Howard Davies, Deputy Governor of the Bank of England, said yesterday the next step in the provision of safeguards to prevent banking collapses "is for banks to develop models of market risk which allow them to calculate regulatory capital charges and to stress test their portfolios".
Speaking at the World Economic Forum in Davos, Switzerland, Mr Davies cited the possibility of financial crisis in Japan or a delay in plans for monetary union in Europe as examples of where banks need to be assessing their exposure to future market events.
"Banks need to know how they would be affected by different possible market scenarios," he said at a seminar on financial fragility. Afterwards, Mr Davies said that the Bank had discovered several cases in the City of financial institutions whose pay structures had a tendency to encourage excessive risk taking by traders and other employees.
The Bank of England is planning to publish the results of an in-depth study of pay and risk taking in the City within the next few weeks. Mr Davies stressed that this was not an attempt to interfere in how investment banks remunerate their employees. However, if remuneration policy was shown to be encouraging undue risks, then the Bank might take it into account in setting capital adequacy levels or through other channels of banking supervision.
Mr Davies insisted good progress was being made in setting up a "common language of risk" which operated across different jurisdictions. Banking supervisors had now provided, through capital charges, an incentive for banks to hedge their exposures to individual price moves and to focus on the degree of diversification in their portfolios.
However, most of this risk assessment was "backward" looking in its effect; banks needed to be encouraged to look at future risk as well. "Today banks should be asking themselves how they would be affected by a financial crisis in Japan or by a decision not to proceed with Economic and Monetary Union on the current timetable."
Convergence in European bond markets was one possible danger point, he said. If convergence is being driven largely by political factors and the expectation of EMU, there could be an extreme reaction if EMU does not happen on time, or some nations that have benefited from the convergence trend are excluded from the first wave.
At the same seminar, Andrew Crockett, general manager of the Bank for International Settlements, said that banking supervision and risk management was now being set internationally on the basis that there would be no state bail-outs when a bank runs into difficulties.
Only in extreme circumstances, when a collapse shows signs of causing wider danger to the international financial system, could central bankers and governments be expected to step in.