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Risk Management for BeginnersTargeted for beginners, this blog will focus on regulation, modeling and best practices as applicable to contextual risk issues and will present them in an easy to understand manner July 30, 2011 Scenario Implications - US Sovereign RatingsOn July 14th 2011, Standard & Poor's had placed the 'AAA' long-term and 'A-1+' short-term sovereign credit ratings on the United States of America on CreditWatch with negative implications. Over the last fortnight, the ongoing debate between the opposing camps has not resulted in any resolution of the deadlock. Continue reading "Scenario Implications - US Sovereign Ratings" Posted by Venkatesh NS at 08:48 AM | Comments (0) May 14, 2011 Basel III & Gulf Banks Challenges & OpportunitiesThe recently concluded 4th Annual Middle East Risk Management forum in Doha, Qatar (Download conference agenda here) was focused on the impending regulatory changes of Basel III. Debates on the relevance of these regulations were quite useful and I thought it would be useful to capture these discussions here for those who were not part of the conference proceedings. Continue reading "Basel III & Gulf Banks Challenges & Opportunities" Posted by Venkatesh NS at 03:33 PM | Comments (2) November 19, 2010 Can Basel III prevent Systemic Crises?During an interaction in a risk management conference, the CEO of a Bahrain based Investment Bank asked me innocently whether the proposed Basel III regulations would prevent another systemic crisis that the financial world witnessed in 2008. In fact this CEO is not alone in this regard; many bankers carry the impression that Basel III is a kind of permanent fix (however costly it might be) and if diligently implemented the world will not see another crisis yet again. Looking back, has Basel I, II mitigated systemic risks? Continue reading "Can Basel III prevent Systemic Crises?" Posted by Venkatesh NS at 02:06 PM | Comments (2) May 15, 2010 Flash Crash 2010: The Dow Jow Plunge & RecoveryAs readers are aware, the Dow Jones Index suffered an intraday loss of 9.2% on May 6th, 2010, which has been dubbed a Flash Crash as the index recovered most part of the loss and closed only 3.7% down at the close of the trading session. How does this compare with previous stock market plunges? Continue reading "Flash Crash 2010: The Dow Jow Plunge & Recovery" Posted by Venkatesh NS at 10:09 AM | Comments (0) December 10, 2008 The Circle of Financial Innovation and RegulationThe recent events in the global financial system have kindled a debate which has periodically come to the fore. Some of the blame of the current predicament is being put on the unbridled growth of financial innovation and also the fact that regulation has not been pro-active in taming the growth of financial innovation. Financial Innovation = Financial Instability? Continue reading "The Circle of Financial Innovation and Regulation" Posted by Venkatesh NS at 08:22 AM | Comments (1) August 15, 2008 When Banking Regulation Meets Accounting StandardsOne of the advantages of a working in a consulting environment is the opportunity to work on cross over assignments. One such example is the intersection of bank regulation with accounting standards. Continue reading "When Banking Regulation Meets Accounting Standards" Posted by Venkatesh NS at 07:48 PM | Comments (1) May 13, 2008 Are Islamic Banks Riskier than Conventional Banks?The Middle East Financial Services Summit -2008 which was recently held in Bahrain had interesting sessions on the progress of Islamic banking. While the growth in assets of Islamic banks has been satisfactory, the perception among the bankers was that Islamic banks in the GCC region still lagged behind their conventional counterparts when it came to risk management. The evidence presented in this regard was a survey conducted by Mckinseys Risk Summit, November 2007 in which 17 GCC banks had participated. While perceptions (from a small sample) may not be fully representative, it is nevertheless useful to understand the issue from a conceptual background: other things being equal are Islamic banks riskier than conventional banks? To put in another way, do Islamic banks have different risk structures than their conventional counterparts Continue reading "Are Islamic Banks Riskier than Conventional Banks?" Posted by Venkatesh NS at 08:00 PM | Comments (2) April 16, 2008 Basel II Plus : Prescriptions for the current Market TurmoilThe month of April has seen prescriptions emanate from two influential quarters: the IMF which released the spring 2008 Global Financial Stability Report, and the Financial Stability Forum which finally released the recommendations on enhancing the resilience of markets and financial institutions. While the GFSR is issued every six months, the FSF report was prepared at the behest of the G 7 Finance Ministers and central bankers with the objective of coming up with recommendations on improving the resilience in the financial system in the light of the current market turmoil. The IMF report is highly analytical and has some incisive analysis. The IMF says that the risks to global financial stability have increased sharply since the last report in October 2007, and estimates almost $1 trillion in losses and mark-to-market write downs. In terms of the blame game it has apportioned all stake holders: a collective failure to appreciate the extent of leverage taken on by a wide range of institutions. Private sector risk management was found wanting (always the case and especially so in times of turmoil, write downs and meltdowns), regulators have lagged behind financial sector innovation (where did GARP get the courage to award the European Central Bank as Financial Risk Manager of 2007?). Finally, disclosures have not helped in communicating risks, especially in the originate to distribute business model. Net result: disorderly unwinding - the stuff of the nightmares for central bankers - has crystallized into reality. The FSF report is more prescriptive and provides guidance (as well as a timeline) on the regulatory areas which will receive attention in view of the shortcomings in Basel II. The crisis has helped regulators to test the efficacy of some of the Basel II regulations; it is indeed refreshing to read that BIS acknowledges the need to strengthen elements of Basel II when it is still getting off the ground in most countries! This is an implicit admission that supervision has lagged behind rapid innovation and the shifts in business models. Nevertheless, the FSF report still maintains that the starting point for improving the banks capital adequacy is the timely implementation of Basel II. Going forward, supervisors also need to rigorously assess banks compliance with the Basel II framework. The IMF and the FSF reports both talk of the procyclicality effects of Basel II capital requirements and fair value accounting practices. It would appear that the presence of both these triggers has actually exacerbated the current downturn in the economy. Thus while the roots of the crisis lie in the US sub prime market; the spreading of the crisis much beyond could be attributed to the procyclicality effects. The FSF report says that BCBS has already put in place a data collection framework to monitor the impact of Basel II on the level and cyclicality of the capital requirements over time and will take further action as appropriate. Some of the proposals of BCBS relating to capital requirements: the need to raise capital requirements for certain complex structured credit products, the need to capture default risk in the trading book (this is where most of the structured products are held for many banks and securities firms). By far, the most eagerly awaited sound practice guidance is for the supervision of liquidity (due in July 2008). The FSF report highlights the need for effective liquidity risk management practices and the fact that high liquidity buffers play an important role in maintaining institutional and systemic resilience. Both the FSF and IMF reports underscore the importance of the Pillar 2 mechanism. The IMF says that supervisors will need to better assess capital adequacy related to risks that may not be covered in Pillar 1; more attention could be paid to ensuring that banks have an appropriate risk management system and a strong internal governance structure. The FSF reports echoes a similar view: Supervisors should use Pillar 2 to strengthen risk management practices and to control tail risks and mitigate the build up excessive exposures and risk concentrations. Indeed both the IMF & FSF reports suggest that national supervisors have their tasks cut out. Some actions points (1) More intense supervision and ensuring stricter implementation of Basel II (2) greater attention to applying fair value accounting results, (3) ensuring that risk management capital buffers and estimates of potential losses are appropriately forwarding looking taking into account the uncertainties associated with models valuations, concentration risks, and expected variations through the cycle. Tail Piece: Modelling Financial Stability! The sub prime crisis has provided IMF the impetus to expand the scope of research to quantitative financial stability modelling. Considering that financial stability as a term came into existence just about 12 years back when the Bank of England first used the term in 1996, this indeed is a major push for FS reporting. I particularly liked the work on the construction of a Banking Stability Index. In a broad sense, evaluating financial stability in the banking system is nothing but evaluating the interdependencies between the individual banks. A large loss in a systemically important bank is more often likely to trigger losses in other banks in the system. The IMF has modelled this by evaluating the joint probability of default (JPoD) of a portfolio of banks, by taking the individual probability of default and modelling the interdependencies using non parametric copulas. The concept of joint default analysis is also used by Moodys to determine the impact of external support on banks ratings so in a way they are also modelling the interdependencies. The JPoD represents the joint probability of default of all banks in the portfolio given that at least one bank has defaulted in the system and is thus a measure of the Banking Stability Index. The IMF has actually tested this on portfolio of 15 large systemically important banks in and has determined that the JPoD for this portfolio has risen almost 10 times from mid 2007 till the present! Posted by Venkatesh NS at 08:33 PM | Comments (0) March 20, 2008 Operational Risks from External EventsAmidst all the carnage from the fall out of the sub prime crisis, operational risk has come back to occupy centre stage. For this, the credit goes to Jerome Kerviel, the Societe Generale trader whose allegedly unauthorised trades cost the bank US$7bn. Clearly, there was a breach in the internal process which allowed the rogue trader to build large positions in the futures markets. Another ongoing (but not so well known) example of operational risk pertains to OTC currency contracts between banks and software exporters in India. The mid sized exporters whose earnings are primarily in US$, have faced the brunt of a depreciating dollar (and an appreciating rupee). This, coupled with higher operating costs, put pressure on the bottom line and naturally enough they were in search of some quick fixes. The villain in this piece viz. the Indian banks, apparently were only too eager to sell them currency derivatives. Corporates booked upfront the premium received, while in other cases boosted reported profitability through back to back structures. However, following a sudden and steep decline in the value of the US$ against the Japanese yen and the Swiss franc many corporates are staring at losses in their positions and are contemplating suing the banks on grounds of mis-selling complex structures. (Long term observers will note the similarity between this example and Procter & Gamble which successfully sued Bankers Trust in the mid nineties on similar grounds.) The issue that that I intend to discuss here is not the reputational risks for Indian banks, but the more broader issue of definition of operational risk - defined as the risk of loss resulting from inadequate or failed internal processes, people and systems or from external events. In a Basel II context, the goal of operational risk management is to focus on internal events (people process, technology) since they are only within the control of the firm. For example, a risk control self assessment process will help document operational processes, identify key operational risks and evaluate controls from an internal perspective. What kind of external events pose operational risk to the firm? Political, tax, regulatory events can indeed lead to operational risk. To this list, one more factor can be added: risks of selling to uninformed or even illiterate clients. I deliberately choose to categorize this as an external event because the risks that clients are exposed to (arising from the advice given by the bank) is ultimately transformed into operational (legal) risk for the originating bank. Note that the asymmetry of risks in this case: if the client had made money on OTC contracts, the bank and the client would be mutually patting each other on the back and not engaged in a legal duel. It is natural enough to evaluate the preparedness of banks in selling risky products. However one should not forget to evaluate whether clients are sophisticated or naive when it comes to buying these risky products. Do they have policies, tools, and methodologies to identify, measure and control risks? Do they have board approval? Are they hedging or speculating? In the Bankers Trust case, I have always wondered how P&G could claim that they were not fully informed of the risks in speculative derivative positions especially when their treasury was considered cutting edge. Surely, they would have also assessed downside risks? It seems a reasonable assumption, but no there is information on this aspect. In the case of the Indian corporates clearly, they may not have cutting edge treasuries or the sophistication to understand risks in exotic instruments. (In fact a recent risk management survey conducted by a leading financial daily highlighted that most Indian companies are still quite far from having good risk management processes). Nevertheless, it remains a fact that they willingly entered into contracts on the hope of making money through speculation. It would be interesting to see whether the Indian corporates can follow the same path as P&G and recover not just their losses but end up making gains from suing banks! Interestingly, banks seem to have anticipated the possibilities of law suits. Reportedly, voice recordings with clients is likely to be a key input to demonstrate the banks had indeed clearly spelt risks to corporates before hand. The above example only demonstrates the pervasive nature of operational risks for banks - they can be quite diverse and plentiful. Given this pervasive nature, is it possible to capture all key risk events? Finally, will the operational risk charge under Basel II fully capture all the risks faced by the bank? Posted by Venkatesh NS at 07:33 PM | Comments (1) March 09, 2008 Credit Risk / Investment Risk- two sides of the same coin?Recently, I was talking to a senior risk manager in one of the offshore banks based in this region. This particular bank had private equity exposures, which are required to be classified in the banking book as per local regulations. Fair enough. But what followed was confusing. Since private equity which has investment or price risk is classified alongside credit exposures, and the same advanced model (PD/LGD) is used to determine capital charges, the bank equated investment risk with credit risk and treated them as equivalent for practical purposes! While this was not what Basel II set out to achieve, nevertheless there are some areas with respect to equity exposures in the banking book which needs to be debated. Risk weights for credit exposures vary from 0% to 150%. Capital is held is to protect against both migration risk and default risk. On the other hand, equity exposures in the banking book are weighted at 300% (publicly traded) or 400% (other equity holdings). The higher risk weights for equity exposures reflect the higher levels of unexpected losses as well as the greater variability of returns in equity exposures. On a portfolio basis, credit risks may be granular i.e. distributed across large number of clients, while equity exposures may be lumpy in nature. In addition, the additional risk charge (100%) for non traded equities reflects the liquidity risk in fire-sale situations. These three factors explains why price risk in equity investments is not the same as credit risk even if they belong to the same banking book. The confusion is understandable if one looks at models based approach for estimating investment risk for equity exposures. Normally, the PD/LGD model is associated with the credit risk estimation; pray how is this relevant for estimating the investment risk of equity exposures? In fact the initial consultative papers by Basel acknowledge that default risk is itself a difficult concept to define for equity. It goes on to clarify that the PD/LGD approach, incorporates elements of both general market and idiosyncratic (i.e. specific) risk associated with equity holdings. This unfortunately, is not readily apparent or explained. If banks decide to use the PD/LGD model for measuring credit risk (oops! Sorry, investment risk!), there are further issues. Banks are required to estimate the PD of a corporate equity exposure in the same way that it would do for a debt exposure for that company. What happens when the bank does not have a debt exposure for which it has an equity exposure? In such cases, it is difficult for banks to have access to information. Basel recognises that in such cases, “the equity definition of default is likely, on average, to deliver a later outcome than the corporate definition”. In recognition of this lagged/delayed effect, Basel has recommended a 1.5 scaling factor be applied to the PD/LGD weights in such circumstances. Given these difficulties, most banks would prefer to stick to the simple risk weights method, rather than venture into the models based approach. While this means additional capital charges, it is not a problem for many Gulf based banks, as they have much higher capital adequacy levels than required by their regulators. That is, as long as credit risk and investment risk is not equated and are treated differently! Posted by Venkatesh NS at 11:13 AM | Comments (0) February 08, 2008 Brave New World of Pillar 2It is entirely appropriate that I write about Basel II in my first post, given that financial institutions and regulators in many countries have taken a big leap into the brave new world of Basel II. In the good old days of Basel I, capital adequacy rules were uniform, non discretionary and non judgmental. In the brave new world of Basel 2, the focus of capital adequacy determination has shifted from a rule based process to one which is a combination of rules and judgment emanating from a supervisory review of the bank’s capital assessment process. The imposition of additional capital charges under Pillar 2 may translate into capital raising requirements. The target and trigger ratios for a bank will be determined individually and could be set at high levels if outcome of the supervisory review process is unfavourable or the likelihood of a “supervisory risk event” is high. The depth and rigor of the ICAAP is crucial - this means that banks have to take this process very seriously – material risks need to be identified, methods of testing capital levels against downturns need to be implemented; policies and procedures need to be streamlined and most importantly, internal control mechanisms need to be strengthened. All this sounds like spring cleaning - hopefully, banks will put their best foot forward when being assessed under Pillar 2. On the regulatory side, this means a lot of work. The ICAAP has to be reviewed and additional capital levels need to be arrived at for each bank. This process raises doubts among banks. How will regulators quantify risks like reputational risk, strategic risk and concentration risk to name a few? Some of these risks may be common across particular licensees – will the regulator apply the same yardstick or will use a different interpretation for each bank? Is the process open to appeal? (credit rating agencies have an appeal process in which issuers can provide additional information if they are not satisfied with the assigned ratings). A high capital guidance ratio for a bank in relation to its peers could mean that the bank has high level of risks or has poor internal controls or poor risk governance mechanisms or some combination of all three factors. In turn, this could invite supervisory intervention, or business restrictions. Further it could send negative signals to stakeholders and could be viewed unfavourably by market participants, especially when disclosed under the Pillar 3 requirements. The supervisory review process is also likely to place a lot of demand on the regulators in terms of time and expertise. Regulators will have to beef up their understanding of banking risks, quantification methods and also have an in-depth understanding of each bank to argue with smart and sophisticated licensees. How will regulators bring in their micro prudential regulatory framework into the supervisory review process? Sounds like quite a bit of work? To put in other way, Pillar 2 represents an opportunity to banks to align risk management practices with the regulatory capital levels. This was one the basic flaws under the earlier system which is sought to be corrected. On the regulatory side, Pillar 2 represents an opportunity for regulators to strengthen the supervisory framework and customize responses for each bank depending upon its risk, governance and controls. However this means a lot of work on both sides of the table and will not necessarily be smooth. Capital guidance is likely be debated and challenged by banks and regulators will have to find ways of dealing with the smart and sophisticated licensees. Sounds exciting indeed! Posted by Venkatesh NS at 09:38 AM | Comments (0) December 12, 2007 About NS Venkatesh, FRM, PRMCurrently, I work in Barwa Bank as Head of Credit Risk. My role encompasses credit risk in both the bank as well as its subsidiaries. Earlier, I was in the Financial Risk Management practice of KPMG in Bahrain. Our consulting work is focused on four broad themes: Risk Governance, Risk Quantification, Risk Infrastructure and Risk Intelligence. Much of our work currently is related to Basel II. Prior to KPMG I was with the Central Bank of Bahrain with the responsibility of evaluating macro prudential risks from a financial stability perspective. Bahrain is the fourth largest offshore centre in the world and is host to more than 110 banks. The CBB pioneered financial stability analysis and reporting in this part of the world. I was privileged to be part of the team which conceived, developed and implemented financial stability analysis.
I get quite a few mails from risk aspirants from developing countries on how to pass these exams. I have uploaded a presentation here which I normally make to my students at BIBF. This presentation introduces the PRM exam, the exam content, the benefits of passing this exam and the reference books. My areas of interest include regulation, Basel (as applied in emerging markets), and risk modeling. On the weekends, I like to teach as this gives me an opportunity to get back to books. One key reason for wanting to write on risk management is to provide beginners a non technical understanding of contextual issues in risk management. Some of my recent articles can be accessed here. Posted by Venkatesh NS at 10:02 AM | Comments (11) |
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