25 October 2004	Monday	10 Ramazan 1425

The dictionary meaning of "risk" is danger, peril or hazard. It also means chances of loss and the degree of loss probability. Everything in this world is exposed to "risk", including all persons, their assets, business, families and investments etc.

Human ingenuity and intelligence has devised different methods and mechanism to protect persons and their assets. One can take an insurance policy on his life or insure his assets against fire, earthquake or other natural disaster. Managing risk means dealing with all its aspects. However, risk can never totally be eliminated.

Every business, faces "uncertainty" about its future earnings and cash in-flows. The wide-range of "uncertainties" which threatens a business usually are:

Natural perils: For instance, windstorm, floods, earthquake etc.

Technical risks: The introduction of new process carries risk of failure.

Liability risk: The possibility that a single or more than one event may involve it in crippling liabilities to third parties.

Loss of personnel: Death or injury to key and strategic employees which may threaten its survival.

Labour risk: Non-availability of suitable labour,

Political\social risk: The risk of nationalization, change in economic policies affecting business, industry or trade, besides other government interventions, acts of terrorism, kidnappings for ransom may also be included in this category.

Risk components: Any risk to the business is made up of four components, which are:

1. Threats: Different range of forces which produce adverse results.

2. Resources: Assets, people or earnings may be affected by threats.

3. Modifying factors: Those particular factors- internal or external- to the resources, which may increase or reduce the possibility of threats becoming a reality.

4. Consequences: The manner or the extent to which the threat affects the resources.

There should be a strong and effective risk management system and controls within an organization, which would promote stability. An internal risk management system based on the above lines provides following advantages:

* Protects an entity against market, credit, liquidity, operational and legal risk.

* Protects an entity's assets and investment from possible risk of loss.

*Protects an entity's customer from non-market-related losses e.g. organization's failure, misappropriation, fraud etc. and;

* Protects an entity and its subsidiaries or group from reputational risk. Major risk to which an entity is exposed are as follows:

Market risk: Market risk is the risk that an investment will not be as profitable as the investor would have thought due to fluctuations in the market. Market risk is the risk when prices or rates change adversely due to market forces. The risks include bad effects of movement in equity and interest rate currency exchange rates and commodity prices coupled with the cost of borrowing securities, dividend risk etc.

Such risk can also include the the danger inherent in the market as is highlighted in the bankruptcy of a municipal corporation whose treasure used its investment pool in derivate securities namely "structured notes" and "inverse floaters". When interest rates went up, rates on these derivative securities declined along with market value of these notes, since they were at the rates below those generally available in the market. This resulted in a $1.7 billion loss to the municipal corporation.

Credit risk: Credit risk can be defined as the possibility of one of the parties to the contract not fulfilling its obligations. It comprises risk of loss due to counter-party default on loans, swaps, etc. Credit risk can be minimized by proper management, control and procedures that require the parties to maintain adequate collateral, make margin payments and have contractual provisions for netting.

In the financial crises of Southeast Asia in 1998 many of the US banks in January 1998 reported that their quarterly results were adversely affected by the crisis. An example is J.P. Morgan's reclassification of nearly $600 million loan as non-performing.

Liquidity risk: It is the risk that a party to a security instrument may not be able to sell or transfer that instrument quickly and at a reasonable price resulting in a loss. Liquidity risk includes that risk that a firm will not be able to hedge a position. A company specializing in mortgaged-backed debt instrument suffered a loss of $600 million because they carried the highest credit and interest rate risk. When interest rate went up sharply, trading in these instrument ceased as such no quotation was available near the price paid by this company from market participants.

Operational risk: Operational risk is the risk that improper operation of trade processing or management system will result in financial loss. Operational risk covers the risk of loss due to the breakdown in controls within the firm including but not limited to, unidentified limit excesses, unauthorized trading, fraud in trading or back office functions including inadequate books and records and lack of basic internal accounting controls, inexperienced staff, and unstable, easily accessed computer system.

Maintaining adequate books, records and internal controls is essential to effectively manage operational risk. A strong internal audit system which is independent of the trading and revenue side of the business, clear limits on personnel, and risk management and control policies exercise control over operational risk.

The importance of "operational risk" management is highlighted by the collapse of "Barings" in February 1995. The Board of banking supervision in UK was of the view that Baring's failure was due to immense losses from unauthorised and hidden derivates trading of an employee of Barings Futures Pvt. Ltd in Singapore, which went undetected by the management. The employee had been left unsupervised in his dual role as head of futures trading and settlements. Baring's failure to independently monitor this particular employee's activities, as well as its failure to separate front and back office functions, created operational risk resulting in large losses and finally the total collapse of the firm.

Similar poor management control resulted in even larges losses to Japan's Daiwa Bank Ltd in the bond market. In 1995 it was discovered that a bond trader (employee) at Daiwa was able to conceal nearly $1 billion in trading losses because of his access to accounting books. As with "Barings", the Daiwa trader was in control of accounts as well as trading activities, separation of trading and support functions, a fundamental risk management practice, was violated in both.

Legal risk: It arises from the possibility that an entity may not be able to enforce a contract against another party. Legal risk arises from possible risk of loss due to an unenforceable contract or an "ultra vires" act of counter party. Legal risk involves the potential illegality of the contract, as well as the possibility that the other party entered into the contract without proper authority. An example of legal risk is that recently Orange county has asserted an ultra vires claim in its suit against Merrill Lync that Merrill lynch should have known that the contracts violated several provisions of the California constitution, hence rendering the contracts unenforceable.

Systemic risk: Systemic risk encompassed the risk that failure in one firm or one segment of the market would trigger failure in segment of or throughout the entire financial market. Defaults of unprecedented nature and magnitude could occur in the event of heavy volatility across capital markets such as currency and equity crashes. Systemic risk is possibly the greatest challenge to the regulators and to the financial market. A uniform, flexible framework of risk management and controls, coupled with adequate capital standards is essential to the continued orderly operation of financial market(s).

Commercial banks and other financial institutions worldwide recognize an extensive set of risk categories, which are managed within the framework of various objectives and strategies. The major categories of risk to which a financial institution is exposed are:

Liquidity risk: This risk is present when a bank's liquid assets like cash, cash equivalent and other assets that can easily be converted into cash without the bank having to suffer a loss on their conversion are not enough to meet the bank's short-term obligations. In such a situation the bank may find itself "locked in" or unable to meet its obligations without converting its illiquid assets at a loss.

Credit or default risk: Credit risk is the risk to the lending bank where the borrower during the loan outstanding period is unable to meet the terms of the loan agreement. These terms relate primarily to the ability to pay interest and repay principal when due.

Portfolio risk: Portfolio risk refers to the risk in connection with the structure of bank's loan portfolio. The risk can be minimized through diversification by placing limits on total amount of exposure of each borrower, by increasing the number of industries represented in the portfolio, the geographical diversification of borrowers and or number of borrowers.

Industry risk: This risk refers to the risks associated with the activities of specific spheres of economic activity. Industry risk is closely related to portfolio risk in the sense that the loan portfolio dominated by loans to industries with comparable characteristics carries a higher risk than a portfolio diversified by different industry types.

Country risk: Country risk is a function of economic and political climate found in foreign countries in which a bank has an exposure. Just as with other types of risk, lenders try to quantify country risk by rating countries according to both political and economic risk.

Foreign exchange risk: It may be defined as the "risk of loss due to changes in the values of foreign currencies in terms of a bank's domestic currency". Therefore, it only affects bank(s) engaged in buying, selling, or holding foreign exchange assets and/or any other assets.

Given the wide variety of foreign currency - denominated assets and liabilities that banks hold or trade at any one time, foreign exchange risk are in many forms. Such risk may be minimized through hedging, what to hedge, when to hedge and to what extent to hedge are important management decisions. The most important policy to follow is to avoid foreign exchange risk altogether. This means to limit foreign exchange transaction to only those originated by customer and to hedge any foreign exchange exposure to the fullest extent.

Interest rate risk: This risk like all other types of risk is equated with uncertainty as to the timing and direction of future changes in interest rates. It may be defined as the variability of return or prices of financial assets caused by changes in interest rates. Interest rate risk management is difficult in the absence of well-developed money market with comparable low levels of inflation. In such countries it is usually limited to policy of maximizing interest margins.

In every bank and financial institution risk management activities broadly takes place at strategic, macro and micro level. At strategic level risk management activities is confined to senior management and board of directors. At macro level it covers a business area or across business lines. At micro level it involves the activities where risk are actually created.

The risk management activities at this level is performed by individuals who on bank's behalf take risk e.g. loan originating departments and front office. Due to various reasons like increased competition, expanding business, globalization, deregulation and invention of new financial products there is a need of an effective risk management system in financial institutions.

Risk management must start at the highest management level. Its responsibility rests with the board of directors. Senior management has to be sure that the policies of risk management is ingrained in organization's culture.