May 01, 2009
RISK and REWARD NOT NECESSARILY TWO SIDES OF THE COIN
Several Professors teaching risk management invariably used to tell the students that risk and reward are two sides of the coin. Some half-baked theories used to say uncertainty and risk are also two sides of the coin. The events that unfolded after the sub-prime crisis have disproved both of them. Risk arose from unknown quarters. All the mathematicians and statisticians engaged in creating risk technology platforms proved their ignorance of the ways the finance would behave with the theorists. 'Risk is a state of nature while uncertainty is a state of mind.' Indian almanacs and meteorologists predict weather and monsoon. Their prediction in a year was that monsoon would be good on average. The copious rainfall occurred for three months continuously flooding the areas, excessive flows of rivers and rivulets that had to join the sea and the damage to crops occurred irreparably. The next six months there was not a drop of rain and the re-sown crops dried up for want of water. The predictions were right in the averages. But they were useless for the farmer and the economy. Is risk definable and predictable on the basis of past trends? Does theory of probability help the monetarists and market specialists? Can the failures be insured successfully? Can human greed be predicted? Crisis after crisis we keep learning new lessons in answering some of these questions. But the dog's tail can never be straightened. The Obama's rescue package based on some sensible conditions has not brought senses to the Citi when it announced that it would consider paying bonus to its executives notwithstanding the infusion of capital to save itself from collapse. Therefore, it is not capital infusion or its adequacy that is an insurance against the failure of banks. Adequacy of capital, it is proved, is no insurance for the risks that the institutions face. It calls for properly understanding risk, uncertainty and safety.
In 2006 and 2007, the institutions that failed the market were all flush with capital and well above the Basel norm of 8 percent capital adequacy. Capital was the core item of regulation of Basel II which was embraced by entire Europe and Asia. US expressed its reservations on implementation date and applicability to smaller Banks. Adequacy of capital, it is proved, is no insurance for the risks that the institutions face.
Peculiarly enough, when liquidity risk was seen to be the one that would require immediate mitigation at the hands of the regulator and the governments, in India at least, Rs.440,000crores was released through monetary and fiscal stimulus. The risk turned out to be the liquidity surplus. Credit absorption capacity of the markets shrunk and the domestic demand for goods and services depressed, unemployment in the key services sector that contributed a little over 50 percent of the country's GDP surged, bond market yields also lost their shine and Banks were sinking in net margins. (It is a different issue that most banks showed reasonably good profits for the 2008-09 fiscal.) All the firms accessing external commercial borrowings with even enlarged window of opportunity could not access credit from outside as the global credit markets depressed terribly in the wake of recession. The unwinding commenced but with a prospect of visible unwind only by the middle of 2010. The surplus liquidity in Indian Banks came to be parked in the Treasury Bonds inconsiderate of the low yields.
The interest rate risk and market risk are taken to be more welcoming than the credit risk at the moment. It is like the chicken and egg- which comes first? When would the Banks move into risk appetite zone from the risk aversion zone? When would they commence seeing leveraging their resources as the fundamental key to their successful balance sheet exposures instead of parking their surpluses in safe havens?
When would the regulators see capital as secondary to leveraging as a key regulatory platform? When would the financing institutions re-engineer their processes? The G-20 had set up a Financial Stability Board under Basel oversight. If they start looking at Capital will the story of risk henceforth be different?
This calls for understanding risk, uncertainty and safety. The simplest definition of risk is risky. Nevertheless let me mention as I understood. Risk is an event that unpredictably happens despite all precautions. It is no soothsayer's game. To measure it is to gamble. It can be managed only if all the players act as per the rules of the game and do not misbehave or do not become greedy. Who originates the risk? Who bears the risk? In other words, who are the stakeholders? There can be multiple players and each player has a different game plan. Uncertainty generates risk. The rise and fall of markets can be uncertain like the direction of the wind in cyclones or holocausts – we are actually witnessing them now. Other questions that haunt us are: given this understanding of risk and uncertainty, will certain cultural aspects contribute to safety or otherwise of the risk mitigation measures? Japanese conservatism, Germany's loyalty, or Chinese inward-looking attitude or Indian's neo-liberalism are all found to be having a bearing on the market movements. It is time regulators broaden their framework to re-examine most of these aspects and integrate them with the technologies and systems so that systemic risks could be held at bay.
*The author is an economist and Regional Director, PRMIA, Hyderabad Chapter. Can be reached at yerramr@gmail.com
Posted by rajubehara at 04:07 AM
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