The Hindu Business Line : Make risk governance sustainable

When assets are created by banks to transfer risks, there could be the possibility that such assets were contracted with limited due diligence, with the support of ‘modern’ lending practices such as ‘arm’s length financing’ with excessive reliance on the external pool ratings.

A.V.Arunkumar

The Organisation for Economic Co-operation and Development (OECD), in a recent estimate, outlined that the overall losses caused by the US mortgage market crisis could hit $300 billion, and the broader credit crunch could inflict greater damage on equity markets. It was also emphatically indicated that delinquencies and ultimate losses on mortgages could be even more.

Against this backdrop, a ‘Super Fund’ has been mooted to tide over the problem, to some extent. A look at the banks and other financial intermediaries involved in the complex collateralised debt obligation (CDO) based repackaging can be regarded as the pioneers of the modern risk management; and they are all hard hit by the crisis. After all, risk management simply means to introduce systems and practices to contain potential losses.

Despite the introduction of Basel II norms, most of the banks have become victims of such financial exposures and party to the credit risk contagion, which is expected to dampen the economic growth prospects of many nations at least for the present.

The question is, does it reflect poorly on the modern risk management practices? This is an issue the financiers, econometricians and policymakers have to examine at this juncture.

In India, the October 2007 Credit Policy of the Reserve Bank of India, has acknowledged the potential of derivative instruments to amplify systemic risks and, accordingly, made proactive suggestions to introduce oversight structure, targeting both credit and market risks. Introduction of such measures is timely as extensive use of credit derivative instruments can spread risks within the entire economic system.

Modern Risk Management

Modern financial risk management as a discipline aims at monitoring, measuring and mitigating the risks the financial intermediaries confront, so that the deposit holders’ interest are protected at all times. This is further reinforced in the revised capital adequacy norms, popularly called as the Basel II norms, which suggest that banks have to maintain capital according to the risks they perceive, so that the interest of the deposit holders are protected.

The higher the perceived risk, the higher must be the capital, and vice-versa. The risk management tools help the decision-makers measure and mitigate the risk and hence protect the financial intermediary from unexpected losses. Since capital is required to protect banks against unexpected losses, this, coupled with higher credit expansion, has opened up avenues for banks to explore ways for efficient capital allocation or management.

Many banks and investment institutions worldwide have transferred the credit risk through structured financial products such as CDOs from their books to other investors. Such moves have had the twin objectives of releasing capital for additional asset creation, apart from profit maximisation. The results indicate that financial intermediaries were also successful in meeting these objectives, at least in the short run.

The securities issued are being bought by other institutions worldwide. When assets are created by banks to transfer the risks, there could be the possibility that such assets were contracted with limited due diligence, with the support of ‘modern’ lending practices such as ‘arm’s length financing’ with excessive reliance on the external pool ratings.

There could also exist the possibility that the bank manager might not have had a personal interaction with the borrower. Though the modern method of financing has its merits and demerits, the fact is risk management tools are extensively used to transfer such credit risks. This calls for re-assessment of the scope of the risk management framework and its ability to assess the intentions of true sale of such securities.

Sustainable Risk Governance

The issue per se is not whether certain banks adopt complex risk transfer strategies. Other things remaining the same, the economic system must not be a victim of such financial engineering; financial transactions must not create economic instability.

After all, when the objective is to ensure efficient capital allocation and better dividends to the shareholders, the economic sustainability also has to be an equally relevant factor. The ongoing international developments seem to indicate that sustainable corporate social responsibility (CSR) has been delegated to the background while undertaking massive risk transfer strategies. This aspect needs introspection. A sustainable CSR programme of the management can only promote sustainable risk governance, which keeps in view the overall impact of risk transfer strategies.

The Basel II norms, per se, highlight the ‘supervisory review process’ through which the regulator assesses the capability of the financial institution to meet with the minimum capital adequacy at all times.

But such impact assessment does not appear to have adequately captured the impact of a default contagion arising out of derivative products.

As an evolving subject, risk management still revolves around econometric models and forecasts.

The developments warrant in-depth appreciation of risk management in every layer of the organisational structure. More than the software, seasoned risk management specialist with deep exposure on credit is crucial.

Duty of care

Sustainable CSR suggests that businesses have a duty of care to all of their stakeholders. While taking financial decisions, the endeavour must be to balance the financial, economic, social, environmental and other consequences of their activities, and their impact on society at large.

Therefore, the questions are whether corporations are still not serious about sustainable corporate governance? How long will corporations take to shift their focus from corporate governance to sustainable corporate governance? Can institution-specific short-run profit maximisation emanating from risk transfer strategies sustain?

Are the capital adequacy norms, such as Basel II norms, broad enough to capture sustainability and stakeholder interest? What should be the kind of regulatory and governmental intervention in such a situation, especially when the corporations, though public, are not government corporations?

The answer seems to be in the form of drawing a fine line between social performance and financial performance. Rather, business must not look only at short run financial gains. For that matter, the financial intermediaries must evolve sustainable risk management and governance strategies along with their CSR policy.

Though the results may not be quick in the short run, the long-term sustainability is contingent upon sustainable risk governance functions and policies.

(The author is DGM, Risk Management Department, Vijaya Bank. The views are personal. E-mail: av_arun@indiatimes.com)

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