Governance and Risk Management in Global Capital Markets: A New Problem or A Very Old One that Won’t Go Away?

As the capital markets stumble, burdened by their own apparent excessive risk appetite, there are many questions to ask. The first and most obvious question is how did this happen. Does the fault lie with inadequate regulation of the banking industry, inadequate internal monitoring and risk modeling among those who create and market risky financial instruments, the inherent flaws and risks in capitalism where high levels of risk are acceptable in the quest for high level reward, or it is something else that we have not even thought about? As the pundits and finance professionals insist, this is not a problem with an easy answer. Panacea pushers beware!

But even before we speculate on the reasons for what has happened, we should first be very clear about what has happened. The “what” is not an easy question to answer either. It is not easy to answer since many things have happened: bad subprime mortgage credit risks unfolding, complex debt instruments imploding, interbank confidence eroding, rogue traders guessing wrong with few people looking over their shoulders, and all of these things happening in such a way that underscores that financial systems are not local and contained but global and intertwined. The media murmurs about sub-prime meltdowns and monoline bond insurers and asset back commercial paper but all of these stories conceal a mysterious and subterranean personality unknown to all but a few who toil in secretive meth labs of finance devising new opiates and addictions for our financial system. For the rest of us, it is a new and strange story every day, a new headline about something gone wrong with the financial system, a new thing we learn about that apparently has been so important to how our financial systems function that when something goes wrong, the implications can be dire. But what really went wrong? Do we know? And who, if anyone, bears the burden of blame, or should? Or is the web of fault and complicity too intricate to trace? Or, perhaps, as some suggest, this market “meltdown” is actually an illustration of capital markets functioning properly: squeezing out excessive liquidity, the excessive risk taking, the borrowers who should not have been borrowing and the lenders who should not have been lending? But if capital markets were truly functioning properly and efficiently, why was this presumably excessive risk-gluttony allowed in the first place? Is risk-taking a self-regulated trial and error process where the best we all can hope for is that we learn some lesson when the risk-takers turn out to be wrong? Is this capital markets functioning efficiently? Is this risk regulation for our financial system at its modern pinnacle of success?

Though there are many parts of this story, and many things that will never be understood since the interrelationships are too complex, something did go wrong. This is not risk regulation at its best or capital markets functioning properly. There are important questions that need to be asked and things that need to be better understood.

This is a story about risk. It is a story about our collective failure to understand risk, our failure to disclose the risks we know and the failure to regulate those who neither understand nor disclose the risks they take.

By Robert Adamson, Executive Director, CIBC Centre for Corporate Governance and Risk Management
June 13, 2008