“The management and control of risk is the most significant topic in the business world today” – ROBIN KENDALL
“Emerging economies constitute the major growth opportunity in the evolving world order.” – DAVID ARNOLD, JOHN QUELCH
Introduction
The objective of this study is to explore risk management in emerging economies. We were not interested in determining whether individual markets are more or less risky – that is inherent in emerging economies given the scale and pace of change and their current level of economic development. Experience tells us the conditions that make them riskier than mature markets will continue to apply for some time, hence, in an increasingly interconnected global economy, managing risk in emerging economies is and will continue to be an essential competence for multinational organizations.
Our goal is also to build a picture of best or leading practice to see how risk management professionals are successfully managing risk in order that others can leverage their work.
Risk management professionals can measure risk across markets in terms of their potential impact on profit and loss, quantify capital allocation to markets and dealers, establish meaningful risk limits and supervise performance. This study also covers definition of emerging economies and spectrum of risks associated with emerging economies and general best practises followed in order to manage risk effectively.
Definition of Emerging economies The term emerging economy is relatively new however it is one that is broadly utilized now a days. One way to depict emerging economy as simply “all those countries not considered developed”. Developed here meaning essentially the major European countries plus the US, Canada, Japan, Australia and New Zealand Key Attributes A more useful way to look at defining emerging economies is to consider some of their key attributes and see what help this gives us. The major ones would be: a) Level of income This is a commonly used measure. The World Bank, for example, uses Gross Domestic Product (GDP) per head as a measure to classify countries as set out in following Table. (Source- World Bank)
Classification
GDP per head USD Low <755 Lower Middle 755<2995 Upper Middle 2995<9265 High >=9265
b) Growth Rate One reason that emerging markets have been considered attractive has been that they often exhibit a high rate of GDP growth. Many Asian economies averaged 4–7 per cent growth during the eighties and nineties for example, compared with 1–3 per cent for developed economies, but this has not been the case for all emerging market countries.
c) Stage of development This is a factor that fits more closely with the word emerging. There are a number of dimensions we could consider: ● the degree of openness in the economy as measured by the degree of deregulation, privatization of state enterprises, or the extent of tariff and other barriers to trade; ● the size of the market in terms of goods such as cars, telephones, electronic goods ● the state of financial markets including the existence, size and degree of concentration of the stock market, and the size and depth of local bond markets. d) Stability A defining characteristic of many emerging economies is a lack of stability either economically or politically
“We will define emerging economies as: those countries which have started to grow but have yet to reach a mature stage of development and/or where there is significant potential for economic or political instability.” Key Characteristics of Emerging economies The key defining characteristics, therefore, are maturity and instability. a) Maturity is used to describe one of the stages in a continuum or life cycle of development. The stages are birth, growth, maturity and decline which follow a pattern such as that depicted in Fig 1
Fig 1. Life Cycle
In the context of the stage of development of a country, the key measure is usually GDP, as income and development are closely linked. b) Instability is the concern with many emerging economies. It is the uncertainty over what might happen in the future. This uncertainty may be political or economic, sometimes it is both. Political uncertainty arises where there is a history of instability or a high probability that change will occur. The causes of this instability are many and include religious or tribal tensions, repressive regimes, domestic insurrection, war or threat of war, economic problems, etc. Comparison of emerging economies over other economies Change is more likely to occur in emerging economies and the changes that occur happen more quickly and are more unpredictable. Risk is greater in two ways. ● Firstly, emerging economies are different from developed economies and this gives rise to new risks; ● Secondly, risks which have a low probability of occurring in developed countries, have a higher likelihood of occurring in emerging economies. The nature of emerging economies Covers various physical, social, political and economic aspects that underlie the weaknesses and instabilities that characterize their economies. 1. Physical- Emerging economies exhibit a wide range of physical attributes that in one way or another tend to place some limitations on the growth opportunities of a country or make it vulnerable to external influences. Some of these factors are: • geography – large or small size, inaccessible regions or barriers to travel, distance from developed economies; • dependency on weather patterns –rains, El Nino • vulnerability to natural disaster – floods, earthquakes; • poor infrastructure – transport, utilities, etc; • reliance on a few agricultures and/or primary commodities.
2. Social- The social fabric of a country will support or hinder its development. Some of the factors • language – often there are many local languages but a foreign language is needed to conduct international trade (English, Chinese, Spanish or French being the most common); • tribal divisions; • religion; • population growth; • skewed population distribution – large percentage less than 15 years of age; • poor health (AIDS in some countries) or poverty; • concept of the extended family (provides safety net); • education levels low.
3. Political- In only a few emerging economies has democracy been the norm for more than 10–15 years • stable but despotic/one party rule or regular change in government; • democratic but not free elections; • multiparty governments with changing factions; • historical legacy – colonial past or former communist state; • potential for violent overthrow; • corruption; • control of the press though this is being undermined by the Internet and satellite television; • strong influence of the military; • lack of legal framework or laws in place but not enforced; • contracts not always honoured; • internal conflict/repression; • war or threat of war; • many regulations, together with a propensity to bring out new ones without consultation or thinking them through.
4. Economic- Sound economic performance requires the country to have some competitive advantage to start with, which is then effectively exploited. • skewed income distribution; • managed economy – subsidized prices; • dependence on primary exports and/or tourism and/or aid flows for foreign exchange; • net oil importers (few notable exceptions); • protected home markets; • IMF/World Bank support required; • large black economy; • high unemployment or underemployment (but no or limited state support); • poor quality/quantity of data – lack of transparency; • state control of large parts of the economy • small or no stock exchange while those that exist are heavily influenced by trading in a few stocks; • limited amount of stock in public hands; • few large conglomerates operate in many sectors – including banking; • limited tax base – tax avoidance common; Pull and push factors have combined to increase the level of interest in emerging economies as target markets as well as production bases
Risk types in emerging economies a) Business • Whole range of issues make emerging economies more volatile and unpredictable so companies which are not well managed and robust financially will be vulnerable. b) Credit • lack of transparency, limited disclosure (accounting risk) • counterparties unwilling to share information
• inter-connected businesses common c) Credit–sovereign • credit risk of the sovereign entity will generally be well known. It may be weak due to dependencies on external factors such as exports, investment inflows or poor management of income and expenditure. d) Market • exchange rates and interests rate liable to move significantly and with little warning; • two tier exchange rates may operate (official and black market); • pegged exchange rates, currency boards or crawling peg mechanisms may operate but limited resources to defend them leaves them vulnerable to speculation. e) Liquidity • often high degree of reliance on central bank which may have limited resources, particularly in time of need. f) Operational Staff • quality and quantity of staff will vary enormously as will work ethic and time keeping g) Technology • technology in use may be outdated and difficult to maintain h) Outsourcing • if contracts have little meaning this may increase risk considerably if service standards are not met; i) Fraud • Heightened vulnerability particularly where management has limited understanding of local practices or there is collusion amongst staff; j) Processes and procedures • Need to be adapted to local conditions including compliance with local regulations k) Accounting • Accounting standards weak, income sources and profits often understated l) Political • Power tends to be concentrated and is open to abuse even in nominally democratic countries m) Environmental • Lower standards or non-enforcement may reduce environmental risks but this is changing and poor practices today may store up problems for the future n) Legal • Problems can arise through a lack of understanding, unclear requirements, lack of enforcement or laws not being in place o) Systematic • Increased interconnectedness with the outside world as trade barriers are removed and deregulation occurs creating opportunity but make emerging economies more vulnerable. p) Reputational • International companies in emerging economies are prime candidates for adverse publicity. This may be vindictive.
Qualities of Risk Management Professional in emerging economies With the consistent shifting and evolving regulatory and technological landscape, following are list of skills which we accept a Risk Manager should have or should he/she want to become successful in risk management career. a. Financial Acumen Having financial acumen is more than just understanding numbers. The ideal risk professional must comprehend and master the different financial indicators which are tied to the firm’s assets, business lines, markets, regulations and stakeholders. Mastering numbers empowers a risk professional to make sound and quick decisions. b. Analytical skills and an eye for detail In our experience, whatever the category of risk we specialise in, as a risk manager we must possess analytical skills and have an eye for detail. It is therefore crucial that you keep focus on both the broad aspects of your work (e.g. your firm’s business objectives, your department P&L and the firm’s potential top risks) but never losing sight of smaller details that happen on the day to day. c. Industry and Market Knowledge By understanding well, the industry and market where the firm operates, the risk professional will be much better equipped to identify the posing risks. Above all, the risk professional will have a better notion on how to rank, score and group any potential risk for the firm at a given time. An experienced risk professional or potential CRO should be proficient in a specific discipline, such as market risk, credit risk or operational risk, yet with a good knowledge of broader risk issues and regulatory developments. d. Ability to endure and work under stress Some people are essentially emotional dealing with stressful situations, while others can keep focus and respond with their rational assessment. It is a fact that two individuals with the same training, exposed to the same stressful situation, can have totally different reactions and hence a different resulting performance. Successful risk professional must be able to work under pressure as quick decisions will need to be taken in high stressful times. e. Technical skills, negotiation skills and ability to influence people The ability of influencing people is also a very important trait but not everyone has it. The ideal risk professional or CRO must know to listen and to inspire people. These are two skills that any good leader must pursue. f. Good communication and presentation skill They must also be able to convey complex financial products and risk management concepts, practices, and processes to senior, less technical audiences, including front office directors, senior management and the board of directors. Strong interpersonal and communication skills are imperative for risk managers to be successful. g. Holding academic credentials in Finance and Risk When scanning a candidate’s resume, firms seek risk professionals who have strong academic finance or/quantitative credentials. MBA’s in finance, ideally having rigorous courses loads in quantitative finance, from top universities. This always gets the attention of recruiters and hiring managers. h. Strategic thinking capability Solid risk managers must be forward-looking and strategic minded, having the ability to understand potential risks for the firm, both at departmental level as well as in a wider firm perspective.
i. Endurance to regulation Risk management in banking has been transformed over the past decade, largely in response to regulatory requirements following the global financial crisis. Also risk management will experience more changes in the next 10 years. j. Networking ability In the fast paced, risk professional should constantly make to put effort of connecting with other fellow professionals.
General guidelines for Risk Management Best Practices in emerging economies A tentative set of guidelines would include the following points: • Regulators should work together with market participants to establish and enforce risk management rules. Banks and insurance should be encouraged to discuss common policies for risk management, and joint regulators in their efforts to minimise systemic risk. • There should be a clear distinction between regulation of risk control for insurance and banks even if some of the material requirements are the same for both kinds of institutions. • Besides capital requirements and other quantitative requisites, regulators should set forth and enforce qualitative requirements for internal controls; financial institutions should be required to have written risk control policies. • There should be an efficient auditing of insurance and banks with respect to their exposure to risk and their internal controls. • Well-developed clearing facilities should be in place, in order to enhance risk management at an aggregate level; cooperation agreements between clearings acting in different markets are essential for supervision across markets. • At firm levels, VaR and similar quantitative models are an important tool, but useless without a corporate culture of risk management, that includes proper internal controls, flow of information, engagement of senior management and qualitative standards in general. • Due to the lack of trained professionals, a technical expertise in handling quantitative models should be gradually developed. • Attendance at international seminars and training programs is an important source of knowledge for both regulators’ and firms’ employees. Such programs should be regularly held on a domestic basis, as a means of disseminating knowledge, experience and the culture of risk management. Conclusion The challenges facing risk managers in emerging economies are both numerous and complex. In the early years of the 21st century, Insurers and banks in emerging economies went through a period of tremendous growth, showing solid fundamentals in capital requirements, liquidity, and asset quality compared with insurers and banks in developed markets. Over the last few years, though, the business environment has shifted: an increasingly demanding regulatory and policy environment, growing risk costs, and declining profitability levels are presenting significant new challenges. Risk management has a major role to play.
Risk in emerging economies is higher than in developed ones. Expectations are that the level of risk will continue to increase, as will volatility. This, however, is not a reason for retreating to one’s comfort zone, as risk creates opportunity and seizing opportunities is the way in which companies develop and grow. The rewards from doing business in and with emerging economies can be sufficient to cover the increased level of risk but they can only be achieved through proper risk assessment up front and continual reassessment, because we cannot know the future. All we know is that it will be different and that we will probably have to manage risks in coming years’ time that we cannot currently conceive. This is exciting as well as challenging, and requires everyone to understand and manage risk much better than they generally do now From humble beginnings, risk and risk management have grown into a veritable industry. In the future companies will succeed not through bigger and bigger risk management departments but through line managers understanding and managing risk effectively. Tools and techniques will continue to develop and technology will help this process, but the key will be people, as only they can use judgement and respond well to the unexpected which occurs all too often in emerging economies. Hope for the best but plan for the worst must be the watchword when dealing with emerging economies.
