Encountering Risk in Prudential Markets

Theme

The global financial credit crunch was a clarion cry for a fundamental rethink on risk. Financial behemoths burned; their once acclaimed risk management practices came under fire from all quarters. A paradigm shift in regulation is being demanded. The responsibility of the management in decision-making and execution is being questioned. It took a catastrophe to make corporates aware of the flip side of "Higher the risk, higher the return". The salvation lies only in implementing systems that have jurisdiction over the amount of risk an enterprise can absorb. But therein lay the fundamental questions: Can some numbers capture all the latent risks? If not, is there any assurance that another such tsunami will not come back to haunt us? If yes, why did the tsunami arise in the first place? Was it a regulatory failure? Was it sheer rapacity? Or was there a genuine systemic failure that can be corrected through appropriate measures?

Recent research confirms that businesses around the world are increasingly laying more emphasis on different types of risks as the global economic conditions continue to remain affected by the aftershocks of the credit crunch. Under these circumstances, businesses must clearly understand their risk profile and try to mitigate risks to justifiable levels. This is true not only for the financial industry, which is possibly going through the lowest trough deemed imaginable, but also in regard to each of the projects that companies undertake. Sector-specific and project-specific challenges have to be dealt with to prepare for a risk-less future.

Corporates might need to scrutinise different dimensions of a project in an unprecedented manner. Earlier, project management incorporated issues relating to a particular project and those related to the company in general. The new financial world might need to look at business cycles and the stage of growth of the company. Operational risk issues become more significant in a more globalized world. A company dealing with a foreign company needs to look as far as the country risk associated with the foreign company. Integrated risk management practices are emerging, and these include managing risks like those associated with implementation of new technologies, software and foreign exchange risks amongst others. The finance sector needs to come back from the abysmal levels it hit during the recent recession. Operational risk management practices don't only need to ensure conformance to established norms but also take into account human and extraneous factors. Questions arise: Regulations are considered panacea to the ills of the modern financial system, yet why do they come into the spotlight only after a major crisis has occurred? Will separating operational risk from credit risk work? Are they really different when the credit rating would ideally be dependent on the operating factors? It would be interesting to see if the three pillars of Basel-II can help manage the risks facing the banking industry. It is hoped that the current crisis will help create more efficient risk management practices in the banking industry.

After the sub-prime crisis, financial innovators need to put in some thoughts to the inherent risks before coming out with products. As has been seen, financial innovations like CDOs and CMOs have the potential to create a global economic havoc. Sometimes an event external to the financial world might lead to illiquidity in the markets, which cause drastic changes in the values of products like exotic options. Credit rating agencies, which also came under fire for not being able to reflect on the inherent risks in the financial products of investment banks, also need to delve more deeply on the associated risks before rating any company. Would these agencies be able to look more deeply into these issues henceforth? Will the investment banking industry make a comeback with better products? The complexities associated with these industries and the products that they offer ensure that such questions will always arise.

In an increasingly globalized world, developing countries like India are not immune to the risk of systemic failures. Risks of inter-linkages between sectors became clear as falling real estate prices triggered the financial meltdown. A fundamentally strong economy may ensure that the effects are not cavernous, but it is better to learn from others' mistakes than to experience them. Until recently, risk management was not given much importance. In the coming years, we might see more CROs in companies not necessarily belonging to the finance sector. Managing risk is to ensure that the Indian growth story does not halt due to the glitches caused by inextricable inter-linkages of economies. Whether financial innovation should continue or not is debatable, but regulatory measures are being increasingly laid stress upon. The big question for the future is: How do we encounter risk in prudential markets under these constraints? This summit aims to bring out the industry perspective in this regard - whether we can have measures to fortify us from such predicaments and implant them in the system itself.