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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 May 1, 2009 04:07 AM
Sub-prime Crisis in "US" and Global Meltdown of 2008 is an exception and one time affair; an off-shoot of accumulated mis-governance for over a decade. Similarly, occurrence of Tsunami is unpredictable, risky and devastating.
Only after these events hitting - the policy makers, regulators, rating agencies, academicians et al wake up to shift the blame. RISK is built-in in any economic or business activity; and it can not be avoided but only (may be) minimised.
If permitted, while agreeing to continue to call Risk and Reward as two sides of a coin, I would urge to establish a third dimension for all such extra-ordinary events. If monsoon can not be predicted because it is nature, our Planners and Policy Thinkers wanted to go in for integration of rivers and conservation of water resources; but politics came in their way by shelving Suresh Prabhu Committee. What should we call such an unfortunate development? Fourth side of a Coin?
On one side economy is dwindling, GDP and all other metrics are going down, job losses are taking place; but Politicians are pouring in money in Elections and Film / Sports Celebrities are enjoying IPL matches elsewhere. Loan waivers are liberally announced besides other election promises to poorer sections but farmers continue to suffer losses and resorting to suicides. What is this dichotomy? Where are we heading? Modern India is referred as Emerging Market Economy and vying to be called an Economic Super Power.
May be I am wrong, but let us deliberate for good. I am open for correction to my thinking.
Posted by: Chowdari Prasad at May 2, 2009 05:10 AM
All those unknown quarters (re.sub prime) are linked to reward. Excessive investments into mortgage by prime borrows, purchses by sub primers, banks relaxing its lending norms, govt. creating exotic lending agencies, bundling out and selling risk (CDOs), risk participation. What are the ones that are not linked to reward? I tend to uphold the risk reward concept. I am of the view that it would be better to establish more areguments to prove the subject in question.
Posted by: Nandika Nawagamuwa at May 2, 2009 09:47 AM
On risk and reward the fact remains that under the guise of risk management,new products to satisfy the greed of some experts in the field emerge without worrying about the end result and regulators presence. When the experts introduce new products in the name of transferring risk they literally transfer the risk to ultimate consumers and to the general public. Risk with the institution remains as hidden risk and the introducers of risk get compensated as bonus for taking the institutions to almost bankruptcy and passing on the blame to market risk. The money spent in the name of risk management since its evolution is much more than the results it has achieved. There is a total disconnect between risk management,regulatory prescription,supervisory norms, and managements' commitment on integrity of thought,speech and action.The greatest risk the banking system is facing today is that it has lost its original function of inter mediation between savers and investors and is dragged into the market of greed and uncertainties with the aid of mathematicians whose theories unfortunately have failed to assess the greed and suggest remedies.
Capital adequacy is surely not an insurance for failure as revealed so far. Pure capital with the backing of commitment with all sincerity will be the answer. How to assess the amount of such backing is a major risk?
Posted by: Dr.T.V.Gopalakrishnan at May 2, 2009 06:06 PM
I find this article both interesting and confussing. First, I agree that capital serves as a cushion against unexpected loss. It was never meant to be an insurace as the author wants us to believe. Adequate capital under Basel II especially the more advanced approaches reflect[ or should reflect] the underlying risk of the firm. Capital was only an aspect of the Accord as the Pillar 1 was meant to work hand-in-hand with the other two pillars.Let me also mention that uncertainty is an element or part of risk and, therefore, their separation in the article is wrong and misleading.Risk is the divergence between expectation and outcome and what risk management is all about is to try and bridge the gap and cannot be completely closed at all times.Risk and reward are indeed two sides of a coin. If you want reward, you must take calculated risk. We must always look at the two sides of the coin when making decisions.
Posted by: Dr . Emmanuel Moore Abolo at May 7, 2009 08:14 AM
The article is short but has touched upon the very practical and sensitive aspect of inadequate understanding of risk, uncertainty and safety.
Averages, like appearances, are often deceptive and have to be studied before adopting them for policy making be it public policy, corporate policy or a project policy.
The article has rightly discussed the related issues.
Posted by: Dr. Kishore at May 7, 2009 01:51 PM
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