Project Management Methods and Industrial Process - Essay Example

VALUE AT RISK (VAR) A BENCHMARK TO MANAGING FINANCIAL RISK TABLE OF CONTENT PAGES An Helicopter View of Risk 03 From Origin of Basel till Implementation 04 Value At Risk (VAR) 06 Market Risk 08 Credit Risk 08 Operational Risk 09 Limitation of VAR 11 RBS failure and VAR 11 Conclusion 14 References 15 A HELICOPTER VIEW OF RISK: As per a Chinese Proverb, A smart man learns from his own mistakes, A wise man learns from the mistakes of others, And a fool never learns From the last decade risk management is the most researched and exciting area in the financial industry as it elaborates how to minimize and avert the hazard of risk from the portfolios of different assets and from the operations of financial institutions. Regulators and depositors mainly emphasize on the risk management, as per them risk management is an essential ingredient to enhance the value of shareholders and increase their level of confidence (Christoffersen, 2003). Risk management is the assessment of risks to mitigate, monitor and control the probability or impact of uncertain events. Risk management methods and nature varies from industry to industry like it can't be same for project management, industrial process and financial portfolios. From a management view point, risk management is an important tool which is used in decision making because it is systematic and well structured. For better utilization of risk management in management's decisions, risk analyst's reports must be based on the latest and best available information. The cause behind the mentioning of the Chinese proverb above is that risk management is the only tool which differentiates a good management with a bad one. From a bank's standpoint the term is usually used synonymously with specific uncertainty because the usage of statistics allows us to quantify the uncertainty which is called the measure of dispersion (Shirref, 2004). We know that every country have mostly two regulators on their heads, one for the banks and one for the companies. Usually Securities and Exchange Commission (SEC) regulates the companies while the Reserve bank regulates the financial institutions. Bank of International Settlement is the regulator of the regulators. From the same concept there is another regulator which regulates the financial institutions risk management department regarding the capital requirement and capital adequacy ratio. The name of the regulator is Basel Accord. Let's see in detail, what Basel accord has in its regulation. FROM ORIGIN OF BASEL TILL IMPLEMENTATION: Basel was an attempt to reduce the quantity of bank failures in a country, due to the insufficient capital which ties a bank's Capital Adequacy Ratio (CAR) to the risk of the loan Bank's makes. In 1988, The Basel Committee for Banking Supervision (BCBS) did the first attempt to implement such methods worldwide, which enhance the risk absorption power of the banks. Basel I was the initial or first set of capital requirement for all actively international banks because it sets charges for the credit risk which is known as crude capital charges. It instituted for the first time the requirement of minimum capital which must be held by the international banks to avoid the financial risk. In 1980, credit risk was the dominant player in risk class for banks but by the early 1990s, banks became more anxious to be a part of the capital market and for those markets which are larger and more liquid, and to play their role, and they did that. The significance and importance of risk then arose in the banks, but the Basel I merely emphasized on the credit risk. To overcome the risk of all traits, a new framework was desperately required to make the risk calculation and reporting more sophisticated. The BCBS agreed upon the market risk amendments in 1996 from there the concept of Basel II was born (Reuvid, 2008). Initially, the capital charges were based on definite standards, defined by the BCBS, which gave an idea about the capital adequacy requirement which initially covered the credit risk and then the market risk. The latest rule by the Basel Committee on Banking Supervision (BCBS), which is known as Basel II were finalized in June 2004, represented a sophisticated and extensive revision of the capital charges that creates more risk sensitive capital requirement (Philippe & jorion). The Basel II is agreed by all the members of the committee and also endorsed by the Central bank Governors and Head of Banking Supervisions of the G-10 countries. The minimum capital requirements which are stated in Basel II are adopted by a number of banks of around 100 countries and United States (U.S) regulators are ready to implement the Basel II on top of the US banks. The new framework (Basel II) is based on 3 pillars which are mentioned below. Minimum Capital Requirement: It is adopted to cover the market, credit and operational risk and reduce the fear of bankruptcy. Comparatively, in Basel II the banks have a wider choice of computing the risk charge. The BCBS decide the level of capital in the global banking system, which is set as 8% of the risk-weighted assets. Supervisory Review process: The Basel Committee of Banking supervision (BCBS) urged the supervisors to ensure that the minimum regulatory capital ratio and capital in relation with risk is up to an adequate level. Market Discipline: The new accord emphasized on the importance of risk reporting or risk disclosure in the financial statement of the banks. The disclosure regarding the risk gives a general idea to participant to evaluate bank's risk profile and the adequacy of their capital position. In 1993, the Bank of International Settlement (BIS) members guided the banks to hold in reserve enough capital which covers 10 days of Value at Risk (VAR). Let's see Value at risk (VAR) and its implementation in details. VALUE AT RISK (VAR): Since the mid 1990, a new measure of risk is been introduced and became popular. J.P Morgan is known as the pioneer of developing and measuring Value at Risk. It is defined as the worst loss that is possible under the normal market conditions during a given time period. VAR is determined by what are estimated to be normal market conditions and by the time period under consideration. It is assumed that for a given set of market conditions, the longer the time period or horizon, (termed as Holding Period), the greater the value at risk. This measure of risk is increasingly used by fund managers, financial institutions as well as corporate treasurers as a summary measure of the total risk of a portfolio. Value at Risk (VAR) has proved to be a very powerful and sophisticated way of assessing the overall market risk of trading positions over a short horizon, let say 10 days period, and under normal market conditions. In effect, the methodology allows us to capture in single number the multiple component of market risk, such as curve risk, volatility risk and basis risk. Finance officials and some influential commentators seem worried regarding the usage of VAR in a crisis period (Christoffersen, 2003). Whenever the economic slump crashes the market, the limitation of even the most sophisticated measure of risk fails because VAR is unreliable in the long run market or under abnormal market conditions. Risk management experts argue that the herd mentality that is so typical of the financial industry means that market sensitive risk management system, like VAR, makes market less stable and more prone to crisis. This is merely because financial institutions have to sell assets when the market becomes volatile which urges the market to fluctuate in both the directions rapidly, which is done in order to keep the market in line with the VAR limits set by senior management. Let's consider an example which pertinently defines the applicability and also defines what the measurement reveals. For instance, if we have a position which has a daily VAR of $8 million at the 99 percent confidence level, It mean that the realized daily losses from the position will on average be higher than $8 million on only one day in every 100 trading days. If I take a laymen's approach to elaborate this above mentioned thing in a sentence then I would say that, there will be a 1 percent chance to lose greater than $8 million in a trading day. This means that the question of the financial institutions remains the same that how much I will lose in a given time period Value at risk (VAR) offers a probability statement about the potential change in a financial market factors over a specified period of time. Actually, the VAR measure also does not state the figures that by how many actual losses are likely to exceed with the figure of calculated VAR, it simply states how likely (or unlikely) it is that the VAR measure will be exceeded. Generally, most VAR measure models are designed to measure risk over a short period of time, let say one day or 10 days in the case of the market risk measurement required by the regulators to comply with the capital requirement stated in Basel II. However, the confidence level for the computation of market risk introduced by the Basel Committee, way back in 1998 which set to 99 percent, it also stated that for allocating the internal capital, VAR may be derived at a higher confidence level, let say 99.97 percent, then we would have calculated the 3-basis point (bp) quantile, and we would have finished up with a huge number of VAR. As mentioned earlier, the higher the confidence level the higher the VAR, which manifests a higher number of loss in a specific time period. Value at risk is used to calculate all the three main types of financial risks, which a financial sector envisages while operating, which are mentioned below. Market Risk Credit Risk Operational Risk Let's see each terminology in details with appropriate examples, which must be helpful to get a thorough idea regarding the financial risks. MARKET RISK: The risk which occurs by the losses due to movement or rapid fluctuations in financial markets or volatilities is referred as marker risk. For instance a trader purchases 1 million worth of British pound (BP) spot from Bank A. The current rate is $1.5/BP, for settlement in two business days. So, our bank will have to deliver $1.5 million in three days in exchange for receiving BP 1 million. This simple transaction involves a series of risks. During the day, the spot rate could change. Say that after a few hours the rate moves to $1.4/BP. The trader cuts the position and enters a spot sale with another bank, Bank B. The million pounds is now worth only $1.4 million, for a loss of $100,000 to be realized in two days. The loss is the change in the market value of the investment. We can easily observe from the example that a fluctuation of one basis point drastically changes the overall portfolio worth and deteriorate by $100,000. CREDIT RISK: Credit risk is the risk of losses due to the fact that the counterparties may not intend or probably unable to fulfill its financial promise or contractual obligation. With respect to the same example mentioned above, suppose that on the next day, Bank B goes bankrupt. The trader must now enter a new replacement trade with Bank C and now the bank sell its remaining BP. If the spot rate has dropped further from $1.4/BP to $1.35/BP, the gain of $50,000 on the spot sale with Bank B is now at risk. The loss is the change in the market value of the investment, if positive. Thus, there is interaction between market and credit risk. The credit is also known as settlement risk or Herstatt risk because in 1974 a German Bank "Herstatt" has been defaulted on such obligations which potentially destabilize the whole financial systems. OPERATIONAL RISK: The risk of loss which may be faced by the financial industry due to the failure of insufficient internal process, system and people, or from external events is known as Operational Risk. Again consider the same example in order to assess how operation risk occurs. Suppose that our bank wired the $1.5 million to a wrong bank, Bank D. After two days, the management realizes the mistake of the operation and fortunately our back office gets the money back, which is then wired to Bank A plus compensatory interest. The loss is the interest on the amount due. Despite, these benefits, there are some places where the Value at Risk (VAR) lacks or precisely we can say that there are some limitation of VAR. Let's see its limitation in details. LIMITATION OF VALUE AT RISK (VAR): VAR is in many ways a crude measure of market risk. Its limitations include: The simplification of the complexities of portfolio risk into positions in a relatively small number of risk factors. The assumption that market data is available for all risk factors that accurately captures the risk of holding the position going forward. The assumption that the portfolio is fixed over some time horizon, oft en 1 or 10 days. For some assets this may be reasonable, but the risk horizon for others might be much longer than that due to their illiquidity. Moreover, if a simple t rule is used to Scale from 1- to 10-day VAR, another distributional assumption is introduced: 10-Day VAR is in general only 10 time's 1-day VAR for normal returns. Value at risk (VAR) is unable to work in some condition like in financial turmoil, because VAR depends on the short term strategy, that's why a number of banks filed bankruptcy this year, which shows that the most sophisticated and reliable measurement of risk fails to measure the worst loss in the financial distress (Vernimmen, 2000). ROYAL BANK OF SCOTLAND FAILURE AND VAR: As we are well cognizant with the fact that financial institutions are the main victims, who are badly hurt by the current credit crisis. Britain had a very strong and very big banking sector 1 or 2 years before, but the bank plunged as badly as it showed a record loss in the corporate history of United Kingdom (UK). One of the main causes of severe losses of banking sector is to merely emphasize on a risk measure tool Value at Risk (VAR), albeit the tool is the most reliable and authentic in front of risk managers, but the problem persists VAR prone when the economy is in severe recession or willing to calculate the worst loss for a given time period. Royal bank of Scotland (RBS) is the Britain's biggest bank which owned by the Government. The bank enjoyed net profit after tax for consecutive years as the annual reports reveals that the net profit after tax were m5289, m 5558 and m6497 for the financial years 2004,2005 and 2006 respectively. The bank earned profit of m245 FY 2007 before the current financial tsunami broke its backbone. The bank filed a record of 857 million pound in the year 2008, which is the biggest in the history of U.K. The Chief Executive Office (CEO) of the bank "Stephen Hester says" Royal Bank of Scotland is the 3rd bank this week after Lloyd Banking Group Plc and Barclays which indicates bad loans may increase this year". (Retrived from www.rbs.com.uk) That was the time, where the most sophisticated and reliable source of measurement which is known as VAR got failed, as it can anticipate the loss for a long time period. The prediction of finance official regarding the measure of VAR seems wonderfully correct that the tool prone at the time of economic slump because of the problem it had to tackle with the financial crisis. The bank has slashed more than 11,700 jobs, ousted directors and sold assets of RBS, which felt into government control after it recorded the biggest loss in the corporate history of United Kingdom (U.K). Hester says "The condition for the Royal Bank of Scotland (RBS) will be tougher in the current year as well as FY 2010 as I am unable to seeing green shots in the long run and over the next two years the effort of the executives and management will be drowned out by the current continuing recession, which is the worst after the great depression of 1930. Not VAR is the only cause for RBS to report such a big contribution was there of Bernard Madoff, which is a pleading company. In December 2008 the company admitted that it collapsed $64 billion investment fund. Royal Bank of Scotland was the biggest victims of the Bernard Madoff which lost 600 million in the scam. As far as I researched there are some pitfalls in the computation of VAR. First is the same as we discussed earlier that it relies on historical norms and as per the finance experts past is not a reliable guide, neither for predicting future nor for anticipate the worst. So as per my perception, the bank failed because of their long term strategies, although long term strategies are good to be made and implement but not for this case. Second it didn't take the effect of sub prime loans and they are the main ones which immensely pushed the bank to be almost bankrupt and are the main cause of the current financial turmoil. The third and the last problem with the VAR is that the pricing models are assumed that the prices of securities and currency follows a normal distribution, but this fact does not always work, some security prices are not systematically distributed because it exhibits fat tails. From a practical prospective, Value at Risk (VAR) is not the only risk measurement tool, there is so much but the major tool on which the financial institutions merely emphasize failed to detect of the United States (US) sub-prime mortgage which collapsed the market as badly that the market loss more than $130 billion in just 3 months and urged the giant groups like Citigroup, Morgan Stanley, Merrily Lange and UBS AG to be default. No doubt that Value at risk (VAR) is still the most sophisticated and reliable tool to forecast about the worst loss but only relying on this tool is not a wise decision. Stress or back testing must be implemented after the computation of VAR which shows the shortage of liquidity or credit in the bank and indicates that weather or not the bank is in safe position to lend money. Another recommendation is that they should try to work on short term strategies in current scenario due to volatility in the prices. CONCLUSION: From the above controversy regarding the computation of Value at Risk (VAR), we can say that there is no perfectly reliable resource to anticipate the worst. Yes we can say that from available tools we can apply our best but cannot rely on any one. Precisely, it can be said that VAR alone doesn't extract the desired result, but if we apply Stress or Back-testing then definitely it becomes worthwhile. Recently 19 banks in USA did their stress tests, from which 3 banks found on the brink of bankruptcy due to shortage of credit. JP Morgan, Citi Group, Bank of America (Boka) and American Express are found guilty. To avoid bankruptcy, the said banks have to inject money in their banks to sustain in the competitive market. Respectively the said banks need $36 billion, $58 billion and $30 billion to survive. Back and Stress must be applied and calculated after every quarter, which ensures that the bank have enough capital to meet its regulatory requirements. REFERNCES: Christoffersen, P (2003), "Elements of Financial Risk Management", Academic Press USA, (2003). Cinnamon, R & Larsen, B.H (2006), How to understand Business Finance, British Library Publications. Philippe & jorion, "Value at Risk", 3rd Edition. Reuvid, J, (2008), "Managing Business Risk" Edition: 5, Korgan Page Limited, USA. Royal Bank of Scotland, annual reports (2005-2008) "Retrieved from www.rbs.com.uk" Shirref, D, (2004), "Dealing with Financial Risk", Profile Books Limited (2004). Vernimmen, P (2000), Corporate Finance Theory and Practice, British Library Publications. Read More