Overcoming Risk Management Challenges for Banks in Emerging

Overcoming Risk Management Challenges for Banks in Emerging economies: 

Overcoming Risk Management Challenges for Banks in Emerging economies Dr. B. Yerram Raju Regional Director, PRMIA, Hyderabad Chapter Presentation at the Risk Management Conference at Kuala Lumpur Nov 2-3, 2011

The Context: Basel III Concerns Major Challenges in Risk Management Central Banks’ approaches The Way Forward? : 

The Context: Basel III Concerns Major Challenges in Risk Management Central Banks’ approaches The Way Forward? Structure of Presentation

*Unprecedented disasters-Ash clouds, Earth quakes Turkey in ‘Q’ after Japan *Global equations are changing *EMEs calling shots *Markets lost confidence in Europe *G-20 at Cannes on Nov 3-4 request China’s support for debt markets.: 

*Unprecedented disasters-Ash clouds, Earth quakes Turkey in ‘Q’ after Japan *Global equations are changing *EMEs calling shots *Markets lost confidence in Europe *G-20 at Cannes on Nov 3-4 request China’s support for debt markets. Reuters The Context

Global Macro Economic Developments: 

11/21/2011 yerramraju@prmia 4 11/21/2011 yerramraju@prmia 4 Global Macro Economic Developments “The global risk scenario has improved, though there are signs of a slowdown in growth during 2011 in most countries, including some developing economies in Asia. The main underlying factors causing global imbalances remain largely unaddressed, increasing the uncertainty around the path of global recovery. The sovereign debt crisis in some Euro area countries and the increasingly high levels of government debt in some advanced countries remain threats to global stability.”

Revenue growth rates segmented by geographic market,1 compound annual growth rate (CAGR)%: 

11/21/2011 yerramraju@prmia 5 11/21/2011 yerramraju@prmia 5 Revenue growth rates segmented by geographic market,1 compound annual growth rate (CAGR)% By location of company headquarters Overall growth Growth in home markets Growth in developed markets (other than home) Growth in emerging markets (other than home) Emerging market companies 23.9 17.9 22.4 30.7 Developed economy companies 10.7 7.5 11.7 12.6 Growth rate advantage in emerging market cos 13.2 10.4 10.7 18.1 Source: McKinsey Survey April 2011

Our Central Bankers expect: 

11/21/2011 yerramraju@prmia 6 11/21/2011 yerramraju@prmia 6 Our Central Bankers expect Robust demand and growth in EMEs have strong structural and cyclical impetus to commodity prices but the increasing financialisation of commodity markets together with higher speculative interest might be distorting the tradeoffs between inflation and growth for many Asian Economies and EMEs and escalating volatility. This in turn causes shocks from commodity markets to spread to other markets.

Challenges of Emerging Markets: 

11/21/2011 yerramraju@prmia 7 Challenges of Emerging Markets Emerging markets are shaping the future businesses ‘Private equity is emblematic of an industry hit hard by the financial crisis’ Collapse of leveraged financing and implosion of M&A Product designs, infrastructure, innovations and value chains in EMEs turn indigenous firms global EMEs would contribute more to the World’s GDP in the next ten years. (McKinsey predicts GDP per capita will be five times more than the OECD) Planning around commodity and currency markets’ price shifts

Challenges of Emerging Markets: 

11/21/2011 yerramraju@prmia 8 Challenges of Emerging Markets Clean-tech industry is going to be the biggest challenge because of the rising forces of environmental protectionism Growth and rising demand for safety nets with the ageing population demanding its cake Roughly 40 percent of world’s population will have achieved middle class status – up from less than 20% now. EMEs are drivers of consumption as they are in low-cost operations. These economies will provide capital and talent Outsourcing business pose huge risks in the backdrop of sovereign risks

Baffling Sovereign Debt: 

11/21/2011 yerramraju@prmia 9 Baffling Sovereign Debt Source: The Economist Aug 13 2011

Baffling Sovereign Debt: 

11/21/2011 yerramraju@prmia 10 Baffling Sovereign Debt Source: The Economist Aug 13 2011

Emerging Economies & Currency War: 

11/21/2011 yerramraju@prmia 11 Emerging Economies & Currency War The Rupee slides with Increasing global fears And commodity declines Though Oil is rising

Emerging Economies & Currency War: 

11/21/2011 yerramraju@prmia 12 Emerging Economies & Currency War An index of emerging stockmarkets prepared by MSCI has fallen by over 20% since August 1st, despite a rally on September 27th. The worry now is that bonds will follow suit. Foreign investors hold a third of the local-currency debt issued by Indonesia, Korea, Malaysia, Mexico, Poland and Turkey. In a conference call, Bhanu Baweja of UBS worried that the stomach-churning developments in Europe and America might prompt these investors to “puke” up their bondholdings.

Emerging Economies & Currency War: 

11/21/2011 yerramraju@prmia 13 Emerging Economies & Currency War A cheaper real, zloty and rupee will help emerging economies win a bigger share of global spending. But that is small consolation if global spending declines. The volume of exports from Latin America and Asia did not surpass its pre-crisis peak until the first quarter of this year, according to the Netherlands Bureau for Economic Policy Analysis. And foreign sales are bound to fall again as America stagnates and a two-speed Europe converges on a single, slower pace.

Accommodative Monetary Policy: 

11/21/2011 yerramraju@prmia 14 Accommodative Monetary Policy Indonesia and Singapore have begun easing interest rates Bank of Thailand could cut rates by 50bps before year-end RBI may pause its next monetary policy review China could pursue rate hikes and cut reserve requirement ratio to neutralise the policy effect

PowerPoint Presentation: 

11/21/2011 yerramraju@prmia 15 Country/Yr 2007 2008 2009 2010 2011E 2012E China 4.14 2.25 2.25 2.75 3.5 3.5 India 7.5 7.75 5 5 6.75 8.5 Thailand 3.25 2.75 1.25 2 3 3.5 Malaysia 3.5 3.25 2 2.75 3 3 Indonesia 8 9.25 6.5 6.5 6.25 6 Interest Rate in %

PowerPoint Presentation: 

11/21/2011 yerramraju@prmia 16 Country/Yr 2007 2008 2009 2010 2011E 2012E China 23.8 20.7 20.4 20.5 20.4 20.6 India 78.1 76.2 75.5 72.5 69.4 66.9 Thailand 24.1 23.5 29.2 28.3 29 28.5 Malaysia 41.7 41.5 53.7 54.6 55 53 Indonesia 35.2 33 28 26 25.5 25 Public Debt as % of GDP

PowerPoint Presentation: 

11/21/2011 yerramraju@prmia 17 Country/Yr 2007 2008 2009 2010 2011E 2012E China 1528.2 1946 2399.2 2847.3 3313.5 3655.7 India 199.1 299.1 241.6 252.8 273.7 278.4 Thailand 85.2 108.7 135.5 167.5 183.5 190 Malaysia 101.3 91.5 96.7 104.9 135 153 Indonesia 56.9 51.6 66.1 96.2 121.9 140.3 While Asia has substantial precautionary reserve, pooling forex reserves via currency swaps is required to buffer confidence in a country’s external liquidity position. Pooled Foreign Reserve $USbn

Basel III Concerns If you have a wound in the toe heal it in the stomach?: 

11/21/2011 yerramraju@prmia 18 Basel III Concerns If you have a wound in the toe heal it in the stomach ? A fireman fights major fire in Russia That killed 52 persons - Reuters

Sound Practices v/s Capital Requirements : 

11/21/2011 yerramraju@prmia 19 Sound Practices v/s Capital Requirements

PowerPoint Presentation: 

11/21/2011 yerramraju@prmia 20 BASEL III new requirements Phased-in arrangements As of 1 January 2011 2012 2013 2014 2015 2016 2017 2018 2019 Leverage Ratio Supervisory Monitoring Parallel run 1 Jan 2013-1 Jan 2017 Disclosure starts 1 Jan 2015 Migration to Pillar 1 Minimum Common Equity Capital Ratio 3.5% 4.0% 4.5% 4.5% 4.5% 4.5% 4.5% Capital Conservation Buffer 0.625% 1.25% 1.875% 2.50% Minimum Common Equity plus Capital Conservation Buffer 3.5% 4.0% 4.5% 5.125% 5.75% 6.375% 7.0% Phase-in of deductions from CET1 (including amounts exceeding the limit for DTAs, MSRs and financials 20% 40% 60% 80% 100% 100% Minimum Tier 1 Capital 4.5% 5.5% 6.0% 6.0% 6.0% 6.0% 6.0% Minimum Total Capital 8.0% 8.0% 8.0% 8.0% 8.0% 8.0% 8.0% Minimum Total Capital plus Conservation Buffer 8.0% 8.0% 8.0% 8.625% 9.125% 9.875% 10.5% Capital instruments that no longer qualify as Non-Core Tier 1 Capital or Tier 2 Capital Phased out over 10 year horizon beginning 2013 As of 1 January 2011 2012 2013 2014 2015 2016 2017 2018 2019 Liquidity Coverage Ratio Observatio n period begins Introduce minimum standard Net Stable Funding Ratio Observation period begins Introduce minimum standard

PowerPoint Presentation: 

11/21/2011 yerramraju@prmia 21 BASEL III new requirements Key reforms and core objectives Ensure banks have sufficient high quality liquid resources to survive acute stress scenario lasting 1 month Strengthen capital requirements for counterparty credit risk from derivatives & securities financing activities Raise level of minimum capital requirements, for T1 and CET1 LIQUIDITY Introduce Liquidity Coverage Ratio (“LCR”) 1 1 Raise quality, consistency & transparency of capital base Better able to absorb losses on going and gone concern CAPITAL 2 3 4 5 6 Introduce Net Stable Funding Ratio (“NSFR”) Promote resilience over longer-term horizon Creating incentives for banks to fund activities with more stable sources of funding on an ongoing basis 2 Incentivise conservation of capital through build-up of capital buffers above minimum requirement which can be drawn down by individual banks as losses are incurred Promote build-up of countercyclical buffers at system level to protect banking sector from periods of excessive credit growth Maintain flow of credit in economy during downturn Introduce non-risk based leverage ratio to reinforce risk-based requirements Constrain build-up of leverage Mitigate effects of excessive de-leveraging in banking system during distressed periods

PowerPoint Presentation: 

11/21/2011 yerramraju@prmia 22 Impacts on the banking sector BASEL III’s impacts will be felt by individual banks, then flow to financial system and economy Financial system Weak banks crowded out More difficult to raise capital & funding Individual banks ROE pressure Increased pressure on margins & decreased investor returns Legal entity re-organisation Drive M&A, disposal of portfolio & entities Inconsistent implementation Jurisdictions implementing at different timeline / method Reduced risk of systemic crisis Reduced risk of bank failure, reduced interconnectivity Reduced investor appetite Equity issuance less attractive as lower dividends Shadow banking system Hedge funds may be used by firms without access to capital markets Real economy Reduced credit volume Loan facilities will have stricter assessment parameters Lower GDP Reduction in available credit

The Building Blocks: 

11/21/2011 yerramraju@prmia 23 The Building Blocks “The building blocks of Basel III are by now quite well known: higher and better quality capital; an internationally harmonized leverage ratio to constrain excessive risk taking; capital buffers which would be built up in good times so that they can be drawn down in times of stress; minimum global liquidity standards; and stronger standards for supervision, public disclosure and risk management.”

The Building Blocks: 

11/21/2011 yerramraju@prmia 24 The Building Blocks Banks unwilling to accept the lower returns on equity, or ROE, that result from higher capital requirements may fuel a new bubble by chasing high returns in commodities or emerging markets. Regulators, while focusing their restraints on banks, may drive risk-taking into unregulated funds that may pose danger to the system.

PowerPoint Presentation: 

11/21/2011 yerramraju@prmia 25 Capital The Major Concerns Capital of the nature required – where does it come from? What cost has to be paid? Would it insulate EMEs from the type of recession that we are facing today? EMEs, which depend on external trade, provisions weigh too heavy? How do the regulators cope with such eventuality? Between 2013 and 2019 during which period the implementation of Basel III is expected to settle down, is there any guarantee that the world would not get hit with another recession? If it happens, where will Basel III stand? G-20 has concerns – but has no solutions excepting capital buffers Finally, does capital cap it all?

PowerPoint Presentation: 

11/21/2011 yerramraju@prmia 26 Major Challenges in Risk Management Courtesy: Reuters Risk Culture Sovereign Risk Systemic Risk

PowerPoint Presentation: 

11/21/2011 yerramraju@prmia 27 Banks are highly bureaucratised institutions and in bureaucracy it is implicit obedience that rules In many EMEs, the man in the midst of risk ocean feels that there is a risk manager to take care of him He is the cause and effect – when do we bring this realisation in him and how? – this is the major challenge of future. Risk Culture

Central Banks’ Approaches: 

11/21/2011 yerramraju@prmia 28 Central Banks’ Approaches Are the three pillars enough? One more pillar to add?

PowerPoint Presentation: 

11/21/2011 yerramraju@prmia 29 Courtesy: FT Systemic Risks Distribution of risk within the system at any given point of time – a cross-sectional dimension. It arises due to the inter-connectedness of institutions, Balance sheet engagements, common exposures and sometimes, even common business models of financial institutions. Time dimension: How aggressive the risks evolve over time – the procyclicality issue.

PowerPoint Presentation: 

11/21/2011 yerramraju@prmia 30 Lito Camacho of Credit Suisse suggests ASEAN+3 Bond Fund to promote investor appetite in the region and to contain the sovereign risks under a PPP mode. A Private trusted Investor company is expected to take care of this Fund. ASEAN to expand trade as trade and capital are still Available in plenty in the region through more intra-regional trade agreements. US and Europe can continue to be trading partners. Indiscriminate risk aversion can be mitigated by more aggressive investor relations programs. Issuers need to do more to differentiate their credits and investment stories. Senior government officials should take all opportunities to explain how their economies can continue to perform amid the problems in the West, and support domestic companies in communicating with the market. FT 26/10/11 Sovereign Risks

PowerPoint Presentation: 

11/21/2011 yerramraju@prmia 31 Capital flows – a double edged sword ` Resource constrained Emerging Economies value capital flows ` There remains risks from such flows in a closely interconnected world as strongly demonstrated by the financial crisis ` Sudden reversals / volatility in flows especially if the composition of flows is skewed towards portfolio flows ` Risks of inflows concentrated in “sensitive” sectors like real estate leading to asset price bubbles ` Challenges have been accentuated by recent policies in some advanced economies - Quantitative easing and stimulus policies to support ailing economies, ` Leading to increased flows to EMEs

PowerPoint Presentation: 

11/21/2011 yerramraju@prmia 32 A menu of policy options ` EMEs are resource constrained and value capital flows ` How to benefit from the flows without stress of reversals? ` EMEs manage capital flows by one or more of many policy tools ` Floating exchange rates ` Accumulating reserves – sterilized and unsterilized interventions ` Adjusting interest rates ` Fiscal policy measures ` Reinforcing prudential regulations ` Liberalizing capital outflows ` Capital controls ` Challenges in selection of optimal policy response ` ‘C ircumstances in which capital controls can be a legitimate component of the policy response to surges in capital flows ’. IMF (February 2010)

PowerPoint Presentation: 

11/21/2011 yerramraju@prmia 33 Liquidity Management ` The global financial crisis (GFC) ` under-scored the criticality of liquidity for financial stability ` Brought central banks to the forefront in liquidity management ` A series of conventional and un-conventional policy measures were adopted by central banks ` In the wake of unprecedented funding market dislocations ` Even as many questions were raised both about the resilience of global funding markets and about the management of such liquidity ` .... Albeit at a significant cost in terms of ` Expanded central bank balance sheets ` Diluted quality of collateral

PowerPoint Presentation: 

11/21/2011 yerramraju@prmia 34 The Way Forward Short term: Economies like China and Brazil to contribute to IMF to support the sovereign debt markets or to recapitalize the European Banks Medium Term: With more and more MNCs moving to EMEs, the cost equations are changing – If EME employment moves to produce goods and services for domestic consumption, risk mapping would alter. Pressure on currency values will continue to increase. If dollar and Euro devalue? Structural pressures will be more. LIGHT AT THE END OF THE TUNNEL?

PowerPoint Presentation: 

11/21/2011 yerramraju@prmia 35 The Way Forward Providing capital for operational risk arising from human misbehaviour, greed and systemic risk is a major challenge Capital after all is not going to help in all these situations where solution has to be found in recruiting standards, incentive and punishment systems, due diligence and co-ordination among institutions Data frames moving to cloud computing inter-sector and inter-institutional sets need the rigour of verification and validation EMEs to have regional benchmarks and performance standards for providing capital. Credit Rating Agencies shall move to transparency and accountability frames and the Banks should insist. Investment rating and debt rating instrumentalities and SME rating instrumentality should be different. Regulatory arbitrage should be avoided.

PowerPoint Presentation: 

11/21/2011 yerramraju@prmia 36 The Way Forward "The traditional universal bank concept had been extended into businesses that [banks] didn't need to be in," says Terry Moore, managing director of the North America banking practice at the consulting firm Accenture. "Now they've gotten more focused on a core set of businesses that provide diversity but don't cause them to get too far out there." Since they are in the market for risk, proper pricing is important and collateral risks can be captured when the assessment is done on the same canvas. Countries in Euro markets craving for bail-outs should behave more responsibly in fiscal management and this should be the principal monitorable condition for the EMEs joining the effort.

PowerPoint Presentation: 

11/21/2011 yerramraju@prmia 37 The Way Forward IMF to multiply its ‘free resources’: Should shoulder increasing responsibility to rescue emerging economies that experience BoP problems through similar structured EU bailout packages G-20 agreed to move more towards flexible, market-determined exchange rate system.

PowerPoint Presentation: 

11/21/2011 yerramraju@prmia 38 Never be afraid to do something new. Remember, amateurs built the ark; professionals built the titanic. Thank you yerramr@gmail.com