RISK MANAGEMENTPROF. GANGADHARAN MANI

• Risk is defined as uncertainty resulting in adverse outcomes-adverse in relation to a planned objective or expectations.

• Financial risks are uncertainties resulting in adverse variations or fluctuations of profitability or outright losses.

What is risk???

• UNCERTAINTIES IMPACT THE NET CASHFLOW OF ANY BUSINESS OR INVESTMENT

• THE UNCERTAINTY COULD BE EITHER FAVOURABLE OR UNFAVOURABLE

• THE POSSIBLE UNFAVOURABLE IMPACT IS CALLED RISK ASSOCIATED WITH BUSINESS OR INVESTMENT

What is risk???

• THE RISK COULD BE EITHER LOWER OR HIGHER.LOWER RISK IMPLIES LOWER VARIATIONS OR FLUCTUATIONS IN NET CASHFLOWS- HIGHER RISK IMPLIES HIGHER VARIATIONS OR FLUCTUATIONS IN NET CASHFLOWS

• ZERO RISK IMPLIES NO VARIATIONS- BY IMPLICATION IT ALSO MEANS LOWER RETURNS AS COMPARED TO OTHER ‘RISKY’ OPPORTUNITIES AVAILABLE IN THE MARKET.

• TO ASSUME ZERO/ LOW / HIGH RISK DEPENDS ON THE RISK APPETITE OF THE BUSINESS OR THE INVESTOR.

IN ESSENCE RISK IDENTIFICATION CONSISTS IN IDENTIFYING VARIOUS RISKS ASSOCIATED WITH THE RISK- TAKING AT THE TRANSACTION LEVEL AND EXAMINING ITS IMPACT ON THE OVERALL PORTFOLIO AND ON CAPITAL REQUIREMENT. THE RISK CONTENT IS ALSO TAKEN IN TO ACCOUNT WHILE PRICING A PARTICULAR PRODUCT /INSTRUMENT/EXPOSURE.

Risk Identification

Risk Identification

• EXAMPLE:• FOR EXAMPLE, A BANK HAS GIVEN A LOAN OF 1 CRORE FOR 5 YEARS

IN ACCORDANCE WITH ITS LENDING POLICY AT 1% OVER THE BASE LENDING RATE (BLR) WHICH IS SAY 9% PA.

• THE LOAN IS TO BE REPAID BY THE BORROWER IN EQUAL QUARTERLY INSTALMENT WITH A ONE YEAR MORATORIUM (MEANING REPAYMENT HOLIDAY).

Risk Identification

• THE BANK IS FUNDING THE LOAN BY RAISING A DEPOSIT OF 3 YEARS FOR THE SAME AMOUNT AT 7% PA—NOW WHAT ARE THE RISKS ASSOCIATED WITH THIS TRANSACTION? WE WILL IGNORE SLR/CRR REQUIREMENTS FOR THE SAKE OF SIMPLIFICATION

Risk Identification

• THE TENOR OF THE LOAN IS 5 YEARS WHICH IS LONGER THAN THE TENOR OF THE DEPOSIT WHICH IS 3 YEARS. AND THE END OF 3 YEARS THE DEPOSIT BECOMES DUE AND PAYABLE WHEREAS THE LOAN IS STILL OUTSTANDING (REMEMBER, THE LOAN IS ONLY PARTIALLY REPAID BY THE BORROWER) TO THE EXTENT OF ONLY 50%.

• THEREFORE,AT THE END OF 3 YEARS THE BANK FACES THE FUNDING RISK / LIQUIDITY RISK/DEFAULT RISK-INCASE THERE IS A DEFAULT BY THE BORROWER

Risk Identification

• THE INTEREST ON THE LOAN IS LINKED TO THE BLR OF THE BANK WHEREAS THE DEPOSIT CARRIES A FIXED RATE OF 7% PA THROUGHOUT ITS TENOR. IF THE BLR IS REDUCED SAY FROM 9% TO 8% DURING THE SECOND YEAR OF THE LOAN AND FROM 8% TO 7.5% IN THE THIRD YEAR OF THE LOAN, A BASIS RISK WOULD ARISE. THE SPREAD GETS REDUCED TO 2% AND 1.5% IN THE SECOND AND THIRD YEAR RESPECTIVELY.

Continued

• AFTER 3 YEARS, WHEN THE QUESTION OF FUNDING THE LOAN ARISES, THE DEPOSIT RATE MAY NOT REMAIN THE SAME. THE TRANSACTION NOW FACES THE GAP OR MISMATCH RISK AT THE END OF 3 YEARS.

• FURTHER AS THE LOAN GETS REPAID, THE REPAYMENT PROCEEDS WILL HAVE TO BE DEPLOYED IN TO SOME OTHER INVESTMENT AVENUE. THE RATE AT WHICH THIS WILL BE DONE WILL NOT BE ON PAR WITH THE RATE BEING CHARGED ON THE LOAN AMOUNT. HERE

THE BANK FACES THE REINVESTMENT RISK.

• IT IS ALSO POSSIBLE THAT THE LOAN IS PREPAID AND THE DEPOSIT IS WITHDRAWN PREMATURELY GIVING A NEW DIMENSION TO THE RISK VALLED THE EMBEDDED OPTION RISK.

• THUS WE SEE A PLETHORA OF RISKS ASSOCIATED WITH A SINGLE TRANSACTION NAMELY, CREDIT RISK (DEFAULT RISK)/ FUNDING RISK/BASIS RISK/GAP OR MISMATCH RISK/EMBEDDED OPTION RISK.

• WHAT WE DISCUSSED ABOVE IS AN EXAMPLE RISK IDENTIFICATION

Risk Measurement

• RISK MEASUREMENT:

• RISK MEASUREMENT IS AN IMPORTANT ASPECT OF RISK MANAGEMENT. IT QUANTIFIES THE AMOUNT OF RISK. RISK MEASUREMENT SEEKS TO CAPTURE VARIATIONS IN EARNINGS, MARKET VALUE,LOSSES DUE TO DEFAULT ETC.

• QUANTITATIVE MEASUREMENT OF RISK CAN BE CLASSIFIED IN TO THREE CATEGORIES:

• MEASUREMENT BASED ON SENSITIVITY• MEASUREMENT BASED ON VOLATILITY• MEASUREMENT BASED ON DOWNSIDE POTENTIAL

Risk Measurement

• SENSITIVITY: CAPTURES THE DEVIATION OF A TARGET VARIABLE IN RESPONSE TO A UNIT MOVEMENT OF A SINGLE PARAMETER. HERE THE TARGET VARIABLE COULD BE BOND PRICES ( in case of a portfolio of bonds) AND THE PARAMETER COULD BE THE INTEREST RATE. THAT IS TO SAY WHAT WOULD BE THE DOWNWARD MOVEMENT IN THE PRICE OF A COUPON -BEARING BOND (TARGET VARIABLE) FOR A 1% UPWARD MOVEMENT IN THE INTEREST RATES (PARAMETER).

.

Risk Measurement

• VOLATILITY: CHARACTERISES THE STABILITY OR INSTABILITY OF A RANDOM VARIABLE.THIS IS A STATISTICAL MEASURE OF DISPERSION. HIGHER THE VOLATILITY- HIGHER THE RISK.

• DOWNSIDE POTENTIAL: IT IS THE MOST COMPREHENSIVE MEASURE OF RISK AS IT INTEGRATES SENSITIVITY & VOLATILITY WITH THE ADVERSE EFFECT OF UNCERTAINTY. THIS IS THE MEASURE THAT IS MOST RELIED UPON BY THE BANKING AND FINANCIAL SERVICES INDUSTRY AND ALSO THE REGULATOR. THE VALUE AT RISK ( VaR) IS A DOWNSIDE RISK MEASURE.

Risk Pricing

• RISK IN BANKING TRANSACTIONS IMPACTS BANKS PRIMARILY IN TWO WAYS:

• NEED TO MAINTAIN CAPITAL AS PER REGULATORY REQUIREMENTS

• THE BANK NEEDS TO PAY THE INVESTORS WHO HAVE INVESTED IN BANK’S CAPITAL (BOTH DEBT AND EQUITY) THROUGH SERVICING OF DEBT AND PAYMENT OF DIVIDEND AND TO GENERATE INTERNAL SURPLUS TO FUND BUSINESS GROWTH.

Risk Pricing

• THEREFORE ADEQUATE CAPITALIZATION IS REQUIRED WHICH COMES AT A COST.

• NEXT, IN ANY LENDING ACTIVITY THERE IS ALWAYS THE PROBABILITY OF LOSS. IF THE PROBABILITY OF LOSS IS TWO PERCENT FOR A PORTFOLIO OF LOANS AND ADVANCES THEN THE RISK PREMIUM GOES UP BY 2%

Risk Pricing

• THEREFORE WHILE PRICING THE RISK THE FOLLOWING FACTORS SHOULD BE TAKEN IN TO ACCOUNT:

• COST OF FUNDS RAISED

• OPERATING EXPENSES-INFRASTRUCTURE COST AND COST OF EMPLOYEES

Risk Pricing

• LOSS PROBABILITY (RISK PREMIUM)

• CAPITAL CHARGE –CAPITAL SET ASIDE FOR LOANS /ADVANCES AND OTHER ASSETS AND INVESTMENTS BASED ON THEIR RISKINESS. HIGER THE RISK- HIGHER THE AMOUNT OF CAPITAL THAT SHOULD BE SET ASIDE.

 

RISK MONITORING AND CONTROL

• IN ORDER TO ACHIEVE THE OBJECTIVE OF RISK MONITORING AND CONTROL THE FOLLOWING ARE PUT IN PLACE:

• PROPERLY STRUCTURED RISK MANAGEMENT ORGANIZATION

• A COMPREHENSIVE APPROACH TO RISK MANAGEMENT

RISK MONITORING AND CONTROL

• RISK MANAGEMENT POLICIES THAT ARE CONSISTENT WITH BUSINESS STRATEGIES AND THE RISK APPETITE.

• PROPER INTERNAL GUIDELINES ON PRUDENTIAL LIMITS/EXPOSURE LIMITS/DISCRETIONARY POWERS.

Risk Mitigation

• RISK MITIGATION OR RISK REDUCTION IS ACHIEVED BY ADOPTING STRATEGIES THAT EITHER REDUCE OR COMPLETELY ELIMINATE THE UNCERTAINTIES ASSOCIATED WITH VARIOUS RISK FACTORS.

Risk Mitigation

• RISK MITIGATION AIMS AT REDUCING THE DOWNSIDE VARIATIONS IN NET CASHFLOWS BUT SIMULTANEOUSLY PUTS A CAP ON UPSIDE POTENTIAL.RISK MITIGATION CAN ALSO BE ACHIEVED BY DIVERSIFICATION , COLLATERALIZATION OF RISK BY OBTAINING MARGIN MONEY AND OTHER SECURITIES,BUYING INSURANCE,USING DERIVATIVE INSTRUMENTS, NETTING OF EXPOSURES AND OTHER IMMUNIZATION STRATEGIES.

Risk Mitigation

• FROM THE RISK MANAGEMENT POINT OF VIEW BANKING BUSINESS LINES MAY BE GROUPED IN TO THE FOLLOWING HEADS:

• THE BANKING BOOK• THE TRADING BOOK &• OFF-BALANCE SHEET EXPOSURE

Risk Mitigation

• ALL ASSETS AND LIABILITIES IN THE BANKING BOOK ARE HELD TILL MATURITY AND ACCRUAL SYSTEM OF ACCOUNTING IS FOLLOWED. THE BANKING BOOK IS GENERALLY EXPOSED TO LIQUIDITY RISK, INTEREST RATE RISK, DEFAULT RISK AND OPERATIONAL RISK

Risk Mitigation

• THE ITEMS IN THE TRADING BOOK ARE NORMALLY HELD FOR TRADING PURPOSES AND TO PROFIT FROM THE SHORT-TERM PRICE MOVEMENTS. THESE ITEMS ARE LIQUIDATED WHEN MARKET CONDITIONS ARE FAVOURABLE. THE DIFFERENCE BETWEEN THE BOOK VALUE AND THE PRICE REALISED IS THE PROFIT OR LOSS. THE TRADING BOOK IS MAINLY EXPOSED TO MARKET RISK, MARKET LIQUIDITY RISK,DEFAULT OR CREDIT RISK & OPERATIONAL RISK.

Risk Mitigation

• OFF-BALANCE SHEET (OBS) EXPOSURES MAY BECOME FUND-BASED ON CERTAIN CONTINGENCIES-THAT UPON THE HAPPENING OF CERTAIN EVENTS. OBS EXPOSURES MAY HAVE LIQ RISK / INT RATE RISK/MKT RISK/DEFAULT RISK/ OP.RISK.

Types of Risk

• LIQUIDITY RISK: LIQ RISK IS DEFINED AS THE INABILITY TO OBTAIN FUNDS TO MEET CASHFLOW OBLIGATIONS AS AND WHEN SUCH OBLIGATIONS ARISE AT AREASONABLE COST. THIS MAY HAPPEN WHEN LONG TERM ASSETS ARE FUNDED OUT OF SHORT TERM LIABILITIES MAKING THE LIABILITIES SUBJECT TO ROLL OVER OR REFINANCING RISK. AT THE OTHER EXTREME BANKS MAY FAIL TO FUND THE LIQUIDITY GAPRESULTING IN DEFAULT WITH ITS SERIOUS CONSEQUENCES.

Types of Risk

• THE LIQ RISK MAY BE OF THE FOLLOWING TYPES:

• FUNDING RISK- ON ACCOUNT OF UNEXPECTED WITHDRAWAL OR NON-RENEWAL OF DEPOSITS.(the deposits may be withdrawn by the depositor due to certain emergencies or unexpected need for funds)

• TIME RISK- NEED TO ARRANGE FOR FUNDS ON ACCOUNT OF NON RECEIPT OF EXPECTED CASH INFLOWS OF FUNDS –FOR EXAMPLE FAILURE ON THE PART OF THE BORROWER TO REPAY LOAN INSTALMENT.

• CALL RISK: ARISES DUE TO CRYSTALLIZATION OF CONTINGENT LIABILITIES- FOR EXAMPLE WHEN A GUARANTEE IS INVOKED FOR NON-PERFORMANCE BY A CUSTOMER ON WHOSE BEHALF THE GTEE HAS BEEN ISSUED BY THE BANK.

Types of Risk

Types of risk

• INT RATE RISK: (IRR) ARISES ON A/C OF EXPOSURE OF BANK’S REVENUE TO ADVERSE MOVEMENTS IN INTEREST RATES. IRR IMPACTS NET INT INCOME / NET INT MARGIN OF THE BANK.

• GAP RISK or MISMATCH RISK: ARISES FROM HOLDING ASSETS AND LIABILITIES AND OBS ITEMS WITH DIFF PRINCIPAL AMOUNTS, MATURITY DATES OR REPRICING DATES THEREBY CREATING EXPOSURE TO UNEXPECTED CHANGES IN THE LEVEL OF MARKET INT RATES.

Types of Risk

• BASIS RISK: WHERE THE INT RATES ON DIFF ASSETS AND LIABILITIES MAY CHANGE BY DIFFERENT MAGNITUDE . FOR EXAMPLE IN AN RISING INT RATE SCENARIO THE INT RATES ON ASSETS MAY CHANGE BY A DIFFERENT MAGNITUDE AS COMPARED TO INT RATES ON LIABILITIES CREATING VARIATIONS IN NET INT INCOME. BASIS RISK BECOMES EXTREMELY PROMINENT WHERE A COMPOSITE ASSET PORTFOLIO IS CREATED OUT OF A COMPOSITE LIABILITY PORTFOLIO.

Types of Risk

• MARKET RISK: RISK ON A/C OF ADVERSE DEVIATION OF THE “MTM” VALUE OF THE TRADING PORTFOLIO. MKT RISK RESULTS FROM ADVERSE MOVEMENT IN INT RATES, EXCHANGE RATES, AND PRICES OF COMMODITIES. MARKET RISK IS ALSO KNOWN AS PRICE RISK.

• RISK MANAGEMENT THEREFORE IS A FASCINATING AS WELL AS IMPORTANT FACET OF MODERN DAY FINANCIAL MANAGEMENT.

Case Study - 1

Lessons from failures in Risk Management:

BARINGS BANK CASE:

 

Barings was a highly respected British Bank. The Bank collapsed in the year 1995 as a result of huge losses caused by a trader in the Bank’s Singapore office. Nick Leeson their star trader had posted strong performances in the past and the bank had placed absolute faith in him. Emboldened by this, the trader took huge positions in the Nikkie Index Derivatives (Futures and Options) in the Tokyo Stock Exchange. Strangely enough he was also managing the back office operations (which is totally against risk management principles- the back office functions should not be in the hands of the front office trader). While front office must solely engage in trading activities, it is the back office that is in charge of confirmation of trades, accounting, settlement and reconciliation. When his bets on Nikkie Index Derivatives failed miserably, the bank ran in to huge losses on account of margin calls ( it may be noted that all trades in futures and options are subject to margin calls).

Main Lessons to be learnt:• The first principle of risk management- separation of trading and back office activities was not followed at

all. This allowed Leeson to hide the mark to market losses successfully and hoodwink his superiors.• Even though the trader may be extremely successful and has a good track record, his activities must always

be subject to scrutiny by his superiors- in this case this did not happen.

Case Study - 2

Procter and Gamble Case:

P& G is a huge multinational company and is in the business of fast moving consumer goods (FMCG) that is soaps, toiletries, detergents , over the counter medicines etc. P&G suffered huge losses –over 100 million dollars in 1994 by entering in to complex derivative contracts. The company sued the bank ‘Bankers Trust’ claiming that the full implications of the derivative contracts were not explained to the company. The matter was finally settled out of court. In this case the derivative contracts were not hedging mechanisms but speculative positions that went wrong.

Lesson to be learnt:

Never enter in to any complex derivative structure unless it is fully understood and the entire transaction is transparent.

Other Important Lessons

• Avoid complex derivative products. Go for simple hedging strategies. Understand the product and its financial implications.

• Never try to predict the market nobody can ‘correctly’ predict the financial markets – one can only have a view on the markets. Be ready to change your views based on the facts available on the ground.

• The markets are more efficient than all of us put together and the unexpected can happen.

• Do not borrow short-term to take long-term positions in the market.• For corporates, their main business is manufacturing/services –

depending upon the industry they are in. Their profits should come from their core activities and not from currency or derivatives trading.

• The top management and the Board should always be kept abreast of any deviations from the laid down policies and procedures.