Hot markets require closer attention: OSFI

High-flying markets and few investor complaints may sound like an idyllic financial setting, but it is exactly the kind of scene that requires extra vigilance on the part of regulators, according to Julie Dickson, acting superintendent, Office of the Superintendent of Financial Institutions Canada.

“We have to remember that if shocks could be anticipated, they would not be called shocks,” she told the 2007 Financial Services Invitational Forum in Cambridge, Ont. Dickson says that in the good times, the industry has a tendency to relax and ignore potentially harmful developments.

“In the financial markets, the longer the good times continue — and the more frequent the markets successfully come through small tests, such as the events of February — the more resilient the markets are seen to be and the more complacent players can become, which can create challenges for regulators.”

She says this is particularly true in today’s market, where the very things that have brought about the market upswing also have downsides with potential effects that remain largely unknown.

One area that OSFI is closely monitoring is the increase in risk dispersion. One of the ways the market has responded to previous shocks is to disperse financial risk across a broad cross-section of market participants rather than have it consolidated among the banks.

Dickson views this development as mainly positive, but says it has created a huge X-factor in the marketplace, because it’s harder to monitor where potential shocks might occur. It is also unclear if participants who are assuming more financial risk fully understand the implications.

“Risk dispersion is generally seen as a positive, provided it has been transferred (i.e. there are no obligations to take it back) and the acquirer understands what has been purchased,” she says. “One can never know with certainty where incidents may occur, which is why if an institution is transferring risk, or keeping it, vigilance is required.”

While risk is being spread about, asset classes are being integrated. Dickson says risk and geographic asset allocation have been dispersed but there is some evidence to suggest that there is an unprecedented linkage of asset classes, which could result in a cascade effect in the event of a crisis.

“While investors used to be able to achieve diversification by putting their money into different investments such as emerging market economies, hedge funds, small cap stocks, etc., the same correlations may not exist today. This is a big unknown,” she says.

The problem with asset class spill-over is compounded by increasingly complex financial products which require extra scrutiny. Dickson says innovation is generally a good thing, but an increase in product complexity also makes identifying potential risks increasingly difficult. She notes red flags go up when a financial institution explains a type of transaction with a “thick binder” full of tax issues, legal issues and expert opinions, because it points to an investment with a level of difficulty few will comprehend.

There is a flip-side to that.

“If the documentation behind a complex product is slim, you have to ask yourself whether you have all the facts,” Dickson says. “It is not OSFI’s job to tell the institutions how to run their day-to-day business, but we do have role to play when we see risks that we feel are not being adequately addressed.”

Filed by Mark Noble, Advisor.ca, mark.noble@advisor.rogers.com