The current financial crisis tells us that risk management is vital for every bank and insurance company. Stress testing and scenario analysis will play a big part
The good news is that the world economy is out of recession. There is growth in the USA, some growth in Europe, and Asia is once again at full speed.
At the same time, all the problems that led to the financial crisis in 2007 are still present.
Globalisation gave us 25 years of high world-wide growth in which east and west complemented the other.
However, the world economy is now suffering from structural imbalances. The most important one is that the USA has become a deficit country, while China has moved the opposite way. Something has to be done to stop these imbalances from growing.
There are other major problems: environmental issues, access to commodities and energy, and the price of oil up from $30 to $80 a barrel just as economies begin to grow.
As well as these unresolved issues, the state of the world banking industry is still delicate, with many banks locked into government support and in some cases nationalised.
There have been several crises in the last 50 years but it is different this time, and what is needed is a fundamental redesign of the world economy. It will be a mistake if we consider the current situation to be normal.
Insurance is about protecting against risk. What the chaotic situation in the world economy has shown us is that risk can transform itself quickly, leading to contagion.
Who would have forecast that a crisis caused by subprime loans in the USA in 2007 would lead to the effective bankruptcy of Greece in 2010?
The way that the many strands of the financial world connect and react to each other, and how finance links to the commodity market and all other aspects of the real economy, presents a major challenge in terms of risk management. We are no longer under the illusion that risk can be quantified in efficient and rational markets.
Fortunately, insurance was not hit as hard as banking in the downturn. However, while the insurance industry stands apart from pure financial markets, lessons learnt during the banking crisis will affect insurance companies.
In the dotcom crash of 2001-03, insurance suffered more than banking. We might be seeing the same thing again, as a number of insurance companies are exposed to Greek and Spanish debt.
There is a clear case for banks and the insurance industry to rethink risk management.
Everybody should be aware that risk-free banking is impossible, but the lesson from the most recent crisis is that risk management must be a core consideration for the senior managers of banks and insurance companies.
You cannot outsource risk management, and you cannot simplify it based on models. In the financial industry, it has become clear that relying only on models is not enough anymore, and other approaches must be considered.
We are not going to throw away these models because they are valuable, but in the future they will be only a part of the process. There will be more interest in analysing the underlying economic environment and the political environment using stress testing as well as scenario analysis.
Solvency II, if it is put in practice, will be based essentially on models. Its approach seems to be far more correct, economically, than the banking regulation of Basel because it is really trying to assess the risks and quantify them.
The risk with Solvency II is that if you don’t take care, it becomes nothing more than a mathematical process, which would be a fatal error.
Finally, if you are optimistic you can hope that steps like taxing countries over government debt, and having support mechanisms in place, will avert future financial crises.
In an ideal world, we would then be able to carry out a restructuring to ensure that an economy remains fundamentally sustainable.
Unfortunately, I suspect that the current volatility in financial markets will be with us for a while longer. We can look forward to a changeable future with all sorts of crises. Each of these will carry a risk of contagion, and they will need the most careful management. GR
Freddy Van den Spiegel, chief economist at BNP Paribas Fortis, was interviewed by Muireann Bolger