Rethinking Risk Management in Financial Services Practices from other domains potx

The World Economic Forum is proud to release this report on the topic of Rethinking Risk Management inFinancial Services, which was part of the organizing theme for the Forum’s 40thAnnua

Rethinking Risk

Management

in Financial Services

Practices from other domains

IMPROVING THE STATE

OF THE WORLD

Prepared in collaboration with The Boston Consulting Group

World Economic Forum

April 2010

The views expressed in this publication do not necessarily

reflect those of the World Economic Forum USA.

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@ 2010 World Economic Forum

All rights reserved.

No part of this publication may be reproducted or transmitted in

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Rethinking Risk Management

in Financial Services

Practices from other domains

Prepared in collaboration with The Boston Consulting Group

World Economic Forum

Appendix 3: Summary of Risk Management Lessons from Fisheries Management 56

Appendix 6: Summary of Risk Management Lessons from Pharmaceuticals 58Appendix 7: Summary of Risk Management Lessons from Telecommunications 58Appendix 8: Summary of Risk Management Lessons from Wildfire Fighting 59

The World Economic Forum is proud to release this report on the topic of Rethinking Risk Management inFinancial Services, which was part of the organizing theme for the Forum’s 40thAnnual Meeting in 2010:

“Improve the State of the World: Rethink, Redesign and Rebuild.” This report is part of an Industry Partnershipproject endorsed by the Financial Services Governors’ community at the Forum’s Annual Meeting in 2009

The recent financial crisis acquired unparalleled proportions and inflicted long-term damage on economies,countries and people As the true impact of the crisis becomes evident and the financial system stabilizes, it iscritical not to “let a good crisis go to waste.” Internalizing the lessons learnt and making the necessary improvementsnow will make the global financial system more resilient and better able to handle the next meltdown, when ithappens

The crisis has highlighted the need to improve risk management strategies at both the system-wide and institutionallevels in the financial services industry It has demonstrated that efforts limited to specific institutions or jurisdictionsare insufficient to address a problem that is global in scope New thinking is required to rebuild a damagedfinancial system

While other efforts have largely focused on improving risk management in financial services “from the insideout,” this report looks at it “from the outside in” – trying to learn from practices and patterns in domains such

as aviation, fisheries, wildfire fighting, immunology/epidemiology, telecommunication and pharmaceuticals.While not all of these practices are directly transferable to finance, many are and most of them provide muchneeded fresh perspective and thinking Over the past nine months the World Economic Forum, in collaborationwith The Boston Consulting Group, analyzed the outside domains and engaged multiple stakeholders Inputfrom over 100 subject experts, risk managers, academics and business leaders was sought in trying to answerthe question: What can the financial services industry do to better monitor, manage and maintain the resilience

of the financial system?

We trust that the report will stimulate your thinking, introduce new ideas and add to the broader discussionaimed at improving the long-term stability of the global financial system

On behalf of the World Economic Forum, we wish to particularly thank the members of the Steering Committee,the Working Group, the interview and workshop participants, Project Manager Isabella Reuttner and our partners

at The Boston Consulting Group (notably Duncan Martin, Kenny Pun and Rachel Hirsch) for their boundlesssupport

Kevin Steinberg Gian Carlo Bruno

Chief Operating Officer Director and Head of Financial Services Industry

Preface

The members of the Steering Committee and the Working Group support the recommendations and viewsexpressed in the report However, they do not all necessarily agree on every detailed point made herein.The opinions expressed are of a personal nature and do not necessarily reflect the stance of the companies

represented by the Steering Committee and Working Group members

Chief Risk Officer

Zurich Financial Services

Wharton Risk Management and Decision Processes Center

The Wharton School, University of Pennsylvania

David Rhodes

Senior Partner and Managing Director

The Boston Consulting Group

Raj SinghChief Risk OfficerSwiss Re

Paul SmithTreasurerState Farm Insurance

Jim WebberChief Risk OfficerAviva

Tom WilsonChief Risk OfficerAllianz SE

Vanessa WittmanChief Finance OfficerMarsh & McLennan Companies Inc

Mark YallopChief Operating OfficerICAP Plc

From the World Economic Forum:

Gian Carlo BrunoDirector and Head of Financial Services IndustryWorld Economic Forum USA

Kevin Steinberg Chief Operating OfficerWorld Economic Forum USA

Steering Committee

The financial crisis has, to put it mildly, seriously challenged our traditional approach to risk management.Consequently, a number of individuals and institutions have advanced ideas for improving not only the analyticalframework, but also the status and relevance of risk management

This report, not only reacts to the most recent episode (although we indeed reference many relevant examples),

it also attempts to address a deeper problem: the demonstrated inability of the global financial system toconstructively mitigate and deal with financial crises Over the past 40 years, the IMF has counted 88 bankingcrises Hence, a fundamental question presents itself: Can the financial services industry benefit from experiences

in other domains that, over time, have developed sound practices and successful patterns to deal with risk?

We believe the answer to be an emphatic “yes” This report explores both what these practices and patternsare, and how they can be applied to the financial services industry

Obviously, there are efforts already in progress to improve risk management in the financial services industry initiated

by such bodies as the Financial Stability Board and the G20 Many of these efforts are highly relevant, such asthe re-alignment of individual compensation with institutional and systemic goals To avoid replication, our reportwill not dwell further on initiatives already underway

In contrast to other and perhaps more conventional studies, our report tries to shed new light by focussing onthe lessons that the financial services industry can learn from other environments We take an “outside-in” perspective,thereby differentiating this report from others that focus on improving risk management using traditional concepts,tools, and ideas that always have been and will continue to be inherent and very relevant to the financial sector

It is important to recognize that risk-taking is an integral part of many financial institutions’ business models.This is a crucial difference to some domains that we have examined Also, we are well aware that outside domainsmay not provide ready guidance to all aspects of financial services (see Appendix) This report concentrates onstylized patterns and lessons that are potentially transferable to the financial sector while acknowledging that

no domain is perfect at managing risk or indeed fully comparable to financial services

We further acknowledge that some of our commentary on the industry is by default overly generalized for reasons

of brevity We do realize that no two financial institutions are identical: relative performances during the crisis haveborne that out We ask readers to keep these caveats in mind if, at times, what we depict or suggest does notresonate with what they know from their own institution’s vantage point

Letter from the Steering Committee

Our goal is to provide food for thought rather than an off-the-shelf solution Many of the outside practices weexplore are somewhat distant from conventional thinking We are aware that some of our ideas will be controversial.

We therefore do not necessarily speak of them as “recommendations.” Instead, we hope that our report willinspire a fruitful discussion between those stakeholders that have an interest in a more resilient financial system:policy-makers and supra-national bodies at a global level, regulators and governments at a national level, andsenior managers at a firm level It is our intention to stimulate, provoke, and challenge – and by doing so tohelp transition the financial system to a more resilient and less failure-prone state

The Steering Committee and the Working Group would like to thank those individuals who generously gavetheir time to support this project We hope that all will find our report as stimulating to read as we found it toresearch, debate and write

Steering Committee Co-chairs

Lázaro Campos Axel Lehmann

The recent financial crisis exposed many weaknesses in risk management in financial services Issues aroundincentives, governance and culture at many market participants have been well documented and need no furtherdiscussion However, the trouble ran deeper than that: reading any account of the last years’ events that broughtthe financial sector to the brink of collapse, it is obvious that many of the actors ‘flew blind,’ with neither adequateinformation nor preparation Moreover, what was good for an individual firm or country in the short term wasnot necessarily good for the system as a whole in the long run Regulators thought nationally, not globally, until

it was too late; firm, product and trading strategies became complex yet homogeneous, leading to a stampedeonce positions did deteriorate While some of the decisions made under intense pressure have so far held up

to the test of time, it is hard not to conclude that things could have easily been much worse

Financial services is not the only domain with issues of system-wide stability or conflicts between the individual(short-term) and systemic (long-term) good In this spirit, seven domains outside financial services were analyzedwith the belief that their risk-management techniques might hold lessons for finance The findings were groupedinto three non-mutually exclusive areas of focus: (1) system-wide perspective, (2) transparency and informationflow, and (3) governance and culture

(1) System-wide perspective:

Drive diversity Homogeneous systems are less resilient than diversified ones For example, in 2007, a virus

killed millions of farmed Chilean salmon The fish had been farmed at high density, treated with similar antibioticsand subjected to similar preventive measures They were, therefore, all vulnerable to a single threat Applyingthis lesson, financial institutions could encourage diverse and contrarian approaches towards modelling riskand selecting business strategies Competitive forces would make this difficult to achieve at an institutional level.Regulators could, therefore, encourage variation in institutions’ risk management approaches and increasecapital charges for systemically crowded high-risk/high-return business strategies (this initiative would need to

be carried out with sound understanding of the strategies, rather than as a blanket measure) In promoting alevel playing field one should recognize that diversity in risk management is important and complete regulatoryconvergence should be avoided The overall approach towards achieving diversity in financial services should

be based on broadly agreed principles as opposed to strict one-size-fits-all rules

Simulate system disasters The World Health Organization (WHO) helps nations develop action plans activated

by the global pandemic alert level and encourages simulations and real-life rehearsals to prepare for crises and

to improve planning Pilots train extensively on realistic flight simulators to prepare for emergency situations.Similarly, the financial services industry should put more emphasis on creating and rehearsing contingencyplans for large systemic events across institutional and national boundaries Such plans and simulations should

be realistic and concrete and should address not only short-term operational concerns, but also longer-termstrategic issues

Manage “fire” Since forest ecosystems need fire to rejuvenate, some wildfires that do not endanger human

lives and property are allowed to burn out Controlled burning is also conducted selectively to reduce fuel build-up.The parallel in financial services could be that failure of some individual institutions is acceptable, even desirable,for the overall system, and therefore government guarantees should be limited In addition, the financial servicesindustry could consider developing “fire breaks” to contain incidents locally and prevent system-wide spread.One such measure, as suggested by the United Kingdom Financial Services Authority (FSA) is to require institutions

to create “living wills” so that, if necessary, they could be wound down with minimal impact to the system

Executive Summary

(2) Transparency and Information Flow:

Aggregate system-wide data The aviation regulator in the US conducts a collaborative government and

industry programme known as the Aviation Safety Information Analysis and Sharing programme (ASIAS), whichaggregates national aviation incident reports and safety data The programme provides a comprehensive andconsistent data environment that enables systemic issue analysis and identification This ultimately helps detectsystemic issues earlier and more effectively In financial services, large amount of data is already collected fromfinancial institutions, but this data is not aggregated or exploited for systemic issue detection On its own, theaggregation of data will not increase the resilience of the system Therefore, the industry should first focus on

“asking the right questions” in order to determine a set of critical systemic stability indicators that could contribute

to an efficient early-warning mechanism Development of these indicators should be adaptive to keep pacewith technological and financial innovation, and could work alongside efforts to enhance data mining andmanagement techniques

Scrutinize complexity The pharmaceutical industry conducts in-depth studies to analyze the efficacy, side

effects of, and interactions between new drugs The fishery industry models the effects of fishing on the ecosystem

as a whole, and restricts methods that also kill untargeted (or “by catch”) species Similarly, the financial servicesindustry could mandate deeper and broader assessments of the impact of new products and business strategies

on financial markets These assessments would look beyond the direct impact and explicitly target the secondand third order effects Regulators could then consider performing “unintended consequences” studies on productsthat breach system-wide threshold volumes, and could be empowered to restrict volumes if the products weredeemed potentially unsafe to the system Obviously, such restrictions would have to be set with a deep technicalunderstanding of the products

Innovate transparently In immunology, pathogens that mutate before the adaptive immune response can

kick in are particularly dangerous, as the immune system perpetually lags the pathogen’s invasion Moreover, ifthe host immune system misinterprets the nuances of the new strain, it may be deceived by apparent familiarityand gear up to fight an old strain Similarly, financial institutions and regulators should be wary of rapidly “mutating”products by carefully monitoring instruments with exceptional growth and variation They must also make surethat established risk management techniques continue to apply when “new strains” have developed In thetelecommunications industry, the best practice is to write simple code in discrete modules so that system-wideerrors are hard to make and easy to find The financial services domain could consider instituting a standardizedmodular nomenclature covering all products so that their risks could be better decomposed and understood.New products originally seen as complex and “leading edge” do generally become more standardized as volumesincreased, suggesting that it is not impossible to break down complex products into simpler components

(3) Governance and Culture:

Look for trouble The World Health Organization utilizes web crawlers and an extensive informal human network

to seek out emerging infectious disease outbreaks, especially unfamiliar ones This enables early detection andtherefore swift mitigation In immunology, white blood cells constantly circulate in the human body, seeking dangerouspathogens The financial services industry should encourage and adopt a culture of actively searching for emergingthreats at both the institutional and system-wide level – “looking for trouble” – and in addition respecting individualswho raise warning signals Institutions and the industry could create dedicated teams to proactively investigateinstitutional and systemic risks and continuously experiment with new warning-indicators

Value experience Wildfire fighters value the experiences of those who have fought very large fires, and document their

stories Airline companies and regulators conduct in-depth analyses on all accidents and near-misses and convertthe lessons learnt into new regulations and procedures that improve safety Similarly, the financial services industrycould emphasize the value of experienced employees (both at institutions and regulatory bodies), improve their retention,and have a cadre “on call” to respond when a new crisis occurs In order to ensure that lessons from past crises arepassed down, institutions should carefully analyze events and document and aggregate experiential testimonyfor training new generations

Empower the front line Pilots, co-pilots, and mechanics can delay a take-off if they deem the aircraft to be unsafe.

In the cockpit, co-pilots are encouraged to raise safety issues Front-line wildfire fighters are empowered to maketactical decisions at the fire scene Similarly, financial services institutions could consider further encouraging front-linerisk managers and business-unit employees to take charge of local risk management issues, and raise alarms withoutfear of retribution Since the financial services industry (in theory) already has much of this capability in place, upgrading

it is more a case of reinforcing the existing framework than radically redesigning the process As an example, seniormanagement could explicitly reward proactive flagging and management of risk issues, improve channels foranonymous reporting, and communicate that consistent smooth sailing would be considered ‘too good to betrue’ Clearly this will require an appropriate set of incentives

The adoption of one or more of the suggestions could aid in strengthening the financial services industry as awhole In assessing appropriateness of the suggestions, it might be helpful to consider a framework that looks

at the nature of a risk event (exogenous shock vs endogenous systemic malfunction) and its consequence(large non-systemic event vs systemic melt-down) Depending on what the reader is trying to combat, someanalogies are more powerful than others For example, many risk management practices in aviation try to avoidlarge non-systemic events such as plane crashes, and have limited consideration for the system as a whole(other than where events pertain to a component or process affecting many aircraft).1

While the financial system appears to be stable for the immediate future, the financial industry should pause andreflect on past risk-management practices and actively explore potential changes that could be made goingforward The following questions are critical:

• How can the industry make the proper trade-off between information protection and disclosure as it seeks toenable system-wide risk monitoring and management?

• How can the “rejuvenation” and safety of the financial system be balanced without either creating moralhazard or system fragility?

• Is the industry on the right track with the current regulatory approach? How can the benefits and vulnerabilitiesassociated with regulatory convergence be balanced?

• How can the industry adapt (structurally and culturally) to new threats and innovations of the future, giventhat it does not yet know the products, the markets, the players, and the consumers of the future?

• Given that the next crisis is very unlikely to be prevented by a central controller, how can the industry resist the temptation

to “solve” stability issues by over-centralisation and instead strengthen the resilience of individual systemic nodes?

The implementation of any needed changes will neither be easy nor can it happen overnight Some require aphased approach; others require voluntary initiatives from the private sector; yet others require regulatory mandates.Above all else, international and cross-industry cooperation and trust are crucial to achieving system-wide resilience,and it is in this spirit that this report has been researched and written The project team thanks those who havecontributed to this effort, and looks forward to the ongoing debate

1 The Project Background and Approach section in the Appendix of this report provides a detailed framework

1.1 Introduction

Managing risk in a complex environment requires a comprehensive view of the entire system Leading up to therecent crisis, many financial institutions had similar risk exposures, although this fact was not widely deemedimportant Institutions held near-identical classes of investments, most used a high degree of leverage, and manyfinanced themselves through short-term funding Thus, when liquidity receded following the collapse of housingprices and subsequently of financial assets linked to mortgages, many institutions suffered losses simultaneouslyand sought to close similar positions As these institutions had similar funding structures, risk-managementpractices, and mitigation strategies, it was as if someone had yelled “Fire!” in a packed theatre, and all ran tothe same exit

Global regulatory uniformity also encouraged homogeneity, particularly concerning the reliance on rating agencies.Regulation in all major financial centres allowed the same solutions to reduce capital (such as through conduitsand structured investment vehicles) Moreover, many practitioners relied on historical correlations of individualunderlying risks to calculate diversification benefits, forgetting correlations could change in a stress scenario

In addition, financial institutions and investors had become accustomed to the idea that governments wouldarrest severe market downturns and, as the rescue of Long-Term Capital Management (LTCM) illustrated, intervene

to mitigate the impact of failing institutions Markets may have even assumed, rightly so to some degree, that

an institution could be “too big or too interconnected to fail.” Some participants considered that tail risk wasidiosyncratic in nature, effectively denying the existence of systemic risks

Ultimately, neither regulators nor the industry were prepared for a systemic crisis Most regulators had failed todevelop a system-wide perspective and were still figuring out contingency plans as the crisis unfolded At theinstitutional level, most senior management teams had never experienced a significant crisis They operatedunder the belief that a system-wide crisis would never happen Although sound decisions were eventually madethat helped bring the system back from the brink, the danger should have never been permitted to develop

How does the indu stry construct an all-encompassing, system-wide view, and enhance the resilience

of the global financial system?

The financial services domain could (1) drive diversity (as homogeneous systems are less resilient), (2) simulatesystem disasters, and (3) manage “fire” (to maximize system resilience)

1.2 Drive diversity

“Increases in complexity did not come with more diversity On the face of it, market participants

looked more and more different in their legal status, investment strategies, and business objectives.

It has now become apparent that, behind these veils of diverse colours, there was a profound

uniformity in the approach to risk, its measurement, its management, as well as in the drivers of

risk appetite This uniformity had very destabilizing consequences.”

Jean-Pierre Landau, Deputy Governor, The Bank of France, 8 June 2009 2

Chapter 1 – System-Wide

Perspective

Chilean farmed salmon suffered from a viral disease in a homogeneous environment

Chile is the second largest farmed salmon producer in the world The industry is crucial to the economy andemploys tens of thousands of people Thus, when a viral disease hit its salmon farms in 2007, killing millions offish, many plants had to be shut down Thousands of jobs have been shed since the outbreak

The viral disease, infectious salmon anemia (ISA), was first detected in Chile in 2007 ISA is a highly contagiousand lethal virus in the salmon population, but does not affect humans It can cause severe anemia and haemorrhages

in salmon internal organs

ISA is not a problem unique to Chile and has previouslycaused trouble in other countries, including Norway,Canada, and Scotland However, the scale and speed

of infection in Chilean salmon farms were unprecedented.Environmentalists have reported that Chilean salmonfarms yield (on average) 25 kilos of fish per cubic meter,compared to 15 kilos per cubic meter in Norway Thisover-crowding further encouraged ISA, as its transmissioncould be aided by sea lice that plague overcrowdedfarms In addition to saturated facilities, Chilean salmonfarms were characterized by close facility proximity,making disease control even more difficult.3

To combat diseases, farmers began to use a high level

of antibiotic treatment.4Yet this step made the farmedsalmon as a whole more vulnerable to contagion inthe long run When the outbreak occurred, the combi-nation of high density, close proximity and drug resis-tance resulted in rapid spread and catastrophicdamage

2 Landau, J “Introductory remarks by Mr Jean-Pierre Landau at the Conference on “The macroeconomy and financial systems in normal times and in times

of stress”, jointly organized by the Bank of France and the Deutsche Bundesbank, Gouvieux-Chantilly” Bank of International Settlements,

Robust Systems: Heterogeneity, Redundancy, and Modularity

By Simon Levin

In complex systems, strong non-linearities may lead to the magnification of disturbances, thereby to loss

of robustness and to regime shifts Examples include desertification, eutrophication, and disease outbreaks.Economic analogues include market collapses and recoveries, bank runs, and shifts in social preferences

Sudden transitions are driven by feedbacks Positive feedbacks, which directly enhance perturbations,are clearly destabilizing Each new case in an epidemic has the potential to cause others Less intuitively,strong negative feedbacks, which initially correct deviations, can destabilize, as in the collapse of the

dynamically unstable Tacoma Narrows Bridge

Robustness hinges on the balance between heterogeneity, redundancy, and modularity Heterogeneityrepresents adaptive capacity, the ability to find new solutions in the face of change Genetic heterogeneity

is the essential ingredient on which natural selection acts However, redundancy, which trades off in obviousways against heterogeneity, also confers robustness, compensating for the loss of key elements In 2004,

a lack of robustness was evident when one of the major suppliers of flu vaccine to the United States

could not deliver Fortunately, the flu season was mild Finally, modularity creates both barriers to theuncontrolled spread of disturbance and building blocks for recovery after disturbance Diseases mayspread rapidly within particular risk groups, like drug users, but then slow down because of the modularnature of social contacts Forest fires are contained through fire breaks, which confer modularity Similarly,the recent economic meltdown can be attributed, in large part, to the excessive over-connectedness

of the banking system – that is, to an absence of sufficient modularity – as well as to the absence ofheterogeneity and redundancy

Simon Levin, PhD

Moffett Professor of Biology

Princeton University

Application to financial services

Prior to the financial crisis, many financial institutions were running similar business and risk management strategies

at the product-line level As evidenced by players’ relative performance through the crisis, only a few institutionswere pursuing a more diversified approach Indeed, many institutions were simultaneously building large positions

in structured credit products derived from the same underlying asset classes, utilizing short-term money-marketfunding, and making risk management decisions with similar assumptions and techniques Capital requirementswere calculated under similar methodologies, with similar underlying models Reliance on external credit ratingswas pervasive When the U.S sub-prime housing bubble burst, financial institutions with the same vulnerabilitiesall went for the same exit door The financial services industry needs to rethink how it can foster diversity inorder to make the system more resilient

Indeed, while some measure of emotional comfort can come from herding, financial institutions should avoidcrowded business strategies and vary modelling assumptions for risk management Boards, executives andinvestors should think for themselves rather than implementing me-too strategies and obsessing with benchmarks

It is understandable that when everyone is judged on relative performance financial institutions should seek tocompare themselves, but just copying strategies (or even trading positions) is not healthy for either the organisation

or the system As it turned out, many institutions assumed that super-senior tranches of collateralized debtobligations (CDOs) were safe based on their AAA credit rating This view failed to account for the fact that theratings were based on precarious assumptions about default risk, house prices, and cross-correlations amongthe risks of the underlying assets Financial companies also kept large inventories on their balance sheets, andultimately suffered substantial losses – failing to recognize that there would be a penalty on homogeneity and aprize for diversity Thus, financial institutions should seek diverse and contrarian approaches and opinions interms of risk modelling, business strategies, and assumptions The winners in the next crisis (as indeed in thelast) will be those organizations that get these difficult calls right

Of course, when competitors are all apparently winning from a given strategy, and shareholders demand the samehigh level of return on equity, it is difficult for financial institutions to stand on the sidelines It is also challengingfor them to strike the right balance between building consensus in decision making and encouraging variedopinions within their organisations internally

Regulators should refrain from promoting complete systemic uniformity, and perhaps endeavour to encourage

a larger degree of systemic heterogeneity They could encourage institutions to manage risk with varied approachesand increase capital charges for systemically crowded high risk/high return business strategies (this initiativewould need to be carried out with sound understanding of the strategies, rather than as a blanket measure).Since homogeneity leads to shared vulnerabilities, counter-intuitive as it may seem, not all practitioners shouldadopt the same “best-practice” risk management techniques, methodologies and assumptions – both domesticallyand across borders The trend of complete regulatory convergence is simply not desirable

Although convergence leads to benefits such as the interoperability and comparability of institutional financialhealth across jurisdictions, homogeneous supervisory practices create a future selection bias, exposing thefinancial system to as yet unknown threats Although differences in regulatory approaches could lead to “arbitrage,”properly-managed diversity can help close loopholes and make the system more resilient in the long-term

Needless to say, a balkanization of regulatory regimes could be equally (if not more) detrimental to the stability

of the global financial system One of the problems leading up to the recent financial crisis was that the demarcationbetween various players in the financial market had become blurred Commercial banks began behaving likeinvestment banks and hedge funds – creating a large shadow banking system – and certain insurers startedbehaving like banks Consequently, levelling the playing field according to outdated institutional demarcationlines is inefficient and potentially a source of systemic risk A more promising approach would be to regulateand supervise according to functional and activity lines that better reflect the fluidity in the modern financial world

In other words, regulation should emphasize a principles-based and behavioural approach over a rules-basedand institutional approach

1.3 Simulate system disasters

“As the crisis developed, in too many instances supervisors (…) were not prepared to discuss

with appropriate frankness and at an early stage the vulnerabilities of financial institutions which

they supervised Information flow among supervisors was far from being optimal, especially in the

build-up phase of the crisis This has led to an erosion of mutual confidence among supervisors.”

De Larosière Report to the European Commission, February 25, 2009 5

The WHO sets the global alert level to activate national contingency plans

On April 27, 2009, considering cases of H1N1 in the United States, Mexico, and Canada, as well as potentialspread to other nations, the WHO raised its global pandemic alert level from 3 to 4 On April 29, nine countrieshad officially reported 148 cases of H1N1, including one death in the United States and seven in Mexico Level

5 alertness was declared A month and a half later, on June 11, the highest alert level, level 6, was activated asalmost 30,000 confirmed cases were reported in 74 countries.6

5 The de Larosière Group “The High-Level Group on Financial Supervision in the EU Report” http://ec.europa.eu/commission_barroso/president/pdf/statement_ 20090225_en.pdf, February 2009.

6 World Health Organization, http://www.who.int/, 2009.

The WHO is responsible for setting global pandemicalert levels, which correspond to actionable responsemeasures based on the current degree of epidemicspread These levels refer solely to spread of theinfection, not to its severity or potential deadliness.Levels 1 through 3 indicate that the disease residespredominantly in animals with limited human infection.Level 4 indicates a sustained level of human-to-humantransmission Levels 5 and 6 indicate widespreadglobal human infection.7

Member states are encouraged to develop specificaction plans to manage epidemics in their region.These plans typically activate based on shifts in theglobal pandemic alert level The WHO builds tools

to support nations in developing detailed responseprocedures Action-plan categories are organized byplanning and coordination, situation monitoring andassessment, communication, reduction in the spread

of disease, and continuity of health-care provisions

The WHO also encourages nations to test their plans, outlining three types of simulations8: (1) table-top exercises,

in which major stakeholders discuss scenarios and how they should respond; (2) functional exercises, in whichseveral entities complete simulations for a given scenario without deploying resources; and (3) full-scale exercises,

in which participants enact scenarios as realistically as possible These exercises involve all participants outlined

in the plan – ideally from multiple nations and regions – and include deployment of resources The lessons fromthese simulations can then be used to modify and improve overall crisis plans

Pilots simulate disasters

Pilots train extensively on flight simulators to prepare for multiple emergency scenarios, including severe (yetinfrequent) events These simulators vividly recreate real-life situations using visual cues, motion sensors, andactual cockpit tools Pilots feel like they are experiencing a critical event, such as facing an engine failure inconjunction with an electrical system malfunction while attempting to land in a storm

Most commercial pilots are required to log a minimum number of simulator hours every year to stay up-to-date

on procedures In some countries, pilots must be re-evaluated and re-trained on simulators every six months inorder to keep their licenses

7 “WHO pandemic phase descriptions and main actions by phase” World Health Organization, http://www.who.int/csr/disease/influenza/GIPA3AideMemoire.pdf, 2009.

8 “Considerations on exercises to validate pandemic preparedness plans” WHO, http://www.who.int/csr/disease/influenza/ExerciseConsiderations.pdf, 2009.

Practitioners in the Telecommunications industry develop contingency plans

Telecommunications providers also make detailed contingency plans for emergency situations These plans aretailored to specific regions since the probability of various threats – especially those related to weather – differ

by geography There are also generic contingency plans that providers put in place For example, if the centralcontrol room shuts down, mobile trucks with operating equipment can be used to avoid network failure

Application to financial services

During the course of the recent financial crisis, a series of financial institutions faced bankruptcy In each casethe response of regulators and the government differed: some were bailed out while others were propelled intoshotgun marriages In September 2008 it was Lehman Brothers’ turn The Federal Reserve Bank of New Yorkcalled in prominent financial CEOs to figure out a plan However, the government declined to rescue the firm,and potential suitors backed away Lehman Brothers had to declare bankruptcy, the largest in US history.When the markets opened the following Monday, trust had disappeared and trading froze This took marketparticipants and regulators by surprise and almost led to the collapse of the global financial system Reflecting

on this ‘near miss’, the financial services industry could benefit from better preparation for severe events andsystemic crises, utilizing detailed contingency plans based on associated simulations

When creating sweeping contingency plans, it is important to understand what each party is responsible forregulating, so that all angles are covered Equally, it is also important that institutions and regulators acrossjurisdictions coordinate efforts All should agree on a priori protocols concerning how to collaborate in the face

of a large-scale crisis and test those through realistic simulations At the extreme, the industry could explore thepossibility of publishing these plans – sanitized for corporate confidentiality where necessary – to help engendertrust in the stability of the system

Contingency plans need to be simulated to ensure they are applicable and implementable Simulations shouldnot only address operational concerns such as infrastructure failure or natural disasters but also strategicissues such as capital, buy/sell activities, and shifts in management/ownership – possibly involving multipleinstitutions and across jurisdictions Simulated crisis scenarios should of course be highly realistic, like flightsimulations, and could be run with “fake feeds” when markets are closed (such as over a weekend), similar tothe disaster recovery exercises that financial institutions already conduct Such “fire drills” could highlight potentialvulnerabilities, and increase preparedness for systemic events The lessons learnt from such simulations would

of course be incorporated into contingency plans

1.4 Manage “fire”

“The Government’s macroeconomic framework has delivered unprecedented stability, with 62

consecutive quarters of GDP growth in the UK – the longest sustained expansion on record.”

Gordon Brown, John Hutton, Alistair Darling, March 2008 9

Wildfire fighters manage fire risk by controlling the fire’s environment

For most of the twentieth century, full fire suppression was the official policy in the United States After 79 wildfirefighters were killed in a fire in the Southern Rockies in 1910, the U.S Forest Service adopted a zero tolerancepolicy In 1933, after another large wildfire in Oregon wiped out three million acres of forest, the strict “10 (acres)

by 10 (a.m.) rule” was instituted, requiring all fires of over ten acres in extent to be extinguished by 10 a.m theday after they had broken out

However, nature needs to burn In fire-prone climates, fire is part of the ecosystem Organisms have evolvednot just to cope with fire, but to depend on it Fire reduces fuel loading, clears land for new shrubs and flowers

to grow, and attracts birds that do not inhabit trees to nest in burned areas It removes forest litter that nurturesinsect infestation and kills diseased trees

9 Brown, G, Hutton, J, Darling, A “Enterprise – Unlocking the UK’s Talent”, HM Treasury Department for Business Enterprise & Regulatory Reform, http://www.berr.gov.uk/files/file44993.pdf, March 2008.

Decades of full fire suppression in the United States resulted in significantly harmful landscape alteration.Therefore, in 1978, the U.S Forest Service revised its wildfire policy to be consistent with land and resourcemanagement objectives Today, wildfire fighting has evolved into wildfire management Wildfires that do notthreaten human lives and property are left to burn out Furthermore, prescribed burning – igniting small firesintentionally to reduce fuel build, create fire breaks, and clear land – has been affirmed as an appropriate fire-management practice.10

Prescribed burning is highly controversial, however, and requires balancing the interests of multiple stakeholders.Wildfire is hard to control Wind direction and weather patterns can change suddenly, spreading the wildfire andpotentially causing a much larger fire than intended Fire management politics have become more complicated

as real estate development has encroached on forests that border urban areas Prescribed burning efforts inthese regions can interfere with highway traffic and make residents ill at ease

10 “Fire Ecology Eco-link”, Temperate Forest Foundation, http://www.forestinfo.org/Products/eco-links/Fire-Eco2.PDF, 2002

Creative Destruction in Nature’s Economy

By Stephen J Pyne

In recent decades, the realization has grown that fire is not something that happens to biotas from theoutside like a flood or an ice storm Rather, it is an integral process that many biotas expect and need.Simply put, fire recycles nutrients, rearranges ecosystem structures, and recharges landscapes that

have fallen into lethargy It is the quintessential agent of creative destruction in nature’s economy

People had long recognized this fact, and had used controlled fire in domains such as hunting, foraging,herding, and farming But industrialization, particularly when combined with colonization, shook up theseancient arrangements Fire came to be perceived as mostly destructive, and state-sponsored conservationintervened Officials misidentified fire, qua fire, as an agent of damage and sought to suppress it At first,this movement seemed to succeed Over time, however, it became apparent that burning could not beabolished and that even the attempt to do so was disruptive and led to even greater damage

Successful programmes have thus shifted from fire suppression to fire management Agencies appreciatethat they cannot just shut down fires, nor can they simply stand by and let a transcendent nature haveuntrammelled sway Accordingly, many agencies fight fires only when wildfire threatens life and property.They allow fires some room to roam when flame and smoke do not pose hazards to people or hard assets.They deliberately start fires to stimulate ecological benefits and to compensate for past suppression

programmes Also, they seek to shape the general landscape so that whenever fires occur – whether byaccident, arson, or lightning – they will have properties that promote fire’s benefits and lessen its costs

It’s a tricky business, to be sure But the concept that techniques must be mixed and that fire cannot beremoved from land management overall provides a strong analogy to the economic crises of recent years

Stephen J Pyne, PhD

Regents’ Professor

School of Life Sciences

Arizona State University

Author of over 20 books including Year of the Fires: The Story of the Great Fires of 1910 and Tending Fire: Coping with America’s Wildland Fires.

Application to financial services

While many banks have failed in the past, this reality was far from the public mind in the years leading up to therecent crisis Recent government intervention, including explicit and implicit bailouts such as LTCM and BearStearns, made many financial practitioners believe that the government would bear the consequences of poorinstitutional risk management In order to change this perception, it is essential that governments and regulatorsallow institutional failure or creative destruction as part of a necessary, rejuvenating process

Simply put, national governments could actively manage financial fires that are burning Of course, it is alsoimportant to try to contain fires locally and prevent broader spread A potential example of such a fire break is

a “living will,” as suggested by the FSA.11If all else fails, a living will can be activated to minimize the impact of

an institutional failure on the financial system as a whole In order to be effective, such a will would need to beupdated regularly to reflect the pace of business change among successful industry participants Regulatorswould need to set incentives (such as capital relief) to ensure that institutions take preparation efforts seriously

In the spirit of a level playing field, they also need to watch out that transparency around such living wills doesnot unfairly penalize some institutions, for example via reduced credit ratings On the other hand, just as firebreaks restrict the size of forest fire, taken to the extreme, this could mean some entities too big to fail need toshrink – which should be evaluated on a firm-by-firm basis, taking into account its management structure andcapabilities Extreme care needs to be taken around defining an appropriate time horizon for such changes

If unchecked, such side effects could lead to the very type of destabilizing shock that the measures aim to prevent

What is more, arbitrage within the legal framework could help identify vulnerabilities in the system It could weedout weak practices and players that could potentially contribute to another systemic crisis Allowing arbitrage(even of the regulatory kind) is analogous to a small fire, and can be systemically helpful as long as appropriatemonitoring is in place and quick counteraction available if needed

In other words, small fires are essential to the overall health of the financial system Indeed, the absence ofsmall institutional failures in a certain business niche could be seen as cause for concern rather than evidence

of stability Of course, it will at times be difficult to differentiate what is truly a “small fire” from a situation thatcould degenerate into a systemic event

11 “FSA’s Turner backs living wills for banks” The Financial Times, http://www.ft.com/cms/s/0/d67f2976-9805-11de-8d3d-00144feabdc0.html, 2 September 2009.

Prior to the recent crisis, simple products were packaged into complex structured products (such as singlemortgages into CDOs, and from there into CDO-squared) This was often done with good reason, and solvedgenuine risk-management problems for clients However, in the absence of necessary transparency, such complexinstruments made traditional risk assessment and portfolio aggregation more difficult For example, a specificindividual mortgage will, over its lifetime, behaviourally and dynamically “select” which tranche of the CDO it ispart of Although product specifications were documented, few customers, practitioners, or regulators couldtruly understand the details involved even if they had taken the time to read them Thus, institutions had difficultymanaging the associated risks, and some institutions did not even know their own risk exposures.

Securitization was originally intended to spread risk across the financial system to institutions that were willingand better able to hold the risks However, when the usage of some structured products “mutated” from theiroriginal intent (e.g., from risk management to yield enhancement), complexity grew - blurring the boundariesbetween risk origination and risk ownership and complicating accountability for risk management Few couldunderstand where the risks truly resided in the system

Packaging complex products as off-balance-sheet, special-purpose vehicles exacerbated the problem, hidingultimate liabilities from the market Investors and regulators could no longer discern institutional risk exposure.Moreover, different accounting standards, regional exemptions for capital treatment (e.g., domestic lendingportfolios), and a large, less-regulated “shadow banking” sector made it nearly impossible to get a consistent,system-wide view of overall risk

Thus, in the period leading up to the financial crisis, there was insufficient transparency in the financial system;

no one was really aware of the aggregate system-wide risk (e.g total credit derivative exposure, overall leverage,counterparty interconnectedness) The industry did not or could not fully understand institutional and productinteractions What started off as the bursting of the sub-prime housing bubble in the United States evolved into

a global, system-wide liquidity problem and ultimately turned into a solvency crisis for some financial institutions.The speed and ferocity of this evolution caught most industry practitioners and regulators by surprise

The lack of transparency and insufficient consideration of complex interactions prevented virtually everyonefrom fully comprehending cascading effects at the systemic level Regulators did not see the need to intercedeearlier or knew how best to address the situation when they did react Also, adaptations in regulations, alongwith the processing of information relevant for supervisors, significantly lagged behind innovation and industryevolution

How does the industry increase transparency, thereby reducing the odds of a systemic meltdown?

The financial services domain could (1) aggregate system-wide data, (2) scrutinize complex products (consideringsecond- and third-order systemic effects), and (3) innovate transparently

2.2 Aggregate system-wide data

“The task of a systemic regulator will be superhuman without the transparency and tools to instil

market discipline The trouble with the old system is it is too easy for institutions to deny problems that allow systemic risks to fester and grow This denial contributed significantly to the distrust that froze the system.”

Lloyd Blankfein, CEO, Goldman Sachs, 13 October, 2009 12

Aviation aggregates incident data to enable systemic safety analysis

Aviation is a highly complex system Since plane crashes can cause many deaths, there is zero tolerance forsafety risk in aviation Over the past 50 years, practitioners have greatly improved safety by intensely focusing

on improving technology and learning from past incidents

As accident rates began to plateau in the 1990s, theindustry has looked for new methods to continue toimprove safety in the new millennium In the U.S.,many agencies collect aviation safety data, including,for example, the Federal Aviation Administration(FAA)’s Aviation Safety Action Program (ASAP) andNASA’s Aviation Safety Reporting System (ASRS) Theseprogrammes rely on voluntary reporting of incidentsand near misses by commercial airlines and by individualaviation professionals; they have processed aroundone million incident reports to date To encouragereporting, all reports submitted are de-identified sothat names of individuals and carriers are secure Atthe individual airline level, many operators also collectand analyze flight operation data, or what is calledFlight Operation Quality Assurance (FOQA) data, toimprove aviation safety Nevertheless, since multipleindependent efforts are involved, the data are oftenfragmented and not very effective at unravelling deepand complex systemic issues Therefore, to addressthis problem, the FAA developed the Aviation SafetyInformation Analysis and Sharing (ASIAS) programme

in 2007

12 “To avoid crisis, we need more transparency” The Financial Times, http://www.ft.com/cms/s/0/3de2aab8-b78f-11de-9812-00144feab49a.html,

13 October 2009.

The ASIAS programme is a collaborative government and industry initiative allowing national aggregation ofexisting aviation safety data from different data sources It also complements incident and flight operation datawith contextual information on weather, terrain and air traffic control By combining isolated data sources, theASIAS programme provides a comprehensive and consistent data environment that enables systemic issueanalysis and identification

Additionally, the ASIAS board – a mix of public and private constituents including the FAA, NASA, engine andairframe manufacturers, airlines and pilot unions – flags specific issues and employs analysts to dive into data

in search of answers Ultimately, through more extensive data sharing and better safety information extractionfrom the data, the goal is to more effectively detect potential systemic safety issues before they occur and tomitigate them

13 Basehore, M “National Transportation Safety Board, FAA Presentation - ASIAS” National Transportation Safety Board,

http://www.ntsb.gov/Dockets/Aviation/CEN09MA142/426930.pdf, 23 September 2009.

ASIAS Programme

By Margaret Gilligan

Aviation is one of the safest human endeavours, yet the industry is always looking for ways to identifyrisk – as well as to eliminate, mitigate, and manage it Because commercial aviation accidents are sorare and random, we cannot wait for the risk to manifest itself in a system failure We have to find ways

to identify emerging risks before they cause catastrophes

An industry/government initiative has been forged to collect safety data across the aviation community.Named the Aviation Safety Information Analysis and Sharing (ASIAS) initiative, it integrates data from manysources to accomplish several objectives First, data can help determine whether a risk that occurs atone operator is common to other operators Then, safety professionals can fashion mitigations that improvethe entire system Second, data can measure whether the safety initiatives have been implemented andare having the intended effect of improving safety Ultimately, data analysis can uncover risks that no onehas yet identified and allow the community to develop safety improvements It has been said that ASIAS

is the closest thing to a “crystal ball” that the aviation safety community will ever have

While this initiative is just getting underway, we have already seen its potential It enables analyses thatintegrate pilot reports as well as data collected on aircraft, routes flown, air-traffic procedures, and topo-graphy It has shown that we can improve pilot training, aircraft automation, and air-traffic practices toenhance safety It is a multidimensional solution that has addressed potential risk in many ways

Margaret Gilligan

Associate Administrator for Aviation Safety

United States Federal Aviation Administration

Application to financial services

There are clear differences between aviation and financial services from a risk management perspective Mostpertinently, taking risk is undesirable in aviation, whereas it is a vital part of the business model in many areas offinancial services However, both industries generate large amounts of data in their operations and rely on it tomanage risk

Financial services firms already process significant data volumes and share them with their regulators and otherparties (e.g., market and pricing providers) Similar to the aviation industry pre-ASIAS, this information is currentlyfor the most part fragmented and not consistently structured, ultimately preventing a coherent view of riskacross the system During the recent crisis, it was therefore not possible to get a precise system-wide reading

on key parameters of systemic stability, such as leverage, liquidity and counterparty connectedness

The direct ASIAS analogy in financial services would be to create a complete system-wide database of transactionlevel data for every trade made to monitor risk While such a deep and detailed data repository in the financialsystem is neither feasible nor desirable, the broader analogy has some merit, particularly with regards to how theaviation industry uses the aggregated data We, therefore, propose a two-step approach for consideration:

1 Through a working group between regulators, experts from research institutions, and industry participants,

determine a framework of critical systemic stability indicators for which ongoing collection of data would be

beneficial (i.e identifying the right questions to be asked) A starting point for discussions, based on lessonsfrom the recent financial turmoil, could be indicators including the following:

2 For those indicators, aggregate the relevant (which does not necessarily mean most granular) data to bothmonitor ongoing systemic risk, and allow deep-drill analyses in case of ‘near misses’ The exact nature of a

‘near miss’ is harder to define in financial services than in aviation, but could include hedges that did notwork as intended, or losses in single product lines that, while significant, did not ‘bring down the house’ Thedata would have to be at a level of granularity appropriate for each indicator (e.g., aggregating the embeddedleverage in many derivative products) While ultimately the analyses need to be anonymous for competitivereasons, the data should be available to the analysing body on a named basis wherever relevant for measuringsystem connectedness

To ensure that this effort is targeted it should apply to all financial institutions where systemic risk is accumulatedrather than to specific types of institutions (e.g., insurers or banks) This will ultimately allow treatment of similaroperations in the same way, while not trying to fit a solution to institutions where it does not apply It should benoted that while building such a data collection will not be trivial, a lot of the data already exist (e.g., withexchanges, regulators, BIS, market data providers), and it will often be only a matter of improved coordinationand common taxonomy between data sources, rather than building systems from scratch The move towardscentralised clearing for many products should also make this endeavour easier

Some regulators are already going down this route in certain instances – e.g., the UK FSA is mandating near-livereporting of banks’ liquidity The Financial Stability Board is engaging in an exercise that is similar in spirit towhat is described here.14By getting the indicators (the ‘questions to ask’) right and moving away from blanketdata dumps, it is our hope that such efforts can be made both less cumbersome and more effective

Connectedness of counterparties Measure of potential for contagion

Significant changes in transaction volumes Potentially linked to product ‘mutations’ and crowded trading

strategies Concentration of exposures Monitoring the knock-on effects from price or valuation volatility

Ultimately, the information should be gathered and monitored at a global level, due to the global nature of financialmarkets But starting the effort at a national level with all relevant institutions (particularly collecting ‘near misses’

in a systematic fashion) will be initially more feasible and still be an improvement from today’s situation

The practical details of such a scheme need to be further worked through and the industry’s concerns overimplementation need to be addressed However, the experience in aviation (and that of the recent financial crisis,where system-level data were often unavailable at crucial moments) suggests strongly that such a repository, ifproperly constructed, will be of great value to maintaining systemic stability in financial services When doingthis, it needs to be understood that simple product-level data composition will not enhance stability on its own –the data need to be complemented with systemic understanding (as expressed in “asking the right questions”)

It could be argued that crashing an individual plane is unlikely to cause a systemic issue in aviation, whereasfailure of a single financial institution can more easily be systemic (as proven by Lehman) So the ASIAS analogyneeds to be applied carefully – it is relevant where it identifies common components or procedures that, if leftfaulty, could cause a plethora of crashes and thus destroy confidence in air travel In that spirit, the ‘near miss’concept in particular is very pertinent Finally, this report does not propose that financial services and aviationshould converge to an identical regime of supervision and monitoring

2.3 Scrutinize complexity

“The shortcomings of the originate-to-distribute model can be attributed mainly to the failure of

individual players to develop a holistic view on the risks due to excessive focus on their narrow,

individual perspective, losing sight of system-wide drivers of risk and interdependencies.”

78thAnnual Report, Bank of International Settlement, 30 June 2008 15

The pharmaceutical industry seeks out adverse drug effects

Taking Paracetamol while drinking large quantities of alcohol could cause liver failure Mixing some formulations

of Warfarin (used to reduce blood clots and prevent heart attacks and strokes) with Naproxen could lead toserious gastro-intestinal bleeding

Drugs are used to treat diseases or alleviate symptoms However, many also come with adverse (side) effects,some of them serious or even lethal According to the U.S Center for Disease Control (CDC), nearly 20,000Americans die each year because of unintentional drug poisoning, usually the result of harmful drug mixes.Such mixtures are now the second-leading cause of accidental death in the United States, after automobilecrashes.16

14 The Financial Crisis and Information Gaps – Report to the G20 Finance Ministers and Central Bank Governors,

http://www.financialstabilityboard.org/publications/r_091107e.pdf, 29 October 2009

15 78 th Annual Report 30 June 2008 Basel: Bank of International Settlement.

16 Paulozzi, L “CDC Congressional Testimony: Committee on Energy & Commerce, Subcommittee on Oversight & Investigations, United States House of Representatives” Centers for Disease Control and Prevention, http://www.cdc.gov/washington/testimony/2007/t20071024.htm, 24 October 2007.

Drugs may have natural side effects (second-order effects) and also react differently when in contact with other drugs

or environmental factors (second- and third-order effects) Pharmaceutical companies conduct extensive clinicaltrials to try to understand side effects and interactions by gradually increasing the sample size so that small or rareeffects and interactions are detected However, since drug effectiveness is measured on average across a population(rather than for a particular individual), individual patients with particular health or disease traits may react differently.Some researchers now conduct pharmacogenomic studies which examine individual genetic variability in response

to a drug with the hope of enhancing the effectiveness of drug reactions and one day personalizing medicine

Post commercial release, the sample size is much bigger (the entire consuming population) and the environment

is not controlled, so unknown interactions will surely occur Pharmaceutical companies work with regulators todetect this (post-marketing) and change labelling information if needed Regulators have begun requiring companies

to develop ex-ante risk management plans prior to product launch for certain new drugs deemed particularlycapable of producing side effects

Since drug consumption can potentially be lethal, regulators have a critical role to play in product approval Indeed,regulators are engaged at an early stage in the drug development process – which typically lasts eight to fourteenyears – and are the ultimate arbiters on whether a drug’s benefits outweigh its risks Once a drug is approved,regulators impose strict labelling rules to ensure that potential adverse effects are clearly communicated

Nonetheless, there have been cases in which drugs were withdrawn after launch because companies and regulatorsdiscovered adverse side effects For example, Vioxx, an anti-inflammatory drug administered to millions of consumersfor five years, was believed to have caused between 88,000 and 139,000 heart attacks, of which about one-thirdproved fatal, before the drug was taken off the market.17

17 Graham, D., “Testimony of David J Graham, MD, MPH” United States Senate Committee on Finance,

http://finance.senate.gov/hearings/testimony/2004test/111804dgtest.pdf, 18 November, 2004.

Fisheries management considers the overall ecological system

When a fishing vessel retrieves its net, along with the target species, other types of fish, or “by-catch,” oftenget caught in the web In 2005, the Food and Agriculture Organization of the United Nations noted that theaverage proportion of the global catch discarded between 1992 and 2001 was 8%.18Apart from being a sheerwaste of resources, by-catch can include endangered species such as sea turtles, sea lions, and dolphins.Similarly, when fishermen use certain deep-sea trawling techniques, they can damage the ocean floor anduproot coral reefs

In order to avoid such second or third-order consequences to the ecological system, fishery managementagencies explicitly restrict certain fishing activities and techniques For example, they require fishing nets to be

of a certain type and length with specifically-sized holes

In addition, scientists model fish stock levels and predict species behaviour as inputs to management decisions.Certain species such as blue fin tuna are more commercially valuable than others and naturally attract moreresearch While scientists initially used single-species models, they gradually – realizing the importance of thepredator-prey relationship – began utilizing ecological models that consider all species in a given area

18 Kelleher, K Discards in the world’s marine fisheries – An update 2005 Rome: Food and Agriculture Organization of the United Nations.