the same model based on the same assumptions.The others criticized that these models may exacerbate the economic cycles and overestimate the benefits for the diversity of portfolios. However, the risk models have been improved further, such as addressing the liquidity issues in their models or taking account of liquidity risk in stress testing. I believe these improvements will be continuous. One thing should be emphasized that more accurate risk measurement and better
management do not mean the absence of loss. Every risk model has its limit. The small probability in the tails of distributions still may occur. No matter how perfect the risk model is, it should not replace, but rather supplement, the judgment and experience of the senior managers of
financial institutions. The board of directors and senior managers of financial institutions will assume the final responsibility of risk management.

Another similar process is the development of the international capital standard. In 1998, The Basel Committee recognized the internal measures of ¡§value-at-risk¡¨ model for trading activities when banking organizations calculated the capital requirement of market risks. Furthermore, the Basel Committee issued the second consultative document of ¡§The New Basel Capital Accord¡¨ in January 2001. The new Accord substantially revised the credit risk measurement methods to include the Standardized Approach and Internal Rating Based Approach and incorporated the capital requirement for operational risk for providing more risk sensitivity, flexibility and greater incentives to improve risk management of financial institutions. It is worth mentioning that the new Accord consists of three mutually reinforcing pillars, including minimum capital requirement, supervisory review process and market discipline. These three pillars working together will substantially contribute to safety and soundness of the financial system. Although there still are many works to be settled in order to finalize the new Accord, we believe that the new regime aligned more closely to risk management will further encourage financial institutions to adopt more risk-sensitive
management practices and maintain more adequate level of capital relative to their risks.

Accompanying with the increasing uses of risk model to measure and manage various risks and
the new development of the New Basel Capital Accord, how to evaluate and analyze the effectiveness of these approaches or models implemented by financial institutions and how to assess the adequacy of capital charge relative to their risks are a great challenge for all banking supervisory authorities. These topics are worthy to be discussed in class. In coming days, you will learn the natures of various financial instruments and the methods to identify, measure, monitor and control market risk inherent in the risk profiles. I am confident that every participant will gain a better understanding on market risk and share the related supervisory experience of your country with each other from this course.

In closing, let me wish every distinguished guest and participant a pleasant and rewarding stay in Taiwan, and thank you all for your kind attention.