Advertisment

Transforming Risks into Rewards

author-image
DQI Bureau
New Update

Global markets have become increasingly volatile and inter-related. More and

more complex instruments, leveraged for increasing profits substantially, are

being traded — the implications of which are yet to be fully understood.

Lending has become commoditized. And, as usual, NPA’s persistently dot the

balance sheets.

Advertisment

The critical question therefore is: Have all dimensions of risk been taken

into account that impact both short-term and long-term goals of liquidity,

profitability and solvency? This indeed is a pertinent question, especially

since risk is at the core to achieving profits.



Gourish Hosangady

To appreciate the magnitude of the problem, let us focus on banks. Today,

banks are faced with both credit and market risk.

Advertisment

Whereas as per RBI guidelines, all banks have based their capital adequacy

ratio on credit risk, only one in 25 banks have accounted for market risks. What

does this mean?

Capital adequacy ratio gives a measure of the risk cover that a bank must

have in terms of amount of capital, in event of defaulting creditors/risky

investments to remain solvent. However, if the entire extent of risk exposure by

the bank does not form the basis of measurement of capital adequacy ratio —

that becomes the biggest risk of all.

Credit risk is just one aspect of risk taken by the banks — the other

critical component being the market risk. Market risk is the risk that arises

from the movement in market prices and deal with interest rate risks,

debt/equity risk, foreign exchange risk and commodities risk. It is this risk

factor, which currently contributes to more than 50% of the banks profit

margins, that is not being covered. This indeed is a precarious situation.

Advertisment

Worse, the vulnerability of the situation does not end there. Even if all

dimensions of risk are considered to calculate capital adequacy ratio, there is

a lack of IT solutions in place that can measure risk accurately and

dynamically, across all possible parameters/scenarios to arrive at a sound risk

management strategy. At this stage, therefore, though there is an appreciation

of the upside of risk vis-à-vis returns there is no way to measure the

implications of downside risk So the problem is two fold: one is of banks not

taking into account the market risks whilst calculating their capital adequacy

ratio and second is of not being able to measure risk accurately across all its

dimensions.

Let us consider the first problem. To tackle this issue, as per RBI

guidelines, in keeping with Basel II recommendations, by March 2003, banks have

to incorporate the underlying market risk measures, along with credit risk, to

arrive at the Capital Adequacy Ratio. However, this is easier said than done as

it leads into the second more challenging problem.

To elaborate, conventional IT systems/methods typically prove to be

inadequate to dynamically measure all dimensions of risk. To begin with, the

data is not accurate. This is plainly reflected in the crucial risk:return

ratios arrived at by key decision makers/managers, typically based on past

experience, a ‘sense’ of whether the current risk position is

aggressive/moderate and ‘static’ reports from disparate data sources.

Secondly, these ratios reflect only the current position of investments made,

validated by marking to market the existing portfolio, to arrive at the current

market exposure. It does not take reflect future market risks.

Advertisment

Thus, traditional IT systems are neither capable of providing current

accurate data and nor can it take into account the future volatility in markets

- change in interest rates, currency market movements et.al. These external

factors are the essential underlying factors of risk with far reaching impact on

investment portfolios and capital adequacy ratios thereof. Consequently, these

external factors have to be identified to compute its future impact on profit

via probalistic what-if simulation analysis and arrive at single measure of

risk. In other words, investment portfolios have to be marked to the future to

derive current accurate risk exposure.

This is a critical point that can’t be emphasised enough. When the entire

extent of underlying risk factors, marked to the future, is measured, it gives

the banks the vital option of taking proactive decisions on rebalancing its

portfolio and ensuring a optimal risk:return measures. Further, it provides for

the true picture of risk of current exposures at hand to arrive at an accurate

measure of capital adequacy ratio.

This is what Value at Risk (VAR) is all about. VAR is but one measure of Mark

to Future analysis, others being, what-if market simulations, sensitivity test

to exposures etc. Simply put, a one day VAR of $10 million using a probability

of 5% means that there is a 5% chance that the portfolio could lose more than

$10 million in the next trading day. This powerful concept/data allows banks to

arrive at an accurate capital adequacy ratio, besides giving them the power to

make informed decision on its existing investment portfolio. From this it

emerges that the critical success factor for these new risk measures to be

effective is for it be integrated into the decision making process.

Advertisment

This calls for enterprise-wide risk solutions that provide for accurate data,

that measure underlying credit and market risk factors, answer multi-dimension

queries, modifying it to create hypothetical situations and if necessary quickly

adapt to match changes in the organisation or market. For this, managers need to

radically shift their mindset from returns per se to measuring risk and finally

to risk adjusted returns. This is the key differentiating factor between

traditional tools and the enterprise-wide risk solutions that measure risk for

future solvency.

To conclude, in a scenario where the markets are volatile, where majority of

profits are derived from trade, topped by the ongoing accounting scandals

epidemic, one can no longer afford to avoid measuring the scope of risk and

managing its implications thereof. Undeniably, crossing the chasm will involve

systemic changes coupled with the characteristic uncertainty and pain that it

brings — but it is a risk worth taking. After all, as Warren Buffet said:

"To finish first, you have to first finish."

The author is managing director of SAS India Pvt Ltd

mail@dqindia.com

Advertisment