Transforming Risks into Rewards

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.

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.

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.

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

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.

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 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.

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

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