MANAGER

An IIMA, IIMB and IIMC Initiative | JAN 2010

MONEY

Enhancing Value in Uncertain Times

INSIDE Lessons in Risk Management Prof. Datar, Harvard Business School Markets 2.0 - e Changing Face of Finance Mr. Ranodeb Roy, MD, Morgan Stanley Regulating the New Normal Prof. Jones, Columbia Business School

Risk Management

THE

FROM THE EDITORS DESK

JAN 2010

MONEY MANAGER

From The Editors Desk

Its natural for human beings to want to swim with the tide. A risk manager has to swim against it. The formal study of risk management began over three hundred years ago but never before has the discipline been thrust so squarely onto centre-stage. Its techniques, methodology and rationale is being exposed to intense public scrutiny with its very existence being called into question by increasingly shrill voices that are backed by impressive reputations. Having witnessed possibly the most severe economic crisis since the Great Depression, it is natural to ask if sound risk management practices could have mitigated or even staved off the upheavals in the financial system that have spilled over to the real economy. As a tremulous recovery cautiously takes hold, Money Manager 7 looks ahead and examines if managing risk intelligently can have strategic implications beyond mere survival can it be used as a competitive weapon to render a sustainable, value-creating advantage? Interviews conducted with distinguished personalities from eminent business schools and reputed global financial institutions throw up interesting insights on the shortfalls of both risk management models and the users who relied blindly on them. They highlight the role and response of regulatory authorities and their thoughts on the evolution of risk management systems in the aftermath of this crisis. The student articles are exceptional in their range of coverage and clarity of analysis. From aligning executive compensation with risk management systems to the impact of cognitive biases, covering a wide swath from financial markets to private equity they present a panoply of perspectives and possibilities on the topic at hand. On behalf of the Money Manager team, I would like to express our deepest gratitude to the eminent luminaries who provided their ideas and perspectives on this topic, the distinguished faculty who kindly agreed to judge the student entries and our sponsors of this edition, Brics Securities and Gujarat Alkalies and Chemicals Limited. As Money Manager completes seven successful editions, we thank you, our discerning and eversupportive readers, for the encouragement and succour you have provided us. We hope that this issue lives up to the high standard you have come to expect from us. Please send in your valuable feedback to beta@iimahd.ernet.in. Happy reading! Samrat Ashok Lal (IIM-A)

MONEY MANAGER

JAN 2010

ACKNOWLEDGEMENTS

Acknowledgements
The Money Manager team would like to express its deepest gratitude to the leading luminaries who shared their insights and ideas in the five thought-provoking interviews Prof. Srikant Datar from Harvard University, Mr. Ranodeb Roy, MD, Morgan Stanley, Prof. Charles Jones from Columbia Business School, Mr. Pradip Shah of IndAsia and Mr. Ridham Desai, MD, Morgan Stanley India. We are very grateful to the esteemed faculty of IIM Ahmedabad for judging the student entries, namely Professors Ajay Pandey, Joshy Jacob, Prem Chander and Sidharth Sinha who put in considerable time and effort into the rigorous multi-stage blind review article judging process. Wed like to thank our sponsors, Brics Securities (Principal Partner) and Gujarat Alkalies and Chemicals Ltd. (Associate Partner) for their support and encouragement. Their patronage has helped create a much richer and more visually appealing Money Manager, one that we hope the readers will enjoy. We were quite overwhelmed by the phenomenal response from the student community across the country the broad range of topics covered and analytical depth of the articles was extraordinary. A big thank you to all those who sent in articles for this issue we hope to have your continued support in forthcoming editions as well. Last, but by no means least, wed like to thank you, our readers, whose unstinting support has helped the Money Manager grow to the national presence it enjoys today. We hope you will enjoy reading this edition as much as we enjoyed putting it together!

THE MONEY MANAGER

Editor-in-Chief Samrat Ashok Lal Editorial Board Amit Mittal Harsh Bhimani Corporate Communications Nisseem Nabar Parijat Banerjee Coordinating Committee Mohit Gupta Himanshu Sharma Neha Gupta (IIMB) Rahul Bajaj (IIMB) Shishir Kumar Agarwal (IIMC) Jaykumar Doshi (IIMC) Design Avik Ghosh Logistics Pankaj Taneja G Vinamra Feedback/ Queries beta@iimahd.ernet.in

JAN 2010

MONEY MANAGER

Contents
Expert Opinions
2 7 9 Lessons in Risk Management Prof. Srikant Datar (HBS) Markets 2.0: The Changing face of Finance Mr. Ranodeb Roy Regulating the New Normal Prof. Charles Jones (CBS)

13 A Private Equity Perspective Mr. Pradip Shah 16 Risk: An Equity Strategists View Mr. Ridham Desai

Student Articles
22 Analysis of Credit Risk Models 27 A Review of Complex Securities Modeling, Assumptions in modeling and Risks 32 Risk Management Framework An Insight 38 Can EVT & VaR prepare us for a financial crisis? 42 Risk Management in Private Equity 48 High Risk, High Reward A Review of Changing Currents on Executive Compensation 53 Money, Money everywhere Not a Penny to Spare 59 Impact of Cognitive Biases on Effective Risk Management

MONEY MANAGER

JAN 2010

PREFACE

Preface
The Money Manager was started with an aim to collect the views of students, practitioners and academicians on the current developments and most relevant issues in finance. Its stated objective was to provide a platform for management students to express their views on all areas of finance from private equity to capital markets, corporate finance to insurance. The Money Manager is not a research journal; rather, it is a collection of interesting and current ideas in finance. It is the first of its kind, a joint endeavour of the finance clubs of IIM Ahmedabad, Bangalore and Calcutta. To provide not just an Indian perspective, but a truly global one, we try and get contributions from professionals and academicians from across the world. Interviews with professors in world-renowned institutes and practitioners in the highest echelons of the world of finance feature in the pages that follow. Student articles are solicited from reputed institutions around the world. The articles are then screened for originality and then judged by an elite panel of professors from IIM A, B and C. The winning articles are tested on originality, depth of analysis, relevance of topic and presentation style. We hope to include eminent industry persons in the panel of judges for future editions. Six editions of the Money Manager have been published and we hope to continue to provide relevant and thought -provoking articles to read for anyone who is interested in finance. To enable the Money Manager to reach an even wider audience, it will be available for download online. All current and past editions are available on our websites, including http://stdwww.iimahd.ernet.in/beta, the website of Beta, the Finance Club of IIM Ahmedabad. These will be updated regularly, so do keep checking in! -The Finance Clubs of IIM - A,B & C

COVER STORY

JAN 2010

MONEY MANAGER

Cover Story - Lessons in Risk Management

An interview with Prof. Srikant M. Datar
Srikant M. Datar is the Arthur Lowes Dickinson Professor of Accounting at Harvard University. A graduate with distinction from the University of Bombay, he received gold medals upon graduation from the Indian Institute of Management, Ahmedabad, and the Institute of Cost and Works Accountants of India. A Chartered Accountant, he holds two masters degrees and a Ph.D. from Stanford University. Talking about the current risk management models, how they may have contributed to the crisis, and whether they may help in moving out of it. What are your thoughts on that? Risk management models made assumptions about lending risk based on historical data, leading to very different perceptions and evaluation of risk regarding subprime borrowers. Im referring to risk evaluation with respect to different tranches of the CDOs and CMOs that were produced after the initial amount of debt was taken. Clearly, the risk management models showed risk to be a lot less than it was later proved to be. The first kind of risk I was talking about was at the level of the individual entity. There is a also second element of risk that is perhaps different and needs to be looked into - i.e. systemic risk. The systemic risk is much more a regulatory issue the too big to fail dilemma, counterparty risk affecting the system as a whole etc. Where risk management might have failed is at the level of the system as a whole, and clearly some of the regulations will be targeted at correcting this systemic risk. It seems that the failure of rating agencies to capture this risk in their ratings was a contributing factor for the crisis. So, why have they been let off the hook? Do their compensation structures contain perverse incentives? One possible reason that there has not been too much public scrutiny is that there has been no bailout needed for them, no public funds propping them up. They didnt actually take any counterparty risk. Unlike AIG, they have not needed a federal rescue. But there is no doubt that there was a clear failure on the part of rating agencies. Their assessment of risk focused primarily at the individual level and largely ignored the systemic risks I spoke about. There is some debate about their compensation structure as well. As you know there are just a couple of big ratings agencies. Were they independent, cynical or critical enough? There is a fear that clients may have chosen the higher rating perverse incentives indeed! My belief is that there were problems in the way the models were applied, though perverse incentives might have played a role too. Some big banks are now making huge quarterly profits. But there is also a rising fear that these profits are coming out of their trading operations as they are taking more and more risk. Their VaR has been rising. Do you think that the rising VaR is justified given that the profits are rising? Unfortunately I havent studied it that carefully. From what has been written, and given the state

MONEY MANAGER

JAN 2010

COVER STORY

of the economy, there is no question a major chunk of the profits are indeed through trading. More generally I should say that even the VaR models suffer from the same set of issues. They look at a certain set of contingencies over a certain period of time and they dont take into account the systemic issues. The way derivatives are accounted for in books of banks and other corporations, there has been a lot of difficulty in valuing them particularly when there is a liquidity crisis. What are your views on MTM of derivatives? It is tough to assess what the trade-off might be. When the market itself is not operating well, especially in a liquidity crisis, the market price might be artificially low. But to be fair, at least this is some objective value which may be better than the book value which is clearly wrong. Another issue with MTM is that when markdowns flow into the income statement, they begin to affect the retained earnings and any kind of capital requirement numbers that banks need to maintain. These requirements arent just accounting numbers they have some real economy implications. Currently, some requirements have been suspended because artificially low prices will cause more problems for the system, like freezing up of the credit markets. I think that going ahead, we will end up making some kind of long term assessment of the value of these derivatives. Though the benefits of MTM might be overshadowed in situations of panic and stress, one cant go straight to the book value because that is not correctly the right value. The long term value is obviously a very hard number to determine and whether the models themselves do a good job of it is another issue. There are really no good choices here. But I somehow doubt that the MTM approach will survive the crisis given how much problems it caused in the credit world.

How do you see management accounting and control adding to the strategic risk management of a company? How can it evolve to prevent or reduce the probability of such a crisis recurring? Risk management (RM) models are actually well-directed to thinking about operational or enterprise RM because they both end up having an impact on the total risk that a corporate can bear. There are 3 basic things that are going on right now all of which seem to work in a good way:

Source - Image: slayerphoto, Creative Commons, Flickr

First is that more and more corporate governance practices are taking a look at risk in and of itself. So anytime a company is making decisions you are always managing risk and return but given what has happened now is that the focus is more on risk and you are hearing more and more about Chief Risk Officer and systems like that because it has become a prominent role. Identifying all the risks that a company faces is difficult since they can be all over the place! Second is to calculate the probability of the risk and ways and means by which it can be mitigated or managed. These companies are going for much better management control systems where the person

COVER STORY

JAN 2010

MONEY MANAGER

who actually makes the decision assesses the risk. The third level where I see a lot of the internal audit departments moving is what role the internal auditor plays in managing the risk. So if I were to broadly summarize, one should think about the corporate governance mechanism for handling the risk, make sure the operating managers pay attention to it just as they do to the benefits of their decisions, think about specific risk management functions and make sure that it ties in to the internal audit system. There is a need to go beyond just the risk modeling part to actual strategic risk management. Coming to a question about the shape of the recovery - this is something which has been speculated a lot about. What shape do you think it will take? With the Fed holding rates low, what do you think can be done further? There are as many views on this as the people you ask. From everything I have read and experienced, it depends on what aspect of the recovery you are talking about. If you are talking about just the technical definition of when the recession ends, I would imagine that would happen sometime next year (2010). The biggest concern is to ensure that we begin to see GDP growth as soon as possible, and leaders across the world are coordinating in this regard. So by that standard definition, the recovery should be somewhat fast. However the other, perhaps more important question is regarding unemployment. Most forecasts that I have seen suggest that by that standard it would be a lot longer. No one is anticipating big changes in employment in the coming year. Whether this is a 2 year or 3 year problem, one doesnt know. There is no doubt in my mind that GDP growth will occur before employment growth. We have already seen that in other recessions. This will be true for this recession as well and perhaps

even more lagged. To me the unemployment question is a very big concern. Regarding the steps that the Fed should take, firstly do you think the Fed would be looking at exit strategies in near future and secondly if this were to happen, what would be its impact on US economy and world economy as a whole? Do you think that the recovery that we are witnessing is real or is it primarily due to government infused liquidity? There is no doubt that the recovery is aided significantly by government provided liquidity, especially early on, but now there is also a real recovery underway. There is no rush for the Fed to look at exit strategies because from the perspective of society, things like unemployment matter a whole lot. At this point you dont want to pull out so fast that it stalls everything. My prediction is that the Fed will be extremely careful when they do this, so Im not too worried about a premature exit. Another burning issue is the compensation at major banks. Is the government going to do anything proactively, and is this also a huge corporate governance issue? This is a very tricky question because the performance is there and all indications are that unless banks act voluntarily, bonuses will be paid. But I wouldnt discount voluntary action. Most of the senior partners at some of these firms didnt take bonuses last year when they could have. I think that there will be a lot of care and caution. Some of these firms like Goldman have just announced a $500 Mn donation in terms of helping people with various trainings. There is already a lot of public outcry against these bonuses, because even repayment of TARP funds might not absolve them of the moral obligation not to pay out the bonuses. The preferred solution, according to me, will be to have a voluntary moratorium on it than to take legal recourse. There is a certain amount of visibility that goes with payment of bonuses to very senior people and I somehow suspect they will be more muted and toned down. 4

MONEY MANAGER

JAN 2010

COVER STORY

Sir, what are your views on the Indian Banking system? I don't follow the Indian Banking system too closely, but all I have read and discussed suggests that thankfully its not over-regulated in terms of how risk is managed. There is a feeling in some quarters that even if there was over-regulation, it protected Indian banks from the issues that their Western counterparts faced. There is no doubt that Indian banks are currently on a much stronger footing. Right or wrong, the controls imposed on Indian banks by the regulators have to a large extent prevented them from crashing in this crisis. Are there lessons to be learnt from Indian Banking sector for the US or the UK? There is a balance between risk and innovation that always needs to be struck because people are very innovative and unless you know how they are going to innovate, it is hard to figure out how you are going to regulate. For sure this idea about targeting systemic risk is going to be a big deal. A question still remains about the moral hazard problem. Some people are critical that had Lehman been saved, a lot of this could have been avoided. Moral hazard associated with too big to fail and risks that people take means that some form of regulation targeted at systematic risk, I think, will come. Now whether it will be as strict as RBI does in India or not, whether there are ways to get the balance better, only time will tell. There are interesting ideas about making explicit upfront the amount that the Fed is willing to put in, so that it does not remain a blank cheque. Regulators could also try to get into the banks before they go bankrupt, a sort of pre-emptive measure. All this is in addition to the proposal that banks

themselves will set up a fund so that tax payers dont have to put in money every time one of these crises occurs. Broadly speaking, if the system targets systemic risk, is explicit, worries about trade-off between long term risk curtailment and innovation, it will be right. Whether there will be an attempt to re-impose the distinction between commercial and investment banks remains to be seen. Regulations moving somewhere from where we are right now towards where countries like India were, is probably likely. Finally, coming to operational risk management, our understanding is that its much more specific to industry than financial risk management. Are there any general principles that we can apply across industries in operational risk management specifically? Four points that I mentioned would be there (i) That you want to keep this as a separate function and it has a lot of prominence right from board level down. (ii) Matching of rewards and risk over a long term. If risk is longer term and reward is shorter term, you run into problems. So trying to get that better matching in the minds of operating managers will force managers to consider correctly the risk and reward. (iii) Specific risk management functions be set up within companies. It can be in legal, accounting, fraud management, product liability, etc depending on the particular issue. This will be the second line of defense. (iv) And the third line of defense will be internal audit - making sure that internal audit function evolves from pure internal audit to also evaluators of how well risk management is being done. I think these four points will generally apply to different companies. Their exact form and structure will depend upon the specific industry.
Compiled by: Parijat Banerjee, Anurag Gupta & Sanjay Vasudevan

JAN 2010

MONEY MANAGER

Know your risk model

Gaussian Copula
Gauss-copula approach had been one of the most popular approaches for calculating correlations in asset classes till the crisis happened. The co-relations derived were extensively used to value credit derivatives especially CDOs, CDO squares and CDS which came under Quant models have come under criticism from all quarters for having caused the crisis. Gaussian-copula model, developed by David X. Li, has been amongst the most criticized models. Some people have gone to the extent of calling it a recipe of disaster (Salmon, 2009).

securities (Li, 2000). After having arrived at the hazard function of each of the securities in a portfolio the next step is to determine a copula function which is a joint multivariate distribution of default. Various copula functions are commonly used viz. Frank Copula, Bivariate Normal etc. The appropriate function is chosen depending on which function fits best to the data. Once the joint distribution is determined, an implied correlation can easily be calculated.

Criticism
The Gaussian Copula approach has come under tremendous criticism from all quarters. It had been used for determining default-correlations of the underlying assets in credit derivatives. The rating agencies using these models had given high rating to tranches which became virtually worthless during the crisis (Salmon, 2009).

What is it?
In his model, Li introduced a new random variable called time-until-default. Further the co-relation between the time-until- default for various assets was studied (Li, 2000). Before Li introduced his approach, analysts used models which calculated default correlations using discrete time models. Further, these models used data at an interval of one year. Li argued that discrete time model couldnt be as accurate as the continuous time models. Also, he argued that the choice of time period (one year in most cases) is completely arbitrary (Li, 2000). To understand this point it is important to appreciate that defaults are time dependent events. While the probability of default on the following day for a given bond may be zero, it is much higher for one decade. Therefore, while default correlations calculated for two bonds (one of them which is safe and another which is junk) may be very high if we take a 100 year horizon (where we may expect a default event for even the safest of the issuers), they would be lower if we took a smaller horizon. In the Gaussian Copula approach, the first step is to estimate the survival probabilities of the securities whose correlation we want to estimate. These survival probabilities can be used to determine the distribution of time-until-default. The distribution is mathematically related to the hazard function, which represents the probability of default of a security in the immediate future given that it has survived until now. Hazard function is easy to measure using implied default rates from the current market prices of the

Is the model really at fault?

Like any model Gaussian Copula model is far from being perfect. It cannot with certainty predict default correlations. Also, the output which the model gives is completely dependent on the inputs to the model. Securitization of mortgages is a fairly recent phenomenon. We do not have enough data to input to the model. The input given to the model by most analysts was the recent data which didnt reflect true correlation (In defence of Gaussian Copula, 2009). Given the input data, the model was bound to underestimate the default correlation. The data available from the crisis, in a sense solves the problem of lack of data. Along with this, if the incentive structures at rating agencies are improved to encourage analysts to use appropriate inputs, the model can prove to be very useful.

Works Cited
In defence of Gaussian Copula. (2009, April 29). The Economist . Li, D. X. (2000). On Default Correlation: A Copula Function Approach. Risk Metrics Group - Working Paper . Salmon, F. (2009, february 23). Recipe for Disaster: The Formula That Killed Wall Street. Retrieved 12 28, 2009, from Wired Magazine: http://www.wired.com/techbiz/it/ magazine/17-03/wp_quant?currentPage=all

Himanshu Sharma, IIM Ahmedabad 6

MONEY MANAGER

JAN 2010

EXPERT OPINION

Markets 2.0: The Changing Face of Finance

An interview with Mr. Ranodeb Roy
Mr. Ranodeb Roy is Managing Director, Head of Interest Rate Currency Credit Asia Pacific in Morgan Stanley. He is member of the firms Asia Executive Committee and Interest Rate Currency Credit Operating Committee. Prior to joining Morgan Stanley he worked at the FICC group in Merrill Lynch in Hong Kong, New York and Tokyo. He has also worked at Barclays, Peregrine and Bank of America. An alumnus of IIM Ahmedabad, he has a degree in Computer Science and Engineering from IIT Kanpur.

Regulations and guidelines like Basel II or the Sarbanes-Oxley Act, have made companies more aware of the importance of risk management over the past few years. Do you see that as enough from a regulations perspective, or do you think that the fresh round of regulations being talked about is warranted? Regulation targeted at plugging loop holes will be welcome as long as it is ultimately directed to help investors, retail and taxpayers. While over regulation may often stifle growth, we need to be cognizant that this time around regulators may well err on the side of conservativeness. In the aftermath of the credit crisis do you think there should be changes made to the way banks manage liquidity and the asset mix on their balance sheets? Yes, absolutely. Liquidity management should be dependent on asset-liability mismatches. (The assumption that trading positions have very short durations proved costly to some organizations.) This will lead to reduced leverage, higher requirements of excess liquidity and more conservative balance sheet management. The asset mix of banks will immediately shift to the more liquid end of the

spectrum and the various illiquid risks (private equity, distressed, real estate) will find an appropriate home, out of bank balance sheets and into dedicated, locked up, longer duration funds. During this crisis, mark-to-market accounting amplified price gapping and volatility among illiquid securities resulting in market losses which might not ultimately materialize. What are your views on mark to market accounting, and the regulators views on the same? Mark-to-market accounting is here to stay. I think regulators think the same way. In fact, financial institutions are moving to marking both the asset and liability side of their balance sheet. What innovations in the field of risk management do you expect from the community in response to the crisis? We can expect further refinement of VaR (value at risk), cost of capital allocation, the evaluation of tail risk scenarios, and compensation structures. Recently there have been calls for a superregulator, a kind of a global risk manager

EXPERT OPINION

JAN 2010

MONEY MANAGER

which can prevent such crisis in the future. Do you think this is feasible? This may happen, but crises may still emerge. The global markets seem to be thinking that we are through with the crisis and caution is being thrown to the winds. Is it being overoptimistic? Yes, probably. The basic cause of this crisis is not over yet. The government have prevented a collapse of the financial system, but idiosyncratic defaults, high unemployment and the process of deleveraging will continue for some time. Dubai has some $80 billion of debt. We have seen what happened to Iceland. Do you really think that the world is better prepared for what has happened in Dubai? The world is never prepared for large defaults. Some of Dubai Worlds subsidiary debt was trading above par before Dubais announcement of a stand still agreement. A few days later (today) it is trading at 60. So the world is not prepared for it. Do you think debt markets in India would go on to further improve equity markets? Will they have some crossover from debt to equity? The equity markets are quite well developed and liquid but we dont have a well functioning corporate debt market. Yes. Debt and equity are a continuum of the same balance sheet. One will improve the other. Cross cover products like CBs/warrants exist and will develop further. The government debt market in India is well developed and the corporate debt market is improving every year. Have you seen clients looking for more sophisticated and structured profiles? Is it

time in India for more complex products or do you see people shying away from them saying these are what caused the crisis? Every crisis leads to investors shunning complex products for some time. Complexity increases as normal returns fall. This leads to structures that have hidden or added leverage. This will return as returns fall for an extended period and investors stretch for yield. There is nothing wrong with sophisticated and complex products as long as it is for suitable investors and they know what risks they are getting into. If you take no risk, one will get return similar to zero risk products (government bond yields). To state the obvious, if an investor is getting a better return, there are added risks he is taking on. What are your views on how RBI is going to deal with credit flows or inflation which a lot of people are now fearing? One of RBIs stated objective is inflation control. I am sure they will be proactive about it and balance the need for growth with control of inflation. The global markets are currently marked by instability and uncertainty. What risks does this pose for globally operating financial service providers? The risks are threefold: re-leveraging too early; assuming the crisis is over; and going back to its old way of lax risk management. What would be your advice to students like us who are soon going to be a part of the corporate world? Do they need to learn different things or do they need to learn things differently? Both. Every crisis is a learning opportunity. I learnt a lot from the 1997-98 Asia crisis and the 2007-09 Subprime crisis.
Compiled by: G Vinamra & Anindya Dutta

MONEY MANAGER

JAN 2010

SPECIAL FEATURE

Regulating the New Normal

An interview with Prof. Charles Jones
Prof. Charles Jones is the Robert W. Lear Professor of Finance and Economics. He is also the Chair of the Finance and Economics Division, Columbia Business School, New York. He holds a S.B. (Mathematics)from the Massachusetts Institute of Technology and a PhD from the University of Michigan. His areas of expertise include the structure of securities markets, liquidity, and trading costs. He is noted for his research on short sales and for recent work on why liquidity varies over time. There have been many cycles you must have witnessed during your career. What is the difference in the attitude towards risk managers in the various stages of the cycle? At the top of the cycle, risk managers are kept out of the meetings, are ignored and their role is minimized. But now risk managers are at the front and centre but pretty soon every one focuses on short term profits and those can generally be higher when you ignore the risk managers. What is the reason, according to you, that people do not learn from their mistakes? I dont think that they are not learning. I think the incentives are there to marginalize the learning. What is your opinion on risk management measures in banks and going forward what are your suggestions? There is a real question right now whether value of risk was working right and whether some of these models, like Gaussian-Copula etc., which the people use to do the modeling were right and appropriate. In the terms of models, I think the models were fine - it was just that the inputs were wrong. Basically we were looking at too short a history. It was a history of pretty much a boom period and the banks did not incorporate much of a down scenario in their distributions. Do you consider that the people who were using these models really did not understand these models. They were looking at VaR and model outputs without understanding what each of these measures represented and what it did not? I think it is right. I think very few people really understand what risk actually means and in particular people dont appreciate that 1% of time or maybe 5% of time it could be worse than what your model tells you and infact you dont even know how much worse than that it is going to be. So what are your suggestions going forward to this? Well in terms of our data, now we have a pretty big down scenario so that problem in some sense solves itself as now people have tail realization and they will use that in forming inputs to their models. This problem is solved. Regarding values at risk make sense going forward-I think the same kind of thing is true. Now we have a pretty big and extreme event to bake in and as long as people take these events into account, they are probably going to get much more reasonable answers from their risk management models. I still think we have the problem that people dont understand what these numbers mean. I dont really see that particular problem solving anytime soon, nor do I have a

SPECIAL FEATURE

JAN 2010

MONEY MANAGER

good proposal for something good to be used instead. Given the fact that there is a lot of talk going about the role of banks in the society being very large, do you think banks should have a proprietary trading desk or should we leave it to the hedge funds to do it? Well I would love to say that cut out the prop trading and these investment banks could just be advisory firms or underwriting firms but the problem is you can never really draw the line. See we can never cut off all their prop trading but we can put limits. Prop-trading is a fairly recent development. If you go back 20 years you would see all these banks had much smaller balance sheets and they took much smaller trading positions and those were mostly related to market making or positioning rather than long term bets. I think we can go back to that with vigorous regulation and bank oversight. These guys are under the Fed now and we can have the Fed take them back to the period where we had much less dangerous balance sheets. Regulations like Basel-II and Sarbanes Oxley Act have made companies more aware of the importance of risk management, do you see them enough from the regulations perspective or fresh rounds of regulations being talked about is warranted? I think we need more direct regulations; we need something more than the models to say to companies that you guys need to have less on the balance sheet. Your research focuses a lot on short selling. Do you have any specific example of regulations in that domain that would help manage risk better? As a risk management tool in short selling, one of the things happening is that we are in the process of making it much more difficult to do what is called as naked short selling (i.e. shorting without actually borrowing the securities and delivering them). The penalty for that is going up and I think that is a good thing. 10

Shorting is really a contract and if you do not deliver the shares you promised you are breaking the contract. People are taking advantage of the wiggle room which is not very obvious when you think of all those companies like clearing houses. I feel that such a regulation enforcing the performance of contracts is an example of good regulation.

The recovery rate in unemployment is troubling the Fed, so do you think there is need of another kind of stimulus right now? We are certainly doing what we can do in terms of monetary policy. The quantitative easing is having some impact. But I think we have not seen the full effect of stimulus so far mainly because a lot of things we were spending on have a longer lead time. I think we are going to see a lot more effect on the money we have already spent so another stimulus package in my opinion is not needed. Right now we see all the assets classes having a good run in the short term (except the dollar). What do you think is the next hot assets class? Is it going to be TIPS or gold to protect against inflation or equities? I think gold has already has it run so I dont see it having a good boost. I am not sure and if I were I should not be teaching! As of now I see most of the things fully valued so I dont see a lot of opportunities. I guess currently stay away from dollar denominated assets and concentrate on other currencies.

MONEY MANAGER

JAN 2010

SPECIAL FEATURE

How pro cyclical is the risk management in the modern day financial systems? Well certainly in this last cycle it ended up being incredibly cyclical because of the short term memory feature. I am hoping thats the one thing we will fix this time around. So do you think there needs to be changes made on how banks manage their liquidity and assets mix on their balance sheet? Absolutely, because even though there was securitization a lot of these people were exposed to assets even in the form of residuals or

true in general. A bunch of people bought CDOs based on the rating they got from the rating agencies and not understanding the full range of conflict of interests present for these rating agencies. We can never fix it as Wall Street originators or the sellers are always going to know more about whats inside this black box than the buyers going to know. Hopefully this will teach the buyers lesson that they need to be a little more sceptical of whats beings sold. Credit Suisse raised debt without using rating agencies and the debt getting reasonably priced. Do you think that this may become a trend and rating agencies can now not take their job for granted? I dont think that companies have the necessary kind of resources to perform this job and they will outsource it to the rating agencies hence we I cannot see rating agencies going, although we might see more competition for Moodys or S&P from rating agencies having less tainted reputation. There is a natural role for such information intermediaries. Hence I think that the Credit Suisse thing was just an aberration.

Source - Image: Logan Ingalls, Creative Commons, Flickr

servicing and a lot of assets that they pushed out through SIV (structured investment vehicles) ended up coming back to their balance sheet. I think that there was a lot more risk than people actually thought and that is something that the regulators will need to seriously look into. There are many cases which elucidate that, during the sale of any financial instrument investors are misinformed about the risks. For example if you look into auction rate securities many investors claim to have been told that these were sold to them as cash equivalents. So do you think this also plays a part in forming the assets bubble as investors are not fully informed? I think thats right and I think some of these securities were misadvertised but I think thats

Do you think it is prudent to break the bank into smaller institutions so that nothing is ever big enough to fail from a risk management perspective? You have to do something to control the systemic risks so we talked about limiting the balance sheets based on the amount of prop trading these banks can do, or charging tax based on the amount of systemic risks or we can break them up. I dont like the idea of breaking them up because I feel that would be awfully arbitrary. But if we cant figure out ways of managing risks in other ways or the amount of tax to be charged or how to limit the balance sheet, then we might have to consider this. The crisis also presents a big behavioural risk. When the retail investors see a crisis coming they go awry and they move the market like anything. Do you think there is any fix for that?

11

SPECIAL FEATURE

JAN 2010

MONEY MANAGER

I dont know whether you can encourage them to take more risks because at the moment they have a lot of money deposits in the bank or in treasuries and that might be creating a bubble in treasuries. But I dont know how you make that go away because this is just a natural cycle of things and this is the reason why a lot of investors will underperform in the long run because they will be doing the wrong thing at the exact wrong time and hence they actually deserve it. So anything that we can do that helps that maintain their discipline like not liquidating all their equities or other rules of investing will be good but I dont see what you can do other than encouraging people. There has been talk of a new regulatory body and taking back the powers of Fed. What are your views on that? Well it is a question of how you go about national regulation. I happen to think that the Fed would make a very good national regulator for both banks and financial systems. I understand that people have different views on this and I certainly think that the Fed will have to open up if it wants to be the overall regulator. It cannot be as private and as off the balance sheet as it has been in the past and I am not sure whether the Fed is ready to for that kind of transparency and they seem to be fighting it tooth and nail. What are your views on central clearing houses and exchange traded derivatives as opposed to OTC trading?

I think we absolutely need a central clearing on those because that is the way to get the handle on counter party risks and to have a collateral management that makes sense. I dont think we need exchange trading as it would make sense if we feel that these contracts can be standardized enough and will benefit in terms of liquidity from being commoditized. While I think that it would be true for some of the standard interest swaps and for some of the basket CDS, the effect will be limited in general. We should not mandate it and let the market figure out whether it needs exchange trading. Has the constant basis CDS trading created any material impact on trading or on the companies? I think it has helped liquidity somewhat because basically it helps in standardizing the contract and also it makes a lot easier to get out of whatever CDS contract you got into. I think its a modest change and central clearing will bring a much bigger change. What is your advice to students going to work in financial institutions as there is always this temptation to taking short term risks which are often unwarranted? Well I think people who are generally more about institution or who think more broadly about their self interest get recognised. People will notice it and I think thats a good way to move up the ladder and will probably be rewarded at most places.
Compiled by: Himanshu Sharma & Harsh Gupta

12

MONEY MANAGER

JAN 2010

EXPERT OPINION

A Private Equity Perspective

An interview with Mr. Pradip Shah
Mr. Pradip P Shah started IndAsia, a corporate finance and private equity advisory business, in April 1998. IndAsia entered into a joint venture with AMP in 2001 for the private equity business in India. Prior to starting IndAsia, he was the founder Managing Director of The Credit Rating Information Services of India Limited (CRISIL) and assisted in founding HDFC in 1977. Mr. Shah has also served as a consultant to USAID, the World Bank and the Asian Development Bank. Mr. Shah holds an MBA from Harvard Business School and a Bachelor of Commerce degree from Sydenham College, Bombay and is a qualified Chartered Accountant and Cost Accountant. We have seen a lot of talk about risk management in the financial sector. As far as private equity goes, are the risk management techniques in private equity very unique to it. What are the kind of risk management practices you would follow? Whether it is private equity or not, no investor likes to take risks. Private equity likes its investing companies be it manufacturing sector, services sector, financial sector or agricultural sector to reduce risks wherever it is possible. If you are a fund, there are risk reduction approaches that are unique to you. For example, take a fund that invests in only sports. This fund will have a much higher risk than a fund investing across multiple sectors. Correct, because of diversification. It depends on what your objectives are. If your objective is to invest within the sports business, you can still try to reduce the risk. For example, in the sports sector you do not fully invest in football. One reason may be football is played in small leagues, it is not global, whatever may be the reason and so I decide not to invest only in football. I will thus also invest in sports like cricket, ice hockey, sports related to American football etc. In the end I will have diversification across geographies and of customer base, 13 therefore diversification of revenue sources. For example, London is cold in the winter and people may not be able to play cricket there but they can still play cricket in India. Therefore, this kind of portfolio risk assessment has to be done. Now a broader private equity fund like a leveraged buyout fund where there is debt and equity may have to take a different view. You may have to have a construct where the investments start yielding cash flows. You cannot just invest in growth capital where you invest something and then it takes some time for the investing company to build assets and generate returns; so the returns start flowing in later. This kind of a fund needs to have regular cash flows to service the debt. A better way to approach this whole risk management is to see different approaches to risk. First and foremost a business needs to decide what risks to take. If you do nothing and take no risk, then you can only invest in government securities or low return investments. So you need to decide what risk you want to take and then within that maximize your possibility of return with minimal variability of return. Markowitzs portfolio theory tells us that

EXPERT OPINION

JAN 2010

MONEY MANAGER

there are always trade-offs out of diversification, but these are the trade-offs one has to deal with. Sir, given that the private equity firms will be investing in firms that are private or will be taken private; given that the market is not valuing these firms, what kind of risk mitigation techniques would you use and do you see more risk in the investments you make? As I said, risk mitigation is at the portfolio level and the other is at the company level. At the portfolio level, you want to have a diversified portfolio even if you are within a sector. Say, I will invest no more than 20% in football and 20% in cricket. Secondly, you can have allocation across individual companies. I will not invest more than 10% in any single company. You will also have allocation across geographies. For example, you may have a Banana Republic game that you may be investing in and there are riots in the place, there is a major upheaval and then there are no matches held there. So, you decide that you will not invest more than 25% in any single country. You develop rules to act on this philosophy of mitigating risk and acting on the philosophy of diversifying your portfolio; so that is first at the portfolio level. So, you want to have in your portfolio as much as possible of projects that have a high degree of negative correlation within themselves. And then you may have currency overlay for example your investors may invest in dollars and you invest in rupees for instance. You may want to invest more or a certain portion in industries in export oriented industries, since if the dollar appreciates and the rupee depreciates you may lose out and dont forget that you are investing on behalf of the investor. There are currency risk mitigation strategies. The simplest is this kind of a natural hedge. But there are other instruments to hedge this risk. Ill read out a quote from an old Daimler Benz 1994 annual report that I found, Because of the persistent weakness of major currencies against 14

the Deutsche mark, the company undertook foreign exchange hedging transactions but since this was not seen as enough protection, the company decided to become independent to such incalculable currency related factors by shifting production activity to other countries. So, not only did they make adjustments on the basis of hedging and derivatives, but also operating decisions. There is no single answer to currency requirements. It is just that derivatives arent good enough. If you are a private equity investor, you have a long term investment potential; you may want to have more of operating strategies. In other situations, parallel loans are taken. Let us say you are a global private equity fund reporting in dollars and you want to invest in a depreciating currency you might take a loan in the local currency but give a parallel loan in the depreciating currency. Just take the example of the Vietnam dong which just got devalued. Some of my private equity funds were also investing in Vietnam, so I give a guarantee to the bank of Vietnam here in India and take a loan in Vietnam. So, there is a parallel loan arrangement but there is a hedge in this. At company level again, you would do things like import financing, lagging/leading or foreign currency liabilities or exposures and so on. Sir, at the company level can you tell us more about the operational risk management measures that you would take because I understand that those are very critical at the company level. Private equity is just one little part of the business. Let us see how a business should address risk. For instance you have so many firms dependent on commodities like Sterlite, Tata Steel. People have used various strategies for mitigating commodity risk. I can give you a classic illustration of how people do it. There was a company called Sunshine Mining. It was one of the largest silver companies in the world.

MONEY MANAGER

JAN 2010

EXPERT OPINION

Now, they issued silver backed bonds denominated in dollars for ounces of silver. Now, when they issued, the prevailing price of silver was low. They had silver stock available. This way they sold the future output of silver effectively. They gave the option of paying back in dollars or in ounces of silver. Now, who was buying from such a company? Not everyone wants this kind of risk. Basically an investor who was comfortable with an upside potential on the silver side would be the buyer in this kind of thing. So, the company got funds at an acceptable price in dollars and their liability was covered but they lost on the upside of the silver. Because if the silver price went up, the buyers would say that they want back their investments in ounces of silver rather than the dollars. So the buyer went in with the idea that he would get the upside on silver, the company went in with the idea that they would not get the upside on the silver but they would not face the downside on the dollar. So here is the situation where the risk is passed on. The commodity risk of silver is passed on. And you will see similar structures in case of exchangeable bonds when you borrow. Sir, you have given these examples, can you give other examples where risk management can actually create value? Sure. For instance, you lock yourself by investing in futures of gold, silver. That by itself is creating value. Lets say, Reliance is expecting to produce 50,000 barrels per day for the next few years out of the KG basin and it knows that oil is currently say $40 per barrel. Now, they want to lock their profits. What happens if the price goes down to $30? They will lose out. So let me hedge myself by selling oil forward. And the buyer is buying because he too wants to be locked into buying oil at that price. Take or pay contracts are of a similar kind. They are typically used for buying in the oil and gas sector because you cant store oil/gas. On the other side, if you are in the business of pipe

laying, you want a guy on the other side who is willing to buy even if he doesnt need it. So take or pay contracts are there to facilitate these kinds of transactions. For instance in Gujarat, Adani is the biggest producer of edible oil. What would their strategy be? They are buying oil seeds all the time. If they are of the mind that they dont want to take risk, they will sell the oil output that they produce every day. Sir, do you see that because of the current crisis, companies are going to change their risk mitigation/risk management strategies going forward? People have not explored all the operational opportunities. In operational, they have tried to cut down the fixed cost whether it is cutting down on interest, by selling off assets, by cutting off employees. These are some ways of doing it. But there may be other ways of doing it. For e.g. paper has gone down in price. Newspaper is going out of fashion because of electronic delivery of news. But at one time, NY Times used to be investing in a paper company because they were short of paper. So, if newspaper print prices went up, it would make money on its investments in the paper company. Thats the kind of hedge strategies people were following. You dont see those kinds of strategies in India. So, more focus of the operational risk mitigation strategies is what you see in India. India has not focused enough on operational risk mitigation strategies to address emerging challenges. Did you think of Tata Tea, Tata coffee as risk substitutes for instance? They were very big in tea so they started Tata coffee. Now, they are saying we will go into water also. These are all risk mitigation operational strategies. These are strategies not obvious to general people. But they work as risk mitigation strategies for the ultimate investor.

Compiled by: Mohit Gupta & Sahil Aggarwal

15

EXPERT OPINION

JAN 2010

MONEY MANAGER

Risk - An Equity Strategists View

An interview with Mr. Ridham Desai
Ridham Desai is the Chief India Equity Strategist for Morgan Stanley. He is a Managing Director and co-head of the firms institutional equity business in India. He joined Morgan Stanley in 1997 and was JM Morgan Stanley's Head of India Research before this. He also sits on the Board of Directors of JM Morgan Stanley Securities Pvt Ltd.

How do you think the financial crisis is going to affect the risk management practice in general? And how will the competitiveness of the banking industry be affected by it? There are two aspects of risk management. In my view risk is the variability of returns from the expected value. What the financial crisis did was that it basically exposed the banking sector in terms of the heavy exposure that the sector took and alerted both the sector and the regulator to the impact of variability in returns to the balance sheet. What drove the banking sector to its nadir was that it was running very high leverage and when one is running very high leverage even a slight deviation from expected returns can lead to heavy losses. So there is no tolerance to any deviation from the expected outcome. This is where I think there is going to be a sea change. Balance sheets will have to be built for greater tolerance for deviation from the expected outcome and there has to be more build-up for tail risk scenarios. The era of point forecasts or budgeting is out and scenario analysis is in. I think that is the big change that could come out of the financial crisis and it doesnt apply only to the banking sector. During the crisis, before and after, we saw a lot of tail events unfold, like in crude oil. It went up to $145 and a lot of companies which used crude oil derivatives and raw materials obviously suffered massive problems and they had not 16

built that in their budgets. Clearly now there will be much more focus on scenario analysis which will therefore build businesses more resilient to tail events. Would you say that risk management is procyclical and to what extent will it in some cases exacerbate the downturn? For example, we saw in 1987, portfolio protection which caused that crash because everybody started selling at the same time. I think the fundamental issue here is the assumptions which we make with respect to the outcome for variables. Most variables are assumed to be normally distributed and in real life very few variables follow that curve. That, I think is the failing. If you go back to the 1987 crisis it is a very good example of this. At that time everybody thought they were buying protection and the reason why they thought that they were buying protection was because they thought that the outcomes were under a normal distribution. They thought they knew the probability of tail events in advance whereas that is not the case because these variables especially stock market returns are definitely not distributed under a normal curve. And when they are not, you have to be careful of the way you make assumptions regarding the behaviour of the variable. There is to a certain extent misuse of statistical tools which leads to this

MONEY MANAGER

JAN 2010

EXPERT OPINION

problem. If you approach this in a little more informed way and use mathematical tools understanding their limitations, then I think we are likely to be more prepared for such extreme outcomes. I hope I have not prejudged but it appears that the world is slightly more prepared for what has happened in Dubai. Dubai has some $ 80 billion of debt. We have seen what happened to Iceland. Do you really think that the world is better prepared for what has happened in Dubai? I dont want to specifically comment on Dubai but I think the world has just come out of some tail events, memories are still fresh and when memories are fresh we are better prepared. Its like a terrorist attack. Immediately in the aftermath of a terrorist attack, the alertness, preparation, security, intelligence is on a high point and therefore the probability of another terrorist attack happening immediately is very low. It is usually a safe time to be venturing out and as time passes we lose memories and things come back to us. The reason why I would say the world is better prepared for Dubai is because it happened very quickly after the severe tail events of last year so the world should be better prepared. But as time goes by and memories fade, and a new generation comes to the forefront, people will forget and we will again get exposed. I think the mistake really is that the alertness drops and we end up making similar mistakes in our assumptions in respect of the behaviour of the variables and thats when things tend to blow up. The global markets seem to be thinking that we are through with the crisis and caution is being thrown to the winds. Is it being overoptimistic? No, I dont think that the consensus view is that the crisis is over. I think the consensus view is that the tail risk is behind us. The fundamental situation that we have to deal with is that the western world is overleveraged and must deleverage and it will take a lot of time to happen. They will have to increase their savings rate and 17

bring down their debt. The other way is the Keynesian way which is that you can inflate the debt away but that is not a path which administrators will seek. Their path will be to basically encourage more savings and therefore we may see lower growth in the western world for some time while that adjustment takes place. I dont think anybody believes that that adjustment is behind us. There is still a multiyear adjustment that western economy has to go through. What the markets have come to believe that the tail risk is behind us and very clearly the Dubai event will create some doubt in some peoples mind and I should mention not only the Dubai event because we have had four back to

Source - Image: Elembis, Creative Commons, Flickr

back events in a few days- capital controls in Taiwan, devaluation of currency in Vietnam, Greece in some sort of trouble apart from Dubai trying to reorganize its debt. Its not only the Dubai event which has spooked the markets. It has been a string of events that would probably cause some doubt that the tail risk is still not behind us. But in my mind that is the only assumption you can make with respect to the markets belief. I dont think that they believe we have come out of the systemic problem. I think those gloom days, of believing that we would see an end to capitalism and that there was no room for financial markets in the world, are definitely something of the past. Do you think debt markets in India would go on to further improve equity markets? Will they have some crossover from debt to

EXPERT OPINION

JAN 2010

MONEY MANAGER

equity? The equity markets are quite well developed and liquid but we dont have a corporate debt market. So will the development of a corporate debt market in turn help the equity market? Of course it will. The genesis of global financial markets is all around debt not around equity. 800 years ago when Italians started the first so called bank in the world it was to borrow money, it was not for partnerships, so it was the debt market which really created capital markets and it is the cornerstone of all markets. If you see most of the crisis was also created from the debt market not the equity market. Surely we need a much better debt market and if that happens, t ransmission of financi al

I think the balance sheet should reflect the true value of the business. There is a bit of judgment involved in that. If you apply the price of security which is thinly traded on a very large position in someones balance sheet and say that this is the mark to market value of the balance sheet then I think it may be a misstatement of the balance sheet because the objective of accounting is to present a conservative and fair picture. So even though on the face of it, it looks like a conservative picture, the reality is that that security might not be able to extract the market value. Human psychology is to simplify things. So we see that this is the price of the security and this is the quantity that we hold, so let us multiply the two and this is the value of the balance sheet. But real life is not as simple. We are torn between our desire for simplicity and our desire for accuracy and the middle road is where we would end up being on. There would be situations where mark-to-market works fine and there would be others where it wont work fine. So, individual judgment needs to be applied and not blanket rules. There would always be some unscrupulous operators who would take advantage of this to swindle people. So thats always the danger of allowing people to take their judgment. How effective do you think have the SEBI and RBI been in dealing with the crisis? I think the regulators in India have been exemplary and a lot of people I meet abroad cite the example of RBI and SEBI as regulators who have conducted themselves very well through the crisis. RBI did a wonderful job both pre and post crisis and you have to look at the document dating back to 2006 on how they went alerting the market to the impact that asset bubbles could have and how they were taking steps to shield the banking sector from asset bubbles which is why our banking sector came out virtually unscathed from the crisis. That credit goes completely to the central bank. Likewise, with SEBI, I think investors are generally very pleased with the way they have conducted themselves. So our regulators have done a really 18

Source - Image: mphaxise, Creative Commons, Flickr

intermediation in the country will go up a couple of notches. There are opinions which say Mark-tomarket accentuated the losses in the crisis. What are your views on that?

MONEY MANAGER

JAN 2010

EXPERT OPINION

fine job. What are your views on how RBI is going to deal with credit flows or inflation which a lot of people now fear? Our view is that the central bank will start tightening early next year. That is really in the nature of end of easing rather than tightening because the current policy rates reflect the crisis situation rather than normal cyclical downturn. So I think we are out of that crisis situation. So interest rates need to normalize and come back to levels which reflect normal cyclical downturn. And next year, I think the cycle will start turning up so there is a case for it to rise to keep inflation at bay and have an orderly growth cycle. Recently there have been calls for a superregulator, a kind of a global risk manager which can prevent such crisis in the future. Do you think this is feasible? No, I think it is very difficult; its not a practical solution. The nuances of each market are so complex and so distinct that it is very difficult for one single entity sitting in one place to monitor that. So I think we are best left with local regulations. What we can do is have more interactions. Regulators should interact and share more information with each other so that they get alerted to any possible event. But ultimately you are dealing with market forces and they usually come unannounced. Yes regulators play a role but it is not an easy task to prevent an event. What would be your advice to students like us who are soon going to be a part of the corporate world? Do they need to learn

different things or do they need to learn things differently? My advice to students is do things that you like doing. Dont take up a career which is paying well and is attractive. Pick up a career which you like, which you are in love with. Eventually you will succeed. The criteria of picking up a career should not be the money which the career is paying you; but passion. Second thing is in all jobs you do, think long term. Dont think about the next salary or next bonus. Long term thinking is very important. Build a long term relationship with the corporation you work with. Its like a family. You are not a hotel guest in a corporation. You are not looking to just park yourself for a few months and then move on. Most people who have been successful have built long term associations with corporations and done things which they are passionate about. The third thing is integrity. People who have come out well through the crisis are really the people who have genuine integrity in what they do and how they do it. So, dont compromise your values and ethics. Its difficult in the most difficult times but its the most important time when you need to hang on to them and eventually you get a payoff. And you dont do it because you get a payoff. You do it because thats how you live your life. It makes a tremendous difference to your career. Some of us are going to be risk managers in the future. So whats your advice to us? Be fearless. The people who have survived this have survived because they had people who were willing to ring the bells and raise an alarm and warn others of the problems that they may face. And thats how the most successful risk managers have succeeded.
Compiled by: Nisseem Nabar & Rahul Daga

19

Student Articles
Winning Articles
1st Prize
Analysis of Credit Risk Models
Nilesh Gupta & Samrat Ashok Lal (IIMA)

2nd Prize
Complex Securities: Modeling, Assumptions and Risks: A Review
Shivam Srivastava (IIMK)

3rd Prize
An Insight into Development of Risk Management Framework
Firoz RV, Prashant Shukla & Sourav Kumar Gupta (NMIMS)

STUDENT ARTICLES

JAN 2010

MONEY MANAGER

Analysis of Credit Risk Models

Abstract
The financial crisis and credit crunch have drawn attention to the capital requirements of banks, especially the role of internal models used to assess regulatory capital related to market and credit risk. This paper reviews two popular methods, the Credit Metrics method and the KMV method. While the Credit Metrics method is based on transitions from one credit quality to another, the KMV method uses the asset value method originally proposed by Robert Merton. BIS requirements mandate a capital charge for specific risks. This piecemeal approach does not distinguish between credit risk and market risk, and thus may either lead to double counting or omission. Some interaction effects are captured in certain models, but a wholesome treatment of the same has not been established as of yet. The models reviewed in this paper assume deterministic interest rates and exposure, making them suitable for vanilla bonds and loans, as opposed to the more complex derivative products that proliferated in the runup to the crisis. We believe that future models should provide for stochastic interest rates and a derivation for both credit exposure and the loss distribution. The analysis given here is based on (Crouhy, Galai, & Mark, 2000) The first model that we shall evaluate is the Credit Metrics model, developed by JP Morgan. It involves estimation of forward distribution of the changes in value of a portfolio of loan and bond type products. Its methodology applies to all those credit instruments whose credit ratings are known and forward distributions can be estimated. For derivative instruments such as swaps, the calculation for Credit Metrics involves some simplifying assumptions.

Challenges credit VaR

of

measuring

Credit risk portfolios are not normal; rather they are skewed and fat-tailed. The reason is that there are very limited upsides for an improvement in credit quality. But there are very significant downsides in case the credit rating deteriorates. For measure of the credit risk of portfolios we need an estimation of the correlations in credit quality of changes for all obligors which cannot be observed directly. To calculate these correlations Credit Metrics needs to calculate the joint probability of asset returns, which are calculated making simplifying assumptions regarding the capital structure of the firm.
Initial rating AAA AA A BBB BB B CCC Rating at year end (%) AAA AA A 0.7 7.8 91 6 0.7 0.2 0.2 BBB 0.06 0.64 5.52 86.93 7.73 0.43 1.3 BB 0.12 0.06 0.74 5.3 80.5 6.48 2.38 B 0 CCC 0 Default 0 0 0.06 0.18 1.06 5.2

90.81 8.33 0.7 0.09 0.02 0.03 0 0.22 90.7 2.27 0.33 0.14 0.11 0

0.14 0.02 0.26 0.01 1.17 1.12 8.84 1 83.5 4.07

11.2 64.86 19.8

Table 1: Transition matrix: Probabilities of credit rating migrating from one rating quality to another, within 1 year

Credit Metrics also assumes no market risk. The only uncertain event in Credit Metrics is credit migration across the spectrum of credit ratings available. Credit Metrics has 4 building blocks.

Credit-VaR for a bond

We specify a rating system, with rating categories, together with the probabilities of migrating from one credit quality to another 22

MONEY MANAGER

JAN 2010

STUDENT ARTICLES

over the credit risk horizon (Transition Matrix, e.g. given below). From this table we can then determine the average cumulative default rates. Term 1 2 3 4 5 7 10 15 AAA 0.07 0.15 0.24 0.66 1.40 1.40 AA 0.02 0.12 0.25 0.43 0.89 1.29 1.48 A 0.06 0.16 0.27 0.44 0.67 1.12 2.17 3.00 BBB 0.18 0.44 0.72 1.27 1.78 2.99 4.34 4.70 BB 1.06 3.48 6.12 8.68 10.97 14.46 17.73 19.91 B 5.20 11.00 15.95 19.40 21.88 25.14 29.02 30.65 CCC 19.79 26.92 31.63 35.97 40.15 4.64 45.10 45.10

of 10% and a face value of 100, the one year forward price of the bond is (assuming it stays at BBB):

Proceeding similarly, we get the following prices based on the year end rating: Year end rating AAA AA A BBB BB B CCC Value (Rs) 118.30 118.04 117.28 115.65 107.83 102.46 83.01

Table 2: Average cumulative default rates (%)

An important assumption made by Credit Metrics is that all issuers are credit homogenous in each asset class, with the same transition and default probabilities. Note that KMV framework is issuer specific. The next step is Specification of the risk horizon: generally one year but multiple horizons can be chosen. The forward discount curve at the risk horizon for each credit category and the recovery rate in case of default is specified. So we end up with seven spread curves and seven corresponding forward discount curves. Category AAA AA A BBB BB B CCC Year 1 Year 2 Year 3 Year 4 5.4 6.255 7.095 7.68 5.475 6.33 7.17 7.755 5.58 6.48 7.395 7.98 6.15 7.005 7.875 8.445 8.325 9.03 10.17 10.905 9.075 10.53 12.045 12.78 22.575 22.53 21.045 20.28

Table 4: Hypothetical one year forward values for a BBB bond

Derivation of the forward distribution of changes in portfolio value using the forward prices and probabilities of transition. Yearend rating AAA AA A BBB BB B CCC Probability Forward Change of state p price V in value (%) (Rs) V (Rs) 0.02 118.30 2.65 0.33 118.04 2.39 5.95 117.28 1.62 86.93 115.65 0.00 5.3 107.83 -7.82 1.17 102.46 -13.20 1.12 83.01 -32.64

Table 3: Hypothetical one year forward zero curves for each credit rating (%)

Table 5: Distribution of bond values and changes in values of BBB bond in 1 year

Empirically, high grade bond spreads tend to increase with time to maturity, while low grade bond spreads are wider at the short end of the curve. Given a 4 year BBB rated bond with a coupon 23

The first percentile of the distribution of V corresponding to Credit VaR at 99% confidence interval is -13.2, much larger than if we had just assumed a normal distribution.

STUDENT ARTICLES

JAN 2010

MONEY MANAGER

Figure 1: Plot of 1-year forward prices and changes in value of BBB bond

Credit VaR for a loan or a bond portfolio

Correlations are significant for a loan or a bond portfolio and must be calculated accurately as they are very dependent. Correlations are expected to be higher for a firm in the same industry or in the same region, than for firms in unrelated sectors. They also vary with the relative state of the economy in a business cycle. Default and migration probabilities cannot stay same over time. There is a need for a structural model that bridges the changes of default probabilities to fundamental variables whose correlations stay stable over time. For an analysis of credit diversification a Monte Carlo simulation is used to generate the full distribution of portfolio values.

average historical frequencies of default and rating migration. The two critical assumptions made in the Credit Metrics model are that all firms within the same default class have the same default rate and the current default rate is equal to the historical default rate. Hence it implies credit rating changes and credit quality changes are synonymous. But rating changes are discrete whereas the default risk is continuous. KMV has carried out simulation exercise to show that the historical default rates are not equal to the current default rate. In fact the average historical default probability overstates the default rate for a typical obligor. Also substantial difference in default rates may exist in the same rating class. KMV uses the firms stock price and balance sheet to extract a probability of default. The derivation of the Probability of default has three stages

Estimation of the market value of the firm and the volatility of the firms assets. Calculation of the distance to default based on (Merton, 1974) model of valuing firms. Scaling of the distance to default to actual probabilities of default using a default database

Estimation of asset correlations

Equity price is used as a proxy for the asset value that is not directly observable this is a strong assumption of this method. Mertons model of equity as a call option on the assets is extended to determine asset correlations.

Estimation of the asset value and the volatility

The market value of the firm asset is assumed to be lognormally distributed with constant volatility. The problem here is that the all the liabilities of firms are not traded. If that were possible then the value of the firms assets could be taken as equal to the value of liabilities and the value and volatility could be measured directly. In practice only the equity of the firm and some parts of the liability are actively traded. To simplify the model it is assumed that the capital structure of the firm is only composed of equity, short term debt which is considered equivalent to cash, long term debt 24

KMV Model
A more robust model statistically is the KMV model developed by the erstwhile KMV corporation (now Moodys KMV). KMV contended that the Credit Metrics model dependence on transition probabilities and the

MONEY MANAGER

JAN 2010

STUDENT ARTICLES

which is assumed to be a perpetuity, and convertible preferred shares. Then the equity value of the firm and the volatility of equity returns become a function of value of assets, volatility of assets, leverage ratio in capital structure, average coupon paid on the long term debt and the risk free interest rate. An iterative technique is then used to find out the value of the assets of the firm.

Scaling of the distance to default

The distance to default is only an index measure of the probability to default. KMV then uses an historical default database containing information of hundreds of defaults. The distance to default is mapped to an actual expected probability of default over the next one year. These values are called as KMV EDF (Expected Default Frequency). A whole term structure of EDFs is derived for each of the firms under consideration. Pricing of bonds in the KMV model follows the classical option pricing methodology. This necessitates use of risk-neutral EDFs. The EDFs derived till date are real world EDFs. These have to be modified to an appropriate risk -neutral measure. The formula for the risk neutral EDF is given as

Calculation of the distance to default

Default is an event where the equity value of the firm misses the payment on a coupon and/or the reimbursement of principal at debt maturity. Often there are cross-default clauses wherein if a firms defaults on a single payment it is declared default on all its obligations. Based on an analysis done on several hundred companies KMV comes to the conclusion that firms default when the asset value reaches a level somewhere between the value of total liabilities and the value of the short term debt. This value has no theoretical basis and is purely based on empirical analysis. It gives adequate weightage to both the current short debt and the long term debt. From the figure given below DD=

where is the mean return and r is the risk free interest rate. The CAPM model can give us an estimate of -r. KMV does not simulate a full forward distribution of losses. It only calculates an expected loss of the portfolio at the horizon T. If the portfolio is widely diversified then the loss of the portfolio can be assumed to be a normal inverse distribution. From the standard values one can find out the capital one needs to set aside (in terms of portfolio loss standard deviation) for a given correlation and probability of default. The final piece in the KMV model is the calculation of the asset correlations. For a portfolio of N assets if pairwise asset correlations are calculated then one has to calculate N(N-1)/2 correlations. KMV reduces the computation by assuming that the asset corelations are influenced by some common factors (say K). In such a case the number of estimation of parameters becomes KN+K(K25

Figure 2: Distance-to-default (DD)

STUDENT ARTICLES

JAN 2010

MONEY MANAGER

1)/2. For a value of N=1500 and K=15 the parameters reduces from 1124250 to 22605.

exposure to each country and industry. At the second level there are country and industry factors and at the third level there are global, regional and industrial sector specific factors. The figure given below explains the same. There are other models for Credit Risk measurement such as Credit Risk+, Credit Portfolio View etc. But these two are the ones that are mostly well known. Credit Metrics is the dominant model between these two models in terms of usage. Banks usually supplement their internal models with these proprietary models. Other models try to model the process of default using exogenously specified default rates, whereas others try to relate the default risk to macroeconomic factors. The key factor in managing a portfolio is to take care of the correlations in defaults between the assets under consideration. KMV stands on a much higher statistical ground as compared to Credt Metrics on this count.

To calculate the parameters KMV constructs a three layered factor structured model. In the first level there is a company specific factor which is constructed for each firm based on the firms

References
Crouhy, M., Galai, D., & Mark, R. (2000). A comparative analysis of current credit risk models. Journal of Banking & Finance, 24(1/2), 59-117. doi: Article. Merton, R. C. (1974). On the Pricing of Corporate Debt: The Risk Structure of Interest Rates. The Journal of Finance, 29(2), 449-470.

About the Authors

Nilesh Gupta is currently a second year Doctoral Student in Finance at the Indian Institute of Management Ahmedabad. Prior to joining IIM Ahmedabad, Nilesh worked for two years in TCS developing Anti Money Laundering software. He has obtained a B.Tech. in Electronics Engineering from Uttar Pradesh Technical University. Nilesh can be reached at nileshgupta@iimahd.ernet.in Samrat Ashok Lal is currently a second year PGP student at IIM Ahmedabad. His interests lie in the fields of corporate finance, financial economics and strategic financial management. He holds a degree in Electronics and Telecommunications engineering from Mumbai University. Samrat can be reached at 8samrata@iimahd.ernet.in

26

MONEY MANAGER

JAN 2010

STUDENT ARTICLES

Complex Securities: Modeling, Assumptions in modeling and Risks: A Review

"Option sellers, it is said, eat like chickens and go to the bathroom like elephants" - Nassim Nicholas Taleb Author of Fooled by Randomness and The Black Swan uncertainty and it is important to differentiate the two. Payoff of any asset is inherently uncertain, and there is little getting around this. This uncertainty is modeled as risk and the price of an asset reflects the risk involved. Complexity on the other hand refers to highly sophisticated and intricate structure of financial instruments which make it very difficult to understand the risk involved. Note that, this difficulty is due to the complex nature of the instrument rather than any uncertainty involved in the payoffs.

Abstract
Complex securities have received a major share of the flak for instigating the current financial crisis. Complex securities are considered to be beyond the understanding of the common investor, yet she is heavily affected by the shortcomings in the designing in these securities. The paper is a review of the concept of complex securities, the models used in their creation and the assumptions made in the models. It is hoped that a better understanding of the assumptions made in the models would help in making the existing models more robust and would also help the investors by making them more aware.

How do investors deal with complexity?

The various mechanisms used by investors to encounter complexity can broadly be grouped into three categories: Breaking down the problem into smaller subproblems Standardization and Commoditization of securities, Security Approvals, Disclosures Use of models

Introduction
In the aftermath of the crisis, the prices of assets across asset classes have come tumbling down. This has been attributed the long-overdue risk correction or a re-pricing of risk. It is obvious that this drastic turn of events raises serious questions about the applicability of the models and frameworks currently used to price assets and measure risks. It can be argued that models with such performance either need a rethink and correction, or a replacement with a better model. Complex financial instruments are getting a major share of the blame for instigating this crisis, and the reason is that these complex instruments are too complex to ascertain risk with any reasonable degree of accuracy. There are two concepts involved here: Complexity and 27

What are complex securities?

It is very difficult to arrive at a formal definition of complex securities and in fact, this is one of the limitations in effectively regulating complex securities. Securitization is generally considered synonymous with complexity, but this need not be strictly the case. For e.g., valuation of stock price of a finance company (holding a lot of complex securities) can be very difficult using the fundamental bottom-up approach. But, if the stock is fairly liquid and adequately traded, this would not be considered a complex security. Therefore, we can only very broadly define complex securities as financial instruments that represent either assets or liabilities, and which derive their value from a range of possible

STUDENT ARTICLES

JAN 2010

MONEY MANAGER

payoffs, expected to be delivered at a future date. [2]. Complex securities can be classified into four broad groups: Equity Derivatives Stock options Warrants Convertible preferred shares Debt Instruments Convertible, callable, puttable debt securities Structured Instruments CDOs ABS Hedges Securities aimed at hedging against various events

in the figure 1 given below.

Fig. 1 Increasing leverage in the US markets

(ii) By their very nature, high risk complex securities are subject to periods of lesser market liquidity. When the liquidity is low, offloading the risk (delevering) becomes very difficult. Not only that, because of a lack of trading activity, market valuations lose their validity and it becomes difficult to value these securities. (iii) Lack of price transparency It is often the case that these complex securities are valued using complex models and are traded OTC. It is difficult to ascertain and observe the inputs of these models, and because of their OTC nature, price discovery does not take place. Therefore, as stated earlier, it is also possible that a security which is otherwise not very highrisk might be treated as so because of the lack of liquidity and price transparency.

However, this vagueness of definition can be mitigated, if we understand some of the characteristics that are common across such securities. (i) Leverage High leverage is the underlying tenet of all high risk complex securities. Leverage may generally refer to the borrowing of money to supplement investment. In case of high risk complex securities, they acquire a specialized meaning. Here, leverage allows an investor to obtain a greater exposure for a very small investment. Options are an example of leverage. In 2004, the US Securities and Exchange Commission (SEC) allowed five investment banks- Merrill Lynch, Bear Stearns, Lehman Brothers, Goldman Sachs and Morgan Stanley to increase their leverage ratios. This reduced the hold of regulatory safeguards (capital adequacy requirements came down), increased risks and culminated in the downfall of three of the five investment banks given above. Increasing leverage in the economy is depicted 28

Asset Pricing Models

Asset pricing theories make assumptions (a lot of!) to arrive at analytically convenient forms. The assumptions vary with the model, but three assumptions are most often made in all asset pricing theories and financial models: Complete markets A complete market is one in which investors can buy any contingent claim. In other words, the family of assets in an economy is so rich that an investor can buy (explicitly or through synthetic combination of assets) a security that can pay any payoff in any state of the future. The introduction of derivative trading is said to have

MONEY MANAGER

JAN 2010

STUDENT ARTICLES

done a great deal to make markets more complete, but there is ample evidence that markets are far from complete given the underdeveloped markets for many asset classes and the underdeveloped capital markets in many countries. Representative investor The theories assume a representative investor. This assumption manifests itself in the choice of a utility function. Generally, two facets of investor behavior like utility maximizing (u > 0) and risk aversion (u < 0) are used. But, this might not represent specific pockets of investors which might place emphasis on other aspects like ruin aversion (u > 0). A certain payoff distribution In many theories, a payoff distribution has to be assumed. A normal distribution is widely used. Rarely would a payoff actually follow normal distribution, but its usage is mostly justified because of the central limit theorem. But, often it is not known whether the approximation to a normal distribution would yield results which would fall under acceptable confidence intervals or not. The use of computers for pricing complex securities is now universal. We would look at the computational models of asset pricing in a subsequent section. Risks specific to complex securities Apart from the risks of the economic models mentioned above, complex securities face certain other specific risks. The two most prominent risks are: Prepayment risk Credit and default risk: Much of the current crisis can be attributed to the gross misinterpretations of default risks.

for its estimation. To estimate the probability of default, the following elements need to be specified: A model for investor uncertainty. A model for available information and its evolution over time. A model definition of a default event. A model for risk-free interest rates. A model for the premium investors require as compensation for bearing systematic credit risk. This is not all. We would also need to specify a model for linking default of different entities for a securities whose payoff depends on the credit risk of multiple users (which is case when assets of different asset class are pooled together). It is very clear that accumulating such a large number of inputs with a reasonable degree of accuracy would be a very difficult task and obviously an error in input estimation would result in an erroneous model output.

Quantification of Credit risk

There are three main theories governing the modeling of credit risk. Structured credit models This structural approach was proposed by Black, Scholes and Merton for corporate liabilities and is based on the assumption that corporate liabilities are contingent claims on the assets of a firm. There are three further classifications in this: (a) Classical Approach: The classical approach makes two main assumptions. First, that a firm can neither repurchase shares nor issue new senior debt. Second, we assume a distribution of firm value at debt maturity (generally a lognormal distribution with constant volatility is used). The probability of default is given by the area under default probability curve between zero and face value (as shown in the Fig. 2). (b) First Passage Approach: This generalizes the classical approach by saying that the default can 29

Modeling Credit Risk

The distribution followed by credit losses is intensely complex and many inputs are required

STUDENT ARTICLES

JAN 2010

MONEY MANAGER

happen at any time, and not just at the time of maturity.

tasks faced by the credit rating agencies. Each asset has its own set of drivers. An extensive list of performance drivers for different types of securities is given in. Credit rating agencies have faced their fair share of criticism. However, by looking at the extensive list of drivers, it is easy to understand that the job of ascertaining credit risk is indeed a very complex one. Computational models used in pricing of complex securities and assumptions thereof

Fig. 2 Default interpretation in Classical Approach

Based on the techniques used, asset pricing models can be divided into three categories: Models that use discretization Discretization models generally involve a binomial approximation. Models using optimization Models generally assume quadratic utility, normality of prices and Brownian evolution process. Surrogate problem approach This refers to a broach set of theoretical or empirical approaches to complex securities which are too difficult to model analytically. These are analytical models that make a lot of assumptions to achieve mathematical tractability. For e.g., Taylor series expansions are a common feature in all these models, although it is known that it is in no way optimal, especially in relation to error behavior.

(c) Dependent Defaults: Dependent defaults further tries to capture the economic environment by stating that the credit spreads of different issuers are correlated through time. One of the stark assumptions of this model is that we can predict the future. The assumptions imply that default can be anticipated and also the model credit risk tends to zero as maturity date approaches. This means that investors do not face any short term credit risk. This is not a representation of actual market realities. Reduced form credit models This is a refinement over structural model in the sense that it assumes that default can occur at any time and hence, investors do face some short term credit risk. It is easy to overlook one other assumption about these two models. Like many other classical economic and financial models, they also assume complete information. Incomplete Information credit models This model starts with the understanding that investors work with imperfect information. In this an unpredictable default risk is modeled on the basis of imperfect information. This model performs better than the above two models, but still information in the market has to be modeled which represents a challenge. Lets also spare a thought for the enormity of the 30

Shadow Banking, CDOs and the credit crisis

The complex interplay between Special Investment Vehicles (SIV) and the use of CDOs, CDSs and MMF (Money market funds) in instigating the credit crisis has been extensively studied and understood. The important point to note is that the complex structure had opaque risk characteristics and these were priced through extensive use of mathematical models.

MONEY MANAGER

JAN 2010

STUDENT ARTICLES

An intuitive understanding of the risks involved was very difficult and investors relied heavily on the judgment of the credit rating agencies. The mathematical models and credit ratings suffered from many of the risks mentioned in the article. In fact, MBS structures were in essence turning into a classis asset/liability mismatch (funding long term illiquid assets with short term liquid liabilities).

Conclusion
The current credit crisis has taught a lot of lessons. The world knows where it went wrong. We understand that the complexity involved in structured complex products is very high. It is fraught with assumptions at every step and this along with the complexity makes it very difficult for an investor to understand the underlying risk. The government is mulling over various measures, including increased regulatory intervention, to protect investors from such a

pitfall in the future. Some of the measures suggested are: Increasing the sophistication of the agents involved. This is proposed to be achieved by restricting the sale of high risk complex securities to only sophisticated market participants. (However, since many sophisticated institutions failed during the crisis, the success of such an initiative is suspect.) More comprehensive disclosure requirements. Ensuring consistent diligence standards for issuers. Regulation is a two-edged sword. Such regulation could strangle the formation of a vibrant financial market, but also on the other the interests of an ordinary investor should be protected. It is obvious that the government has do the unenviable job of balancing the two things.

References
Retrieved 7th September, 2009.G20 avoids stimulus exit, The Economic Times. Retrieved May 2009, Inter Change Alert, , Ernst and Young report. Cochrane, J.H., Asset Pricing, Princeton Press, 2001. Katz, H. Rating Agency Approach to Structured Finance, Chapter 35, Handbook of Fixed Income Securities, edited by Frank J. Fabozzi, Tata McGraw Hill, 2005. Selby, M.J.P., Computational Aspects of Complex Securities, Guest Editorial, Jrnl of Economic Dynamics and Control, 24 (2000), pp 1491-1497. Brunnermeier, M.K. and Martin Oehmke, Complexity in Financial Markets, Draft Paper. Section III, High-risk complex financial instruments, Containing Systemic risks: The Road to Perform, CRMPG-III Report. Heyer, Stochastic Dominance: A tool for evaluating reinsurance alternatives. Kapadia, A., Jayadev, A., The Credit Crisis: Where it Came from, What Happened, and How it might end, Economic and Political Weekly, Dec 6, 2008

About the Author

Shivam Srivastava is currently a second year student of PGDM at the Indian Institute of Management Kozhikode. His academic interests are in the field of financial economics, asset pricing and fixed income markets. Before joining IIM Kozhikode, Shivam obtained a B.Tech. in Civil Engineering from Institute of Technology, Banaras Hindu University. Shivam can be reached at shivams12@iimk.ac.in 31

STUDENT ARTICLES

JAN 2010

MONEY MANAGER

An Insight into Development of Risk Management Framework

Abstract
True value of business can be drawn by correct identification and hedging of risks faced by it. In order to achieve this, a generic framework is established, which can handle all the risks and can be customized for individual sectors and industries. The framework contains the potential of answering the grave problems faced by the current business world, namely, the credit crisis and the risks associated with it. Risk encompasses the uncertainty of future reward in terms of both the upside and the downside. And opportunity in business arises from managing the future. Companies today must face (and manage) the future knowing that they cannot simply carry on with business as usual. Richard E. S. Boulton, Barry D. Libert and Steve M. Samek (Cracking the value code-How Successful Businesses are creating wealth in new economy) Uncertainty, a word that describes the whole business environment, can make or break things. In this fiercely competitive world, only businesses which can manage this uncertainty and enhance their value will prosper. Incorporating risk management practices in corporate strategy itself can empower companies to manage the uncertainty and enhance value. Gone are the days when a silo approach was applied by companies to risk management, where each risk was considered in isolation. Now is the time for companies to take a holistic approach where they integrate the risks across the organisation and design risk response strategies. This paper aims to develop a risk management framework which helps executives in companies to incorporate risk into their strategic decision making. 32

Top down approach

Implementing an enterprise-wide risk management strategy is the responsibility of toplevel managers. Framing the risk policy, identifying the risks involved at various levels strategic, operational and financial and their interrelation is the responsibility of senior management. We describe here a five step framework which will help managers to manage risk in a better way. Detailed explanation of the five steps is given below: 1. Identify and understand your major risks Not knowing the critical risk embedded in the business is a crime in todays business world. The first step for the successful implementation of the framework is to identify the risks which really matter. For example, a mining company can come up with a long list of risks but the major risks that affect them are price risk, foreign-exchange risk, country risk, operational risk, etc. Thus, in general four to five risks accounts for major portion of cash flow volatility. Probabilistic distribution of outcomes can be calculated but they are subjected to various assumptions and subjective assessments. Moreover, though rare, one cannot ignore extreme outcomes because they can have a major impact, as was seen in the current credit crisis. For a complete analysis of risk exposure, the company also needs to discuss such extreme possibilities. 2. Decide which risks to hedge Hedging of risk is dependent on the comfort of the company with the risk. For example, J.W. Marriott, giant in hospitality industry, faces two major risks while developing hotels, operational risk and property price risk. They find

MONEY MANAGER

JAN 2010

STUDENT ARTICLES

themselves comfortable in handling operational risk but not property price risk. Thus they sell their hotels to real-estate developers say Raheja Developers to eliminate the real-estate price risk. In other words, if an organization has a comparative advantage in handling a particular risk i.e. it has a natural hedge, then the organization should capitalize on that risk whereas it should try to eliminate or mitigate the risks which are not natural for it.

remain cash rich and maintain a low percentage of debt. This leads to high cost of capital and hurts growth opportunities. In many such cases, the companies may opt for hedging in fields where they have a natural hedge, thereby increasing redundancies. By quantification of risks, companies can better map themselves with their risk appetite and get a better understanding of their risk exposure. 4. Embed risk in all decisions and processes Effective implementation of any strategic decision calls for the development of coherent mindset across the organization. The same goes for risk management. Like the popular kaizen concept which ensures the continuous improvement at all the levels of individuals, the risk management decisions should also be incorporated at daily operational level. This will ensure bridging the gap of planning and actual implementation. Quantification of risk implemented in area of investment decision can aid the companies to take informed decisions. An example worth mentioning is the sale of MW Petroleum Corporation to Apache Corporation. The valuation included options of development of the formers reserves under various categories. The usage of Black-Scholes option pricing formula under this situation covered the risk-assessment aspect and helped in comprehensive valuation of the deal. The utility can be extended to categorise assets and securities in firms. This categorization is primarily on the basis of risk complexities and helps in quantitatively matching various hedging techniques with individual categories. Moreover the decisions related to the capital structure of a firm should be based on risk on the cash flows rather than on arbitrary financial ratio guidelines. Apart from financial field, the operational decisions of a company can also benefit from quantification of operational risk. 5. Align governance and Organisation around risk Proper alignment of organization with respect to the different risks faced by the company is 33

3. Determine your appetite and capacity for risk After the identification and classification of risk next comes the quantification of risk and its mapping with the strengths of the Organization. Different organizations have a different capacity to bear risks, depending on the type of Industry they are in and the variability of their cash flows. Risk probability distribution can be developed by using various what-if analysis scenarios (Monte Carlo Simulation). After such a strong risk analysis company can resolve between two extreme situations, viz. overestimation or underestimation of risk appetite. The former can make the company land up in a situation where due to lack of provisions for handling risk, the company suffers a cut back in important cash outflows. While the later situation tempts the company to

STUDENT ARTICLES

JAN 2010

MONEY MANAGER

required for proper implementation of the risk management strategies. Everyone in the organization should be clear with regard to the different risk management strategies and the perspective of the management. In order to ensure that risk estimation and management is done at every level and decision, companies can form a Risk Management Committee which would continuously keep a check on all the departments of the corporation so as to make sure that employees adhere to the risk policy in their day-to-day practices. The crux of the matter is to develop a culture in the company which involves risk management in their decision making.

fraudulent activities. One of the biggest scandals seen in history was of Nick Lesson and Barings Bank. Nicks job was to arbitrage price differences between NIKKEI futures traded on the SIMEX and Japans Osaka exchange. What he really did was take market positions by entering into unmatched trades. As the NIKKEI fell he took long position, expecting NIKKEI to rise, which did not happen. He could hide the losses in an error account because he had the managerial control of the trade process from inception in the front office through accounting and settlement in the back office. With this error account he left a $ 1.4 billion hole in Barings balance Sheet. This fraud exposed two very important aspects of risk management which were broken 1) No independent authority was there to check and confirm the trading activities and 2) There was no segregation of duties between front and back office. With proper implementation of risk management framework as discussed above these two open links would have been addressed and Barings Bank could have saved itself from bankruptcy. A Risk complaint policy adhering to Basel II norms would have taken care of these two shortcomings. The impact of current credit crisis could also have been lessened by using a stringent risk management framework for securitization. It was seen that banks offloaded junior CDO tranches and kept the super senior ones. Their exposure to risk was reduced with this activity but still the super senior tranches bear certain risk. As the real estate prices fell, banks suffered huge losses even on the super senior debt. They did not pay much attention to the possibility of price fall when they were rising and they found it difficult to shed risk when the prices started falling. Thus, this shortcoming indicates a need for proper risk management framework in Securitization of assets done by banks. With respect to the above mentioned framework

Implementation of the framework

The generic framework discussed above can be customized as per requirements in various sectors such as Financial Services, Metal and Mining Sector, Power and Energy Sector, FMCG, Pharmaceuticals etc. To demonstrate the applicability of the framework, this paper discusses its implementation in Financial Services and Mining sector. Also, to highlight the importance of this frame work in a live situation, the following section attempts to answer the risk identification problem of current credit crisis.

Implementation of the framework Financial Services

Financial Institutions business is risk and the effectiveness with which they manage that risk determines their success and position in market. History has shown that though they have a business of risk but they have also been dealing with risk management in silos. Though they have been successful in managing risk but it has been seen that operational risk is one which has troubled this industry from ages. Operational risk basically indicates towards fraudulent activities of employees. Numerous examples can be taken up from this sector to demonstrate the amount of loss that has been caused due to the 34

MONEY MANAGER

JAN 2010

STUDENT ARTICLES

certain guidelines can be framed for risk management in Securitization

Clear understanding of implication of securitization

concept

and

Risk tolerance limit for securitized assets should be set for the organization Stringent monitoring should be done on a regular basis regarding securitized transactions and the value of underlying assets Flags should be raised as the value of securitized assets reach the risk tolerance limit of the organisation and proper communication should be done to the top-level management Provide a clear distinction between position taking activities and transaction activities A separate risk management team should be formed, which would help in resolving conflicts and check that employee activities are compliant to the risk management policy Quantifying the risk should not only use VaR methodology but should also use Scenario analysis and analyze the extreme possibilities which if they occur can create the worst impact

bullion loans, forward sales (eliminating downside exposure), option-based insurance strategies (mitigating downside risk while reaping benefits of upside) and Spot Deferred Contracts or SDCs (forward sale contracts with rollover facility). With the help of these strategies, American Barrick had gained from various gold-price fall situations in the market, the popular one being 1992 when the firm was able to sell 1,280,000 ounces of gold at average price of $422 per ounce, while the market price was around $345 per ounce. This example illustrates the importance of this framework in commodity industry. This can be extended to various other commodities like oil, gas etc.
Source - Image: Jean-Pol GRANDMONT, Creative Commons, Flickr

Implementation of the framework Mining Sector

American Barrick Resources Corporation, one of the most financially successful gold-mining concerns can be taken as an example of successful implementation of this framework. The company identified its major risks as operational and gold price risks. By virtue of its strong operations as compared to competitors, the company had a natural hedge against operational risks. Hence they correctly identified the price risks as the one they would hedge. They successfully limited there price exposures by implementing numerous strategies like gold financing (innovative vehicle for raising funds, paying back investors as output of the mines),

Conclusion
The Black Swan: The Impact of the Highly Improbable book by Nassim Nicholas Taleb shows how events which are at the least likely points of ones probability distribution can create a major impact. Recent credit crisis is a perfect example of the same. With the analysis presented in this paper it can be concluded that a proper risk management framework coupled with stringent guidelines and a risk culture development from top to bottom in the organization enables an organization to enhance value in ever uncertain business environment.

35

STUDENT ARTICLES

JAN 2010

MONEY MANAGER

References
Making enterprise risk management pay off By Thomas L. Barton, William G. Shenkir, Paul L. Walker The New Finance Library: Risk the new management imperative in Finance by James T. Gleason Kevin Buehler, Andrew Freeman, and Ron Hulme Owning the Right Risks, Harvard Business Review, September 2008 Robert C. Merton You have more Capital then You Think, Harvard Business Review, November 2005 Virginia Garcia Enterprise Risk Management in Financial Services: From Vision to Value, Bank Accounting & Finance, DecemberJanuary 2005 Kenneth Froot, David Scharfstein, and Jeremy Stein A Framework for Risk Management, Harvard Business Review, November-December 1994. Banks Securitization and Risk Management By, Hugh Thomas, Associate Professor of Finance, The Chinese University of Hong Kong Shatin, NT, Hong Kong SAR, China And Zhiqiang Wang, Associate Professor of Finance, Dongbei University of Finance and Economics, Dalian, Liaoning, China Peter Tufano and Jon Serbin American Barrick Resources Corporation: Managing Gold Price Risk Harvard Business School http://www.stock-market-crash.net/barings.htm

About the Authors

Firoz RV is pursuing MBA (finance major) at Narsee Monjee Institute of Management Studies, Mumbai. Email: firozr.v@nmims.edu Prashant Shukla is pursuing MBA (finance major) at Narsee Monjee Institute of Management Studies, Mumbai. Email: prashant.shukla@nmims.edu Sourav Kumar Gupta is pursuing MBA (finance major) at Narsee Monjee Institute of Management Studies, Mumbai. Email: sourav.gupta@nmims.edu

36

MONEY MANAGER

JAN 2010

Crossword
By: Harsh Bhimani (IIMA)
27. An event or occurrence that deviates beyond what is normally expected of a situation and that would be extremely difficult to predict

Down
1. A cash settled derivative that has

Across
3. Widely used risk measure of the risk of loss on a specific portfolio of financial assets 4. A risk management technique that mixes a wide variety of investments within a portfolio 7. A bank loan repackaged as a bond under a 1980s debt restructuring for less-developed countries 8. The ability to convert an asset to cash quickly 11. Government program created for the establishment and management of a Treasury fund 14. Account recording sales made in a period and the accompanying costs 17. It is a matrix decomposition with one lower and one upper triangular matrix 21. The process of identification, analysis and either acceptance or mitigation of uncertainty in investment decision-making 23. Accumulate over time 24. A risk-adjusted performance ratio used in investment management 26. Having liabilities which reprice later compared to assets

an underlying denominated in one currency, but settles in another currency based on a fixed exchange rate 2. A bonds loan agreement 5. The buying or selling of a security by someone who has access to material, nonpublic information about the security 6. How a loan from a bank will be included in a companys balance sheet 9. Technique used to take into account the time value of money 10. Act of recording the price or value of a security, portfolio or account to reflect its current market value rather than its book value 12. A path dependent option whose payout depends upon the maximum or minimum underlying value achieved during the entire life of the option 13. The monetary policy that the Fed fostered from the late 1980s to the middle of 2000 15. An option that periodically "locks in" profits 16. The Greek factor sensitivity measuring a portfolio's first order (linear) sensitivity to the implied volatility of an underlie 18. When forward prices exceed spot prices 19. Banks takeover of hypothecated mortgage asset 20. The process of selecting investments with higher risk in order to profit from an anticipated price movement 22. A ratio developed to measure risk-adjusted performance in Mutual Funds 25. A measure of the volatility, or systematic risk, of a security or a portfolio in comparison to the market as a whole

37

STUDENT ARTICLES

JAN 2010

MONEY MANAGER

Can EVT & VAR prepare us for a financial crisis?

Abstract
The recent economic turmoil clearly indicates the need for a revamped look at existing risk management practices. This article focuses on Value-at-Risk (VaR), one of the most widely used models in risk management. An assumption made in the standard VaR model is that returns follow a normal distribution. This crucial assumption is tested empirically with data spanning from 19 years. A VaR model, using Extreme Value Theory (EVT) is also analyzed and tested against extreme events that occurred during the crisis. The results indicate a much higher performance of EVT-VaR when estimating risks at times of an economic crisis. the upcoming year. Using this inference as an indication of the risk in the near future, financial institutions plan and manage their portfolio of investments. The Standard VaR model (S-VaR) assumes that the returns are normally distributed (Pritsker, 1997). This implies that the S-VaR model depicts the losses under normal conditions accurately. However, the normal distribution does not emphasize extreme events, thus making the S-VaR model underestimate the risk of such events. The performance of the S-VaR model with 95% and 99% confidence will be analyzed under extreme events. This will be done using 19 years (July 1990 to October 2009) of S&P CNX NIFTY, obtained from the NSE website.

Introduction
The recent financial crisis, considered to be the worst since the Great Depression has seen several major institutions fail, getting acquired or requiring significant government intervention. Traditional risk management practices have failed to account for such an extreme event. This article focuses on the shortcomings of Value-atRisk (VAR) and how Extreme Value Theory (EVT) can be used to account for such events.

Fat Tails
A fat tail or heavy tail is a property of some probability distributions, which exhibit extremely large kurtosis particularly in comparison to normal distribution functions.

ValueatRisk
Value-at-Risk (VaR) is one of the most widely used tools in risk management (Damodaran Value At Risk). This tool is used by financial institutions, fund managers and even individual investors to estimate the current risks in their investments. Value-at-risk indicates the maximum loss that can be incurred on a portfolio, with a certain degree of confidence. For example, consider that it can be stated with 95% confidence that a portfolio has an annual VaR of Rs 2 crores. This implies that, there is a 5% probability that the portfolio will fall by more than Rs 2 crores in

Figure 1

The Frechet distribution shown in Figure 1 is a classic example of a fat-tailed distribution (Gencay & Selcuk, 2006).

38

MONEY MANAGER

JAN 2010

STUDENT ARTICLES

Extreme Value Theory

EVT is a tool in mathematics that deals with the occurrence of extreme events. This has been traditionally applied to the study of catastrophic events such as floods, earthquakes, fire losses, etc. Nowadays, EVT is also being applied in the field of risk management (Embrechts, Resnick, & Samorodnitsky, 1999). EVT gives more allowance for the occurrence of extreme events by considering distributions with fat tails. This is in contrast to the normal distribution (used in S-VaR) which presumes thin tails. The theory gives an estimate known as the tail index which indicates the characteristics of the distribution and the frequency of extreme events.

standard VaR. This study will be concluded with a comparison of the performance of the S-VaR and the VaR obtained through EVT, which will provide a good estimate of the usefulness of SVaR and EVT-VaR during extreme events.

Observations
The following graph shows the frequency distribution of the maximum daily loss in a nonoverlapping 60-observation period.

Methodology
EVT will be applied to daily lognormal returns of the S&P CNX NIFTY using the block maxima method (Gilli & Kellezi, 2006). As per the method followed, the lognormal returns will be broken down into non-overlapping periods with 60 observations each. The maximum daily loss made in each period is considered as a proxy for an extreme event. The tail index for this set of data is calculated using the Hill estimator. Based on the value of the tail index, i.e. if it is greater than, lesser than or equal to zero, the distribution can be determined to be a Frechet, Weibull or Gumbel distribution respectively. The case where the tail index is greater than zero is of a greater interest. This is because a value greater than zero signifies a fat tail and also indicates that it is a Frechet distribution. Once the tail index and the distribution are determined, the standard deviation and the mean value for the distribution can be calculated using the data set. Using this distribution, we can estimate the value-at-risk for a specified value of confidence. The same set of data is also used to estimate the

Figure 2

The graph (in Figure 2) shows that the losses distribution is fat-tailed and also, hints that it resembles a Frechet distribution. In order to observe the effectiveness of S-VaR during extreme events, the maximum daily loss for every non-overlapping period is plotted against S-VaR values (Refer Figure 3). Each of the periods encompass data of 60 observations and the S-VaR values have been calculated one day prior to the occurrence of the extreme event. This has been done keeping in mind that an investor will use one days S-VaR value to estimate the expected loss to be incurred the day after. The performance of S-VaR is shown in Figure 3. The 95% S-VaR successfully captures only 35% of all extreme events. The 99% S-VaR captures 65% of the extreme events.

39

STUDENT ARTICLES

JAN 2010

MONEY MANAGER

Figure 3

Figure 4

EVT VaR
The Hill estimator is a widely used method of calculating the shape parameter (tail index) which in turn governs the degree of tail heaviness. The equation for the tail index is given below (Haan & Ferreira, 2006).

Both the 90% and 95% EVT-VaR successfully capture all extreme events in the 19-year period. However, another aspect that must be kept in mind is that EVT is used to estimate the maximum value that would be at risk due to large market swings. As demonstrated in Figure 4, considering very high confidence levels would over-estimate the risk and provide a very conservative estimate. It can be seen that the EVT-VaR with 95% confidence is not a very practical model to be used with the data under consideration. The 90% EVT-VaR, on the other hand performed very well in 2004 and 2008 by accounting for the large single-day losses with good precision.

Where,

for k = 2, 3,, n Here, is the tail index. is the maximum loss for the ith 60-day period. is the number of non-overlapping 60-day periods. The value of the tail index using the above equation is calculated to be 0.465. This clearly indicates that this is a Frechet distribution which is fat-tailed. Therefore, a normal distribution (which is thin-tailed) will not be a good fit for the data under consideration. A Frechet distribution with this tail index is used to obtain the EVT-VaR values at 90% and 95% confidence. The results are plotted in Figure 4. 40

Results and Inferences

The following table summarizes the success rate of each model in capturing the occurrences of extreme events. Model 95% S-VaR 99% S-VaR 90% EVT-VaR 95% EVT-VaR
Table 1

Success Rate (%) 35.06% 64.94% 100.00% 100.00%

The data clearly reiterates that a normal distribution of losses does not adequately account for catastrophes. This is because normal distributions have thin tails. Hence, this assumption effectively leads to the failure of the

MONEY MANAGER

JAN 2010

STUDENT ARTICLES

standard VaR model to account for extreme events. The extreme value theory suggests using a Frechet distribution to estimate VaR. This EVTVaR calculated using appropriate confidence levels shows tremendous potential in terms of the usage and prediction capabilities during times of great volatility. This can be seen during the recent financial crisis, where the 90% EVT VaR, with a surprising degree of accuracy, managed to capture the extreme losses.

Conclusion
It is better to adopt an approach which uses both the S-VaR and EVT-VaR models appropriately and in conjunction with each other. Failing to do so will lead financial institutions to either perceive their investments to be more secure or over-estimate the risks involved. Both situations present a sense of false confidence or insecurity that can accelerate the onset of a crisis and prevent investors from realizing what situation they are in and what the stakes actually are, until it is too late.

References
Damodaran, A. Value At Risk. Retrieved Oct 25, 2009, from Damodaran Online: http://pages.stern.nyu.edu/ ~adamodar/pdfiles/papers/VAR.pdf Embrechts, P., Resnick, S. I., & Samorodnitsky, G. (1999). Extreme Value Theory as a Risk Management Tool. North American Actuarial Journal. Gencay, R., & Selcuk, F. (2006). Overnight borrowing, interest rates and extreme value theory. European Economic Review. Gilli, M., & Kellezi, E. (2006). An Application of Extreme Value Theory for measuring financial risk. Computational Economics. Haan, L. d., & Ferreira, A. (2006). Extreme Value Theory - An Introduction. Springer. Pritsker, M. (1997). Evaluating Value at Risk Methodologies. Journal of Financial Services.

About the Authors

Santosh Prabu C is a student at BITS Pilani, Goa campus, currently pursuing M.Sc.(Hons) Economics and B.E.(Hons) Electrical and Electronics Engineering under a dual degree program. He has a keen interest in corporate finance and has founded Wall Street Club, the finance club of the campus. Vidyashankar M V is a student at BITS Pilani, Goa Campus, currently pursuing M.Sc.(Hons) Economics and B.E.(Hons) Computer Science Engineering under a dual degree program. He headed the Economics Association and was also a core-committee member of Wall Street Club. His interests lie in the area of Financial Economics.

41

STUDENT ARTICLES

JAN 2010

MONEY MANAGER

Risk management in Private equity

Abstract
The article studies various aspects of risk management, with regards to private equity investments. Private equity investors face two basic categories of risk, one impacting their ability to raise funds from institutional investors and the other impacting their portfolio investments and exit strategies. The article gives an overview of the methods used commonly by private equity funds to mange each of those risks faced by them. Risk management is defined as identification, assessment, and prioritization of risks followed by coordinated and economical application of resources to minimize, monitor, and control the probability and/or impact of unfortunate events. Private equity is an asset class which consists of investments in the equity of private businesses. Over the past fifteen years, it has been the fastest growing market for corporate finance, far surpassing others such as the public equity and bond markets and the market for private placement of debt. Today the private equity market is roughly one-quarter the size of both the market for commercial and industrial bank loans and the market for commercial paper in terms of outstanding amounts (Figure 1). In recent years, private equity capital raised by partnerships has matched, and sometimes exceeded, funds raised through initial public offerings and gross issuance of public high-yield corporate bonds. As private equity is becoming an attractive investment option for institutional investors, the risks facing them needs to be understood and managed effectively. Understanding risks for investors is also important, as private equity investments are not 42
Figure 1: Growth of capital committed to private equity across years1995 2007 Source: Thomson financial and National Venture capital association

only impacted by macroeconomic factors like interest rates, or economic conditions but are also dependent largely on the business of the underlying portfolio companies. This makes it extremely difficult for Limited partners (LPs) to monitor and quantify risks faced by their private equity investments.

There has been a big debate going on disclosure and reporting of material risks faced by Venture capital and Private equity firms to their investors on a quarterly basis. A recent proposal under the Accounting Standards Update (ASU) suggests that venture capital and private equity firms should identify risk factors faced by these firms, do a sensitivity analysis of these factors on their portfolio investments; to be disclosed to their investors on a quarterly basis. (National Venture Capital Association, 2009) This comes in the backdrop of an effort to regulate this unregulated class of investments after the economic meltdown of last year. While most venture capital and private equity firms have resented such a move, they have contested this on the basis of unquantifiable

MONEY MANAGER

JAN 2010

STUDENT ARTICLES

nature of the risks faced by them. Further since the value created is not directly co-related with one factor of risk. They are faced with a full spectrum of risks from those arising out of economic downturns to specific events faced by their portfolio companies.

Sources of risk of private equity investments

These firms face two basic kinds of risks; one of not being able to raise funds at the right point in time, the other is not being able to extract adequate returns from its equity portfolio. Though the two may seem independent from each other, they are impacted by factors which are quite similar in nature. a. Funding risk: Private equity investors raise funds from big institutional investors such as pension funds, sovereign funds, wealth funds, university endowments, insurance companies, fund of funds, etc. Each fund raising investing fund close cycle is of about 10 years duration.

Source - Image: john wardell, Creative Commons, Flickr

Before we go into the risks faced by private equity firms it is important to understand the way it creates value for its investee companies.

There are times, when private equity funds find it difficult to raise capital for new funds. Such a situation may arise due to adverse economic conditions like the one being witnessed currently or due to factors specific to the fund.

Sources of value creation by Private equity investments

1. Operational efficiency: Improving operations may include rationalization of costs, helping the company increase revenues, hiring or laying off people, getting customers, etc. 2. Multiples expansion: Private equity investing takes place at multiples of EBITDA or earnings of the investee. These multiples are a function of a number of factors such as attractiveness of the industry and business segment of the investee, competitive strength of the company, capability of the management team, etc. 3. Leverage or financial re-engineering: The capacity of a private equity investor to raise debt is normally higher compared to the portfolio firm. This makes it to raise debt from the market and infuse into the investees balance sheet. This leverage helps to increase returns on the equity held by the private equity investor.

Figure 2: Sources of risk for private equity investors

The ease of fund raising depends on a number of factors like the size of the fund, reputation of the fund sponsor, past returns and the team of general partners managing it.

43

STUDENT ARTICLES

JAN 2010

MONEY MANAGER

Managing funding risk A number of private equity firms maintain a group of preferred set of limited partners of the fund, those which are more predictable than others. Firms prefer raising large funds during better economic conditions and draw capital in form of capital calls, during the life of the fund rather than raising smaller sized funds. Many firms tweak their compensation structure during down cycles, making it attractive for limited partners of the fund. From the regular 2% management fee and 20% carry, firms are seen to reduce the fixed management fee to 1 1.5% keeping the carry same or increasing it slightly. Many big firms maintain a level of overhang, or raised but not invested capital. This gives them a competitive advantage of investing in difficult times, when there is not much capital around and valuations are low. b. Risks of adverse economic cycles and exit environment: The major source of this risk comes from the fact that an economy goes through cycles, and valuations of the same cash flows may differ considerably.

of investing activity gaining high momentum during formation of bubbles. Figure 3 shows the total size (blue bars) and number (brown line) of buyouts during the period from 1995 till 2009 1H. The activity levels reached during 2007 were considerably higher than ever. Vintage Year Return Ratio Chart LP Distributions Vintage Year Re- + Current NAV / turn Ratio Chart LP Contribution 1981-1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 Overall
Table 1: Vintage year return ratios Source: National Venture capital association, report 2009 (National Venture Capital Association, 2009)

3.24 6.06 4.45 2.89 1.45 0.88 0.92 0.98 1.02 1.09 0.98 0.92 0.92 0.84 0.88 1.53

These cycles have a very adverse impact on valuations and therefore on the returns private equity companies are able to realize on these investments.
Figure 3: Total size and number buyouts in years 1995 2009 1H.

A good example of the impact of this is being faced by most private equity groups today. A close study on investments of the 2006 -07 (Table 1) vintage indicates that only a fraction of investments of this vintage have been able to 44

Control premium paid by private equity investors are much higher during boom times, than times of recession. This is largely because

MONEY MANAGER

JAN 2010

STUDENT ARTICLES

return even the premium invested by the private equity groups. The current NAVs and the distributed capital, is lowest at 84% of invested for investments of vintage year 2007. This risk is faced more by smaller and relatively new funds which do most of their fund-raising during boom cycles and therefore make more investments during those times. Mitigation of risks of funding cycles To mitigate this risk of economic cycles, the following practices are adopted by private equity groups: Invest uniformly across economic cycles. They do not invest in spurts. Invest based on valuations of future cash flows of the company and not just on comparables and multiples as market comparables may sometimes be misleading. Avoid competitive bidding; co-invest in deals of large magnitude. Have concrete exit plans in place, with key milestones and targets for the portfolio.

focused VC and PE firms shut down. An evidence of this can be shown from the vintage year ratio chart; investments of the 1999 -2001 vintage have resulted in distributions less than those of the invested capital. Mitigation of risks arising from investing in industry segments While investing in a particular industry segment, private equity firms invest uniformly across economic cycles. Diversify within the industry segment. Invest across seed, early and late stage companies in that particular segment.

c. Risks originating from the industry segments: There are a number of private equity firms which specialize in a particular industry, or an industry segment or even a particular product category. This is mostly to leverage their understanding of that particular segment. It has been shown that this strategy is better compared to a diversified investment strategy, as it is easy for investors to diversify their portfolio at their level. But being too specific brings risks associated with that particular segment. Companies that specialize in certain industries carry additional risks of facing downturns in that particular industry. For instance, many PE firms invested only in hightechnology companies during the dot com bubble of 2001 when valuations were at their peak. After the bubble burst there was little value left in their portfolio and many tech 45
Source - Image: incurable hippie, Creative Commons, Flickr

d. Risks originating from portfolio companies: A number of risks may emerge from inside of the investee companies. These risks include: Technology Risk Risk of the technology not seeing light of the day or not being commercially viable. Market Risk - Will a new market develop for this technology? How would the market respond to the product or service offered by the company? Company Risk - Does the company have the right capital structure? Is the management team capable enough for executing the strategy? Are incentives of key managers aligned rightfully?

STUDENT ARTICLES

JAN 2010

MONEY MANAGER

Mitigating portfolio risks The way a firm deals with these risks defines its portfolio management philosophy and helps it create a difference. Some of the best practices while dealing with the above risks are:

customer samples. Help the investee develop a sustaining business model, leveraging on its industry experience. Company risks: Private equity partners invest a lot of time and effort with each of their portfolio companies managing unique risks faced by them, with respect to management and technical team, capital structure, cost and revenue management, etc. Incentives of management team are often realigned with those of the investors, usually by way of granting equity options as part of their compensation. Performance based milestones are often set for the management team to achieve.

Technology risks: Invest in technologies which they understand, or get opinion from external experts. Stage investments in parts and set milestones for the management team. Invest in competing technologies with smaller ticket sizes. Invest in developing an ecosystem. Invest across different stages in their lifecycle seed, early, late and mature stage companies. Market risks: Work closely with the management team, help it develop prototypes and get feedback from key

References
National Venture Capital Association. (2009). Proposed Accounting Standards Update, Fair Value Measurement and Disclosure (Topic 820), issued August 28, 2009. NVCA Update , 6. National Venture Capital Association. (2009). Venture capital performance as of Q2 2009 impacted by poor exit. NVCA Update , 3.

About the Authors

Manu Midha is a second year student in the Post Graduate Program at IIM Ahmedabad. His area of interest include Venture and Growth capital with a concentration on technology and education industry sectors. Email: 8mmidha@iimahd.ernet.in

46

MONEY MANAGER

JAN 2010

Know your risk model

Value at Risk (VaR)
Value at Risk (VaR) is a technique used to measure the risk of loss for a portfolio. By definition, it is the maximum loss with a given probability that will occur for a portfolio in a certain fraction of time over a particular period. For example, if a portfolio has a 5% VaR of $1 million that means the portfolio has a 5% probability of losing $1 million in value in a single day. One reason for VaRs popularity is that it is the only commonly used risk measure that can be used for any asset class be it equities, bonds or derivatives. Despite all its popularity it has come under harsh criticism after the current economic crisis since VaR doesnt measure the extreme risks like the possibility of a financial meltdown. To quote Nassim Nicholas Taleb- the author of The Black Swann VaR is like an air bag that works all the time, except when you have a car accident (Nocera, 2009). In this article we try to look at weaknesses of VaR and the alternate methods that could be used as a measure of risk.

VaR estimate using the past data have been underestimated since the estimate of the volatility was low.

Frequency of Large Returns. (Hopper, 2007)

The models used to estimate VaR assume that the returns follow a normal distribution. However, there are evidences which suggest that normal distribution might not be adequate because large positive or negative returns occur more often than suggested by

Source - Image: Risk, Creative Commons, Flickr

Weaknesses of VaR
Recent criticisms of VaR include
It underestimated the risk and led to excessive risk

normal distribution. Even if the non-normality of return is accounted for, the basic problem that we are constructing a model based on past data to estimate the future would still remain.

taking by financial institutions

It focused on manageable risks which are at the

VaR is Sub-additive. (Verma, 2009) This means

VaR of a combined portfolio can be larger than the sum of the VaRs of its components. For example, one asset which has a 0.75% chance of losing $1 million in a day has a zero VaR since the probability is less than 1% (using 99% VaR level). Similarly another asset with 0.75% chance of loss has a zero VaR. However, a portfolio consisting of the two assets has a non zero VaR because there is a 1.5% chance that the loss would be more than $1 million in a day.

center of the distribution and ignored the tails

It created a false sense of security among senior

management even when they were deep in crisis All this stems from the inherent limitations of the methods used to calculate VaR, a few of which are mentioned below

Liquidity Risk. (Hopper, 2007) VaR measures

loss by assuming that the assets could be sold at current market prices. However, if the firm has highly illiquid assets VaR might underestimate the true losses.

Works Cited
Das, S. (2007). Perfect Storms Beautiful & True Lies In Risk Management. Hopper, G. (2007). VALUE AT RISK: A new methodology for measuring portfolio risk. Nocera, J. (2009). Risk Mismanagement. nytimes. Verma, J. R. (2009). Risk Management Lessons from the Global Financial Crisis.

Structural change in the economy. (Hopper,

2007) VaR may also underestimate the true risk in case of sudden changes in the underlying economy. For example, due to certain changes in economic policies in a country, the stock market might see a large fall and the volatility of returns would increase faster than the figure estimated using past data. The

Binay Kumar Agrawal, IIM Ahmedabad 47

STUDENT ARTICLES

JAN 2010

MONEY MANAGER

High Risk, High Reward: A Review of Changing Currents on Executive Compensation

Abstract
The financial crisis has exposed dangerous flaws in even the most sophisticated executive compensation practises based on the risk-reward framework. Attempts to align pay with corporate performance have led to huge top executive pay checks in both good times and in bad times, sparking public outrage. By aligning executive compensation with sound risk management practises, a firm can reduce regulatory costs and also achieve long term sustainable growth. Accordingly, the paper identifies concerns with the current and proposed compensation frameworks and provides recommendations for a better pay methodology to disincentivize reckless risk taking by senior executives. Keywords: firm risk; executive compensation; corporate performance same rate, it would have been more than $22 an hour in 2006 instead of $5.15.

Compensation and Firm Risk: Theoretical Framework

Firm risk has been shown to be strongly positively correlated to both the incentive and non-incentive compensation components. If an executive's performance equals the standard, then he earns his target bonus. Bonus plans also often specify a minimum bonus (corresponding to a threshold performance level) and a maximum bonus, both usually expressed as a percentage of the executive's target bonus. The pay-for-performance relation is shown by the "incentive zone" in Figure 1. The probability that an executive receives a bonus greater than or equal to his target bonus is independent of the bonus the executive received in the prior period. The theory underlying the use of stock option compensation derives from the financial and economic assertion that stock options offer upside potential, but limit downside risk. Specifically, building on the fundamental assumption of a positive relationship between risk and return, increased stock price volatility will increase stock option value. In the US, options as mode of compensation gained popularity in the 1980s in response to shareholder pressure to link pay more closely to performance. But they only came to dominate compensation packages after 1993, when Clinton administration imposed a cap of $1 million on cash payouts to be eligible for corporate tax deductions, many firms shifted compensation to guaranteed bonuses, such as the controversial AIG payouts. Researchers have generally tested the correlation between incentive pay and risk preference alignment by examining the extent to which 48

Preamble
Financial institutions have recently been recording enormous losses, yet those losses are barely reflected in employee compensation. For instance, AIG had intended to pay out $165 million in bonuses and compensation having lost a record $62 billion in the fourth quarter of 2008. CEO Edward Liddy, however, assumed some responsibility and agreed to take a pay of $1. According to Raghuram Rajan the justification was that many employees had a banner year, and their compensation should not be held hostage to mistakes that were made in the sub-prime market. Also, many of these pay outs are claimed to be legally binding. Clearly something is not right here. Studies by BusinessWeek and other publications show that compensation for big company CEOs was more than 400 times the pay for average workers last year, up from a 42-to-1 ratio in 1980. If the minimum wage had gone up at the

MONEY MANAGER

JAN 2010

STUDENT ARTICLES

incentives increase executives risk taking. For example, Datta, Iskandar-Datta and Raman examined the influence of CEO stock option compensation on acquisition behavior. They found that option pay (measured as the ratio of the Black-Scholes value of options granted in the year before the acquisition to total compensation), was negatively associated with acquisition premiums. They further found that option pay positively influenced the acquisition of high-growth targets and was associated with greater post-acquisition firm risk. They concluded that stock option pay encourages CEOs to undertake riskier investments.

On Wall Street, for example, focus on short term gains is pervasive. Misaligned risk-taking incentives for banks force traders to make trades and carry spread bets. Spread bets pay small amounts most of the time, so traders book this fake alpha masquerading as outperformance as profits, collect bonuses, and cross their fingers hoping to avoid the inevitable blow-up. For instance, an investment manager who bought AAA rated tranche of CDOs in the past got a return of 50 to 60 basis points more than a similar AAA rated corporate bond. That excess return was actually compensation for the tail risk that the CDO would default, no doubt perceived as small when the housing market was rollicking along, but not zero. If all that the manager disclosed was the high rating of his investment portfolio, he would have looked like a genius, making money without additional risk, even more so if he multiplied his excess return through leverage. Similarly, the management of Northern Rock followed the oldest strategy in the book of taking on tail risk, borrowing short and lending long, and praying that the unlikely event of a liquidity shortage in financial markets never materialized. Also, there is the question of internal equityhow the highest-paid executives pay compares with that of everyone else in the organization. A bias to focus only on the external market in recent years has helped push executive compensation way out of whack. Because of the yawning gap between the leaders and the led, employee morale is suffering, talented performers loyalty is evaporating, and strategy and execution are suffering at companies. A smaller gap makes for greater solidarity, and, as a result, better performance, throughout the workplace. Executive compensation was at the forefront of the concerns that G-20 leaders had when they began thinking about restrictions that needed to be imposed on the financial institutions. Since October 3, 2008, the date on which the Troubled Asset Relief Program (TARP) was established

Fig. 1 A typical executive annual bonus plan

Similarly, in a study of the relationship between stock options and risk taking in oil and gas firms, it was examined whether stock options encouraged CEO risk taking, measured as the coefficient of variation in expected future cash flows from exploration. It was concluded that stock options increased exploration, which is viewed as riskier than exploitation.

Role in Financial Crisis

With top management compensation being tied to a companys stock price, a booming stock market allows executives to pocket huge, often undeserved, profits. Management is incentivized to boost share price by beating investor expectations. One way is for management to surprise the market by taking on more risks, which often involves betting the farm. 49

STUDENT ARTICLES

JAN 2010

MONEY MANAGER

in the US, Congress and the Treasury each have issued legislation and guidelines regulating the timing, form, and amount of compensation that could be paid to executives employed by financial and other institutions receiving government assistance under TARP. Moreover, the White House appointed a special master for compensation who would be responsible for establishing and monitoring the executive pay packages at the seven firms that received the most TARP funds, e.g., AIG, Citigroup, and Bank of America.

least 4 years. However, this proposal has many shortcomings. For start, it involves micromanagement of top executive pay at more than 28 large banks and several regional and other organizations to ensure compliance. More importantly, any options based pay suffers from the fundamental flaw that stock-option plans can also demotivate management when options go under, either because of stock market crashes, as in 2002 and 2008, or when a company reaches maturity and its stock peaks. Holders of stock options are then penalized regardless of their actual performance. Although it is logically appealing to expect positive accounting-based performance to increase investors firm valuations, and thus market performance, accounting based measures reflect current (and recent past) performance, whereas market-based measures reflect investors perceptions of future value. Thus, anticipated earnings are typically factored in to market valuations. As a result, maturity reduces investor expectations about future growth and they value firms accordingly. Thus, executive options lose their value, no matter what the executives' input. Alternatives such as say-on-pay are reliant on activism by institutional investors such as pension and hedge funds. However, empirical studies have shown that due to lack of block shareholding in majority of US corporations, shareholders generally approve respective boards decision on executive pay or sell the stock. Some PE funds have resorted to clawbacks i.e. taking back some of the compensation if the investments perform poorly. However, while these systems are similar in spirit, Alex Edmans8 argues that claw backs are a less effective way to deter manipulation than escrow accounts. He says, "If you have paid out bonuses and the company then tanks, trying to claw back the bonus seems like shutting the barn door after the horse has bolted." Rather than paying out the bonus and then clawing back, it is better to just

Source - Image: pfala, Creative Commons, Flickr

Current Status: Concerns and Recommendation

With worldwide outcry over executive pay, the G-20 seems to have decided to implement pay curbs and reduce risk taking among executives through the use of long term measures that align compensation with sound risk management and through increased transparency and shareholder control. The US has proposed primarily the use of salary stocks which are long term grants that cannot be exercised for at

50

MONEY MANAGER

JAN 2010

STUDENT ARTICLES

not pay it out in the first place. Edmans has also proposed a compensation structure based on long-term escrow accounts. The optimal contract takes a surprisingly simple form, and can be implemented by a Dynamic Incentive Account. The executives expected pay is escrowed into an account, a fraction of which is invested in the firms stock and the remainder in cash. The account features statedependent rebalancing and time-dependent vesting. It is constantly rebalanced so that the equity fraction remains above a certain threshold; this threshold sensitivity is typically increasing over time even in the absence of

earthquake insurance can only be measured over a period long enough for earthquakes to have occurred. This solution is better than the common practice of rewarding short term changes in share prices. Also, apart from linking an executive's compensation to the performance of the firm over a longer horizon, this method also takes into account changing conditions within the firm, thus, making a firm better off in the long run.

Conclusion
The failure of executive compensation to be aligned with corporate performance was brought to the public's attention as part of the economic meltdown of the financial services industry in 2008. The resulting effects of this meltdown on the United States and the world economies, such as the freezing of the credit markets, the bankruptcy of Lehman Brothers, and the near failure of AIG, have been unprecedented in terms of their speed and breadth. Indeed, compensation practices in the financial sector are deeply flawed, and contributed to the ongoing crisis. More generally, unless we fix incentives in the financial system, we will get more risk than we bargain for. The foregoing suggestions help align executive compensation to long term performance and discourage excessive risktaking, providing incentives that ultimately improve the health of the company. The recommended framework based on escrow accounts will have a far-reaching effect and will significantly impact the compensation paid to t he ex ecut i ves . Even t hou gh t he recommendation is for financial institutions, the relevance of this new standard at some point may very well extend to most public corporations.

Source - Image: Sam Fox, Creative Commons, Flickr

career concerns. It includes post-retirement periods to mitigate risk profligacy in immediately preceding period. This solution is based on the principle that true alpha of an investment can only be measured in the long run and with the benefit of hindsight in the same way as the acumen of someone writing

51

STUDENT ARTICLES

JAN 2010

MONEY MANAGER

References
Barkema, Harry G. and Luis R. Gomez-Mejia. Managerial Compensation and Firm Performance: A General Research Framework. The Academy of Management Journal, Vol. 41, No. 2 (1998): 135-145. Berrone, Pascual and Jordan Otten. A GLOBAL PERSPECTIVE ON EXECUTIVE COMPENSATION. Gomez-Mejia and Werner. Global Compensation Foundations and Perspectives. Routledge, 2008. 113-128. Black, F. and M. Scholes. The pricing of options and corporate liabilities. Journal of Political Economy (1973): 637-654. Cyert, Richard M., Sok-Hyon Kang and Praveen Kumar. Corporate Governance, Takeovers, and TopManagement Compensation: Theory and Evidence. Management Science, Vol. 48, No. 4 (2002): 453-469. Datta, S., M. Iskandar-Datta and K. Raman. Executive Compensation and Corporate Acquisition Decisions. The Journal of Finance, 56.6 (2001): 2299-2336. Devers, Cynthia E., et al. Executive Compensation: A Multidisciplinary Review of Recent Developments. Journal of Management (2007): 1016. Edmans, Alex, et al. Dynamic Incentive Accounts. 24 Aug 2009. Murphy, K. J. Performance standards in incentive contracts. Journal of Accounting and Economics (2001): 245-278. Rajan, Raghuram. Fake alpha or Heads I win, Tails you lose. 2009. Rajgopal, S. and T. Shevlin. Empirical evidence on the relation between stock option compensation and risk taking. Journal of Accounting & Economics (2002): 145-171. Schneider, Paul J. The Post-Stimulus Bill Era of Executive Compensation. JOURNAL OF FINANCIAL SERVICE PROFESSIONALS (SEPTEMBER 2009): 21-24. Starks, Jay C. Hartzell and Laura T. Institutional Investors and Executive Compensation. The Journal of Finance 58.6 (2003): 2351-2374.

About the Author

Anand Goyal: He is a final year student in PGDM program at IIM Calcutta. His areas of interest include Corporate Governance, CSR and sustainable development. He has worked with IBM Software Lab in the past. email: anandg2010@email.iimcal.ac.in

52

MONEY MANAGER

JAN 2010

STUDENT ARTICLES

Money, Money Everywhere, Not a Penny to Spare

Abstract
In the aftermath of the current crisis, risk management has come up as one of the prime focus areas for banks around the world. Liquidity risk management and implementation of leverage ratios in particular has caught the fancy of regulators given the cash crunch faced by the biggies like Lehman, Bear Stearns and AIG. Even though the new regulations aim to address the concerns through several proposals, we evaluate the practical issues and repercussions of implementing those measures through this article. decade, the liquid asset holdings of the banks have decreased to alarmingly low levels.

Figure 1: Government Security Holding of US Banks

Introduction
The BASEL II Accord addressed the seemingly most prevalent risks: the market risk, credit risk and operational risk, but could not predict what lay ahead. With biggies like Lehman Brothers and Northern Rock collapsing for want of cash, the contemporary focus is now shifting towards the new rising demon: the Liquidity risk. Basel Accords ensure capital adequacy and hence attempt to address insolvency, but nothing much has been done to avert banks running out of liquid assets. Nor does it prevent the expansion of balance sheets, creating the mammoths too big to fail.

Delving deeper management

into

liquidity

Historically, banks have been relying on the confidence of depositors and debt providers for funding. However, once their confidence erodes, banks are vulnerable to severe crisis situations. One way of insuring against such debacles is to increase the cash and equivalent holding, but there lies an obvious trade off in this approach as shown below in Figure 2. Liquidity management is thus a costly affair for banks.

Banks are holding lesser liquid assets than before

The liquid asset holdings of a bank comprises of assets readily convertible to cash: thus including cash, cash equivalents, government securities, deposits and short term paper. Since these assets earn negligible or almost zero returns, holding a larger proportion of these assets affects the profitability of banks. With aggressive competition in the banking sector over the past

The current liquidity composition of banks

The graphs below show the liquidity composition of a few major banks across the world. From figure 3, the following trends can be observed: Major form of liquid assets is in the form of short-term bank securities. The proportion of government securities in the portfolio is relatively lesser.

53

STUDENT ARTICLES

JAN 2010

MONEY MANAGER

Scenario Analysis Banks conduct a stress test to assess the minimum level of liquidity required to be held (Example: testing the impact of an event that could cause panic withdrawal of funding) A bank must carry sufficient liquid assets to survive this test

Measured by:

Assets Increased holdings of liquid assets provides increased capacity to cope with short term run on liabilities(deposits) Higher quality liquid assets are more likely to be convertible to cash in all scenarios

Liabilities Longer dated funding preferred given no near term rollover need Shorter term and offshore funding more vulnerable to being withdrawn in a crisis Retail funding regarded as stickier than wholesale funding (since less likely to be withdrawn in a crisis) Longer dated funding is usually higher cost than shorter term. With increasing competition, retail funding can be costly Lower interest margin

Key liquidity drivers Impact on interest margins

Liquid assets are typically lower yielding relative to bank lending

Increase in liquidity Figure 2: Liquidity Management Framework

But the regulatory threat looms over

The regulatory threat that looms over the banks is now a mandatory stipulation by central banks across the world regarding the percentage liquid assets that the banks would need to hold. In addition, the banks would also need to follow strict guidelines over what assets would qualify as liquid assets. This uncertainty in the regulatory environment has brought about a huge risk with regards to the profitability and the RoE of banks. There are three factors for reforms:

term funding sources, in term providing an incentive for banks to increase the term of their funding Whereas the Australian regulation has tightened the definition of liquid assets to include only the Commonwealth government securities, the United Kingdom FSA regulation has kept the definition relatively broader. The FSA definition applicable in UK includes both the government bonds as well as Supras.

Extending the current stress tests on the ability of bank to meet their liquidity requirements even in case of a sudden withdrawal of funding Tightening the definition of liquid assets Shortening run-off assumptions around shortFigure 3: Liquid asset composition of major banks

54

MONEY MANAGER

JAN 2010

STUDENT ARTICLES

The New Zealand government has also adopted the same tone as above, but has included high yielding securities (lower credit ratings) within definition with haircuts. Thus even state owned securities with a BBB rating can be included into the definition but with a higher haircut.

The liquidity focus under regulation would now shift in two ways: holding higher number of bonds (the asset side liquidity) and holding deposits of longer tenure (funding on the liability side). As per our analysis, a regulation asking for as high as 80-90% of liquid assets in government securities seems highly infeasible to implement. The government securities currently form around 10% of the total liquid securities in case of a US bank. However, it is almost equal to 20% of the total US treasuries [Figure 5]. So in case of banks increasing their government security holdings to 90%, it would come to 180% of the outstanding government securities in the market. With the current fiscal deficit already touching its peaks, such an increase in supply of government bonds is unlikely to happen. The case is almost similar in case of Australian banks as well.

Implications regulations

of

stringent

The implications of the new liquidity risk management regulations are two-fold:

Changing liquidity composition of banks Rising IT and administrative costs in implementation of liquidity risk management systems

As can be seen in figure 4, currently the liquid assets of the banks have a high proportion of inter banking assets (almost 10% of total assets). However, in case of a crisis, it becomes difficult to liquidate this short term paper, as none of the other banks or investors would be willing to buy it. Given the bank-to-bank circularity, these would probably not even be accepted in the current regime. The follow on effect of this norm would result in the drying up of the short term debt markets, where banks are typically major buyers.

Figure 5: US & Australian bank treasury holdings Source: US Treasury Data, RBA

Similarly the short term unsecured assets would qualify on the liquidity metric as per their stability. For instance, promissory notes are considered to be more stable than the commercial paper. On the liability side, a major source of funding for banks would be the wholesale funds with longer-term time deposits. However, the increased competition for these funds is likely to increase the interest rates that the banks would need to pay for these funds.
Figure 4: Composition of liquid assets for all US Commercial banks

Ultimately, banks would face deteriorating Net

55

STUDENT ARTICLES

JAN 2010

MONEY MANAGER

Interest Margins (NIM) whilst adhering to regulations

sheets disproportionately, such that the available capital can absorb the losses on the asset side.

Regulations And the expenses of implementation

Interestingly, all these risk management regulations would stalemate at the implementation level. To cite an example, as per UK FSA stipulations, banks would need to report their liquidity statistics on a monthly or even at the daily basis in case of a crisis threat. From a situation where global banks find it tough to evaluate their liquidity positions on a regular basis given the inherent complexity in global operations and structured products, satisfying the above metric would indeed be a daunting task. According to estimates drawn up by the FSA (published in The Banker, 2 Sep 09), smallscale organizations may get away with spending as little as 50,000 to get such reporting systems in place. But banking groups operating a number of subsidiaries may be left with a bill ranging from 3.3m to 7.4m, excluding the ongoing running costs associated with frequent reporting requirements and stress testing, which may exceed 700m (extrapolated from FSA data). Moreover, the subsidiaries of banks in UK would need to prove self-sufficiency in funds, independent of the parent and other branches. This would inevitably cause funds to get locked up at the global level, leading to higher inefficiencies in the financial markets.

Advantage of using leverage ratio

The key advantage of leverage ratio lies in the simplicity of its computation and its ability to complement the Basel Accord II. Since the Basel Accord necessitates provision of capital as per the riskiness of assets, it might encourage the banks to increase the low risk assets, while providing very minimum capital for it. If these assets are illiquid, the lower amount of capital does not provide a sufficient buffer. In addition, this might cause the banks to structure products that get high credit ratings, but are inherently illiquid.

Leverage ratio problems too!

has

its

own

There are several hurdles involved in the actual estimation of the leverage ratio - the first being the discrepancy in accounting regimes. The use of IFRS, in particular, results in significantly higher total asset amounts, and therefore, lower leverage ratios for similar exposures compared to US GAAP. This is because IFRS requires the gross derivatives exposure of derivatives to be shown on the balance sheet, even when there exists a counter position. US GAAP on the flip side, allows for the netting of exposures.

Leverage Ratio: Deceptive

Simple,

yet

Another term becoming a buzzword today is the Leverage Ratio, mandated to be a minimum of 4% by the wary regulators. Leverage ratio is the Tier 1 capital as a percentage of total adjusted assets. This is different than the earlier used Tier 1 capital ratio, which uses risk-weighted assets in denominator. The intention of this metric is to prevent the banks from expanding their balance 56

Table 1: Leverage ratio calculation for banks

However, since bankruptcy laws allow for the netting of exposures in case of insolvency, grossing up exposures is incorrect. That is, if I owe you $50 and you owe me the same: in case you default, I do not have to pay you anything.

MONEY MANAGER

JAN 2010

STUDENT ARTICLES

The contract is netted out. Even in the calculation of risk-weighted assets, the positions are netted as above. The discrepancy in Deutsche Bank is almost around a 100% (Table 1). The second hurdle in the implementation of

thus acts as an incentive for the banks to increase their off balance sheet exposures, adding further to their riskiness. Fortunately, Basel II Accord addresses this shortcoming, hence further reinforcing the positioning of this metric as a complement to the Basel norms.

Figure 6: GAAP Leverage Multiple v/s IFRS Leverage Multiple for Major Banks across the world

leverage ratio lies in its international acceptance, given that it has the ability to reduce the profitability of banks. Leverage ratio indirectly caps the debt that can be raised on the books, which thus reduces the tax shield that could have been otherwise accrued. Not only this, higher capital on the books reduces the riskiness of the banks, which in turn reduces the governments safety cover that the banks would have otherwise been entitled to in a crisis situation. This thus acts against the interest of the executives of the banks, who would treat increasing the ROE as their prime motive. Last, since leverage ratio is the ratio of the tangible equity to tangible assets, it ignores the off balance sheet exposures of the bank. This

Conclusion
Regulations pertaining to liquidity risk management and the leverage ratio metric are here to stay. They would certainly impact the profitability of the banks and change their liquidity compositions. Also, with the mandated leverage requirements, the expansion of a banks books would relatively slow down. Overall, the uncertainty in the banking sector now lies in the implementation and subsequent execution of the regulatory norms as set by Basel II and central banks around the globe. The objective would however be towards harmonization in these international financial regulations.

References
US Federal Reserve: http://www.federalreserve.gov/datadownload/Choose.aspx?rel=H.8 Source: Bloomberg and Annual Reports Unicredit Report: FSA on UK Liquidity Regulationhttp://www.thebanker.com/news/fullstory.php/aid/6827/ The_liquidity_trap.html?current_page=2

57

STUDENT ARTICLES

JAN 2010

MONEY MANAGER

Australian Banks Regulatory Reform Some Cause for Concern: Report By CitiBank, Australia http://www.thebanker.com/news/fullstory.php/aid/6827/The_liquidity_trap.html?current_page=2 Background Note: Banking and the Leverage Ratio Prepared by the Financial Systems Department of the World Banks FPD Vice Presidency. Keefe, Bruyette and Woods Ltd: European Banks Reregulation: Analyst Report Keefe, Bruyette and Woods Ltd: European Banks Reregulation: Analyst Report Keefe, Bruyette and Woods Ltd: European Banks Reregulation: Analyst Report

About the Authors

Ashish Chordia: A graduate from IIT Kharagpur, Ashish worked with Lehman Brothers for 2 years before joining IIM Bangalore. He regularly plays hockey and is a part of the debating society at IIMB. Gazal Heda: She is a 2nd year student at IIM Bangalore. An electronics engineer from NIT Nagpur, she likes to play word games, solve math puzzles and painting.

Crossword Solution

58

MONEY MANAGER

JAN 2010

STUDENT ARTICLES

Impact of Cognitive Biases on Effective Risk Management

Abstract
Human beings are far from rational. But the assumption of rationality underlies the celebrated models in finance. People bring in their biases when taking any decision and it is no different for risk management. This has a serious impact on how organizations and economies perform. Understanding biases and the different ways in which they can hamper effective risk management can help an organization to design effective measures to reduce the possibility of improper decision making.

Second-order Effects of Management Innovations

Risk

Introduction
A fundamental assumption in finance is that people are rational. This is the basis for many finance theories including the famous CAPM model. However, time and again, one faces situations where people have reacted in ways that suggest that we are not always rational. The decisions that we take are subject to the current state of our mind. These effects have been captured in a few well-known biases such as anchoring bias, overconfidence bias, confirmation bias, representation bias etc. This article looks at the effects of the various biases on the risk taking nature of human beings. Since it is not quantifiable, no model can capture the impact of these biases and hence this makes risk management extremely difficult. The article also suggests approaches that can be followed to mitigate the effects of biases on risk management.

Over the past few decades, there has been significant progress on identifying, analyzing, and mitigating risks. However, in spite of all the advances made, there has not been a decrease in the frequency of occurrence of crisis events (such as bubbles, crashes, and recessions). In fact, one can argue that there may have been an increase in such events in the recent decades. One reason for this is that there is ignorance that there is a reaction function to risk management innovations. Though more risk is understood, measured, and managed better, people become overconfident and take risks that they would not have taken earlier. Risk management innovations can actually end up encouraging risk-taking.

Overconfidence Illusion

and

Control

Cognitive Biases
This section describes the common cognitive biases which impact that part of human behavior which is associated with risk management.

Overconfidence is a well documented behavioral bias which is present in most human beings. In fact, research suggests that this bias is higher among decision makers and experts. Overconfidence can result in decreasing the subjective probability of risky events. Control illusion is a kind of overconfidence where one feels that they have control over a situation while in reality, they do not. Such an illusion can get exacerbated by having some risk mitigation and control mechanisms in place since people are liable to think that since some of the risk is being actively managed, they have in fact got control of the whole range of possibilities. Such a bias can result in insufficient or delayed response even when faced with contradictory new information. This overconfidence bias is further reinforced by self-

59

STUDENT ARTICLES

JAN 2010

MONEY MANAGER

attribution and hindsight. Bankers and traders tend to take the credit for any profits that they make, while they blame the markets and other macroeconomic factors for their failure and fail to consider the effects of randomness. Hindsight bias refers to the fact that people tend to selectively recall evidence that confirms their ability to correctly predict the future outcome, thereby overestimating their abilities.

markets using mechanisms such as exchange rate swaps, forwards, and futures. It is possible that they are not seriously considering using real options (such as developing an ability to source from multiple countries), which can serve the same risk mitigation purposes more effectively in many scenarios. This preference for the status quo is higher when risk management decisions are taken at the executive level with little involvement of the operational level managers who can probably provide more insights on real option possibilities.

Herding Along with Regret Bias

Individuals tend to choose actions which minimize their regret. Herding refers to the tendency to take the same action as that of others without attempting to fully comprehend and objectively analyzing a situation. Herding also has the effect of minimizing bias since an individual can rationalize in the future that she did not do worse than others. This behavior is widely observed in many financial organizations resulting in improper estimation of the risks involved in the strategies undertaken by the firms. Current compensation structures for bankers also play a part in this since performance is typically evaluated in relation to peers. Also, when there is herding behavior, the individuals who originally take an action that is followed on by others later can feel more convinced that they had taken the right action resulting in a positive feedback loop producing short term self fulfilling prophecies. This phenomenon is called an informational cascade and can result in improper and insufficient analysis of earlier actions (as it would now appear to be right) impacting risk management.

Source - Image: sandstein, Creative Commons, Flickr

Ignoring the Fat Tails

Humans tend to ignore low frequency but high impact possibilities. This is because of overemphasis of recent events which can lead to disaster myopia. Therefore, the subjective possibility of disaster like situations is taken by managers to be zero (ignored) rather than a small value. This can lead to a false sense of security, resulting in a lower estimation of risk than actual and a misallocation of capital and other resources.

Preference for Status Quo

Another related bias is not considering other possibilities to reduce risks once one method of reducing risk has been tried and appears to work well. This is due to the status quo bias people not tending to change an established behavior unless the incentive to change is compelling. For example, man y organizations (like manufacturing companies) can generally mitigate risks in multiple ways operationally, financially, and many combinations of the two. More organizations nowadays seem to be reducing their risk mainly through the financial 60

Natural Humans

Risk

Perception

of

People, by nature, prefer financially superior gambles to inferior alternatives and are therefore likely to gamble away their money in the absence of restrictive incentive structures. This risk taking nature is captured by prospect theory,

MONEY MANAGER

JAN 2010

STUDENT ARTICLES

which states that when faced with either a sure loss or a gamble that holds open the prospect of breaking even, most people opt for the gamble, even when its expected payoff is less than the sure loss. People are always willing to throw good money after bad. Other research has also shown that people tend to put more money into a failure that they feel responsible for than into a success. This is referred to as the escalation factor. For example, when given the choice of certain financial gain (Rs 250) or a chance at a bigger gain (25% chance of winning Rs 1,000 / 75% chance of getting nothing), humans tend to go with the sure thing. This is due to the risk aversion nature. But when given the choice of a sure and significant loss (Rs750) or a big chance of losing even more (75% chance of losing Rs 1,000 / 25% chance of losing nothing), humans tend to take the risk. This indicates that humans are generally risk averse when they are gaining but tend to take greater risks when they are faced with losses. This causes issues during risk management as people have a natural inclination to cut off the profit half of the tail, but not to do anything about the loss half of the tail. Research has also shown that people value what they possess at about twice as much as others do. Therefore, with a natural bias to retain (and overvalue) that which traders and bankers already have, they may be tempted to continue using trading strategies past their prime and to continue using older risk quantification methodologies longer than they should be.

inevitable due to the rapid pace at which new information is being generated and the short response times. Under such a situation, experience can make all the difference. It has been shown that analyzed and proven that an analyst who has no prior experience of a crash on the stock markets or a recession in the economy handles the probabilities and the consequences of events differently from an economist or a trader who has.

Source - Image: cannonsnapper, Creative Commons, Flickr

Confirmation and Anchor Bias

The amount of risk that we deem appropriate for the portfolio may be subject to anchor bias if there are no maximum permissible limits defined by the organization. Analysts try to predict the results of a company in advance. However, when new information is available nearing the date of actual announcement of results, the analysts do not revise their position and tend to stick to the original position by downplaying the new information. This is also related to the confirmation bias which talks about how people reject any new information that does not confirm their previous decision. Use of heuristics exacerbates the confirmation bias as the choice of heuristics is made based on its ability to confirm the hypothesis under consideration. All these biases appear to cast a dark shadow on the possibilities of rational risk management itself. So what, if anything, can be done? 61

Representation Bias
When people are unable to estimate the probability of occurrence of a rare event, people resort to unscientific techniques such as applying heuristics or mental short-cuts, which help them to reduce the judgments to simple ones. They may also end up providing undue importance to a limited set of information or trying to find patterns in random events. Using heuristics for making decision is almost

STUDENT ARTICLES

JAN 2010

MONEY MANAGER

Ways to Reduce the Impact of Biases on Risk Management

Reducing the impact of biases is not simple because most of these biases are inbuilt in our thought processes having served some useful function or the other during the course of evolution. However, there are a variety of methods which can be applied to different scenarios to mitigate or remove the effect of particular kinds of biases. Some of the important possibilities are briefly mentioned below.

analysis should be done properly for both the successful and the failed strategies.

Companies (particularly, in the financial sector) should set limits to their exposure to new products on the market whose risks are incompletely understood. They should independently investigate these products rather than relying on what outside experts say. Overconfidence bias can be handled by being skeptical of ones own abilities and by making it a point to get confirmation from external sources periodically. The problem of ignoring fat tails can be reduced by performing scenario analyses of a wide set of possible eventualities without regard to their probabilities of occurrence. Real options thinking must be made a part of the organizations arsenal in risk management to reduce status quo bias. Real options should be considered as being both complimentary and supplementary to the usage of financial risk management techniques. Also, this can be promoted by devolving some of the risk management functions to operational level managers. Incentive structures should impose acceptable limits on losses. By trying to cover up their existing losses, many traders end up in deeper losses. They end up in a vicious circle due to their loss aversion nature. One must avoid the temptation to go for quick rewards. It is very likely that when people are looking for short-term gains, they tend to miss the complete picture. Anchoring bias must be avoided by continuously updating the model with the latest available information. The source of the new information must be checked to ensure that this information is reliable and accurate. Even minority opinions should be given due consideration and analyzed as to whether they can be incorporated into the model or not.

Source - Image: r-z, Creative Commons, Flickr

Herding can be diminished by promoting contrarian views within an organization. This can be enabled through changes in the structure of employee compensation packages. Increasing the time horizon of evaluating the success or failure of an employees action can also help in reducing the impact of informational cascade. Also, the post mortem

62

MONEY MANAGER

JAN 2010

STUDENT ARTICLES

References
Robert Merton, Judy Lewent, Donald Lessard, Andrew Lo, Lakshmi Shyam-Sunder, 2008, MIT Roundtable on Corporate Risk Management, Journal of Applied Corporate Finance, Volume 20, Number 4, Fall 2008, pp 20-38. M. Granger Morgan, Max Henrion. Uncertainty: A Guide to Dealing with Uncertainty in Quantitative Risk and Policy Analysis. Cambridge: Cambridge University Press, 1990. Hubert Fromlet, 2001, Behavioral Finance Theory and Practical Application, Business Economics, July 2001, pp 63-69. Joseph V. Rizzi, 2008, Behavioral Basis of the Financial Crisis, Journal of Applied Finance, Fall/Winter 2008, pp 84-96. Robert Merton, Judy Lewent, Donald Lessard, Andrew Lo, Lakshmi Shyam-Sunder, 2008, MIT Roundtable on Corporate Risk Management, Journal of Applied Corporate Finance, Volume 20, Number 4, Fall 2008, pp 20-38. Joseph V. Rizzi, 2008, Behavioral Basis of the Financial Crisis, Journal of Applied Finance, Fall/Winter 2008, pp 84-96. Hersh Shefrin, 2001, Behavioral Corporate Finance, Journal of Applied Corporate Finance, Volume 14, Number 3, Fall 2001, pp 113-124. Tomorrows Risk Management, Thought Leadership Series, September 2009, BNY Mellon Alternative Investment Services Hubert Fromlet, 2001, Behavioral Finance Theory and Practical Application, Business Economics, July 2001, pp 63-69. Tomorrows Risk Management, Thought Leadership Series, September 2009, BNY Mellon Alternative Investment Services Joseph V. Rizzi, 2008, Behavioral Basis of the Financial Crisis, Journal of Applied Finance, Fall/Winter 2008, pp 84-96. Robert Merton, Judy Lewent, Donald Lessard, Andrew Lo, Lakshmi Shyam-Sunder, 2008, MIT Roundtable on Corporate Risk Management, Journal of Applied Corporate Finance, Volume 20, Number 4, Fall 2008, pp 20-38.

About the Authors

Arun Manohar is a 2nd year PGP student at IIM Bangalore. He holds a Bachelors degree in Electrical Engineering from Indian Institute of Technology (IIT) Madras and can be reached at arun.manohar08@iimb.ernet.in Vivek R is a 2nd year PGP student at IIM Bangalore. He holds a Bachelors degree in Electronics and Communication Engineering from College of Engineering Guindy, Anna University and can be reached at vivek.r08@iimb.ernet.in

63

Beta, The Finance Club of IIM Ahmedabad Beta is the most prestigious club of IIM Ahmedabad and has been an integral part of IIMA culture since decades. Beta aims to generate and promote interest in finance among IIMA students. However, its activities are not limited to IIMA alone. It has organized several national level case contests, trading games and workshops in the past. It has also been associated with distinguished people from academia and industry. Some of Betas regular activities are organizing placement oriented sessions, internships experience talks, contests and informal discussions on current issues. Networth, The Finance Club of IIM Bangalore Networth is Everything Finance at IIM Bangalore. Its primary driving force has been to establish a connect with the world of finance and develop synergies around the function, both within and outside the campus. Through its broad portfolio of activities, the club encourages students to explore the realm of finance. It conducts workshops and organizes talks wherein students get exposed to the high priests of finance. It also encourages participation from students through its trading events, online quizzes and case contests. At the same time it assists students in their pursuit towards their dream careers in finance through its popular gyaan sessions for placements.

Finance & Investments Club of IIM Calcutta Finance & Investments Club of IIM Calcutta, popularly known as the Finclub is a student driven initiative that collaborates with both the corporate and academia from the financial sector to provide a platfor for students to improve their quantitative and analytical thinking abilities. The club also manages and maintains the IIM Calcutta Finance Laboratory in collaboration with the Department of Finance and Control. The club organizes industry talks, workshops, stock trading and other finance based simulated events.

Please send your feedback and queries to: E-mail: beta@iimahd.ernet.in Website: http://stdwww.iimahd.ernet.in/beta

MANAGER

MONEY

THE