November 24, 2007
Can Booming Emerging Markets Save the World Economy?
Shocking as the heading may seem, this time it comes not from some Saturday afternoon weird dream but from the well respected mag The Economist ( November17th-23rd, 2007). The picture in the cover of the issue reminds you of The Jaws, the movie that kept us at the edge of our seats in the golden days of childhood. It shows the wild beast of finance coming from the depths to gobble up the beautiful economy growing at a rocking 3.9 per cent as of Q3,2007. The Economist ( worth every fil of the three and a half dinars I spent on it) tells us that Q3 is past and with subprime shocks getting crystallised into losses, the American economy is slowing down noticeably. Joblessness, homelessness, coupled with a tightening of credit availability has pushed the consumerist households in a difficult position.
The broader question raised is what concerns us in this part of the world, booming at present thanks to a multitude of factors triggered by economic reforms. What will be the effect if US goes into recession mode and Europe and Japan grow rather slowly. Can the world economic engine go puff-puff pulled by the economic growth of China , India, Middle East and East Asia?
Statistics shows us that emerging markets contribute half the global GDP now, provides assured returns to global investors with stable financial markets and hence seen unprecedented capital inflows through FDI and Portfolio routes. A good guess would be that things look good , the emerging markets can pull it off. But, when joys of risk comes, can the jaws of risk be far behind?
US Recession
Let's look at the US economy. Frankly speaking, the financisl sector was taking too many risks without adequate risk management practices ( read Chris Whalen's blog on Subprime crisis).
Risk taking is not bad, not bad at all.On the contrary, taking no risk is actually the greatest risk of all! Risk is what makes our life worth living, giving rich rewards and vluable exposure.
But it will be terribly wrong to underestimate the frightening jaws of risk even as you bask in its ecstacy. A personal account to explain the point. Few years back, I was doing research on financial modeling for emerging markets at UC-Irvine. Even though the beauty of Irvine and Orange County is something to cherish, I decided to see the whole of US. The prime objective was to learn the actual risk management practices used by financial experts. So I was travelling across the US on AMTRAK on a shoestring budget. As I met professional in all parts of the country ( while at the same time absorbing the country's grandeur an diversity) , I wondered how such simple systems of risk management sustains such a complex financial architecture. Simple models, with simpler assumptions, seemed to be delivered the results. While the going was good, there was no problem. Then the Black swan struck. Rest is history, or history in the making.
Emerging Market Perspective
While we are in safer waters, at least for the time being, in order to avoid financial instability and disruptions to growth, the fllowing key areas needs to be strengthened:
1. Central Banks are very crucial in this context. They must develop Early warning systems so that they put in place prompt corrective framework.
2. Financial entities must take Basel II or other relevant best practices in Risk Management seriously to avoid embarrasing shocks towards their financial. They should strive to implement solid systems and not wait for the regulators to push them towards best practices in risk.
3. Supervisors will face resource constrain while overseeing the implementation of Basel II or other best practices., Enhancing the quality of supervision is likely to emerge as a key issue, especially as financial systems implement Pillar I and move to Pillar Ii issues that are much more compex and less definitive. It is best to have an online surveillace system ( as part of off-site supervision) to improve on reaction time. No point waking up from slumber, once the damage has been done.
4. There is a need to introduce collaborative approaches to meet the above goals. The private and the public sector should work together and there should be cross-border collaborations to boost risk management systems.
Many a times, the advanced economies bailed out emerging markets from crisis. If good risk management systems are in place and growth is insulated from adverse financial shocks, emerging markets will pull the world economoy along a pretty decent growth path.
The time to return the favour has come.
Sunandoroy@gmail.com
Posted by sunandoroy at 08:16 AM
| Comments (3)
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 10:13 AM
| Comments (3)
November 13, 2007
My Frustrations with Stress Testing
This blog is concerned with my general dissatisfaction with Stress Testing. While enormous theoretical and empirical work of diverse qualities have been done in many spheres of risk modelling and quantification, Stress testing happily lives in a world which is pathetically slow in which one variable moves at a time. This is surely not our world, a world in which subprime losses get transmitted to all corners of the globe even before the most bragged about sophisticated risk management systems wake up from slumber. Whom are we fooling? In a world of cointegrated movements in macro variables and risk factors, the standalone stress testing models are bound to be deficient. The defensive response citing absence of good alternatives may seem reasonable to those who live in the present but such line of argument badly fails to satisfy those who dream of a better tomorrow.
There is no doubt we need good techniques for multivariate stress testing in a situation where credit risks and market risks are intertwined. We essentially need a good VaR estimate (my experience tells me this is not as easy as it may seem), coupled with a good model where risk factors can be efficiently shocked to predict future scenarios. Probing into financial econometrics, I have a feeling that the technique of Vector Autoregression holds promise. The technique of VAR ( not VaR) has several useful characteristics- the vector of variables move together ( thats real),and you have a fairly advanced technique of providing shocks( of your chosen intensity) with scientific choice of lag lengths that leads you to attractive impulse response functions. Used in inflation predictions, it has outperformed structural models routinely. It has been useful in judging the interrelations between segments of financial markets. Time to put this to good use in risk management and stress testing? I am trying out models using the following course of action a)Calculate VaR for various instruments in your portfolio b) conduct risk aggregation, if you wish to c) put possible variables that can shock the VaR values (do not put too many variables as things may go out of hand) d) instead of conducting standalone stress test, map the impulse response paths- those curves can throw much light on the shape of the things to come. Thats the broad idea.
( to my pleasant surprise, I find a presentation of Stress Testing from Monica Mars uploaded from Greece ! )
Posted by sunandoroy at 11:25 PM
| Comments (2)
