Corporate Financial risk management: A Practical Approach for Emerging Markets 9781774075449, 9781774072035

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CORPORATE FINANCIAL RISK MANAGEMENT: A PRACTICAL APPROACH FOR EMERGING MARKETS

CORPORATE FINANCIAL RISK MANAGEMENT: A PRACTICAL APPROACH FOR EMERGING MARKETS

Edited by:

Scott Stanley

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Corporate Financial risk management: A Practical Approach for Emerging Markets Scott Stanley

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ABOUT THE EDITOR

Scott Stanley is a Financial Planning and Analysis Executive with over 30 years of experience working for industry leading global Financial Organizations in a financial management capacity. He is a subject matter expert in organizational and operational financial analysis, business management, forecasting and management reporting for Fortune 100 firms. He has a proven track record of increasing profitability, managing costs and development and implementation of strategic plans and operational budgets. Scott is skilled at leading project teams and cross divisional initiatives by advocating collaboration and teamwork. His strengths include excellent organizational, analytical and interpersonal skills. Having worked on Wall Street for most of his career, Scott has proven leadership skills and an ability to drive results in fast paced, deadline driven environments. Scott was an Executive Director at Morgan Stanley, where he worked for 13 years in various Financial Management and Business Management capacities. Prior to that, Scott worked at JPMorgan Chase for 8 years. Other financial firms round out his portfolio of work experience. In 2016 Scott founded J2 Financial Solutions Group, LLC. J2 provides comprehensive financial consulting services across an array of financial planning and analysis disciplines. Scott obtained his undergraduate degree in Business Administration from Gettysburg College and his MBA from Drexel University.

TABLE OF CONTENTS

List of Figures ................................................................................................xi List of Tables.................................................................................................xv List of Abbreviations ...................................................................................xvii Preface.................................................................................................... ....xix Chapter 1

The Evolution and Scope of Risk Management .......................................... 1 1.1. Risk Management: Concept ................................................................ 2 1.2. Risk: Introduction ............................................................................... 2 1.3. The Scope of Risk Management .......................................................... 3 1.4. The Atmosphere of An Emerging Market ............................................. 8 1.5. The Value of Risk Management ......................................................... 14 References ............................................................................................... 24

Chapter 2

Types of Risks And Their Control: Market, Credit, Operational, And Legal Risk ......................................................................................... 27 2.1. Corporate Risk And Its Management ................................................. 28 2.2. Market Risk....................................................................................... 37 2.3. Credit Risk ........................................................................................ 39 2.4. Liquidity Risk .................................................................................... 41 2.5. Operational Risk ............................................................................... 43 2.6. Legal Risk ......................................................................................... 47 2.7. Legal Risk Management .................................................................... 49 2.8. Financial Risk Management Methods And Techniques ...................... 53 References ............................................................................................... 55

Chapter 3

Corporate Financial Risk Management: Organizational Structure And Functions.......................................................................... 57 3.1. Introduction ...................................................................................... 58 3.2. Organizational Structure For Risk Management ................................ 62

3.3. Principles For Risk Management Functions ....................................... 68 3.4. Risk Appetite With Respect To Its Adoption And Framework For Risk Management................................................... 74 3.5. Roles And Responsibilities Of Various Implementers ......................... 77 3.6. Conclusion ....................................................................................... 81 References ............................................................................................... 83 Chapter 4

Credit Risk Management And Control ..................................................... 85 4.1. Introduction To Credit Risk Management .......................................... 86 4.2. Traditional Approach To Manage The Credit Risk............................... 90 4.3. Business Risk .................................................................................... 95 4.4. Financial Risk ................................................................................. 100 4.5. Transaction Risk .............................................................................. 103 4.6. Market Imperfections ...................................................................... 106 4.7. Conclusion ..................................................................................... 112 References ............................................................................................. 113

Chapter 5

Methods And Techniques For Market Measurement ............................. 115 5.1. Introduction .................................................................................... 116 5.2. Measure of Performance ................................................................. 116 5.3. Return on Marketing Investment ..................................................... 117 5.4. Measuring Marketing Performance.................................................. 119 5.5. Prediction And Projective Markets .................................................. 122 5.6. Credit Report Analysis..................................................................... 123 5.7. Value At Risk (VAR) ......................................................................... 124 5.8. Volatility ......................................................................................... 130 5.9. Explanation Of Regression Analysis ................................................ 131 5.10. Investment In Emerging Markets: Risks And Barriers...................... 132 5.11. Sharpe Model ............................................................................... 134 5.12. Conclusion ................................................................................... 137 References ............................................................................................. 139

Chapter 6

Focus on Commercial Banking .............................................................. 141 6.1. Introduction .................................................................................... 142 6.2. Commercial Banks.......................................................................... 144 6.3. Functions of Commercial Banks...................................................... 146

viii

6.4. Types of Commercial Banking ......................................................... 150 6.5. Various Types of Risks And Their Management by Commercial Banks ....................................................................... 150 6.6. Credit Risk and Their Management ................................................. 154 6.7. Basel Norms ................................................................................... 158 6.8. Management of Foreign Exchange (FX) Risk by Commercial Bank ........................................................................ 161 6.9. Old Methods For Calculating Market Risks ..................................... 164 6.10. Role of Commercial Banking In Economy ..................................... 165 6.11. Conclusion ................................................................................... 166 References ............................................................................................. 168 Chapter 7

Risk Management Information System and Its Implementation ............. 169 7.1. The Role of Information Technology In Risk Management ............... 170 7.2. Identification of Risky Events .......................................................... 171 7.3. Categorizing And Measuring Financial Risk .................................... 172 7.4. Formulation of Strategies To Control Risk ........................................ 174 7.5. Technological Improvements In Risk Management .......................... 176 7.6. Risk Management Systems: The Dimension of Benefits ................... 188 7.7. Risk Management Systems: The Dimensions of Cost ....................... 190 7.8. Risk Management Systems: How Should They Be Selected? ............ 191 7.9. Future Research In The Following Areas Would Also Be Helpful In Providing Management With Additional Guidance ...... 192 7.10. Six Steps To Implement Risk Management Information System ...... 193 References ............................................................................................. 195

Chapter 8

Efficient Approaches In Risk Management Activities in Emerging Market Settings ...................................................................... 197 8.1. Introduction .................................................................................... 198 8.2. Types of Risk ................................................................................... 200 8.3. Evolution of Risk Management........................................................ 203 8.4. Principles For Designing Risk For Different Sectors of Corporate World In Emerging Markets ...................................... 205 8.5. Need For Approaches ..................................................................... 206 8.6. Efficient Approaches ....................................................................... 207 8.7. Lessons Learned While Managing Risk............................................ 211

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8.8. Risk Management In Emerging Markets........................................... 215 References ............................................................................................. 222 Chapter 9

Case Study............................................................................................. 223 9.1. Case Study: Financial Risk Management For Management Accountants ............................................................ 224 9.2. Conclusions .................................................................................... 246 Reference .............................................................................................. 247 Index ..................................................................................................... 249

x

LIST OF FIGURES

Figure 1.1. Different forms of financial risks Figure 1.2. Risk and reward Figure 1.3. Different dimensions of risk management Figure 1.4. Risk chart depicting different forms of risk Figure 1.5. Different types of policy risk Figure 1.6. Value of risk management Figure 1.7. Three dimensions of risk management Figure 2.1. Classification of financial risk Figure 2.2. Different types of systematic risk Figure 2.3. Different forms of interest rate risk Figure 2.4. Classification of market risk Figure 2.5. Classification of purchasing power risk/inflation risk Figure 2.6. Unsystematic risk and its different types Figure 2.7. Different forms of business risk/liquidity risk Figure 2.8. Classification of financial risk or credit risk Figure 2.9. Various forms of operational risk Figure 2.10. Structure of types of risk in finance Figure 2.11. Risk management continuum Figure 3.1. Appropriate measures for corporate governance for risk management Figure 3.2. Organizational structure of a financial organization Figure 3.3. Types of risks and risk management Figure 3.4. Example of the ERM coordinating role and the management of various risk areas Figure 3.5. Important implementers of an organization for managing risk

Figure 4.1. Credit risk Figure 4.2. Counterparty or issuer risk Figure 4.3. Credit score of counterparty Figure 4.4. Netting agreement in finance Figure 4.5. Business risk management Figure 4.6. PEST analysis Figure 4.7. SWOT analysis Figure 4.8. Financial risk mitigating techniques Figure 4.9. Transactional risk in finance Figure 4.10. Tips for good lending Figure 4.11. Market imperfections Figure 4.12. Liquidity risk Figure 4.13. Risk-averse Investor Figure 5.1. Value at risk Figure 6.1. Barter system Figure 6.2. Ancient banking system Figure 6.3. Commercial banks Figure 6.4. Functions of commercial banks Figure 6.5. Types of risks faced by commercial bank Figure 6.6. Credit risk in commercial banking Figure 6.7. Basel norms Figure 6.8. Basel-2 Figure 7.1. Client-server architectures versus distributed databases Figure 7.2. Distributed database technology with interconnected servers Figure 7.3. An example of a distributed object-oriented databases Figure 7.4. Architecture of a neural network Figure 7.5. Business value linkages for two risk management system Figure 7.6. Six steps to implement risk management information system Figure 8.1. Alignment of risk management using Bow-Tie approach Figure 8.2. Credit risk management Figure 8.3. Value at risk technique Figure 8.4. International accounting standards boards xii

Figure 8.5. Individual market enrolment Figure 8.6. Risk culture Figure 8.7. Marketing communication Figure 8.8. Profit and risk statement Figure 8.9. Security cycle Figure 8.10. Knowledge risk Figure 8.11. Financial risk Figure 9.1. Categories of financial risk Figure 9.2. The risk management cycle Figure 9.3. A likelihood/impact matrix Figure 9.4. Risk strategies and tools Figure 9.5. Comparison of approaches to the quantification of risk Figure 9.6. Risk management tools for different categories of financial risk

xiii

LIST OF TABLES

Table 7.1. Characteristics of the derived-class and super-class

LIST OF ABBREVIATIONS

AI

artificial intelligence

ALM area

asset and liability management area

CLV

customer lift value

CMO

collateralized mortgage obligations

COSO of

Treadway Commission Committee of Sponsoring Organizations the Treadway Commission

CPC

cost per click

CRO

chief risk officer

EC

economic capital

EPS

earnings per share

ERM

enterprise risk management

EVA

economic profit

EXCH

euro/sterling exchange rate

FX

foreign exchange

FXAA

foreign exchange auditing assistant

GAS

price of gas

GNMA

Government National Mortgage Association

INT

interest rates

IOSCO

International Organization of Securities Commissions

IRR

internal rate of return

ITs

information technologies

LAN

local area network

LTCM

long-term capital management

MBS

mortgage-backed securities

MESS

market expert surveillance system

MIS

management information system

NPV

net present value

NUES

Norwegian Corporate Governance Board

OTC

over-the-counter

PRISM

pattern recognition information synthesis modeling

RMT

risk management technology

SMS Surveys

text messaging surveys

SOX

Sarbanes Oxley Act

TARA

technical analysis and reasoning assistant

PREFACE

Risk management has evolved as a very crucial aspect of corporate financial risk management policy, predominantly in light of current global financial and economic crises. Corporate financial risk management particularly focuses on the potential benefits of hedging with other financial instruments to address the question of why companies should use them, under what circumstances, and to what extent. The main aim of corporate risk management is to safeguard the accomplishment of strategic objectives of a company and to strengthen its financial stability by minimalizing the effects of potential financial risks and the magnitude of their consequences. Active integrated risk management of a company will lead to an increase in the predictability of operation, investment, and other financing activities of the company. Financial risk management is a framework to evaluate and manage any financial risk that are closely allied with financial products such as foreign exchange risk, credit risk, market risk, inflation risk, liquidity risk, business risk, volatility risk, etc. This book will trace how the term corporate financial risk management specifies the organizational structure, different procedures, control systems, etc. of a company to manage financial risk. There is a surplus of information on corporate financial risk management where each state of affairs demands a tailored approach. The existing risk management practices in a company can give the best signs on what improvements can be made while dealing with the financial risks of a company. But it is a thorough study of individual risk management practices and behavioral patterns of different organizations that give rise to real-life strategies that can work to fight against various types of risk in a company. In the same context, a framework can be developed that can be modified as per the organization’s culture. That is precisely what the book will be identifying. As defined in this book, corporate financial risk management is defined as the practices and procedures that a company uses to optimize the amount of risk it handles with its financial interests. This definition throws light on how several factors can affect human behavior to get a clear picture of how differences in the application of different risk strategies can be used to achieve the target of

risk reduction in an organization. At the same time, this book will propose very clear insights on the observations that can be worked upon to alter the present working atmosphere that will eventually drive a company’s productivity. The subject matter of this book starts from creating an introduction to the general idea of risk management, its scope, and objective to establish a general framework of how to keep companies away from committing any errors that may lead to a loss in future. The explanation of the same approach is explained in following chapters by discussing the degree till which different types of risks such as market risk, credit risk, legal risk, etc. can be controlled by implementing effective risk management policies. This would be well supported by real-life case studies to enable the reader to achieve direct results. Next focus will be upon different structural functions to manage risk in organizations by implementing various methods and techniques of market measurement. This section would also present the existing areas of enhancement and challenges included under various segments that are aimed to improve the utilization of current risk management properties. Towards the end, a comprehensive detail of the existing efficient approaches in risk management activities in emerging market settings would be covered. This books intuitively covers the risk management plan by entailing the concepts of unexpected risks, minimization of risks and how to cut down on extra costs of risks before they happen. A successful risk management plan always identifies and address potential risks and threats of a company in advance. This book provides the motivation by describing the unique perspective and approach to drive this course of risk management in financial institutions.

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CHAPTER 1

The Evolution and Scope of Risk Management

“Risk management systems and controls may discourage or limit certain revenue-generating opportunities. Failure to ensure the independence of these functions from the revenue generators and risk takers has been shown to be dangerous, and this is something for which the board is accountable.” – Jerome Powell

CONTENTS 1.1. Risk Management: Concept ................................................................ 2 1.2. Risk: Introduction ............................................................................... 2 1.3. The Scope of Risk Management .......................................................... 3 1.4. The Atmosphere of An Emerging Market ............................................. 8 1.5. The Value of Risk Management ......................................................... 14 References ............................................................................................... 24

Corporate Financial risk management: A Practical Approach for Emerging Markets

2

The objective of risk management is to establish balanced criteria for risk assessment. It is extremely important for firms to have in place a strong risk management plan which lets a team carefully measure risk and recommend apt risk management procedures to either completely remove the risk or reduce the negative financial influence of the risk to a considerable extent.

1.1. RISK MANAGEMENT: CONCEPT The process of classifying, measuring, and monitoring threats to an organization’s capital and earnings. These risks or threats could originate from a broad range of sources, comprising financial uncertainty, legal liabilities, strategic management errors, accidents, and natural disasters. All the data related risks, IT security threats and the risk management strategies to lessen them, have become the main concern for digital companies. As a consequence, a risk management plan progressively comprises companies’ processes for identifying and controlling threats to its digital assets, including proprietary corporate data, a customer’s personally identifiable information, and intellectual property.

1.2. RISK: INTRODUCTION Risk suggests means uncertainty in future about deviation from projected income or projected result. Risk evaluates that an investor is ready to take to earn a profit from an investment. Risks are of various kinds and begin from various circumstances. Liquidity risk, insurance risk, business risk, sovereign risk, default risk, and so on. Different risks begin because of the uncertainty emerging out of different elements that impact an investment or a circumstance. The likelihood that a real return on an investment will be lower than the anticipated return (Figure 1.1). Financial risk is distinguished into the following classifications: • • • • • • • •

Basic risk; Capital risk; Country risk; Default risk; Delivery risk; Economic risk; Exchange rate risk; Interest rate risk;

The Evolution and Scope of Risk Management

• • • • • • • • •

3

Liquidity risk; Operations risk; Payment framework risk; Political risk; Refinancing risk; Reinvestment risk; Settlement risk; Sovereign risk; and Underwriting risk.

Figure 1.1: Different forms of financial risks. Source: https://wikifinancepedia.com/finance/financial-management/what-isfinancial-risk-management-techniques-methods-types.

1.3. THE SCOPE OF RISK MANAGEMENT 1.3.1. Risk Appetite Most insurance agencies executing Enterprise Risk Management (ERM) programs have built up an ERM committee. Maybe the most essential part of the ERM board is to characterize risk appetite. A significant number of these ERM committees are characterizing risk appetite as far as their Economic Capital (EC) definition. For instance, they characterize risk appetite as the level of risk that consequents in close to a 0.5 percent possibility of failure over a one-year time period, where failure is characterized as losing 100

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Corporate Financial risk management: A Practical Approach for Emerging Markets

percent of GAAP capital. It is fairly normal to characterize risk appetite in provisions of EC, since EC is typically a key component of an ERM program. In any case, this capital-driven way to deal with characterizing risk appetite: • May not completely capture all risks of the enterprise; and • Does not essentially bring about the ideal level of risk. Not capturing all risks: An essential objective of ERM is to decide the integrated and averaged effect of all risks in the enterprise. Accordingly, it is imperative to choose a risk appetite metric that deals with all enterprise risks. Unfortunately, the EC metric, as a rule, avoids operational risk (e.g., lawsuit) and strategic risk (e.g., poor anticipation). EC modeling commonly functions admirably for market, credit, liquidity, and insurance risks, which are risks that fundamentally identify with estimations of assets and liabilities on the balance sheet. However, EC is less successful for estimating operational and strategic risks, which are risks that affect future incomes or costs. EC models usually address these risks independently by designating an extra static level of EC or basically overlooking them (Figure 1.2).

Figure 1.2: Risk and reward. Source: http://blogs.unwe.bg/pbiolcheva/en/.

Not necessarily optimal: The ideal level of risk can be characterized as the level that best provides the primary stakeholders (investors) while fulfilling the requirements of different stakeholders (rating offices, \

The Evolution and Scope of Risk Management

5

controllers, clients, public, and so on.). Making use of this definition, the ideal level of risk is one that expands investor value. Maximizing investor value is plainly the best approach to best serve the investors. Likewise, the shareholders’ value may be increased by fulfilling the limitations of other stakeholders, to the appropriate extent. For instance, holding large amounts of excess capital may bring about a good rating; however, an excessive amount of fallow capital may bring down investor value. Correspondingly, holding too minimal capital may bring about higher costs of capital, which again may bring down investor value. However, the capital-centric method to describe risk appetite does not essentially consequent in a level of risk that maximizes value. The emphasis is on solvency, which is basically dissimilar from maximizing value. The capital-centric procedure starts with the guess that a particular rating (e.g., AA) is most advantageous. An additional hypothesis is then created about the level of risk that will generate/uphold that rating. Then EC is evaluated, and risk appetite is described at the level of risk constant with the EC formula. There is no thought of the likelihood that a higher or lower level of risk may improve shareholder value. However, there is a way with which this issue can be resolved. It is called as value-based ERM.

1.3.2. Value-Based ERM Value-based ERM is an approach that impacts the evaluation of enterprise value vital to all parts of the ERM procedure. It is a blend of two strategies: • enterprise risk management; and • value-based management’s. For instance, the risk of changes in the expenses of auto repair isn’t probably going to be a significant risk to an insurer that isn’t offering auto insurance. For each applicable risk, a distribution is developed, including probabilities and connections. Moving further to the other side, these pertinent risks work on the organization’s value drivers; for example, incomes, costs, costs of capital, and so forth. The organization’s strategies, including ERM exercises (e.g., reinsurance, hedging, and so on.) and ERM culture go about as the second filter, hosing the effect of the risks on the organization’s value drivers. For instance, in a culture where issues are straightforwardly examined and immediately followed up on, a risk incident is probably going to have less of an effect than in societies where this sort of correspondence isn’t encouraged (Figure 1.3).

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Corporate Financial risk management: A Practical Approach for Emerging Markets

Figure 1.3: Different dimensions of risk management. Source: https://integratedcontinuitysolutions.co.uk/service/corporate-risk-andcyber-security/.

The effect of the risks on the value drivers is measured as an adjustment in enterprises value. Stochastic risk simulations are run to create a scope of enterprise value impacts called “enterprise risk exposure.” The enterprise risk presentation is a key contribution to describing risk appetite. Risk appetite is then characterized as the level of ESR with which the ERM committee is at ease. For instance, the members of the committee may feel that a higher amount of shock resistance would expand enterprise value (e.g., if stock analysts had shown that the monetary after effects of the organization were more unstable than its peer group). Enterprise value might be characterized as the present estimation of distributable income, weighted down at the aggregate cost of capital. Distributable profit incorporates changes in required capital (which might be described by the organization as EC). This is an internal management valuation instead of market value. Value-based management includes decision-making that is driven by its potential effect on value. To deal with the risk exposure to a level consistent with risk appetite, the administration takes actions, for example, evolving business/product mix, participating in different ERM exercises, settling on risk-educated business choices and conceivably changing the risk culture. Each such action changes the risk value profile, bringing about another count of expected scopes of enterprise value and enterprise risk exposure. This re-computation is performed before management action, to educate administration of the risk-value tradeoffs and help with distinguishing key options. With the system above, the value-

The Evolution and Scope of Risk Management

7

based way to deal with characterizing risk appetite captures all enterprise risks and furthermore brings about the ideal level of risk. Captures all risks: The capital-driven approach may not capture operational and strategic risks completely. The EC metric it utilizes is typically constrained to tending to risks that fundamentally affect the balance sheet. However, the value-based approach captures all risks utilizing a risk metric. The value metric can suit every financial effect—those affecting the balance sheet, the income statement and the weighted average cost of capital (Figure 1.4).

Figure 1.4: Risk chart depicting different forms of risk. Source: http://www.pluscapital.co.in/risk-management/.

Ideal level of risk: The capital-driven way to deal with characterizing risk appetite does not really prompt the level of risk that maximizes value. However, the value-based approach is intended to do only that. The way toward characterizing risk appetite starts with an attention on value by considering the distribution of enterprise value (ESR). The board arrives at an accord for the coveted level of shock resistance, which is the level

Corporate Financial risk management: A Practical Approach for Emerging Markets

8

that will expand investor value. In this case, the committee chose a more elevated amount of ESR. The ESR chart develops to be smaller (more shock resistant), and the enterprise value is projected to increase. Describing risk appetite is one of the principal components of an ERM program. Utilizing an EC metric in a capital-driven way to deal with describing risk appetite is a characteristic outgrowth of a developing ERM program. However, the capital-driven approach may not consolidate all risks and does not generally bring about an ideal level of risk. To additionally propel their ERM programs, organizations can adopt a value-based way to deal with characterizing risk appetite. The value-based approach can empower a truly enterprise-wide meaning of risk appetite and can help characterize risk appetite at an ideal level, expanding enterprising value.

1.4. THE ATMOSPHERE OF AN EMERGING MARKET Since the term was instituted in some middle-income nations in Africa, Asia, Europe, and the Americas have been portrayed as ‘emerging markets.’ The arrangement of developing business sector nations perceived by the EMS, while not absolute, has continued to be unaffected since 2008. It incorporates: • • • • • • • • • • • • • • • • •

Argentina; Brazil; Chile; China; Colombia; Egypt; India; Indonesia; Jordan; Malaysia; Mexico; Pakistan; Peru; Philippines; Poland; Russia; South Africa;

The Evolution and Scope of Risk Management

9

• Thailand; • Tunisia; and • Turkey. Emerging market and developing economies now represent near 80 percent of worldwide economic development, twofold their share from two decades back. Their pertinence for the global economy isn’t just as focuses of production or trading centers packaging and delivering products to advanced economies. They have additionally turned out to be progressively vital as conclusive goals for consumer products and services, now representing nearly 85 percent of the development in growth consumption, more than two times their share in the 1990s. These economies have turned out to be more coordinated into the international trading system and global capital markets since the 1990s. And, as this procedure has developed, the relative costs of their exports and imports, external demands, and, specifically, external economic conditions have progressively impacted their development in real income per capita. Our investigation finds, for example, that around 33% of the 1½ rate point’s pickup in the aggregate development rate of earnings per capita since 2005, in respect to the 1995–2004 periods, can be ascribed to additionally stronger capital inflows. After some time, interest for exports from other developing markets and developing economies have applied an all the more effective pressure on these economies’ medium-term growth. Beyond the numbers, the impact of the external condition has reached out to the idea of their development procedure. A few of these economies have encountered circumstances of development accelerations and rehearsals with sustained changes in development rates. These circumstances seem to have a dependable impact on the level of wage per capita. The chapter finds that ideal external conditions improve the probability of growth accelerations and lower that of rehearsals. At the point when a firm with a value producing technological or managerial capability invests abroad, its investors and the host nation’s citizens both remain to profit. However, regardless of how great the obvious fit between what foreign organizations offer and what host nations require, success is a long way from guaranteed. Elections and other political occasions, financial emergencies, and changing societal states of mind can upset the best-laid plans in both rising and advanced economies. The interaction of these powers—and the implications for the political decisions that multinational firms make—will turn out to be particularly prominent

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Corporate Financial risk management: A Practical Approach for Emerging Markets

as national governments graph an unverifiable course toward adjustment following the global financial emergency. Issues, for example, tax collection of executive remuneration, the best possible extent of financial regulation, and international M&A have gone to the forefront in the wake of the emergency, and stark global contrasts in viewpoints and policies on these issues are as of now apparent. The distinctions will just turn out to be more articulated as discussions about the suitable near term policy reaction to the emergency give rise to debates about who should pay and how much. Politicians will battle to balance popular requests to punish those apparent as accountable against fears of blocked advancement and the flight of human and financial capital. More extensive domestic economic worries—for instance, protectionist opinion in light of the realignment of economic power for developing countries, for example, China, and India—will definitely influence the debate also. The multinational firms’ best ready to foresee and deal with the related risks and prospects will have the strongest competitive edge. In the past, foreign investors faced a lot of difficulties and also found it risky investing in developing countries because they had a volatile political structure. The main concern was related to “expropriation risk.” These risks are those where the host governments have the authority to seize foreign-owned assets. But currently, expropriation risk is hardly taken into consideration when it comes to foreign investment. During the 1980s, in many countries, international laws have grown stronger and accommodating nature of growth have helped in reducing the asset seizures to nearly zero. However, in various emerging markets interest rates have ascended these developing countries have learned a lot, according to George Chifor at the University of Windsor in Canada, “that more value can be extracted from foreign enterprises through the subtler instrument of regulatory control rather than outright seizures.” The risk that a government will discriminatorily change the laws, contracts, or regulations governing an investment or will fail to enforce them in a way that reduces an investor’s financial returns is what we call “policy risk.” But, when it comes to policy risk, data are not that clear-cut because of the terms used in this sector like, “political risk,” “political uncertainty,” “policy risk,” “policy uncertainty,” “regulatory risk,” and “regulatory uncertainty.” All these terms indicate that there has been a rise and the seizure risk has fallen.

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Press mentions of actual seizures have also increased somewhat since 2001, but that does not reflect a broad-based resurgence in seizures (Figure 1.5).1

Figure 1.5: Different types of policy risk.

In many countries like Brazil, China, Turkey, and Russia, the markets have witnessed political stability in recent days. Their economies have now gained momentum and have started creating profits for businesses, and new opportunities are open for the fresh entrepreneurs who have also created ample amount of job opportunities for people living in these countries. After having involved in all these activities, political leaders have enjoyed great popularity. Although these economies continue to grow, they are slowing from the extraordinary rates of growth observed in recent years. This is somehow an expected consequence of success which has increased labor costs, thus reducing whatever advantages they might have had overdeveloped market producers. The commodities cycle, in the year 2015 went through a great deal of turn down, which left various emerging economies exposed due to the fall in prices. Any hope of continued growth in emerging markets is now heavily dependent on interest rates remaining low in developed market economies. In such situations, it is important that the central banks in developed countries should revamp their monetary policy which is favorable for the countries’ economy. 1

The Changing Face of Risk in Emerging Markets.

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Corporate Financial risk management: A Practical Approach for Emerging Markets

Emerging markets and developing economies are in a stable situation. Min Zhu, Chairman, National Institute of Financial Research in 2014 stated that “we forecast a moderate pick-up in emerging and developing economy growth to 5.1% this year, and to 5.4% in 2015. One key reason is that several tailwinds that supported growth in the past are fading. We estimate China’s decades-long, double-digit growth rate, which supported its trading partners’ growth, to have slowed to an average of 7.7% in the last two years. Commodity price surges, which have helped resource-rich countries have ended.”2 Despite unique levels of peace and global prosperity, in many economic instabilities has contributed towards anti-establishment, democratic politics, and a repercussion against globalization. Economic recovery is not easy to achieve especially when there is a situation of economic crisis. Boosting growth alone is not sufficient in those countries where there is a political economy. More fundamental reforms to market capitalism are necessary to tackle, in particular, an apparent lack of solidarity between those at the top of national income and wealth distributions and those further down. Economic concerns pervade the latest The Global Risks Report (GRPS, 2017) results.3 The GRPS report in its 12th edition stated that “This is not immediately evident from the evolution of the top five risks by impact and likelihood, which shows economic risks fading in prominence since the height of the global financial crisis and missing entirely for the first time in the latest survey.” However, to evaluate the impact and possibilities of individual risks, it is important to understand the influences and inter-connections of all those measures which would help in shaping the risk landscape. In such cases, the economy is in a dominant situation. “Growing income and wealth disparity” has been regarded as the most trending factor used to determine the global development in the future. Trends that determine Global Developments are: • Rising Income and wealth disparity; • Changing climate; • Rising cyber dependency; • Aging population; • Increasing polarization of societies. Over the past 30 years, inequality between countries has reduced at a tremendous level. But this not the same case in all the countries. Since the 2 2014. 3

What are the main risks for emerging markets? at http://weforum.com, The Global Risks Report, World Economic Forum, 2017.

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beginning of the 20th century, there has been a decline in inequality in the industrialized world at a consistent level, but since the 1980s in the countries like the United Kingdom, the United States, Canada, Australia, and Ireland, the share of income has increased. Although the same change was not witnessed in countries like Japan, Sweden, Germany, France, Netherlands, or Denmark. The main reasons behind these changes are: • •

Skilled manpower found in different regions of the countries. Influential technological changes are contributing in the corporate sector. • Factors responsible for contributing towards the return in education. • Combined with scale effects as markets became more interconnected, and there has been an increasing level of global competition for acquiring talent. Among other things, this has led to an increase in compensation provided to the Chief Executive Officers of the firm. Global communications have also helped in increasing returns for individuals who could successfully cater to a global audience what Sherwin Rosen described as “the economics of superstars.” In advanced economies, there has been a reduction in the incomes of the traditionally well-off middle classes and the pace of this class is comparatively slow with the incomes of the emerging middle classes of countries in Africa, Latin America, and particularly Asia. The slow pace of economic recovery since 2008 has intensified local income disparities, with a more dramatic impact on many households than aggregate national income data would suggest. CEOs of big MNCs generally talk about the need for economies to be open. According to them, foreign direct investment is best in those countries where it welcomes direct investment by multinational corporations, although companies can get into countries that don’t allow foreign investment by entering into joint ventures or by licensing local partners. Still, companies should always keep this in their mind the concept of “openness” which can be deceptive. Financial markets could be volatile for the foreseeable future. The main reason is that an orderly transition to a world without unconventional central bank policies will likely face multiple challenges. Some of those challenges have been discussed below:

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• • • • • •

Expectations for having a smooth adjustment of short-term interest rate; Gradual return to normal of the difference in yields on long-term and short-term bonds; Continuously liquid markets; Gradual slowing down of excessive leveraging; Economic growth gaining strength; Smooth portfolio adjustments.

1.5. THE VALUE OF RISK MANAGEMENT Risk management is very essential for any company. In this part of the chapter, the importance of risk management has been described in detail. Risk management improves the management system of a company, and a value is added through financial risk management. Financial risk management is that kind of management which helps in overcoming all those hurdles which might affect the company in an adverse manner if not implemented accurately. The value of risk management is complicated and not clearly defined (Figure 1.6).

Figure 1.6: Value of risk management. Source: https://wikifinancepedia.com/e-learning/definition/what-is-investment-banking-and-services-offered-by-investment-bankers-banking-basics

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This was first studied in academic circles, as it is of great practical interest, but not completely because some of the functions of risk management are not considered useful in the financial environment. It also sheds light on what should be considered a risk-neutral position. Risk management contributes a lot in a company through three different sections. Those three sections of a company are: systematization, objectivity, and uniformity. These are the new framework which are modified if risk management activities are performed systematically. The three divisions have been discussed in detail below (Figure 1.7):

Figure 1.7: Three dimensions of risk management.

1.5.1. Systematization The accurate form of systematization defines the management has precision in taking a risk and have control over all the actions performed by the management team. There is a proper evaluation of performance which provides flexibility to the team members to take advantage of business opportunities. The first factor that contributes towards systematization is the implementation of a management information system (MIS). The MIS helps in keeping records of complex data in one single system and could be modified according to the changes occurring in the system. But, the person-in-charge of MIS should capture with predefined frequency in order to answer all the questions that arise during the decision-making, control, and risk-reward evaluation processes. Systematization is also directly proportional to the explicit definition of policies and procedures and, in general, of all the elements of the risk management implementation process.

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1.5.2. Objectivity If risk management strategies are implemented systematically, then it helps in achieving objectivity in the company. Objectivity reduces the level of uncertainty in risk estimation as a result of new measurement methodologies. Objectivity in any company helps in facilitating the forecasting process, and generally, the focus is towards the estimation of expected returns due to the variations in different risk factors. An improvement in objectivity does not reduce the importance of management, and in fact, it helps in making the system more flexible. In general, expert knowledge should be exploited in risk measurement as well as in the selection of methodologies, the definition of initial parameters, and the identification of specific risks not adequately captured in the systems. Risk measurement helps in successfully establishing the risk limits, which might prevent a manager from causing excessive losses to the company.

1.5.3. Uniformity Uniformity is highly required in any company. It is required when any business processing is evaluated and also when any marketing decision has to be taken. When there is a uniform comparison between the return which has been received by the company with the risk assumed (uniform measures specifically), it helps in identifying those individuals and businesses that have helped in contributing towards the value creation, the reorientation of the future activities and towards their adequate compensation. At the same point of time, two managers who have the same return expectations and equal estimates of the risks involved should make the same decision related to its acceptance or rejection. Only then are efforts adequately focused towards the achievement of company objectives. The above-mentioned advantages are augmented when all decisions take place within the scope of risk management and are controlled and evaluated frequently. In the financial market environment, opportunities can present themselves quickly and are in abundance. There is a space for the risk-reward profile which might change rapidly. For that reason, information and management systems are required to be much faster than those used for budgeting and accounting processes. The new risk framework pays particular attention to the rapid availability of information to management. The high losses that can result from a management structure that cannot keep pace with the business cycle fully justify the material and human investments necessary to stay in step.

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Once the utility of risk management has been acknowledged by a company, the next part of risk management is towards the control and management of all the risks that might evolve in an organization. The attention is also drawn towards specific risks which might affect the company adversely. Specifically, the extent to which active risk management adds shareholder value has been questioned, with the argument that investors can take financial-market positions based on their own views, thereby enjoying the advantages of diversification. For example, because of depreciating value of the dollar with respect to the value of the local currency, if the profits of the company get affected leading to affect the value of the company adversely (this will also affect the exports to the United States), there are chances that shareholders could protect themselves by investing in dollars or buying a forward contract. In this situation, the opinion that financial risk management does not create shareholder value implies that an investor would not pay more for the company’s shares just because the company’s policy is to protect its future profits from currency risk, because the shareholder could acquire this protection by him or herself. This kind of attitude or sensibility towards any company, which assumes that efficient investors are effective in managing a portfolio of stocks, holds that they need not manage the individual positions of each company separately but only the net position of the portfolio. In this way, transaction cost savings would be achieved (commissions for financial transactions) and management time would not be dedicated to taking financial positions. As per this rationale, the main components of financial risk management by any company mainly includes communication with the shareholders, identification of its position, and the prevention of significant deviation from these positions. Risk control and management would take charge of all the relevant features, the technique mentioned above is grounded on the assumption that all the relevant information related to position of organization is available to managers and investors of the company without any differentiation, and that there are no secondary repercussions due to the lack of active position management of organization in which financial costs are not included. This case is not in practice because, •

It is known to everyone that managers in the company have always been more aware regarding the stature and position of the organization in the market than the investors are.

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•

Financial risk management is known to substantially decrease the costs of the company like fiscal, bankruptcy debt, underutilization of available capital and illiquidity that results in increased cash flows to investors and shareholders with no increase in the risks. The only way out that is feasible and ensures equality in maintaining the parity of information between the company managers and investors, on the position at all times, would start from management side by communicating a benchmark position to investor and shareholders and to make sure that they will guide and correct them when the investors deviate from that position. There are several reasons that prove that it is impossible in reality like: •

•

•

Disclosure of positions to the public might place the organization at a disadvantage as compared to competitors. For instance, if an airline declares not to hedge costs of fuel in local currency, and this information is reported to investors, and by chance, the fuel process increases steeply, a smart competitor that has already hedged its fuel prices in local currency might start a price war to increase its market share, as they already know that their rival company is exposed. From this, it can be seen that a mere revelation of currency position can trigger the competitors of the market in which that organization operates or the nations from which imports its raw materials. The place and positioning of investors in the organization would be related to the risks, especially the financial risks that are faced by leading businesses, whose estimation is subject to great uncertainty. For example, this is important to understand how the sales in the domestic region of an organization would get an impact in the case of depreciation of a neighbor nation’s currency positively impacted the entry of a new competition. Huge financial damages can be caused to investors due to minor estimation errors, who based on this wrong information, can conclude to hedge their foreign exchange risk and blame the managers and other management teams, legally responsible for delivering the wrong placement. There can be the modifications in the financial risks that are related to the businesses, which can be achieved by frequently adjusting the benchmark position. For example, the foreign currency risk of an organization can change from a mere change in the products range offered by the organization that imports its

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raw materials. As a case of the above statement, the information related to the positioning of company that investors have is very limited, it is recommended to withhold a large part of financial risk management within the company only. On the other hand, it can also be seen as the fact that if risk management is mostly withholding in the company itself, it can add value to shareholders by bringing the considerable reductions in the various costs. • Bankruptcy costs: proper risk management is the key to reduce the chances of bankruptcy, which in turn increases the expected cash flow in the near future to the shareholders by substantially reducing the prospects of incurring costs of bankruptcy. These costs must be taken not as a damage in the rate of stakeholder asset but in its place as a share of the corporation’s value which will not fulfill the privileges of the creditors and the stakeholders. Liquidation cost is one of the most significant bankruptcy cost that covers loses on the value of liquidation, legal expenses, salaries to employees, and other costs. The rate of expected recovery of these costs is very less. Due to this fact, it makes them to ask for higher reimbursement at the time when these costs are lent, that in turn decreases the expected returns to the stakeholders. The other prominent bankruptcy costs due to which efficiency is severely impacted are: • The change of guidance in management from those shares of the firm which are lucrative, profitable or creates capital; • Decrease in the morale of employees; • Problems in working usually with suppliers (who demands guarantees in payment), clients (there is no guarantee that they will receive the supplies in the future), etc. There are strong chances that all of these troubles can happen the legal declaration of bankruptcy afore. In case of ignorance of bankruptcy costs, a stockholder would be unconcerned to the long-term debts of the organization that are gained via issuing floating or fixed rate bonds; none of the financial instrument can be compared and prioritized, and due to which both these instruments are in existence The stockholder can regulate their place in accordance to the rates of interest by purchasing few or more Treasury bonds that are at fixed-rate, rendering the fact that the company provides floating or fixed rate debt. However, in case company management guesses a depression, followed by

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a decrease in rates of interest which are not yet accounted by the market and fall in sales of sales products, it is highly recommended that floating rate debts should be taken into consideration so as to pay for the fall in sales of products with reducing financing costs. The probability of bankruptcy will increase significantly if the following measures are ignored and not taken into consideration.

1.5.4. Debt Cost The abridged chances of bankruptcy by efficiently managing the position of finances minimalize the cost of debt, that too with no increase in capital investments. And with no additional costs being spent, if this development in solvency has happened by the means of exploiting the financial positions initiating from the business dynamics, as discussed in the example in the last paragraph, the value of shareholders is clearly improved. If the abridged likelihood of bankruptcy is accomplished by the means of cost hedges, like introducing the buying options that safeguard in contradiction of a rise in rates of interest rates), these expenditures must be matched with the savings attained in the financing. As an alternative, the development in creditworthiness could be taken into consideration to upsurge debt, in place of reduction in costs and hence to start new assignments that can also create value for shareholders.

1.5.5. Fiscal Costs Taxes are another type of expenditure that can be taken care with financial risk management. For example, let’s assume that the rate of taxes is based on the profit levels. If the floating rate debt is reserved, a rise in rates of interest can bring up the profits of the company to $100 million before taxes, and the tax rate is 30% at this level. If the rate of interest decreases, the profit will rise to $200 million that will be under the tax bracket of 40%. And in another case, if the interest rates remain constant, the profits be $150 million, and 32% will be the tax bracket for this amount. If all the above-mentioned cases are equally probable, it can be said that expected profits after taxes would be somewhere near $97.3 million. If we hedge the interest rates on current levies, profits would be around $102 million after taxes, and it is around $4.8 million more without hedge which was $97.3 million, the reason being pre-tax profits underneath hedging will be the similar as average pre-tax profits without hedging that is $150

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million, but then again, it would dodge the negative tax impact of unhedged profit distinction.

1.5.6. Costs of Illiquidity The absence of liquidity in the capital markets also announces added indirect costs, explicitly the opportunely costs, that is the outcome of the necessity in order to delay the projects that are profitable, the reason being an inability to gain the required additional extra costs and financing costs in some cases. By implementing proper financial management, stability in profits or stability can be achieved, also safeguards firm accessibility of funds that are generated internally, that can be used to take advantage of investment opportunities. This feature is serious in the capital markets that are less-developed, the main reason being the high costs and difficult execution in obtaining an adequate financing level in a quick manner (with capital or debt) rapidly. At times, potential investors are uncertain about the half company management that acts upon the interests of present stakeholders, who are willing to follow a new investment prospectus they that half the organization is overvalued on the Stock Exchange. For half reason, the potential investors ask for noteworthy discounts on prices of shares, which are further integrated into the actual issuance prices, like publicly, underwriting costs, etc.

1.5.7. Underutilization Costs of Capital In case the organization has more funds than the projects they have for investments, they should share or return the sum eventually to the stakeholders via share repurchases or through dividends. Though, if these extra funds were only for a short time and are provisional in nature, and also did not persuade creditors to better understand the quality of credit in the organization and in return diminishes the capital costs of the company, the funds that are left must be invested, that would substantially increase the risk taken by the firm in searching profitable returns demanded by the stakeholders. Financial management permits firms to regulate the estimated risks levels, understand the capital needs in order to cover risk, and then execute a comparison between the available capital and risk capital, that enables in making effective decisions. Some of the previously discussed points should be considered while setting a standard. Suitable risk management is required to uphold the external credit rating (that are brought into action by leading

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rating agencies or generally by the banks’ internal classifications) that are in sync with creditworthiness as projected by the management of the company. To attain that, the firm must prove to lenders and rating agencies that they are aware of the risks and can control them, and that any investment decision is analyzed adequately. Risk management also enables to show the regulatory agencies the potential to develop the business while keeping safe the interests of the third party for examples depositors in the bank, even when it is not required by the law to form a specific risk measurement and management. When demanding superior approvals from government and regulatory agencies, the thoroughness of risk management can be a decisive feature. Likewise, in a probable consultative stage before the way of a new regulation, the complexity of the entities made in risk management tends to be booked into justification, to focus the controls on verifiable and critical extents. As a noteworthy case, in this case, the directives of the Basle Committee must be taken into consideration that permits the banks to use their own systems to amount Value-at-Risk in their financial treasury operations and portfolios. A bigger benefit of this approach is that the regulators should take charge of risk in the same manner as done by management at the time of rational decision-making that reduces the restrictions that might sound absurd in few cases. This kind of regulation integrates more value for: •

The stakeholder, by removing redundant limitations imposed on the business. • Company management that focuses its attention on the important aspects of the business, with minimal disruptions. • Regulatory and rating agencies that can control and recognize the factors important for their purposes. • Society, this is done by enhancing economic efficiency. In total, risk management is important for organizations that are linked to the entity, and as a result, it incurs credit risk. Profits and activities are impacted negatively due to the restrictions imposed on the companies that are willing to maintain relations with an entity. To conclude, the investment firms make to improve risk management, and it can be justified by several reasons: Any organized firm handle its risks, but required investments must be made so as the management remains objective, systematic, and uniform.

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Most of the risks related to finances must be managed internally by the organization and bot by investors, particularly in cases when company management has better data as compared to the investors at all the times in respect to the position of the organization. Whole risk management enterprise-wide can underwrite to the value of stakeholders, improve the trade-off in risk-reward by attaining proper consumption of available funds, of the firm and decrease the bankruptcy debts, illiquidity costs and fiscal costs.

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REFERENCES 1.

BusinessDictionary.com, (2018). When Was the Last Time you Said This? [online] Available at: http://www.businessdictionary.com/ definition/risk.html [accessed 9 April 2018]. 2. Gruss, B., Poplawski-Ribeiro, M., & Nabar, M., (2017). Emerging Markets and Developing Economies: Sustaining Growth in a Less Supportive External Environment. [online] IMF Blog. Available at: https://blogs.imf.org/2017/04/12/emerging-markets-and-developingeconomies-sustaining-growth-in-a-less-supportive-externalenvironment/ [accessed 9 April 2018]. 3. Henisz, J. W., & Zelner, A. B., (2010). The Hidden Risks in Emerging Markets. [online] Harvard business review. Available at: https://hbr. org/2010/04/the-hidden-risks-in-emerging-markets [accessed 9 April 2018]. 4. Khanna, T., Sinha, J., & Palepu, G. K., (2005). Strategies That Fit Emerging Markets. [online] Harvard business review. Available at: https://hbr.org/2005/06/strategies-that-fit-emerging-markets [accessed 9 April 2018]. 5. Rouse, M., (2016). What is Risk Management? – Definition from What Is.com. [online] Search compliance. Available at: https:// searchcompliance.techtarget.com/definition/risk-management [accessed 9 April 2018]. 6. Scott, I., (2017). Environmental health in emerging markets, [eBook] Available at: https://ems.gtc.ox.ac.uk/sites/ems.gtc.ox.ac.uk/files/ Full%20Report%20-%20Environmental%20Health%20in%20 Emerging%20Markets%20NE.pdf [accessed 9 April 2018]. 7. Shimpi, A. P., & Lowe, S., (2006). Risk Management. [eBook]. Available at: https://www.soa.org/./risk-management./2006/july/rmn2006-iss8-lowe-shimpi.pdf [accessed 9 April 2018]. 8. The Economic Times, (2018). Definition of Risk. What is Risk? Risk Meaning – The Economic Times. [online] Available at: https:// economictimes.indiatimes.com/definition/risk [accessed 9 April 2018]. 9. The Global Risks Report (12th edn.), (2017). [eBook] Available at: http://www3.weforum.org/docs/GRR17_Report_web.pdf [accessed 9 April 2018]. 10. Wilkinson, B., (2015). Emerging Markets Turbo-Capitalism Turns to Political Crisis. [eBook] Available at: http://www.oliverwyman.

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com/content/dam/oliver-wyman/global/en/2014/dec/RJ2014%2003_ Political%20Risks_Ipad.pdf [accessed 9 April 2018]. 11. Zhu, M., (2014). What are the Main Risks for Emerging Markets? [online] World Economic Forum. Available at: https://www.weforum. org/agenda/2014/01/main-risks-emerging-markets/ [accessed 9 April 2018].

CHAPTER 2

Types of Risks and Their Control: Market, Credit, Operational, and Legal Risk “Not taking risks one doesn’t understand is often the best form of risk management.”

― Raghuram G. Rajan

CONTENTS 2.1. Corporate Risk And Its Management ................................................. 28 2.2. Market Risk....................................................................................... 37 2.3. Credit Risk ........................................................................................ 39 2.4. Liquidity Risk .................................................................................... 41 2.5. Operational Risk ............................................................................... 43 2.6. Legal Risk ......................................................................................... 47 2.7. Legal Risk Management .................................................................... 49 2.8. Financial Risk Management Methods And Techniques ...................... 53 References ............................................................................................... 55

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Financial risk implies the possibility of a firm’s loss due to changes in market factors such as interest rate, currency fluctuations, equity market rates, commodity price variation, and changes in the legal and regulatory environment. In this context, this chapter defines different types of financial risks like market risk, credit risk, operational risk, and legal risk in detail along with challenges faced by these financial risks. The chapter also explains financial risk management and legal risk management and the extent to which regulatory factors impact risk assessment.

2.1. CORPORATE RISK AND ITS MANAGEMENT Corporate risk implies the degree to which any desired action or inaction may lead to a loss or some undesirable outcome. The idea of corporate risk signifies a decision of choice that may leave an influence on the outcome that has existed or already exists. However, risk in financial management refers to material loss that is attached to a project which may affect the factors like productivity, tenure, legal issues, etc. of that project. Corporate risk management refers to the different methods that a company utilizes to minimize its financial losses. Managers, executives, and other employees perform practices to avert the loss of the company by implementing loss control measures and technologies (Figure 2.1). In corporate finance, a different form of risk is classified under two major groups, that is;

Figure 2.1: Classification of financial risk. Source: http://kalyan-city.blogspot.in/2012/01/types-of-risk-systematic-and. html.

Types of Risks and Their Control: Market, Credit, Operational, and Legal Risk

• •

29

Systematic risk: Systematic risk refers to a risk that is uncontrollable by any organization and is macro in nature; and Unsystematic risk: Unsystematic risk refers to a risk that is controllable by an organization and is micro in nature.

2.1.1. Systematic Risk The risk that occurs due to the impact of external factors in an organization is known as systematic risk. Generally, such external factors are uncontrollable from the point of view of an organization. These risks are macro in nature where they affect a large number of organizations that operate under same segment or domain. Systematic risk cannot be planned by any organization. Some of the different types of systematic risk are depicted below (Figure 2.2):

Figure 2.2: Different types of systematic risk. Source: http://kalyan-city.blogspot.in/2012/01/types-of-risk-systematic-and. html.

• Interest rate risk; • Market risk; and • Purchasing power/inflationary risk. Above described systematic risk are discussed in detail below: •

Interest rate risk: The risk that arises due to variability in the rates of interest from time to time is known as Interest-rate risk.

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This type of risk predominantly affects the debt securities because they carry a fixed rate of interest which becomes highly variable due to external factors. Interest rate risk is further divided into two types of risk that are listed below (Figure 2.3):

Figure 2.3: Different forms of interest rate risk. Source: http://kalyan-city.blogspot.in/2012/01/types-of-risk-systematic-and. html.

•

•

•

Price risk: The risk in the prices of a commodity arises due to the likelihood of changes in the prices of shares, commodity, investment, etc. which are subjected to decline or fall in the near future. Reinvestment rate risk: Reinvestment rate risk refers to the risk that results from the fact that any interest or dividend received from doing an investment can’t be reinvested again with the same rate of return as it was done earlier. Market risk: Market risk refers to a risk that is associated with constant fluctuations that are visible in the trading price of any shares or securities of a company. Generally, the market risk arises due to the rise and fall in trading prices of shares or securities in the stock market.

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Different types of market risk listed below (Figure 2.4):

Figure 2.4: Classification of market risk. Source: https://www.simplilearn.com/financial-risk-and-types-rar131-article.

•

•

•

•

•

Absolute market risk: The risk that occurs without any content is known as absolute risk. For instance, if a coin is tossed, then there are an equal percentage of getting a head and vice-versa. Relative market risk: The assessment or valuation of risk done at different levels of business functions is known as relative risk. The increasingly high rate of relative risk has been observed when a company’s maximum sales are accounted by export sales, and it may get subjected to some other form of foreign exchange fluctuation. Directional market risk: Directional risk refers to those risks where loss rises due to an exposure of company’s stocks to assets of a market. For instance, if an investor holds some shares and due to some sudden market fluctuations, the price of those shares falls then he may experience a loss in shares which is directional in nature. Non-directional market risk: Non-directional risk happens in the market when the practice of trading is not followed consistently by the trader. This type of risk occurs when dealer buys and sells the share simultaneously to lessen the chances of risk foreseen. Basis market risk: When a possibility of loss arises due to incorrectly matched risks then basis market risk rises. These

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types of risks are generally found in offsetting positions in two related but non-identical markets. • Volatility market risk: A risk that generates due to a fluctuation in the price of securities because of changes in the volatility of a risk-factor is known as volatility market risk. This type of risk is generally found in ranges of derivative instruments, where the factor of volatility of particular instrument is majorly affected by a change in market prices. • Purchasing power risk: Risk of purchasing power is also known by the factor of inflation risk. This is so because this type of risk originates from the circumstance that it majorly affects the purchasing power of people undesirably. Generally, it is not desirable to put finance in securities during the time of an inflationary period. The types of power or inflationary risk are depicted and listed below (Figure 2.5):

Figure 2.5: Classification of purchasing power risk/inflation risk. Source: https://www.simplilearn.com/financial-risk-and-types-rar131-article.

•

Demand inflation risk: When an increase in price results in the market because of an excess of demand over supply than demand inflation, risk occurs. It happens when supply fails to handle the demand of a commodity and cannot expand anymore in market. In

Types of Risks and Their Control: Market, Credit, Operational, and Legal Risk

•

33

other words, demand inflation is seen when factors of production are utilized at their maximum. Cost inflation risk: When there is a constant increase in the prices of goods and services, then cost inflation risk arises in market, which occurs due to higher cost of production. An initial rise in the cost of production leads to inflated final price of finished goods and products.

2.1.2. Unsystematic Risk A risk that arises due to internal factors that prevail within an organization is known by unsystematic risk. The factors affecting this risk are generally controllable in nature from an organization’s point of view. Unsystematic risk is usually micro in nature as they impact only a particular organization. As these risks are already planned, so necessary actions can be implemented by an organization to moderate the effect of risk. Different types of unsystematic risk are listed below (Figure 2.6):

Figure 2.6: Unsystematic risk and its different types. Source: https://www.siplilearn.com/financial-risk-and-types-rar131-article.

• Business/liquidity risk; • Financial/credit risk; and • Operational risk. Above said each risk is classified in detail below:

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•

Business or liquidity risk: Business risk is also known by the name of liquidity risk because it originates from the sale and purchase of securities that get affected by measures like business cycles, technological changes, etc. Two different types of business risk are listed below (Figure 2.7):

Figure 2.7: Different forms of business risk/liquidity risk. Source: Business Risk/Liquidity Risk.

• Asset liquidity risk; and • Funding liquidity risk. The meaning of asset and funding liquidity risk is as follows: •

•

2.

The risk that arises due to the loss from an inability to sell or purchase assets at their carrying value when required is known as asset liquidity risk. This happens when assets are sold at a value lesser than their book value. Funding liquidity risk arises when there are not sufficient funds to make a payment on time. This occurs when commitments made to customers are not justified as discussed in the service level agreements. Financial or credit risk: Financial risk is also known by the name of credit risk which occurs due to change in the capital functioning of an organization. Basically, there are three ways in the capital structure through which funds are sourced for different projects. These are listed as follows:

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35

• Owned funds like share capital; • Borrowed funds like loan funds; • Retained earnings like reserve and surplus funds. The types of financial/credit risk are listed below (Figure 2.8):

Figure 2.8: Classification of financial risk or credit risk. Source: http://kalyan-city.blogspot.in/2012/01/types-of-risk-systematic-and. html.

•

• •

• •

•

Exchange rate risk: Exchange rate risk is also known as exposure rate risk. Exchange rate risk is a component of financial risk that occurs due to potential change seen in the exchange rate of one country’s currency with respect to another country’s currency and vice-versa. Recovery rate risk. Credit event risk: One of the neglected parts of credit-risk analysis is recovery rate risk which needs a true evaluation of risk entailed with credit. Non-directional risk. Sovereign risk: Sovereign risk is observed in association with the government where a government is unable to meet the obligations of loan. Settlement risk: Settlement risk arises when other party is not able to deliver a security or its term value in cash as per the agreement made on the basis of trade and business.

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3.

Operational risk: The business process that fails due to errors made by humans is known as operational risk which differs remarkably from one industry to another industry. The main reason behind the breakdown of these risks are internal procedures, methods, people, policies, and systems. Some of the operational risks are listed below (Figure 2.9):

Figure 2.9: Various forms of operational risk. Source: http://kalyan-city.blogspot.in/2012/01/types-of-risk-systematic-and. html.

•

•

•

Model risk: Model risk is evaluated by using different models to measure financial securities. This type of risk arises due to the probability of loss that results from assessing and managing a risk. People risk: When people do not adhere to organization’s procedures, practices, and rules then people risk is seen in market. This is basically due to deviation of people from their expected behavior. Legal risk: Legal risk is also related to regulatory risk that arises when parties are not lawfully competent to enter an agreement among themselves in a mutual manner.

Types of Risks and Their Control: Market, Credit, Operational, and Legal Risk

•

37

Political risk: Political risk occurs when there are any changes in government policies because such unwanted changes leave an unfavorable impact on an investor. Political risk is especially visible in the third-world countries

2.1.3. Conclusion (Figure 2.10)

Figure 2.10: Structure of types of risk in finance. Source: https://www.simplilearn.com/financial-risk-and-types-rar131-article.

So, these are some basic types of risk seen in the domain of finance. There are several ways to categorize company’s financial risks. In this context, one approach is to divide separate financial risk into four main categories: market risk, credit risk, liquidity risk, and operational risk.

2.2. MARKET RISK Market risk refers to the risk that arises due to fluctuations in investment market. Under this risk, the value of an investment decreases sharply due to some changes in factors of market where these factors leave heavy impact on the overall performance of financial markets. Market risk can be reduced by diversification of assets which are not correlated with the forces of market. Market risk includes the risk of changing conditions in the specific marketplace under which a company competes for business.

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Also, market risk is called by the name of “systematic risk” as it relates to external market factors like recession which adversely impact the entire market. On the other hand, market risk contrasts with specific risk, which is known by business risk or unsystematic risk, which is confined directly with a financial market sector or performance of a company. Thus, market risk implies to the overall security markets, while specific risk is involved only in a part of it. Some of the factors affecting market risk include recessions, political disturbances, and fluctuations in interest rates, natural calamities, and terrorist attacks. The risk factors that are associated with market risk include: • • • •

Interest rates; Stock prices; Commodity prices; Exchange rates.

2.2.1. Interest Rate Risk A commodity or business is subjected to interest rate risk when its value is dependent upon the level of interest rates in the financial markets. An entity is exposed to interest rate risk when: •

•

•

The change in the value of assets resulting from a fluctuation in market interest rate does not match the changes in the market value of its liabilities. In addition to this, the difference is not equalized by the changes in the market value of off-balance sheet mechanisms. The sensitivity of both assets and liabilities of market factors vary when these assets have different time of maturities, varied amortization schedules, different coupon reference rates, credit ratings and other characteristics options of repayment, prepayment or extension, etc. Future earnings from remaining transactions are dependent upon interest rates.

2.2.2. Equity Risk A commodity is vulnerable to equity risk when its value is dependent upon the prices of certain stocks or stock indices. The risk of equity exposure will sustain in market when a company has made investments in other entities, irrespective of whether they were made for some speculative purposes or

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to impact the management of a company. Any single entity is also exposed to risk when it retains the derivatives whose underlying value is exposed to equity risk.

2.2.3. Commodity Price Risk An entity is vulnerable to commodity price risk when the value of that entity is affected by the fluctuations in prices of commodities in international markets. Commodity price risk arises due to following factors, when: • • • •

The investment in entities is done for speculative purposes or for business purposes. The entity has derivatives positions of whose underlying asset is subjected to commodity price risk. A single specific commodity is used intensively in the production processes of entity. Any specific commodity is a substitute for one of its products.

2.2.4. Exchange Rate Risk Exchange-rate risk which is also known as currency risk rises from any change in the price of one currency with respect to another currency. Mostly, investors or firms that hold their assets in another country are subjected to high rate of currency risk.

2.3. CREDIT RISK The risk that arises in businesses due to extension of credit to customers is known as credit risk. It also refers to the company’s own credit risk with their own suppliers. A financial risk occurs in any business when it provides finances to its customers and their remains a high possibility of default on payment by customers. A company can reduce its financial risk if it can handle its own credit obligations by making sure if it has sufficient cash flow to pay the bills for their account on time. If this is not adhered, then suppliers may either stop offering credit to the company or may stop doing business with the company at the same time. Credit risk is simply defined as, “the potential that a bank borrower or counterparty will fail to meet its obligations in accordance with agreed terms.” The main goal of credit risk management is to maximize risk-adjusted rate of return of bank by sustaining the risk of credit exposure within the parameters

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of acceptable limits. Banks should consider the relationships between credit risk and other risks. The management of credit risk forms one of the critical mechanisms towards the comprehensive approach to managing the risk which is essential for the long-term success of any banking organization. Credit risk implies to the probability of loss on the part of borrower’s failure to make payments with respect to any type of debt. In this context, practice of credit risk management is followed to mitigate the losses of bank by considering the adequacy of bank’s capital and losses in loan reserves at any given time. This process has seen as a big challenge for many financial institutions.

2.3.1. Challenges Some of the challenges for successful management of credit risk have been described below: •

•

•

•

•

Inefficient management of data: This refers to inability to access the right data at right time which further causes problematic delays No risk modeling framework: Without the framework of risk modeling banks are not able to generate complex and meaningful risk measures to get a better picture of group-wide risk. Constant rework: Analysts can’t change model parameters easily, which results in too much duplication of effort and negatively affects a bank’s efficiency ratio. Insufficient risk tools: Without an effective solution of risk mitigation, banks can’t identify portfolio concentrations or regrade portfolios to efficiently manage risk. Cumbersome reporting: Sometimes manual and spreadsheetbased reporting processes overload analysts and IT personnel.

2.3.2. Best Practices to Manage Credit Risk 1.

2.

The first step towards an effective credit risk management is to achieve a complete consideration of banks overall credit risk by analyzing the risk at the individual, customer, and portfolio levels. Most of the banks attempt to extract an integrated approach to mitigate their risk profiles, but much information is often scattered among different units of the business. Thus, some of

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3.

• • • •

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the vulnerable banks are on close target of the regulators and investors. The key to reduce the losses in loan is to ensure that reserves of capital should appropriately reflect the risk profile, to implement an integrated and quantitative solution towards credit risk solution. This solution should head the banks up to run quickly with simple portfolio measures which include following measures: Better management of model that extends to entire life cycle of modeling. Real-time scoring and limiting monitoring. Vigorous stress-testing capabilities. Implementation of tools like data visualization capabilities and business intelligence to extract important information and give into the hands of those who are in need of it as when they need it.

2.4. LIQUIDITY RISK Liquidity risk includes both “asset liquidity and operational funding liquidity risk.” In this context, former refers to the ease according to which a company can convert its assets into cash when there is a sudden or substantial need for cash flow in market and, later refers to a daily cash flow to meet the requirement of funds. Sudden seasonal downturns in revenue can lead to a substantial risk for a company if company finds itself with no cash in hand to pay for the basic expenses to continue the functioning of their business. This is the reason behind the requirement of cash flow management for success of any business. Also, both the analysts and investors look at metrics like free cash flow to evaluate the company’s strength in terms of an equity investment. Generally, liquidity risk is seen when an individual investor, business or financial institution is not able to meet its short-term obligations of debt. In this, the investor is not able to convert an asset into cash without giving up capital and income due to lack of buyers or presence of an inefficient market. Due to risk of liquidity, investors should consider whether they can cover their short-term debt obligations into cash instead of investing in longterm illiquid assets.

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To manage the liquidity risk following measures and strategies are used by banks: •

•

Assessment of bank’s ability to meet the demand of cash flow and collateral under both normal and strained conditions without leaving a negative impact on day-to-day transactions and overall financial position of banks. Moderate the rate of risk by structuring strategies and implementing necessary actions to confirm if necessary funds and collateral are present in banks when needed.

2.4.1. Challenges Some of the challenges for successful management of liquidity risk have been described below: •

•

•

•

No centralized measure of liquidity: Presence of isolated departments and business units, bounds a firm’s ability to comprehend its liquidity position in financial market. It also leaves a negative impact to understand the implication of illiquid assets and different types of asset according to different geographies, business units, and asset classes. Limited analytic abilities: Due to the absence of enough analytic capabilities, firms experience extreme trouble in projecting cash flow for different types of underlying transactions, especially when those transactions are in millions. Insufficient stress testing: It has been observed that many firms have ignored the liquidity considerations of trading and funding under stress testing. Also, these firms are unprepared to face the impact of market shocks which makes it tough for them to get out of these shocks easily or to attract new funding from the market. Overcoming the mindset of compliance: If a firm focus completely on the requirements of compliance which is surrounded by the liquidity risk management, they it may overlook the benefits gained by the business.

2.4.2. Three Key Steps towards Right Liquidity Risk Management For an effective liquidity risk management system following three steps should be followed in an organization:

Types of Risks and Their Control: Market, Credit, Operational, and Legal Risk

1. •

•

2.

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Development of analytic framework to calculate risk, optimize capital requirements and to measure liquidity of market. This requires the minimization of market shocks by seeking better arbitrage opportunities to analyze the changing effects of cost and liquidity in real time. It helps to quickly optimize the solutions of firm’s liquidity and capital needs by assessing market liquidity of firm. It also assists the optimization of firm-wide operations by using rapid and on-demand based analysis of scenario which is dependent upon complex portfolios, positions, and instruments that are used across multiple time horizons.

Management of data: •

3.

Management of data helps to gain an overall view of firm liquidity by assimilating different dimensions like latest market information, updates on portfolio, returns on capital investment and overall view of market liquidity on the daily intraday transactions.

Integration of risk management: •

Integration of risk developments leads to the valuation of complex portfolios and asset management on a single platform. It also helps to instantly evaluate the potential impact of future market shocks on liquidity.

2.5. OPERATIONAL RISK The risk that arises from company’s ordinary business activities is known as operational risk. Operational risk also includes some lawsuits, fraud risk, employee’s problems, and business risk model that lies under company’s models of marketing which prove to be inaccurate or inadequate sometimes. Operational risk mainly emphasizes on how things are achieved within an organization and not what is endowed within an industry. These risks are generally linked with active decisions that relate to the various functions of an organization. Though these risks are not definite to result in failure as they are seen as higher or lower depending upon the various internal decisions of management.

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2.5.1. Challenges Some of the challenges for successful management of Operational Risk has been described below: •

Rise in the costs of compliance: Advancement of an Operational Risk Management model as a part of regulatory and economic capital (EC) context is complex in nature which takes time. Thus, it is seen as a general treaty that challenge nature of Operational Risk Management increases the cost of compliance. • Access to proper information and reporting: Efficient management of operational risk demands diversification of information from variety of sources that includes reports on risks, risk control profiles, operational risk incidents, key indicators of risk, risk heat maps along with rules and regulation defined for regulatory and EC reporting. • Development of database: A well-organized operational risk framework entails the advancement of business line databases to seize any loss of events which is visible in various categories of operational risk management. The requirement of historical data that includes external data as well has been a great cause of concern for many financial institutions. • Lack of organized measurement of operational risk: Most of the enterprises has said that their institutions can measure operational risk but, among all very few of them are able to fulfill the quantification requirements of Basel II norms. While some are yet to agree to the measurement process of Basel II framework. • Implementation of operational risk management system: Amongst all the regulatory measures taken to reinitiate industry’s immunity against operational risk and its consequences on effective financial intermediation, most of the organizations are viewing beyond conventional isolated approach to implement a more consolidated Operational Risk Management framework throughout the whole entire value chain. But construction of ORM model as a constituent of regulatory capital framework is little complex which takes time. Some of the factors like absence of upcoming technology with respect to operational risk management, failure to appoint the top management to focus on the benefits of program, increased productivity and quality, and lack of expressive and timely database across

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all the business unit and product lines make the execution of an Operational Risk Management system even more challenging. •

Tone at the top: Operative risk management program starts with “The Tone at the Top”- which is driven by top management and followed by the bottom line. If top leaders of banks see management of operational risk as a regulatory mandate, instead of an important measure to enhance the competitiveness and performance of banks, then they may be less supportive to put such efforts. The board of management should understand the status of operational risk to determine their full support for its management.

2.5.2. Analytical Framework of Operational Risk Vigorous operational risk management framework constitutes following core components: •

•

•

•

Governance: It is the process through which Board of Directors outlines the key objectives for bank and manages the progress to achieve those objectives. It defines overall operational risk culture in an organization which sets the tone of implementations by banks and execution of operational risk management strategy. A successfully accomplished risk strategy often investigates the vision, strategies, tools, and tactics of the organization which results in the risk being firmly distributed among all the segments. Governance sets the platform for strategy, structure, and execution of risk management. Strategy: A well-structured bank’s strategy to drive the operational risk merges the other components as well within the management framework that provides clear direction on risk aversion, tolerance, policies, and processes to manage day to day risk. Policy: A perfect process of risk management guarantees that organizational behavior of any organization should be driven by its risk appetite. Acceptance of operational risk strategy along with risk appetite, leads to path of informed business and investment choices. Clear communication of policy: Top management of any organization should identify, assess, choose, implement, audit, and manage their strategic risks. At a broader level, strategic

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implementation of policy is required to focus on managing the risk at different levels. Thus, conscious efforts should be executed to make sure that these policies are well connected at different levels across the whole value chain. • Periodic evaluations based upon both internal and external factors: A model of risk management looks for the development of risk performance of an organization on a competitive level while keeping in mind the other concerns of mission. This is done periodically to evaluate the performance goals of operational risk management with respect to both internal and external factors. Based upon the seriousness of internal operating environment and major external factors, all the organizations must investigate strategic policies inside out. • Structure: Bank’s complete structure of risk set-up should serve as a guideline to design the structure of operational risk management. This structure should include the initiatives like placing down of hierarchical structure that influences current risk processes, development of risk measurement models to regularly assess the economization of capital, and allocation of EC to confront the actual risk. Unified collection of operational risk information which is collected through other self- assessment measures across the organization, provides a useful insight to establish a desired hierarchical structure. Implementation of these risk-averse measures allows the risk to be handled steadily throughout the organization. •

Execution: Once the framework of operational risk management has been recognized by an organization, and appropriate actions should be planned and applied to execute these policies at business level. The first step in execution inculcates the assessment of operational risk which is intrinsic in day-to-day proceedings of banks. After doing the assessment of risk, tolerance limit of targeted risk should be established which is achieved by evaluating the likelihood of materialization of risk, by seeing the drivers or causes of risk along with the assessment of its impact. The results of risk assessment and quantification process helps the management to compare the inherent risks with its operational risk strategy and policies to identify risk exposures that are highly unacceptable to the institution or may lie outside the institution’s risk appetite. Therefore,

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appropriate selection of mechanisms for the purpose of risk mitigation is required.

2.6. LEGAL RISK By legal definition, risk is the uncertainty of outcome of a certain event. Many businesses are subjected to variety of risks on a daily basis. The practice of business assumes to approach the right type of risk that results in positive consequences in terms of increased share of profit or high rate of market share, while reducing the possibility of negative consequences, like litigation or fines at the same time. Though many risks seem to have a legal implication, but that does not necessarily make all risks legal ones. There are four broad categories of legal risk, or four areas of legal uncertainty: structural, regulatory, litigation, and contractual that are mentioned below:

2.6.1. Litigation Risk The most discussed legal risk in many of the organizations is litigation risk. Litigation is often public and always distracting. Misconduct by employees, accidents, product liability and so on are the broad measures of litigation risk. Litigation occurs in a situation when management meets the company’s manager to discuss about the chances to lose a case or what can be the likelihood of damages resulting from this case, which is too late for risk management. Earlier to litigation, there is a need to identify the areas of uncertainty that affect the objectives of litigation risk management. Risk management is not fortune telling; thus, companies are required to speculate the area of interest first by narrowing down the possible outcomes from events. Most of the organizations invest high number of sums to prevent litigation which is helpful to weigh the cost of the risk management against the possible outcomes.

2.6.2. Contract Risk The most pernicious and difficult to track among all the legal risks is contract risk. The conventional approach of contract risk mainly focuses on a breach of contract by one party and the extra-contractual liabilities that might arise from another party in contract. This traditional approach treats each contract

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individually and in isolation as well. Organizations majorly focus on risk management strategy of contract risk by drafting effective agreements. Quality contract drafting is necessary, but not sufficient to manage contract risk. Some of the cases where contract can create significant risk are listed below: •

When an exceptional share of revenue is tied to one single contract; • Acquisition of service contracts leads to disruption in services or rise of prices; and • Uncertainty of risk arises when other party does not compensate for the damages that carry exceptional consequences like unpaid taxes and environmental problems. Although in most of the cases, individual contracts do not have their own gravity of litigation. The most common, substantive, and difficult task is to track the risk that arises from the uncertainty in the contract portfolio. Systemic under-management of contracts leads to substantial leakages and missed opportunities to generate revenues.

2.6.3. Regulatory Risk The growth in the transparency of administrative branch on the behalf of government is miserable to most of the business leaders. Regulatory risk implies the uncertainty of the consequences due to an agency’s action. A few examples will describe this point: •

•

For example, a transportation company may apply for a license to increase its operations in different domains which leads to an increase in the rate of uncertainty of agency’s decision as well as its scope in decision making. Under section ISO 31000, agency’s decision may leave positive effects which raise the rate of uncertainty in an organization. Most of the product manufacturers and distributors offers a fresh warranty on range of products to generate extra revenue. In this context, state insurance commissioners regulate that warranty given on a product should be classified as insurance. Then depending upon the state statue imposition of fines, applications of insurance, and several other conditions on the product are imposed to pursue civil remedies

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Though the identification of regulatory risks is challenging in nature, but uncertainty regarding its effect is measurable. Also, penalties imposed on these risk ranges from huge fines to strict administrative orders.

2.6.4. Structural Risk One of the rarest risks among most of the organizations is structural legal risk. This type of legal risks rises due to ambiguity in the key features of an industry such as technology or system of doing the business. The scope of a structural legal risk is broad in nature which generally alters the competitive landscape of an organization. Structural legal risks can arise from sources other than legislation. “Antitrust litigation can significantly alter pricing in an industry or key business relationships.” Enforcement of consumer protection actions leads to a change in the fundamental assumptions of an industry while adhering to the marketing practice which is unacceptable. The potential properties of structural legal risk vary differently in nature that ranges from some positive, useful effects to some harmful negative effects. A structural alteration can benefit one organization while harming another.

2.7. LEGAL RISK MANAGEMENT Six steps are required to improve the legal risk management of any organization. The underline process is not meant to prevent every lawsuit or regulatory penalty, but it is a step to bring more clarity of legal risks so as to improve the responses action of an organization’s.

2.7.1. Selection of Framework Following are the objectives of risk management framework: A legal risk management framework should meet following four objectives: • Simple but not simplistic; • Scalable but not overbearing; • Adjustable but with clear guidance; and • Practical but not regimented. The best objectives of risk management framework are met by ISO 31000. ISO 31000 defines risk as, “the effect of uncertainty on objectives.”

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Corporate Financial risk management: A Practical Approach for Emerging Markets

This definition contains events that bring unanticipated costs, convention thought of “risk,” and more threats than opportunities (Figure 2.11).

Figure 2.11: Risk management continuum. Source: https://www.risk.net/risk-management/operational-risk/2480528/top10-operational-risks-for-2017.

2.7.2 Acquiring Organizational Commitment The initiatives of risk management generally stagnate because most of the organization emphasizes on “doing it right,” which means to implement a framework of risk management for the entire enterprise. Enterprise risk management (ERM) is an important endeavor towards regulation of risk, but it is not an essential starting point of an organization. Legal professionals like general counsel, compliance officers, and contract managers implement legal risk administration within their own domain. Legal risk yields twofold benefits. Firstly, the wider enterprises will gain from clarity and extent of formerly opaque risks. Secondly, the limit for approval of software processes is lower than risk management because systems are simpler, and field of use is much constrained.

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Following four key questions are addressed to obtain organizational commitment: •

The scope of the legal risk management initiative that spreads to different departments, divisions, and enterprise. • What Types of legal risk that will get tracked with the initiative of organizational commitments such as contracts, regulations, litigation, etc.? • Target audience to report legal risk in management layer, corporate functions, etc. • How much budget is available to track and treat legal risk in terms of time, money, and staff. To answer these questions, focus on organizational commitment needed to get initiated.

2.7.3 Identification of Legal Risks The objective of risk identification is to assemble a broad list of risks. Following listed are the three steps to identify legal risks: Step 1: Find sources of legal risk: The primary feature of legal risk includes contracts, regulations, litigation, and operational changes. Step 2: Recognition of potential and actual risks: Uncertainties in the legal consequences can rise from hazards such as physical injuries, events that are unplanned, situations like entering into a new international market, and development of scenarios from other party. Step 3: Recording of risks: A risk register is basically a list that captures few features of each risk. It starts with tracking the name of risk, likelihood of risk, scaling of risk, estimation of risk, consequences of rating on a simple scale as an estimate, and at last combination of risk rating on a simple scale.

2.7.4 Analysis of Legal Risks Risk analysis is all about understanding different risks given in risk register. Analysis of legal risks starts with the assessment of risk controls. Various measures to control risk depends upon different forms of risk, given industry, and the organization. For example, to manage contract risk, an organization may use a tracking system to make sure that obligations of each individual are satisfied. Risk analysis is an iterative process. Some risks will fall off the list; some will merge with others; new risks will emerge after analysis.

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Once the effectiveness of risk controls has been gauged, analysis of likelihood and consequences of each risk is carried out. “The likelihood of a legal risk is the combination of the chance of discovery (will a claimant or regulator identify the problem) and the chance of an adverse decision. Similarly, consequences are the product of damages (usually in financial terms) and frequency (the number of incidents).” Precise measurement of risky consequences is found rarely. Risk involves uncertainty. Risk analysis aims to refine, but not to resolve the identified risks. The final task of risk measurement is to build risk assessing parameters and variables to look for the damages done to the organization.

2.7.5. Evaluation of Legal Risks Evaluation of legal risks is very different from the analysis of usual risks. To evaluate a legal risk is to prioritize the response given to a risk and at the core of risk evaluation is the organization’s risk tolerance. Some of the legal risks that lie above the line of intolerance demand high-risk treatment. The notion behind the risk treatment is simple: “modify the risk so that it is tolerable.” On should note that it is not necessary to eliminate the risk, but to render the risk. Risk treatment options are as diverse as the risks management options, but still, there are many repetitive techniques used in this option such as: •

Avoiding of risk by not opening or continuing the activity that can lead to uncertainty. • Increase in rate of those activities that creates the risk, if the consequence is valuable. • Removing the source of risk. • Change in the likelihood or consequence of the risk. • Sharing of risk through contracting or insurance. Each of the above-said techniques can change the character of legal risk. Adjustment of these techniques to legal risks fetches legal professionals closer to the operations of organization to lessen the cost and impact of uncertainty.

2.7.6 Communication and Advice Once legal risks are inventoried and examined in the risk register, it is significant to communicate the results to the broader enterprise. However,

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many risk professionals diminish the power of their message and the effectiveness of their communication by presenting each risk. To make a long-lasting impact on the organization, holistic approach to communicate clearly is advice. Risk management is the edge for lawyers, compliance officers, and contract managers to add value to their organizations. A pragmatic approach to legal risk management is within the reach of every organization.

2.8. FINANCIAL RISK MANAGEMENT METHODS AND TECHNIQUES For an appropriate management of risk, a firm needs to recognize the intensity and different types of potential risks for which firm is prone to. Finance managers are required to analyze the situation thoroughly in which they have to choose the most suitable approach or process or method to measure the financial risk. Following measures are used for effective risk management:

2.8.1. Regression Analysis Regression analysis is used to study the effect on one variable when the other variable changes. For instance, any change in the rate of interest such as increases, or decreases will bring a huge change in the cash inflow of resources.

2.8.2. Value at Risk (VaR) Another significant approach to measure and check the financial risk is VaR analysis. VaR is measured “with respect to the amount of potential loss, the probability of that amount of loss, and the time frame.” For example, a financial firm is exposed to 10 percent one-month value at risk of $50,000 which implies that there is a 10 percent chance that firm may have to bear a loss of $50,000 in any given month. This concept is explained with another example. Let’s suppose another firm retains an investment proposal on which they regulate VaR of $100,000, at a 50 percent confidence level over a 30-days holding period. Now, if none of the investments are made or sold out within 30 days period, then there is a 50 percent chance that firm might lose out $100,000. VaR is basically an estimate of possible maximum loss as actual losses can be above or below the estimated value.

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2.8.3. Security Analysis “Analysis of tradable financial instruments like debts (money borrowed from market), equities (owner’s fund), mixture of these two and warrants of company is known as security analysis.” Under this, at times futures contracts and tradable credit byproducts are also included as well. Also, security analysis is sub-categorized into fundamental analysis that works in agreement with different fundamental business factors like financial statements and technical analysis that primarily focuses upon price trends and momentum.

2.8.4. Scenario Analysis Scenario analysis is another beneficial line of risk that quantifies different types of risks. It is well known by the terms like “stress tests,” “sensitivity tests,” or “what if?” analyses. Scenario analysis consists of financial managers that create more than one scenario and ask “what if” this situation may occur? Also, this concept deals with certain market questions like What if stock market crashed by 42 percent? What if interest rates were to gain by 100 basis points? What if the exchange rate were to rise by 30 percent? What if a significant client were to leave firm? Hence, the following results of above said hypothetical scenario analyses are transformed into risk measure by calculating the exposure against risk which is based on calculations and estimated maximum in the worst-case scenario.

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investopedia.com/ask/answers/062415/what-are-major-categoriesfinancial-risk-company.asp [accessed 10 April 2018]. Metricstream.com., (2018). Operational Risk Management (ORM) Framework in Banks & Financial Institutions. [online] Available at: https://www.metricstream.com/solution_briefs/ORM.htm [accessed 10 April 2018]. Operational Risk Management Framework | RMA, (2018). Rmahq.org. Available from: https://www.rmahq.org/operational-risk-managementframework/ [accessed 11 April 2018]. Operational risk, (n.d.). Investopedia. Available from https://www. investopedia.com/terms/o/operational_risk.asp [accessed 11 April 2018]. Rmahq.org., (2018). Credit Risk Management | RMA. [online] Available at: https://www.rmahq.org/credit-risk/ [accessed 10 April 2018]. Sas.com. (n.d.). Credit Risk Management: What it is and Why it Matters. [online] Available at: https://www.sas.com/en_us/insights/ risk-management/credit-risk-management.html [accessed 10 April 2018]. Sas.com. (n.d.). Liquidity Risk: What It Is and Why It Matters. [online] Available at: https://www.sas.com/en_in/insights/risk-management/ liquidity-risk.html [accessed 10 April 2018]. Shah, S., (2018). Financial Risk Management Techniques, Methods, and Types. [online] Wikifinancepedia. Available at: https:// wikifinancepedia.com/finance/financial-management/what-isfinancial-risk-management-techniques-methods-types [accessed 10 April 2018]. Simplilearn.com., (2017). Financial Risks and Its Types | Simplilearn. [online] Available at: https://www.simplilearn.com/financial-risk-andtypes-rar131-article [accessed 10 April 2018]. Syndicateroom.com. (n.d.). Market Risk Definition & Examples | Syndicate Room. [online] Available at: https://www.syndicateroom. com/learn/glossary/market-risk [accessed 10 April 2018]. Top 10 Operational Risks for 2017 – Risk.net, (2017). Risk.net. Available from https://www.risk.net/risk-management/operationalrisk/2480528/top–10-operational-risks-for-2017 [accessed 11 April 2018].

CHAPTER 3

Corporate Financial Risk Management: Organizational Structure and Functions

“Some risks that are thought to be unknown are not unknown. With some foresight and critical thought, some risks that at first glance may seem unforeseen, in fact, can be foreseen. Armed with the right set of tools, procedures, knowledge, and insight, light can be shed on variables that lead to risk, allowing us to manage them.” – Daniel Wagner

CONTENTS 3.1. Introduction ...................................................................................... 58 3.2. Organizational Structure For Risk Management ................................ 62 3.3. Principles For Risk Management Functions ....................................... 68 3.4. Risk Appetite With Respect To Its Adoption And Framework For Risk Management................................................... 74 3.5. Roles And Responsibilities Of Various Implementers ......................... 77 3.6. Conclusion ....................................................................................... 81 References ............................................................................................... 83

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Corporate Financial Risk Management and its strategies are highly dependent on the organizational structure and its functions. This chapter talks about the three lines of defense required for the governance of risk management. The organizational structure for risk management has been discussed in detail along with the principles for risk management functions. Functions of organizational framework play an important role in outlining the strategies for managing risk which also determine the risk appetite and its development in an organization. In this chapter, the importance of communicating between the committees has also been highlighted to discuss the importance of regular monitoring of risk appetite of an organization.

3.1. INTRODUCTION For any organization risk management plays an important in keeping control over uncertainties and other risk factors which might affect the organization in an adverse manner. Risk management is that process which helps in identifying, measuring, and treating property, income, personnel exposure to loss and liability. The main objective of risk management is to preserve the physical and human assets of the organization to successfully attain the organizational objectives. Another main objective of Risk Management is to maintain smooth operations and peace of mind in a situation where there are certainties that risk can be evaluated. It also promotes an environment which would help in having safe and enjoyable learning. In order to achieve these objectives, it is important to delegate various risk management functions and strategies from System Administration to the team handling the management of the organization. A firm-wide, broad, and effective risk management system is essential in assuring the long-term stability of any financial organization. This system establishes basic risk management and control principles that are adopted from a wide range of risk management strategies helping financial corporations identify and manage risk effectively. These activities should be reflected in various forms like capital adequacy assessment, and decisionmaking processes. An effective and efficient risk management governance is based on three lines of defense, and those three lines are: • • •

Business line management; An independent risk management function; and Internal Audit.

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Appropriate corporate governance for risk management is based on the above-mentioned three lines of defense and have been discussed in detail below:

3.1.1. Business Line Management Business line management is responsible for the assessment, monitoring, identification, reporting, management, and mitigation of risks intrinsic in activities, systems, products, and processes in their purviews. It is also essential to have a sound environment of risk management control. Support functions such as IT management are part of the first line of defense.

3.1.2. Independent Risk Management Function An independent risk management function is the second line of defense. It is basically adopted to complement the management activities of the business line. It has got a reporting structure independent of the risk-generating business lines. The main responsibilities which fall under this function are maintaining, ongoing development and planning of the financial sector’s risk management framework. The main aim of this function is to challenge the capability of the business lines’ inputs for risk measurement, risk management, the banking corporation’s reporting systems, and the adequacy of the outputs obtained. Other compliance, monitoring, and control functions such as the compliance and anti-money laundering officer, the Chief Accounting Officer, and control of financial reportage are part of the second line of defense. A financial sector should have a well-defined interface between all functions that comprise the second line of defense to ensure coordination and cooperation.

3.1.3. Internal Audit Internal audit provides independent review of all the functions and activities performed in an organization. It helps in analyzing challenges which are addressed during a company’s risk management controls, processes, and systems. Its duties are specified in Proper Conduct of Business Directive, known as “Internal Audit Function.” A strong risk culture and good communication among the three lines of defense are important characteristics of appropriate risk governance. Internal audit is basically responsible for performing two important functions, and they are:

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•

Providing independent objective assurance over the risk management, control, and governance of the organization; and • Evaluating and improving the effectiveness of risk management, controls, and governance. Internal audit should not be confused with the responsibilities related to operational risk management. Internal audit is an independent third line of defense which is different from the first (business) and second (risk management) line of business. But, internal audit is responsible for auditing the second line (risk management), that does not mean that it will also be a part of risk management. Internal audit is required in the financial sector, where the Basel Committee, specifically states in Principle 2 of the “Sound Practices for the Management and Supervision of Operational Risk.” Principle 2 states that “the internal audit should not be directly responsible for operational risk management (Figure 3.1).”

Figure 3.1: Appropriate measures for corporate governance for risk management.

For having a strong risk management system, it is important to have following essential elements in an organization: •

For any organization the most important element to mitigate risk is having an appropriate risk culture. It reflects full understanding of business activity and risks related to it;

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• •

A risk appetite framework should also be well-determined; Sufficient resources for the oversight and control of risks which have been identified in an organization; • Formation of an independent risk management function which should be headed by a Risk Officer; • Oversight of the correspondence of the banking corporation’s business profile to this framework; and • A provision of forward-looking risk assessment and measurement tools should be provided. Risk assessment is required and is generally performed when an evaluation process is conducted to determine the potential for financial damage to the company or physical danger to its employees or facilities. The assessment of risks that affects a company’s organizational structure is a far-reaching investigation into the different ways the company’s operations may be at risk from regulatory constraints, competition, personal problems, environmental conditions, and social responsibility concerns. Risk management is a process used for identifying risk and its evaluation. It also helps in measuring the risk exposures and keeps a check on other ongoing determination of appropriate capital requirements, monitoring, and assessment of decisions relating to risk taking, mitigation of risk, and reportage of risk exposures and capital positions to senior management and the board of directors. Risk management is also a pro-active, coordinated, and systematic approach which is focused on the evaluation and treatment of uncertainty and events which can impact the achievement of goals. This includes amongst other things the organization’s ability to: • • •

• •

Understand or exploit correlation between various types of risk. Have an influence over the probability and positive or negative impact of events occurring in the organization. Initiate activities which would align the path of development with the required direction and helps in taking the right decision for the organization. Build a culture which ensures the implementation of activities and leads to sound risk management. Monitor development of the risk profile over time.

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The details and sophistication of a financial sector’s risk management system should be parallel to the scale and complexity of the corporation’s business activity and the overall level of risk that it assumes. However, once it has become established, the responsibility for the function should be passed across to an independent operational risk management unit.

3.2. ORGANIZATIONAL STRUCTURE FOR RISK MANAGEMENT Before enterprise-wide risk management entered the corporate world, most financial institutions like banks took a fragmented approach towards risk, managing different kinds of risk in different organizations or sectors. It involved less efforts in order to integrate these sectors through risk management functions. There are many organizations which are still following traditional risk management functions. A chief credit officer, who is adhered to report to the President or the Board of members, is responsible for formulating credit policies and is also responsible for approving exposures. Similarly, the market risk management functions independently and formulate policies, measures, and reports on market exposures and limits. Like the chief credit officer, the market risk executive is independent of the trading floor and might report to the CFO or the President. Organizational structure is the framework which is responsible for handling an organization together. The entire structure works on defining the lines of authority within a company, non-profit organization or governmental agency. A well-defined organizational structure provides a well-defined pathway for assessing all the procedures required to examine the risk that might pertain in an organization. Before practicing any function related to risk assessment and management, it is first important to have a clear working understanding of the company has been organized and have a clear view regarding the organizational framework. The organizational structure will show team members who is responsible for each area or operation being evaluated. Operational risk management is fragmented and does not have a wellstructured functioning. Separate and scattered departments such as Internal Audit, Insurance, and Legal are responsible for reviewing controls and risks. Managers of business lines take risk and manage it as it arises in the day-to-day functioning of the business. Thus, many individuals around the

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company are responsible for having risks in the company, and all those risks are eventually reported to senior management. Some team members or managers, such as a chief credit officer are generally responsible for risks across the organization, but only within their specific domains. Traditionally all the major risks are managed by the managers, and small risks are over-looked by the management. The modern risk management functions are framed in such a way that whether big or small all risks are managed effectively and efficiently. The organizational structure and functions are assigned to one or more organizational committees, which generally consist of representatives of various departments such as finance, internal audit, legal affairs, and compliance. It also comprises the heads of some business units. One or more committees are typically responsible for financial risk, credit risk, assets, and liabilities, market risk, operating risk, and liquidity. The risk assessment and managing committees make it difficult to achieve uniformity in methodology, measurements, or policy. The important question that arises out of these strategies is, “Who, if anyone ensures that the agenda covers the most substantial risk exposures?” It is not clear that who is going to be accountable during the intervals between the committee meetings. For example, in one of the biggest U.S. investment bank, there is a separate department for keeping a check on credit risks and all the reports that gets on the CFOs table. It also has a separate committee which is responsible for monitoring market risk and reports to the CEO. Various operations throughout the financial sectors incur risks and manage them separately. An executive management committee which represents business units, finance, credit, legal, and operational personnel; and risk management keeps a check on all the assets and liability risks, risk concentrations, and model risks. This committee is charged with establishing reserves.

3.2.1. Types of Organizational Models for Risk Management Financial sectors organize their risk management efforts in different manner. The strategies and functions for risk management is dependent upon the company’s history and its strategic objectives. It is also concentrated at the skills of the individuals involved in performing the risk management functions for an organization. Accordingly, in many organizations, it has been discovered that the authority and responsibility of the Chief Risk Officer

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(CRO) vary dramatically from firm to firm.1 Various types of organizational structures allow companies to have greater flexibility to react and adjust to changing market conditions and advancing technology. There are possibilities that these risk assessment teams might find modern organizational structures difficult to understand. The modern organizational structure so not have clear lines of authority for reporting the risk identified by an individual. In response to these changing business realities, many organizations are now heading towards enterprise risk management systems to evaluate and control risks. Enterprise risk management helps in defining how risk factors are interrelated in an organization. However, the organization structure of the risk management function in most of the financial sector that have designated a CRO can be classified according to one of the following models: The financial risk models: The Financial risk management model is an important factor responsible for integrating financial risks only and is one of the core reason behind the existence of a CRO to whom the market risk and credit risk functions report. However, the drawback of this approach is that responsibility for operational risks remains undefined and scattered among various organizational units or, perhaps, is addressed by a separate committee. The risk management function generally concentrates on risk policy, measurement of risks, and analysis of the strategies adopted by the committee members. But it does not have the authority to approve exposures. For approving exposures, there is a separate officer appointed for the same. It is the Chief Credit Officer who approves limits and transactions in an organization for risk assessment and management. At one money-center bank, a CRO heads a team which comprises credit and market risk management. The team is in charge of various activities including; seeking ways to optimize the firm’s risk-based return on capital. This team is also responsible for maintaining a common risk management framework, which then establishes and controls market risk limits and credit risk concentrations and oversees the allocation of balance sheet capacity and adherence to capital targets. Other committees in the money-center bank are (Figure 3.2): • •

Operating Risk Committee; Liquidity Risk Committee;

1 Organizing a Financial Institution to Deliver Enterprise-Wide Risk Management, Kaan H. Aksel PricewaterhouseCoopers, LLP.

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• •

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Capital Committee; and Investment Committee.

Figure 3.2: Organizational structure of a financial organization.

The all-risk models: The all-risk model comprises a CRO, who is responsible for the full range of the company’s risks including operational risks as well as credit and market risks. Generally, the role has an approach inclined towards consulting. The CRO has to maintain and develop awareness of risk issues throughout the organization and is responsible for formulating and implementing various risk policies, strategies to measures risk, reporting, and approving exposures, and has to think about operational risk. The CRO is not responsible for managing the back office, Information Technology, or other areas in which risks occur. The Legal and Internal Audit department is also taken care by another committee. But all these risk-related areas have a dotted-line relationship with the CRO. Those who have the authority to take actual risks are in the business units, credit offices, and committees. One investment management firm follows an all-risk approach in which one unit creates the risk framework and performs analysis and reporting functions across all business units. The CRO takes a consultative role, monitoring, and reporting rather than making decisions or approvals. The CRO describes his role succinctly: “My job is to monitor and assess risk. Risk-taking decisions are in the business.” Like any other risk models, an all-risk approach has different strategies and functions depending upon the culture and the talent available there. For example, in one money-center bank, a “Global Risk Management Group” performs analyses, sets risk-management methodologies, and reports on all

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types of risk. Outside of the group is a Chief Credit Officer who approves transactions and sets credit policy. The risk governance model: A very fascinating substitute to the allrisk method is one that incorporates risk evaluation with the linked control functions under a solitary CRO. This particular method is less consultative and additionally administrative. A watchdog like role is assumed by the CRO and is answerable for Internal Audit and other submission purposes. The market and credit risk officers, who are accountable for agreements, work diligently with the CRO and may either be inside or outside the risk management structure. With digitization and automation, more models are being incorporated into procedures of business, presenting institutions to more prominent model risk and resulting operational losses. The risk lies similarly in defective models and model abuse. A flawed model caused one leading financial institution to endure losses of a few hundred million dollars when a coding error contorted the stream of data from the risk model to the portfolioadvancement process. The market provides models aimed for coordinating an organization’s risk administration. COSO’s (Committee of Sponsoring Organizations of the Treadway Commission) presents an ERM model that takes over key and operating perspectives related to risk management. This model has been embraced by offices and by the US government as a way to control authoritative risks and meet the necessities of the Sarbanes-Oxley Law.

3.2.2. Risk Management at Various Organizational Levels Risk management happens at different levels of the organizations subject to the relevant core interest. In ERM the emphasis is on the outcome for the whole enterprise. In the event that the emphasis is in regard of individual objectives or objectives inside the person’s own business area, this can be characterized as “personal” risk management. The totality of personal risk management in an association which can result sub-optimization from the point of view of the enterprise as a whole. The performance of task risk management must additionally have a foundation in an enterprise-wide viewpoint through amongst several other issues the goal setting and any incentive structure. These three separate viewpoint (Figure 3.3): • •

ERM; Task risk management; and

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• Personal risk management. These are represented below:

Figure 3.3: Types of risks and risk management. Source: https://iia.no/wp-content/uploads/2017/05/2017-Guidance-for-theRisk-Management-Function.pdf.

The aim of ERM is to keep up the risk at an optimal level and guarantee the ideal balance probable between threats and opportunities, in line with the risk appetite and business plan of the Board3 and Administrative Management. The main concern is about confirming the accomplishment of objectives as the enterprise progresses and right management of the organization’s assets, together with evasion of losses as a consequent of undesirable proceedings. This will incorporate issues happening in all levels of the company. A pre-requisite for having the capacity to practice sound risk management is therefore that there are noticeably defined objectives at the strategic level, to which objectives at different levels in the organization might be connected. Along these lines, risk assessments at all levels will be connected to a progressive system of goals which underpins the enterprise’s general strategy. Practically speaking this implies guaranteeing the most ideal basis for arriving at decisions at the different levels of the organization, with the goal that the decisions made will back the overall targets. Hence, it is critical to have a sound mechanism to make sure the accomplishment and observing of the decided activities.

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3.3. PRINCIPLES FOR RISK MANAGEMENT FUNCTIONS 3.3.1. Functions for Risk Management in an Organization In these guidelines, the expression of “risk management function” does not really mention to there being one individual, or one settled group of individuals completely committed to these tasks. Rather, the risk management tasks represent to a precise and target way to deal with identifying, analyzing, and assessing risk; and additionally, designing and executing activities which will enable risk to be overseen within characterized risk parameters. Furthermore, the tasks should provide input to plan and development plans. In an enterprise, it will be the Board or the most noteworthy decision-making body that will guarantee that the enterprise has recognized adequate risk management and internal controls. As per the prerequisites of the Norwegian Code of Practice for Corporate Governance issued by the Norwegian Corporate Governance Board (NUES) this duty includes among others the following: •

The top managerial staff must guarantee that the organization has sound internal control and frameworks for risk administration that are suitable in connection to the degree and nature of the organization’s activities. Internal control and the frameworks ought to likewise incorporate the company’s corporate values, moral rules, and rules for corporate social duty. • The executive board should complete a yearly review of the company’s most critical regions of introduction to risk and its internal control arrangement. • The top managerial staff must give a record of the principal highlights of the organization’s internal control and risk management frameworks as they identify with the company’s financial reporting. The Chief Executive has complete operational responsibility regarding risk management. In their daily tasks, all managers might make sure that there is satisfactory risk management and internal control within their areas of obligation in accordance with the organization’s overall goals. The Risk Management function should help the company in its work in planning and executing effective and effective procedures to recognize, analyze, and treat risk. In addition, the Risk Management work has an independent duty to screen the risk profile and to flag developing patterns

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for existing risks and the potential outcome of new threats/opportunities – supposed “emerging risk.” The risk management capacity should have duty to regulate and review the execution of risk management tasks taken as a whole, and to help line administration in communicating applicable risk information to a larger amount in the organization and to external parties. The function must: •

Make operational rules for risk management, describing parts and duties and establishment of objectives for the execution of the risk management tasks. Risk management tasks should be assimilated with the companies’ strategy work. • Organize a structure for risk management incorporating the entire organization, and where fundamentally addressing particular procedures, functions or divisions of the organization. • Promote risk management knowledge throughout the organization. Endorse risk management knowledge all through the organization. • Establish a common risk management terminology (e.g., in regard of risk classifications and concepts applicable to likelihood and effect evaluation). • Choose show/tool for the identification proof, scoring, assessment, and monitoring of risk including emerging risk. • Help management in the development of risk reporting and screen the risk reporting procedure, including setting up a framework for early warning flags or a trigger framework for breaches of the organization’s risk appetite or risk limits. • Make certain progressing communication with the Chief Executive and the Board in light of an independent and qualified assessment of risk management and guarantee that choices are operationalized. The risk management function shall place the basis for and monitor the application of: • • •

Effective risk management standards for Executive Management and help risk owners in characterizing planned risk exposure. Communication of risk related data to the organization, including making expert pronouncements. Reporting lines that guarantee that risk related information is imparted to the right hierarchical level at the ideal time and that

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this communication is in a reasonable and balanced format. The risk management function should be involved at the beginning to guarantee that risk measurements frame a piece of every single significant decisions while in the same time, and when important, impacting, and testing decisions which may cause material risk. Also, the risk management function might regulate that the previously mentioned forms are performed in practice and respond if the circumstance should emerge that these are insufficient. In addition to a centralized risk management function (which is a piece of the second line of defense), a few organizations have built up a different compliance function to screen risk related to breaches in lawful regulations and internal and external regulations (including fraud risk). The compliance function will regularly report straightforwardly to Executive Management. There is an assumption that the compliance and risk management function firmly together, particularly in regard of the areas of legitimate risk, reputation risk, foundation of a sound risk culture and monitoring of moral rules. Risk management incorporates the overseeing of both financial and operational risk (including for instance risk identified to internal procedures, frameworks, human conduct and different parts of the organizations). Other relevant risks can be identified to compliance with laws, controls, and moral standards (compliance risk), ecological risk and so forth and also the treatment of outer external risk factors such as political risk, macroeconomic variables or catastrophe situations. In short, ERM involves utilizing a methodical way to encourage the organization’s ability to understand its targets through organizational structure, business forms, control activities, and decision making. A vital task for the risk management function is in this way to guarantee that goals are sufficiently communicated among the different control conditions and grounded in these (cf. Figure 3.4). Besides it is significant to guarantee that information from these situations is considered and included as a part of the work with ERM.

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Figure 3.4: Example of the ERM coordinating role and the management of various risk areas. Source: https://iia.no/wp-content/uploads/2017/05/2017-Guidance-for-theRisk-Management-Function.pdf.

3.3.2. Functions of the Operational Structure The operational system includes several areas of the entity in charge for implementing the strategy and executing the risk management policies in lines with their allocated functions in the organization. The operating structure comprises four different areas, whose duties must be kept evidently distinct: • • •

•

Risk analysis and control area; Asset and liability management area (ALM area); Business areas: like the business committees, each business area will represent a segment of the activity of the entity (treasury, commercial banking, investment banking, asset management, etc.); and Support areas: these areas perform structural functions inside the organization. From the risk management point of view, the most important areas are:

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• Back office; • Technology and systems area; • Legal and tax advisory; • Human resources and training; • Internal Audit. Two-way communication must be followed between the operating areas in order to make sure proper and efficient integration of performance of the functions assigned to each area.

3.3.3. Risk Analysis and Control Unit Analysis and control is the responsibility of risk analysis and control unit on a daily basis for the risks faced by the company (market and credit risk). The risk analysis and control unit’s duties can be clubbed around as two basic functions:

1. Risk control function: • • •

• • • •

To apply and guarantee performance of the processes and policies characterized by the Risk Committee. To measure positions and mark them to market. To set up which independent sources should be utilized to get hold of the market variables (interest rates, volatility, etc.) required to value and measure risks. To evaluate market and credit risks with agreed methodologies and observe defiance with established limits. To enumerate operating outputs and the RAROC of the different business units. To analyze the use of capital-at-risk by the different business units. To form the entity’s liquidity against proven limits.

2. Risk analysis function: •

•

Improve and describe market and credit risk valuation and measurement practices and authenticate the systems at present in place at the entity. Make a creditworthiness analysis on clients and counterparties and, by means of that analysis, allocate them a credit rating. The

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ratings must be revised frequently (at least yearly), and whenever important changes take place that could have impact on them. • Examine the operating areas’ suggestions on market and credit risk parameters. Present these suggestions to the Risk Committee. • Examine the division of capital-at-risk amongst the different business units. • Study the possible losses the entity could undergo in a market emergency (stress testing). • Calculate requests for exceeding limits. Endorse approval, as applicable, to the Risk Committee. • From a risk standpoint, estimate proposals on new products or activities that are offered by the various business units. • Formulate reports for the Risk Committee with the subsequent information: • Short depiction of the market positions (e.g., mapping cash flows) and credit positions (e.g., equivalent loans). • Examination of credit risk attentiveness by country industry term, ratings or counterparty • Study of the risk factors that have impact on the possible profits and losses of the positions. • Evaluate risk/return profiles and their delicately to modifications in positions. • Situation analysis (e.g., stress testing). • Examine performance and variances from established targets. Identify explanatory factors. • Analyze prospects of business and market trends. • Evaluable substitute strategies to achieve current risk. • Make risk management reports for external agencies (e.g., investors, analysis, regulations, etc.) Most of the big companies perform all their control and analysis functions by taking two different areas into consideration. To avoid misunderstandings and conflicts of interests in an organization, one single committee should be formulated to have authority or control over both the areas which should be parallel to the methodologies related to analysis and control over the credit and market risk management methodologies.

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The size of the risk analysis and control area should be based on the volume of activity and complexity of the products. The instruments offered for risk management system should be mainly in a part of the treasury area. For example, a medium-size company that offers standard products like deposits of funds, loans, bonds, forwards, future, etc., do not require a large team to manage, as a few technical skills are used to control these products. A large company offers more complex products like loans with embedded options, exotic options, and structured products. In general, the risk analysis and control committee should comprise people with highly technical backgrounds and those who have experience in risk control.

3.4. RISK APPETITE WITH RESPECT TO ITS ADOPTION AND FRAMEWORK FOR RISK MANAGEMENT For many organizations, risk appetite is the subject of interesting theoretical content meant for discussions regarding risk and its management. But it is not necessary these strategies through theoretical discussions would effectively integrate into the concept for their strategic planning or day-to-day decision making. Many researchers believe that discussions about applying risk appetite is not limited to theoretical interpretations and implementations, it demands for proper communication. Risk appetite provides a boundary around the amount of risk an organization might pursue. An organization which have an aggressive appetite for risk might set aggressive goals, on the other hand, an organization that is risk-averse, with a low appetite for risk, might set conservative goals. Similarly, when a board put forward a strategy, it should first evaluate that whether that strategy would properly align with the organization’s risk appetite or it would create more issues in the organization. If all the strategies are communicated properly, risk appetite provide guidelines for management in setting goals and taking appropriate decisions so that the organization is more likely to achieve its goals and sustain its operations. The development and establishment of an effective Risk Appetite Framework is an interactive and evolutionary process. It requires ongoing communication throughout the risk management system and helps in attaining buy-in across the system. The framework sets the system’s risk profile and forms part of the process of development. It also helps in implementing the strategies and determining the risks which have been undertaken with respect to the system’s risk capacity.

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An effective risk management structure should be able to reflect a common framework and comparable measures across the entire managerial system for senior management and Council to communicate. This would help in understanding and evaluating different types and level of risks that the teams are willing to accept. It clearly defines the boundaries within which management should expect to operate while pursuing the strategies for managing risk. The risk appetite framework helps in simplifying the determination of the team and keeps a regular check on the risk appetite. It also helps in bridging the gap between the financial sector’s strategy and its risk management framework. The risk appetite should be regularly updated in line and all the changes made to the strategy of the organization should also be monitored timely (and vice versa, as neither the strategy nor the risk appetite should be developed in isolation from the other but rather as part of a unified process) and should also evolve in line with the development of its risk management framework. There should complete transparency while adopting measures and formulating a framework for managing risk and understanding risk appetite. The Treadway Commission Committee of Sponsoring Organizations of the Treadway Commission (COSO) Enterprise Risk Management for Risk Appetite Framework, stated that “The amount of risk, on a broad level, an entity is willing to accept in pursuit of value. It reflects the entity’s risk management philosophy, and in turn, influences the entity’s culture and operating style. Risk appetite guides resource allocation. Risk appetite [assists the organization] in aligning the organization, people, and processes in [designing the] infrastructure necessary to effectively respond to and monitor risks.” An organization must consider its risk appetite at the same time when it takes decision for achieving organizational goals. For the same, operational tactics to be pursued by the team should also be overlooked by the team members. To determine risk appetite, management, with board review and concurrence, three steps should be evaluated. Those three steps are: • • •

Development of risk appetite; Proper communication of risk appetite; and Regular monitoring of risk appetite along with its update.

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3.4.1. Development of Risk Appetite Risk appetite and its development do not involve avoiding risk as a part of its strategic initiatives. It is important to understand for any organization that developing risk appetite is proportional to setting up of objectives which would help in developing different risk appetites. There is no fixed standard or universal risk appetite statement that applies to all organizations, nor is there a “right” risk appetite. It is the responsibility of the management and the board members to make choices in setting up a risk appetite, and understand the trade-offs involved in having higher or lower risk appetites. This kind of understanding towards risk management and risk appetite is beneficial in further management of strategies adopted by the committee.

3.4.2. Proper Communication of Risk Appetite Communication is the key to success in big organizations especially when it comes to management of risk. Various common approaches have been used to communicate risk appetite. •

• •

The first approach is to create an overall risk appetite statement that is broad enough and also self-explanatory for organizational units to manage their risks consistently within it. The second approach is focused towards the communication of risk appetite for each major class of organizational objectives. The third and last approach is focused towards the communication of risk appetite for different categories of risk.

3.4.3. Regular Monitoring of Risk Appetite Along with Its Update Once risk appetite has been developed, managed, and communicated with the support provided by the board members needs to be revisited and should be reinforced. It is not possible to set risk appetite for once; it needs proper vigilance with regular update. The risk appetite should be reviewed with respect to the way an organization operates, especially if the entity’s business model changes. It is the responsibility of the management to monitor activities for having consistency with risk appetite through a combination of ongoing monitoring and separate evaluations. Internal auditing can support management in this monitoring. Moreover, when an organization starts monitoring risk appetite, it should focus on creating a culture that is related

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to awareness of risk and should have organizational goals which has to be consistent with the board’s organizational objectives. As an organization takes a final decision on its objectives and its approach for achieving strategic goals, it should take all the risks involved in it into consideration and should take a dig into its appetite for such risks. This would help in taking important decisions for the benefit of the organization. Those in governance roles should explicitly understand risk appetite when defining and pursuing objectives, formulating strategy, and allocating resources. The board should also consider risk appetite when it approves management actions, especially strategic plans, budgets, services, new products, or markets (in other words, a business case). In working towards their objectives, organizations choose strategies and develop metrics to show them how close they are to meeting those objectives. Managers should be motivated to achieve the objectives through rewards and compensation programs. The strategy is then operationalized by decisions made throughout the organization. Decisions are made to achieve the objectives (increase market share, profitability, etc.). But achieving objectives also depends on identifying risk and determining whether the risks are within the organization’s risk appetite.

3.5. ROLES AND RESPONSIBILITIES OF VARIOUS IMPLEMENTERS People who are responsible for developing, communicating and monitoring risk appetite can be categorized into four distinct categories, namely implementers, support function, oversight, and assurance providers. These four categories are then further divided into three different departments and are headed by an individual manager (Figure 3.5).

Figure 3.5: Important implementers of an organization for managing risk.

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These three departments or managers have been described in detail with their roles and responsibilities below:

3.5.1. The Accounting Officer (Municipal Manager) The Accounting officer is eventually responsible for managing risk within the parameters of accounting. The officer is accountable to the Council for the processes related to the effectiveness of the risk management. The accounting officer is responsible for the promotion of various activities related to accountability, integrity, and other factors that create a positive control environment. The roles and responsibilities of the Accounting officer related to the risk appetite have been discussed below: •

•

•

•

•

•

He is responsible to establish an appropriate risk appetite for the organization in collaboration with the CRO. This is consistent with the accounting department’s which comprises short and long-term strategy, business, and capital plans and risk capacity. For any accounting officer the priority is to be accountable, again in collaboration with the CRO and managers. This promotes integrity of the Risk Appetite Framework, including the timely identification and escalation of breaches in risk limits and of material risk exposures. He is supposed to ensure, in conjunction with the CRO, that the risk appetite is appropriately translated into risk limits. This helps in formulating strategic and financial planning, decision-making processes and compensation decisions. He ensures that the organization’s wide risk appetite statement is implemented by the management and not by any random team member. He is responsible for providing leadership in communicating risk appetite to internal and external stakeholders. This helps in embedding appropriate risk-taking capabilities into the financial sector’s risk culture. A proper structure should be facilitated by providing varied examples to empower and support the CRO in his/her responsibilities. He should effectively incorporate risk appetite into the organization’s decision-making processes to have a meaningful delegation of responsibilities amongst different department working on the same project.

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The accounting officer should ensure that the managers should have appropriate processes in place to effectively measure, report, identify and monitor the risk profile related to establishment of risk limits on a continual basis. He should dedicate sufficient resources and expertise to risk management, internal audit and IT infrastructure to help provide effective oversight of adherence to the framework. From any accounting officer, the organization expects that he should act in a timely manner to ensure that all the activities have been managed effectively. He should be careful for necessary mitigation of material risk exposures, particularly in those areas that are close to or exceed the approved risk appetite statement and/or risk limits.

3.5.2. The Management Management at all levels within the organization owns the risks. To take such heavy responsibilities, the management is entirely accountable to the accounting officer. This helps in integrating the principles of risk management into their daily routines to enhance the achievement of their service delivery objectives. In delivering their high-level responsibilities which are related to communicating and monitoring risk appetite, management should fulfill below-mentioned roles and responsibilities: •

•

• •

•

The management should ensure configuration between the approved risk appetite and other processes of the organization. The main components of the process are planning, compensation, and decision-making processes of the organization. The management is responsible to set the risk appetite statement and risk limits into management’s activities. This would help in setting up of prudent risk-taking risk culture and risk management system into consideration. It should establish and actively monitor adherence to approved risk limits. The management is responsible for implementing controls and processes which should be eligible to effectively identify, monitor, and report against allocated risk limits. It is required that the management should act in a timely manner to ensure effective management and should adopt ways through

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•

it becomes easy to mitigate material risk exposures, in particular, those that exceed or have the potential to exceed the approved risk appetite and/or risk limits. He should immediately escalate breaches that occur in risk limits and material risk exposures to the CRO and senior management in a timely manner.

3.5.3. Chief Risk Officer (CRO) Accountability for risk management in the financial sector is generally assigned to the Accounting Officer (Municipal Manager) and is sub-delegated to the CRO. This helps in facilitating and coordinating the development and implementation of risk management strategies. The main responsibilities of CRO is to provide specialist expertise in providing a comprehensive support service to ensure systematic, uniform, and effective enterprise risk management. The CRO plays an important role for constructing the communication link between the management, operational level, senior management, financial department, risk management committee and other important committees related to risk management. Other than these responsibilities, CRO has various high-level responsibilities to achieve in an organization for managing risk. This includes: •

•

•

•

•

The CRO is responsible for developing an appropriate risk appetite for the organization that should meets the needs of the financial sector in the market place. He should obtain committee’s approval of the developed risk appetite and should regularly report to Committee on the organization’s risk profile which is related to risk appetite. The CRO being the responsible head for risk management system should actively monitor the risk profile which is in context to its risk appetite, strategy, and risk capacity. He should also establish a process for reporting on risk and on alignment (or otherwise) of risk appetite and risk profile with the municipality’s risk culture. The integrity of risk measurement techniques and information systems should also be ensured. These are actually used to monitor the risk profile relative to its risk appetite which is an important part of risk management in financial sector.

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He should also establish and approve appropriate risk limits for the company that are consistent with the risk appetite statement. The limits related to aggregate risk profile should be independently monitored to ensure that there is a level of consistency with the risk appetite. He/She should act in a timely manner to ensure effective management. Necessary mitigation of material risk exposures, in particular, those that are close to or exceed the approved risk appetite and/or risk limits should be taken care of. The CRO is responsible to escalate immediately about the material risk breach to Council and to the Accounting Officer. This places the organization at the risk of exceeding its risk appetite, and in particular, of putting in danger the financial condition of the company.

3.6. CONCLUSION From the above discussion, we can conclude that all the risk in an organization are identified differently. So, it is important to have a clear perspective towards the risk penetrating in a financial organization. In this chapter various corporate, strategic processes, risk appetite and organizational structure to tackle risk was discussed. Each level of a committee formed for managing risk in an organization is responsible for various activities allotted to them. But, before working on any strategy, it is first important to identify the type of risk, and there should be an assurance regarding the information dependent on such risks. In various cases, risks are specific to each level. Corporate financial risks are typically difficult to quantify and manage. These risks include the political, legal, environmental, and financial elements of an investment. To evaluate risks and to examine the right kind of strategy, principles for risk management functions are important to focus upon. Project risk management often entails risks being assessed in even greater detail as they become more specific to the project rather than higher level risk considered at strategic business and corporate levels. To ensure that all risks at all levels are managed it is paramount that an overall risk management system is implemented by the implementers (CRO, Accounting officer, and Management). The risks identified at all levels should also be managed over the life cycle of the investment. The

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risk register held by the risk officer at the strategic business level forms a database for all levels of the organization. This risk register should be accessible to stakeholders, particularly shareholders investing in a project.

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REFERENCES 1.

Aksel, H. K., (n.d.). Organizing a Financial Institution to Deliver Enterprise-Wide Risk Management. [eBook] Available at: https://www. pwc.com.tr/en/assets/about/svcs/abas/frm/operationalrisk/articles/ pwc_enterprisewiderisk.pdf [accessed 8 April 2018]. 2. Carlos, D. S., De Oliveira, L., & Siegert, S. L., (2011). Organizational Risk Management – A Case Study in Companies That Have Won the Brazilian Quality Award Prize. [eBook] Available at: https://Scielo. Conicyt.Cl/Pdf/Jotmi/V6n2/Art16.Pdf [accessed 8 April 2018]. 3. Crespo, I., & Kumar, P., (n.d.). The Evolution of Model Risk Management. [online] Mckinsey & Company. Available at: https://www.mckinsey. com/business-functions/risk/our-insights/the-evolution-of-model-riskmanagement [accessed 8 April 2018]. 4. Joestgen, T., (2018). Risk Management Functions. [online] Risk management. Available at: https://www.wisconsin.edu/riskmanagement/manual/functions/ [accessed 8 April 2018]. 5. Lihou, M., (2017). Cedarburg Municipality Risk Management Risk Appetite Framework. [online] Cederbergmun.Gov.Za. Available at: http://www.cederbergmun.gov.za/download_document/1052 [accessed 8 April 2018]. 6. Oster, V. K., (2018). Risk Assessment Plan & Organizational Structure. [online] Smallbusiness.Chron.Com. Available at: http://smallbusiness. chron.com/risk-assessment-plan-organizational-structure–58158.html [accessed 8 April 2018]. 7. Risk Management and Corporate Governance, (2014). Paris: OECD Publishing. Available at: http://www.oecd.org/daf/ca/riskmanagement-corporate-governance.pdf 8. Risk Management, (2012). [eBook] Available at: http:// www.boi.org.il/en/bankingsupervision/supervisorsdirectives/ properconductofbankingbusinessregulations/310_et.pdfx [accessed 8 April 2018]. 9. Rittenberg, L., & Martens, F., (2012). Committee of Sponsor in G Organizations of the Tread Way Commission. [eBook] Available at: https://www.coso.org/documents/erm-understanding-andcommunicating-risk-appetite.pdf [accessed 8 April 2018]. 10. Stevens, W. M., (2017). Guidelines for the Risk Management Function. [eBook] Available At: https://iia.no/wp-content/uploads/2017/05/2017-

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guidance-for-the-risk-management-function.pdf [accessed 8 April 2018].

CHAPTER 4

Credit Risk Management and Control

“The world economy would collapse if a significant number of people were to realize and then act on the realization that it is possible to enjoy many if not most of the things that they enjoy without first having to own them.” —Mokokoma Mokhonoama

CONTENTS 4.1. Introduction To Credit Risk Management .......................................... 86 4.2. Traditional Approach To Manage The Credit Risk............................... 90 4.3. Business Risk .................................................................................... 95 4.4. Financial Risk ................................................................................. 100 4.5. Transaction Risk .............................................................................. 103 4.6. Market Imperfections ...................................................................... 106 4.7. Conclusion ..................................................................................... 112 References ............................................................................................. 113

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This chapter describes credit risk management and the various components that comprise it. Different ways to handle credit risk management have been explained in detail, with a brief description of financial risk, business risk and transactional risk between counterparties. Strategies like credit limits, netting agreements, and collateral agreements provide support in measurement and control of overall risk. Risk mitigation strategies with immense knowledge of business through PEST and SWOT analysis provide proof to manage the credit risk. Various tips for a good credit manager have been described to handle the issues related to them and in addition to that market imperfections and measures to it have been discussed to eliminate it.

4.1. INTRODUCTION TO CREDIT RISK MANAGEMENT Lending has been the essential function of banking from the past time, and perfectly assessing creditworthiness of the borrower has been the one and only important method of lending successfully as per the most of the debtor’s report. The analysis method that is required for debt issue differentiates from borrower to borrower. It also differentiates in function of the various types of lending being considered for the debt issuance. For instance, the risks in the banking related to financing the debt for the building of a hotel or solar project, of providing debt secured by assets or a huge overdraft granted for a retail customer would differ considerably with different borrowers. For financing of project, you would look to the funds produced by future cash flows to reimburse the credit, for asset secured loaning, you would take the benefits of an assets, and for an overdraft facility, you would take a look at the way the accounting record has been kept running in the course of recent years. In this chapter using a credit risk management, we will take a look at the appropriate techniques for investigation for lending to organizations, a subject all the more regularly known as ‘corporate credit (Figure 4.1).’

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Figure 4.1: Credit risk. Source: https://i1.wp.com/www.au-group.com/wordpress/wp-content/uploads/2016/06/creditrisk.jpg?fit=300%2C194.

Estimating and managing credit risk, regardless of whether for loans, bonds or subordinate securities, has turned into a key issue for money related institutions. The risk examination can be performed either for standalone exchanges or for the portfolio of arrangements. The last approach considers risk diversification crosswise over trade and counterparties. As will be demonstrated later, overlooking risk diversification can prompt incorrect risk management choices, expanding instead of diminishing the risk introduction of the money related institutions. Diversification of risk occurs at both stages counterparty (obligor) level and mostly at the global level. At the obligor level, risk diversification is the end result of the netting of the exposures of various exchanges with the similar trade obligor. Portfolio diversification also occurs throughout both the counterparties since numerous organizations do not default simultaneously. As a result of this, the owner’s equity that must be secured against defaults for a well-diversified portfolio is only a part of the overall exposure of the risk for the portfolio. Traditionally, credit risk aggregates two different types of risks: “counterparty risk and issuer risk.” According to the definition, “counterparty risk is relevant for loans and derivative transactions, whereas issuer risk refers mostly to bonds.” This chapter covers mainly with the former

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one. Numerous credit derivative contracts are related to both risk types. Counterparty risk is estimated over a long-time period, as the positions are illiquid which means hard to turn into cash and it is hard (if at all possibility is there) to have exchange out of them. Issuer risk for bonds is calculated over a time period of a very few days – similarly belongs to older time market risk. Bonds are generally estimated as a liquid, easy to turn into cash – i.e., they can be exchanged very normally if the need occurs; generally, in practice, however, this is not the possibility all the time (Figure 4.2).

Figure 4.2: Counterparty or issuer risk. Source: https://prmiadc.files.wordpress.com/2012/10/counterpartyrisk2.jpg.

For example, consider, a portfolio with the market value represented as ‘V.’ In order to estimate the market risk of the portfolio over a taken time period, here a need to calculate the worst value that could be possible of ‘V’ over this period. This market risk value could be negative if cash flows are traded between the two trading counterparties the lender and borrower, as it can be seen in case of an interest rate swap. Market risk is normally derived by the differentiability of changing market variables continuously, such as stock prices for firms and interest rates for the countries. The time horizon over which market risk must be estimated is generally only a small-time period since it is normally possible to exchange out of positions out of this time period. For instance, a liquid stock which can be converted into cash easily that has negated in value can generally be sold easily (receiving at a

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loss) in fair time, whereas assets which have more credit risks, such as debt (loans), are not generally exchanged on the secondary market. Derivative contracts, such as counterparty swaps, are more illiquid as compare to the previous one since it is usually not possible to exchange or even get them to unwind. If the value of ‘V’ is negative in reference, there is no gain or loss in this position to the holder if his counterparty defaults though the similar amount of finance is to be paid to the counterparty. It is mandatory to put stress into that credit risk which still present, even though most likely diminished, since there is still a possibility that ‘V’ turns into positive over the time period of the exchange. Credit risk is even more valuable when ‘V’ is positive, as finance owed at the default of risk will not be in exchange in full. Only the recovery value in that matter will be received by one party. Therefore, risk in terms of credit is derived by two components: the final value of the trade positions and the actual “credit state” of the counterparty that tells a lot in that reference. The former one is similar to market risk (though a move in opposite side) and has the same underlying factors driving the exposure to the risk. The latter one is specific to credit risk and can be generally look at as default or no-default. This now starts a binary element into the specific credit risk, which usually is not an important element of risk. The “credit state” of counterparty can be enhanced by assigning good or bad credit ratings to them, which are generalized by the default possibilities and the ‘credit migration matrix’ related to counterparties. As described in the chapter, the characterization of a credit portfolio’s risk offers the identification of concentration in exposures related to credit, which takes naturally to the active management of portfolio’s credit risk through exchanging in the secondary markets, if they persist, use of credit derivatives and securitization becomes important for both the parties.

4.1.1. Types of Credit Risks Credit risk occurs through the potential changes in the quality of credit of a counterparty in the financial exchange. It has two essential components: default risk and, credit spread risk. Default risk: Default risk is derived by the capable failure of a counterparty to pay promised payments, either partly or completely. In the case of default by one party, a fraction of the essential obligations will usually be paid, which is identified as the recovery value for the other party.

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Credit spread risk: If there is no default by a counterparty, there is a risk that is still there due to the possibility broadening of the credit spread or getting the worst in credit quality. Here, the distinction between two components is known as ‘credit spread risk’ (Figure 4.3).

Figure 4.3: Credit score of the counterparty. https://prmiadc.files.wordpress.com/2012/10/creditscoreandrisk2.jpg.

4.2. TRADITIONAL APPROACH TO MANAGE THE CREDIT RISK The discovery of the secondary markets related to debt (loans) and other debt attached securities, along with the nurture of the credit derivatives market and the enhancement of techniques related to securitization, has started up new opportunities and chances for actively cited credit risk management. For overall, here the review of some of the traditional approaches used by most of the organizations to credit risk management, which are still generally utilized, such as ‘credit limits,’ ‘netting agreements,’ and ‘collateral arrangements.’

4.2.1. Credit Limits In the past, credit limits have been utilized to control the amount of risk exposure to a financial institution can have the exposure to each transacting counterparty. In this reference, there has been an upper cap on the overall risk

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exposure, the value of which is dependent on the good credit rating of the counterparty especially the borrower. However, here is an odd probability with the “Banker’s Paradox,” since it means that a financial institution should refrain from transacting with a counterparty with whom very good relationship have been observed so far, but with very high exposure to the risk. This is the situation on the grounds that the risk of a position will increment with expanding exposure. In spite of the fact that it is likely that a bank will have various vast exposures with specific customers, these must be controlled where possible, and the profits influenced must to genuinely mirror the risk taken. Taking a look at credit risk from a portfolio point of view permits the risks and returns of each situation to be legitimately evaluated. This approach is more secure and more proficient than the to some degree self-arbitrary approach of credit limits, as the last considers counterparties on an individual premise and not their commitments to the portfolio as in whole. Regardless of whether a borrower has a credit extension or a charged card, as far as possible works the same. Basically, the borrower may spend up to as far as possible, however, in the event that he surpasses that amount, he ordinarily faces fines or punishments notwithstanding his standard installment. In the event that he has spent not as much as the upper limit, he can keep on using the card or credit extension until the point that he achieves the limit. For example, if a borrower has a credit card with a $10,000 limit, and he spends $6000 for own expenses, he has an additional $4000 that he can spend or available for spend. If he makes a $400 payment and incurs a finance charge of $60, his balance falls to $5660, and he now has $4340 in available credit that can be utilized for expenditure. Debt to Credit usage rates is a compelling component with regards to estimating your credit score. Around 30% of the general credit rating is credited to this factor, and it is an immense determinant on our general advance qualification. To take in more on how you can enhance your financial assessment and estimation, set up a long-term objective, deal with your investment funds and that’s only the tip of the iceberg. On credit reports, each document in connection to a credit card or credit extension demonstrates the credit furthest reaches of the record, the high balance, and the present balance. Unfortunately, having a high credit score and numerous credit extensions may hurt a man’s general credit score. In

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these cases, new potential banks can see that the candidate approaches a lot of open credit. This reality sends a warning to the moneylender and service provider essentially in light of the fact that the borrower may pick to maximize his credit extensions and credit cards, overextend his debts and end up unfit to reimburse them. Since high credit limits have this potential impact using credit card scores, a few borrowers at times ask for banks to bring down their credit limits for their improved management. As per the suggestion from various research, “using the H-Score, (the measure of the company’s financial strength) and the PoD, it also takes into account the number and value of any County Court Judgments recently served against the company.”

4.2.2. Netting Agreements Netting is applicable just when there is in excess of one exchange with a counterparty. A netting contract is an agreement that is legitimately binding through the presence of a consented to a master agreement. It enables exposures under the master consent to be aggregated in case of default. The sum owed by a defaulted counterparty can be counterbalanced against any sum that will be received, and just the net remarkable sum should be paid. This will lessen the overall loss. Without a master understanding, all cash owed to a counterparty must be paid, while a small amount of all cash owed will be received. Netting is very natural in the swap markets with the two parties. For instance, suppose two parties enter into a swap contract on a particular debt or obligatory security. When swap period ends, Investor A is due to get $500,000 from Investor B. At the same time, Investor B is due to receive $25,0000 from Investor A. Instead of Investor B giving Investor A $500,000 and Investor A giving Investor B $25,0000, the payments would get netted. The total amount that Investor A would give to Investor B $0, while the amount Investor B would give Investor A $25,0000. This netting procedure happens on a wide variety of swaps; however, there is one kind of swap where netting does not happen. With currency swaps, since the notional sums are in various monetary forms, the notional sums are traded in their particular monetary forms, and all installments due are traded in full between two parties; no netting happens. Netting saves organizations a lot of time and expenses by dispensing with the need to process a substantial number of exchanges every month and lessening the exchanges essential down to one installment or payment.

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For banks exchanging across borders over limits, it constrains the quantity of outside trade exchanges as the quantity of streams decreases. With netting in foreign trade, organizations or banks can merge the quantity of monetary assets and remote trade compromise introduction bigger exchanges, receiving the rewards of enhanced estimation of the risk. At the point when organizations have more composed time periods and consistency in trade settlements, they would more be able to precisely gauge their revenue streams for the organization (Figure 4.4).

Figure 4.4: Netting agreement in finance. Source: http://www.rayadatacenter.com/portals/0/Business%20Partnership.jpg.

4.2.3. Collateral Agreements An approach to decrease a credit exposure is to take insurance in terms of collateral from the counterparty, as this can be exchanged in case of default and put aside against any misfortunes acquired. In any case, there is as yet the risk that the introduction at the time of default will be more than the market estimation of the collateral security. There may, along these lines, likewise be postings of security to represent the adjustment in the exposure of the position. And still, at the end of the day, there remains the risk that the exposure will rise and default will happen before a required margin call. To show the impact of collateral suitably, we should first think about the underlying limit (or “haircut”), which decides the cushion concerning the underlying presentation. The likelihood that more security will be required

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at that point relies upon the instability of the exposure. The minimum call amount (and the time between a margin call and the due installment) will impact the amount that can be lost between margin calls. At last, we ought to likewise think about the connection between the exposure and the collateral esteem. On the off chance that these qualities are emphatically connected, the credit risk on the position will be additionally diminished, as the estimation of the security is probably going to have increment with the exposure. For instance, if the security for a cross-finance swap position is designated in the cash we get, we are better ensured against the reinforcing or debilitating of that cash. In the following chapters, we talk about the liquidation of collateral in an illiquid market, which is a circumstance that is frequently experienced by and by. In order to counter the existence of a collateral agreement, there are four simple elements required to establish a collateral agreement as follow: • • •

the statement is promissory in nature for both parties; the promise is followed by a statement given by them; complete consistency between the main contract and alleged contract; and • the collateral agreement must contain all elements of an agreement. The case of De Lassalle v Guildford is a good example to explain that, “collateral contract must be consistent with the main contract. In this case, the parties negotiated a lease of a house by the letter to the former. The tenant seeks an assurance (the drain in good order) from the landlord before signing. The terms of the lease were agreed by both parties; however, the tenant refused to conclude the deal unless he receives an assurance that the drain in order. This assurance was held to be a collateral contract. The landlord argued that they were in order, but it turned out that they were not in order and the plaintiff sued. The court held that the representation made by the landlord as to the drain be in good order was a warranty which was collateral to the lease. A promise which is not a term of the main contract what could be enforced as a collateral contract.” One of the elements for identifying the existence of a collateral agreement which is the collateral contract must be well consistent with the mainstream contract. An example is to be found in Hoyts Pty Ltd v Spencer. “Hoyts subleased premises from Spencer. When sublease stated

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Spencer could terminate the lease at any time by giving four weeks’ notice in writing. The parties agree on verbally Spencer would not terminate the lease unless he was given to the main lessor. Spencer subsequently terminated lease under none of the specified circumstances. H claimed assurance was a collateral contract. High court ruled against Hoyts because assurance was not consistent with the main contract in any situation.” For a person who makes a collateral agreement, this person must show he or she entered into the main contract in consideration to be and not just the representational to be a collateral agreement. As to the obligatory nature of the statement see J.J. Savage and Sons Pty Ltd v Blakney. “Blakney purchased a boat from J.J. written in a letter that engine of the boat would go maximum speed. However, Blakney found out the engine was slower than what JJ’s written after the completed deal. Blakney sued J.J. breach of collateral contract. The high court held the statement was the only opinion which was made with the specific requirements into the contract. Firstly, Blakney would have made the statement legally binding when the letter was written. Secondly, Blakney would have required the speed of the boat to be inserted in the specification as a conditional contract. The last option, he would have satisfied the maximum speed of the engine by himself. This case was an unsuccessful case for arguing collateral contract.”

4.3. BUSINESS RISK Business risk spotlights on the risks the organization faces in its environment. Such risk analysis and investigation utilize models (SWOT, PEST, Porter’s Risk Assessment Matrix and the Five Forces model) to estimate competitor positions, business strategy and plans, industry, market, and available products in the market, and arrange these components into different models that assistance to think about, position, and evaluate the different risks included. It is interesting to take note of that the credit score organizations put extraordinary emphasis on the stability of organization execution from year to year (looking to monetary proportions, and so on.), yet that actually organizations are in a steady condition of transition, purchasing, and selling activities, moving assets into and out of special purpose vehicles, and replacing different managers with the recurrence of lights. In like manner, every one of these elements which one could freely classify as the ‘new economy’ (a deregulated free-for-all supported by the quicksands of traded

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off bookkeeping practice may be a more suitable description) needs to consider new systematic analytical approaches (Figure 4.5).

Figure 4.5: Business risk management. Source: https://cdn.pixabay.com/photo/2013/07/18/10/56/business-163501_960_720.jpg.

In like manner, this new economy is serving bankers with new lending openings, regularly with technologically situated new companies or ventures in new zones. These organizations’ absence of recorded information usually historical data implies that evaluating these new organizations require new investigative strategies since the great analysis system is to a great extent review and subsequently of limited utilize. It would be misinformed however, to fail in favor of extraordinary caution and maintain a strategic distance from the risks of the new economy by and large, since this would not just outcome in lost opportunities to the bank yet additionally would be an abdication of their part as moderate suppliers of capital bound to stimulate the advancement of new concerns which constitute revenue loan. In this way, we will likewise be taking a look at the significance of the ‘new venture criteria’ of the ‘website’ economy – criteria which essentially expect to comprehend an organization’s capacity to adapt to future development or to reimburse extraordinary loan facilities.

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4.3.1. Mitigating Business Risk a. PEST analysis: Risks pertain to environmental can be summarized by the acronym PEST which stands for (Figure 4.6): • • • •

Political/regulatory/legal; Economic Business risks; Social; Technological.

Figure 4.6: PEST analysis. Source: http://web24it.com/wp-content/uploads/2015/07/PEST-Analysis.png.

Here, few questions related to all 4 points are given that a person to go with regards the calculation of environmental risk.

b. Political/regulatory/legal factors: • • •

Do governments and administration impose import quotas/tariffs on various products? Does the government impose an entry barrier to the market? (For example, by awarding concessions). Are there government grants or subsidies available for a specific market or products? In a global market, how do these compare to those available to the competition?

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• •

Does the government impose duty or taxes on various products? Are there different sorts of regulatory requirements? (For instance, for safety, consumer protection, and free competition reasons). • Are companies in the industry exposed to legal matters and lawsuits which could have a material adverse effect on any individual company? Like product liability claims (such as tire manufacturer, pharmaceutical companies), passenger liability claims (like airlines), pollution claims (such as oil and chemical companies) and employee death/accident claims (here, oil means exploration and production companies). These risks and question associated with this can be mitigated through insurance. However, claims, especially in the US, have in some cases limited the maximum cover the insurance market is ready to provide.

c. Economic: • • •

• •

• •

How does this impact on customer demand as well as the necessity to make higher interest payments? How is your company and the industry in which it operates affected by high-interest rates? How is the industry/company affected by fluctuating foreign exchange rates? (Fluctuations like them are important with a company that for example has its costs in GBP but sales in EUR and USD.) How cyclical is the industry? How does the industry relate to the general economic cycle? Does it lead or lag the economic cycle, or is it countercyclical? (to check this, try to evaluate the company’s performance over the last economic cycle or last 5–10 years) How is the industry affected by high inflation rates? How price-elastic are the industry’s products and its raw materials?

d. Social: Questions pertaining to risks related to social are: • •

Is the industry inherently stable? Is the industry affected (either positively or negatively) by changes in social tastes or fashions?

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Are there ‘green’ issues? What is the industry’s record on pollution?

e. Technological: Technological issues affect the industry and company in two main ways: •

•

First of all, is the product obsolete and likely to be superseded by a better new product? (‘Better’ might be in terms of price or quality.) Has there been a fundamental change in the cost structure of manufacturing the product?

f. SWOT analysis: Another strategy for estimating a borrower’s competitive position is SWOT analysis. This is a structured in the investigation of the (Figure 4.7): • • • •

S – Strengths; W – Weaknesses; O – Opportunities; T – Threats.

Figure 4.7: SWOT analysis. Source: https://research-methodology.net/wp-content/uploads/2015/12/SWOTAnalysis1.png

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That the organization could face in successfully conducting its business process. Strengths and weaknesses are connected internally to the company and cater to the better quality of its products and processes, the capabilities of its management, the available experience of expertise amongst its employees, cost structures, operational flexibility, etc. Opportunities and threats are connected externally to the organization, and relate to the markets, environmental influences, and competition, such as regulation from the government and changes in the economic factors of the country. Credit Risk Management: Credit risk management via SWOT analysis is a lucid technique which can be used at a fairly executive level, but that can support focus on relevant factors. Laying out the SWOT analysis model in the format of table leads it easier to summarize and reach a conclusion for decision making. The SWOT analysis supports that it is the winner in its market segments prevailing today but has a few organizational malfunctioning and few financial weaknesses, and the threat of raised overall competition. The SWOT analysis suggests that a research of the company’s assets and strategic orientation be developed before a plan that is strategic in nature is implemented, and a monitoring or feedback system is developed for finetuning of the strategic plan in the future.

4.4. FINANCIAL RISK The financial risk analysis is based on financial statement analysis and begins with an introduction to financial statement analysis and interpretation on the purpose and usage of annual accounts of the company. Then, it takes a detailed cite at the background of the annual report developed and accounts including the background of the latest Companies Acts and Statement of Accounting Standards. In addition to this, it also examines the content and relevancy of auditors’ report and directors’ report and guidelines. Then, the balance sheet is treated narratively, focusing on the various principal accounts related to the company: • • • • •

Creditors; Debtors; Borrowings; Stock and Work in Progress; Share Capital;

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• Fixed Assets; • Reserves and surplus. The financial risk of the company can be examined by the workings of the profit and loss (P/L) account and cash flow statements of the organization and ends up with a ratio analysis and interpretation of the limitations of accounts which are published.

4.4.1. Mitigating Financial Risk There’s presumably that beginning of a new business has risks associated with it. Statistics contrast on what number of organizations fail in the initial year or two, yet unmistakably a bigger number of organizations fail than those that survive in the initial couple of years. In the event that you are an entrepreneur about beginning another business, what should be possible to enhance those risks? In particular, by what method would entrepreneurs be able to decrease the money related risks of another business? Here are a few things to consider doing to help eliminate the finance-related risks in case you’re beginning another business. Develop a Solid and Applicable Plan: One of the initial steps to enable entrepreneurs to lessen the monetary risks of another business is to build up a strategy for success. Before you jump in with the both feet, you have to know how much time and capital you will be putting resources into your new business. Also, statistical surveying ought to be finished. This gives you a thought of regardless of whether your new business has a shot at progress or finishes in disappointment landing you in the poorhouse. Perform Quality Control Tests: You should execute client service reviews of your products or services before offering them on a wide scale. Have a test gathering or beta test so you can enhance them before your genuine dispatch. This will give you a more prominent shot of achievement in your wander. It causes you to abstain from launching a product that will require significant work with a specific end goal to be a feasible product. Keep Good Records: Create a record-keeping management system that works from the very initial stage of your new enterprise. If you develop a filing system and maintain up with paperwork, it may save you both money and time when it’s time to submit and pay your bills or submit your taxes (Figure 4.8).

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Figure 4.8: Financial risk mitigating techniques. Source: http://www.jhdarchitects.co.uk/wp-content/uploads/2014/07/Financial-Risk.jpg.

Limit Loans: If you initiate your business with a business loan, make it as less as you can perfectly manage while still having a hope of providing enough capital and cushion to manage the success of your new enterprise. That may look vague; however, the amount you need to have in loan depends on your personal unique financial situation and the type of business you are initiating. To eliminate the financial risk associated with your business, only take out a loan if you are required to and try to maintain it as lesser as you can. If there is a possibility to have funds for your business with no loans, that would be optimum to minimize financial risks associated with your business. Keep Accounts Receivable Low: To stay for a long time in business, you are required to collect on the product or service you are dealing with. Keep manageable track of your accounts receivables and ensure your customers are paying bills on time. Your success or failure is completely dependent on the capability to take the money into your cash flow. Diversify Income: Whenever it is possible, make income source from more than one source. If your business doesn’t develop it, having a backup and supportive plan to keep you out of bankruptcy is good business sense especially for new businesses. Buy Insurance: Buy insurance against death, disaster, and other various things you feel could capably hamper your business. Although it will cost

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you some finance to buy insurance, the peace stage of mind it brings is well worth the attached cost if it saves you from losing everything. Save Money: Save as much cash as you can. Develop some cushion as additional “insurance” in the event that calamity comes upon your business and you need to close shop. This implies you may need to center around enhancing your own accounts and having your very own just-in-case account before you begin a business. As a business person, you can’t take care of the quantity of new organizations that fail every year nor would you be able to 100% assurance that your own particular achievement will succeed. However, you can find a way to diminish the financial risks of your new business, giving it a more noteworthy achievement.

4.5. TRANSACTION RISK Transaction risk associated with the business is the exchange rate risk attached with the delay in time between entering into a contract and handling it. The higher the time difference between the entrance and handling of the contract, the higher the transaction risk associated, because there is higher time for the two different exchange rates to fluctuate. Despite the gap between agreement and execution of the contract, there are strategies organizations can utilize to eliminate any potential loss (Figure 4.9).

Figure 4.9: Transactional risk in finance. Source: https://dbt7a3rwdhupy.cloudfront.net/Pictures/480xany/8/4/6/32846_ Money_handover.jpg.

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At the point when organizations repatriate benefits or pay for merchandise abroad, there is a period of delay in agreeing to the buy and executing the foreign trade exchange to finish the arrangement. For instance, if a U.S. organization is repatriating profits from a deal in the U.K., it should move British pounds to U.S. dollars. In any case, there is time between the choice and the execution and settlement of the arrangement, this period is known as transaction risk. In this occurrence, the risk lies in the GBP/USD cross rate. Should the cash combine fall, the organization has been antagonistically influenced by transaction risk since it will get less U.S. dollars from the deal as the estimation of the GBP falls.

4.5.1. Mitigating Transactional Risk Effective transactional risk management process will incorporate certain common elements that may result in the development of an environment conducive to the effective management of the risk: • • •

Effective overlook and oversight by a board of directors. Significant risk management policies and processes. A quantitatively accurate system for reporting exposures related to the country. • An effective procedure for quantifying country risk. • A country risk rating system for the nation. • Country exposure limits established by the nation. • Continue monitoring of country conditions. • Frequent stress testing of foreign exposures. • Significant internal controls and an audit function for the nation. Within this specific context, it is vital to build up clear tolerance limits, portray clear lines of responsibility and accountability for choices made, and recognize ahead of time attractive and unwanted sorts of business. Arrangements, benchmarks, and practices ought to be clearly communicated, and implemented, with influenced staff and workplaces. Quarterly announcing ought to be forced—all the more as often as possible if foreign trade exchange impacts an investment given by investors. It is normally likewise important that investigations be enough recorded and determinations communicated in a way that gives managers a precise premise on which to measure exposure levels, and that adequate resources be committed to the task of assessing risk. Since the Crisis, a few banks

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have brought together the analytical procedure and participate in occasional appraisals of risk on a more regionalized premise (rather than entirely on a country-specific basis). Optimum practices dictate that various actions should be opted to create a transactional risk management process. Among them: •

The management function of transactional risk should be centralized. • Guidelines of transactional risk should be established and widely disseminated. • Limits related to country/sector should be established. • A system to better minimize the criticality of perceived risks must be established. • Reporting of quarterly transactional risk should be implemented. • A company should make the maximum use of internal information possibilities while incorporating a broad array of external information sources into analyses. Much can be educated at a corporate level by the approach and experience of universal banks in tending to transactional risk. Almost all banks have created formal projects to oversee transaction risk, and the vast majority of these are incorporated in order to build up and keep up control over a whole system of activities. All banks allocate formal nation evaluations, the greater part of which cover an expansive meaning of risk. Ratings are regularly assigned to a wide range of credit and investment related risk, including local cash-based lending (Figure 4.10).

Figure 4.10: Tips for good lending. Source: http://newshawktime.com/wp-content/uploads/2017/09/P2P-Lending. jpg.

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Transactional risk ratings build up a ceiling that additionally applies to credit risk appraisals. Most banks don’t, for the most part, have formal provincial points of confinement to lending, yet a few banks monitor exposures for a given region casually, and most have particular nation limits. Numerous banks apply an individual nation rating to a wide range of exposure, while recognizing outside and nearby cash subsidizing. Formal exposure limits have a tendency to be set every year and oversaw using total country exposures. It is imperative to set up clear tolerance limits, outline clear lines of obligation and responsibility for risks created, and distinguish advance management and unfortunate kinds of business. Approaches, measures, and practices ought to be unmistakably mentioned, and implemented, with influenced employees and workplaces. Quarterly reporting ought to be imposed—all the more as often as possible if foreign trade exposure impacts a given project. The capacity to acquire essential information through contributions from local workplaces, and additionally by generic visits with respect to country risk managers, can’t be overemphasized. Best practice ought to energize in-house evaluations before depending on outsourcing of vital data so as to fabricate internal rating applications. In many organizations, the country risk project works self-ruling, as there has a tendency to move with interests between the working side of the business and risk management. It is along these lines critical for senior management to adequately supervise connection between the two sides. The risk evaluation choice chain ought to be straightforward and autonomous of trade-off by business unit practices. Regardless of whether there is a rating process available to one, it is best to use information from an assortment of sources, distinguish the iterative topics that continue returning, and make a judgment about the fundamental idea of the risk. This ought not to be done in a vacuum, nonetheless. The underlying and valuing process ought to be seen as collaborative, looking for the confirmation of others in the basic decision-making process.

4.6. MARKET IMPERFECTIONS Previously, we talked somewhat from our principle subject to examine three themes identified with credit: effect of market illiquidity, non-constant rebalancing of supporting portfolios and asymmetric information among

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various participants of the market. In financial terms, the above would be alluded to as market imperfections. With a specific end goal to keep mathematics simple and lucid, we have chosen to show the initial two applications in equity context (Figure 4.11).

Figure 4.11: Market imperfections. Source: https://catch.joanneum.at/wp-content/uploads/2015/12/ Fotolia_74381071_S-300x267.jpg.

These market imperfections are predominant to a littler or higher degree in most of the markets yet have a probability to be imperative in most credit markets. In spite of the fact that we have not yet connected these ideas to credit, we trust that they can give more practical models that imitate all the more intently the working of the genuine markets. Obviously, we understand that their multifaceted nature and troublesome adjustment issues could confine their appropriateness. We can just characterize liquidity chance as: the failure to execute at significant volumes at the overall market cost related to security. The market cost reflects the cash amount we can hope to pay or get for small exchanges. In a market that does not have a considerable measure of depth in terms of risks, the “market cost” for vast exchanges can be generously not quite the same as the above, which punishes the financial analysts and portfolio managers. To consider this potential powerlessness

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to exchange, we have to alter the cost of the securities by a liquidity spread. This liquidity spread does not reflect the risk possibility, but instead the potential absence of an adequate number of market members with which to execute. We show these thoughts in the evaluation of collateralized debts generally considered as secured loans, where the value is held as security. In the event that the borrower neglects to post margin, we may need to sell the security in a brief time-period, unfavorably affecting the market cost. A symptom of market illiquidity is the failure to change the hedges constantly while executing a dynamic supporting system for the risk measurement. The Black–Scholes cost is completely substantial just when the hedge is constantly rebalanced, as managed by the prescribed model. This could be genuine additionally for small exchanges or trades, for example, as within the sight of safe exchange costs. It is even conceivable that the fundamental does not exchange persistently, similar to the case for indices or funds. We will show the impact of discrete supporting by analyzing a call choice on a security, where the hedge is rebalanced just at discrete time focuses. It is interesting to take note of that the “residual variances” is good, regardless of whether the rebalancing occurrence is higher as compared to the previous one. Asymmetric information, the third issue we are tending to, is again firmly identified with market liquidity. In a market where information is freely accessible, we anticipate that risk that financial analysts will exchange risk to institutions with high-risk resistance. In the capital markets, data on every now and again exchanged or tradeable liquid instruments is openly accessible and is reflected in the cost. Access to data has been a hindrance for the incredible increment in exchanging volumes lately. In illiquid markets, certain financial analysts have prevalent information and a premium is accused for execution of them. This extra cost, because of unbalanced information, can make trading costs restrictive and avoid generally commonly supportive trade of risks. In the chapter, we propose an unforeseen expense structure that incompletely settles the asymmetric information issue and after that show the hedge in the accompanying settlement of the transactions. A trader of financial instruments pays for imported products in US dollars and gets incomes in neighborhood cash. Business at this stage is negligible yet is relied upon to develop significantly if the economy progresses. In the last case, the nation’s credit score can be utilized as an intermediary for that matter. At the present volume, the importer would not have any desire to

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support their foreign exchange exposure, but rather if business develops, they might need to go into a progression of forwarding contracts. This is like the unforeseen contracts examined in derivative contracts. In this area, we propose a totally unique risk management process. We will infer to this as a restrictive financial hedge which is confidential.

4.6.1. Liquidity Risk Risk related to liquidity can be narrated as the inability to transact at relevant volumes at the existing market price. For instance, when we wish to buy or sell on-the-run (the current issue related to price) US Treasury securities, it is possible to execute at practically on any volume and at any time. In different words, US Treasury securities are liquid in most of the cases. This is usually not in the case for most of the corporate bonds. In credit crises happened in the past, the market had recovered out, and it had become almost impossible for financial institutions to sell without incurring losses which are very large at some times (Figure 4.12).

Figure 4.12: Liquidity risk. Source: https://www.liquidityrisk.net/wp-content/uploads/2016/04/logo.png.

We wish to receive cash for our various securities; sometimes we may not be able to–at least not if we insist on receiving the existing “market price” prevailing in the market. The reason for this is not the probability of risk that one party may default, but the missing of sufficient potential purchasers to trade with. This effect, related to credit risk, is definitely variable in all the cases. Liquidity risk has attracted a lot of interest both from academics and practitioners similarly, but few models only have been created that could possibly be of empirical use.

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4.6.2. Discrete Hedging In previous chapters, discussion about the support of credit derivatives and fixed income derivatives subject to credit risk, separately. All through, here the presumption has been developed that the default swaps utilized for supporting could be exchanged consistently. It is notable this isn’t the situation and that this discreteness in support rebalancing would diminish the viability of the hedge. The relating circumstance in credit derivatives is the change of the Black– Scholes cost to consider nonstop exchanging. A central supposition in standard finance related practices (market estimating in the Black– Scholes model) is that the costs of derivative instruments can be totally duplicated by constantly exchanging a management of major underlying securities. The costs of these derivative and reference securities are controlled by the inclinations of the speculators, while derivative securities can be estimated utilizing arbitrage misbalance. Financial analyst inclinations in this structure are not applicable when valuing derivative instruments and its underlying assets. This outcome separates when exchanging which is limitless and finish replication which are not possible. In this part, the assumption has been made that can just rebalance the support at discrete time focuses. To cost in this deficient market system and to determine a supporting procedure, utilization of various methods from dynamic programming. Consideration of a European choice on a stock S with result g(S) happening at maturity T. The underlying must be exchanged on pre-determined discrete time focuses 0 = t0, t1,…, Tn = T. The inference here can be the ideal delta supporting change minimization system, which limits the vulnerability of the total sources of income of the supported position amid the life of the option.

4.6.3. Asymmetric Information In a market where data is unreservedly or freely accessible, the anticipation of that risk opposed financial analyst will exchange risk to organizations with high-risk resistance or tolerance. In the capital markets, information regards too much of the time exchanged liquid instruments is freely accessible. Access to data has been a catalyst for the marvelous increment in exchanging volumes as of late. In illiquid markets, certain speculators have prevalent data, and a premium is accused for executing of them. This is, for instance, valid in the credit markets. Insiders in organizations that are not taken after nearly by experts have a tendency to have huge information

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in regards to the risks they confront that isn’t accessible to general public (Figure 4.13).

Figure 4.13: Risk-averse investor. Source: https://images.yourstory.com/2015/10/yourstory-Investors-look-before-investing-in-startups.jpg.

An organization that gives a finance-related hedge to these customers is presented to asymmetric information, which is reflected in the valuation of the company. This extra cost can make exchanging costs restrictive and anticipate generally commonly gainful trade of risk. The effect of Hilter Kilter data is considerably more interesting when managing non-finance related risks. An institution that hedges a customer against certain business or insurance of risks is liable to moral risk and unfavorable selection. Non-linear estimation of prices, the utilization of deductibles, screening, and scoring systems contracts and charge premiums as indicated by normal losses. Not knowing the correct likelihood of a particular policyholder enduring a loss isn’t essential. In any case, if contracts are moderately huge or their risk is non-diversifiable, unbalanced data shows a genuine estimating issue. In this part, the representation of a broader answer for the valuing of risk with unbalanced information that is publicly available. The propose charging two expenses: a charge paid and an expense restrictive on a particular occasion happening are standard in the insurance business. Sellers of insurance hold huge management of generally small risks.

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4.7. CONCLUSION The initial phase in viable credit risk management is to pick up a total understanding of a bank’s overall credit risk by review risk at the individual, client, and portfolio levels. While banks take a stab at a coordinated understanding of their risk profiles, much data is frequently scattered among specialty units. Without an intensive risk evaluation, banks have chance to get off knowing whether capital saves precisely reflect risk or if debt loss or simply known as bad debts save sufficiently cover potential here and now credit loss. Powerless banks have few focuses for investigation by controllers and financial analysts, and also incapacitating misfortunes. The way to reducing amount pertaining to bad debts – and guaranteeing that capital holds properly reflect the risk profile is to actualize an incorporated, quantitative credit risk management. This kind of management ought to get banks up and running rapidly with straightforward portfolio measures and analysis. It ought to likewise suit a way to more complex acknowledge risk management measures as requirements develop. The management or the solution should ideally include: • • • •

Better model control that spans the entire life cycle of the modeling; Real-time scoring and monitoring to the upper and lower limits; Robust stress-testing capabilities for both the parties; Data visualization potential and business intelligence tools that get important information into the hands of those who need it, when they need it in case of requirement.

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REFERENCES 1. 2. 3. 4. 5.

6.

7. 8.

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Altman, E., (1989). Measuring corporate bond mortality and performance. The Journal of Finance, 44(4), pp. 909–922. Bis.org., (2018). [online] Available at: https://www.bis.org/publ/ bcbs54.pdf [accessed 6 April 2018]. Caouette, J., Altman, E., & Narayanan, P., (1998). Managing Credit Risk. New York: Wiley. Deventer, D., Imai, K., & Mesler, M., (2013). Advanced Financial Risk Management. Singapore: Wiley. Ed, X., (2018). An Introduction to Credit Risk Management. [online] Available at: https://www.edx.org/course/introduction-credit-riskmanagement-delftx-tw3421x–2 [accessed 6 April 2018]. Ey.com., (2018). [online] Available at: http://www.ey.com/Publication/ vwLUAssets/EY-credit-risk-management/$FILE/EY-credit-riskmanagement.pdf [accessed 6 April 2018]. Gestel, T., & Baesens, B., (2009). Credit Risk Management. Oxford: Oxford University Press. Golub, B., & Tilman, L., (1997). Measuring yield curve risk using principal components, analysis, value, at risk, and key rate durations. The Journal of Portfolio Management, 23(4), pp. 72–84. Gourieroux, C., Laurent, J., & Scaillet, O., (2000). Sensitivity analysis of values at risk. Journal of Empirical Finance, 7(3 & 4), pp. 225–245. Gregory, J., (2012). Counterparty Credit Risk and Credit Value Adjustment. Chichester, West Sussex: Wiley. Irmi.com, (2018). Effective Transactional Risk Management | IRMI. com. [online] Available at: https://www.irmi.com/articles/expertcommentary/effective-transactional-risk-management [accessed 6 April 2018]. Lando, D., (1998). On Cox processes and credit risky securities. Review of Derivatives Research, 2(2 & 3), pp. 99–120. Milidonis, A., (2016). An empirical investigation of CDS spreads using a regime-switching default risk model. North American Actuarial Journal, 20(3), pp. 252–275. Mousavi, M., & Ouenniche, J., (2018). Multi-criteria ranking of corporate distress prediction models: Empirical evaluation and methodological contributions. Annals of Operations Research.

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15. Rmahq.org., (2018). Credit Risk Management Best Practices & Techniques | RMA. [online] Available at: https://www.rmahq.org/ credit-risk-management-best-practices-techniques/ [accessed 6 April 2018]. 16. Sas.com, (2018). Credit Risk Management: What it is and Why it Matters. [online] Available at: https://www.sas.com/en_us/insights/ risk-management/credit-risk-management.html [accessed 6 April 2018]. 17. Sloan, K., & Sloan, K., (2018). How Entrepreneurs Can Reduce The Financial Risks of a New Business – Due. [online] Due. Available at: https://due.com/blog/entrepreneurs-can-reduce-financial-risks-newbusiness/ [accessed 6 April 2018]. 18. Staff, I., (2018). Transaction Risk. [online] Investopedia. Available at: https://www.investopedia.com/terms/t/transactionrisk.asp [accessed 6 April 2018]. 19. Zmijewski, M., (1984). Methodological issues related to the estimation of financial distress prediction models. Journal of Accounting Research, 22, p. 59.

CHAPTER 5

Methods and Techniques for Market Measurement

“You need to have a lot of human judgment involved in the financial industry in terms of risk management, in terms of investment decisions, and things that really allow us to blend the best of technology and the human brain.” —Adena Friedman

CONTENTS 5.1. Introduction .................................................................................... 116 5.2. Measure of Performance ................................................................. 116 5.3. Return on Marketing Investment ..................................................... 117 5.4. Measuring Marketing Performance.................................................. 119 5.5. Prediction And Projective Markets .................................................. 122 5.6. Credit Report Analysis..................................................................... 123 5.7. Value At Risk (VAR) ......................................................................... 124 5.8. Volatility ......................................................................................... 130 5.9. Explanation Of Regression Analysis ................................................ 131 5.10. Investment In Emerging Markets: Risks And Barriers...................... 132 5.11. Sharpe Model ............................................................................... 134 5.12. Conclusion ................................................................................... 137 References ............................................................................................. 139

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Market measurement is evolving and also taking a central position in situations where companies are operating and running their operations. As the regulation requires, the initial and basic step involves establishing and maintaining the procedures, controls, and policies for mitigating and managing risks. The effectiveness of financial markets reflects a lot on a country’s economic growth. Ways in which financial resources are assigned to assess the return, risk, and cost and therefore the additional value developed by the investments. This chapter will highlight methods and techniques for measuring the market performance with respect to financial risk, Credit report Analysis, Value at Risk, Regression Analysis. It will also discuss in detail the concepts related to Volatility and Sharpe Model.

5.1. INTRODUCTION Market forecasting and measuring need analyzing and assessment of market that has objective and aim to express the results in quantitative and qualitative values both at present and in future. All over the world, market measurement is evolving and also taking a central position in situations where companies are operating and running their operations. Since the emerging markets are also moving in the similar directions, they are requoted to fasten their speed and pace, particularly when there is a need to incorporate management of financial risk in the growth and strategy of the business. In the realm and dominion of managing financial crime policy, a traditional and established approach is there for giving a response to the legislative and statutory evolutions. As the regulation requires, the initial and basic step involves establishing and maintaining the procedures, controls, and policies for mitigating and managing the risk. In parallel to this, a wide majority of companies may have to set up the policies and regulations in place that covers the following disciplines of financial crime: prevention of fraud, corruption, and anti-bribery, sanctions, Counter financing of terrorism and anti-money laundering.

5.2. MEASURE OF PERFORMANCE A metric is known as a measure of performance which must be reviewed by the management of the company and must be evaluated regularly in most appropriate way. Many a times, the Marketing measurement is defined as a deliberately designed and formulated set of evaluation and measurement techniques for market. Using marketing metrics is known to be a significant part of control process and marketing evaluation.

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Metrics must be dynamic in nature and must evolve along with the development of a business. It is very important to understand that a market measurement is not a synonym which is used for metrics. It must always be adequate for the purpose of review, consistent, precise, and relevant. The importance of marketing measurement emerges from the anticipation that a corporation will have prosperity if it is having a clear and wellexplained business model and strategy. Therefore, marketing measurement is strategically significant for assessment of progress. It serves the purpose of indicating the future and subsequent flow of cash in the economy along with present flow of cash. The measurement of marketing is helpful and supportive in subsequent development of business plan and future marketing, by assessing the previous activities of marketing and designing some new activities. Similarly, the significance of marketing plan and data which the measurement techniques may give to the managers and marketers lies in understanding that presently the marketers change and modify the budgets from conventional to digital channels, that they want for being able to assess the accurate spend in various channels for being able to be accountable towards top management1.

5.3. RETURN ON MARKETING INVESTMENT Having the ability for measuring, the marketing measure may have accountable value. The given factor helps marketer for translating the cost of marketing into related revenue and income, by breaking down every channel of marketing which the marketers can observe in previous earnings from past activities of marketing and formulate new objectives to get Return on Marketing Investment, which they hope and aspire to achieve by moving ahead. While linking and associating the financial performance and shareholder value with marketing, the marketers may not afford to ignore to balance the pointers of previous financial health- marketing metrics, indicators, and pointers of prospective financial health and financial metrics. No doubt, marketing measurement is gaining and acquiring more attention being a vital part to measure market and process of evaluation, in spite of the contributions and help over the subject marketing researchers metrics, the marketing efficiency and performance measurement studies 1

Claessens & Rhee (1994).

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can be expanded by providing structured framework or process for the organization of marketing remedies and measures. The researchers for marketing measurements provide different ways for to classify these methods of measurement and also point out and indicate often used parameters. If every marketing metric, as well as information it gives for the company, is accurately examined, the method in which this information must be analyzed, the marketing metrics may be classified as qualitative and quantitative, therefore the authors give a proposal for following category of metrics: Quantitative Marketing Measurement Metrics which assess the assets of tangible nature and may be quite easily and conveniently expressed in quantitative and monetary value, percentage, and count. These measures are Customer Lift Value (CLV), promotion lift, baseline sales, net reach, Cost per Click (CPC), impressions, Internal Rate of Return (IRR), Payback, Net Present Value (NPV), Economic Profit (EVA), Net profit, Penetration, market share, Profitability, Gross margins, Sales, and Customer Count2.

5.3.1. Qualitative Measures of Marketing Qualitative measures of market measurement assess intangible assets in which more than previous 40 years have turned out to be more important as market value drivers. Indirectly, these metrics derive or originate at value which not regarding money only, instead it is concentrated around the reaction of consumer. These measures are perceived quality, willingness for recommendation, willingness to conduct search, word of mouth, satisfaction, likeability, awareness, and loyalty, etc. Many metrics are there for the marketers to make a choice from and also, they should keep in mind that no single golden metric is there which can be suited to all the business and company situations. Variations in the kinds of marketing messages, channels, and tools used as well as the way in which they are used can make hard the process of application of various metrics, however for better and appropriate management, control, and implementation of marketing, the authors give suggestion that corporations must apply and implement both qualitative and quantitative methods to measure marketing performance with future and present and past assessment of performance. According to N. Kumar (2004), the corporate nature and attribute of marketing metrics being characteristics, which is common in huge enterprises and corporations by stating “Corporate marketing can influence 2

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the definition of the relevant marketing metrics at each of the five levels of business (products, brands, channels, customers, markets) and ensure that each division and country tracks, collects, and reports the appropriate metrics using a common methodology so that executives can compare data across the firm.” However, the researchers have explained that various metrics may be utilized in differently profiled corporates for huge range of objectives in the model for marketing mix- different kinds of media (television, print social, etc.), Marketing activities (sponsorship, promotions, campaigns, etc.), channels, and many more. Furthermore, the research for present situation depicts that these metrics are getting huge acknowledgment and also utilized in small level companies as well as in large and medium-sized companies, although a small gap in executives and marketer’s knowledge can be easily noticed and taken care of3.

5.4. MEASURING MARKETING PERFORMANCE The researchers provide a review of characterizations and definitions of marketing performance, effectiveness, and marketing efficiency for gaining a better knowledge regarding these aspects of implementation process and marketing management. As the time passes, marketing performance, effectiveness, and efficiency have attracted a huge deal of attention and consideration in academic literature and in managerial staff of the corporations. Literature of marketing along with other publications over the marketing issues take care of these concepts and contexts in different ways and methods, as it has been depicted in literature that marketing should focus and concentrate over delivering efficacy that delivers high value and importance to the corporations and customers at lesser cost. Both effectiveness and efficiency are crucial to the performance of marketing. The marketing performance is classified as a multifaceted process which involves the three distinctive dimensions of adaptability, efficiency, and effectiveness, the efficiency, and effectiveness of the marketing activities of organization with respect to objectives related to market like market share, growth, and revenues. For understanding the performance of market, various measures are required as marketing performance refers to retention and acquisition of customer which is known as the primary objective of business for most of the 3

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companies. No doubt, conventional techniques for market research like focus groups and surveys are used broadly, many latest techniques and methods of market research for making things spiced up. As the socioeconomic and technological trends change, so will the means and tools to get the customer insights.

5.4.1. A Change from Collection of Data to Analysis of Data At present, the real data for customer behavior is gathered with convenience, to the point and portion where data mining or analysis is more challenging instead of getting the data. For instance, Google Analytics gives webmasters much information regarding the visitors of web that includes screen resolutions, page visited and languages, etc. all this information may be utilized for refining the website for the audience. One more instance for big data mining is for predictive recommendations of Amazon (Figure 5.1).

Figure 5.1: Value at risk. Source: https://g-square.in/finalytica-jan-2018/.

By consistently monitoring and analyzing the products that are viewed and purchased by users as well as correlating and comparing the information

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with buying history of other individuals, Amazon is efficiently presenting the recommendation of product. All this can be easily done by using data mining. This avoids the company to ask other users as what substitutes you would prefer to buy. Twitter is known as another source for readily available information which can be easily mined. In a popular talk show Jonathan Harris, he beautifully demonstrated the benefits of readily available information which can be visualized.

5.4.2. Mobile Market Research Methods Tablets and Smartphones are overcoming the globe by storm. All these devices are getting a platform which is preferred by many people for most of the markets and applications that includes market research. Instances of how these devices are utilized in market research involve: •

•

•

•

4

Voting and text messaging Surveys (SMS Surveys): One of the best instance of this is called a corporation known as “Poll Everywhere.” They permit the seminar attendees for responding to and voting to all the poll questions through SMS (text messaging). Surveys designed for Smart Phones: Good and Efficient mobile surveys are designed particularly for the Smartphone designed factor. Many corporations are there working over this, like Opinion Meter and I Opinion-Surveys. All these surveys are based on web, enhanced for phones, otherwise, they may be native applications that are developed specially for windows mobile operating Systems or iOS Android. Awareness about Location: Advanced Research techniques for phone market can accelerate information for Smartphone location for triggering questions as well as tracking the movement in time4. For instance, it can be imagined of a survey question which appears only when a mobile is aware about the user being at gas station. Biometrics techniques for market research: New methods for biometric research which measures a physical response of a subject towards stimuli give valuable data which a subject may not be willing or able to verbally express (Example television commercial). Instances of biometric methods of market research involve eye tracking, brain activity (by making use of functional Harvey (2003).

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MRI), muscle activity, skin activity, respiration monitoring, and heart rate monitoring.

5.5. PREDICTION AND PROJECTIVE MARKETS A projected market is similar to a small stock market, at a place where people may sell and purchase projections of different events. For instance, one event can be “presidency can be won by whom?” Participants may use their real or fake currency for purchasing or selling who so ever they think can win. Before this, the amount of single candidate will increase quite closer to approx. $1.00. When the election ends, one candidate is equivalent to $11.00 while other is $0.00. All the individuals may sell or buy their interest in a candidate all through the way5. The main advantage of these projections is that it intends to be a great indication of actuality. All the companies in forward thinking are settling these projected markets for tapping into employee wisdom. For instance, a corporation may ask the employees for bidding into the prediction market which is related to success of concepts of products, industrial trends, and competitors in order to get initial reach and access over these ideas.

5.5.1. Virtual Shopping It involves using virtual simulation of store for mimicking an experience of shopping for participants- a great way for testing small retail problems such as packaging, store layout, and product placement, etc. Again, the main idea involves replicating the actual condition for researching the subjects as well as observe the behavior which is opposite as to what according to them they will perform.

5.5.2. Response of Live Audience In lectures or conferences, the presenters face difficulty in engaging with people. One method for remedying this issue involves systems of live response of audience. These frameworks include a handheld control remote for the members of audience for responding to the queries which appears on screen. 5

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5.5.3. Tools for Online Collaborations Tools such as Shared whiteboarding, instant messaging and Skype (video calling) allow or permit the researchers for conducting various traditional techniques for market research by using latest technology. All these technologies are quite cheaper in comparison to physically collection of people. Also, they allow researchers for gathering people through wider geographies easier.

5.5.4. Market Research Using Social Media Social Media have dominance over web; therefore it is quite natural and convenient that market researchers are identifying the ways for leveraging and accelerating this technology. People have different perceptions for market research using social media: Research of Social Media, research using data of Social Media, research making use of social media being a part of delivery mechanism and methodology, Surveys using QR Code (It overlaps using market research of mobile phone).

5.6. CREDIT REPORT ANALYSIS Granting in-store credit to your customers can grow your sales and increase your profits. It allows existing customers to purchase more of your items and potentially attracts new clients. Before granting credit, you must ensure that your customer has the means and desire to pay his invoices. Developing a written credit policy sets out the procedures to analyze a customer’s financial risk. The policy should comply with federal and state credit laws, such as the Equal Credit Opportunity Act, so all customers are evaluated fairly. Your customer’s business credit report should be the first document you analyze. It shows the name and address of your customer’s creditors and the opened, closed, current, and delinquent accounts. You are looking for customers with high credit scores that are current on their obligations. Have your customer complete a credit application and make sure an officer with the authority to bind the company signs the application. Business credit reports are available through agencies such as Dun & Bradstreet, Experian Business and Business Credit USA.

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5.6.1. Measuring Credit Risk The credit risk is how likely your customer is to default on her invoice payments, go out of business or file for bankruptcy. The credit risk is based on the customer’s past credit history, including account charge-offs, accounts that are overdue 60 days or more, the number of accounts in collection and the number of recently opened accounts6. The credit risk also includes lawsuits filed against your customer for unpaid invoices, judgments obtained against your customer and prior bankruptcies. The credit risk score is usually included with the customer’s credit report.

5.6.2. Measuring Financial Risk You can determine your customer’s financial risk by analyzing his business financial statements. Look at your customer’s cash flow, including how fast accounts receivable accounts are collected. The sale price of your customer’s goods and services should be enough to cover the costs and still leave a profit. You want to look at the customer’s assets in relation to the liabilities. Use financial ratios to see if your customer’s financial statements are in line with the industry average or if they are stronger or weaker.

5.6.3. Measuring Business Risk Business risk measures your customer’s ability to remain a going concern. Business risk assesses the long-term continuing demand for your customer’s products or services. It also takes into consideration your customer’s ability to introduce new products to the marketplace. Business risk looks at how changes in demand impact your customer’s profits. Other factors influencing business risk are the number of your customer’s competitors and the size of their operations. Analyzing your customer’s overall financial risk determines whether you should grant in-store credit along with the initial credit limit.

5.7. VALUE AT RISK (VAR) The Value at risk assess the risk of loss which is related to financial assets. For a stipulated period of time, which ranges from 1 to 10 days and having a given confidence of probability which is equivalent to 95 percent of 99 percent. This measure shows or demonstrates the highest loss which is suffered by inventor while holding or assets of finance. The horizon of time which is used for calculation of VaR is completely dependent on duration 6

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of investment, the value at risk is utilized for computing the minimum requirement of capital which is necessary for compensating the losses which results from risk of markets, as per BIS regulation of banking. Value at risk assess the loss of risk related to financial assets. The time period that has been mentioned and with a stated level of probability. This assessment shows the highest loss which an investor may suffer and experience while holding the assets of finance. This loss or suffering derives through implementation of model and replicates the interaction and collaboration of number of factors presumed correlated and associated one with other.

5.7.1. Methodologies to Calculate VaR The horizon of time which is selected for calculating VaR is as per the duration of investment or with minimum amount of time which is required for disinvestment in the case of harm. Also, VaR is utilized for determining the minimum requirement of capital which is necessary for compensating the loss that results from risk of the market. This tool of measurement is applied, thus, anytime there is evaluation of risk of market which is done for derivatives portfolios, foreign currencies, bonds, and equities. Major Methodologies for VaR calculation involve: the Monte Carlo approach, the Delta Normal approach, and the Historical simulation approach. •

Hysterical Simulation Approach: Historical simulation approach for calculation of VaR bases the prospective spread of return of assets on its past attitude. Indeed, it projects the spread of future returns by initiating from a definite number of observations from past. These methodologies recognize VaR as x percent quantile of distribution of historical returns for financial assets. It is the simplest methodologies for VaR to be used as only it needs the data for time series for observing asset price and also presumes that future will duplicate past behavior. Due to this, no other hypothesis over the probability distribution is required for future returns. Once designed the time series for return on assets, VaR is known as the left tail which corresponds to chosen level of confidence7. This chosen level of confidence makes sure that over the x percent of cases and situations, the future return on assets will be much more than approximated VaR, however 7

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only over 1 to x percent of cases, the subsequent return on assets will be much lower in comparison to VaR itself. The weakest point for this methodology of calculation is show by lack of presumed factors or elements in estimating VaR, being it is the basis of its previous experiences. In situations of using methods for historical simulations for calculating VaR, for quantifying the market risk, it is required by Basel Committee to make sure sufficient consistency of outcomes by using time series that have minimum a year of regular observations. •

Delta Normal Approach: It is on the basis of assumption that every asset comprising the portfolio of investment has the profitable returns which follows a normal distribution. Due to this, the aggregate returns from portfolio of probability distribution will form a linear and significant combination of single asset return distribution. Resultantly, the standard deviation of portfolio returns is dependent over the standard deviation of individual elements as well as over their correlations. The estimates and projections of correlations between factors of individual input of model can result in difficulty because of lack of or scarcity of market for liquid exchange for minimum one asset (as a result, an unreliable and variable statistical distribution for the factors) or because of poor or bad quality of historical information which is used to estimate. In the given case, a person can rely over using a single parameter, rather than many, that approximates each element and factor of variability which is considered originally (For instance, rather than considering viewing n equities which are eligible for affecting the financial assets returns, only the average return will be considered of stock market where all these n shares will be exchanged. Simplifying the quantity of n factors through using k factor in the model is considered as an activity of “risk mapping.” The normal limit for normal approach to calculate VaR is shown by normality presumption of all metrics in model, hypotheses which is never parallel to actual situation. •

Monte-Carlo Simulation Approach: It is on the basis of a concept which is similar to approach of historical simulation. It begins from historical information to explain the most appropriate probability distribution for describing behavior and trend of past returns. The initial step involves identifying and estimating input factors which affect performance of financial assets. For every

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factor, a hypothesis will be designed regarding its probability distribution. Subsequently, all these parameters and metrics will be associated with each other through formulating the model of mathematics in which input parameters are known to be independent variables, whereas the returns on financial assets are considered as dependent variable. After choosing the distribution which appropriately suits the curve of returns, it is utilized as a pseudo-random quantity generator for creating hundreds and thousands of scenarios of evolution for underlying elements of models which result in random distribution of assets returns. Finally, the VaR will be measured using generated random distribution, The primary weakness point of this methodology of calculation is that selecting the statistical distribution for estimating parameters cannot be considered as an easy process. In this way, calculating VaR by making use of this method can need long time for processing as it can be dependent over various factors.

5.7.2. Methods to Measure the Market-Based on Historical Return Series Methods which are on the basis of historic historical return series make attempts for predicting the future volatility on the basis of past fluctuations and variations in return. Based on the treatment of this information, these instruments may be divided in methods of regression and methods of historical volatility. These methods start by measuring the appropriate estimator or projector of volatility in a given period and in a different number of periods for extrapolating this projector to desired period in future. There are various ways to arrive at this estimate8. For instance: Make use of volatility estimated directly from returns for various past day’s equivalent to subsequent period for being analyzed. If the subsequent period is of less than 20 days, a person may take minimum previous 20 days for being able to get a reliable estimator. • • 8

Assess the volatility measure for different periods in history and get the maximum or average. Use the instability projected over period of time, ceasing at current date. Sarker and Wang (2003).

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•

Identify the historical periods where financial, political, and economic uncertainty was identical to current date and measure the volatility estimator in the periods. Choose the maximum or average value. Many other choices are there; however, the instances represent all the possible alternatives and substitutes. As it can be observed that though all the models described are primarily based on analysis and assessment of historical returns, the estimations and expectations are considered by selecting the sample periods which are expected to have or consist of some assumed value with respect to prospective behavior.

5.7.3. Selecting the Appropriate Method Before choosing a method, various tests should be conducted on previous dates by making use of observations that are present for determining whether they may literally have been best analysts of volatility post those dates. In spite of all these as well as other challenges, the requirement to assess the volatility for different variables as well as for establishing goals, systematic procedures for measuring and controlling risks usually lead the corporates to base and put their calculation metrics (number of periods, number of data etc.) on a first come first serve analysis and then hold them constant to calculate subsequently. Periodic and systematic checks are required to be done for assessing the quality of measurement of risks outcomes, that may need that method of calculation be used for one year or giving relevant and important information.

5.7.4. Factors Influencing Methodology As it is stated above, comparing the methods as described in instances needs that the predictive authority be verified in every particular case, by utilizing the methods which are explained later. However, some of the benefits and issues can be indicated which arise and emerge in the process that is mainly associated with various historical observations that are to be involved in the calculation period. •

Number of Observations: The lesser the observation numbers, the higher is the influence of every current observation. For instance, if paces are to get modified or changed today, the estimate of volatility may increase, which indicates higher uncertainty and risk for immediate future. It may give a high-risk estimate instead would an estimate got by using various observations since a sharp

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jump at present may have an impact only over the average which defines and explains the estimator of volatility. However, this statement may be not correct in markets for specific variables where it is likely that an extended and expanded period of calm jumps followed by huge and steep jumps are controlled by local authorities but are subject to lower valuations at a fixed interval. If no current crises are there, the estimated volatility with a very small amount of observations will be low; however, it is not an assurance that a huge steep jump won’t occur in instant future. •

Representativeness of Sample: The next factor to take into consideration is how the sample is representative. A hugely small quantity of observations may lead to lesser statistical reliability that translates into modification of volatility estimators in nonappearance of any significant change or alteration in risky environment. It can lead to practical issues while managing the risk. For Example, A trader has taken a position which puts his level of risk very close to limit that are assigned to him. Today, if there exist a higher than normal fluctuation of price, the volatility estimator can raise the level of risk calculated that may force the retailer for reducing the position. However, if the perception of risk for risk control and management and trader’s unit did not change, it can be stated that lack of or scarcity of statistical reliance in calculating volatility estimator is leading to decrease or scarcity in position which is not in line or unparalleled with levels of risk accepted by entity. Thus, apart from the period of time for which volatility of future is being projected, the entity should set few observations as the lowest number which is necessary for obtaining the sample which seems to be representative of asset behavior. A very less number of observations helps in adjusting or regulating the estimator towards present situations and can also ignore or avoid the effect of albeit infrequent issues. It can also lead to insufficient statistical reliability. All these issues explain the reasons as to why the regulatory institutions have preference of using estimators on the basis of long historical series of minimum one year as they are quite stable and steady, however it is not very easy for adjusting them with most current situations. It can be very harmful when the current risk is quite higher in comparison to average level for current years. When the crisis occurs in the time period which is used for estimate which includes long periods of stability, it can denote that estimate

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of volatility obtained cannot reflect or show the risks of condition having high probability of latest devaluation.

5.8. VOLATILITY A decent solution towards this dilemma involves estimating the volatility for a long period and a short period which involves a crisis as well as to take the higher of the two. It can lead to highly conservative measurement of risk which underutilizes the due assets. Also, for using various short periods for determining the distribution of estimators as well as for selecting one of them by utilizing either a fixed criterion or any additional examination which indicates comparison between current situation and chosen period. The former is costly if it is daily performed over a huge number of financial variables. While assessing the wellbeing of relationship of customers, three parameters are at the core of many studies: Customer advocacy (likelihood to recommend the suppliers towards others), loyalty of customer (probability to choose the supplier at subsequent purchase) and customer satisfaction9. However, all these parameters are not sufficient as they give a snapshot of health of customers but do not reveal the ways for improving the position. Two of the main approaches and methods can bring our understanding and knowledge to subsequent level. One option or choice involves asking directly from customers as to why they are not or are they satisfied, advocates or loyal. It can be unveiling, but people often face issues in providing correct guidance over their motivations. •

They can never have anticipated their encouragements and motivations, providing apparent or artificial answers. • They can identify and assume their motivations and encouragements tough for articulating. • They can provide undue weight for rational factors like pricing, particularly in Business to Business Markets. Therefore, instead of directly asking the customers, a substitute approach involves applying a statistical method and approach known as Regression Analysis for deducing what actually matters. 9

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5.9. EXPLANATION OF REGRESSION ANALYSIS Regression Analysis comes in various flavors that best suit a specific situation like Ridge Regression, Stepwise Regression, and Linear regression. Irrespective of the Flavors, the variables may change or vary and are permanently at the core. The dependent variable is known as the factor that can be easily moved for example score of satisfaction of customer or Score of Net Promoter. Independent variables are known as the factors which bring the modifications and change in all the dependent variables. For example, we can hypothesis is that a high quality in services of the customers can lead to huge level of complete satisfaction for the customer. Regression Analysis develops the relationship and association between the independent and dependent variables. For doing so, it restricts all the bars of independent variables and then recognizes and establishes the influence of the change in this single variable has over the dependent variable. It is repeated and duplicated for very independent variable turn wise10. The outcome is that individuals are able to recognize the authority of every independent variable to move the dependent variable.

5.9.1. Interpretation of Output of Regression Analysis The analysis can be done using SPSS or Excel as these software’s related with the model of regression: •

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Reliability of Model: The F-value assess the statistical importance of model. Particularly, an F value having significance or value less than 0.05 is known to be statistically relevant and meaningful, and thus one can become confident that result from these analysis and interpretation are not because of the chance only. Accuracy of the model: Adjusted R square or the R-Squared depicts how much and quantity of the movement is explained in the dependent variable by the independent variable. For instance, R squared value of 80 percent of 0.8 value of the movement in dependent variable may be clarified by tested independent variables. It shows that it will be easily predictive and can be accurate and reliable as well. The other two crucial elements when interpretation of Regression analysis is associated to every independent variable.

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Reliability of Model: Similar to the F-Value, another measure for statistical significance is the P-value; however, it indicates and shows that whether the effect of only the independent variable instead of the complete model is significant statistically. The value, in order to be significant, must be lower than 0.05. Accuracy of the Model: If various components in independent variables are tested, the coefficient depicts how much is expected in a dependent variable to increase by if independent variable in consideration is increased by a single person and various other independent variables are being held at similar value. Many a times, the coefficient is substituted with a uniform coefficient that depicts the associated contribution of every independent variable to move the dependent variable.

5.10. INVESTMENT IN EMERGING MARKETS: RISKS AND BARRIERS The markets in emerging and developing phase in developing nations experience various obstacles in investment by foreigners and nationals. All these issues may be direct in nature and come from regulations of economic markets, or even indirect like lack of financial and economic expansion of market of stock exchange. Market and monetary politics, lack of personnel who have expertise in managing portfolio, lack of proper strategies to inform investors, lack of relevant infrastructure in development of market, investment regulations and market and monetary policies are some of the factors which help in keeping away the prospective investors to invest in markets for stock exchange. The emerging markets economy are dependent over the economic condition (export-based economies). This dependency with a low country income, always negatively impact the process to accumulate capital as well as on the capacity to save. It must be mentioned that various factors like high inequality in revenues, lack of measures to protect clients, lack of papers, various procedures which are used for sharing information of market and rate of inflation are completely handicap in accumulating saving which may otherwise be invested in markets of stock exchange. The unfavorable or hostile character to invest in emerging market is augmented by reluctance of economic elements in making investment in

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these markets and industry. In almost all the developing nations, there are family owned business, which is explained by availability of less information regarding stock exchange markets as well as by facts that represent the existence of substitute investment options. Also, there are various other issues which prevent or avoid the integration of developing markets in worldwide economy. All the foreign investors who are not allowed for intervening in these sectors or for acquiring these properties are considered as a major example of these barriers and hurdles. Similarly, level of capital gains, regulation for dividend payout and taxes are known as other factors which may discourage or enhance the investment in developing markets. The risks and uncertainty of political and liquidity instabilities that are particular to developing markets may also discourage and demotivate the foreign investors. Chuchian in the year 1992 stressed over the issue of information diffusion being a dissuasive element for the foreigners for making investment in emerging economy, since these markets face asymmetric issue of information over good financial and economic situation of local companies which is introduced or launched in market for stock exchange.

5.10.1. Emerging Markets Investment: Risk Analysis In the year 1995 Harvey researched for five elements which are associated with making investment in developing markets: Risk associated to inflation production, exchange rate risks, risk related to increasing industrial production, risk related to instability and unstructured process of oil and systematic risk related to worldwide market. All these five elements are taken care of, although a majority of developing markets and industries are insignificantly exposed towards these factors. For instance, more than 20 emerging or developing markets have been researched, only one percent of Beta coefficient (covariance with global portfolio) higher than 1, indicating a low integration of emerging market in the global market (Claessens, 1995). Many studies are dedicated towards analyzing the integration of emerging markets. Many researchers including Werner, Tsar, Harvey, Buckberg, and Bekaert (1995) have identified the difficulty in measuring and assessing the integration degree in emerging markets11. 11

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5.10.2. Integration of Emerging Markets with Global Markets Claessens (1995) showed some methods of measurement. The initial method consisted of barriers in modeling for investment, evaluating the influence of financial assets on equilibrium model and after that assessing the model. Another method or measurement which is used at a large scale involves interpretation of relation between global portfolio and a market by making use of an equilibrium model. Bekaert in the year 1995 have depicted that as the betas of developing markets have significantly increased, it indicates a high market integration. The main goal of this section involves measuring the level of integration of developing markets in global or worldwide markets for measuring the risk which is related with making investment in the markets as well as for benchmarking the outcomes against those achieved with markets which are already developed.

5.11. SHARPE MODEL Using the Sharpe market model, the risks are classified in a portfolio: • • •

Of systematic risk, measured by the Beta coefficient; Of market risk; Of specific risk, represented by the variance of the return regression of the portfolio over the market return. The concepts which is widely used in calculating risk and return is Standard Deviation. It helps in measuring scattering of actual returns near expected return from an investment. Standard deviation is the square root of the variance, and hence it is another important concept in understanding measurement of risk and return. The value of variance is measured by weighing every possible dispersion with its associated probability (taking the variance between expected return and actual return, and then squaring the value obtained). The standard deviation of the expected return of an investment is known as a basic measure of risk. If there is similar expected return of two prospective investments, the investment having lower value of standard deviation will be considered as having lesser potential risk12. Risk measures are of three types which are used for predicting return and volatility: 12

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•

Beta: Beta is the measure of volatility in stock price which is solely based upon general movements in market. Typically, the market as a whole is assigned a beta of 1.0. So, a stock or a portfolio with a beta higher than 1.0 is predicted to have a higher risk and, potentially, a higher return than the market. Conversely, if a stock (or fund) had a beta of 0.85, this would indicate that if the market increased by 10%, this stock (or fund) would likely return only 8.5%. However, if the market dropped 10%, this stock would likely drop only 8.5%. • Alpha: It is the measure of volatility in stock prices on the basis of particular features of a specific society. Similar to beta, the higher the value, the higher the uncertainty or risk Alpha= [(sum of y) (b) (sum of x))]/n where: n = number of observations; b = beta of the fund; x= rate of return for the market; and y = rate of return for the fund. An alpha of 1.0 means the fund outperformed the market 1%. •

Sharp Ratio: It is a complex measure which makes use of standard deviation of portfolio or a stock for measuring the volatility. It helps in measuring the incremental reward to assume incremental risk. The higher the share ratio, the higher will be potential return. Sharpe Ratio (σ) = (Total return – Rate of Return (Risk-Free)) The reverse or opposite of this statement “The higher the share ratio, the higher will be potential return” holds true. The “lesser the Sharpe Ratio, the lesser the potential return.” If the Sharpe ratio of security were equal to “0,” there will be no reward to take over the huge risk, and the investor will be better off holding simply treasuries (whose returns is equivalent to the riskfree return component of equation). If a general index representing the global market is available, one can use the market model at an international level to measure the integration and the risks of emerging markets. The global index MSCI (MSW) can be used for this purpose13. Although the emerging markets are less represented in this index, it is commonly used in these markets as a benchmark. Hence, we propose to use it in this study as the portfolio of global market. The index 13

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consists of a large number of financial assets of developed markets and emerging markets with different weight, which are determined in proportion to their size: The model is: Rj, t = αj+ βj MSWt+ εj,t where, Rj, t: is the weekly return of the market j. MSW: Return of global market, measured as the difference of logarithms respective of the MSCI. βj: Indicate the return between fluctuation of market j and the global market. It measures the sensitivity of the market j to the variations of global market. This model is used for two reasons. First, to estimate the integration degree of each market in the global market, and second, to estimate the systematic risk over these markets. The higher this coefficient, the higher the integration of the market in the global market, and then the more systematic risks are present. “αj+ εj,t” is the specific risk, reflects the effect of specific factors of the market j on Rj,t, the variance of the error εj,t is used to measure the specific risk of each market. This model indicates that the fluctuations of returns of market j are divided into fluctuations that have impact on the global market, and the fluctuation of the market subject to the study. Indeed, we have: σ2 (Rj,t) = β2 σ2 (MSW)+ σ2 (εj,t) The first part of the equation is the systematic risk of the market j. The second part is the non-systematic risk. To assess the importance of each one, we calculate the coefficient of determination of the regression model. This coefficient measures the percentage of the variations of returns of market j explained by factors that affect the market as a whole14. Coefficient of determination is higher (lower) if εj,t are less important than the mean, specific risk of the market j is less (more) important in comparison to other factors affecting the global market as a whole. The coefficient of determination, which measures the variations of returns of markets explained by the factors of the market, is low for the emerging markets. It 19 shows the unfitness of the model to characterize the return in the emerging markets (see also Harvey, 1995), the weak integration 14

Chuhan (1992).

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of the emerging markets in the global market, and the existence of more advantages of diversification in the emerging markets. This coefficient is higher for industrialized markets. It fluctuates between 0.12% in Denmark, and 0.586 in the U.S. In contrast, for the emerging markets, the higher one is for Malaysia 0.178, and the lowest one is 0.0001. The Beta coefficient, which measures the integration of markets in the global market, is more significant for the industrialized markets and less significant in the case of emerging markets. Beta coefficient fluctuates between 0.290 in Italy and Morocco and 0.422 in Malaysia for emerging markets with a lower degree of significance15. From this comparison, it is clear that the industrialized markets are more integrated in the global market than the emerging ones16. It follows that the systematic risk is more important in the industrialized markets. However, the specific risk is more important for the emerging markets. For the industrialized markets, it fluctuates between 1.239E-04 in U.S.A and 12.18E-04 in Hong Kong, and between 3.193E-04 in Morocco and 52.64E04 in Turkey. In all markets, the specific risk is greater than the systematic risk except for the U.S.A. From the above, four conclusions can be drawn concerning stock exchange market for the emerging as well as industrialized markets: •

• •

•

The weak integration of emerging markets into the global market. Existence of direct and indirect barriers to the investment is the principal reason for this. The systematic risk is more important in the industrialized market due to the higher integration of these markets in the global market. The specific risk is more important in the emerging markets. This is due mainly to the organization of these markets, to the specificity of their economic, political, and financial environments, and to the significance of the volatility and the lack of liquidity in these markets. There are several advantages to diversifying investments through emerging markets, because the specific risk can be diversified.

5.12. CONCLUSION The era between 1980 and 1990 have seen changes and modifications in 15 16

Errunza (1994).

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international financial landscape. Most of the funds were designated to investment in market for stock exchange, and much of the investment is done in developing markets that had been avoided for many years in international portfolios. Making investment in developing markets incorporates huge benefits and advantages for diversification. Nonetheless, the presence of hurdles and obstacles towards investment as well as the significance of particular risk and constraints in these markets restricts the investment in the given markets and therefore also limit integrating these markets with worldwide markets. Currently, the establishments of huge number of developing markets have gained knowledge about the fact that abolishing the economic and political barriers, hurdles, and obstacles to exit or enter the exchange markets, the repatriation and deportation of hard currency and tax barriers was useful to the economies. Developing the financial environment favorable to investment are sine qua non-conditions designed for a deep and profound integration and incorporation of financial markets in worldwide economy. The increase of investment in developing markets is completely dependent over the informative and operational efficiency. In this chapter, there was a representation of features of developing markets and typical evolution and development of these markets. Various stock exchange markets fulfill these criteria. These markets, however, are heterogeneous. Significant disparities and variations exist in these markets with respect to their mini-structures that shows the framework of transforming the orders in transactions and in volume or quantity of registered activities. A low value of correlation between the return of two kinds of market may also contribute towards reduced volatility by keeping the portfolios highly diversified which includes financial assets cited in emerging markets. The comparative research of effective frontiers of developing markets as well as industrialized markets ensures this belief. Along with the benefits derived from diversification, the developing markets show the benefits and advantages of high prospective returns. A comparison made between industrialized markets and developing, or emerging markets on the basis of systematic risks, specific risk, and degree of integration conclude that developing or emerging markets show a weak integration in worldwide markets along with a huge specific risk. While, on the other side, industrialized markets show a high systematic risk.

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REFERENCES 1. 2. 3.

4.

5. 6.

7.

8. 9.

Alexander, C., (2005). The present and future of financial risk management. Journal of Financial Econometrics, 3(1), 3–25. Aui.ma., (2018). [online] Available at: http://www.aui.ma/personal/~M. Derrabi/Fin5308/derrabi-All.pdf [accessed 11 April 2018]. Circle Research, (2018). Using Regression Analysis in Market Research • Circle Research. [online] Available at: https://www.circle-research. com/2016/using-regression-analysis-market-research/ [accessed 11 April 2018]. Eltalpykla.vdu.lt., (2018). [online] Available at: https://eltalpykla.vdu. lt/bitstream/handle/1/1071/ISSN2335–8750_2014_N_70.PG_91–105. pdf?sequence=1&isAllowed=y [accessed 11 April 2018]. Errunza, V. R., (1994). Emerging markets: Some new concepts. Journal of Portfolio Management, (Spring), 82–87. Guy, M., (2018). New Market Research Methods and Techniques. [online] My market research methods. Available at: http://www. mymarketresearchmethods.com/new-market-research-methodstechniques/ [accessed 11 April 2018]. Michetti, M., (2018). Value at Risk (VaR) (Encyclopedia). [online] Bankpedia.org. Available at: http://www.bankpedia.org/index.php/ en/132-english/v/23634-value-at-risk-var [accessed 11 April 2018]. Pfaff, B., (2016). Financial Risk Modeling and Portfolio Optimization with R. John Wiley & Sons. Stream, (2018). Market Measurement and Forecasting. [online] Available at: http://www.authorstream.com/Presentation/ aSGuest70408–563937-market-measurement-and-forecasting/ [accessed 11 April 2018].

CHAPTER 6

Focus on Commercial Banking

“Adventure is the life of commerce, but caution is the life of banking.” —Walter Bagehot

CONTENTS 6.1. Introduction .................................................................................... 142 6.2. Commercial Banks.......................................................................... 144 6.3. Functions of Commercial Banks...................................................... 146 6.4. Types of Commercial Banking ......................................................... 150 6.5. Various Types of Risks And Their Management by Commercial Banks ....................................................................... 150 6.6. Credit Risk and Their Management ................................................. 154 6.7. Basel Norms ................................................................................... 158 6.8. Management of Foreign Exchange (FX) Risk by Commercial Bank ........................................................................ 161 6.9. Old Methods For Calculating Market Risks ..................................... 164 6.10. Role of Commercial Banking In Economy ..................................... 165 6.11. Conclusion ................................................................................... 166 References ............................................................................................. 168

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This chapter deals with the evolution of the banking system, and its development into the modern banking system. How the concept of banking came into existence in the ancient world, and the formation of various financial institutions which deal with lending and borrowing, form the core of this chapter. Various types of risks associated with commercial banks like credit risks, foreign exchange (FX) rate settlement risk have been discussed in detail. The chapter also explains the management of different types of risks. Functions of commercial banks which are categorized as primary and secondary function have been discussed in detail. The concept of Basel norms which is the international set of agreement to be followed by every financial institute or commercial banking is also explained.

6.1. INTRODUCTION The concept of banking system dates to the ancient times when the first prototype merchant bank was introduced, where farmers and traders were given grain loans who carried goods between cities and this gave birth to a system popularly known as a barter system. The barter system began in Assyria and Babylonia around 2000 BC. With the passage of time, during the Roman Empire and in ancient Greece, lenders based in temples made loans and further added two more important innovations. First deposits were accepted, and secondly, money was changed (Figure 6.1).

Figure 6.1: Barter system. Source: http://www.masala.com/sites/default/files/styles/gallery_slideshow_ cache_734/public/images/2015/06/25/barter.jpg?itok=1cSccgwO.

According to archaeologists, the evidence of money lending activity is also evident from the ancient China and India during this period. The modern banking system’s origin is found to medieval and early Renaissance Italy and many rich cities like Siena, Venice, Lucca, Genoa, Florence, etc. Many

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wealthy families of ancient Rome like the Bardi and Peruzzi dominated the banking system in the 14th-century. They started establishing branches of bank in other parts of the Europe. Medici Bank was one of the most famous banks, established by Giovanni di Bicci de’ Medici in the year 1397. Bank of St. George one of the earliest known state deposit bank, which is also known as Banco di San Giorgio was founded in the year 1407 at Genoa, Italy. The establishment of banks was first started in the Italy, and it is proved with the history of ancient banks. In the seventeenth and eighteenth centuries, emergence of modern banking system took place. It includes issue of banknotes and fractional reserve banking. The goldsmiths of London who had private vaults began giving service of storage of gold to the merchants. Merchants now store their gold to that goldsmiths, and in return, goldsmiths charged a fee for that service. To keep the records of gold deposited, the receipts were issued which certify the quantity and purity of the deposited precious metal that they held as a bailee. There were also rules and regulations for the receipts. These receipts could not be assigned to someone else. To collect the stored goods, only the original depositor had to come and with the receipt (Figure 6.2).

Figure 6.2: Ancient banking system. Source: http://upload.wikimedia.org/wikipedia/commons/e/ee/UsuryDurer.jpg.

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6.1.1. Modern Banking System The modern banking system came into existence during seventeenth and eighteenth centuries when merchants started to deposit their gold to the goldsmiths and in return goldsmiths charged some money for this service, and with the passage of time on behalf of depositor the goldsmiths began to lend the money and gradually this system led to the development of the modern banking practices. This era marked the beginning of promissory notes which were issued for money deposited as a loan to the goldsmith. The modern banknotes are the outcome of this promissory notes. On the deposits, the merchants got the interest which was paid by the goldsmiths. The promissory notes were payable on demand. And the loans or the advances given to the goldsmith’s customers were repayable over a long period of time. This marks the beginning of the fractional reserve banking. The development of promissory notes led to a trusted instrument which could circulate as a safe and convenient form of money attached with a promise by the goldsmith to pay. This promissory note allowed goldsmiths to advance loans with little risk of default. The forerunners of banking system were the goldsmiths of London who created new money based on credit. For global economy, the banking system is a crucial component, as it accounts for trillion in assets worldwide. The concept of money-changing and money-lending is as old as money. The banking system has played a major role in uplifting the many Italian city-states as the world economic powers. The well-being of an economy and the health of its banks are closely linked with each other. Such as the global credit crisis, which is precipitated by the collapse of the subprime-fuelled U.S. housing bubble. In the world of financial institutions, banks are just one part, which stands in addition with investment banks, insurance companies, finance companies, investment managers, and other companies that profit from the creation and flow of money. Banks stand between depositors and borrowers, where former supply capital and latter demand capital. Banks are the world most heavily regulated businesses in the world as huge amount of commerce and individual wealth rest on it.

6.2. COMMERCIAL BANKS A financial institution which performs the functions of accepting deposits from the general public and also deals with the loan given as an investment

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with the aim of earning profit. There are numerous activities which are undertaken by the commercial banks like pooling and absorbing risks for depositors and provide a stable source of investment and working capital funds to various sectors of the economy. These activities play an important role in the development of the economy. Apart from this, Commercial banks provide a smooth functioning of payment system that allows financial and real resources to flow relatively freely to their highest return uses (Figure 6.3).

Figure 6.3: Commercial banks. Source: http://cdn.brownstoner.com/wp-content/uploads/2015/08/356-FultonSt.-CapOneBank-CB-PS.jpg.

To cope with any difficulty in any of the sectors of the economy, they keep some backup source of liquidity. For small borrowers who have no free or limited access to external sources of finance, banks are of vital importance as they provide source of funds to them in a very easy way. There are three main interrelated functions of commercial banks like holding of deposits, create credit through lending and investment activities, providing a mechanism for payments and transfer of funds for various productive activities. The principal activity of a commercial bank is linked with the extension of credit or lending. Commercial banks as the name suggests are the institution which seeks profit; it means they do business of banking to earn profit.

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Trade and commerce having need of short-term loans are financed by the commercial banks. The main source of profit of these banks is the high rate of interest they charged from the borrowers but pay much less rate of interest to their depositors. The result of this interest rate difference between the borrower and the depositor become the source of profit of the banks.

6.3. FUNCTIONS OF COMMERCIAL BANKS Commercial banks are concerned with borrowing and lending. They accept deposits and lend money to various projects and instruments as an investment to earn profit in the form of interest. The summary of the entire commercial banking process is just borrowing and lending but with different interest rates. Banks just borrow only to lend it further. There are two types of rates; they are borrowing rate and lending rate. The former is the rate of interest offered by the banks to its depositors and other is the rate at which banks lend the money to someone else is called rate of lending. The financial institute which performs the dual functions of accepting deposits and giving loans are coming under the commercial bank. It is misunderstood with Post office, but it does not deal with lending of loans (Figure 6.4).

Figure 6.4: Functions of commercial banks. Source: https://image.slidesharecdn.com/functionsofacommercialbank-160124102547/95/functions-of-a-commercial-bank-5–638. jpg?cb=1453631219.

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6.3.1. Primary Function of Commercial Bank The primary functions of the commercial bank are acceptance of deposits. Lending of loans, allowing deposits to withdraw through cheque on demand. The commercial bank’s business is based on keeping deposits and make loan and advances for a short period of time, i.e., up to one or two years made to industry and doing trade either by the system of overdrafts of an agreed amount or by discounting bills of exchange to make profits to the shareholders. •

•

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It includes receiving deposits from the public, and this deposit comes in the form of saving bank account, current account and term deposits from the savers that are from the public. Commercial banks are popular among the public because of the safety, security, and liquidity provided by them to the saving deposit of the public. The data showing this trust on the commercial bank is the deposits of scheduled commercial banks in India rose around four folds that is from 822 crores to about 3763 crores in 1967, and this figure is keep on increasing that is from rupees 4661 crores to rupees 34237 crores within a decade that is a growth rate of about 735 percent. Giving loans and advance. This is the second major function of the commercial banks after receiving deposits from the public. Loans and advances are given to all types of persons which range from businessmen to investors. These loans and advances are given against personal security, gold, and silver and many other immovable or movable property or assets. The loans are given in the form of cash credit, call loans, overdrafts, and discounting bills of exchange to businessmen. Commercial banks also started to give loans and advances for vehicles, housing, consumer durables, etc. apart from traditional businesses. It has been done to increase the base of lending activities. System of cheque and credit cards. This facility will allow the depositors of the bank to withdraw and make payment of their amount in their bank account through cheques. To make the payment debit and credit cards are allowed by the banks. One of the most important functions of the commercial banks is creation of credit. To earn profit is the aim of commercial bank like any other financial institutions. To earn profit commercial

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•

•

•

•

•

banks, accept deposits and advance loans by keeping small cash in reserve for daily transactions. When a bank advances a loan, it opens an account in the name of the customer and allow him to withdraw the money by cheque according to his needs but does not give him in cash. The creation of credit or deposit by a bank is done by granting a loan. Financing of foreign trade is also done by these commercial banks. They do so by accepting foreign bills of exchange of its customers and collecting them from foreign banks. The commercial banks also deal with the other FX business as well as buys and sells foreign currency. Commercial banks also involve in transferring of funds. It helps its customers to transfer their money from one account to another account, also from one place to another place through cheques. Now the funds can be transferred from one place to another place, or from one party account to another party account or one bank to another bank through electronic fund transfer. This mode of fund transfer helps in easy transferring of funds from one bank to another bank or to account of another party easily. Magnetic Ink Character Recognition technology helps the banks to have innovative banking like anywhere, anytime, and virtual banking and so on. Commercial banks also perform agency functions like it acts as an agent for customers to buy and sell shares, securities on their behalf. Insurance premiums, mutual funds, rent, water taxes, electricity bills are also paid by the commercial banks on behalf of its customers. Commercial banks act as a trustee and executor of the property and will of its clients. Apart from these functions, various other miscellaneous functions are performed by the commercial banks like facility of safety locker, making, and receiving payments on behalf of its depositors, issuing letters of credit and issuing of traveler’s cheques, etc.

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6.3.2. Secondary Functions There are numerous secondary functions performed by the commercial banks apart from the above- mentioned primary functions. They are given below. •

•

•

•

•

•

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Working for the bills of exchange or bundles: commercial banks deal with the bill of exchange which represents a promise to pay a fixed amount of money at a specific point of time in future. A bill of exchange can be encashed earlier through discounting process of commercial bank. In other words, a bill of exchange is a document acknowledging an amount of money owes in consideration of goods received. A bill of exchange is a paper asset signed by the debtor and the creditor for a fixed interval of time. The facility of overdraft is also a secondary facility given by the commercial banks to its clients. It is given as an advance which allows its customers to overdraw his current account up to an agreed limit. For a depositor, it is a facility for overdrawing the amount than the balance amount in his account. An arrangement with the banks is made by a depositor that in case a cheque has been drawn by them which are not covered by the deposit or which is not available currently, then the bank should grant overdraft and honor the cheque. Financial assets like shares, debentures, life insurance policies of the account holder, etc. are deposited as security for granting overdraft. Commercial banks also act an agent for its clients. For being an agent of its customers and to perform various functions like transfer of funds, collection of funds, payment of various items it gets commission from its clients. Fund transfer facility is given by commercial banks which is cheap and easy remittance of funds from place-to-place through demand drafts, mail transfers, telegraphic transfers, etc. Fund collection is also done by the commercial banks. It collects funds through cheques, bills, bundles, and demand drafts but on behalf of its customers. Commercial banks also indulge in payment of taxes, insurance premium, bills, etc. for its clients.

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6.4. TYPES OF COMMERCIAL BANKING Any financial institution which deals with depositing and borrowing of money comes under commercial banking. Commercial banking is classified in two broad categories namely scheduled banks and non-scheduled banks. Those banks which are scheduled in the second schedule of central bank of a country came to know as scheduled banks. A scheduled bank must have paid up capital and reserves of at least rupees five lakhs. Special facilities like credit facility are given to them by the central bank of the nation. Nationalized banks and foreign banks are such examples of scheduled banks. Non- scheduled banks are those commercial banks which are not included in the second schedule of the central bank. These banks have a paid-up capital and reserves of less than rupees five lakh. Non-scheduled banks are generally small banks, and their field of operation is also limited. Apart from scheduled and non-scheduled commercial banks, there are some other types of commercial banks too. They are industrial banks, agriculture banks which provide financial support to a particular area like industries and agriculture. The banks which provide finance to industrial concerns by subscribing or buying shares and debentures of companies and also approve long-term loans to industrialists to purchase machinery, plants, etc. FX Banks are one of the commercial banks which are the branches of foreign banks, and they help in facilitating international financial transactions through buying and selling of foreign bills. Other commercial bank is agricultural bank which as name suggests finance agriculture and it provide long-term loans for purchasing of various agro-chemical and other machineries like tractor, tube-wells, etc. Post office savings bank is a saving bank which mobilizes small savings of the people in saving account. Banks like cooperative banks are organized by the people for their own collective benefits. The members of cooperative banks can get advance loans at a fair rate of interest.

6.5. VARIOUS TYPES OF RISKS AND THEIR MANAGEMENT BY COMMERCIAL BANKS The business of commercial banks is a risky process as in the process of providing financial services, commercial banks assume various kinds of risks associated with the finance. Various market participants seek the service of the commercial banks which are financial institutions because

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of their ability to provide market knowledge, efficiency in transaction and capability of funding (Figure 6.5).

Figure 6.5: Types of risks faced by commercial bank. Source: https://4.bp.blogspot.com/-knZJVwm71nQ/VwUjQYcKtQI/ AAAAAAAAAQU/sxsGVuoQd9wRNWd0Ago1tuEGgySyQ89qw/s1600/ risks.png.

These facilities which a commercial bank perform they act as a principal in the whole process of transaction. To facilitate the transaction and to absorb the risks associated with the transaction commercial banks use their own balance sheet. There are activities performed by banking firms which do not have direct balance sheet implications. Services like agency and advisory activities such as management of trust and investment, private, and public placements through best efforts or by contract facility, standard underwriting through section 20 subsidiaries of the holding company or the packaging, securitizing, distributing, and servicing of loans in the areas of consumer and real estate debt mainly.

6.5.1. Kinds of Risks Being Absorbed by Commercial Banks The principal activities of commercial bank involve various risks like risk in its own balance sheet and the basic business of lending and borrowing

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as these all activities are not borne by the bank itself. The mitigation of risks involved in the finance associated with transaction by following proper business practices it means banks will shift the risks through a combination of pricing and design of product to other parties. Banking system only manages risk at the firm level, and it also recognized that it does not engage in business in a manner that impose unnecessarily risks upon it as well as it also not transfers risk to other participants as well. According to Oldfield and Santomero that risks associated with financial institute can be divided into three types. These are (a) risks that can be eliminated or avoided by simple business practice, (b) risks that can be transferred to other participants and, (c) risks that must be managed at the firm level.1 Three types of actions are followed to avoid common risks practices. These are the standardization of process, contracts, and procedures to prevent any inefficient or incorrect decision related with the finance in its very first phase. Another one is the construction of portfolios that benefit from diversification across borrowers and that reduces the effects of any one loss experience. Third and the most important is the contracts which are incentive-compatible should be implemented with the institution’s management to require that employees to be held accountable. Through the process of risk transfer, some of the risks can be eliminated or at least reduced to a maximum extent. Risks like interest rate can be transferred by swaps or other derivatives. To alter the borrowing terms a change in their duration can be made. The commercial bank can also sell or buy financial claims to diversify or concentrate the risks that result in from servicing its client base. At the bank level, two activities which include the risk must be absorbed, first one is inclusion of financial assets or activities where the nature of the risk may be complex and difficult to communicate with the third party. The second case includes proprietary positions that because of the risks associated with their acceptance and expected return.

6.5.2. Management of Risks These all risks need to be managed so that banks can run their business efficiently and gain profit. According to a standard economic theory, 1 Commercial Bank Risk Management: Analysis of the Process by Anthony M. Santomero.

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managers of value-maximizing firms ought to maximize expected profit without regard to the variability around its expected value.2 Management of risks include managerial self-interest, the non-linearity of the tax structure, the costs of financial distress and the existence of capital market imperfections. There is sequence of steps for a risk management system. They are standards and reports, position limits or rules, guidelines related to investment, and incentive contracts and compensation. To measure exposure, and to define procedures to manage these exposures these tools are established which further limit individual positions to acceptable levels and encourage decision-makers to manage risk in a manner that is consistent the goal and objective of the firm. These tools and techniques are applied to manage each of the specific risks faced by the banking community like standard and reports which is first of these risk management techniques involves two different conceptual activities like standard setting and financial reporting. The sine qua non of any risk associated with the banking system is standard setting and financial reporting and so they are listed together. The traditional tools of risk management and control are underwriting standard, risk categorization and standards of review. To understand the risks in the portfolio and the extent to which these risks must be mitigated and absorbed by consistent evaluation and rating of exposures of various types of risks. For an investor to gauge asset quality and firm-level risk, outside auditing, reports on regulation and rating agency evaluations are important. Standardization of reports has been done for better or worse. This goes beyond public reports and audited statements to the need for management information on the asset quality and risk posture. Internal reports also need standardization and frequent reporting intervals with daily or weekly reports substituting for the quarterly GAAP periodicity. Use of position limits, and/or minimum standard for participation is a second technique for internal control of active management. The domain of risk-taking is restricted to only those assets or counterparties that pass some pre-specified quality standard. Some limits are costly to establish and administer, and their imposition restricts the risk that can be assumed by any one individual or any organization as a whole. 2 Stulz (1984), Smith, Smithson, and Wolford (1990), and Froot, Sharfstein, and Stein (1993).

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There is a well-defined limit for capital which a person can commit. The same is valid to traders, lenders, and portfolio managers. To show limits as well as current exposure by any business unit is shown by summary reports. But making of summary reports for a large organization having thousands of positions maintained, an accurate and timely reporting is difficult, but at the same time it is essential too. Guidelines and strategies for investment and recommended positions for the immediate future are the most commonly and popularly risk management technique. For a particular area of the market, strategies are outlined in terms of concentrations and commitments, the extent of desired asset-liability mismatching or exposure, and the need to hedge against systematic risk of a particular type. These limits lead to avoidance of passive risk and/or diversification. They do so as firms operate within position limits and prescribed rules. Guidelines and rules lead to firm level hedging and matching of asset-liability. Firmlevel advice as to the appropriate level of active management are offered by the guidelines. To absorb the risks implied by the aggregate portfolio the market’s state and the willingness of senior management is necessary. Schemes related with incentive is also an important factor for the management extent which can enter incentive compatible contracts with line managers and make compensation related to the risks borne by individual and the need for lengthy and costly controls becomes less.

6.6. CREDIT RISK AND THEIR MANAGEMENT Credit risk is most simply defined as the potential that a bank borrower or counterparty will fail to meet its obligations in accordance with agreed terms.3 Credit risk management is done with an aim to maximize a bank’s risk-adjusted rate of return by maintaining credit risk exposure within acceptable parameters. The management of credit risk is needed in a banking system’s entire portfolio as well as the risk in individual credits or transactions (Figure 6.6).

3

Principles for the Management of Credit Risk.

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Figure 6.6: Credit risk in commercial banking. Source: https://www.fdic.gov/bank/analytical/fyi/2003/images/011403chart4. gif.

The relationship between credit risk and other risks is also a part of consideration by the banks. For the long-term success of the banking system, the effective management of credit risk is a critical component of a comprehensive approach to risk management. The most obvious and largest source of credit risk is loans, but this is not the same for every bank but true for most of the banks. Apart from loans, the other sources of credit risks include banking book, trading book, and both on and off the balance sheet. There are various other financial instruments other than loans including acceptances, interbank transactions, financing of trade, FX transactions, financial futures, swaps, bonds, equities, options, and in the extension of commitments and guarantees, and the settlement of transactions. The leading source of problems in banks around the globe, is exposure to credit risk as it continues to be the first problem. There should be learning from past experiences from the credit risk the banks and their supervisors. The need to identify, measure, monitor, and control credit risk as well as to determine that they hold adequate capital against these risks and this credit risks are adequately compensated for risks incurred, and a keen awareness is being generated among the banks.

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For determination of the level of risk involved in the credit, various arrangements are considered. Factors in such arrangements that have a bearing on credit risk and credit risk management.

6.6.1. Credit Risk Management Principles •

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This will be the responsibility of the board of directors to approve and review periodically at least once in a year the strategy related with the credit risk and also significant credit risk policies of the bank. This credit risk strategy should reflect the tolerance of banks for risk and the level of profitability the bank expects to achieve for incurring various credit risks. The implementation of the strategy related with credit risk approved by the board of directors and for the development of policies and procedures for identifying, measuring, monitoring, and controlling credit risk is on the shoulder of senior management. These policies and procedures are made to address the credit risk involved in all the banking activities and also at both the individual credit and portfolio levels. There is a need to identify and manage credit risk involved in all products and activities. Before introducing any new products, banks should ensure the risks related with the new products and activities and pass them through proper risk management procedures and controls, and they should be approved by the board of directors or any committee in advance. A well-defined credit-granting criterion must be within banking system. A clear indication of the targeted market of the bank and a detailed understanding of the borrower or counterparty, as well as the purpose and structure of the credit, and the repayment source should be included in these credit risk criteria. An overall credit limits at the level of individual borrowers and counterparties, between groups of connected counterparties that aggregate in a comparable and meaningful manner different types of exposures should be established by banking system both in the banking and trading book and on and off the balance sheet. A very clear and lucid process have in the banking system for approving new credits as well as the amendments, renewal, and re-financing of existing credits without any confusion to its clients.

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Authorization of Credits related to companies and individuals must be done and monitored with particular care and other appropriate steps which are taken to control or mitigate the risks of non-arm’s length lending, i.e., all credit extension must be made on an arm’s- length basis. There should be a system for maintaining a proper credit administration, measurement, and monitoring process in the banks. There should be a system for the ongoing administration of their various credit-risk portfolios. A system for monitoring the condition of individual credits, which include determining the adequacy of provisions and reserves should be in place in the banking system. An internal system for risk rating in managing credit risk is developed in the banking system. This system of rating should be in line with the activities of the bank whether with the nature, size, and complexity of activities differ. Adequate information on the composition of the credit portfolio, including identification of any concentrations of risks are provided by the management information system. The information systems and analytical techniques are must be able enough that manage the credit risk inherent in all on-and off-balance sheet activities. There should be a system for credit portfolio for monitoring its overall composition and quality of the credit portfolio. When assessing credit of any individual and their credit portfolios, the banking system should take into account the potential future changes in economic conditions, and there is assessment of their credit risk exposure under stressful condition. To ensure proper control over risk related with the credit, a system of independent, ongoing assessment of the bank’s credit risk management processes is to be established, and the results of such reviews should be communicated directly to the concern members of the board and to the senior management. To manage credit risk the credit-granting function is adequately managed, and it is ensured by the banks, and also exposure to credit must be within levels in line with internal limits and prudential standards. Establishment and enforcement of internal controls and other practices should be done by banks itself and

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procedures, and limits are reported in a timely manner to the concerned authority. To cope with any early remedial action on deteriorating credits, to manage the problem credit and other similar situations a system is must have with the banks.

6.7. BASEL NORMS The headquarters of Bureau of International settlement, i.e., BIS gave the set of agreement for all the banks around the globe with a common goal of financial stability and common standards of banking regulations. It is situated in a city of Switzerland called as Basel, and so it is named as Basel norms. The Bank for International Settlements is one of the world’s oldest international financial organization established on 17th May in the year 1930 (Figure 6.7).

Figure 6.7: Basel norms. Source: https://3.bp.blogspot.com/-y5JQEXMhICM/We97oN09UbI/ AAAAAAAAEoI/-sPhE8PbimYQFrkR-Gh3vYJQ3koYSlnlACLcBGAs/ s400/BIS%2B%2526%2BBasel%2BNorms%2Band%2Bits%2Beffect%2B%2Bwww.achieversrule.com.jpg.

BIS has sixty-member countries from all over the world it covers approximately 95% of the world GDP. BIS has two more offices apart from Basel, and these are in Mexico City and Hong Kong. The purpose of BIS is to inculcate a feeling of co-operation among central banks to enhance the financial stability and common standards of banking regulations.

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It has given a set of agreement which is made by the Basel Committee on Banking Supervision, which focuses on risks to banks and the financial system and these are popularly called as Basel accord. This accord has been made to ensure that financial institutions must have enough capital on account to meet the obligations and be ready for any unexpected losses. Many developed and developing country has accepted the accord and India is also one of them. According to Basel Accord, there are three norms which are known as Basel one, two, and three norms.

6.7.1. Basel-1 Basel-1 is introduced in the year 1988 by the Basel Committee on Banking Supervision. It is a system for capital measurement known as Basel capital accord. Basel-1 is focused entirely on credit risk. It defined as Basel capital accord as it defines the capital and structure of risk weights for banks. With the Basel-1 the minimum capital requirement was fixed at 8% of riskweighted assets. It is adopted by India in the year 1999.

6.7.2. Basel-2 In the year 2004, Basel Committee on Banking Supervision came with Basel-2 norms which is, in fact, a refined and reformed versions of previous Basel-1 accord. The guidelines of the Basel norms are • •

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A minimum capital adequacy is required to maintain, and it is fixed at 8% of risk assets for all the banks. For all the types of risks that are credit and increased disclosure requirements banks were guided to develop and use better risk management techniques. Operational risk, market risk, capital risk are the three types of risks which every financial institution has to go through and ready to cope with the situation. It is made mandatory for the banks to disclose their risk exposure to the central bank (Figure 6.8).

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Figure 6.8: Basel-2. Source: http://www.indianmba.com/Occasional_Papers/OP206/Op206.jpg.

6.7.3. Basel-3 The guidelines regarding Basel-3 were released in the year 2010, and it was an outcome of the financial crisis of 2008. The need for a fundamental strengthening of the Basel-2 norm was realized when Lehman Brothers collapsed in the year 2010. •

The main aim of the Basel-3 norms is making activities of the bank like as trading book activities more capital-intensive. The Basel-3 norms aim to promote a more resilient banking system by focusing on four vital banking parameters which are capital, leverage, funding, and liquidity.’

6.7.4. Implementation of Basel Norms Bureau of International Settlement has sixty-member around the globe, and it includes many developed and developing country of the world. India is also its member, and it has accepted the Basel norms in the year 1999. In order to implement Basel-3, the government of India started to scale their disinvestment holdings in public sector bank to 52 percent.

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6.8. MANAGEMENT OF FOREIGN EXCHANGE (FX) RISK BY COMMERCIAL BANK The market in which individuals, firms, and banks buy and sell foreign currencies or FX is known as FX market. FX market is established to permit transfers of purchasing power denominated in one currency to another that is to trade one currency for another. This is needed as a Japanese company sells automobiles to a U.S. company for dollars, and U.S. company sells tools to Japanese company for yen. So, it would be very difficult for an individual buyers and sellers of FX to seek out for one another, so the need of an intermediary is felt, and then FX market came into the picture. The need to exchange one national currency to another by individual, firms, and banks is important as the demand for foreign currencies arises when tourists visit another country and they have to exchange their currency with the currency of the country which they are visiting or when a domestic firm wants to import from other nations or when an individual wants to invest abroad and many more. Thus, a clearinghouse for the FX demand and supply in the course of foreign transactions by the resident of a nation, commercial banks are the remedy for all this. There are four levels in FX. At the first level, tourists, importers, exporters, investors are the participants. Commercial bank came in the second level and act as clearing house between users and earners of FX. Then at the third level, FX brokers come through whom the commercial banks of a nation even out their FX inflows and outflows among themselves. At the fourth and final level, the central a bank of a nation comes which acts as the lender and buyer of last resort when the nation’s total FX earnings and expenditures are unequal.

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Banks: They exchange currencies according to the requirements of their customers. Governments: Government of any country takes part in the FX market through the central banks, and their participation is necessary as they are helpful in stabilizing the exchange rates and also constantly monitor the market. Non-bank Entities: There are many non-bank entities apart from the bank like many multinational companies which exchange currencies to meet their import or export commitments or hedge

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their transactions against market variations in the process of exchange. Arbitrageurs: Those investors who make profit from price differential existing in two markets by simultaneously operating in two different markets. Speculators: Commercial and investment banks, multinational companies and hedge funds are included in this category that buys and sell currencies with a view to earning profit due to fluctuations in the rate of exchange.

6.8.2. Techniques for Forecasting of Exchange Rates There are four ways to forecast the rate of exchange namely technical, fundamental, market-based, and mixed. They have been discussed below: •

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Technical method of forecasting involves the use of historical data in order to predict the future values. Time series is one of the examples of technical forecasting. This model is useful in predicting day-to-day movements. The only limitation with its use in multinational companies is that it mainly focuses on the near future and rarely provide point or estimation of range. Forecasting based on the market condition uses the indicators of the market to develop forecasts. Spot or forward rates are used currently as speculators will ensure that the current rates reflect the expectations of the market of the future exchange rate. Fundamental forecasting is a method of forecasting based on the fundamental relationships between economic variables and rate of exchange. It also certain limitations like the timing of the impacts of the factors in uncertain, there is a need to forecast factors that have an immediate impact on exchange rates, omission of the factors that are not easily quantifiable, and changes in the sensitivity of currency movements to each factor over time. Mixed forecasting is defined as a combination of various forecasting techniques, and the actual forecast is the weighted average of the various forecast developed.

6.8.3. Management of Settlement Risk in Foreign Exchange The settlement risk is synonymous with the FX transaction process. It is a risk of loss when a bank in a FX transaction pays the currency it sold but

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does not receive the currency it bought. For any traded product there is an issue of settlement risk, but the size of the FX market makes FX transactions the greatest source of this settlement risk for many market participants like banks, governments, non-bank entities, etc. There should be system in banks that provide appropriate and realistic estimates of FX exposure on a timely basis. It includes various policies and procedures which will help in the understanding of the risk settlement and helpful in formulating a clear and firm plan on the risk management.

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To manage FX settlement risks, a well-defined procedure must be in the banking system that should be in line with the range and scope of its banking activities. FX settlement risk management is most important for any commercial bank, and it should be in the priority list of the bank and having a policy on FX settlement risk from the board of directors of the bank. An integral and consistent part of the commercial bank’s overall policy towards counter-party risk involves settlement risks. There is a need for timely review and modification whenever required to consider new circumstances like changes in the scale or nature of the bank’s FX operations. An appropriate oversight of settlement exposures should be exercised by the senior management yet there are differences in organizational approaches and which may vary across banks, FX settlement risk management process. There are different functional areas of bank-like trading, credit, operations, legal, risk assessment, branch management, and correspondent relations and all these are in list of FX settlement risk management. A prerequisite for the proper functioning of the overall risk management process is having a clear and well-defined procedures for managing and measuring the exposures of all components of credit risk towards a counter-party. Fully understanding of the FX settlement risks incurred by the banks by the management committee as well as lines of authority and responsibility to manage any type of settlement risks. All the staffs of any financial institution who are responsible for

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the risks associated with the FX settlement process must be given proper training. Counter-party default must be kept in mind by the senior management and staff associated with the settlement risk.

6.9. OLD METHODS FOR CALCULATING MARKET RISKS Earlier for calculating market risks, commercial banks used traditional methods like gap and simulation methodologies. The initial phase of traditional methodologies includes an implementation process for measuring the market risk of commercial banking by creating a balance sheet for the commercial banking in order to create a balance sheet known as ALM balance sheet which will allow financial institutions to manage market risks efficiently. Further using ALM balance sheet as a base, the risk of commercial banking is measured by gap and simulation methodologies. There are two stages involved in the process of making ALM balance sheet for commercial banking. The process of defining and structuring the ALM balance sheet comprises of following stages. The first stage is sensitivity analysis in which entries of the balance sheet of the commercial banks which are sensitive to interest rate variations are separated from those interest which are not sensitive to the interest variation. Then comes, product grouping into ALM balance sheet lines. The products of the commercial banks which are grouped according to the sensitivity, then they are placed into similar balance sheet lines having same behavior, according to contract periods, benchmark rates, spreads, reset period, currency, etc. and the last stage is a discussion of the model with the concerned areas. After the making of ALM balance sheet and its estimation is made for the commercial banks, a round of interview is conducted with the concerned areas involved. These interviews are conducted to critique the model and reach a consensus so to gather some different opinion from those responsible for the products reflected on the ALM balance sheet lines, like definition of ALM balance sheet lines, allocation of the institution’s product to the ALM balance sheet lines, date of maturity and rate reset dates, operating characteristics of the product, policies governing contract periods and prices and customer options. The definition of ALM balance sheet for the commercial banking must include the number of balance sheet lines, and that should be set so as

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to achieve a breakdown that captures and permits analysis of the current situation of the institution, while not making future maintenance of the balance sheet much difficult.

6.9.1. Gap Method This is one of the traditional methodologies for calculating market risks by the commercial banking sectors. It is actually the difference between assets and liabilities that are sensitive to rate of interest and also rate resets and maturity dates within a specific period of time. This gap acts as an index of the exposure of the commercial bank’s balance sheet to rate of fluctuations of interest. The gap method is a useful methodology as it gives a very basic estimate of the change in the financial margin and this financial margin is calculated by multiplying the gap by the anticipated change in the benchmark rates. Apart from its advantage, the gap methodology has some limitations too. They are like assumptions that volume always remain in balance and are always renewed at maturity, parallel shift of yield curves and fails to consider the possibility of specific movements for different terms on these curves, the change in rates affects all periods, currencies, and products equally and fails to consider sensitivity to interest rate variations.

6.9.2. Method of Simulation The technique for projecting the financial margins and value of commercial banking based on combining possible interest rate scenarios with policies governing the institution’s contractual periods, prices, and budgeting strategies is called simulation. The efficiency of simulation method is depended on the ability of the institution to foresee the evolution of the balances of its commercial banking products and also take into account the contractual policies governing periods and prices.

6.10. ROLE OF COMMERCIAL BANKING IN ECONOMY Commercial banking plays a decisive role in building the economy of a nation by lending and borrowing and by managing the different types of risks. Some of the roles performed by the commercial banking in making of an economy has been discussed below

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Formation of capital: commercial banks help in the formation of the capital, vital for the development of the economy of a nation. Commercial banks help in mobilizing small savings of the people scattered over a wide area through their network of branches spread all over the country and make it available for the nation building. Creation of credit is done by the banks for the purpose of providing more funds for projects related with the development. Credit creation also generates a way for increased production, employment, sales, and prices and in this way help in faster economic development. Banks not only help in mobilizing the funds but it also helps in channelizing the funds to productive investment that is pooled savings should be distributed to various sectors of the economy with a view to increasing the productivity of the nation. Commercial banks help in the fuller utilization of resources as the savings pooled by banks are utilized for development purposes. Commercial banks help in encouraging right type of industries by extending loan to right type of persons. This helps in the industrialization of the country along with the economic development of the nation. Commercial banks also finance to government as government is acting as the promoter of industries in developing countries and to promote industries they need finance for it and commercial banks help them by providing long-term-credit by making investments in government securities and short-term finance by purchasing treasury bills.

6.11. CONCLUSION For the development of any nation commercial bank play an important and decisive role in building the economy of the nation by managing different types of risks like credit risk, liquidity risk, counter-party risk, FX settlement risk and so on. The development of the industry and trade is depended on the efficiency of the commercial banks. Commercial banks help in mobilizing small saving of the people through their network of banks spread all over the country and also giving a right direction for the investment of this pooled saving in generating employment

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and building various industries and development projects. Commercial banks act as not only as the custodian of the wealth of the country but also a resource of the country, which plays an important role in the economic development of a nation. Commercial banks act as an entrepreneur for any country as it provides 100% credit for many worthwhile projects which are both technically feasible and economically viable too. Commercial bank also follows some rules and regulations like Basel norms to cope with any unwanted situation happened with the economy of a nation. Commercial banks evolve its strategies too like gap method and simulation method to technical forecast and market analysis and help in the management of the risks associated with credit or FX rate. In short, for any strong nation, there is an immense need of a well-managed commercial banking system so that country is ready to cope with any risk associated with finance and at the same time prosper as well.

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REFERENCES 1.

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5. 6.

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Bankexamstoday.com., (2018). Basel Norms – Explained in Simple Language. [online] Available at: https://www.bankexamstoday. com/2015/04/basel-norms-explained-in-easy-language.html [accessed 11 April 2018]. Bis.org., (2018). [online] Available at: https://www.bis.org/publ/ bcbsc125.pdf [accessed 11 April 2018]. Cima.ky., (2018). [online] Available at: https://www.cima.ky/upimages/ commonfiles/SOG-foreignexchangeriskmanagement_1515702515. pdf [accessed 11 April 2018]. Economics Discussion, (2018). Commercial Bank: Definition, Function, Credit Creation and Significances. [online] Available at: http://www. economicsdiscussion.net/banks/commercial-bank-definition-functioncredit-creation-and-significances/607 [accessed 11 April 2018]. Gaynullina, R., & Efimov, O., (2016). Commercial banks in the economy. Internetnauka, 6, pp. 130–143. Money matters | All management articles, (2018). Role of Commercial Banks in Economic Development of Country. [online] Available at: https://accountlearning.com/role-of-commercial-banks-in-economicdevelopment-of-country/ [accessed 11 April 2018]. Santomero, A., (1997). Journal of Financial Services Research, 12(2/3), pp. 83–115. Soler, R. J., Staking, B. K., Ayuso, C. A., & Beato, P., (2000). Financial Risk Management. [eBook] Available at: http://file:///C:/Users/vinit/ Downloads/Financial%20Risk%20Management%20%20(2).pdf [accessed 11 April 2018]. Stephen, D., & Simpson, C., (2018). The Banking System. [online] Investopedia. Available at: https://www.investopedia.com/university/ banking-system/ [accessed 11 April 2018].

CHAPTER 7

Risk Management Information System and Its Implementation

“The risk management needs to lift up from risk control to risk intelligence which can identify the potential business growth opportunities.” —Pearl Zhu

CONTENTS 7.1. The Role of Information Technology In Risk Management ............... 170 7.2. Identification of Risky Events .......................................................... 171 7.3. Categorizing And Measuring Financial Risk .................................... 172 7.4. Formulation of Strategies To Control Risk ........................................ 174 7.5. Technological Improvements In Risk Management .......................... 176 7.6. Risk Management Systems: The Dimension of Benefits ................... 188 7.7. Risk Management Systems: The Dimensions of Cost ....................... 190 7.8. Risk Management Systems: How Should They Be Selected? ............ 191 7.9. Future Research In The Following Areas Would Also Be Helpful In Providing Management With Additional Guidance ...... 192 7.10. Six Steps To Implement Risk Management Information System ...... 193 References ............................................................................................. 195

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This chapter deals in risk management information system, a critical function for firms across the globe. The role of the risk management system and its association with IT initiates with the identification of risky events, categorizing and measuring various risks like business risk, financial risk, and transactional risk. Once the risks are identified, various strategies are formulated to mitigate them. This chapter lays down numerous technological improvements to manage various risks of a firm.

7.1. THE ROLE OF INFORMATION TECHNOLOGY IN RISK MANAGEMENT To automate trading activities, information technology has been used extensively. Systems such as Merrill Lynch – Bloomberg reports information about market conditions and market changes for the fixed income market and also being used to assist traders and portfolio managers. While mainframe databases, non-automated, and a variety of traditional information technologies (ITs) and approaches are still in use for tracking of basic market indicators. Thus, there has been a major move on the part of Wall Street firms towards more advanced, state-of-the-art technologies, like artificial intelligence (AI), parallel processing and neural nets. Major investment banks use these ITs with the idea of gaining a competitive advantage with the aim to focus of strategic cost management. Substantial growth has been in the availability of highly specialized commercial databases, including those from firms like Reuters/I.P. Tracking of securitized lending portfolios are supported by Sharp and Loanet. Computerized financial modeling systems and commercial databases help a trader to manage a portfolio and ward off excess risk by supporting the creation of complex or synthetic securities apart from supporting the routine activities. And the implementation of other hedging strategies that neutralize risk. Creation of securitized loans, for illustration, permits mortgage loans to be securitized on the basis of the risk involved in their prepayment and their expected return. These mortgage-backed securities (MBS) are freely traded in the market. To conducting money market trading operations, investment banking strategists require ITs in defining the basis of a set of new approaches. At the heart of these developments is the realization by investment banking strategists that IT is crucial in defining the basis of a set of new approaches to conducting money market trading operations.

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Building new financial products that have attractive risk characteristics for the parties involved in a transaction, also including the intermediaries to the transaction, is mainly limited by the willingness of the firm to know the capabilities of the technologies that support the innovations. Another important part is the enhancement in the ability of firms to manage the risks related to the global investments on a real-time basis from a centralized location. This is possible due to the combination of new advancement in communication technologies and increasingly favorable transmission costs. Over the last decade, major commercial and savings banks, securities firms and money center banks nationwide have to make financial commitments involving risks which are not fully understand by these firms, and results in major losses and undesirable write-offs. As a consequence, new ways to identify, evaluate, and predict changes in financial risks to reduce the likelihood of similar outcomes in these firms are seeking by senior managers. Investing in ITs which can help to improve the control of risk. Risk management technology (RMT) is a new emerging area of investment. Which is increasingly viewed as having a potential to affect the competitive and strategic situation of financial firms.

7.1.1. Information Technology Applied to Risk Management Problems RMT is defined in terms of three primary components: • • •

Analytic models implemented using computer software. The data related to the current and prior states of the market. Computer hardware for capturing, consolidating, and evaluation of new information about changing levels of risk. Risk management activities can be further divided into three categories: • identification and classification of risky events; • measurement of risk; and • formulation of relevant actions. IT is used to help portfolio managers and traders to improve job efficiency at each of these steps.

7.2. IDENTIFICATION OF RISKY EVENTS To detect events that can increase organizations exposure to market risk in their investments for which highly sophisticated computerized systems are

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employed. For illustration, to detect changing risks in investment positions computerized databases of financial information is used. An important part is to make crucial changes at the earliest possible time that can affect their business. Which can be executed with the help of trading platform automation that takes in digital signals on market indicators, and then scans them to determine if these signals deliver any information that changes the risk profile of current or contemplated investments1. Risk calculators are used for investments in specific financial instruments and investment banks today to identify risk involved in government securities. For example, in options and foreign exchange (FX) trading, treasury bonds and in MBS. Most of the risk calculators carry out a sensitivity analysis with a simple spreadsheet-type format; however, a few risk calculators are more sophisticated. In-house consulting groups in the major investment banking institutions developed highly specialized tools to determine variations in risk related with specific financial instruments. For illustration, the Strategic Technology and Research Group of Manufacturers Hanover Trust was instrumental in the design and development of an expert system called Trading and Risk Assistant (TARA) that identifies risky transactions in the FX Market. Morgan Stanley has developed another expert system called the GMMA Trading Assistant2. It is a rule-based expert system that helps traders to identify the risks associated with MBS. Both systems are used to identify events that can change the risk baseline for the firm.

7.3. CATEGORIZING AND MEASURING FINANCIAL RISK Measurement of financial risk is very important for senior management to develop strategies for monitoring and evaluating risk. These measurements will help them to make policies to let departmental traders, operating divisions and the firm as a whole to keep within the suitable, pre-determined limits. The first step involved in measuring risk is to develop an understanding of the factors that affect risk (for illustration, in the case of market risk the historical prices of the financial instruments, and the probability of default in the case of credit risk), Further, the range of variations in these factors from their mean values and the overnight price instability can be calculated. The 1 2

MARK90A. KEYE90B.

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measure of volatility determines the riskiness of the financial instrument during the period of observation. By tracking information on credit quality, credit risk is calculated by the parties involved in a credit transaction. This will require the firm to create a consistent measure of credit exposure as a common denominator across all credit products. For this purpose, interest rate and exchange rate contracts (FX spot and forward trades, interest rate and currency swaps), all balance sheet items (notes receivable, terms loans and so on), off-balance sheet items (such as standby letters of credit or pending legal commitments) are converted into a loan equivalent exposure amount. For each grade of credit risk, an equity factor is assigned. Information technology is a very important factor for credit risk measurement. Banks mainly runs on real-time databases. Which supply information on the credit quality of corporations and banks for which bank has to extend loans. Credits can be a monitor with the help of real-time system because of its instantly available updates on credit quality and in the context of decision-making about additional credits. Market risk is estimated by the variation in prices of instruments due to changes underlie in the market. The most common determinants of market risk are adverse movements in FX rates, interest rates (INT), and the extent of the volatility of prices of financial instruments. FX positions are exposed to movements in exchange rates and INT. INT fluctuations measurement is important to equivalent the cash flows related with assets and liabilities that are likely to become due at some future date. A briefcase will serve to explain. Let a one-year working capital loan is made against a one-month certificate of deposit of similar amount. In this state, additional funding for eleven months must be created to cop up with the liability the firm has to carry on its books until the full payment of the loan in the twelfth month. The value to the firm of the one-year loan would decrease (increase) at the end of the first month if the INT are higher (lower), enabling (forcing) the firm to purchase relatively less (more) expensive funds from certificates of deposit or in the form of overnight Fed funds. Clearly, the firm will be profitable by prevailing INT in this kind of lending. To ensure risk is controlled, the set of activities are involved in these situations know as gap management. Devising strategies and tactics are used in gap management to deal with interest rate risk so that cash flows presenting both assets and liabilities should match. With the help of effective gap management, the financial institution can protect themselves

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from unanticipated and costly borrowing in case of liabilities overcome assets, and on the other hand, it can help to eliminate the need for seeking investment opportunities from excess cash balances in the case when assets exceed liabilities. Information technology can help in the calculation of interest rate risk and other types of market risk in a substantial manner. Due to the widespread availability of computer software makes it possible to understand the patterns of variations of the most unstable factors and to know the extent to which they influence market risk. A major step in determining the riskiness of financial instruments is identifying and forecasting these patterns and trends and making it possible for the formal evaluation of worst case scenarios. To derive patterns from historical information sophisticated statistical packages can be used. Also, it is useful in predicting market risk. Operating risk is measured by two factors: • •

Scale of operations; and Flexibility with which the current investments in an operating unit can be used elsewhere at the time when the unit is shut down. It is commonly known that a complete reorganization of a smaller unit in a firm is more probable than for a bigger unit. Consequently, if there are high fixed operating costs of a small unit within a firm then expected losses due to an overhaul may also be high. ITs help in measurement of operating risk by providing advanced database management systems that can calculate the flexibility with which resources can be reallocated within a firm. Other types of financial risk can also be controlled, measured, and distinguished. Though different authors have different classification schemes for the various types of risk, still some of the more important ones include: • • • •

shape risk (non-parallel interest rate shifts related to straight default-free securities); sector risk; currency risk; and liquidity risk.

7.4. FORMULATION OF STRATEGIES TO CONTROL RISK When these types of risks are measured correctly, then they can be marked using common units for comparison purposes. A recent application,

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proposed by Mark (MARK90B), endorses that risk can be denoted in terms of dollars at risk. Dollars at risk specifies the amount of money at risk in a transaction made on its face value and the probability of the occurrence of a loss. Therefore, for instance, if $1 million of investment made and is exposed to a 1 % risk of loss, then $10,000 is the expected value of the loss or dollars at risk. Common factors that cause risk for a set of financial instruments can be identified when the risk has been converted to a dollar equivalent. Many financial instruments exhibit fluctuation in value with changes in factors that affect risk. So, it is possible to combine investments in multiple instruments in such a way that the losses due to opposing changes in risk factors can be regain due to favorable changes. This strategy is widely known as hedging, and the final combination of investments selected to produce the “hedge” is called a portfolio. These portfolios are made to maximizing expected return by combining various instruments with the objective of keeping overall exposure within certain pre-determined risk limits. ITs is considered as most important part in the creation of efficient hedges. Although to produce several different hedges depending upon the ratio of investments in different financial instruments can be varied, only a few hedges are efficient. Efficient hedges by definition are those that make maximum returns on investments for some specified level of risk3. The correlations between prices of each instrument in a portfolio must be calculated to create efficient hedges, which is generally done through statistical analysis of large financial databases. Common factors that affect risk of multiple financial instruments are determined through statistical analysis. The potential of ITs in this application is to sample the permutations and combinations of instruments so as to allow the design of an efficient hedge. These computeraided financial analyses have directed to the creation of new and hybrid hedges which are difficult to identified using manual analysis. Thus, we have seen that information technology has enhanced financial risk management in many ways. Next focus is to examine the specifics of risk management applications that are most affected by changes in information technology.

3 Weston, J. F., and Copeland, T. E. Managerial Finance, The Dryden Press, New York, 1986.

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7.5. TECHNOLOGICAL IMPROVEMENTS IN RISK MANAGEMENT Due to continuing developments in the market for new ITs and resulted in the increase in potential benefits of risk management activities conducted by investment banking and brokerage firms. Five of the most important information technology advancement in this section are: • communication software; • object-oriented programming and distributed programming; • parallel processing and supercomputing; • artificial intelligence; and • neural nets. These ITs are of significant interest to the major accounting firms dealing with risk management in the context of financial auditing.

7.5.1. Communication Software Advances Pertaining to Risk Management Both the elements of communication in risk management like centralized control of risk computation algorithms and immediate access to large amounts of data detailing are required for both historical statistics and current risk characteristics to calculate and manage risk on a global basis. The problem increases in complexity when one considers that the trading units may be dispersed among markets in multiple time zones. Development of an enabling architecture comprised of database and communication technology for centralizing risk calculation, provides an immediate access to data require by an organization. The two main technological approaches to the above problem deal with client-server architectures and distributed databases. In client-server architecture, local area network (LAN) is used to link different workstations with one workstation acting as the database handler (server) for other workstations for request and process information (clients). In this way, a group of traders can gain access to risk calculations directed to the local network by a centralized mainframe which is controlled by the headquarters’ risk management group. All data required for local risk calculation and processing can be upload on the server with “end-of-day” calculations processed data being sent back to the central mainframe. Main feature of implementing this approach is

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that an organization can review “end-of-day” risk calculations from other overseas trading offices, make required adjustments to the risk calculation algorithms, review the overall dollars at risk, and send the new requirements to each node or server in the system for use in the beginning of next trading day. This will establish a form of centralized control by distributed decision making facilitated through the communications technology (Figure 7.1).

Figure 7.1: Client-server architectures versus distributed databases. Source: Bansal, A., Kauffman, R., Mark, R., & Peters, E., (1993). Financial Risk and Financial Risk Management Technology (RMT).

A different technological approach is distributed databases which similarly promote distribution of data and decision-making to regional sites. On the other hand, client-server architectures permit users at workstations to identify remote access to a single database as a local access. Distributed databases allow concurrent access of two or more remote databases to look like a local access4. This allows an organization to save data on a network wherever it is most cost-effective. It does not allow to stage the data at each remote database server as in the case of client-server architectures. In this way, an external office can access information on any financial instrument from other network and does not require to know about all global portfolios that the firm maintains. This concept, location transparency, enables an organization to adopt a low-cost solution to providing data for risk decisionmaking. 4 “An Interview with Michael Stonebraker,” DataBase Newsletter, edited by Ronald G. Ross, 19(1), January/February 1991.

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7.5.2. Object-Oriented Databases and Programming Systems Object-oriented programming languages, for example, C, C++, Java is highly accepted for software development in the financial world. An object is defined as an entity that encapsulates some private state information or data, a set of associated operations or procedures that manipulate the data. A programming language is defined as object-based if it supports objects as a language feature and object-oriented if it also supports the concept of inheritance5. Object-oriented programming languages are based on the concept of a class and an instance. A class is defined as the direct extension to a nonrepresentational data type. Class is like a template according to which objects can be created. Every object is an instance of some class, and a group of objects that have the same set of operations and the same state representations are considered to be of the same class. When there is a difference between the two classes are stated, a new class can be developed from existing classes, and the mechanism is called inheritance. An object sends messages to other objects, to communicate with other objects. While getting a message from other objects, an object enquiry about and check for the request it can be satisfied by using information available within the object. If the request is not fulfilled, then the request is made forwarded to other objects which may be able to provide meaningful information (Figure 7.2).

Figure 7.2: Distributed database technology with interconnected servers. Source: Bansal, A., Kauffman, R., Mark, R., & Peters, E., (1993). Financial Risk and Financial Risk Management Technology (RMT). 5 Chin, R. S., and Chanson, S. T. “Distributed Object-Based Programming Systems,” Computing Surveys, 23(1), 91–124, March 1991.

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For illustration, Security Pacific is using an object-oriented development environment named Nexpert object to create a system for detecting internal frauds. For distributed global risk management, a number of other business firms are using object-oriented systems6. Object-oriented programming is becoming common in investment banking for disintegrating the complex task of observing the portfolio of a firm into several simpler tasks of observing individual financial instruments. Diverse financial instruments fall certainly into different classes they are fixed-income investments, FX, options, and futures, etc. Several sub-classes may be defined under each of these classes. For illustration, fixed-income investments class may be further categorized into the sub-classes of “bonds” and “mortgages.” Each class and sub-class can further possess several instances. Thus, a “5% coupon Government National Mortgage Association (GNMA) instrument” will be an instance of a mortgage instrument. Subclass includes specific properties from the class from which it is derived. For illustration, both bonds and mortgages have specific period of time called their “duration.” For calculation of profitability from investments, duration plays an important role in these financial instruments. Therefore, the formula to ascertain an investment in bonds or mortgages is profitable can be put in the “fixed-income instruments” class and inherited by the sub-classes, “bonds” and “mortgages.” Messages will be passed from one object to another to collect information concerning to the current investments of a firm’s portfolio. Actually, information that regularly changes, like INT and FX rates, which can be grouped together in a separate object with the other objects sending messages to this object to provide updated information. The nature of the risk involved with investments in a financial instrument changes with the type of the instrument. For illustration, while investments in options is generally subjected to market risk and investment in treasury bonds are subjected to mainly interest rate risk. With the enhancements in object-oriented system, financial instruments having the same type of risk can be simply grouped together as one class to make it easy for a portfolio manager to ascertain alternative investments that can decrease a specific type of risk. Modifications to any class of instruments will only be needed in one place due to the addition of an inheritance mechanism. This will automatically deliver updated information to all inherited classes from their parent class. 6 1990.

0’Heney, S. “Banks Finally Solve A1 Mystery,” Computers in Banking, August

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Distributed database is another application area of object-oriented systems. Since the data on financial instruments are gathered from all around the world, invalid or corruption of data has become very serious problem for portfolio managers to manage global portfolios. With the help of distributed object-oriented databases, at a centralized location, a class of portfolios and inherited classes of individual financial instruments can be created. The inheritance mechanism will allow distribution of information from each class to its inherited classes. With the assurance that data for individual financial instruments and the corresponding operations acceptable on these instruments are consistent with permissible operations on the firm’s portfolio. This is very important when data for these financial instruments can be access at any of remote offices of a financial institution. Updated information can be easily provided from one remote office to several other financial instruments. The updated objects from several remote sites can be shipped to a centralized location with the help of a distributed object-oriented system. Which would then automatically detect data discrepancies by checking to see if the transmitted objects exhibit some uninvited properties. A distributed object-oriented system can also be used to hide sensitive information within the firm by making only a limited number of required objects accessible at specific locations (Figure 7.3).

Figure 7.3: An Example of a distributed object-oriented databases.

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Distributed object-oriented system have advantage of fault tolerance that means in the case of failure of local computer system, and the loss is limited to a single object and not to the whole system. And easy of recovery in case of a failure. In the foreign operations of large financial institutions failure of local hardware is not rare. For global risk management, local offices can be asked to maintain only those financial instruments that originate in their markets. Every time local offices update financial instrument; the updated information can be delivered to a centralized location and examine for errors there. Subsequently, this updated information on the object can be delivered to other offices that require information about it. In case of a local failure, only a part of this information will be lost, and it can be easily recovered either from the centralized location or other locations where the most recent information is available (Table 7.1). Table 7.1: Characteristics of the Derived-Class and Super-Class Characteristics of the derived-class

Characteristics of the super-class

Permissible inherited operations include: Buy/sell.

Operations that can be inherited from this class: buy/sell.

Inherited properties include: price volatility, correlation, and time to maturity.

Operations that cannot be inherited: delete or add an entry of instruments originating in other countries, calculation of risk for all investments.

Individual properties: individual instrument risk, separate instrument properties depending on the type of the instrument.

Properties that can be inherited: price volatility and correlation with other stocks, time to maturity.

Individual operations: country Specific-calculations. For example, European options have different calculations than American ones.

Other features include checking for data inconsistencies using certain range checks for portfolio risk

Other features that can be included: error checks by making use of permissible range of values for different financial indicators pertaining to a specific instrument.

Source: Bansal, A., Kauffman, R., Mark, R., & Peters, E., (1993). Financial Risk and Financial Risk Management Technology (RMT).

7.5.3. Optimization and Parallel Processing for Financial Risk Management Computing power has increased by numerous times in of magnitude and are now readily available. In addition, the advent of massively parallel processing and supercomputing capabilities has fundamentally changed the scope of the models that can be solved.

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From the perspective of financial optimization, risk management is seen as “nothing more than taking positions in generic or specific attributes of securities.” Dahl, Meerus, and Zenios describe the difficulties associated with doing this in practice: “An important problem is that generic attributes are not traded in the market! Rather, one can invest in securities, which are in effect packages of attributes. This complicates risk management. For instance, suppose we wish to target a particular exposure to interest rate risk because we expect a parallel downward shift of the yield curve. We could simply buy a pure duration bond (i.e., one exposed to interest rate risk and nothing else) risk management would be simple. But such a bond is not traded. Instead, we can buy a real bond which is simultaneously exposed to interest rate risk and other factors. Targeting duration using one such bond may inadvertently increase [other forms of risk]. This means that comprehensive risk management is faced with the problem of simultaneously controlling the interaction of many securities and their attributes in shaping overall portfolio exposure. “7 The use of mathematical programming in this context is a logical choice: it enables the analyst to “optimize” the risk profile associated with a portfolio. Mathematical programming also enables the analyst to realistically represent institutional requirements or limitations placed on investors and their portfolios. Finally, it provides a ready mechanism to formulate a clear objective function for financial risk management, to identify the set of financial instruments in which portfolio selection occurs, and to carry out structured analysis of the relationship between risk and reward. Such techniques have been successfully applied to a wide variety of financial optimization problems involving risk. These include: • •

• •

bond portfolio immunization; bond “factor” immunization (which alters the assumption in bond portfolio immunization that the term structure of INT is flat and shifts in parallel); bond dedication modeling (which alters immunization models to match cash flows “on average”; downside risk control in option positions; Markowitz models

7 Dahl, H., Meerus, A., and Zenios, S. A. “Some Financial Optimization Models: I. Risk Management,” Report 89–12–01, Decision Sciences Department, The Wharton School, University of Pennsylvania, December 1, 1989.

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representing the mean and variance of non-systematic risk in portfolios; and • multi-period stochastic planning models involving uncertainty. Major advances of Technology used in areas that have especially benefitted in risk management involves collateralized mortgage obligations (CMO), MBS and their derivatives, other financial instruments that are highly responsive to INT and that include many cash flows over time. To build optimal portfolios on the basis of analysis of these instruments, realtime analysis should be carried out proceeding to the termination of the opportunity or changes in the underlying conditions of the market. Modeling mortgage holder behavior as a call option is involved in mortgage-backed security portfolio risk management (since a mortgage holder can select to prepay if INT change to favor this). The financial optimization problem is to determine what securities to include in an MBS pool with a selected risk profile, and the related lending and borrowing decisions associated with MBS cash flows that either lead or lag the expected cash flow schedule at the time the portfolio was created8. Zenios reports on the use of a Thinking Machines Inc. “Connection Machine CM-2” a large parallel computing architecture consists of 32,000 processing elements that take advantage of recent advances in algorithms to solve this problem in real-time for stochastic programming.

7.5.4. Artificial Intelligence (AI) and the Recognition of Patterns Associated with Risk Though there are majority of corporate information processing expenditures are in the area of conventional information systems, but still, some organizations have begun to develop expert systems. This technology is advance from normal approach of storing, collecting, and extracting data to one of defining human decision-making rules or expertise and amending those rules along with the data. Through the use of stored “knowledge resources,” these systems tend to act as an aid to decision making rather than attempting to replace humans with computer automation. Expert systems can be classified according to their level of knowledge and technological complexity. An expert system makes progress on the scale of knowledge complexity as the uncertainty of the information, or its completeness 8 Zenios, S. A. “Massively Parallel Computations for Financial Planning Under Uncertainty,” Report 90–11–10, HERMES Laboratory for Financial Modeling and Simulation, Decision Sciences Department, the Wharton School, University of Pennsylvania, November 1990.

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increases due to the information required from number of different fields in the decision analysis increases. Correspondingly, an expert system is considered technologically complex if the diversity of platforms including hardware and system software used for implementing the system is high. For illustration, an expert system exhibiting low knowledge complexity and low technological complexity such as PC-based personal time management program written using an AI. To exhibit both high knowledge and high technological complexity, a global risk management system that includes market risk, credit risk and operational risk measurement that uses mainframe distributed databases is linked to workstations that are located around the world. An illustration by Lincoln National Reinsurance Company is the Life Underwriting System, with aim to enhance organizational profitability through improved underwriting risk management. This system is supported by multiple technologies and databases and includes in-depth knowledge from both the medical and underwriting domains. The uses of AI in financial risk management are numerous, and some examples are illustrated below: •

•

•

Hanover Trust manufacturers are successful in installing an expert system termed as Technical Analysis and Reasoning Assistant (TARA) to guide traders to deal in FX. The system helps in improving management’s ability to identify changing market risk and identify patterns associated with FX rate movements. For the success of Manufacturers Hanover, capability, and flexibility of TARA to explain its reasoning along with senior management support is very important. An expert system is implemented in Manufacturers Hanover Trust know as Inspector that detect irregular activity and monitors worldwide FX trading. The system is considered as highly cost-effective and matches well with existing technologies in the organization. FX Auditing Assistant (FXAA) at Chemical Bank was developed to provide system support for the analysis of trades by human auditors. Keyes reports that “the use of FX auditing assistant has made auditing of trades more efficient by an astonishing factor of 30.” The American Stock Exchange has developed an expert system called Market Expert Surveillance System (MESS), to detect cases of insider trading. MESS monitors thousands of trade

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transactions on the daily bases and is able to detect a few of these that it considers which may involve frauds in insider trading. • Chase Lincoln Bank create a planning expert system, the Chase Personal Financial Planning System. This system offers financial planning advice to investors and is used to produce output according to specific user interests. Pattern recognition is another area where AI systems have proved themselves to be useful for financial risk management. Pattern recognition comprises analysis of current and previous year data on prices along with yields and other measures that are associated with specific financial instruments. This assists the market on a large scale to access those patterns that are used to build framework of predictive models. For recognizing trends and patterns that are useful to control risk is possible with the ability of these systems to rapidly process and store data for comparison purposes has given them a competitive edge over humans. To conclude meaningful predictions from the patterns detected an expert’s knowledge can now be coded in a system to infer meaningful predictions from the patterns detected. Pattern Recognition Information Synthesis Modeling (PRISM) is one of the examples of such a system developed by the Raden Research Group. AI models are best suited where semi-structured knowledge is available to make decisions, which is a distinct characteristic of this model that makes it compatible several financial risk management situations quite well. In the trading and treasury domain, most of the rules used in expert systems can be extracted from one or more experts. For example, where structured knowledge is available like programmed trading activities involving crossmarket interest rate or market index arbitrage are followed by conventional procedural programming methods which have been used to provide fully automated decision support and trade transaction capabilities.

7.5.5. Neural Nets and the Prediction of Changing Risk Neural network technology is another innovation which is being explored for use in the risk management domain. Neural networks are computer systems whose internal architectures are designed to imitate biological neural systems. Two main objectives of neural net research are: • •

To duplicate human capacity to learn new things at a great pace; To duplicate adaptive behavior of humans.

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For classification and forecasting purposes neural nets are being tested in the financial services industry. Areas, where neural nets could be helpful, are: • Prediction of stock prices; • Prediction of bankruptcy. • Forecasting prepayment rates of MBS. Neural nets are made use in situation where problems are not understood well and the reasoning, as a result, is uncertain. For illustration, neural nets are very useful for forecasting financial indicators in circumstances when there is no universally suitable forecasting model exists. Neural nets model includes a large number of processing units called neurons which possess massively parallelism and high interconnectivity. Each neuron has multiple inputs and outputs. Usually, neurons are arranged in three layers in a neural net: •

Input: Input neurons act as sensors and accept all incoming signals. • Output: Output neurons act as motoring units generating the results for a classification scheme. • Hidden: The hidden layer comprises neurons that together imitate the complex phenomenon of learning from mistakes and finetuning the network so that the predictions achieve more accuracy. Learning stage and a performing stage are two stages of neural networks. In learning phase, a network is trained on a part of the data. A subset of the input data set is provided to the network, and a set of predicted output values is obtained from the network. These outputs are then compared with the actual values. The network is iteratively fine-tuned to reduce difference depending on the difference between predicted and actual values. For all observations, this process is repeated from the training data set. The resulting neural net is used to forecast values of unknown classification variables. For example, the probability of default of loans, the prepayment of mortgages, and the likelihood of a firm’s going bankrupt by supplying known values of required input variables to the net (Figure 7.4).

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Figure 7.4: Architecture of a neural network. Source: http://www.texample.net/tikz/examples/neural-network/

Neural nets perform better than traditional classification techniques like regression, in case classification scheme does not have a well-defined model. For forecasting financial indicators neural network technology is promising, but one should be cautious in while using expensive neural net software and hardware. The problem should be well-structured enough to allow the use of conventional classification approaches. With the successful neural net applications in industry, there is an increase in growth in their use for solving a variety of classification problems. Some examples are: • •

•

Standard and poor’s successfully used Neural Works Professional to predict bond price swings. Chase Manhattan Bank developed a neural network application, ADAM, in collaboration with Inductive Inference. ADAM extracts a collection of Boolean formulas from historical data to determine the borrower’s credit-worthiness. The Nestor Character Learning System is being successfully used in some banks to interpret the dollar amounts scribbled on the face of a check.

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7.6. RISK MANAGEMENT SYSTEMS: THE DIMENSION OF BENEFITS New advances in information technology value research has proven that creation of a business value linkage is useful to recognize the scope of the indirect benefits. Business value is well-defined as the economic contribution that information technology can make to management’s goal of profit maximization in the firm. A business value linkage validates the links between information technology investments and business value through intermediate productions. A business value linkage for risk management systems involves three main features: •

Identifying all input costs or investments needed to install and maintain the system; • Understanding all intermediate production processes, both inside and outside the firm that are affected by the use of the system; and • Identifying all business value outputs whose variations can be attributed to the investments in risk management systems. Below given Figure 7.5 offers a design of a business value linkage for two different risk management systems. The first system given in the figure is a framework of risk management forecasting system that consists of direct output in the form of revenues that results from the sale of forecasted financial indicators of the market. Hence, this system affects the business value productions from two subsequent production processes, i.e., operations of portfolio management and day-today trading desk processes. Though, the business value from the system of forecasting under the portfolio management operations will be derived from the value that is produced by better management of risk. Emergence of business value due to activities of trading are derived from the value of the added returns which are a result of knowledgeable and profitable investment opportunities.

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Figure 7.5: Business value linkages for two risk management system. Source: Bansal, A., Kauffman, R., Mark, R., & Peters, E., (1993). Financial Risk and Financial Risk Management Technology (RMT).

The second system illustrated in Figure 7.5, depicts a scattered objectoriented database system to manage global portfolios which consists of four different possible intermediate production processes from which business value is extracted indirectly. The four production processes are listed below: • •

data hiding control operations; data integrity control operations;

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• portfolio management operations; and • data mailing operations. Thus, by giving limited access of data to different type of users, the system will be able to save on estimated losses which may result due to an inappropriate sharing of information or outflow of information. The system should also be well averse to lower the operating costs by taking care of data integration problems. As the system will gain an updated information in a very short span of time regarding all the worldwide financial instruments, the firm in relation to this will be able to control the risk from portfolio which may increase the returns from investments. Finally, in the long run, the system should be able to control data mailing costs, further reducing the operating costs.

7.7. RISK MANAGEMENT SYSTEMS: THE DIMENSIONS OF COST Though a firm has to incur costs of numerous types to manage risk, but three types of cost are identified as important so as to study in risk management investments, i.e., fixed costs, variable costs, and opportunity cost. Fixed costs contain investments done in computer hardware and related equipment like purchase price of the software. If new system of risk management comprises complete replacement of existing hardware, then it may not be preferred over existing system which needs current equipment even if the latter system is not measured as good as the former in terms of its performance. Variable costs comprise costs of, ‘periodic input data feeds required by the system, the costs of periodic preventive and break-down maintenance, costs of software updates, etc.’ Basically, variable cost is reliant on the amount of service requested by the user of these systems. For example, several data feeds are available in some other forms like online reports; batch reports; daily reports; and monthly or quarterly reports. The actual cost of data will generally vary which depends upon a user’s choice. Additional dimension of cost intricate in the selection of an appropriate risk management system is the opportunity cost that implies the cost of losing business against industry competitors. “Opportunity costs arise when profitable risks are not properly identified due to the inadequate performance of a risk management system.”

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Opportunity costs are important for following two reasons: •

First, they form a foundation to compare performances of different risk management systems. • Second, unlike other types of costs, opportunity costs for not using a specific risk management system differs for different firms depending upon the nature of their businesses and their present investments. For example, if an investor has not invested in fixed income assets, a risk management system providing in-depth analysis of these assets, will be worthless to him than to an investor who has diversified his investments in whole range of products, including fixed income assets.

7.8. RISK MANAGEMENT SYSTEMS: HOW SHOULD THEY BE SELECTED? The first step taken towards the evaluation of risk management systems requires managers to state their present requirements and approximate future needs for computerized tools and the input data feeds. After knowing all these requirements, a cost-benefit analysis can be studied for alternative risk management tools, and data feeds for different systems. We recommend the following steps for selecting an appropriate risk management system: •

•

•

• •

The types of risk your business faces: Identification of business risk is important to verify if the RMS you are considering will help you manage your business risk. List all your objectives in using a RMS: Management usually opts for a RMS with certain objectives in mind. It is essential that all such objectives be listed to make comparison of RMS easier. Possible objectives of a RMS may be: forecasting FX patterns, detecting errors in international data entries, checking for trading frauds, etc. Compile the list of alternative RMSs that can do the job: This step involves shortlisting those RMSs that satisfy the management’s objectives enumerated in Step 2. Gather all costs associated with a RMS: For each RMS calculate the fixed and the variable costs. Sketch a business value linkage diagram for identifying the impacts of the RMS: For each RMS, identify all intermediate

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•

•

production processes that will get affected by the use of the system. This will help to turn up hidden or less tangible benefits. Estimate all direct and indirect business value outputs of the RMS: Ask the individual intermediate production managers to provide an estimate of business value outputs, e.g., savings in operating costs, value-added by better risk management control, etc. Also, estimate the direct revenues that might result from the use of the system. The sum of these direct and indirect benefits also provides a measure of opportunity costs of not using the RMS. Select the system that has the highest expected benefit to cost ratio.

7.9. FUTURE RESEARCH IN THE FOLLOWING AREAS WOULD ALSO BE HELPFUL IN PROVIDING MANAGEMENT WITH ADDITIONAL GUIDANCE • • •

•

Gauging the effectiveness of alternative RMS models under varying risk management scenarios; Measuring the business value of RMS; Examining the relative effectiveness of the new ITs that were identified promising candidates to improve the management of risk in the firm; Combining the capabilities of multiple ITs to increase the power of the risk management function while controlling costs.

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7.10. SIX STEPS TO IMPLEMENT RISK MANAGEMENT INFORMATION SYSTEM (FIGURE 7.6)

Figure 7.6: Six steps to implement risk management information system. Source: Risk management information system- the definitive guide.

1.

Identify your needs: •

•

2.

Discuss requirements with all internal stakeholders: the risk management team, IT, procurement, health, and safety, and senior executives. Request the RMIS providers for help, for example, arranging workshops to review your requirements in detail.

Research the market: •

They may appear similar, but not all RMIS are the same –check to see they provide what you need.

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• •

3.

Check to ensure their business credentials will satisfy your procurement department. Request to speak to other customers to find out firsthand about the provider’s approach and their RMIS reliability.

Plan your timeline: • •

4.

Make sure all your requirements are factored in. Beware of short timescales – corners may be cut – and watch out for cost overruns or add-ons, which can avoid with a fixed-price contract.

Pick a team: • •

5.

Make sure IT, procurement, and executive sponsor are on board for the long-term. Check what specialists your provider will bring to the team, including account and project managers, software, and technical expertise and insurance specialists.

Implement RMIS •

•

6.

A RMIS is not just about technology; it’s also about people and relationships. Work with the right people in place to make rollout a success. Provider should begin with quick wins, so your RMIS delivers value quickly.

Review and evaluate • •

Provider should run a detailed process of continuous reviews to monitor benefits against KPIs. Annual reviews should examine potential future opportunities and keep abreast of technology advances and changes in insurance legislation and regulations.

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REFERENCES 1.

2.

3.

Bansal, A., Kauffman, R., Mark, R., & Peters, E., (1993). Financial risk and financial risk management technology (RMT). Information & Management, [online] 24(5), pp. 267–281. Available at: https:// www.sciencedirect.com/science/article/abs/pii/037872069390004D [accessed 11 April 2018]. Gibson, S. M., (n.d.). The Implications of Risk Management Information Systems for the Organization of Financial Firms. [eBook] Available at: https://pdfs.semanticscholar.org/e3ea/09b01cbf6023e39acb983ff5702 c9e3259d8.pdf [accessed 11 April 2018]. Risk Management Information System- the Definitive Guide, (n.d.). [eBook] Available at: http://cdn2.hubspot.net/hub/208738/file– 30267257./The-Definitive-Guide-to-RMIS.pdf [accessed 11 April 2018].

CHAPTER 8

Efficient Approaches in Risk Management Activities in Emerging Market Settings “Exhaustive prevention is an illusion. We can’t secure misconfiguration, shadow IT, third parties, human error, former employee. Focus on what matters more and be ready to react.” —Stephane Nappo

CONTENTS 8.1. Introduction .................................................................................... 198 8.2. Types of Risk ................................................................................... 200 8.3. Evolution of Risk Management........................................................ 203 8.4. Principles For Designing Risk For Different Sectors of Corporate World In Emerging Markets ...................................... 205 8.5. Need For Approaches ..................................................................... 206 8.6. Efficient Approaches ....................................................................... 207 8.7. Lessons Learned While Managing Risk............................................ 211 8.8. Risk Management In Emerging Markets........................................... 215 References ............................................................................................. 222

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The following chapter deals with the most efficient and popular approaches in Risk Management activities that are implemented and used in Emerging Markets. The chapter starts with a brief discussion of emerging markets, followed by various types of risks, like credit, market, and systematic risks. Further, the chapter deals with evolution of risk management and principles designing risk management strategies. Then the need for risk management approaches and efficient approaches are described. Towards the end of the chapter, various risk management techniques are discussed that are more prominent in emerging markets like political, security, workforce, financial, trade risk management.

8.1. INTRODUCTION Over the past few years, there has been a tremendous increase in the volume and complexity of financial markets, especially derivatives markets. This has also been accompanied by various financial disasters arising from illconceived derivatives transactions, with respect to the worldwide integration of financial markets. These crisis and complexities have increased concern over the risk introduced by derivatives and other complex instruments into the national as well as international marketplace. At an individual firms’ level, the threat to financial department of the firm is comparatively more and poses an increasing threat to their ability to keep control over their exposure to risk in a diverse environment. Collectively, there has been some fears that has been evaded by one firm and have the ability to spread out to others in the same country or even crossborders and become a financial crisis at an extreme level. This is a major area of concern not only for financial risk regulators, but also for markets participants. Therefore, risk management has become an essential part of firms’ and regulators’ activities. A risk management system is a valuable tool for evaluating the exposure to risk that participants in the financial sector, in general, could get subject to. With the help of such effective systems, managers have the flexibility to measure risk across markets in terms of their ability to quantify capital allocation to markets and dealers, potential impact on profit and loss, supervise performance and establish meaningful risk limits. Risk management systems also provide a measure of the amount of capital required to provide strict measures against potential future losses, a vital element for both managers and regulators. The financial marketplace strength, as a whole, ultimately

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depends upon individual firms’ ability to cover unexpected losses with capital reserves. Even firms using the best risk management systems are statistically subject to losses, and then a proper capital cushion is essential. Not surprisingly, setting capital adequacy standards is at the core of regulators’ responsibilities, together with efficient surveillance and supervision of market participants. International Organization of Securities Commissions (IOSCO), main focus is towards the development of “standards of best practices” which are related to regulatory matters, which has been examined and evaluated the current stage of its members, along with the actions they perform and policies related to risk management in financial markets. Several reports have been published on risk management system in financial sector, some of them together with the Basle Committee, focusing on banks and securities houses. As part of this effort, the scope of discussion of the current stage of risk management has been extended to the members of the Emerging Markets Committee.

8.1.1. What Is An Emerging Market? The term ‘emerging markets’ is generally used to describe the group of lowto-middle-income countries pursuing substantial political and economic reform and a more complete integration into the global economy. There is no precise accepted definition, although the search for one can make for useful and thought-provoking reading. The following characteristics are commonly associated with these markets: • •

•

•

There are low-to-middle level incomes on World Bank income per head benchmark; Recent or relatively recent economic liberalization, reduction in the state’s role in the economy, privatization of previously stateowned companies, removal of foreign exchange (FX) controls and obstacles to foreign investment; It highlights the recent liberalization policies of the political system and steps toward greater participation in the political process; There are prominent scale and dynamics of change. This chapter focuses on five markets in particular: Brazil, China, India, Russia, and Turkey. At least for the near future, these can all be considered as emerging markets (Figure 8.1).

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Figure 8.1: Alignment of risk management using bow-tie approach. Source: https://upload.wikimedia.org/wikipedia/en/b/b1/ISO_3100_-_bow_ tie_approach.png.

8.2. TYPES OF RISK 8.2.1. Credit Risk The analysis of the financial soundness of borrowers has been at the core of banking activity since its inception. This analysis is known as credit risk analysis. It is that kind of risk that an opposite party fails to perform and therefore owes an obligation to the creditor. It is still a major concern for banks, but the scope of credit risk has widened up with the growth in derivative markets. Credit risk can also be considered as the cost of replacing a cash flow when the counterparty fails to perform the same. In case of derivatives, credit risk is not that huge when it comes to transactions consummated in organized exchanges, because of the intermediation of clearinghouses, their guarantees represented by margins and daily marking-to-market and the strict monitoring of clearing members’ exposures (Figure 8.2).

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Figure 8.2: Credit risk management. Source: https://upload.wikimedia.org/wikipedia/commons/2/2f/Credit_risk_ management.jpg.

8.2.2. Market Risk The development and globalization of the financial markets, especially derivatives markets, has brought changes in the market by getting different variations of risks which have never been heard about. For example, market risk, or the risk that adverse movements in assets prices would result in loss for the firm. These kinds of risks are not limited to financial and securities firms, but all kinds of firms including Governmental bodies, which get engaged in derivatives transactions gets adversely affected by it.

8.2.3. Systematic Risk At a cumulative level, the risk triggered by an individual firm affects the entire market negatively which is regarded as systemic risk. Depending on the specific circumstances of an individual failure, and on market factors during that period, systemic risk could become a real threat to vast portions of the financial system. The more markets interweave across segments and borders, the bigger the systemic risk becomes. Systematic risk is the risk inherent to the entire market or market segment. Systematic risk, also known as “undiversifiable risk,” “volatility,” or “market risk,” affects the overall market, not just a particular stock or

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industry. This type of risk is both unpredictable and impossible to completely avoid. It cannot be mitigated through diversification, only through hedging or by using the correct asset allocation strategy.

8.2.4. Operational Risk Another kind of risk which has increased the complexity of the financial market and its instruments is the operational risk. Operational risks are those where there is a risk of loss due to human error or due to some drawbacks a firm has in its system or control. In the same way, more complex arrangements and contracts bring about legal risk, or the risk that a firm suffers a loss as a result of contracts being unenforceable or inadequately documented. Finally, “liquidity risk” is the risk that a lack of counterparts leaves a firm unable to liquidate or offset a position, or unable to do so at or near the previous market price. However, the majority of risks are dependent upon the uncertainties and certainties of various strategies or activities adopted by the financial sector which involves decision making and resourcing. Some of the examples are discussed below: •

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Pricing: If the clients are based in the same city or available nearby, then it would be easy to concentrate the risk and manage it locally. If clients are multinational, then the risk needs to be addressed at both levels. Fraud and corruption: In such cases, the approach is dependent on the spill-over effect of a potential fraud. The consequences of the fraud and corruption are taken into consideration and actions are taken accordingly. Market situation: The approach changes according to the market situation. It depends on the competitiveness of risks and whether it could be addressed locally or could be created by conditions outside the local market, i.e., depending upon the actions of global competitors. Currency: In this case, the approach is highly dependent on the size, scope, and type of the local operation. For example, smaller operations may get away with a national hedge, and multinational banks have central treasury departments. Supply chain: If the supply chain crosses borders, then the risk approach needs to adjust at that time. Another set of risks are by

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their nature ‘mixed, ‘requiring management at both the developed and emerging market levels. The two major examples are: Tax: Tax risk is a function of both internal control and processes of the whole organization, as well as the tax regimes in which it operates; and Compliance: Organizations need to be compliant within both jurisdictions.

8.3. EVOLUTION OF RISK MANAGEMENT Risk management was evaluated and measured through a strict banking activity which was directly or indirectly related to the quality of loans, which had a very complex set of procedures and instruments in the modern financial environment. According to a report published by IOSCO, which was named as financial risk management in emerging markets stated that “The first remarkable step to build a framework for systematic risk analysis was the Basle Capital Accord, issued in July 1988. The aim of the Basle initiative was to reach international convergence of rules governing the calculation of levels of capital reserves for banks.”1 It framed the details and agreed upon the framework for measuring capital adequacy and minimum standards. These standards were meant to be achieved by banks within the jurisdiction of the national supervisory authorities represented on the Committee. These frameworks were intended to be implemented in their respective countries. The Basle framework was originally directed towards the evaluation of capital with respect to credit risk. The model sets out capital requirements according to a formula. The formula was based on risk factors applicable to various categories of assets. The requirements were then rated according to their potential risk. The Basle measures are standardized in nature and have been implemented not only in the ten countries that were original members of the Banking Supervision Committee of the Bank for International Settlements, but also in many other countries throughout the world. In 1993, this methodology for risk assessment got revised which further helped in improving the credit risk analysis. But, more importantly, new provisions for market risk got recognized as a necessary development for the organization (Market risk is considered as a major source of risk). 1

http://www.iosco.org/library/pubdocs/pdf/ioscopd73.pdf.

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A new methodology was also kept into consideration which contemplated a standard model for the evaluation of model risk. However, by that time many leading banks and securities houses had already developed their own proprietary models for the assessment of market risk. These models were based on the Value-at-Risk methodology, also known as VaR, which provided levels of capital reserves lower than those produced by the Basle Committee’s proposed methodology. Value-at-Risk was used as a portfolio approach to measure risk in a comprehensive and integrated manner. It also takes into consideration the elasticity of prices of different assets that exist in differentiated portfolios. On the other hand, the standard Basle methodology used a partial analysis which measured risk as the summation of risks of individual assets and ignored correlations and thus the effects of diversification. This leads to the overestimation of total risk. There were many firms which argued that the Value-at-Risk models was not an appropriate model for capturing the overall exposure of large and diversified portfolios as compared to the standard Basle methodology, and consequently, their lower levels of capital reserves did not mean less safety. Therefore, in January 1996, the Basle Committee on Banking Supervision released an amendment to the July 1988 Capital Accord to apply capital charges to the market risks incurred by banks.2 Another important development of the amendment was that it allowed banks to calculate their market risk capital charges according to one of two models (the standardized measurement method or proprietary models based on Value-at-Risk). Banks which used their internal models were subjected to have a set of qualitative and quantitative standards. The result coming out of their Valueat-Risk calculations were supposed to get multiplied by three (i.e., take the model outcome and multiply it by 3 to set the level of regulatory capital required) and their models were then subjected to approval by national regulators. The amendment came into effect by the end of 1997. Currently, market risk management is a major concern not only for the financial sector, which are usually subject to strict regulations in terms of capital adequacy, but also for securities firms and broker-dealers or stock markets. Also, clearing houses have developed models for the calculation of margins in derivatives markets and monitoring of risks incurred by their participants.

2 Response of the Basle Committee and IOSCO to the Request of G–7 Head of Governments at the June 1995 Halifax Summit, May 1996.

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8.4. PRINCIPLES FOR DESIGNING RISK FOR DIFFERENT SECTORS OF CORPORATE WORLD IN EMERGING MARKETS Corporate finance sector and risk related to this sector has been managed efficiently in emerging markets across the world. Ernest and Young in its survey for Risk management gave an insight into the strategies and principles an organization should adopt for managing risk. It stated that there are various senior executives who are successfully managing investments and operations in multiple challenging and changeable markets. It also described that how these strategies work and there are many which do fail at times but have definitely taught a great deal of lesson for handling risk in an organization.3 There is nothing called “one size fits all” approach to risk management in emerging markets. Companies have now started following different leading practices with a structural pattern or framework to set out the full range of risks and manage the risk in an appropriate way. At one point, this is not surprising that risk management infuses all aspects of the business and is certainly not a separate box-ticking activity that can be clearly prescribed and conducted. For a short span of time, it is not possible to minimize business risks through sophisticated modeling or controls. It is important to have a concrete risk culture, with proper alignment of organizational structure and risk management processes with an enhancement in communication. This will help in setting a strong foundation for better risk management. Companies work with different organizations, and they learn different tactics to handle risk. For risk management in the corporate world especially for finance sector, it is important to follow a proper line of business. Below in this section, various principles for risk management has been discussed in detail. Some of those principles are:

8.4.1. Hedge Risks that are Not Specific to the Organization If there were no cost to hedging, organizations would be best off hedging all risks. However, hedging risk is not cost-effective because the cost increases precipitously as the risks hedged become more unique. For any firm it is difficult to reduce their exposure to risks that are unique to their business, it is even more important for them to reduce their exposure to, and hedge, risks 3

Risk Management in Emerging Markets, Ernest, and Young, 2007.

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that are not unique to them. By doing so, they can take on the more difficultto-hedge core business risks themselves.

8.4.2. Effects of Decision-Making under Uncertainty (The Over and Under Estimation of Risks) Risk in the corporate world is many a times under-rated, but sometimes it has over-rated too. Most of the times, companies who comes from other countries over-estimates risk before investing in the host company. The decision-makers consistently over-estimate new risks, assuming greater prevalence and downside to risks they are unfamiliar with. For example, risk regarding workforce. On the other hand, those with a history of and confidence in controls may under-estimate the real risks and take on more risk. These pre-conceptions can be improved to a great degree by having a deep understanding of the market situation.

8.5. NEED FOR APPROACHES The risk-management practices which are going on at present are not sufficient enough in the present era as today’s financial institute has gone to some steps ahead in order to improve the management related with risk practices and it support strategies related with growth and in line with the new regulatory requirements. Some of the shortcomings of the ongoing practices are given below •

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Little attention is being paid to risk culture, talent, and capabilities by the most of the emerging markets: Risk functions are considered as a secondary thing in many of the organization which further struggle to attract, retain, and manage talent. It also led to less effect on awareness related with risk. The management of risk is thought to be a problem, but actually, it is a true partner of the business or any organization. The process of credit is changed a little for more than a decade. In fact, a major source of risk is credit and revenue also for majority of banks of emerging markets, processes of credit and many other mechanisms which are not altered or altered very less even with the growth of banks. Insufficient information regarding data, infrastructure, and applications: This is seen in many of the organizations. To avoid this insufficiency the Financial Stability Board, the

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Senior Supervisor Group, and the Basle Committee on Banking Supervision came with many set of rules of regulations. But emerging markets are not strictly following this, and this further led to the absence of strong risk models. Areas like planning of capital, strategic decisions and managing the regulatory agenda have seriously ignored the risks: The lack of a strong risk-reducing strategy definition in various financial institutions led to absence of capital-allocation decisions and decision making. There is an urgent need for better management regulation like strict rules regarding credit cards and customer loans like in Turkey and in South Africa during the adoption of Basel III norms.

8.6. EFFICIENT APPROACHES •

Value-at-Risk or VaR techniques along with credit risk analysis: According to Capital Accord of year 1988, it is felt that improvement of credit risk management is needed in order to meet the standards and many banks did this improvement work. So, to deal with inadequate or traditional method of market risk exposure management, a new model is developed called as VaR model which mainly concerned over market risk and credit risk management area is kept under improvement process as these two risks are not interdependent (Figure 8.3).

Figure 8.3: Value at risk technique. Source: https://i.ytimg.com/vi/L2xzlvhkagk/hqdefault.jpg.

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Risks faced by banks in the process of agency work: The conflicts of interest between the principal firms and their shareholders and agents which include managers and/or employees led to the agency risks. • Internal controls: In order to provide a qualitative standards which are related to the analysis of the risk quantitatively a welldefined set of rules and regulations are formulated by the banking organization. Accounting standards: Establishing sufficient accounting standards is required not for assessing the exposure of individual firms but for comparing the financial statements as well as aggregation and compiling of risks of various firms for allowing the evaluation of systematic risk and uncertainty. Netting Agreements – These are preparations between two or more firms to balance opposite locations of the similar nature kept with each other, thus resulting in a solitary net payment for one of them. They may differ from fairly simple preparations, involving only two firms and one type of financial instrument, to very multifaceted schemes, enmeshing several administrations and numerous products. This kind of preparations are typical of over-the-counter goods, since in prepared exchanges the clearinghouses accomplish the connected activities. Netting contracts may also be hard to enforce (the legal risk), especially if they include cross-border dealings. There have been numerous proposals for the formation of institutions particularly designed for the gathering and organization of collateral and expenditures associated with multifaceted netting arrangements. Besides necessitating collateral, these companies would also lessen counterparty peril by screening contributors. Separation of Accounts and Safety of Customer’s Funds – Parting between customers’ and branded accounts must be a routine for commercial banks and safeties firms, so that customers’ accounts can be closed out or transferred to other firms in case of bankruptcy. But internal segregation may not be enough, since it may not be fully consistent with insolvency laws within some jurisdictions. For the safety of customers’ funds to be proficient, these laws must provide for their separation from the insolvent institutions’ assets and safeguard them from its creditors (Figure 8.4).

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Figure 8.4: International accounting standards boards. Source: https://www.canstockphoto.com/international-accounting-standardsboard-11677789.html.

Regulatory Burden – It relates to the likelihood of exaggeration of risks (or “overstatement of the reality”) and the subsequent imposition of extreme requirements by controllers with respect to capital reserves and revelation of information vis-à-vis the actual risks experienced. The degree of regulators’ extra (and costly) supplies with respect to data and/or substantial capital charges should be considered against their prices, keeping in mind that there exists a trade-off that should be examined: too much statutory requirements can mean an extreme burden for monetary firms, crippling their doings and making them less well-organized (and also the market); but a lack of supervisory requirements may endanger the security of the financial sector. The main objective in developing markets is to grow. Just as per twothirds of emerging and developed market corporates specify their main goal for being there as market potential and growth of the nation itself. It is a reflection of pure growing and scales economic power of economies. This finding confirms the hypothesis that companies have moved considerably

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from the traditional view that the primary objective of investment in emerging markets is cost saving. Organic Growth is considered as a common means to attain these objectives in China, Russia, and Brazil having partnerships as well as alliances that are quite common in Turkey and India. Organic growth is the most common approach to achieving these goals in Brazil, Russia, and China, with partnerships and alliances the most common in India and Turkey. Emerging markets are consistently dynamic. The findings depict that since most of the nation’s come under primary emerging markets, many more are consistently moving in them. Nearly 38 percent of companies are in these relationships for more than 10 years. Further 40 percent have good relationship in emerging market for lesser than 5 years. Priorities of risk differ and vary as per location. DM corporates put a high emphasis over supply chain risk, operational, and political risk. EM corporates have more likelihood for focusing over competitive and market risk, tax, pricing, workforce ad currency risk. Since Good management of risk requires associating the management and risk processes with business and strategic objectives of the corporates, it is believed that alt of work needs to be done in this specific area. This is very strange to note that despite recent focus on risk management and control norms in the US, merely 25% of companies in North America follow a risk management strategy that particularly focuses on emerging markets. The numbers are higher in European nations, where it is 46% and furthermore in the Far East at 52%, with further opportunities for improvement. The difference in viewpoint in DM and EM regarding the quality of risk management: Companies in DM are expressively do not agree to the fact that data given by local country management is adequate. Though about 71% of EM firms say that they deliver satisfactorily data on risk, merely 44% of the parent companies agree on same. The consequences of this inconsistency are the constant requirement for rich bi-directional communications on risk in a structured manner all over the firm in both, relations of emerging market operations that delivers sufficient detail and management’ readiness to receive it. Internal audit quality: EM firms are more confident as compared to DM companies when it comes to the quality of the internal audit testing of their holdings. This flag the questions like, are internal audit functions of DM companies are lacking in a place to sufficiently test minor controls,

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whether this is a concern regarding the skills of team at the local internal audit, or whether central sources arriving to an emerging market are in a place to provide a correct valuation of the controls in position. Hence, this can be concluded that firms established in EM nations have more sureness in terms of quality of testing related to internal audit. The leading practice: With the support of well-documented risk management strategy, EM subsidiaries covers both the local EM firms and parent company. This manages the risk in a more efficient manner by using a number of other ways that include internal audit, quality of communication along with parent company focus. Risk management in local markets: Most of the risks in local marketplaces are managed effectively. Due to the higher levels of active management throughout the complete range of risks, but there are some exceptions as well like individual risks. Teams working closely with the risks easily understand the nature of risks and assess what required steps to be taken in order to overcome that. They take necessary steps to minimize the exposure and develop benchmark guidance. Political risk: For most of the organizations it is not an easy task to manage the political risks that originate due to adverse political change. To overcome this, organizations are actively looking for and preparing themselves to face the penalties of this potential change, and a considerably small number of large firms seems to have a considerable voice in the local markets.

8.7. LESSONS LEARNED WHILE MANAGING RISK Leaders and management across the emerging and developed markets have a consistent point of view that it is important for organizations to come up with a deep understanding of local market, in order to work closely with local partners and experts, so that they can learn about the local culture and be active, cautious, flexible, and vigilant. •

Know the individual market: This is one of the main lesson to learn. According to market leaders, the easiest way to fall into trouble is to constant failure in developing a thorough market understanding. Markets are very volatile, conditions, and risks vary from region to region. A proper blend of personal interaction, in-house research, and consultation with executives is a necessity on a regular basis. The EMs are more unpredictable, and more

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attention is required in these cases. When attracting any better prospects, it is required that one should not forget the conditions and risks (Figure 8.5).

Figure 8.5: Individual market enrolment. Source: https://www.kff.org/health-reform/issue-brief/data-note-how-has-theindividual-insurance-market-grown-under-the-affordable-care-act/.

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Use local expertise: Local knowledge has no replacement, as advisers working in local scenario have incomparable understanding and in-depth knowledge which cannot be taken from outer sources or imported from outside references. There is no substitute for local knowledge; local advisers have the in-depth understanding and judgment that cannot be imported. Specialists deliver a blend of in-depth understanding and independent data regarding the market, and both of these are very crucial. Find a partner: According to internationally established companies it is very important to maintain concrete relations, be it with large suppliers, clients or joint venture partners. Companies these days consider these factors even before entering the market. This type of tasks cannot be accomplished over a distance. It is often more fruitful to release local experts in positions that require more responsibilities, as compared to the reliance on the expatriates with an incomplete contacts list and knowledge. As per CFO of Business Unit, Brazil, “It is important to have the

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participation of a local partner. To develop commercial activities, it is important not to go it alone.” Know local laws: This includes regulations, laws, and ethical code. The compliance of any organization builds on this only. It is not necessary that the regulations applicable in home market are effective in the new market. Know the culture: Consistent measures respond differently in different markets and produce vivid outputs. Recognizing this is critical in order to do business effectively. In place of taking these differences as the origin of the problem, it is required that executives from developed market realize that they cannot operate in the same way as they used to do in their own country. As per a Business Director of a UK based firm “Employ local people with knowledge and expertise, people with the in-depth knowledge only a local would have. You can’t really import expertise from the UK (Figure 8.6).”

Figure 8.6: Risk culture. Source: https://www.slideshare.net/Lszlrvai/risk-culture-risk-appetite.

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Be vigilant and cautious: To verify and analyze the potential risks without proper research generally pulls the organizations easily as they are eager for new prospects and opportunities. A large/considerable number of businesses remarked that they had understood this at a very high cost, main reason being the lack of attention to details and asking irrelevant questions and by being skeptical about reporting.

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Communication is the key: Between the EM and DM operations and between the business units, the open two-way communication and reporting on risk are very essential. It must into taken into account that it is communication that is understood by other party as compared to what is said. Communication gaps are known as one of the major reason for misunderstanding that hugely impacts the quality of decision making (Figure 8.7).

Figure 8.7: Marketing communication. Source: https://en.wikipedia.org/wiki/Cross-media_marketing.

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Be alert and present: Understanding and relationships are not easy to make and generally take a stretch of years for managers from the DM nations to integrate the information they want to be operative in the local markets. Over the course of time, it has been found that an assignment length of three years may well not be adequate. To-and-fro in both ways is valuable. According to a Group Risk Director of a UK based firm, “You get your fingers burnt if you don’t do it properly. It’s important to pay attention to detail.” Flexibility according to change in conditions: The pace of change and political changes in the EM surprised the companies form DM as these alterations were quickly affecting the business environment. The important outcomes that must be taken into

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consideration by companies are that these markets are more volatile and riskier as compared to the established markets. A more flexible and dynamic approach is needed, while maintaining required formalization and control. Set Long-term goals: It must be checked and ensured that resources and capacity of any EM can support the investment. EMs are highly competitive markets where companies survive on competence and confidence. Risk management is a crucial point, but so are quality, consistency, productivity, and delivery.

8.8. RISK MANAGEMENT IN EMERGING MARKETS 8.8.1. Political Risk Management This is the risk that arises with the change in policy or government that requires a response or change from the businesses, and it does not bring in the unstable rules and regulations at the macro-political level. From both DM and EM, a shared opinion comes out that although, the political risk plays a significant role, and it is very hard to manage these risks. As per Business Director of a firm based in Canada, “We participate in the industry organization, and we have many key people who have a lot of influence. We also pray (Figure 8.8).”

Figure 8.8: Profit and risk statement. Source: https://cdn.pixabay.com/photo/2017/08/18/18/56/dices-over-newspaper-2656028_960_720.jpg.

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Organizations these days are taking necessary steps to be on the right track and follow the necessary laws in order to modify according to the changes in sync with government rules and regulations. Most of the organizations are collecting data regarding the political environment and that too at multiple levels to place themselves in position so that they can respond to any political change taking place and having a subtle impact on the businesses of the organizations. These targets are achieved through the following mentioned measures •

Internal committees and divisions are accountable for developing and monitoring the response of any company; to understand the priorities of the local region audit and consultancy research, specialist legal research; seminars with local administrations are undertaken • Stress testing the strategic plan: this is achieved by proactive communication with the local government. A considerable fraction of businesses are taking vigorous measures to build associations with political parties and government departments to stay as up-to-date as possible, get first-hand data, and also place the company view up front. They are creating a public relations division to retain data flow working in both directions, and also take part in activities that are prearranged politically like sponsorship programs for Beijing Olympics. • Participating in trade and business associations: leading organizations are taking the benefits of these relations as a means for delivering their thoughts and messages to the government. In most of the cases, this happens via direct communication and by the help of links and references as a voice of public for the company leadership. Along with law firms, other advisers include accounting firms and political consultants. Most of the divisions do not look to head office in order to seek some direction that is related to small number of cases to provide direction, necessary advice, and any action. Political risks are prominent in small number of companies. For any organization which is managed in structured and disciplined manner, political risks are not a major concern. Other measures taken by organizations to reduce the risk that are mainly considered by a small number of organizations include:

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Managing an international chain of markets and suppliers. Considering and investing only in the countries that are politically stable. • Minimizing the liquid assets and reducing the capital investments in particular regions. • Evading relations and communication with people that have political exposure. In emerging markets, the dominating way to deal with pricing risk is to accomplish cost efficiencies in production, generation, and logistics. Organizations are arranging and sourcing materials at the best prices and furthermore broadening the supplier base. Developed market organizations make reference additionally to vital sourcing internationally, economies of scale, and more productive worldwide distribution. Monitoring import and export costs is likewise imperative. At the two levels, few organizations are working closely with clients to offer some value for money, and to separate themselves from the opposition. “Having employees out there who can review production on site. Having legal understanding of import and export and monitoring freight costs.” Head of Internal Audit, US

8.8.2. Workforce Risk Emerging markets Training: A noteworthy extent of organizations run training and education projects or planning to increase and enhance the training offered. Giving competitive salaries: As a rule, this implies salary and advantages alterations, there were a few references to consulting with and ‘tackling’ nearby unions. A number are benchmarking salaries, utilizing reports of salaries from large HR advisors. Selecting methods: Comprising background and reference checks. Execution development systems. Implementing evaluation and improvement frameworks, including distinguishing proof and advancement of high performers. Agreeing to nearby laws: Organizations are guaranteeing that they take after laws effectively, some maintaining great correspondence with government employment offices. Utilizing external advisers: This includes outsourcing of examinations and of training.

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Employing outside the local market: Either bringing individuals from outside the nation or moving the work itself outside the nation.

8.8.3. Managing Security Risk Emerging markets by Means of Insurance: This to a great extent includes physical and property insurance and insurance particular to the organization’s industry, illustrations are medical, operational, and chemicals-related. A number have protection panels. Security arranging: Few organizations referred to their security designs, some were produced by outside consultants. “If we’re operating in a more difficult area we do a specific assessment for each deployment, making sure we send trained people with the right equipment and have a contingency plan.” Business Unit Manager, UK (Figure 8.9).

Figure 8.9: Security cycle. Source: https://www.pratum.com/services/it-risk-management/risk-assessment.

Handling supply chain risk: Both EM and DM organizations are spreading the risk crosswise over individual suppliers and markets. DM organizations, specifically, mention to client and supplier reviews and appraisals. This incorporates reviewing suppliers from both a financial and quality assurance perspective. They additionally depend on local activities, considering this to be all the more a nearby issue, relying on specialists to build up great associations with merchants and suppliers. EM organizations

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are reaching customers, and choosing clients that are nearer to their own operations. Efficient transportation is likewise a need.

8.8.4. Handling Knowledgeable Property Risk Patent assurance: In the principal occurrence, organizations in the two markets apply for licenses and acquire trademark assurance. DM organizations guarantee that their licenses reach out to the emerging market country (Figure 8.10). Contract security: They work with legal advisors to guarantee the best possible documentation of agreements, covering mechanical data in contracts.

Figure 8.10: Knowledge risk. Source: https://www.colourbox.com/vector/innovation-acronym-conceptvector-26998843

Physical security: These measures include physical security for processing plants, restricting turnover of nearby laborers and staying away from being seen on public platforms. Observing and following up on encroachment: They are making a move against fake items, working with law offices to distinguish and seek pursue ‘knockoffs.’

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Determination of production markets: Few DM organizations are avoiding risk altogether, and not undertaking basic production of manufacturing items with a high component of innovation in particular markets.

8.8.5. Financial Risks Managing currency or treasury risk: They are also working with different suppliers to spread the risk, pushing the risks on to customers, keeping cash flows to a minimum, setting limits on credit and on fixed investment and financing. Risk not managed at local level. This activity is frequently a responsibility of parent company (Figure 8.11). Emerging markets Hedging: Hedging is occurring at a moderately more elevated level in the emerging markets themselves. Various subsidiaries are doing both external and internal hedges, as a high level of their transactions takes place within the organization. Natural Hedging: EM organizations are additionally attempting to make normal hedges, coordinating receivables and payables in a specific currency, or adjusting importations and exportations. Observing: Like various DM respondents, organizations in the developing markets are nearly checking changes in the exchange rates to plan for currency transactions.

Figure 8.11: Financial risk. Source: https://www.google.co.in/search?q=financial+risks&rlz=1C1CH BF_enIN751IN752&source=lnms&tbm=isch&sa=X&ved=0ahUKEwjopur3 jbLaAhWCqY8KHQgnABsQ_AUICygC&biw=1242&bih=557#imgrc=czM zL_xzqE8VIM.

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Restricting Presentation: They are additionally working with various providers to spread the risk, pushing the risks on to clients, keeping cash flows to a minimum, setting limits using a credit card and on fixed investment and financing. Risk not managed at the neighborhood level: This movement is often an obligation of parent organization. “We work with an external partner to ensure that we abide by the legislation and have an understanding of how it affects us.” Group Risk Director, Sweden

8.8.6. Managing Trade Credit Risk Emerging markets analysis and checking of customers: To work with partners with great credit reputations, and before signing contracts, organizations are evaluating customer credit ratings and histories, internally, and through third parties. Apply internal credit approach: Credit examination and scoring are connected to decide trading partners. Forcing credit terms: Most organizations in this group mention to credit limits and short installment terms. A modest number are enforcing 100% prepayment, and looking forward to stop supplying goods if there is a probability of bad obligation. Getting legitimate guidance: This activity refers especially to recuperation and bad debts. Managing financial reporting risk: A generally high proportion of organizations in both developed and emerging markets say that they are currently overseeing financial reporting risk. However, just a little percentage recognize this as one of their key risks. All things considered, the record of moves taken to manage this risk is generally brief. “Frequent follow up in all the operations and analysis. Providing support with all the decisions taken in financial issues.” Business Unit Head, Brazil “Once every three months, the headquarters goes to India to check if all the procedures are being followed and applied.” Group Risk Director, France

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REFERENCES 1. 2. 3. 4.

Costa, O., Khan, J., Levy, C., Natale, A., & Tanrikulu, O., (2014). Risk in Emerging Markets (p. 19). USA: McKinsey & Company. Finyear.com., (2018). [online] Available at: https://www.finyear.com/ attachment/67799 [accessed 11 April 2018]. Iosco.org., (2018). [online] Available at: http://www.iosco.org/library/ pubdocs/pdf/ioscopd73.pdf [accessed 11 April 2018]. Schmitz, M., (2012). Financial markets and international risk sharing in emerging market economies. International Journal of Finance & Economics, 18(3), pp. 266–277.

CHAPTER 9

Case Study

“Most of the time, your risk management works. With a systemic event such as the recent shocks following the collapse of Lehman Brothers, obviously, the risk-management system of any one bank appears, after the fact, to be incomplete. We ended up where banks couldn’t liquidate their risk, and the system tended to freeze up.” —Myron Scholes

CONTENTS 9.1. Case Study: Financial Risk Management For Management Accountants ............................................................ 224 9.2. Conclusions .................................................................................... 246 Reference .............................................................................................. 247

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The case study on Financial Risk Management for Management Accountants outlines the basic principles of financial risk management. It highlights three basic points related to risk management: the different types of financial risk that firms may face, the basic elements of a risk management framework, and the benefits of managing financial risks. It underlines all the material essential for management accounting guidelines and talks about the main objective of financial risk management. The main purpose is to provide assistance to the management in controlling risks which might affect the success of an organization.

9.1. CASE STUDY: FINANCIAL RISK MANAGEMENT FOR MANAGEMENT ACCOUNTANTS Financial risk management has ranked very high on the corporate agenda since the early 1990s, but the large losses experienced in the last couple of years indicate that many firms are still a long way from managing their financial risks effectively.

9.1.1. Introduction While some of the tools and practices described in this MAG have been developed by risk managers for use in and by financial institutions, the primary target audience for this MAG is the financial manager in non-financial organizations that face an array of financial risks and challenges inherent in doing business in today’s global economy. Risk management is concerned with understanding and managing the risks that an organization faces in its attempt to achieve its objectives. These risks will often represent threats to the organization – such as the risk of heavy losses or even bankruptcy. Risk management has traditionally associated itself with managing the risks of events that would damage the organization. Organizations face many different types of risk. These include risks associated with: • the business environment; • laws and regulations; • operational efficiency; • the organization’s reputation; and • financial risks. These financial risks relate to the financial operation of a business – in essence, the risk of financial loss (and in some cases, financial gain) – and take many different forms. These include currency risks, interest rate

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risks, credit risks, liquidity risks, cash flow risk, and financing risks. The importance of these risks will vary from one organization to another. A firm that operates internationally will be more exposed to currency risks than a firm that operates only domestically; a bank will typically be more exposed to credit risks than most other firms, and so forth. It is frequently suggested that the key driver of change has been a series of economically significant and large-scale financial disasters. To give just a few examples: in 1993, Germany’s Metallgesellschaft AG lost $1.3 billion in oil futures trading, and in the following year the US municipality, Orange County, was forced to file for Chapter 9 bankruptcy following massive losses from speculating on derivatives. In 1995, Barings Bank in the UK failed due to unauthorized derivatives trading by an offshore subsidiary. And in 1998 the hedge fund Long Term Capital Management (LTCM) collapsed – demonstrating that having two Nobel Prize-winning finance experts on its board of directors offered only limited protection from financial risks. Then there was the fall of Enron in 2001 and the accompanying collapse of Arthur Andersen, the major accounting firm that acted as Enron’s external auditors. The last couple of years have witnessed a considerable number of huge losses involving many of the world’s leading financial institutions. Indeed, recent events suggest that many firms – including many financial institutions that should really have known better – still have a lot to learn about effective financial risk management. The financial risk management disasters of the last fifteen years or so have: •

Made it clear that risk management is fundamental to good corporate governance; and • Prompted a number of responses relating to governance and internal control. Among these, the Combined Code in the UK and the King Report in South Africa. All see risk management as part of the internal control process for which the board of directors is responsible. Similarly, in the USA the Sarbanes Oxley Act (SOX) of 2002 requires companies to establish and maintain an adequate internal control structure for financial reporting. Over this same period, company managers have also increasingly recognized the potential for effective risk management to add value to an organization, and the language of risk management has started to permeate the day-to-day

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language of business. As a result, it is now commonplace to consider the risk implications of many business decision-making problems, such as: • making budgetary choices; • choosing between alternative operating plans; and • considering investment proposals. Risk reporting and risk disclosure are also becoming increasingly important as stakeholders wish to know more about the risks that their organizations are taking. Naturally, there is a huge variation in the level of resources that are devoted to risk management across organizations of differing sizes. At one end of the scale, the risk management function may be performed by a single risk champion or a part-time risk manager. At the other end of the scale may be found a dedicated risk management department headed by a chief risk officer with a seat on the board. But no matter how small or large the organization’s dedicated risk management function might be, the current view of risk management is that everyone in an organization carries some responsibility for managing and controlling the risks to which it is exposed. The board of directors holds the ultimate responsibility; it chooses the organization’s risk management strategy and is responsible for putting into place the organization’s risk management framework. Other managers directly support risk management by: • • •

identifying risks in their area of expertise; taking ownership and responsibility for those risks; promoting compliance with the organization’s control systems; and • engendering a culture of risk awareness. Although risk management is primarily concerned with managing downside risk – the risk of bad events – it is important to appreciate that risk also has an upside. This upside involves the exploitation of opportunities that arise in an uncertain world, such as opportunities to profit from new markets or new product lines. Risk management is therefore concerned both with conformance – that is, controlling the downside risks that may threaten the achievement of strategic objectives – and with performance – such as opportunities to increase a business’s overall return. In this way, risk management is linked closely with achieving the organization’s objectives

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and involves the management of upside as well as downside risks. This MAG offers introductory advice on • • •

the nature of financial risks; the key components of a financial risk management system; and the tools that can be used to make decisions under uncertain conditions. The advice will need to be fine-tuned to fit differing organizational contexts, but the underlying message and risk management framework universally provide a basis for discussion among senior management on the drafting of their own organization’s financial risk management strategies. After briefly discussing the different types of financial risk that firms may face and the benefits of managing them, we outline the basic elements of a risk management framework. The core sections of the MAG focus on: •

the interlinked issues of risk assessment (or quantification) and possible tools of control; and • how these may be applied to each of the main types of financial risk – namely, market, credit, financing, and liquidity risks. Risk assessment and control tools are suggested for each financial risk type, and real-world examples are used to illustrate the discussion. A case study of the financial risks and the financial risk management choices available to Pietrolunga, a fictitious specialist Italian lumber merchant, shows how the suggested methods may be applied in practice, and a glossary of key terms provides a quick source of reference.

9.1.2. Different Types of Financial Risk Financial risks create the possibility of losses arising from the failure to achieve a financial objective. The risk reflects uncertainty about foreign exchange rates, interest rates (INT), commodity prices, equity prices, credit quality, liquidity, and an organization’s access to financing. These financial risks are not necessarily independent of each other. For instance, exchange rates and INT are often strongly linked, and this interdependence should be recognized when managers are designing risk management systems financial risks can be subdivided into distinct categories; a convenient classification is indicated in Figure 9.1 below:

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Figure 9.1: Categories of financial risk. Source: https://www.cimaglobal.com/Documents/ImportedDocuments/cid_ mag_financial_risk_jan09.pdf.

Market risks: These are the financial risks that arise because of possible losses due to changes in future market prices or rates. The price changes will often relate to interest or foreign exchange rate movements, but also include the price of basic commodities that are vital to the business. For example; the confectionery giant, Cadbury Schweppes, recognized in its 2007 annual report that it has an exposure to market risks arising from changes in foreign exchange rates, particularly the US dollar. More than 80% of the group’s revenue is generated in currencies other than the reporting one of sterling. This risk is managed by the use of asset and liability matching (revenue and borrowings), together with currency forwards and swaps. Credit risks: Financial risks associated with the possibility of default by a counter-party. Credit risks typically arise because customers fail to pay for goods supplied on credit. Credit risk exposure increases substantially when a firm depends heavily upon a small number of large customers who have been granted access to a significant amount of credit. The significance of credit risk varies between sectors, and is high in the area of financial services, where short- and long-term lending are fundamental to the business. A firm can also be exposed to the credit risks of other firms with which it is heavily connected. For example, a firm may suffer losses if a key supplier or partner in a joint venture has difficulty accessing credit to continue trading. Example 1 for credit risk: Amazon, the global online retailer, accepts payment for goods in a number of different ways, including credit and debit cards, gift certificates, bank checks, and payment on delivery. As the range of payment methods increases, so also does the company’s exposure to credit risk. Amazon’s exposure is relatively small, however, because it primarily

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requires payment before delivery, and so the allowance for doubtful accounts amounted to just $40 million in 2006, against net sales of $10,711 million. Example 2 for Credit Risk Management in The Bank of America: In its 2007 annual report (p.69), Bank of America states that it manages credit risk “based on the risk profile of the borrower or counterparty, repayment sources, the nature of underlying collateral, and other support given current events, conditions, and expectations.” Additionally, the bank splits its loan portfolios into consumer or commercial categories, and by geographic and business groupings, to minimize the risk of excessive concentration of exposure in any single area of business. Financing, liquidity, and cash flow risks: Financing risks affect an organization’s ability to obtain ongoing financing. An obvious example is the dependence of a firm on its access to credit from its bank. Liquidity risk refers to uncertainty regarding the ability of a firm to unwind a position at little or no cost, and also relates to the availability of sufficient funds to meet financial commitments when they fall due. Cash flow risks relate to the volatility of the firm’s day-to-day operating cash flow. For example: Banks often impose covenants within their lending agreements (e.g., a commitment to maintain a credit rating), and access to credit depends on compliance with these covenants. Failure to comply creates the risk of denial of access to credit, and/or the need to take action (and costs involved) to restore that rating. For example, the 2005 annual report of Swisscom AG shows that the company entered into a series of cross border tax lease arrangements with US Trusts, in which sections of its mobile networks were sold or leased for up to 30 years, and then leased back. The leasing terms included a commitment by Swisscom AG to meet minimum credit ratings. In late 2004, however, a downgrading by the rating agencies took the company’s credit rating to below the minimum specified level. As a result, Swisscom AG incurred costs of Swiss Francs 24 million to restore that rating. Another example for the Financing, liquidity, and cash flow risks is: The UK bank Northern Rock provides a classic example of a company that succumbed to financing risk. Its business model depended upon access to large levels of wholesale borrowing. But in late 2007, this funding dried up during the “credit crunch” that arose out of the US subprime mortgage crisis. Without access to loans from other commercial banks, Northern Rock was unable to continue trading without emergency loans from the Bank of England to bridge its liquidity gap. However, even massive emergency

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loans were unable to restore investor confidence in the bank, and the British Government eventually felt compelled to nationalize it.

9.1.3. Why Manage Financial Risk? Firms can benefit from financial risk management in many different ways, but perhaps the most important benefit is to protect the firm’s ability to attend to its core business and achieve its strategic objectives. By making stakeholders more secure, a good risk management policy helps encourage equity investors, creditors, managers, workers, suppliers, and customers to remain loyal to the business. In short, the firm’s goodwill is strengthened in all manner of diverse and mutually reinforcing ways. This leads to a wide variety of ancillary benefits: •

The firm’s reputation or ‘brand’ is enhanced, as the firm is seen as successful and its management is viewed as both competent and credible. • Risk management can reduce earnings volatility, which helps to make financial statements and dividend announcements more relevant and reliable. • Greater earnings stability also tends to reduce average tax liabilities. • Risk management can protect a firm’s cash flows. • Some commentators suggest that risk management may reduce the cost of capital, therefore raising the potential economic value added for a business. • The firm is better placed to exploit opportunities (such as opportunities to invest) through an improved credit rating and more secure access to financing. • The firm is in a stronger position to deal with merger and acquisitions issues. It is also in a stronger position to take over other firms and to fight off hostile takeover bids. • The firm has a better-managed supply chain and a more stable customer base. These benefits show that it is difficult to separate the effects of financial risk management from the broader activities of the business. It is therefore important to ensure that all parties within the organization recognize and understand how they might create or control financial risks. For example, staff in the marketing department might be trained on how to reduce

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financial risks through their approach to pricing and customer vetting. Similarly, buying policies can create financial risks by, for example, creating an exposure to exchange rate movements. Consequently, it is important to establish an integrated framework for managing all financial risks.

9.1.4. A Risk Management Framework Organizations face many different types of risks, but they can all be managed using a common framework. The framework summarized in this section therefore directly applies to financial risk management and provides a context for subsequent sections that: • •

outline the different types of financial risks; and explain how financial risks may be identified and assessed before implementing appropriate strategies and control systems. CIMA’s risk management cycle, illustrated in Figure 9.2, shows that risk management forms a control loop that starts with defining risks by reference to organizational goals, then progressing through a series of stages to a reassessment of risk exposures following the implementation of controls. At the organizational level, the stages of the risk cycle are set against the background of a clearly articulated risk policy. Drafted by senior management, the policy indicates the types of risks senior management wants the organization to take or avoid and establishes the organization’s overall appetite for risk-taking. The starting point is, therefore, a general understanding of: •

the range and type of risks that an organization may face in pursuing its specific strategic objectives, and • The scale and nature of any interdependencies between these risks. This overview can then be used as the basis for constructing a more detailed risk management strategy for each risk category – in this case, financial risks. Based on the cycle illustrated in Figure 9.2, the core elements of a financial risk management system are: • • • •

Risk identification and assessment; Development of a risk response; Implementation of a risk control strategy and the associated control mechanisms; Review of risk exposures (via internal reports) and repetition of the cycle.

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Figure 9.2: The risk management cycle. Source: Risk Management: A Guide to Good Practice, CIMA, 2002.

9.1.5. Risk Identification and Assessment The first stage is to identify the risks to which the organization is exposed. Risk identification needs to be methodical, and to address the organization’s main activities and their associated risks. Risk identification may be carried out via questionnaires, surveys, brainstorming sessions, or a range of other techniques such as incident investigation, auditing, root cause analysis, or interviews. The aim is to use staff expertise to identify and describe all the potential financial risks to which the organization may be exposed. The scale of each identified risk is then estimated, using a mix of qualitative and quantitative techniques. (We will have more to say on these techniques below. For the time being, however, we focus not on the techniques themselves, but on how estimates of these risk exposures are put to use.) After this, risks are prioritized. The resulting risk ranking should relate directly back to overall corporate objectives. A commonly used approach is to map the estimated risks against a likelihood/impact matrix, such as that illustrated below. Often, both likelihood and impact would be classified into high, medium, or low. The more likely the outcome, and the bigger the impact, the more significant the risk would become. And it is especially important to identify and assess

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those risks that have the potential to severely jeopardize the organization’s ability to achieve its objectives, or even to threaten its very survival. The estimated risks can then be prioritized using a likelihood/impact matrix, such as that illustrated in Figure 9.3.

Figure 9.3: A likelihood/impact matrix. Source: https://www.cimaglobal.com/Documents/ImportedDocuments/cid_ mag_financial_risk_jan09.pdf.

The numbers relate to individually identified risks, and risk impact may be expressed in either financial (quantitative) or nonfinancial (qualitative) terms. A private sector business may express impact in terms of forecast income, profit, or cash flow. On the other hand, a public sector organization may measure impact in terms of its ability to provide services to a prescribed level. Let us suppose that risk number five in the grid relates to the likelihood and risk of the impact on bad debts of a rise in INT. For a company retailing small-ticket consumer goods, the anticipated likelihood is shown as high – probably because of prevailing economic conditions – but the impact is relatively low. The accompanying risk register will include more specific details of the risk, such as specific interest rate forecasts, as well as the estimated monetary impact and the assumptions underlying its calculation. In the case of a mortgage provider operating under the same economic conditions, this same risk may be identified as having a much higher impact because of the size of the potential defaults and the fact that lending is its core business. In

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other words, the component risks and also the resulting matrix of likelihood and consequences will vary from business to business and are subject to a degree of subjective judgment. As long as this subjectivity is recognized, the grid provides a useful tool for ranking risks and determining the appropriate levels of monitoring and control. Many firms find it useful to record their risk information in a risk register. Such a register would include information on the type of risk, its likelihood of occurrence, and it’s likely consequence, its potential monetary impact, and its relationship (if any) with other identified risks. The risk register, which would also include information such as forecasts of key variables, the assumptions on which calculations are based, and the institution’s response to each risk, would be regularly updated.

9.1.6. Risk Response The organization then needs to respond to the risks it has identified. An example would include setting out a policy defining the organization’s response to a particular risk and explain how that policy fits in with its broader objectives. It would also, • • •

set out the management processes to be used to manage that risk; assign responsibility for handling it; and set out the key performance measures that would enable senior management to monitor it. In more serious cases, it might also include contingency plans to be implemented if a projected event actually occurred. The organization should take account of the effectiveness of alternative possible responses. This requires that it be possible to identify the level of “gross” risk prior to a response, and the level of “net” risk left after it. The organization should also take account of the costs and prospective benefits of alternative responses, as well as take account of how any response would relate to its risk appetite and its ability to achieve its strategic objectives. The possible responses can be categorized into three categories, as illustrated in Figure 9.4. Internal strategies imply a willingness to accept the risk and manage it internally within the framework of normal business operations. An example would be a decision to use the customer’s currency for pricing of all exports and using internal netting processes to manage currency exposures. Risk sharing strategies relate to strategies that mitigate or share risks with an

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outside party. An example would be a forward contract, which ‘locks in’ a particular future price or rate. This prevents losses from unfavorable currency movements but locks the buyer into a fixed future exchange rate. Another example is a joint venture.

Figure 9.4: Risk strategies and tools. Source: https://www.cimaglobal.com/Documents/ImportedDocuments/cid_ mag_financial_risk_jan09.pdf.

Risk transfer involves paying a third party to take over the downside risk while retaining the possibility of taking advantage of the upside risk. An option, for example, creates the opportunity to exchange currency at a preagreed rate, known as the strike price. If the subsequent exchange rate turns out to be favorable, the holder will exercise the option, but if the subsequent exchange rate is unfavorable, the holder will let it lapse. Thus, the option protects the holder from downside risk while retaining the possible benefits of upside risk. Note, by the way, that the greater flexibility of risk transfer tools is usually accompanied by a greater cost. The pros and cons of the different responses are discussed in more depth within the context of each different type of financial risk, but it is helpful at this stage to recognize that various choices do exist. Risk Control Implementation: Having selected a risk response, the next stage is to implement it and monitor its effectiveness in relation to the specified objectives. Implementation includes allocating responsibility for managing specific risks and, underlying that, creating a risk-aware culture in which risk management becomes embedded within the organizational language and methods of working.

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Review of Risk Exposures: The control loop is closed when the effectiveness of the risk controls is evaluated through a reporting and review process. This then leads to a new risk identification and evaluation process. This process itself has three main components: •

Review process: This should include a regular review of risk forecasts, a review of the management responses to significant risks, and a review of the organization’s risk strategy. It should also include the establishment of an early warning system to indicate material changes to the risks faced by the organization; • Internal reporting to the board or senior management group: • Review of the organization’s overall risk management strategy; and • Reviews of the processes used to identify and respond to risks, and of the methods used to manage them. It should also include an assessment of the costs and benefits of the organization’s risk responses, and an assessment of the impact of the organization’s risk management strategy on the risks it faces; and •

External reporting: External stakeholders should be informed of the organization’s risk management strategy and be given some indication of how well it is performing. This basic framework for risk management can now be applied to each of the different categories of financial risk, namely: market, credit, financing, liquidity, and cash flow risks.

9.1.7. Quantifying Financial Risks Figure 9.3 shows that an organization must decide how to respond to a financial risk and choose between accepting and managing the risk as part of its normal business operations by “mitigating it, avoiding it, or transferring it. From the CIMA risk cycle, we know that the choice will reflect both: •

The priority attached to the risk, for example as shown on the likelihood and consequences matrix; and • The organization’s risk appetite. In other words, managers need to know the scale of the risk they face before they can decide upon the response. Three commonly used approaches to quantifying financial risks are regression analysis, Value-at-Risk analysis, and scenario analysis. It is

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helpful to look at each method in more depth to understand their respective strengths and weaknesses. Regression Analysis: Regression analysis involves trying to understand how one variable – such as cash flow – is affected by changes in a number of other factors (or variables) that are believed to influence it. For example, the cash flow for a UK-based engineering business may be affected by changes in INT, the euro/sterling exchange rate (EXCH), and the price of gas (GAS). The relationship between the variables can be expressed as follows: Change in Cash Flow = 𝛿 + ß1INT + ß2EXCH + ß3GAS + ε

Where INT represents the change in INT, EXCH represents changes in the EXCH, GAS represents changes in the commodity price, and ε represents the random error in the equation. The random error reflects the extent to which cash flows may change as a result of factors not included in the equation. The coefficients ß1, ß2, and ß3 reflect the sensitivity of the firm’s cash flows to each of the three factors. The equation is easily estimated using standard packages (including Excel), and the estimated coefficients can be used to determine the firm’s hedging strategy. To continue the example, suppose ß2 is negative, implying that the firm’s cash flow would fall if the exchange rate went up. If the firm wished to hedge its cash flow against such an event, then it might do so by taking out a forward contract. If the exchange rate rose, the resulting drop in cash flow would be countered by an equivalent rise in the value of the forward contract. Thus, assuming the hedge position was properly designed and implemented, the result is to insulate the firm against a change in the exchange rate. Of course, in practice, no hedge is ever perfect, and this approach to selecting a hedge also assumes a stable regression equation. Even mildly volatile economic conditions make this assumption rather dubious, but the example does illustrate how regression-based hedge positions can help reduce a firm’s exposure to a risk factor. Regression analysis can also be used for financial reporting purposes, as a means of proving the effectiveness of a hedging transaction. In the context of IAS 39, Accounting for Financial Instruments, the rules state that any hedge ineffectiveness must be recorded in the income statement as either a loss or a profit, according to price movements. Additionally, where hedge accounting is being used, formal documentation is required at the inception of the hedge, and this must include evidence of how the hedge effectiveness will be assessed. Regression analysis (either period to-period or cumulative) is one of the

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more common methods used for assessing this effectiveness, although the analysis itself is only reported internally within the business. Value-at-Risk: Another popular approach to risk measurement is Value-at-Risk (VaR) analysis. The VaR can be defined as the maximum likely loss on a position or portfolio at a specified probability level (known as the confidence level) over a specified horizon or holding period. So, for example, a company may own an investment portfolio on which the risk manager estimates the VaR to be $14 million, at a 95% confidence level over a ten-day holding period. This means that if no investments are bought or sold over a ten-day period, then there is a 95% chance of the portfolio falling by no more than $14 million. VaR is, therefore, an estimate of the likely maximum loss, but actual losses may be either above or below VaR. The VaR is an attractive approach because it is expressed in the simplest and most easily understood unit of measure, namely dollars lost, and because it gives us a sense of the likelihood of high losses. However, VaR also has a serious drawback: it tells us nothing about what to expect when we experience a loss that exceeds the VaR. If the VaR at a particular confidence level is $10m, we have no idea whether to expect a loss of $11m or $111m when losses occur that are greater than the VaR. Although VaR was originally developed to estimate market risks, its basic principles easily extend to liquidity risks, financing risks, and different types of credit risk exposure. To give an example, a board of directors might set an earnings target of, say, 80 pence per share, but also be conscious that if the earnings per share (EPS) fell below 70 pence, then there would be a strong adverse reaction from the market, causing the share price to fall. The board may, therefore, wish to ensure that there is only, say, a 5% likelihood of earnings falling to 70 pence per share. It is possible for organizations to construct a model that measures the sensitivity of earnings to changes in the market prices of financial assets or liabilities and use this model to estimate a VaR to assess their potential exposure if such risks are left partially or wholly unhedged. Another example is the application of VaR methods to estimate the riskiness of pension funds. Changes in the accounting standards for postemployment benefits have led to increased management awareness of the value of company pension funds, because of the rules on disclosure of surpluses/deficits. VaR can then be a useful tool for helping manage the risk of huge variations in the potential surplus or shortfall in company

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contributions. Such volatility is a particular characteristic of defined benefit schemes, where managers face uncertainty over the employment, retirement, and salary profiles of scheme members. Besides this application of VaR methods to estimate Earnings-at-Risk and Pension-Fund-at-Risk, other applications include: •

Liquidity-at-Risk: VaR taking account of changes in market liquidity. • Cash flow-at-Risk: VaR analysis applied to a firm’s cash flows rather than P&L. • Credit-at-Risk: VaR analysis applied to a firm’s credit exposure. • Default-Value-at-Risk: VaR analysis applied to estimate a firm’s losses in the event of default. Thus, VaR-type analysis is very flexible and can be applied to any type of quantifiable risk. Scenario Analysis: Another useful approach to quantifying risk involves scenario analyses (sometimes also referred to stress tests, sensitivity tests, or ‘what if?’ analyses). These involve a financial model of the firm and a set of specified scenarios. We ask ‘what if’ one or more scenarios should occur, and we use the model to determine the impact of these scenarios on the firm’s financial position. The scenarios chosen include any we believe might be relevant to our organization. For example, we might ask: • “What if the stock market crashed by 20%?” • “What if INT were to rise by 300 basis points?” • “What if the exchange rate were to fall 10%?” • “What if a firm were to lose a key client or key market?” If we wish to, we can then convert the results of the scenario analyses into a risk measure by assuming the risk exposure to be equal to the largest of the forecast scenario analysis losses. Firms have used scenario analyses in some form or other for many years. Early scenario analyses were often little more than ‘back of the envelope’ exercises, but the methodology has improved considerably over the years, thanks in large part to improvements in spreadsheet technology and computing power. Modern scenario analyses can be highly sophisticated exercises. Scenario analyses are particularly helpful for quantifying what we might lose in crisis situations where ‘normal’ market relationships break down. Scenario analyses can identify our vulnerability to a number of different crisis phenomena:

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Changes in the cost and availability of credit: Scenario analyses are ideal for evaluating our exposure to an (a) increase in the cost, and (b) decrease in the availability, of credit. Sudden decreases in liquidity: Markets can suddenly lose liquidity in a crisis situation, and risk management strategies can easily become unhinged, leading to much bigger losses than anticipated. Concentration risks: Scenario analyses can sometimes reveal that we might have a much larger exposure to a single counterparty or risk factor than we had realized, taking into account the unusual conditions of a crisis. Probability-based measures such as VaR can overlook such concentration, because they tend not to pay much attention to crisis conditions. Macroeconomic risks: Scenario analyses are well suited for gauging a firm’s exposure to macroeconomic factors such as the state of the business cycle, sudden exchange rate changes, and the economic condition of a particular country. Although the principles behind scenario analyses are straightforward, the categories of stress test may vary according to the type of event, the type of risk involved, the risk factors, the country or region, the stress test methodology, the model assumptions, the instruments used, the level of the test (e.g., business unit level vs. corporate level), data requirements, and the complexity of our portfolio. Scenario analysis is thus simple in principle but complex in practice. Scenario analyses can also be very useful for highlighting weaknesses in a firm’s risk management setup. The process of actually going through a scenario analysis should force managers to think through the ramifications of bad scenarios, as well as help them to pinpoint weaknesses or hidden assumptions they might have overlooked. If it is done well, it should not only give some indication of where the institution is vulnerable, but also highlight flaws in contingency planning. Indeed, what risk managers learn about these hidden weaknesses is often more valuable for risk management purposes than the loss figures that such exercises actually produce. It is also worth emphasizing – as the examples in the above discussion demonstrate – that the methodology of scenario analysis is, like VaR methodology, very flexible and can apply to a great variety of different types of risk exposure. Indeed, one very common uses of scenario analyses are to assess credit risk exposures. It is good practice, for example, for firms to carry out scenario analyses to determine their potential losses if a major counterparty to which they have extended credit should default. It is also

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becoming increasingly common for firms to stress-test their exposures to financing and liquidity risks; the benefits of such exercises are amply borne out by the difficulties faced in the credit crunch of 2007–2008 (Figure 9.5).

Figure 9.5: Comparison of approaches to the quantification of risk. Source: https://www.cimaglobal.com/Documents/ImportedDocuments/cid_ mag_financial_risk_jan09.pdf.

Figure 9.5 also shows how rising salary costs can be ‘compensated for’ by an increase in the discount rate, so that liabilities remain close to stable. This information is useful for understanding the financial reporting implications of pension’s risks, because the stock market now views pension liabilities as a form of corporate debt. As a result, high liabilities can serve to reduce the market value of the firm.

9.1.8. Tools and Techniques to Mitigate Risk Knowing the potential scale and likelihood of any given financial risk, management needs to decide how to deal with it. This means deciding whether it wishes to accept, partially mitigate, or fully avoid the risk. Different tools exist for each of these choices and for each risk type. Figure 9.6 summarizes the choices, using the risk management framework developed earlier in this MAG. Choosing the most appropriate tool depends upon the risk appetite, level of expertise in the business, and the cost-effectiveness of the particular tool. The board of directors sets the organization’s risk appetite, so it is important for board members to understand the methods being used to manage risk in their company. If the methods are not well understood, then it is advisable not to use them.

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Figure 9.6: Risk management tools for different categories of financial risk. Source: https://www.cimaglobal.com/Documents/ImportedDocuments/cid_ mag_financial_risk_jan09.pdf.

Market Risk Tools: Internal Strategies: Natural hedging is internal to a business and takes advantage of the fact that different risk exposures may offset each other. – Uses: primarily used in managing foreign exchange and interest rate risks. Internal netting: This is a form of natural hedging. – Uses: to manage multiple internal exposures across a range of currencies. Risk Sharing Strategies: Forwards are contracts made today for delivery of an asset at some specified future date, at a pre-agreed price. – Uses: to protect against possible rises in asset prices – most commonly either commodities (gas, oil, sugar, cocoa, etc.) or currencies. On the agreed delivery date, the buyer takes delivery of the underlying asset and pays for it. At that date, the buyer has a position whose value is equal to the difference between the agreed forward price and the current spot price. Other things being equal, the value of this position will be positive if the spot price has risen, or negative if the spot price has fallen. In some

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cases, forward contracts call for the buyer to pay or receive, in cash, the difference between the forward and terminal spot prices. Either way, the forward contract allows the buyer to lock into the price to be paid, thus protecting the buyer against the risk that the future spot price of the asset will rise. It also protects the seller against the risk that the future spot price will fall. Forward contracts are tailor-made and traded over-the-counter (OTC) between any two willing counterparties, each of whom is exposed to the risk of default by the other on the contract. The forward contracts, therefore, create credit risks that the firms’ concerned need to manage. Futures: Futures contracts are a form of standardized forward contract that are traded exclusively on organized exchanges. Uses: In principle, futures may be used to protect against changes in any asset or commodity price, interest rate, exchange rate, or any measurable random variable such as temperature, rainfall, etc. Contract sizes for futures are standardized, meaning that they lack the flexibility of forward contracts. Additionally, it is not possible to use straightforward futures contracts to protect against price changes for all commodities. For example, jet fuel is not traded on an organized futures exchange, so airline companies have to find alternative tools, such as the commodity swap market, to manage their exposure to the risk of rising fuel costs. Nonetheless, the protection that futures (and also forwards) provide can be vital for all commodities that are significant components of production. Joint ventures imply that an organization is willing to accept a given level of risk, but it may wish to share that risk with another party. Uses: expansion into new markets where shared knowledge, as well as shared costs, helps to reduce risks. The counterparty to any futures contract is the exchange itself. This means that firms taking futures positions face negligible default risk. The exchange protects itself against default risk by obliging firms involved to maintain margin accounts. Every day, the value of the position is marked to market, and gains or losses are settled immediately. So, for example, if a firm has a purchased a futures position (i.e., one that increases in value if the futures price should rise), and if the futures price does in fact rise, then the firm can take its profit. But if the futures price should fall, the firm will realize a loss and may face margin calls. Futures contracts are more

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liquid than forward contracts, but the firm also has to take account of the possibility of margin calls that may strain liquidity. Swaps: A swap is a contract to exchange the difference between two cash flows at one or more agreed future dates. Uses: management of interest rate and exchange rate risks. More recently, markets in commodity and credit risk swaps have developed. Swaps can be used to (a) reduce funding costs, arbitrage tax, or funding differentials, (b) gain access to new financial markets, and (c) circumvent regulatory restrictions. Risk Transfer Strategies: Options: An option is a contract that gives the holder the right (but, unlike forward or futures contracts, not the obligation) to buy or sell an underlying asset at an agreed price at one or more specified future dates. The agreed price is known as the strike or exercise price. An option that involves the right to buy is known as a call option, and one that involves the right to sell is a put option. Options come in a great variety of forms and can be exchange-traded as well as traded OTC. Options can also be classed as European, American, or Bermudan, depending upon when the option may be exercised. A European option gives the holder the right to exercise the option at a fixed future date; an American option gives the holder the right to exercise at any time until the date the option expires, and a Bermudan option gives the holder the right to exercise over some part of the period until the option expires. There are many different types of options. Some of the more common include: caps and floors, in which a price or rate is capped or floored; Asian options, in which the underlying is an average rather than a spot price; and barrier options, of which the most important are knock-out options that automatically become worthless if the underlying hits or exceeds a stipulated barrier.

Uses: •

•

•

Firms might use caps on INT to hedge their interest rate exposure, or caps and floors on exchange rates to hedge their foreign exchange rate risk. Asian options on fuel prices may be used to hedge fuel bills (e.g., by airlines), where the main concern is the average price of fuel over an extended period. A firm might purchase an option with a knock-out barrier on an exchange or interest rate, (a) because it is cheaper than a ‘regular’

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option, (b) because it does not expect the underlying to hit the barrier anyway, or (c) if the firm is otherwise ‘covered’ should the barrier be breached.

Credit Risk Tools: Internal Strategies: The majority of tools for controlling credit risk fall into this category. They include: •

Vetting: prospective counterparties to assess their credit risk. This is the oldest and most basic means of managing credit risk exposure. • Position limits: imposing limits on the credit to be granted to any individual counterparty. These position limits can be both ‘soft’ and ‘hard’; the former would be similar to targets that might occasionally be breached; the latter would be hard and fast limits that should not be exceeded under any circumstances. • Monitoring: Firms should always monitor their ongoing credit risk exposures, especially to counterparties to whom they are heavily exposed. Monitoring systems should send warning signals as a counterparty approaches or breaches a position limit. • Netting arrangements: to ensure that if one party defaults, the amounts owed are the net rather than gross amounts. • Credit enhancement: techniques include periodic settlement of outstanding debts; imposing margin and collateral requirements and arranging to make or receive further collateral payments if one party suffers a credit downgrade; purchasing credit guarantees from third parties; and credit triggers (arrangements to terminate contracts if one party’s credit rating hits a critical level). Risk Sharing Strategies: Purchase of a credit guarantee: the purchase from a third party, usually a bank, of a guarantee of payment. One example is an export credit guarantee, which is often issued by governments as a way of encouraging a growth in exports to developing markets in which credit risks may be relatively high. Credit derivatives: these mitigate downside risk by transfer to an external party.

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Examples of credit derivatives include: Credit default swap: A swap in which one payment leg is contingent on a specified credit event such as a default or downgrading. Total return swap: A swap in which one leg is the total return on a creditrelated reference asset. Total return is defined as the coupon rate plus capital gain or loss. Credit-linked note: A security which includes an embedded credit default swap. The issuer offers a higher rate of return to the purchaser but retains the right not to pay back the par value on maturity if a specified credit default occurs. However, credit derivatives come with a large health warning: they entail their own credit risk because the counter-party may default, and they can also entail substantial basis risk.

9.2. CONCLUSIONS All organizations face financial risks, and their ability to achieve their objectives (and in some cases even their survival) depends on how well they manage those risks. It is therefore critical to establish a framework that: •

Facilitates the identification and quantification of the main types of risk to which a firm is exposed; and • Sets out the main tools and techniques that the firm will use to manage those exposures. The importance of financial risk management is reinforced by the very large losses reported by many institutions since August 2007, which highlight the fact that they still have a long way to go before they can be said to be managing their financial risks adequately. Financial risk management does not come cheap, but it is less expensive than the alternative.

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REFERENCE 1.

Woods, M., & Dowd, K., (2008). Financial Risk Management for Management Accountants. [eBook] Available at: https://www. cimaglobal.com/Documents/ImportedDocuments/cid_mag_financial_ risk_jan09.pdf [accessed 11 April 2018].

INDEX A Administrative Management 67 Aggregate portfolio 154 Analytical techniques 157 Anti-money laundering 116 Arbitrage opportunities 43 Artificial intelligence (AI) 170 Asset allocation strategy 202 Asset and liability management 71 Asset liquidity 34, 41 Asset liquidity risk 34 Asymmetric information 106, 108, 111 B Banking organization 40, 208 Banking Supervision 203, 204, 207 Banking system 142, 143, 144, 153, 154, 155, 156, 157, 160, 163, 167 Bankruptcy 102 Barter system 142 Basle Committee 199, 204, 207 Basle methodology 204 Benchmarking 134

Biometric methods 121 Bond portfolio immunization 182 Borrowed funds 35 Box-ticking activity 205 Business environment 224 Business line management 58, 59 Business risk 2 Business strategy 95 C Capital-centric method 5 Capital Committee 65 Capital risk 2 Cash flow 225, 229, 233, 236, 237 Chief Risk Officer (CRO) 64, 80 Collateral agreement 94, 95 Collateralized mortgage obligations (CMO) 183 Collateral security 93 Commercial bank 145, 146, 147, 149, 150, 151, 152, 163, 165, 166 Commodity prices 38 Computer-aided financial analyses 175 Contingency plan 218

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Corporate Financial Risk Management 57, 58 Corporate governance 59, 60 Corporate risk 28 Cost per Click (CPC) 118 Counter financing 116 Counterparty risk 87 Credit extension 91 Credit portfolio 157 Credit quality 90 Credit-risk analysis 35 Credit risk management 39, 40 Credit transaction 173 Currency risk 39 Customer behavior 120 Customer Lift Value (CLV) 118 Cyber dependency 12 D Database management 174 Data mining 120, 121 Debt issuance 86 Delivery risk 2 Demand inflation 32, 33 Distributable profit 6 Double-digit growth rate 12 E Earnings volatility 230 Economic Capital (EC) 3 Economic crisis 12 Economic growth 116 Economic risk 2 Economy growth 12 Effective risk management system 58 Efficient hedges 175 Emerging market 9 Emerging Markets Committee 199

Enterprise Risk Management (ERM) 3 Enterprise value 5, 6, 7, 8 Enterprise-wide risk management 62 Evaluation process 61 Excessive concentration 229 Exchange rate 173 Exchange rate risk 2 Exchange rates 38 F Face value 175 Financial assessment 91 Financial assets 149 Financial auditing 176 Financial capital 10 Financial crime 116 Financial crime policy 116 Financial damage 61 Financial environment 15 Financial institution 144, 150, 159, 163 Financial instruments 172, 173, 174, 175, 179, 180, 181, 182, 183, 185, 190 Financial loss 224 Financial margin 165 Financial market 38, 42 Financial regulation 10 Financial reporting 68 Financial securities 36 Financial stability 158 Financial statement analysis 100 Fixed investment 220, 221 Flexibility 174 Forecasting techniques 162 Foreign currency 148 Foreign exchange fluctuation 31

Index

Foreign exchange risk 18 Foreign investment 10, 13 Foreign trade 148 Funding liquidity risk 34 FX Auditing Assistant (FXAA) 184 G Gap management 173 Global economy 9 Global financial crisis 12 Government National Mortgage Association (GNMA) 179 H Heart rate monitoring 122 I Identifiable information 2 Illiquid market 94 Implementation process 119 Inefficient market 41 Inflationary risk 29, 32 Information technology 170, 175, 176, 188 Insurance premiums 148 Insurance risk 2 Intellectual property 2 Interest rate 173, 174, 179, 182, 185 Interest rate risk 2, 29, 30 Interest rates 38 Internal Audit Function 59 Internal control process 225 Internal management valuation 6 Internal Rate of Return (IRR) 118 Internal segregation 208 International financial organization 158

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International Organization of Securities Commissions (IOSCO) 199 Investigation utilize models 95 Investment Committee 65 Investor value 5, 8 L Legal risk management 28, 49, 51, 53 Liability matching 228 Liquidation 94 Liquidity gap 229 Liquidity risk 2, 3 Liquidity Risk Committee 64 Liquidity risk management 42 Local area network (LAN) 176 Long Term Capital Management (LTCM) 225 Long-term stability 58 M Management information system (MIS) 15 Managerial capability 9 Market capitalism 12 Market Expert Surveillance System (MESS) 184 Market forecasting 116 Marketing Investment 117 Marketing performance 118, 119 Market liquidity 43 Market risk exposure management 207 Maximizing investor value 5 Mechanical data 219 Modeling mortgage 183

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Mortgage-backed securities (MBS) 170 Mutual funds 148 N Net Present Value (NPV) 118 Neutralize risk 170 Non-identical markets 32 O Object-oriented system 179, 180, 181 Odd probability 91 Off-balance sheet mechanisms 38 Operating Risk Committee 64 Operational flexibility 100 Operational risk management 60, 62 Operations risk 3 Organic Growth 210 Organizational framework 58, 62 Organizational malfunctioning 100 Overdraft 149 P Parallel processing 170, 176, 181 Passive risk 154 Pattern Recognition Information Synthesis Modeling (PRISM) 185 Personal risk management 67 Political change 211, 216 Political risk 3 Political system 199 Political uncertainty 10 Probability 172, 175, 186 Probability distribution 125, 126, 127 Product liability 98

R Real-time system 173 Record-keeping management system 101 Regression Analysis 116, 130, 131, 139 Reinvestment rate risk 30 Reinvestment risk 3 Remote database server 177 Respiration monitoring 122 Retained earnings 35 Risk assessment 2 Risk diversification 87 Risk-generating business 59 Risk identification 231, 232 Risk management 2, 5, 6, 14, 15, 16, 17, 18, 19, 20, 21, 22, 23 Risk management control 59 Risk management framework 59, 64, 75 Risk management technology (RMT) 171 Risk mitigation 40, 47 Risk-reducing strategy 207 Risk response 231, 235 Rule-based expert system 172 S Sarbanes Oxley Act (SOX) 225 Sarbanes-Oxley Law 66 Satisfactory risk management 68 Self-arbitrary approach 91 Senior management 154, 156, 157, 163, 164 Sets credit policy 66 Sets risk-management 66 Settlement risk 3 Shareholder value 117 Sharpe ratio 135

Index

Shock resistance 6, 7 Sovereign risk 3 Statistical analysis 175 Stock exchange 132, 133, 137, 138 Stock prices 38 Strategic cost management 170 SWOT analysis 86, 99, 100 Synthetic securities 170 Systematic risk 29 Systematization 15 T Task risk management 67 Tax liabilities 230 Trading and Risk Assistant (TARA) 172

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Trading platform automation 172 Transaction process 162 U Undiversifiable risk 201 Unsystematic risk 29, 33 V Value-based management 6 Virtual banking 148 Virtual simulation 122 Volatile political structure 10 Volatility 201 W Wealth disparity 12