Risk Management in Emerging Markets

Strengthening Islamic Banking : Takeaways from WIBC,2009

sunandoroy — 2009-12-08T15:16:45+00:00

Strengthening Islamic Banking : Takeaways from World islamic Banking Conference, Bahrain
A few suggestions at the WIBC 2009 to strengthen Islamic Banking

Banks should
1. Understand risks better
2. Avoid mimicking
3. Look for technical expertise- address lack of key Human resource skillset
4. Financial Stability should be considered in Monetary policy
5. Accounting Standards must improve
6. interbank market needs to be strengthened
7. Central Counterparty, better clearing system
8. Understanding implicit and explicit government protection
9.Liquidity Management
10. Need to focus on SMEs/ Social Development, reconsider investment banking model
11. Flexibility in Sharia Interpretation
12.More Sharia scholars

Here is the link to access the presentations at the World Islamic Banking Conference, 2009 ( Dec 6-8) , Bahrain

http://www.megaevents.net/islamic_banking

Dubai : What Next?

sunandoroy — 2009-11-30T09:53:09+00:00

So, its there for all to see - free fall of Dubai and Abu Dhabi index, investor sentiment turning adverse reflected in higher risk premium and the prospect that Dubai may face a major jolt in its aspirations to become a global financial hub. Real estate prices are predicted to fall by 20-30 per cent more. To add to all this, the region as a whole may face a setback just when it was coming out of an inactive first half of 2009. And all of this for a potential debt default which the Central Bank of UAE has vowed to defend in a belated yet notable communication. Why all ths , if the debt can be defended, if other Emirates are willing to come with rescue packages. Wasn't this crisis unavoidable?

The Dubai Deb(t)acle and the High Cost of Poor Reputational Risk Management

sunandoroy — 2009-11-29T10:49:33+00:00

"It takes many good deeds to build a good reputation, and only one bad one to lose it" – Benjamin Franklin once observed. The recent Dubai debt crisis has pointed towards poor reputational risk management. One can understand the need for debt restructuring in the face of a huge liquidity problem, as has happened in the 1980s and 1990s in many emerging markets, leading to IMF led salvage operations. Dubai, clearly, is not in that league. Its funding opportunities had not dried out , it had the support of the other Emirates and seemed solvent to global lenders. Though jolted by the real estate crisis, the Dubai model seemed robust enough to withstand the financial tsunami and making a comeback in due course. The surprise decision therefore reflected poor judgement. And, more importantly, poor reputational risk management.

The Crucial Issue of Board Level Compensation- Emerging Regulatory Framework

sunandoroy — 2009-11-22T14:36:56+00:00

Things are changing fast in an area traditionally shrouded in confidentiality. The issue has raise its head in the afternmath of the financial crisis. As directors give direction to the company's growth trajectory, along with senior management, they play a critical role in the future performance of a company. And they are paid heftily for such action. some such ambitious actions have landed many banks and FIs in trouble in recent times. Therefore, the financial crisis of has brought to the fore a number of policies governing director and executive remuneration.

Some Issues in Board Level Remuneration

Need for Remuneration Policy

Whilst the form, structure and level of directors' remuneration continue to be matters primarily falling within the competence of companies, their shareholders and, where applicable, employee representatives, the Commission considers that there is a need for additional principles regarding the structure of directors’ remuneration, as set out in a company’s remuneration policy and the process of determining remuneration and control on that process.

o The Structure of Director's Remuneration

The structure of directors´ remuneration should promote the long term sustainability of the company and ensure that remuneration is based on performance. Variable components of remuneration should therefore be linked to predetermined and measurable performance criteria, including criteria of a non-financial nature. Limits should be set on the variable components of remuneration. Significant variable components of remuneration should be deferred for a certain period, for example three to five years, subject to performance conditions. Further, companies should be able to reclaim variable components of remuneration that were paid on the basis of data,which proved to be manifestly misstated.
o
Termination Payments under Scanner now

It is necessary to ensure that termination payments, so-called ´golden parachutes´, are not a reward for failure and that the primary purpose of termination payments as a
safety net in case of early termination of the contract is respected. To that purpose, termination payments should be limited to a certain amount or duration beforehand, which, in general, should not be more than two years annual remuneration (on the basis of only the non- variable component of the annual remuneration) and not be paid if the termination is due to inadequate performance or if a director leaves on his own account. This does not preclude termination payments in situations of early termination of the contract, due to changes in the strategy of the company or in merger and/or takeover situations.
o
Remuneration in Shares

Schemes under which directors are remunerated in shares, share options or any other right to acquire shares or be remunerated on the basis of share price movements should be better linked to performance and long term value creation of the company. Therefore, an appropriate vesting period should apply to shares, whereby vesting is made subject to performance conditions. Share options and rights to acquire shares or be remunerated on the basis of share price movements should be not be exercisable during an appropriate period and the right to exercise them should be made subject to performance conditions. In order to further prevent conflicts of interest of directors who hold shares in the company, these directors should be obliged to retain a part of their shares until the end of their mandate.
o
Towards Greater Transperancy

In order to facilitate the shareholders' assessment of the company's approach to remuneration and strengthen the company's accountability towards its shareholders, the remuneration statement should be clear and easily understandable. Moreover, further disclosure of information relating to the structure of remuneration is necessary. In order to increase accountability, shareholders should be encouraged to attend general meetings and make considered use of their voting rights. In particular, institutional shareholders should take a leading role in the context of ensuring increased accountability of boards with regard to remuneration issues.
o
Role Of Remuneration Committee

Remuneration committees, as referred to in Recommendation 2005/162/EC, fulfil an important role in designing a company's remuneration policy, preventing conflicts of interests and supervising the (managing) boards behaviour in the context of remuneration. To strengthen the role of those committees, at least one member thereof should have expertise in the field of remuneration.
o
Exercise Caution in Hiring Remuneration Consultants

Remuneration consultants may have conflicting interests, for instance when they advise the remuneration committee on remuneration practices and arrangements, and at the same time advise the company or the executive or managing director(s). It is appropriate for remuneration committees to exercise caution when hiring remuneration
consultants.

Imagining Basel III : An Agenda for the Future

sunandoroy — 2009-10-16T17:29:34+00:00

In a recent conference,an interesting question was hurled at me- How will Basel III look like? And is there a need for Basel III?

My response was somewhat like this:

Basel Approach has its uses, though time has come for a major enhancement

I said that in the past, particularly after September 2008, lot of my friends have sent it to the dustbin of history. There is a strong feeling that Basel II should be thrown out of the window. However, I made it clear that i do not subscribe to such a view.

The Swine Flu debate in Bahrain

sunandoroy — 2009-10-03T15:39:09+00:00

The Kingdom of Bahrain is actively debating the Government decision to extend the summer holidays in the schools here to prevent an outbreak of swine flu. In media and social circles, the Government's decision is being actively debated. While the Government stands firm on its decision to keep schools shut till Oct 11 and then reopen in a phased manner with the KG segment resuming early November, many parents feel that the decision is more driven by panic and the education of children suffer unnecessarily by this precautionary and preventive action by the Government.

Among the not so small sample of parents encountered by me, majority appears to be against the Government move in no uncertain manner. And I find myself in the minority ( at least in the sample) group that supports the decision. My support comes from my tracking of the spread and intensity of the pandemic from its early days and my belief in the role of good risk management in optimising risk and return.

Let me pen down my views on the issue based on statistical evidence.

1. Fear of the unknown

My first concern with the disease is that we do not know creature. In the present forms of its mutation, the virus is resistant to many drugs. with almost 3,42,000 cases and 4000 deaths,this puts the reported death rate over 1 per cent. This means that 1 out of 100 cases will die of swine flu. This is not due to operational failures, this is because of our lack of knowledge of the disease itself. When complications occur, doctors know little about the course of action.
You are encountering an unknown threat, better be cautious than sorry.

2. Reported Age Profile of cases

Clear statistics is not availble, but there are some indicative trends. In the US, out of 137,000 cases, more than 50 per cent were in the age group of 0-15. kids, it is now more or less accepted , are more prone to risk than adults. Sample statistics of US and Uk puts the death rate for kids in the range of 1.9-3.8 per cent, mostly in the schoolgoing age of 5-15 years. This statistics means that kids are about 3-4 times in danger than the adult population. Utmost care for kids is thus the bottomline.

3. The Death Rate of Swine Flu has not abated

The latest stats from WHO ( Oct 2 update no 68) shows that the death rate from H1N1 virus has actually increased from 0.42 in June 2009 to 0.76 in September 2009. The rise is a matter of concern, even when the media coverage has come down considerably. This means that the disease has become deadlier in the recent past , reversing the earlier trend. This is not good news.

4. WHO guidance on School Closure as prevention

Please read the WHO guidance carefully. It says that it is much more effective to close schools before a substantive outbreak. After the outbreak, a school closure is of limited value. Bahrain Government's action finds support from the following WHO guideline:

Stress Tests, Business Strategy and Capital Allocation

sunandoroy — 2009-05-08T07:05:20+00:00

In 1994, JP Mogan started an effort to come up with a single risk number which can summarise the risk of loss in the huge portfolio of the bank spead across sectors and regions around the world. The methodology, made available over the net in late 1994 gave birth to a very important risk measure- the VaR ( Value at Risk). The risk measure was embraced by the world in no time and by 1996, the Basel Committee had issued its market risk capital calculation paper recommending VaR as a possible internal models approach.

Pretty soon, it became clear that VaR can measure the maximum potential loss under normal conditions. If markets turn adverse, VaR can't predict the loss. The risk manager needed an extra tool to handle such stressed market scenario. The Stress tests were then introduced to handle what VaR could not, the worst case scenario, something like the one we saw last September- October.

Contagion in the Interbank Market : Can we contain it?

sunandoroy — 2008-11-05T12:43:46+00:00

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.

Turmoil in the US Pension Funds Sector

sunandoroy — 2008-10-23T14:26:11+00:00

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.

Uncertainties about Credit Portfolio Models

sunandoroy — 2008-09-18T17:26:43+00:00

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.

Risk Management and Economic Development

sunandoroy — 2008-09-16T02:53:03+00:00

Development Economics , when it started evolving with a lot of new nations getting out of their colonial mould post World War II, was all about growth. growth was the be all and end all indicatorof development of a nation. It was defined by GDP , both overall and in per capita terms. This view of development remained deep rooted over several decades, before economists such as Amartya Sen and others started expanding the concept of development, to be adopted by the United Nation in due course. Thus were born the alternative indicators of development, including inequality, quality of life and human development. this happened in the late 1980s and early 1990s. Further challange to the notions of development was provided by Sen in his 1998 classic Development and Freedom and later in his Identity and violence: The Illusions of Destiny. Sen brought forth the new insight that freedom is a critical aspect of progress without which material wealth failed to find any clear meaning.

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

sunandoroy — 2008-09-16T01:09:48+00:00

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"?

Rocky Road to Economic Capital Modeling

sunandoroy — 2008-09-05T06:30:24+00:00

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.

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

sunandoroy — 2008-08-22T09:59:09+00:00

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.

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

sunandoroy — 2008-05-23T09:20:49+00:00

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.