Enhancing Value in Uncertain Times

RISK MANAGEMENT

Sone Kanwar Class of PGDM 2011 BIMTECH, INDIA

sone.kanwar@gmail.com

Wasif Mukhtar Management Trainee TATA AIG Ltd

wasif.m.shah@gmail.com

Authors are thankful to the director and faculty members of BIMTECH for their support. All the errors are of authors.

Electronic copy available at: http://ssrn.com/abstract=1538142

1. INTRODUCTION Risk is a fact of business life. Taking and managing risk is a part of what companies must do to create profits and shareholder value. Incidentally the current global crisis and the numerous corporate meltdowns in recent years suggest that many companies neither fully understand the risks that they are exposed to nor manage them well. In recent times theres been an intense pressure on executives to ensure higher profits. To enable escalated growth risk became the rule rather than the exception. Credit rating agencies played a vital role in this catastrophe which encouraged already leveraged firms to go beyond justifications. The importance of risk management can be understood by taking into account three rationales which are managerial self-interest, tax effects, the cost of financial distress and capital, market imperfectionsi. In each case the volatility in profits leads to a lower value to at least some of the firms stakeholders. Financial regulatory around the world pay too little attention to systemic risk. As a result, while individual risks are properly dealt with in normal times, the system itself remains, or is induced to be, fragile and vulnerable to large macroeconomic shocks as a result of pro-cyclical risk taking. Fixed capital requirements also dont help the cause. Large complex financial institutions area causes for concern as their financial inter linkages deem them too big to be allowed to fail. 2. RISK MANAGEMENT: AREAS OF FOCUS In light of the above given background the following areas call for a serious introspection so that a prudential risk management policy is bought into practice. Integrated Risk Management Integrated risk management evaluates the firms total exposure, instead of a partial evaluation of each risk in isolation. Because it is the total risk of the firm which typically matters to the assessment of the firms value and of its ability to fulfill its future obligations. Tools for integrated risk management manage risks using operations, targeted financial instruments and capital structure. At the foundation of risk management is the integration of the ternary mechanisms to alter the firms risk profile.ii Risk Reporting Better and fast reporting is a critical success factor in implementing enterprise wide risk management. Whether about liquidity, capital or a risk return decision, accurate and timely reporting should enable affirm to make a better decision. Statistical measures and models are critical tools, but they should not be relied on risk management across the enterprise. A key objective has to be to combine quantitative and qualitative data with business and risk information to shed more light on the business and environmental factors that impact risk. Reporting needs to be timely, comprehensive and forward looking-covering all businesses and risk across the organization.iii

Electronic copy available at: http://ssrn.com/abstract=1538142

Capital Management Capital requirements must operate counter cyclically, so that financial institutions will be required to build capital buffers above the minimum requirements during good times that can be drawn down during more difficult periods. Basel III A revised Basel II? Officially directives 2006/48 and 49, Basel 2 demands that banks and other financial institutions apply an EU-formulated Risk Assessment Model at the end of each and every days trading to show if it is solvent. If not, it must inform the authorities immediately and stop trading. That of course is no problem in a rising market as we have seen generally in recent years. ivBut it is a huge problem in highly volatile or falling market, not at least because the model fails to take any account of inevitable changes in market sentiment. Neither is the short-term impact of new information factored in, regardless of its accuracy or in accuracy. The model also ignores the essential underlying worth of assets. Basel II largely determines risk as faced by individual financial institutions. Yet systemic risk is a well recognized feature of the international financial system. The liquidity crisis, however, appears to be a novel (unanticipated) phenomenon. Crossfailure of institutions may be yet another example of unrelated correlation of outcome, with a peculiar magnification effect. Basel II does not ask- at least not explicitly- whether there is an adequate capital across the entire banking system. The current financial crisis may be an instance where this failed to hold. A revised Basel regime might be need to account for additional capital stored outside individual institutions to assure adequate capital under extreme conditions affecting the broader banking sector The financial changes all the time and those who supervise and regulate the financial world have to be prepared to change too. So I do not have any doubt that soon after Basel II is in place, we start to think about Basel III, Andrew Crockett, Former GM of Bank of International Settlements (BIS), President of JP Morgan Chase International.v As we move towards Basel III the following changes are called for in existing Basel norms: Tier 1 capital must be common shares and retained earnings The level and quality of minimum capital requirements must increase substantially Appropriate principles must be developed for non-joint stock companies to ensure they hold comparable levels of high quality Tier 1 capital The definition of capital must be harmonized across jurisdictions and all components of the capital base will be fully disclosed so as to allow comparisons across institutions to be easily made. A leverage ratio will be introduced as a supplement to the Basel II risk based framework with a view to migrating to a Pillar 1 treatment based on appropriate review and calibration. [INSERT TABLE 1]

Role of Regulation (OTC to exchange) The key to building a framework that makes financial system more stable and less prone to collapse is to identify its sources of systemic weakness-the aspects that, if damaged, will bring the entire system down .if the reform process can identify and mitigate the systemic risks while giving the private agents the incentive to behave responsibly, the system overall will be less prone to failure and more resilient even if major problems occur.. The starting point for building a comprehensive framework that safeguards the financial stability is to the sources of systemic risk in each of the financial systems three essential elements :instruments, including loans ,bonds, equities and derivative instrument; markets ranging from bilateral over- the counter(OTC) trading to organized exchanges; and institutions ,comprising banks, securities dealers ,insurance companies and pension funds among others. All three elements instruments, markets, institutions can generate systemic risks that require mitigation if the financial system is to be safe from collapse. Before the OTC market begins to migrate to a more structured exchange type format ,there needs to be an interim step-centralized clearing allowing banks to net their exposures and get them off the banks balance sheets ,resulting in a reduction of exposure and a net down of counterparty risk. Credit rating agencies played a vital role in this catastrophe which encouraged highly leveraged firms to go beyond justifications. [INSERT TABLE 2] Cultural changes Risk management must be treated as a strategic function within the organization i.e. firms must recognize that risk is everybodys business: from the chief risk officer (CRO) to senior management to the people running the back office .risk management must be managed and owned within the business units and overseen by the governance bodies at the most senior levels of organization. Further risk and finance must work together to share information and jointly support strategic decision making. Risk and finance functions can work more collaboratively on tasks including the following: Forecasting liquidity Risk governance Involving both risk and finance in evaluating potential acquisitions Reporting the impact on profit and loss as a part of the definition and analysis of risk. Creating joint processes and teams to support the publication of financial accounts.

3. CONTEMPORARYRISK MANAGEMENT MODELS Value at Risk (VaR) is by far the most widely used risk management model in finance fraternity; although a slew of other models exist. VaR isnt one model but rather a group of related models that share a mathematical framework. In its most common form it, it measures the boundaries of risk in a portfolio over short durations, assuming a normal market. The recent turmoil has highlighted various aspects the current models which need an up gradation .we need to have the worst possible extreme scenarios in our risk management models rather than extreme historical scenarios as worst cases. Standard models must be incorporated in the regulations rather than firms using them as per their discretion.

[INSERT TABLE 3] Risk assessment is, at its heart, a creative endeavor-an exercise in visualizing and testing the unknown .a task like this cannot be summed up in a single tool, such as a risk model, nor can it be dismissed because reliance on such tools was one of many proximate causes of the recent financial crisis. Risk models tend to be a synthesis of data, expert opinion, and technique; the best thinking and information boiled down to a very educated guess. We must not forget that models can never be a success left to themselves .it is the expertise and skill of the user which decides their success. 4. STRATEGIC RISK MANAGEMENT: A MARCH TOWARDS FUTURE Much of the strength of modern risk management will come from its link to the strategy of the company. Bonded with strategy, risk management addresses one of the pitfalls of many troubled companies-the inability to value assets and initiatives on a risk adjusted basis. Incorporated into strategy, risk management gives the entire organization an appreciation of what risk is, how to value it and with what cultural mindset to approach the days work .risk management and strategy come together in three core areas to ensure elevated level of risk insight and control: Formulating strategy: here the mission of the strategy is established. Roles and objectives are defined within the organization. Strategy management has a people component, which outlines the corporations risk culture, a process component, which defines the rules and regulations that will be used to manage the companys exposure to risks, and a technology component that captures, measures, monitors and reports the risk. Managing strategic risk: For every company, certain risks are inherent in the strategy of the business. Risk management uses tools and insights to identify and evaluate strategic risks and their possible impact in the long term. Those risks could include technological changes, new competitors or long term market price risks. While some short term price risks can be hedged in liquid markets, longer term strategic risks need higher order of risk management. Evolving business strategy: Beyond measuring and protecting existing strategy, risk management uses tools and metrics to evaluate different strategic options .possible new directions are assessed for their risk exposure, using a controlled risk /return model. This gives companies faced change one more tool they can use to evaluate the future direction of the business. It guides them in considering potentially profitable new opportunities .strategic risk management provides a structure to address risk related questions no matter where in the organization they occur-from C suite executives and the risk committee on down to the employees who carry out day- to day operations. 5. CONCLUSION Risk management goes beyond mitigation, compliance and control. It links risk and profitability objectives so that management can make better strategic capital decisions and increase shareholder returns-and ultimately achieve high performance. Risk management goes beyond

mitigation, compliance and control. It links risk and profitability objectives so that management can make better strategic capital decisions and increase shareholder returns- and ultimately achieve high performance. A well managed controls environment will benefit all risk disciplines. Integrating risk and compliance across the enterprise and adopting a risk based approach to the business will enable executives to focus on those risks that could have greatest impact on the organization. Business managers can spend less time on assessments and more time proactively managing risks and capitalizing on opportunities to meet company objectives. 6. REFERENCES
Santomero .M, Oldfield.S, The Place of Risk Management in Financial Institutions." Sloan Management Review. Vol. 39 (1). Fall 1997
i

Meulbroek Integrated Risk Management for the Firm: A Senior Managers Guide Harvard Business School (2002)
ii

Schlich, Prybylski Crisis Changes View of Risk Management (2009)

iii iv v

Atik, J. Basel II and Extreme Risk Analysis(2009) Retrieved Nov 6,2009 from BASEL iii Accord: http://www.basel-iii-accord.com/

7.

ANNEXURE

Table 1 Leverage of Top 25 Financial Service Companies in United States ($ Billions, 03/31/2008) Asset Company Industry Q1 Q1 Rank Asset2008 2008 ToEquity Assets Equity 10 Freddie Mac Specialty 50 803 16
16 5 11 7 4 18 Bear Sterns Morgan Stanley Lehman Brothers Merrill Lynch Goldman Sachs FHLB Of San Francisco Fannie Mae Lender Broker/Dealer Broker/Dealer Broker/Dealer Broker/Dealer Broker/Dealer FHLB 34 33 32 29 28 23

399 1091 786 1042 1189 332 843

12 33 25 37 43 14 39

Specialty Lender

22

15 17 1 14 21 24 19 6 3 13 12 22 2 9 25 23

Prudential Financial The Hartford Citigroup MetLife GMAC Countrywide Financial WaMu AIG JP Morgan Chase Wells Fargo GE Capital US Bancorp Bank Of America Wachovia Farm Credit System Bank Of New York Mellon Berkshire Hathaway

Insurance Insurance Bank Insurance Specialty Lender Thrift Thrift Insurance Bank Bank Specialty Lender Bank Bank Bank Specialty Lender Bank

21 19 17 17 16 15 14 13 13 12 12 11 11 10 7 7

478 344 2200 557 243 199 320 1051 1643 595 684 242 1737 809 197 205 281

23 18 128 33 15 13 22 80 126 48 58 22 156 78 27 28 119

20

Insurance

Source: SNL Financial Table 2 Probability of Migrating from One Rating Quality to Another within One Year (as %age)
Year End Rating Initial Rating AAA AA A BBB BB B CCC AAA 90.81 0.70 0.09 0.02 0.03 0.00 0.22 AA 8.33 90.65 2.27 0.33 0.14 0.11 0.00 A 0.68 7.79 91.05 5.95 0.67 0.24 0.22 BBB 0.06 0.64 5.52 86.93 7.73 0.43 1.30

Source: Standard & Poors Credit Week (April 1996)

Table 3 Lost market capitalization of major financial institutions

Financial Institutions Market Cap in Billion $ (Q2,2007) 49 120 76 67 80 91 108 93 116 75 100 116 255 165 Market Cap in Billion $ (Jan 20,2009) 16 4.6 10.3 17 26 7.4 32.5 26 35 27 35 64 19 85

Morgan Stanley RBS Deutsche BANK Credit Agricole Society Generale Barclays BNP Paribas Unicredit UBS Credit Suisse Goldman Sachs Santander Citigroup JP Morgan