Exchange Ideas

Risk Management in Emerging Markets

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

 

« My Frustrations with Stress Testing | Main | Can Booming Emerging Markets Save the World Economy? »

November 20, 2007

Damages caused by Risk Management Practices

Thanks Beaumont for raising the issue of loss incurred as a result of risk management practices in the blog

http://www.prmia.org/Weblogs/General/BeaumontVance1/2007/11/the_business_da.php

In my experience, very standard RM practices often lead to huge losses to firms. Take the example of Stop Loss Limits. Treauries in Banks use this tool extensively to cut down losses.

Back in the days of onset of the Iraq war, the Indian financial markets were shocked by the news of international financial instability. The debt market ( I was in the team that regulated and supervised the sovereign debt market) was shocked. Primary Dealers(PDs), who had unhedged exposures in the market faced sudden sharp downturn in the mark to market value of their portfolio. Stop Loss limits, duly approved by the Board few months back had to be applied.Distress sale of bonds started, lossed crystallised and the damage to the P&L account was done.
There were few traditional banks still struggling to set up their RM systems. They had no stop loss limits and just sat through the episode.

Within two weeks, global political situation improved and financial markets were back on track.

The Primary Dealers with good RM practices had poor performance at year end and found struggling to get out of the mess created by distress selling triggered by stop loss limits.


The PDs that sat through the whole episode were smiling!

The lessons we learnt

1. There should be adequate in built flexibility in RM processes

2. One should have different approaches depending on the expected time required to overcome the shock.

Many of you, I'm sure, have stories like this to tell.

Posted by sunandoroy at November 20, 2007 10:13 AM

Comments

Thanks Sunando. You have shared a real life scenario in which the naivete has been rewarding. As you have suggested, this underlines some of the inadequacies of the current risk management policies followed.

Posted by: Anujit Mitra at November 21, 2007 05:12 AM


I agree with your postulation but the fact that the stop loss is set does not necessarily mean all position must liquidated immediately. The Asset and Liabilities Committee which the Treasurer is a member must also meet to consider the situation and confirmation of the market situations with projection obtained from PDs before any distrees sales of positions.

Posted by: Victor at November 26, 2007 02:38 PM

The problem with stop loss limit (SLL) is that RM is suckered to set the SL too high so that PDs have the flexibility to sit it out during turbulence hoping this high ceiling will not be breached - BIG MISTAKE!

Posted by: NORMAN at December 4, 2007 05:54 AM

Post a comment




Remember Me?


What can I do with PRMIA online?