Current focus on risk management
The current focus of risk management process is managing around micro risks such as market risk, insurance risk, operational risk etc. to help optimize risk based capital. One of the key measures used in computing the risk based capital is Value at Risk methodology which is a maximum loss that can occur to the business within a defined time frame and defined probability confidence level. However, the risks than can devastate a financial institution are risks sitting in the tail of the distribution whose probability is very small but impact is very high. Such events are often difficult to predict and sources of insolvencies.
To assess these tail risks better, Morden day risk management techniques are using stress test to know the level of loss that can occur if tail event crystallizes. The key in the success of stress test is identification of likely tail scenarios that may happen so that such stresses can be formulated. However, different countries and different regulatory regimes are using different stresses and there is a no common methodology in framing such scenarios at present.
In the current process of risk identification and risk assessment, macro risk analysis is finding very little space. It has been seen in the past that many of the micro risks starts developing from macro environment but its signals are often ignored. Many financial disasters in the past happened due to crystallization of micro risk but key trigger points were macro events. Though
Baring Bank failed due to Nick Leeson’s position into the derivative market, however, it was 1995 earthquake in Japan led to fall in Nikkei index and index in other Asian market triggering unanticipated losses to Baring Bank. Had that earthquake in Japan not come, should the Baring bank would have been in existence today- we do not know. Similarly,
Long-Term Capital Management (
LTCM) was a hedge fund management firm based in Greenwich, Connecticut that used absolute-return trading strategies combined with high financial leverage suffered losses due to failure of Russian Government to honour the payment which was a macro risk event. Both the examples suggest that macro risks assessment is important and should find place in the future risk management framework. Understanding such macro risk may also help in reducing the capital requirement of the company.
Future focus on risk management
Many tail risks results from macro events such as social, economic, political, natural calamities, terrorist attack etc. but get un-noticed leading to financial disaster. With increasing integration of global economy, the correlation between different macro risks factors are increasing at a much faster pace now than ever before. Failure in one economy or fallout in one political system or devastation from hurricane in US or terrorist attack in one part of the world will have adverse impact on the financial system of the world. These events are likely to impact adversely the stock market of other economies, fall in currency value, rising inflation, imbalance in exports and imports leading to crumbling of financial system round the world.
The World Economic Forum have identified following top five global risks in terms of likelihood and in terms of impact :
Likelihood impact
- Interstate conflicts with regional consequences (geopolitical risk)
- Extreme weather events (environmental risk)
- Failure of national governance (geopolitical risk)
- State collapse or crisis (geopolitical risk)
- High structural unemployment or underemployment (economic risk)
Severity of impact
- Water crisis (societal risk)
- Rapid and mass spread of infectious disease (societal risk)
- Weapons of mass destruction ( geopolitical risk)
- Interstate conflict with regional consequence ( geopolitical risk)
- Failure of climate-change adaption (environmental risk)
It was reported that the top global risks in terms of likelihood and potential impact over coming 10 years are interstate conflicts with regional consequences as number one global risks in terms of likelihood and fourth most serious risk in terms of impact. With the increasing geopolitics influencing global economy, geopolitical risks account for three of the five most likely, and two of the most potential impactful risks.
It is important to note that environmental risk is getting more prominent than economic risk. This is particularly so because of negative assessment of existing preparedness to cope up with such extreme weather and climate change challenge.
The interplay of risk is also important in the global risk landscape, the World Economic Forum have identified three key interplays that may exacerbate the overall impact in short to medium term. They are, geopolitical and economics, the risks related to rapid and unplanned urbanization in developing countries and emerging technologies.
Another few areas that require attention in the effort of improving risk management framework is the recognition of correlation between risks, as correlation play an important role in risk diversification and aggregation. The important point considering is that, correlation under the stressed condition increases which should be kept in mind while aggregating economic capital.
Spotting of unusual activities in global landscape is another way to have better risk identification process. Some of the such activities could be political unrest or increased parleys between few countries, too high market returns in the stock market without reason, extreme weather condition prevailing for a long period of time, boom in one sector in the economy without enough rationale, unusual high profit shown by some companies while other competitors are struggling etc are few examples of unusual events. The recent 2008 global economic crisis had shown that boom in the housing market followed by new financial products was an unusual activity, if analyzed and assessed for its impact, the risk might have been reduced.
Enhancement in risk analysis
Understanding of the tail risk through expanding the risk identification horizon to global macro risk factors, spotting the unusual trends in the global activity, better understanding of correlation between different risks under the stressed condition would help identifying tail risks better. Such assessment would also reduce capital, one through release of capital kept aside for catastrophe risk and another through better location of risks.
The regulatory bodies round the world should start including the macro risk analysis as a part of risk management process along with current practice of micro risk analysis as shown in the picture below. By doing this, it will help regulators in spotting early trends as many of the micro level risks germinates in the macro garden and follow a cascading effect. This will give more confidence and increase credibility to the risk management process in fighting against the collapse of another financial disaster that may happen in future. As identified by World Economic Forum, geopolitical and environmental risks are more important risks for the future of this world compared to economic risk as thought today. The initials signs of these risks are spottable even today through an erratic pattern in the environment worldwide is widespread. One may not be surprised if world witness the impact of sustained extreme weather impacting the ability to grow food (just an example) for the world; this may lead to food crisis increasing inflation immediately affecting increase in interest rate; this would further lead to fall in the stock market reducing asset value and creating mismatch between assets and liability. Similarly, geopolitical risk is raising its head in a slow manner in the current unipolar world. It may happen that, the impact of interstate conflicts, failure of national government and current slow economic growth may give rise to long lasting impact on the global economy and it may take years to recover. If this happen financial system round the world will crumble together taking away the confidence of the customers. In such situation, even the national governments may not able to bail out financial institutions due to sheer size of losses. The focus here is to widening the scope of risk management from current narrow focus.
The macro risk analysis process could be made as a combination of regular monitoring of macro risks as a part of risk management or extended to quantification of such risks using multifactor models or extreme value theory feeding into micro risk analysis which flows into the capital calculation. This flow of risk analysis would help in identifying the tail risk better which may not remain a tail risk anymore reducing uncertainty. Currently, regulators have prescribed stress test to get the flavour of tail risk, however, one, such stress testing is not regularly performed, no standardized approach is available, different regulators are doing different tests whereas world is facing common risks. There is a need for all the regulatory bodies to come together and take up the exercise of assessing the key global risk and incorporate into the risk management framework. This will reduce the chances of world facing another crisis, though it is impossible to remove such happening with full certainty, but we can reach closer.
Author
Sonjai Kumar
Vice President (Business Risk) | Aviva India, Aviva Towers, Sector Road,
Opp. DLF Golf Club, Sec -43, Gurgaon – 122003
D: +91-(0)124-2709133 | M: +91-9810389622, +91-9971529922
E: [email protected]
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