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October 19, 2007
Managing Risks in the Age of Turbulence
Emerging economies have entered the age of turbulence. Assets prices are far more volatile, markets are ultra sensitive to news and cross border shocks have started disrupting emerging markets with remarkable regularity.
As traditional risks give way to new risks, let us explore the areas where financial entities should be more alert to address their risks. What are the key issues in this age of volatility?
State in the Scanner
The State and its actions are always of interest to risk managers. in the wake of globalisation and privatisation in India, many obituaries were written about the State as markets started taking over. But, the State has rebounded decisively. In turbulent waters, the State is playing a critical role in guiding the market.It has done a commendable job as far as market regulation and guidance is concerned and in the near future also , State action will continue to impact the market behaviour significantly.
Communication and Risk
What is of particular interest is the growing importance of communication in risk management. The way FM talk on Participatory Notes(PNs) reversed market movements recently is one example of this. Ccommunication and signaling from the State is to be looked at more closely than ever to gauge market movements and anticipate future shocks.
Cross Border Issues
Global integration has increased in the last decade with many emerging economies getting linked in many ways to each other and advanced markets. Volumes in forex markets have grown. Size has become an important explanatory factor for higher returns and stability.
The importance of liquidity has grown manifold as liquidity shocks arise not only from domestic but from beyond the borders. Cross border capital and financial flows have become important for systemic stability. As the recent subprime crisis shows , heightened credit risk leading to liquidity crunches can have huge impact in an interlinked global financial system.
II. Action Points for Financial Entities
In this situation, a financial institution will require robust risk management framework that is enveloped in a prompt corrective action framework set by the regulator. This will limit incentives for excessive risk taking and getting the benefits from usual mispricing in deposit insurance systems.
2. Traditional analysis of risks in emerging econoies should be bolstered with a proper assessment of forex exposures and risks. Many software companies in india got badly hit by not looking into this during early months of 2007 when rupee rose from 46 to a dollar to about Rs 41 to a dollar. In other words, processing forex market information is crucial.
3. Embedding liquidity Risks in traditional risk measurement approach is crucial ( Pillar II of Basel II highlights this)
4. Concentrations should be properly monitored . concentration Risks are going to be a major source of risk. The well known benefits of diversification will be magnified in a globalised world.
5. A review of Stop Loss limits is a must first step for trading desks. There is a need to understand that markets will fluctuate around a trend. For example, in India, the trend is positive and as forecasts indicate ( IMF and others) India will continue to grow at 8.5 or even more. The rigidity in stop loss limits for traders will lead to a lot of distress selling and booking losses. Taking a flexible approach is the need of the hour in trading strategies.
III. Role of Regulation
Regulation is critical to the entire context of risk management. Appropriate regulatory framework enabling prompt corrective measures coupled with legal clarity can go a long way in managing risks in a globalised world
As we are seeing, robust regulation of banks and weak regulatory structure of non-bank entities can lead to shocks in financial system. Non Banks, reinsurers, hedge funds , left in an unregulated space will lead to imbalances in financial systems.
Second, co-ordination of home and host country regulators is important for quick reaction to adverse stress scenarios.
Third, alignment of legal structures internationally is also critical for handling cross border risks.
Posted by sunandoroy at October 19, 2007 05:42 AM
Aptly written article covering conteprory aspects and dimensions. Risk has to be related to the current dynamics and action taken.
Posted by: VK Sudhakar at October 20, 2007 03:21 AM
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