If there is a dumb question, this is it. We operate in a comparatively free market. Markets over-react, and when they do, you have bubbles and crashes. If anyone says they want to do away with bubbles and crashes, they are effectively saying they want to do away with market-based economies. On the other hand, if we want a market-based economy, we have to accept the fact that bubbles and crashes are going to happen; these are just nature of the market. However, we can make rules and regulations to discourage banks from being part of the bubble and hence reduce the impact of crashes on them when they happen.

Banks hold a unique place in modern market economies. They are the facilitators of credit which drives investments. Without banks, or if bank lending activities are severely curtailed, the economy will grind to a halt. That was what happened during the ‘credit crunch’. However, every loan the banks make means they’re taking on additional risk. As a result, increasing capital requirement is not the solution, but only part of it.

In a paper published by a group of mathematicians on “counterparty valuation adjustment”, there is a line buried deep inside the paper which said: “All the calculations regarding the risk management of an existing portfolio, mentioned in this article, are essential. However, the most important risk management strategy is one that signals before entering into an unwanted trade. Therefore, the first line of defence is the in-depth knowledge of the counterparties' credit status. The next relevant risk mitigant, equally important, is a strongly binding legal documentation governing the trading relationship.” The two important risk management methods are in fact qualitative, not quantitative. For all the money that is spend on risk management technology, more should be spent on risk assessment.

In every crash that has involved banks was the result of banks taking on too much risks that they didn’t understand or chose to ignore. Banks were badly hurt because they didn’t understand all the ABS exposures on their books. If they did they would not have put them there in the first place and the ABS bubble may not have happened after all. And the other asset bubbles which grew on the bank of cheap credit may not have developed the way they did.

The problem with risk assessment is that it is highly qualitative and you can’t easily assign quality with a number. Even if you can, it is not as tangible as a figure of, for example, total loss to the bank if there is a fall of a certain amount in a particular market. Without that number, the regulators don’t know whether the banks actually hold sufficient capital.

It is my personal believe that in the past few years, the financial services industry and its regulators have moved away from the qualitative approach to credit risk management and relied increasingly on model and technologies. Unfortunately, for the purpose of good risk management, it is important to have both high quality risk assessment and reliable risk methodologies and technologies. Lacking in one will merely lead to another disaster.

It is my view that we have sufficient sophisticated models and technologies to work out the risks, but lacking in truly understanding our risk exposures, for people within the industry as well as those regulating it.

It is my hope that through this crisis, we find a more balanced approach to manage our industry’s risk.