Introducing Risk Management Systems: Some Common Problems

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FINANCIAL RISK MANAGEMENT IN EMERGING MARKETS

• Introducing Risk Management Systems Some Common
  Problems

Port of Spain, Trinidad and Tobago, February
20-21,2000
Paulina Beato Infrastructure and Financial
Markets Division Inter-American Development Bank
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Purposes

• Present seven recommendations for an efficient
  risk management system
• The recommendations are based on the
  recommendations from the Basle Committee and
  Group of 30
• Identify common problems for following such
  recommendations in emerging markets
• Discuss some solutions for dealing with the
  common problems

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Definition

• A Risk Management System is a systematic,
  objective and homogeneous method for setting
  criteria, both qualitative and quantitative, in
  order to
• Accept or reject financial risks
• Analyze and evaluate the existing risks
• Modify position due to external changes
• Guarantee that all risks are within the limits
  established by the institution

All risks should be included
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Traditional View

Business 2
Business 1
Market
Credit
Market
Credit
Legal and Operational
Legal and Operational
Global Risk in Finantial Institutions
Liquidity
Treasury
Each Unit Manages and control all Risks
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Modern View
Global Risk Finantial Institution
Operational
Market
Operational
Manager
Treasury
Legal
Market
Credit
Market
Credit
Legal
Control
Control
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Standard Recommendations

• Relevant Role of Top Management
• Independence between Risk Control Units and
  Business and Operational Units
• Systematic Method for Managing and Controlling
  Credit Risk
• Systematic Method for Managing and Controlling
  Market Risk
• Consistent Risk Measurement on Daily Basis
• Management and Control of Legal and Operational
  Risks
• Qualified and Experienced Staff

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Issues

• This presentation addresses the following issues
  for each recommendation
• Meaning and basis of the recommendation
• Problems in implementing each recommendation in
  emerging markets
• Approaches for solving these problems in emerging
  market environments

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Role of Top Management

• The Board of Directors and the Executive
  management should define and establish the risk
  management and control policies
• Risks may entail large losses and top management
  is responsible for protecting the institution
  value
• Top Management should define (on behalf of
  shareholders) an acceptable trade-off between
  risk and return
• Top Management should ensure that maximum
  expected losses are backed by sufficient equity
• The Board of Directors and the Executive
  management should approve the procedures for
  implementing the policies
• Policies without control systems are not
  effective
• Staff is reluctant to accept control systems

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Role of Top Management

• What happens in real world financial
  institutions?
• The Board of Directors and the Executive
  management
• are involved in policies and control systems
  related to credit risks
• often forget policies and control systems related
  to market risks
• Top Management decisions regarding credit risk
  and market risk are not consistent
• Top management sets strict limits for credit
  risk, but does not set limits for market risks
• Information regarding market risks usually does
  not reach top management
• Measures of market and credit risks are not
  comparable
• Top Management decisions often skip the risk
  limits set by themselves

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Role of Top Management

• Why the Board of Directors and the Executive
  management are not usually involved in managing
  and controlling market risk?
• They may be unaware of the market risks
  associated with financial activities
• Banking deposits fall when interest rates go up
• They may believe that market risk only appears in
  sophisticated transactions
• We do not have market risk because we do not
  operate with derivative products
• They may ignore the correlation between market
  and credit risk
• The risk of insolvency increases when interest
  rates go up

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Role of Top Management

• What may promote effective involvement of Top
  Management?
• Bank regulation and supervision requirements
• Rating agencies requirements regarding control
  and management systems for both market and credit
  risks
• Investors demand for better disclosure of risk
  management practices
• Fear of lack of liquidity and losses from
  financial crisis
• Low costs associated with risk management and
  control systems in relation to expected benefits

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Independent Risk Control

• What are the functions of risk control units?
• Set risk limits to commercial units and Treasury
  units
• Define rules and parameters to measure the risks
• Supervise compliance by all bank units with risk
  policies and procedures
• Report immediately risk deviations to top
  management
• The units in charge of controlling risks should
  be independent
• Business and Commercial Units Manage credit
  risks
• Treasury Unit Manage market risks
• Independent units should have
• Independent managers to avoids biased decisions
• Independent staff to allow proper specialization
  and avoid interest conflicts

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Independent Risk Control

• What happens often in the real world?
• Lack of culture
• Independence of the credit risk control functions
  from the commercial areas is often accepted
• Independence of the market risk functions from
  treasury department is not usually accepted
• Independent units for controlling risks are
  considered an unnecessary bureaucracy
• Lack of staff specialized in controlling market
  and credit risks
• Less than brilliant people are usually assigned
  to credit risk units
• Salary differences between treasury staff and
  market risks staff are large, while required
  acknowledge is similar

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Independent Risk Control

• What may promote effective Independent Risk
  Control?
• Board of Directors and the Executive Management
  willingness
• Own willingness
• Rating Agency Demands
• Regulatory and supervisory requirements
• Staff rotation in key positions
• Commercial Manager and Treasury Manager from
  institutions with risk control culture
• Removing staff not involved in independent risk
  control
• Visits and internships in financial institution
  with risk control culture

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Credit Risk Control

• The financial institutions should have a unit for
  controlling credit risk with the functions of
• Defining the method for measuring credit exposure
• Setting limits to credit exposure and monitoring
  its compliance
• Avoiding risk concentration country, sector,
  corporate groups
• Evaluating tools for credit risk reduction
  collateral, guarantees
• Credit risk unit should integrate the control of
  credit risk among commercial operations and
  treasury transactions
• Joint limits for both type of transactions
• Rules defining how treasury operations consume
  corporate limits
• Procedures for including compensation agreements
  in risk measures

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Credit Risk Control

• What happens often in the real world?
• Credit Risk Units, directly or indirectly, depend
  on Commercial managers
• Risk analysts often report to commercial managers
• Lack of credit risk control in treasury
  transactions
• Large financial institutions are safe
• Rating institutions and issues with uniform
  criteria are not an extended practice
• How they measure credit risk from two different
  operations
• Assets and liabilities within the same
  institution may not be legally offset (netting)

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Credit Risk Control

• What may promote effective Credit Risk Control?
• Shareholders, rating agencies and supervisors
  demand a unique measure for credit risk
• Consistent guidelines for rating corporations and
  issues
• Establishment of standard netting agreements
• Establishment of limits according to market
  scenarios

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Market Risk Control

• The financial institutions should have a unit for
  controlling market risk with the following
  functions
• Setting appropiate measurement methods and
  limits of market risks
• Looking after all units bearing market risks and
  ensuring consistent market risk management.
• Establishing rules for transferring market risks
  from commercial units to a treasury unit
• The unit controlling market risks should ensure
• Evaluation of positions at market prices,
  independently of the accounting systems
  accounting books for measurement risks
• Ensuring market risks stay within limits
• Measuring market risk consistently

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Market Risk Control

• What happens often in the real world?
• Many financial institutions still do not have a
  system for managing market risks within a unified
  framework
• Responsibility for monitoring and control of
  market risk is distributed among commercial units
  
• Treasury departments manage liquidity, but not
  market risk, i.e., they cover the deficit funds
  of commercial units and invest the excess funds
• Financial institutions with unified frameworks
  for managing market risks may not be able to
  follow the recommendations because
• No daily prices available for many assets and
  liabilities
• Interest rates are not available
• Reluctance to calculate market value fear of
  reporting losses

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Market Risk Control

• What may promote effective Market Risk Control?
• Awareness of market risks to commercial units
• Transfer of market risks to specialized units
• Strengthening capital markets
• Fixed rate securities
• Market- makers
• Ad-hoc procedures for estimating prices and
  interest rates
• Limited information methods
• Financial institution surveys
• Simulation methods

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Daily and Consistent Risk Measurement

• Financial institutions should have a daily
  measure of risk
• A measure of credit risk
• A measure of market risk
• An aggregate measure of risk
• The Value-at-risk may be an appropriate measure,
  but not the only one
• Maximum expected loss with a given probability
• Maximum loss under consistent scenarios may be
  another measure
• Daily and consistent measure is the key
• This measure should be used to set risk limits
• Equity available to back losses
• Based on risk tolerance

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Daily and Consistent Risk Measurement

• What happens often in the real world?
• No information to calculate the standard risk
  measures
• If there are no daily prices, how to develop a
  covariance matrix
• The available models are not adapted to emerging
  markets
• Normal distribution for most relevant variables
• Value-at-risk may have errors due to lack of
  relevant information
• If the estimates of the value at risk are not
  reliable, one may believe that is better off
  measuring the risks

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Daily and Consistent Risk Measurement

• What may promote Daily and Consistent Risk
  Measurement
• A risk measure is necessary, even if it may be
  not fully reliable because the measure may be
  used as ordinal indicator
• Ordinal indicators point out risk changes, but
  not absolute levels
• How ordinal indicators affect institution
  decisions?
• The value-at-risk is a good indicator, but is not
  the only one
• Losses under the worse scenario of the last n
  months
• More attention to stress test
• Random definition of bad scenarios

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Operational and Legal Risks

• Operational and legal risks are difficult to
  measure but have to be monitored and controlled
  
• Operational and legal risks appear in treasury
  and commercial transactions
• Procedures for controlling legal and operational
  risks are different for both kinds of
  transactions
• Commercial transaction decisions flow slowly,
  while treasury transactions usually take place in
  real time

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Operational and Legal Risks

• Recommendations for Treasury Transactions
• Separation of front and back office
  responsibilities
• Operations manual
• Counterpart confirmation agreements
• Common framework for contracts between financial
  institutions ( ISDA, others)
• Previous identification of legal and operational
  problems before working with new products

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Operational and Legal Risks

• What happens often in the real world?
• Lack of a framework to regulate counterpart
  relationships
• Many countries are preparing a model-contract
• Transactions are not confirmed on the same day
• An institution requiring immediate confirmation
  from counterparts may not find counterparts
• Lack of standardized products most available
  products are new with a short life
• Legal and operational departments do not have
  time to identify problems
• If there are no new products, no other products
  are available

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Operational and Legal Risks

• What may promote effective attention to Legal an
  Operational Risks?
• Bank regulations should require specific
  procedures for controlling legal and operational
  risks
• Treasury transactions should have written
  procedures
• Front and back offices should be independent and
  located in different places
• External evaluation of systems for controlling
  operational and legal risks
• Establishing a committee of new products
• Incentive to meet demands of treasury department
• Legal, accounting, back office, and trading
  expertise

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Professional Expertise

• The Risk function requires staff with a wide
  range of knowledge
• Finance, statistics, econometrics, accounting,
  trading
• Only staff with expertise should participate in
  the process of controlling and managing risks
• Front office, back office, risk control, risk
  measurement
• Long term careers for these professionals are
  required
• New products and new systems make staff easily
  obsolete
• Continuous training requirements

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Professional Expertise

• What happens often in the real world ?
• Lack of professionals with the appropriate
  knowledge in the financial institutions and in
  the markets as a whole
• Good professionals go to Treasury Department and
  old fashioned ones goes to risk control units
• Traders are brilliant
• Back office staff does not have appropriate
  knowledge
• Glamour, bonuses, good salaries are in the
  treasury and commercial units
• Losses are not associated with lack of controls,
  but with market crises

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Professional Expertise

• What may promote effective professional
  expertise?
• Training the staff from top to bottom
• From the Board of Directors to commercial and
  back office staff
• Appropriate mix of internal and external training
  
• Manager participation in training activities
• Reevaluation of risk control staff positions
• Defining appropriate knowledge profile
• Setting appropriate incentives wages and
  others
• Selecting the staff according to new profile
  position

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Final Remarks
Monitoring Credit Risk
Bankrupcy

Specialized Management Market Risk
Late commer
Monitoring Market Risk
Homogeneous Market and Credit Measures
Followers
Management VAR and RORAC
Leaders
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Final Remarks

• Risk Management Systems are as necessary in
  emerging market as in mature markets
• However, implementing them is often more
  difficult in emerging markets
• Most problems involved in adopting risk
  management systems can seldom be fully solved,
  but can always be settled in part
• The advantages of implementing a system, even a
  non perfect one, are generally larger than the
  costs

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Final Remarks

• Risk control managers do not have glamour
• If they do their job well, nothing happens
• I they do a bad job, they do not identify other
  people faults, and they loose their jobs
• We should enhance the glamour and prestige of
  risk controllers of financial institutions
• Risk managers avoid losses and increase
  shareholder value
• In all well known cases of large losses, the
  financial institution did not have appropriate
  risk management systems
• But, all of them had prestigious and glamorous
  traders