Risk Management, PRMIA

Risk Management in Emerging Markets

My weblog will focus on risk management and modeling in emerging markets

November 05, 2008

Contagion in the Interbank Market : Can we contain it?

The recent financial turmoil has highlighted the deep rooted problems in the globally integrated interbank market. The recent loss of trust in the interbank market has contributed to bank collapses, huge erosion in market capitalisation and panic among investors. As we slowly and steadily restore a semblence of normalcy, it may be appropriate to take a close look at the crisis of confidence in the interbank sector and the possibilities of containing contagion triggered by this crucial segment of the global financial market.While the research below traverses the period prior to the global financial turmoil, it provides key insights to the contagion routes and possibility of restricting the cascade effect in an integrated financial landscape.

Continue reading "Contagion in the Interbank Market : Can we contain it?"

Posted by Sunando Roy at 12:43 PM | Comments (0)

October 23, 2008

Turmoil in the US Pension Funds Sector

Two disturbing news reached us today. Two major players in the Pension Funds Sector have lost ( notionally, as of yet) billions of US dollars as a result of the current financial turmoil.

First came the news that the Pension Benefit Guarantee Corp (PBGC )lost $3.1 billion in stock investments in its trust fund in the 11 months ended Aug. 31, House Education and Labor Committee Chairman George Miller announced today.Mr. Miller, D-Calif., announced the loss at a hearing in San Francisco, according to the committee’s website. He also said the Pension Benefit Guaranty Corp. invested a significant portion of its funds in mortgage-backed securities, according to the release.

The other news involved the California Pension fund with an investment portfolio of USD 233.4 billion has approximately lost 20 per cent of its investment value.

Continue reading "Turmoil in the US Pension Funds Sector"

Posted by Sunando Roy at 02:26 PM | Comments (0)

September 18, 2008

Uncertainties about Credit Portfolio Models

There is a huge loss of confidence in the financial marketplace. Who would otherwise think that despite the massive US $ 85 billion bailout of AIG by the FED, the markets will continue to slide. The intervention is real, not talking the market up. The faith in the market is completely destroyed, at least for the time being, and the faith is the central bank has dented. The impact of US $ 180 billion is yet to be seen and one hopes that the Central Banks together can overpower this crisis of monster proportion. ( Hooray, the Dow is in the green as I write, so it may be that we still believe our central banks)

One silent casualty has been the Credit portfolio Model that churned out default probabilities and expected loss numbers. Quite clearly, the present group of credit portfolio models will be reassessed and one is hopeful that the soul searching will lead to better modeling in future in arriving at the economic capital.

Once we come out of the current state of the market, and start thinking about the nightmare with some poise ( hopefully, sooner than later)Models that depend upon PD, LGD, EAD and Default correlations will undergo a post mortem. Let's think of a few issues that may come up with credit portfolio modeling.

Continue reading "Uncertainties about Credit Portfolio Models"

Posted by Sunando Roy at 05:26 PM | Comments (3)

September 16, 2008

Risk Management and Economic Development

Continue reading "Risk Management and Economic Development"

Posted by Sunando Roy at 02:53 AM | Comments (1)

The Forgotten Tail of Risk Management: lessons from the financial turmoil of 2007-?

it is evident that Risk Management will no longer be the same once the financial markets risk above the debris of the credit crisis of 2007- ?. It also appears that risk regulation will also undergo a major change if not a complete overhaul. the press conference statement by Paulson a few hours ago reflecting weaknesses in regulation reaffirmed the understanding that lot of soul searching is going on in the regulatory community.In this turbulent time, we are faced with many questions. Why were so many brilliant guys sleeping when the problem was piling up day by day? Why did tons of statistics churned out by agencies, literally on a tick-by-tick basis, failed to capture the early warning signals? Or is it that the sane voices got submerged in what Greenspan termed " creative destruction brought about by financial innovation"?

Continue reading "The Forgotten Tail of Risk Management: lessons from the financial turmoil of 2007-?"

Posted by Sunando Roy at 01:09 AM | Comments (6)

September 05, 2008

Rocky Road to Economic Capital Modeling

Economic capital modeling in financial organisations is aimed at determining the capital requirement for its risk taking activities. With the Banks adopting Basel II standards in emnerging markets, many of them are struggling with quantification of capital to be required under the Internal Capital Adequacy Assessment Process ( ICAAP). With the adoption of ICAAP, economic capital model has gained in complexity. The popular building block approach that adds capital allocated for all significant risks has been supplemented by estimations of business line capital requirement and even disaggregations leasding to calculation of exposure wise capital requirement. In other words, in banks with better economic capital models one can actually look at capital requirements at a granular level.

Continue reading "Rocky Road to Economic Capital Modeling"

Posted by Sunando Roy at 06:30 AM | Comments (0)

August 22, 2008

Beneficial dialogue : Supervisory Risk Review Process in the Banking Sector :

The banking sector performs a crucial intermediation in the economy – it mobilises funds from those who have funds without avenues to utilise them to those who want to use it for business but do not have them. This is the basic process of banking, which gets manifested in diverse forms of deposit attracting and disbursal activities. In this process, banks acquire expertise on various types of business financing and start several advisory and underwriting services.

As they allocate such funds, banks take a variety of risks — while giving loans there is a lurking fear that the beneficiary will not return the money (credit risk ); while investing in assets such as stocks and bonds, there is a probability that the asset prices will crash (market risk), there is a risk that the exchange rates of currencies will change (currency risk) or there can be a sudden demand from the depositors to withdraw money leading to a cash crunch( liquidity risk). Other key risks that the bank faces are from faulty operational processes (operational risk), from damages to its reputation (reputation risk) and from wrong strategic thrust (strategic risk).

The global financial turmoil of 2007 that originated from the sub-prime crisis in the United States is a stark reminder to every financial institution that no matter how strong their systems are and no matter how convincing their business strategy, they are not immune to adverse shocks. The unfolding financial turmoil has thus prompted financial institutions to reconsider policies, business models and risk management practices.

When the going is good, risk management is seen as a burden on business expansion in an organisation. 'Why fix, if something is not broken' seems to be a common argument. There are other reasons for putting aside risk management issues as the business chugs along. Setting up a risk management framework and monitoring risks on a daily basis implies costs in terms of physical and human infrastructure. The management and monitoring of risks require specialised technical skills. Thus, the sector needs the rude shock of the reality of billions of dollars of net worth getting eroded by financial shocks such as the financial turmoil of 2007 to revisit the archaic risk management systems.

It therefore hardly comes as a surprise to see the growing consciousness about risks in banks as well as among regulators worldwide. As a matter of fact, one observes that the obsession with profits gets tempered by a combined assessment of risks and returns in the banking sector. Unbridled business growth is contained and a more prudent business model becomes the preferred choice.

There is thus a resurgence of interest in risk management systems and practices across the world, cutting across financial and non-financial enterprises. In the banking sector, the risk management systems are guided by the prescriptions of Basel II accord, the global benchmark for risk management practices for the banking sector.

While Basel II sets the minimum standards for risk management for internationally-active banks, it gives national regulators (the central banks) the discretion to tweak the rules to suit country specificities. As is evident from the implementation of Basel II accord globally, regulators have also applied such standards for local banks, with a view to enhance the robustness of the financial systems.

Pillars

The three pillars of Basel II, aimed at measuring the capital adequacy of banks ( Pillar 1), managing enterprise-wide risks ( Pillar 2) and disclosing appropriate risk-related information ( Pillar3), are accepted as industry benchmarks of best practices for the banking sector.

In a survey conducted by the Professional Risk Managers' International Association (PRMIA), it was observed that 86 per cent of finance professionals felt that the application of Basel II norms promoted better risk management, of which 74 per cent of respondents believed that Basel II implementation will make the banking system more stable and less prone to shocks.

Briefly, the three pillars of Basel II are being implemented right under the nose of the supervisor, the central banks or the financial services authorities of different countries. In Pillar I, the bank assesses and measures its minimum capital requirements, for credit, market and operational risks. In Pillar II, active capital management by bank and regulatory review of bank's risk profile ensures that banks have systems, processes and funds to manage its risks. In Pillar III, the bank discloses risk information to the market, which in turn rewards sound risk management or penalises banks with weak risk monitoring framework.

Basel II is an improvement over the earlier Basel I accord of 1988, where only Pillar I existed. Basel II adds two more pillars and also refines Pillar I considerably (chart 1).

As supervisors of the financial system, the central banks are interested in maintaining the stability of the financial system to ensure that the economy moves on a steady growth path. As adverse financial conditions are detrimental to economic progress, risk management systems are seen as crucial preventive mechanism.

To ensure financial stability, therefore, the banking supervisor makes an active entry into the risk management scene in the Pillar II Supervisory Review Process (SREP).

The objective is to ensure the robustness of the risk management framework, comprehensive coverage of all the material risks faced by the bank and adequacy of the supporting functions with respect to the size, nature and complexity of the operations of the bank.

SREP aims to enhance the link between an institution's risk profile and its capital. It is essentially based on a dialogue between the supervisor and individual banks, with the intention of ensuring that the institutions have sufficient capital to support all its risks. The dialogue, as the Committee of European Banking Supervisors (CEBS) has noted, '...should embrace all aspects of business risk and control risk, including risk management systems, internal control systems and internal governance'.

The Financial Services Authority in the UK observed, "Our dialogue (in Pillar 2) will be of sufficient depth for us to come to a view on the appropriateness of risk management practices and capital adequacy of each firm in a group." The Australian Prudential Regulations Authority explained that, while conducting the risk assessment exercise, it 'will draw upon all the relevant information sources and analytical tools at their disposal'. The assessment process will include analysis of 'the inherent risks facing the institution, the effectiveness of management and controls and the extent of capital support to meet the unexpected losses'.

The process of risk assessment therefore encompasses all the material risks faced by the bank. In such an assessment materiality and proportionality of risks play key roles. While assessing the risk profiles of the banks, the supervisor asks two questions: (i) how material are the risks faced by the bank; (ii) how important is the bank to the overall financial system?

The depth of the supervisory risk assessment is greater for banks that are inherently riskier and also for banks important in the systemic context.

Finally, the Supervisory Review Process interfaces itself with the internal capital calculation of banks to cover all its material risks (ICAAP). In ICAAP the banks come out with their own assessment of the material risks faced by them. Being the bank's assessment of their own enterprise wide risk, the ICAAP is therefore thoroughly assessed by the supervisor in their risk assessment of banks, involving a detailed flowchart
of functions.

The International Monetary Fund in its latest (July 2008) assessment of world output growth has pointed at Asia and the Middle East as economies where robust growth is expected in the few years to come. As the economy grows, there will be more demand for investments in economic sectors, housing development and greater consumption. Banks will have to do more business in meeting the demands from both investors and consumers. Hectic activity in the banking sector in the Middle East is thus likely in the near future.

SREP has already been initiated in Gulf economies. In Bahrain, the supervisor, the Central Bank of Bahrain, is pro-actively looking at the risks faced by the banking sector in Bahrain. While the ultimate outcome of the process is still not known, this has put banks in Bahrain in an 'alert' mode, in terms of revisiting their risk management models and aligning their framework to the best practices.

The Supervisory Review Process has not only set the ground rules for risk management processes in banks, but initiation of such a dialogue is definitely bringing banks closer to the much-needed enterprise-wide risk management practices, where all risks are discussed not in isolation, but under a single structure.

While the process enables the banks to understand their risks better, it empowers the central banks in their management of financial system, thereby improving financial stability. A robust risk management framework at the bank level, a proactive regulator with necessary information on risks to the banking sector and greater awareness among the masses through improved disclosures — the supervisory assessment of the risks in banks is likely to craft a win-win situation in the financial sector.

-- Recently published in Gulf News Banking Quarterly ( Q3)and targeted at non-risk professionals who are working or interested in the financial sector.

Posted by Sunando Roy at 09:59 AM

May 23, 2008

The Trillion Dollar Meltdown and the Three Trillion Dollar War: Linking Fiscal Policy and Risk Management

Recently, I came across two books. The first one was an obvious choice,The Trillion Dollar Meltdown- Easy Money, High Rollers and the Great Credit Crash by Charles R Morris dealing with the Subprime crisis. The scond book "the Three Trillion Dollar war: by Stiglitz and Blimes discussing the true cost of the Iraq war. Reading both in sequence sets me thinking about the linkages of fiscal policy, macroeconomic management and risk management.

It appears that the contents of the two are linked to each other, like perfect fits in a jigsaw puzzle. The messege that comes across in the book is something like this-

State, even with all the hype about market capitalism, is a big ticket spender in the economy. Its fiscal policy results in the rise in consumption, savings and credit worthiness of millions. If state spending is distributed well, the credit worthiness of many in the economy go up and they are able to service their accumulated debt in a better manner. In a society already stooped in debt, the impact is even higher. If on the other hand, the spending, trillions of dollars in this case , are diverted to replacing military machinery and similar stuff, distributional impact of fiscal policy is uneven. The fiscal policy then creates the unwanted impact, decline in savings of population and consequent erosion of creditworthiness, something which the average credit/gdp ratio will definitely hide. Thereby, fiscal policy create conditions for a financial crisis, which banks and financial institutions , in their zest for greater market share, may lose sight of. Financial crisis, can, thus be seen as a fallout of lack of distributive justice in fiscal policy.

Posted by Sunando Roy at 09:20 AM | Comments (3)

April 18, 2008

Growth of Private Equity in the Gulf region

The rise of Islamic Banking, sharp rise in oil income, increased private sector financing of industrial and service sector development, real estate boom has led to the model of private equity investment in the gulf region, a model that seems well poised for a big leap. The private equity model diverges from conventional debt financing model, but has the same result of leveraging the business. Thus, it is the convenient route for islamic finance , that cannot adopt interest baring securities to ensure compliance to the Shariah. By being imperfectly correlated with other asset classes such as equity, this enables diversification of overall portfolio risks in the Banks.

Continue reading "Growth of Private Equity in the Gulf region"

Posted by Sunando Roy at 10:58 AM | Comments (0)

April 05, 2008

The Power of Central Bank Communications

In Chris Whalen's interesting blog ( April 4,2008) on the Subprime crisishttp://www.prmia.org/Weblogs/Regulation/ChristopherWhalen2/)
, a few lines are particularly interesting :

"As BSC was being shut out of the interdealer market, LEH was also being shunned by other dealers and attacked by the hedge fund hordes in the same fashion as BSC. Several veteran traders in the CDS market say that LEH was essentially in danger of failing as well.

One hedge fund veteran, who was and is short LEH, complains to The IRA that LEH was essentially dead in the water on Monday, March 17, but the Fed intervened. When the markets opened after the Easter holiday, clients and other dealers were backing away from LEH and the shorts were swarming in for the kill, he claims. This apparently explains the unusually long conference call with investors by LEH CFO Erin Callan, who has only held that position since September.

Indeed, the only reason that LEH did not fail as well, claims this well-connected trader, was a conference call on that Monday with the top ten dealers organized by the Fed of New York. During that call, the Fed of New York reportedly told the other dealers that it would lend LEH "whatever is necessary" to keep that leading mortgage-backed security underwriter and CDS house afloat. That open-ended promise, not the Fed's new lending facility, reportedly saved LEH from collapse - for now."

This open ended promise, is nothing but an increasingly powerful instrument in the hands of Central Banks, its signaling policy. A credible central bank, through the use of the media, can effectively and quickly transmit signals in the market.This obvious and very promising tool , which can be used (and abused), is not adequately researched in the context of financial regulation. The academic research, however, dates back a few decades. Jurgen Habermas' critical theory of law is essentially based on the argument that communication channels can be used to reform law and it need not always be driven by official dictat, as Max Weber had earlier suggested. In one of his later accounts of this power of communication, Habermas wrote about the "liberating power of symbols", where communication creates symbols that travels through media, changes public mind and as a result , transforms policy.

Continue reading "The Power of Central Bank Communications"

Posted by Sunando Roy at 05:24 AM | Comments (0)

April 04, 2008

The rise of Sukuks

The global market for Sukuk has exploded since 2006, generating a huge international interest in the product and its risk and return profiles. The Islamic financial market is over USD 500 billion and growing at a rapid pace of about 15 per cent globally. From a small base in 2005, Sukuks have recordrd triple digit growth in many countries, with Malaysia, UAE and Bahrain emerging as key players in the Sukuk market.

Continue reading "The rise of Sukuks"

Posted by Sunando Roy at 07:45 AM

March 29, 2008

Closer look at Intangibles need of the hour

In recent times, regulatory talk on productivity of organisations have zeroed in on one significant development of the "new economy" - the steady rise to prominance of intangible assets- assets that can not be seen physically or difficult to map on the balance sheet, but whose impact is felt in the performance of the organisation. Bernanke talks about its rise to prominance in the US ( Remarks by Mr Ben S Bernanke, Chairman of the Board of Governors of the US Federal Reserve System, before Leadership South Carolina, Greenville, South Carolina, 31 August 2006.) ; Svante Oberg, Deputy Governor of the Sveriges Riksbank, highlights the role of intangibles at a meeting arranged by Danske Bank, Stockholm, 29 January 2008; and Deutschebank comes up with a detailed analysis on intangibles " Value Intangibles" ( Deutsche Bank Research 7,October 19, 2005).

As a matter of fact, financial accounting standards have improved significantly over the last decade or so and sort of converged on the view that intangible assets are as important as tangible assets. Any intangible asset that is associated with contractual or legal rights, such as a trademark, patent or copyright, must be recognized as value enhancing assets for the organisations.

The treatment of intangible assets however vary from a capital adequacy perspective in so far they have to be deducted from Tier 1 capital when it comes to calculating the capital adequacy number. Expressing the overarching view that intangible assets should be deducted from Core capital for capital adequacy purposes as one is not sure how much of such assets can be effectively utilised to pay back depositors for a bank in distress, it explicitly leaves the issue for national discretion due to divergences in regional accounting standards and divergent role of intangibles in advanced and emerging economies.

Thus, in the treatment of Intangible Assets for Capital Adequacy, regulators are left with two choices, a) to treat them as part of core capital or b) as part of other assets with appropriate risk weighting. While one would guess that in modern knowledge driven economies such intangible assets such as human capital will be treated as part of the capital base, surprisingly, Basel II has been static in this respect. And while a difference in the recognition of intangible assets can have enormous implications for the capital adequacy ratios, not significant attention has been paid by Basel II on this issue and the broad outline of the basel I guideline still previls.

Continue reading "Closer look at Intangibles need of the hour"

Posted by Sunando Roy at 11:07 PM | Comments (0)

March 28, 2008

ICAAP Forecasting- The First Critical Step for Business Planning

More and more banking regulators are coming up with their own versions of the high level Pillar 2 guidance provided under Basel 2. APRA came up with their guidance to ADIs in end 2007, Central Bank of Bahrain issued their Pillar 2 directive in January 2008 and the Reserve Bank of India has come up with their Supervisory review process circular yeaterday. Now we have Pillar 2 guidelinesfrom different part of the world and not just Europe, the leaders of the pack.

The overarching philosophy in all these documents is the same - an effort to bridge the gap between regulatory and economic capital through a comprehensive assessment of all material risks facing the organisation and planning the capital as a cushion against unexpected risks.

As you would expect, the work on ICAAP starts early on, alongwith the preparation of the business plan at the beginning of the year. It is important for any bank to have a fully integrated capitl forecast for the financial year that on one hand looks into capital availability based on expected growth of business, profits and dividends and projection of capital requirements for the firm based on the quantification of risks on the other hand . If capital requirement is onot in sync with the capital availability, the organisation may face trouble in the capital management process.

Preparing an ICAAP forecast therefore is a forward loking process starting early on in the entire ICAAP initiative. It may not be as full blown an initiative as the ICAAP document in itself, but a first cut esimate based on several assumptions about businesss profile and estimated growth, emerging macro and micro risks, broad trends in each risks, some assumptions about their correlation structure .

An ICAAP forecast should be an information in the hands of the Board while preparing the business plan while the ICAAP will be a document which will base itself on the business plan of the firm. The two documents are complementary to each other, fulfils different objectives, differ in their degree of details and assumptions. While there is a fair degree of clarity o how an ICAAP document should be arrived at, there is a lack of clarity on ICAAP forecasting as a first step for business planning. As Banks soli their hands in ICAAP preparation, and regulators enter the field for the supervisory review, the issue of forecasting the ICAAP will inevitably come to the fore.

Posted by Sunando Roy at 08:31 AM

February 29, 2008

Pillar 2 : The road less travelled

The supervisors have stepped in as a key actor in the Basel 2 drama that is unfolding in front of the financial community. The second act of the Basel 2 drama has thus just about commenced in the emerging world.
The much-neglected second pillar of the Basel 2 framework is getting greater attention in emerging markets. Regulators have become active by issuing guidelines on Pillar 2. Large banks, which were planning to put resources on advanced approaches in credit, market and operational risk ahead of pillar 2 are now paying attention to the formulation of bankwide capital assessment, stress testing and dealing with other risks such as reputational, strategic, liquidity and interest rate risk in the banking book.

Regulatory guidelines are , always, strong signals to the financial market. Guidelines put financial entities in alert mode. Guidelines with action plans and deadlines puts the markets into active mode. Pillar 2 guidelines are guidelines with some action plan as it promts the supervisor to step in and decide whether banks' calculation of economic capital is in line with its risk appetite , with the proviso that any misalignment between the two may call for supervisory action.

Continue reading "Pillar 2 : The road less travelled"

Posted by Sunando Roy at 09:01 AM | Comments (0)

February 23, 2008

New Directions in Liquidity Risk Management

The market turmoil of 2007 has once again highlighted the crucial importance of market liquidity to the banking sector.What started as weakness in the sub prime markets ( residential mortgage backed securities which were then mopped up by managers of CDOs and asset backed securities)led to Investor's loss of faith arising out of growing arrears in such structured products. This led to tightening of liquidity as banks wanted more liquidity to meet their obligations and a similar necessity for greater liquidity was also seen among asset managers to guard against increased redemption risks. It is now recognised that liquidity risk management is not as easy as earlier and financial institutions need to devise strategies to tackle liquidity shocks such as the one emanating from US sub-prime market.
In other words, the assuring assertions by the best of banks about their management of liquidity has been put to stern tests. The contraction of liquidity in certain structured product and interbank markets, as well as an increased probability of off-balance sheet commitments coming onto banks’ balance sheets, led to severe funding liquidity strains for some banks and central bank intervention in some cases.

Continue reading "New Directions in Liquidity Risk Management"

Posted by Sunando Roy at 04:00 AM | Comments (1)

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Recent Entries

• Contagion in the Interbank Market : Can we contain it?
• Turmoil in the US Pension Funds Sector
• Uncertainties about Credit Portfolio Models
• Risk Management and Economic Development
• The Forgotten Tail of Risk Management: lessons from the financial turmoil of 2007-?
• Rocky Road to Economic Capital Modeling
• Beneficial dialogue : Supervisory Risk Review Process in the Banking Sector :
• The Trillion Dollar Meltdown and the Three Trillion Dollar War: Linking Fiscal Policy and Risk Management
• Growth of Private Equity in the Gulf region
• The Power of Central Bank Communications

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