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Managerial Finance Future trends and challenges of financial risk management in the digital economy Steven Li
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Future Trends and Challenges of Financial Risk Management in the Digital Economy by Steven Li, Senior Lecturer in Finance, School of Economics and Finance, Queensland University of Technology, Brisbane, QLD 4001, Australia
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Abstract In this paper, the future trends and challenges of financial risk management are considered. First, the historical developments and current status of financial risk management are assessed. Then, key features of the financial industry in the digital economy are discussed. It is argued that the technology innovations, particularly in computing and telecommunication, will continue to have an important influence on the future development of financial risk management. Based the past and present of financial risk management as well as the general trends in the financial industry, some future trends and challenges of financial risk management in the digital economy are discussed. Finally, some implications for financial institutions, corporations and emerging economies are given. Introduction Risk is an old concept associated with uncertainty. There have been many different definitions. However, there has been little consensus on the concept of risk, see Gao (2001) for a more detailed discussion. In the course of running a business, decisions are made in the presence of risk. A decision-maker can confront one of two types of risk. Some risks are related to the underlying nature of the business and deal with such matters as the uncertainty of future sales or the cost of inputs. These risks are called business risks. Another class of risks deals with the uncertainty of such factors as interest rates, exchange rates, stock prices, and commodity prices. These are called financial risks. Most businesses are accustomed to accepting business risks such as the uncertainty of future sales. Indeed the acceptance of business risks and the potential rewards can come with it are the foundations of the free market economy. But financial risks are a different matter, as often businesses are not accustomed to accepting and managing them. The paralysing uncertainty of volatile interest rates can cripple the ability of a firm to acquire financing at reasonable cost. Firms that operate in foreign markets can have excellent sales performance offset if its own currency is strong. Managers of portfolios deal on a day to day basis with widely unpredictable and sometimes seemingly irrational financial markets. These examples clearly demonstrate that financial risks can be important for many businesses. In coping with growing financial risks, various derivative products (e.g., options, swaps) have been developed in the past 20 years and they are now widely used by large corporations1, financial institutions, professional investors, and individuals2. Certain types of derivatives are traded actively in public markets, similar to the stock exchanges. The vast majority of derivatives, however, are created in private transactions. The critical importance of using derivatives properly has created a whole new activity called financial risk management. Financial risk management is the practice of defining the risk level of a firm desires, identifying the risk level a firm currently has, and
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using derivatives or other financial instruments to adjust the actual level of risk to the desired level of risk (see e.g. Chance, 2000). Financial risk management has also spawned an entirely new industry of financial institutions that offer to take positions in derivatives opposite the end users, which are corporate or investment funds.
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The need for sound financial risk management was highlighted by a number of high-profile risk management disasters in the1990s. In each of these cases, a single individual or subsidiary company built up huge positions (apparently) without knowledge of senior management or the parent company. The firms involved then suffered very large losses when the risks turned sour. Among the most noteworthy of these cases were (see e.g. Dowd, 1998): *
Metallgesellschaft. A US subsidiary of MG built up very large positions in oil futures in an attempt to hedge some long-term forward contracts it has sold. The fall in oil prices in 1993 then led to very large losses, and the German parent company intervened to liquidate the remaining futures positions. The ultimate loss was $1.3 billion.
*
Orange County. The County Treasurer, Bob Citron, invested much of the County’s investment pool in highly leveraged derivatives instruments that were, in effect, a very large bet on interest rates remaining low. The rise in interest rates in 1994 then inflicted huge losses on the Investment Pool-$1.7 billion in all—and led to the County’s bankruptcy.
*
Barings Bank. Nick Lesson, a trader working out of Baring’s Singapore subsidiary, built up huge unauthorised positions in futures and options. The amounts involved vastly exceeded the bank’s capital, and adverse movements in these markets forced the bank into bankruptcy in February 1995. The ultimate loss to the bank was about $1.3 billion.
*
Sumitomo Corporation. In June 1996, Sumitomo announced a loss of $1.8 billion. These losses had accumulated over a 10-year period from unauthorised trades by its chief copper trader, Yasuo Hamanaka, which he had managed to cover up.
In each of these cases, losses were well in excess of $1 billion. However, there were also many other cases where smaller losses were made in much the same way. These well-publicised disasters had intensified the ongoing debate about risk management practice. Consequently, many risk control measures and concepts such as “Value-at-Risk” (VaR)3 were introduced to prevent such disasters (see e.g. Tortoriello, 2000). In today’s digital economy, computing and telecommunication technologies are progressing rapidly. This will continue to bring new challenges and new opportunities for financial risk management. New products for financial risk management will continue to grow. For example, the rapidly growing e-commerce calls for new financial products to managing e-commerce risks, see e.g. Li (2001). In this paper, we attempt to shed some light on the future trends and challenges of financial risk management, as well as their implications for financial institutions, corporations and emerging economies.
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The Past and Present of Financial Risk Management
Figure 1: Australian Option Market (Source: Bruce et al, 1997)
14000000 12000000 10000000 8000000 6000000 4000000 2000000 0 1975 1976 1977 1978 1979 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996
Contracts Traded Contracts Traded
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In the two decades of 1980s and 1990s, firms have been increasingly challenged by financial price risks (see e.g. Chance 2001). For examples, changes in exchange rates can create strong competitors; similarly, fluctuations in commodity prices can drive input prices to the point that substitute products become more affordable to end users. It is no longer enough to be the firm with the most advanced production technology, the cheapest labour supply, or the best marketing team; price volatility can even put well-run firms out of business. Due to these challenges and the theoretical breakthroughs marked by the publication of the option pricing model by Blacks and Scholes (1973) and Merton (1973), a range of financial instruments and strategies have evolved in the past 20 years. To name a few, swaps and forwards are becoming increasingly popular in controlling the risk of price changes in raw materials, credit derivatives including credit swap, credit spread option etc. are widely used in managing credit risks. As an example, the rapid development of the option market in Australia is clearly demonstrated in Figure 1.
Year Call
Put
Total
At one level, financial instruments now exist that permit the direct transfer of financial price risk to a third party more willing to accept that risk. For example, with the development of foreign exchange futures contracts, a U.S. exporter can transfer its foreign exchange risk to a firm with the opposite exposure, or to a firm in the business of managing foreign exchange risk, leaving the exporter free to focus on its core business. For details of the derivative products available, we refer to Smithson (1998) and Chance (2001). At another level, the financial markets have evolved to the point that financial instruments can be combined with a debt issue to unbundle financial price from other risks inherent in the process of raising capital. For example, by coupling their bond issues with a swap, issuing firms are able to separate interest rate risk from traditional credit risk (Arak, Goodman & Rones, 1988). Innovations in financial-contracting technology (futures, options, and other contractual agreements) have played a central role in this development by expanding the opportunities for risk sharing, lowering transaction costs, and reducing information and
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agency costs (Chance, 2001). The extraordinary growth in the use of derivatives and the huge proliferation of new financial products and markets, have made possible the creation of an increasing number of layers of financial intermediation that are required to capture the benefits of advances in finance. By increasing the number of financing channels and better opportunities for swapping, sharing and spreading risks, more efficient financial systems have emerged in many countries (Blommestein, 2000). The major growth in the use of derivatives has been fueled by trends towards securitization and the increased understanding of the role that derivatives can play in unbundling, packaging, and transferring of risks (see e.g. Scholes, 1998). A typical securitization procedure within the context of mortgage finance is illustrated in Figure 2.
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Figure 2. An illustration of securitization process
Financial Intermediary
Assets Mortgage loans
Special Purpose Vehicle
Issue asset backed securities
Investors
Credit Enhancer
Cash flows (loan repayments)
Service Manager
Cash flows (interest and principal)
Today, no longer do financial service firms only sell the same products they buy from clients. Instead, they break the products down into their component parts or recombining them into new and hybrid custom-tailored financial instrument. And this unbundling and repackaging is only in the beginning stage of evolution. In order to see the future trends and challenges of financial risk management, we need to analyse the key features of the financial industry in the digital economy. Key Features of Financial Industry in the Digital Economy The expansion in technology has had an impact on every major industry segment (see e.g. Jorgenson, 2001). From consumer and industrial products to agriculture and digital communications, technology is an integral part of our everyday life. It provides the means for working longer, getting it done faster, accessing your bank account from anywhere in the world, growing foods in less than optimal climates, and unparalleled medical advances. In readiness for an e-business world ‘without boundaries’, companies must establish a new security framework—putting boundaries around the Internet, which currently
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has none. That is today’s business paradox. The dilemma organisations face is striking the right balance between building trust through openness and the historical protection of their interests from fraud, loss of confidential information, vandalism, employee theft, as well as other forms of economic loss. The key features of the financial industry in the digital economy are outlined below. *
Globalisation A remarkable feature of the financial industry in the digital economy is the internationalisation and globalisation. Grenville (2000) argued that globalisation brings with it huge benefits, but at the same time, creates a need for a much more comprehensive set of rules to govern the way it will be carried out, analogous to the complex and ubiquitous rules which govern interactions in the domestic economy.
*
IT driven According to Moore’s law, the computing speed will grow exponentially, the communication cost will continue to drop quickly. Without any doubt, the advance in IT will continue to play an important role in the development of the financial industry. Improvements in IT have made possible huge increases in both computational power and the speed with which calculations can be carried out. Improvements in computing power mean that new techniques can be used and so enable us to tackle more difficult calculation problems. Improvements in calculation speed then make these techniques useful in real times, where it is often essential to get answers quickly. Decision makers can now use sophisticated algorithms programmed into computers to carry out real-time calculations that were not possible before. The ability to carry out such calculations then creates a whole new range of risk measurement and risk management possibilities. For example, Monte Carlo simulation can now be easily used to accurately price many complex instruments and to obtain VaR estimates.
*
Riskier environment Exchange rates have been volatile ever since the breakdown of the Bretton Woods system of fixed exchange rates in the early 1970s. Occasional exchange rate crises have also led to sudden and significant exchange rate changes. There have also been major changes in exchange rates as the result of shifts in monetary policies. Firms have therefore had to come to terms with ever-present and sometimes very significant exchange rate risk. There have been major fluctuations in interest rates, with their attendant effects on funding costs, corporate cash flows and asset values. Interest rates rose to a very high level in the developed countries in the mid-1970s, largely as a consequence of previous inflationary monetary policies, and then subsequently came down again in the later 1970s. For example, interest rates in the US and UK then both shot up in 1979, peaked in 1981, and gradually came down again (see e.g. Smithson, 1998). Interest rate instability will likely continue to be a major source for market instabilities in the digital economy. Stock markets have also been extremely volatile in the past few decades. Stock prices rose significantly in the inflationary booms of the early 1970s, then fell considerably a little later. Stock markets then recovered, fell again somewhat in
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the early 1980s, and rose to a peak in 1987. They then fell precipitously throughout the world on 19 October of that year. In most countries, equity markets then recovered and proceeded to grow right through until 2000. Besides, there have been many other sources of instability. For example, the oil price hikes of 1973-1974 and 1979. The massive transformation and indeed, the globalisation of the financial services industry, as manifested by the erosion of barriers between different types of financial firms and the emergence of a new breed of financial multinationals operating on a worldwide scale.
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In sum, there is general agreement that the financial environment is riskier today than it was in the past (see e.g. Smithson, 1998). The volatility of foreign exchange rates, interest rates and commodity prices has been increasingly significant. *
Increased complexity As indicated above, the structural changes in the past 20 years have enabled a broad unbundling and repackaging of risks through innovative financial engineering. These changes have resulted in very complex financial products and markets. Common stocks and debt obligations have been augmented by a vast array of complex hybrid financial products, which allow risks to be better allocated and priced. For example, recent hybrid securities are in the border territory between loans and bonds, such as deferred-pay options bonds, floating interest rate subordinated term securities and equity linked venture investment securities. *
Increased competition The competition for capital has increased dramatically, both in national markets and globally (Blommestein, 2000). This fierce competition for the allocation of savings means that investment projects and public policies are more restrictively scrutinised. It also means that this capital, in times of stress, also flees more readily to securities and markets of high quality and high liquidity. The new financial landscape is defining a more competitive beauty contest among countries and markets with greater rewards for good policies and projects but also greater punishments for mistakes. Blommestein (2000) highlights that the competition in the financial industry has increased strongly due to the following structural forces: the removal or weakening of barriers to entry; the liberalisation of diversification; the removal or reduction on ownership structures; globalisation of business activities, innovations and technological advances. Increased competition has resulted in a lower cost of financial services and an increase in the expansion of the range and quality of financial services. For example, the Internet offers investors unprecedented access to financial tools and services worldwide at relatively low cost and relative ease. Asset management services are being now offered at low costs with a wide range of choice of products and other modalities.
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Development Trends in the Financial Industry Balino and Ubide (2000) summarise four fundamental trends that are changing the financial world: consolidation of institutions, globalizations of operations, development of new technologies and universalisation of banking.
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Financial institutions around the world are consolidating at a rapid pace. The number of institutions is declining and their average size is increasing. For example, in the United States, the lifting of interstate banking restrictions in 1994 triggered a wave of mergers. European integration has intensified consolidation in Europe-which the introduction of the Euro in January 1999 has further encouraged. In many emerging markets, such as Argentina, Brazil, and Korea, consolidation is also well under way as banks seek to become more efficient and more resilient with respect to stocks. Nor has consolidation confined by national borders. In a drive that has created powerful “national champions” in many industrial countries, financial institutions have not waited for opportunities for growth and increased profitability to be exhausted domestically before transcending national frontiers. This process of globalization has been dominated by industrial country banking groups’ exploitation of the growth potential in emerging markets, as witnessed by the expansion of Spanish banks in Latin America, German banks in Eastern Europe, and U.S. banks in East Asia (Balino and Ubide, 2000). At a somewhat slower pace, cross-border consolidation is also taking place between industrial countries, initially in the form of strategic alliances that offer the benefits of diversification without the costs of merging different business cultures. Developments in technology, and especially the impressive growth of Internet banking and brokerage services, have allowed globalization to go beyond the ownership structure of financial conglomerates and to reach the retail markets. In fact, many banks are using their online operations to expand into foreign markets, avoiding the costly process of building retail brick-and-mortar networks of branches. Moreover, the emergence of alliances between major banks and telecommunications conglomerates suggests that, in the future, competition in the electronic marketplace will be fierce. In addition, the appearance of virtual banks and the development of electronic money for the global Internet market have created the possibility for the growth of nonbank (and, possibly, largely unregulated) institutions that provide credit to, and collect funds from the public. Faster communications require faster reactions from both markets and policy makers but also quickly make information obsolete. The universalisation of banking is increasingly blurring the boundary between bank and nonbank financial services. This trend is already well developed in certain European countries—as exemplified by the widespread distribution of insurance products through bank branches, the repeal in 1999 of the Glass-Steagall Act (which restricted banks’ involvement in equity financing and artificially separated investment banks from commercial banks). Future Trends of Financial Risk Management The future will be a continuation of the present. Financial innovation will continue at the same, or even at an accelerating, pace because of the insatiable demand for lower-cost, more efficient solutions to client problems. Information and financial technology will continue to expand and so will the circle of understanding of how to use this technology.
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By combining the past developments of financial risk management with the features and trends of the general financial industry in the digital economy as discussed above, we can foresee the following trends of financial risk management in the future. Emerging new risk management instruments and markets
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Theoretical breakthroughs (such as derivatives pricing techniques) enable financiers to invent and price new instruments. The forward and options contracts are the building blocks of modern risk management. New instruments based on these basic derivatives will continue to emerge. For example, there are nascent markets in weather-linked contracts (see e.g. Anonymous, 1999), telecom bandwidth and in corporate-earnings insurance. At the same time, the spread of existing technologies is hastening an upheaval among financial institutions and making it easier for risk to end up with the people most willing to bear it. While much progress has been made in financial risk management, it is still far away from the goal of being able to model and manage almost any conceivable risk. Once financiers can strip out risks at will, a great prize is within their grasp, because firms can lay off the kind of risk they want to, and to just the degree they want to. In the same way, investors can take on precisely the risk that most suits them. To achieve this objective, new theoretical inventions and instruments will be necessary and bound to emerge. Emerging new markets in risk Before recent developments in financial theory such as option pricing techniques, firms typically had few choices about how to manage risk. Gradually, however, many firms began to use derivatives as protection against movements in prices and interest rates. For example, those operating internationally realised that by hedging their exposure to changes in foreign exchange rates, they could make their profits less volatile and hence more valuable to investors. New ideas and instruments are continuously extending this frontier. For example, until recently, an ice cream maker could do little about the risk of a cool summer, which would lower demand for its products. Similarly, energy companies suffer during mild winters, because they lead consumers to turn down their central heating. The risk of adverse weather seems inevitable, but financial wizards have come up with a way to avoid it. Over the past few years traders have done around $4 billion of weather-related deals tailored to firms’ needs “over the counter”. Since September 1999, the Chicago Mercantile Exchange has traded weather-linked derivatives whose value varies with the temperature measured by an index of warmth in four large American cities (cf. Anonymous, 1999). Deregulation of the American and European energy markets has created a deep pool of demand for such instruments. Unbundling and repackaging corporate risks When financiers package business risks as securities of some form or other, they are tinkering with the components of existing securities, such as debt and equity, that today pass aggregated risks to investors. Given the new technology of finance (e.g., bundling and unbundling risks), some of the financial instruments that are taken for granted today may eventually become obsolete. Equity, for example, might be replaced by a series of risk-
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linked contracts offering specific payouts. Loan agreements might routinely include contingencies that affect the interest rate.
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To understand why, consider the mechanism by which firms typically try to protect themselves from harm: insurance. In a normal year, it will experience numerous small setbacks that cause small losses-the firm expects these to happen, just as a bank expects some of its loans to go sour, so these might be called “expected losses”. Insurance premiums paid up-front to cover these expected losses are equivalent to a tax-efficient (but non-interest-earning) bank deposit that is drawn down as the losses occur. In other words, the company has every expectation that most of the premium will be claimed back. But firms can also suffer larger, more expensive reverses, which are a nightmare for managers. The odds that catastrophe might wipe out the entire business are very small. But there is a bigger chance of some event that might seriously dent profits. And financial markets hate the unexpected. Securities analysts, who will discount a surprise gain as a one-off, will panic if presented with an unexpected loss. From the firm’s perspective, therefore, an unexpected loss may be even worse than it looks. This gives a company an incentive to lay off any risk that is not intrinsic to its core business. This sort of insurance is being sought by companies, but it is also being promoted by sophisticated insurers, such as Marsh & McClennan, SwissRe, AIG, XL Capital and Ace. They specialise in pricing the tiny odds of very rare events. They also want to improve their traditional insurance business by wrapping it up with financial protectionforeign-exchange contracts, for example-that used only to be available from the capital markets. They can do this effectively because these risks are uncorrelated with normal insured risks. By packaging them, the insurer creates a portfolio that is more attractive for an investor. In other words, these are “win-win” deals. This broad trend in finance is known as “alternative risk transfer” (ART). It involves the ever-closer proximity of insurance and the capital markets, once almost entirely separate activities. For further details regarding ART we refer to Zalkos (2001). More efficient markets due to technology advances As in the past, technologies, particularly telecom and computing, will play an important role in financial risk management. As these become more powerful, they enable information and ideas to be communicated across vast numbers of people at very low cost. Plenty of traditional businesses, including auction houses and bookshops, are scrambling to react and finance is no exception. Already, new information technology is eroding the distinction between different parts of finance, such as banking and insurance. As the Internet matures, financial intermediaries risk seeing their margins flattened; and entirely new business models will emerge. These technologies enable the financiers to exploit their unbundling skills to the full. Harnessing the Internet, ART providers and other firms will parcel risks into different classes of securities. They may keep some themselves, but mostly they will sell them on to different types of investor. Technology also has the power to demolish existing boundaries between different parts of the financial world. Banks are no longer the only providers of credit. Insurers are competing with investment banks to serve big corporate clients. Mutual and pension
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funds are making direct equity investments, bypassing securities firms. Many of the best financial firms 20 years hence will rely on intellectual more than monetary capital. Their skills, above all, will lie in packaging and marketing. Investors will measure their performance not simply in terms of their returns on capital, but also in terms of how risky they are. If these trends play out, capital markets will approach a state of theoretical perfection. Thanks to the diversification made possible by the Internet, the rewards will go to those who assume the risk of doing badly in bad times. There will be an unprecedented degree of risk-sharing. Far more risks will end up with those investors most willing and best able to hold them. These developments could deliver a new level of efficiency and stability in the global economy.
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Implications for Financial Institutions Risks associated with de-segmentation, securitisation, financial innovations, globalisation and increased competition have emerged. Increased volatility, greater interdependence and new risks have also made the structure of the risk exposure of banks and other financial institutions more complex. For banks, the traditional activity was “on balance sheet” lending, and the associated risk management technique was credit risk analysis. However, lending now accounts for a smaller share of total activity than in the past for many banks. Newer activities are investment banking, organisation, trading (agency and proprietary), mergers and acquisitions and information systems—where the risks are different. The fact that banks will increasingly hold a wider set of instruments (money market assets, bonds, equities, derivatives) and that some of the risks in these assets will be retained while others are passed on implies that risks must be continually identified and systems must be set in place to offset risk or to hold sufficient capital against any risk that is retained. Also OECD capital markets have changed beyond recognition. Domestic deregulation and external liberalisation have resulted in major changes in competitive conditions. Advances in communications and information systems enhanced the capacity of financial market participants to use the opportunities offered by the new financial environment. The product cycle in financial services is operating at a faster pace. New financial services require constant innovation with constant pressure on margins. These developments have increased the need for better risk management. Financial institutions must improve their capabilities for defining, managing and pricing risk. The general objective is to build and use systems for the disciplined management of credit risk, market risk and liquidity risk. The primary components of a sound risk management process are: a comprehensive system for measuring different types of risk; a framework for governing risk taking, including limits, guidelines, and other relevant parameters; and an adequate management information system for monitoring, reporting and controlling risks. To achieve these goals, financial institutions are facing some immediate challenges. Conventional financial assets (equity, bonds, loans etc.) can be measured in a traditional accounting system (book or market valuation). However, swaps and other offbalance sheet contractual arrangements can not be incorporated in a similar value framework. The traditional accounting system is therefore not very suitable to identify risk allocations.
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Value at risk (VaR) is the most widely used risk management model. However, in extreme situations, VaR models do not function very well. That is why these models have been supplemented with “scenario” or “stress” testing. But this approach may not be adequate to control risks. An obvious limitation is that important extreme scenarios will be excluded from the analysis. For example, it seems doubtful that risk managers in their stress scenarios foresaw the extreme “LTCM 1998 episode” (Kimball, 2000). A fundamental limitation of the current generation of sophisticated risk management models is that they are based on the probability calculus of “a game against nature”. In other words, these risk management systems neglect strategic factors in the behaviour of market participants.
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Implications for Corporate Financial Risk Management Corporate financial risk management seeks to manage a company’s exposure to currencies, interest rates, energy, commodities and other factors driven by the financial market. It should be viewed as an ongoing process that continually evolves with the company as it encounters new and unforseen risks. However, in reality, many companies that have identified various risks in their businesses do not have formal risk policies or strategies in place to manage these risks within a corporate approved process (cf. Baldoni, 2001 and Jalilvand et al 2000). Many companies regard risk management as a series of unrelated transactions tied to a specific event or process. With this transactional approach to managing risk, one begins with a blank sheet of paper each time a new issue or problem arises, and then develops an independent solution for each disparate problem. After a time, this string of unrelated solutions themselves can become an exposure as the underlying risks shift. While the dangers of this kind of approach seem obvious, it is surprising how many companies rely on transactional approach. Clearly, companies would benefit from a process that is woven into their overall business strategies and management process. However, for senior management to help shape such integrated approaches to managing risk, they must be better informed about risk and its impact on the company. No doubt there will continue to be a need for unique and innovative risk management strategies and performance measurement methodologies. However, to unlock the true value and potential of the risk management process, we must continue the journey by going beyond current, silo-driven approaches. If we can apply and combine already developed techniques to equip senior management with a deeper, more comprehensive set of decision support tools, risk measurement and management processes can be elevated to their rightful status in the decision making process. Implications For Emerging Economies Emerging economies face more domestic vulnerabilities such as an over reliance on the exports of raw materials, inadequate bank supervision and capitalization, immature capital markets, and policy mistakes by governments etc. Consequently, emerging economies are more volatile than industrial countries4. In addition to domestic vulnerabilities, emerging economies also face risks from global factors beyond their control. First is the health of the global economy, which impacts both the price of commodities and the quantity of imports demanded from developing countries. Also, important are monetary policy and its effects on foreign exchange policy, as changes in developed country exchange rates can dramatically impact both the
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trade and capital accounts of developing countries. Changes in trade policy can also have tremendous impact on the fortunes of emerging markets. Raising tariff on imported goods and services or closing borders all together can devastate developing countries (Martins et al, 2001). Given these characteristics of emerging economies, one can see that the above implications for financial institutions and corporations do apply in emerging economies. Besides, due to the additional domestic uncertainties in emerging economies, financial risk management in emerging economies will face additional complications.
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The financial industry in emerging economies is often heavily regulated and thus many risk management products, which are available in developed economies, may not be available. At the mean time, the technological infrastructures for emerging economies are often lagging behind that in the developed economies. Thus financial risk management in emerging economies has a long way to go5. On the other hand, the awareness and willingness of companies in managing their risks has definitely increased in the emerging economies due to impact of events such as the Asian financial crisis. That is, the demand for financial risk management is increasing, especially in the past few years. Due to the great business potential, financial institutions from industrial economies are keen to explore the financial risk management in emerging economies. Thus the development of financial risk management in emerging economies will be likely at a fast pace. In sum, the emerging economies have to face the trends of financial risk management in the digital economy and thus face similar challenges. But the specific challenges faced by each emerging economies also depend on other factors such as the regulations on the financial industry and the technological infrastructure etc. Concluding Remarks In today’s digital economy, the financial industry is changing rapidly. We are facing an increase in the pace of financial innovations, a rapid expansion of cross-border financial transactions, the faster pace of transmitting shocks or mistakes throughout the international financial system and greater sensitivity on the part of financial market prices to changes in preferences. These changes in turn determine the trends of financial risk management in the future. Financial risk management will evolve at a faster pace: new risk management products will continue to emerge and the financial risk management system will continue to improve. Acknowledgement The author would like to thank Prof. Simon Gao for many useful comments and suggestions.
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Endnotes 1. For example, Fatemi and Glaum (2000) found that a large proportion of German firms (88% of the respondent firms in their study) use derivative instruments. 2. For example, an individual investor may use the protective put strategy to limit the possible loss in an investment. 3. VaR refers to the loss that can occur over a given period at a given confidence level, for details see Chance (2001).
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4. See Hausmann and Gavin (1996) who found the volatility of Latin American GDP Growth was at least twice as great as that in industrial economies over the 1970-1992 period. 5. For example, Lee (2001) claims that the Asian derivatives market is in the very early stages of development and Asia as whole is lagging behind its European counterparts in this sector as much as 10 years.
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References: Anonymous, 1999, Schools brief: the future of finance, The Economist, London, Dec 11, 71-72. Arak, M., Goodman, L.S. and Rones, A., 1988, Credit lines for new instruments: swaps, over-the-counter options, forwards and floor-ceiling agreements, Bank Structure and Competition, 437-56. Baldoni, R., 2001, Financial risk management: journey or destination? Directorship, June, 13-20.
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Balino, T.J.T., and Ubide, A., 2000, The new world of banking, Finance and Development, June, 41-44. Black, F. and Scholes, M.S., 1973, The pricing of options and corporate liabilities, Journal of Political Economy, May-June, 81(3), 637-54. Blommestein, H.J., 2000, The changing nature of risk and the challenges to sound risk management in the new global financial landscape. Financial Market Trends, March,171-194. Bruce, R., McKern, B., Pollard, I., and Skully, M., 1997, Handbook of Australian Corporate Finance, 5th edition, Butterworths. Chance, D.M., 2001, An introduction to derivatives and risk management, 5th edition, Harcourt. Dowd, K., 1998, Beyond value at risk, John Wiley & Sons. Fatemi, A. and Glaum, M., 2000, Risk management practice of German firms, Managerial Finance, Vol. 26 N0 3, 1-17. Gao, S., 2001, Strategic risk management and high-tech risks, The Proceedings of Risk Management Forum on the High-Tech Industry in Taiwan and the UK, May 2001, Taiwan. Grenville, S.A., 2000, Globalisation and the international financial architecture: writing (and righting) the rules, Reserve Bank of Australia Bulletin, July. Hausmann, R. and Gavin, M., 1996, Security stability and growth in a shock-prone region: the policy of challenge for Latin America. In Ricardo Hausmann and Helmut Reisen, eds., Security stability and growth in Latin America, OECD. Jalilvand, A., Switzer, J. and Tang, C., 2000, A Global perspective on the use of derivatives for corporate risk management decisions, Managerial Finance, Vol. 26 N0. 3, 2938. Jorgenson, D.W., 2001, Information technology and the U.S. economy, The American Economic Review, Vol 91 No.1, 1-31.
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Kimball, R.C., 2000, Failures in risk management, New England Economic Review, Jan/Feb, 3-12. Lee, J., 2001, Derivatives market yet to mature, Asia money, London, Vol.12, Issue 3, 36-38. Li, S., 2001, Some thoughts on managing e-commerce risks, Proceedings of the 2nd International We-B Conference, Edith Cowan University, 165-170. Martins, L.F., Petrov, C. and Kelly, J.M., 2001, Managing market risk for an emerging market debt portfolio, Journal of Portfolio Management, Vol. 27, Issue 2, 75-90.
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Merton, R.C., 1973, theory of rational option pricing, Bell Journal of Economics and Management Science, 4(1), 142-83. Scholes, M.S., 1998, Derivatives in a dynamic environment, The American Economic Review, Vol 88, No.3, 350-370. Smithson, C.W., 1998, Managing Financial Risk, A guide to derivative products, financial engineering and value maximization, McGraw-Hill. Tortoriello, B., 2000, Basel Proposal for a new capital adequacy framework, Banking Policy Report, New York, Jan 3. Zolkos,R., 2001, Alternative risk transfer tools growing in popularity, Business Insurance, Vol 35, Issue 20,16-19.
Article information: To cite this document: Steven Li, (2003),"Future trends and challenges of financial risk management in the digital economy", Managerial Finance, Vol. 29 Iss 5/6 pp. 111 - 125 Permanent link to this document: http://dx.doi.org/10.1108/03074350310768797 Downloaded on: 05 March 2016, At: 17:12 (PT) References: this document contains references to 0 other documents. To copy this document: [email protected] The fulltext of this document has been downloaded 3604 times since 2006*
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Future Trends and Challenges of Financial Risk Management in the Digital Economy by Steven Li, Senior Lecturer in Finance, School of Economics and Finance, Queensland University of Technology, Brisbane, QLD 4001, Australia
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Abstract In this paper, the future trends and challenges of financial risk management are considered. First, the historical developments and current status of financial risk management are assessed. Then, key features of the financial industry in the digital economy are discussed. It is argued that the technology innovations, particularly in computing and telecommunication, will continue to have an important influence on the future development of financial risk management. Based the past and present of financial risk management as well as the general trends in the financial industry, some future trends and challenges of financial risk management in the digital economy are discussed. Finally, some implications for financial institutions, corporations and emerging economies are given. Introduction Risk is an old concept associated with uncertainty. There have been many different definitions. However, there has been little consensus on the concept of risk, see Gao (2001) for a more detailed discussion. In the course of running a business, decisions are made in the presence of risk. A decision-maker can confront one of two types of risk. Some risks are related to the underlying nature of the business and deal with such matters as the uncertainty of future sales or the cost of inputs. These risks are called business risks. Another class of risks deals with the uncertainty of such factors as interest rates, exchange rates, stock prices, and commodity prices. These are called financial risks. Most businesses are accustomed to accepting business risks such as the uncertainty of future sales. Indeed the acceptance of business risks and the potential rewards can come with it are the foundations of the free market economy. But financial risks are a different matter, as often businesses are not accustomed to accepting and managing them. The paralysing uncertainty of volatile interest rates can cripple the ability of a firm to acquire financing at reasonable cost. Firms that operate in foreign markets can have excellent sales performance offset if its own currency is strong. Managers of portfolios deal on a day to day basis with widely unpredictable and sometimes seemingly irrational financial markets. These examples clearly demonstrate that financial risks can be important for many businesses. In coping with growing financial risks, various derivative products (e.g., options, swaps) have been developed in the past 20 years and they are now widely used by large corporations1, financial institutions, professional investors, and individuals2. Certain types of derivatives are traded actively in public markets, similar to the stock exchanges. The vast majority of derivatives, however, are created in private transactions. The critical importance of using derivatives properly has created a whole new activity called financial risk management. Financial risk management is the practice of defining the risk level of a firm desires, identifying the risk level a firm currently has, and
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using derivatives or other financial instruments to adjust the actual level of risk to the desired level of risk (see e.g. Chance, 2000). Financial risk management has also spawned an entirely new industry of financial institutions that offer to take positions in derivatives opposite the end users, which are corporate or investment funds.
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The need for sound financial risk management was highlighted by a number of high-profile risk management disasters in the1990s. In each of these cases, a single individual or subsidiary company built up huge positions (apparently) without knowledge of senior management or the parent company. The firms involved then suffered very large losses when the risks turned sour. Among the most noteworthy of these cases were (see e.g. Dowd, 1998): *
Metallgesellschaft. A US subsidiary of MG built up very large positions in oil futures in an attempt to hedge some long-term forward contracts it has sold. The fall in oil prices in 1993 then led to very large losses, and the German parent company intervened to liquidate the remaining futures positions. The ultimate loss was $1.3 billion.
*
Orange County. The County Treasurer, Bob Citron, invested much of the County’s investment pool in highly leveraged derivatives instruments that were, in effect, a very large bet on interest rates remaining low. The rise in interest rates in 1994 then inflicted huge losses on the Investment Pool-$1.7 billion in all—and led to the County’s bankruptcy.
*
Barings Bank. Nick Lesson, a trader working out of Baring’s Singapore subsidiary, built up huge unauthorised positions in futures and options. The amounts involved vastly exceeded the bank’s capital, and adverse movements in these markets forced the bank into bankruptcy in February 1995. The ultimate loss to the bank was about $1.3 billion.
*
Sumitomo Corporation. In June 1996, Sumitomo announced a loss of $1.8 billion. These losses had accumulated over a 10-year period from unauthorised trades by its chief copper trader, Yasuo Hamanaka, which he had managed to cover up.
In each of these cases, losses were well in excess of $1 billion. However, there were also many other cases where smaller losses were made in much the same way. These well-publicised disasters had intensified the ongoing debate about risk management practice. Consequently, many risk control measures and concepts such as “Value-at-Risk” (VaR)3 were introduced to prevent such disasters (see e.g. Tortoriello, 2000). In today’s digital economy, computing and telecommunication technologies are progressing rapidly. This will continue to bring new challenges and new opportunities for financial risk management. New products for financial risk management will continue to grow. For example, the rapidly growing e-commerce calls for new financial products to managing e-commerce risks, see e.g. Li (2001). In this paper, we attempt to shed some light on the future trends and challenges of financial risk management, as well as their implications for financial institutions, corporations and emerging economies.
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The Past and Present of Financial Risk Management
Figure 1: Australian Option Market (Source: Bruce et al, 1997)
14000000 12000000 10000000 8000000 6000000 4000000 2000000 0 1975 1976 1977 1978 1979 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996
Contracts Traded Contracts Traded
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In the two decades of 1980s and 1990s, firms have been increasingly challenged by financial price risks (see e.g. Chance 2001). For examples, changes in exchange rates can create strong competitors; similarly, fluctuations in commodity prices can drive input prices to the point that substitute products become more affordable to end users. It is no longer enough to be the firm with the most advanced production technology, the cheapest labour supply, or the best marketing team; price volatility can even put well-run firms out of business. Due to these challenges and the theoretical breakthroughs marked by the publication of the option pricing model by Blacks and Scholes (1973) and Merton (1973), a range of financial instruments and strategies have evolved in the past 20 years. To name a few, swaps and forwards are becoming increasingly popular in controlling the risk of price changes in raw materials, credit derivatives including credit swap, credit spread option etc. are widely used in managing credit risks. As an example, the rapid development of the option market in Australia is clearly demonstrated in Figure 1.
Year Call
Put
Total
At one level, financial instruments now exist that permit the direct transfer of financial price risk to a third party more willing to accept that risk. For example, with the development of foreign exchange futures contracts, a U.S. exporter can transfer its foreign exchange risk to a firm with the opposite exposure, or to a firm in the business of managing foreign exchange risk, leaving the exporter free to focus on its core business. For details of the derivative products available, we refer to Smithson (1998) and Chance (2001). At another level, the financial markets have evolved to the point that financial instruments can be combined with a debt issue to unbundle financial price from other risks inherent in the process of raising capital. For example, by coupling their bond issues with a swap, issuing firms are able to separate interest rate risk from traditional credit risk (Arak, Goodman & Rones, 1988). Innovations in financial-contracting technology (futures, options, and other contractual agreements) have played a central role in this development by expanding the opportunities for risk sharing, lowering transaction costs, and reducing information and
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agency costs (Chance, 2001). The extraordinary growth in the use of derivatives and the huge proliferation of new financial products and markets, have made possible the creation of an increasing number of layers of financial intermediation that are required to capture the benefits of advances in finance. By increasing the number of financing channels and better opportunities for swapping, sharing and spreading risks, more efficient financial systems have emerged in many countries (Blommestein, 2000). The major growth in the use of derivatives has been fueled by trends towards securitization and the increased understanding of the role that derivatives can play in unbundling, packaging, and transferring of risks (see e.g. Scholes, 1998). A typical securitization procedure within the context of mortgage finance is illustrated in Figure 2.
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Figure 2. An illustration of securitization process
Financial Intermediary
Assets Mortgage loans
Special Purpose Vehicle
Issue asset backed securities
Investors
Credit Enhancer
Cash flows (loan repayments)
Service Manager
Cash flows (interest and principal)
Today, no longer do financial service firms only sell the same products they buy from clients. Instead, they break the products down into their component parts or recombining them into new and hybrid custom-tailored financial instrument. And this unbundling and repackaging is only in the beginning stage of evolution. In order to see the future trends and challenges of financial risk management, we need to analyse the key features of the financial industry in the digital economy. Key Features of Financial Industry in the Digital Economy The expansion in technology has had an impact on every major industry segment (see e.g. Jorgenson, 2001). From consumer and industrial products to agriculture and digital communications, technology is an integral part of our everyday life. It provides the means for working longer, getting it done faster, accessing your bank account from anywhere in the world, growing foods in less than optimal climates, and unparalleled medical advances. In readiness for an e-business world ‘without boundaries’, companies must establish a new security framework—putting boundaries around the Internet, which currently
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has none. That is today’s business paradox. The dilemma organisations face is striking the right balance between building trust through openness and the historical protection of their interests from fraud, loss of confidential information, vandalism, employee theft, as well as other forms of economic loss. The key features of the financial industry in the digital economy are outlined below. *
Globalisation A remarkable feature of the financial industry in the digital economy is the internationalisation and globalisation. Grenville (2000) argued that globalisation brings with it huge benefits, but at the same time, creates a need for a much more comprehensive set of rules to govern the way it will be carried out, analogous to the complex and ubiquitous rules which govern interactions in the domestic economy.
*
IT driven According to Moore’s law, the computing speed will grow exponentially, the communication cost will continue to drop quickly. Without any doubt, the advance in IT will continue to play an important role in the development of the financial industry. Improvements in IT have made possible huge increases in both computational power and the speed with which calculations can be carried out. Improvements in computing power mean that new techniques can be used and so enable us to tackle more difficult calculation problems. Improvements in calculation speed then make these techniques useful in real times, where it is often essential to get answers quickly. Decision makers can now use sophisticated algorithms programmed into computers to carry out real-time calculations that were not possible before. The ability to carry out such calculations then creates a whole new range of risk measurement and risk management possibilities. For example, Monte Carlo simulation can now be easily used to accurately price many complex instruments and to obtain VaR estimates.
*
Riskier environment Exchange rates have been volatile ever since the breakdown of the Bretton Woods system of fixed exchange rates in the early 1970s. Occasional exchange rate crises have also led to sudden and significant exchange rate changes. There have also been major changes in exchange rates as the result of shifts in monetary policies. Firms have therefore had to come to terms with ever-present and sometimes very significant exchange rate risk. There have been major fluctuations in interest rates, with their attendant effects on funding costs, corporate cash flows and asset values. Interest rates rose to a very high level in the developed countries in the mid-1970s, largely as a consequence of previous inflationary monetary policies, and then subsequently came down again in the later 1970s. For example, interest rates in the US and UK then both shot up in 1979, peaked in 1981, and gradually came down again (see e.g. Smithson, 1998). Interest rate instability will likely continue to be a major source for market instabilities in the digital economy. Stock markets have also been extremely volatile in the past few decades. Stock prices rose significantly in the inflationary booms of the early 1970s, then fell considerably a little later. Stock markets then recovered, fell again somewhat in
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the early 1980s, and rose to a peak in 1987. They then fell precipitously throughout the world on 19 October of that year. In most countries, equity markets then recovered and proceeded to grow right through until 2000. Besides, there have been many other sources of instability. For example, the oil price hikes of 1973-1974 and 1979. The massive transformation and indeed, the globalisation of the financial services industry, as manifested by the erosion of barriers between different types of financial firms and the emergence of a new breed of financial multinationals operating on a worldwide scale.
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In sum, there is general agreement that the financial environment is riskier today than it was in the past (see e.g. Smithson, 1998). The volatility of foreign exchange rates, interest rates and commodity prices has been increasingly significant. *
Increased complexity As indicated above, the structural changes in the past 20 years have enabled a broad unbundling and repackaging of risks through innovative financial engineering. These changes have resulted in very complex financial products and markets. Common stocks and debt obligations have been augmented by a vast array of complex hybrid financial products, which allow risks to be better allocated and priced. For example, recent hybrid securities are in the border territory between loans and bonds, such as deferred-pay options bonds, floating interest rate subordinated term securities and equity linked venture investment securities. *
Increased competition The competition for capital has increased dramatically, both in national markets and globally (Blommestein, 2000). This fierce competition for the allocation of savings means that investment projects and public policies are more restrictively scrutinised. It also means that this capital, in times of stress, also flees more readily to securities and markets of high quality and high liquidity. The new financial landscape is defining a more competitive beauty contest among countries and markets with greater rewards for good policies and projects but also greater punishments for mistakes. Blommestein (2000) highlights that the competition in the financial industry has increased strongly due to the following structural forces: the removal or weakening of barriers to entry; the liberalisation of diversification; the removal or reduction on ownership structures; globalisation of business activities, innovations and technological advances. Increased competition has resulted in a lower cost of financial services and an increase in the expansion of the range and quality of financial services. For example, the Internet offers investors unprecedented access to financial tools and services worldwide at relatively low cost and relative ease. Asset management services are being now offered at low costs with a wide range of choice of products and other modalities.
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Development Trends in the Financial Industry Balino and Ubide (2000) summarise four fundamental trends that are changing the financial world: consolidation of institutions, globalizations of operations, development of new technologies and universalisation of banking.
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Financial institutions around the world are consolidating at a rapid pace. The number of institutions is declining and their average size is increasing. For example, in the United States, the lifting of interstate banking restrictions in 1994 triggered a wave of mergers. European integration has intensified consolidation in Europe-which the introduction of the Euro in January 1999 has further encouraged. In many emerging markets, such as Argentina, Brazil, and Korea, consolidation is also well under way as banks seek to become more efficient and more resilient with respect to stocks. Nor has consolidation confined by national borders. In a drive that has created powerful “national champions” in many industrial countries, financial institutions have not waited for opportunities for growth and increased profitability to be exhausted domestically before transcending national frontiers. This process of globalization has been dominated by industrial country banking groups’ exploitation of the growth potential in emerging markets, as witnessed by the expansion of Spanish banks in Latin America, German banks in Eastern Europe, and U.S. banks in East Asia (Balino and Ubide, 2000). At a somewhat slower pace, cross-border consolidation is also taking place between industrial countries, initially in the form of strategic alliances that offer the benefits of diversification without the costs of merging different business cultures. Developments in technology, and especially the impressive growth of Internet banking and brokerage services, have allowed globalization to go beyond the ownership structure of financial conglomerates and to reach the retail markets. In fact, many banks are using their online operations to expand into foreign markets, avoiding the costly process of building retail brick-and-mortar networks of branches. Moreover, the emergence of alliances between major banks and telecommunications conglomerates suggests that, in the future, competition in the electronic marketplace will be fierce. In addition, the appearance of virtual banks and the development of electronic money for the global Internet market have created the possibility for the growth of nonbank (and, possibly, largely unregulated) institutions that provide credit to, and collect funds from the public. Faster communications require faster reactions from both markets and policy makers but also quickly make information obsolete. The universalisation of banking is increasingly blurring the boundary between bank and nonbank financial services. This trend is already well developed in certain European countries—as exemplified by the widespread distribution of insurance products through bank branches, the repeal in 1999 of the Glass-Steagall Act (which restricted banks’ involvement in equity financing and artificially separated investment banks from commercial banks). Future Trends of Financial Risk Management The future will be a continuation of the present. Financial innovation will continue at the same, or even at an accelerating, pace because of the insatiable demand for lower-cost, more efficient solutions to client problems. Information and financial technology will continue to expand and so will the circle of understanding of how to use this technology.
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By combining the past developments of financial risk management with the features and trends of the general financial industry in the digital economy as discussed above, we can foresee the following trends of financial risk management in the future. Emerging new risk management instruments and markets
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Theoretical breakthroughs (such as derivatives pricing techniques) enable financiers to invent and price new instruments. The forward and options contracts are the building blocks of modern risk management. New instruments based on these basic derivatives will continue to emerge. For example, there are nascent markets in weather-linked contracts (see e.g. Anonymous, 1999), telecom bandwidth and in corporate-earnings insurance. At the same time, the spread of existing technologies is hastening an upheaval among financial institutions and making it easier for risk to end up with the people most willing to bear it. While much progress has been made in financial risk management, it is still far away from the goal of being able to model and manage almost any conceivable risk. Once financiers can strip out risks at will, a great prize is within their grasp, because firms can lay off the kind of risk they want to, and to just the degree they want to. In the same way, investors can take on precisely the risk that most suits them. To achieve this objective, new theoretical inventions and instruments will be necessary and bound to emerge. Emerging new markets in risk Before recent developments in financial theory such as option pricing techniques, firms typically had few choices about how to manage risk. Gradually, however, many firms began to use derivatives as protection against movements in prices and interest rates. For example, those operating internationally realised that by hedging their exposure to changes in foreign exchange rates, they could make their profits less volatile and hence more valuable to investors. New ideas and instruments are continuously extending this frontier. For example, until recently, an ice cream maker could do little about the risk of a cool summer, which would lower demand for its products. Similarly, energy companies suffer during mild winters, because they lead consumers to turn down their central heating. The risk of adverse weather seems inevitable, but financial wizards have come up with a way to avoid it. Over the past few years traders have done around $4 billion of weather-related deals tailored to firms’ needs “over the counter”. Since September 1999, the Chicago Mercantile Exchange has traded weather-linked derivatives whose value varies with the temperature measured by an index of warmth in four large American cities (cf. Anonymous, 1999). Deregulation of the American and European energy markets has created a deep pool of demand for such instruments. Unbundling and repackaging corporate risks When financiers package business risks as securities of some form or other, they are tinkering with the components of existing securities, such as debt and equity, that today pass aggregated risks to investors. Given the new technology of finance (e.g., bundling and unbundling risks), some of the financial instruments that are taken for granted today may eventually become obsolete. Equity, for example, might be replaced by a series of risk-
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linked contracts offering specific payouts. Loan agreements might routinely include contingencies that affect the interest rate.
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To understand why, consider the mechanism by which firms typically try to protect themselves from harm: insurance. In a normal year, it will experience numerous small setbacks that cause small losses-the firm expects these to happen, just as a bank expects some of its loans to go sour, so these might be called “expected losses”. Insurance premiums paid up-front to cover these expected losses are equivalent to a tax-efficient (but non-interest-earning) bank deposit that is drawn down as the losses occur. In other words, the company has every expectation that most of the premium will be claimed back. But firms can also suffer larger, more expensive reverses, which are a nightmare for managers. The odds that catastrophe might wipe out the entire business are very small. But there is a bigger chance of some event that might seriously dent profits. And financial markets hate the unexpected. Securities analysts, who will discount a surprise gain as a one-off, will panic if presented with an unexpected loss. From the firm’s perspective, therefore, an unexpected loss may be even worse than it looks. This gives a company an incentive to lay off any risk that is not intrinsic to its core business. This sort of insurance is being sought by companies, but it is also being promoted by sophisticated insurers, such as Marsh & McClennan, SwissRe, AIG, XL Capital and Ace. They specialise in pricing the tiny odds of very rare events. They also want to improve their traditional insurance business by wrapping it up with financial protectionforeign-exchange contracts, for example-that used only to be available from the capital markets. They can do this effectively because these risks are uncorrelated with normal insured risks. By packaging them, the insurer creates a portfolio that is more attractive for an investor. In other words, these are “win-win” deals. This broad trend in finance is known as “alternative risk transfer” (ART). It involves the ever-closer proximity of insurance and the capital markets, once almost entirely separate activities. For further details regarding ART we refer to Zalkos (2001). More efficient markets due to technology advances As in the past, technologies, particularly telecom and computing, will play an important role in financial risk management. As these become more powerful, they enable information and ideas to be communicated across vast numbers of people at very low cost. Plenty of traditional businesses, including auction houses and bookshops, are scrambling to react and finance is no exception. Already, new information technology is eroding the distinction between different parts of finance, such as banking and insurance. As the Internet matures, financial intermediaries risk seeing their margins flattened; and entirely new business models will emerge. These technologies enable the financiers to exploit their unbundling skills to the full. Harnessing the Internet, ART providers and other firms will parcel risks into different classes of securities. They may keep some themselves, but mostly they will sell them on to different types of investor. Technology also has the power to demolish existing boundaries between different parts of the financial world. Banks are no longer the only providers of credit. Insurers are competing with investment banks to serve big corporate clients. Mutual and pension
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funds are making direct equity investments, bypassing securities firms. Many of the best financial firms 20 years hence will rely on intellectual more than monetary capital. Their skills, above all, will lie in packaging and marketing. Investors will measure their performance not simply in terms of their returns on capital, but also in terms of how risky they are. If these trends play out, capital markets will approach a state of theoretical perfection. Thanks to the diversification made possible by the Internet, the rewards will go to those who assume the risk of doing badly in bad times. There will be an unprecedented degree of risk-sharing. Far more risks will end up with those investors most willing and best able to hold them. These developments could deliver a new level of efficiency and stability in the global economy.
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Implications for Financial Institutions Risks associated with de-segmentation, securitisation, financial innovations, globalisation and increased competition have emerged. Increased volatility, greater interdependence and new risks have also made the structure of the risk exposure of banks and other financial institutions more complex. For banks, the traditional activity was “on balance sheet” lending, and the associated risk management technique was credit risk analysis. However, lending now accounts for a smaller share of total activity than in the past for many banks. Newer activities are investment banking, organisation, trading (agency and proprietary), mergers and acquisitions and information systems—where the risks are different. The fact that banks will increasingly hold a wider set of instruments (money market assets, bonds, equities, derivatives) and that some of the risks in these assets will be retained while others are passed on implies that risks must be continually identified and systems must be set in place to offset risk or to hold sufficient capital against any risk that is retained. Also OECD capital markets have changed beyond recognition. Domestic deregulation and external liberalisation have resulted in major changes in competitive conditions. Advances in communications and information systems enhanced the capacity of financial market participants to use the opportunities offered by the new financial environment. The product cycle in financial services is operating at a faster pace. New financial services require constant innovation with constant pressure on margins. These developments have increased the need for better risk management. Financial institutions must improve their capabilities for defining, managing and pricing risk. The general objective is to build and use systems for the disciplined management of credit risk, market risk and liquidity risk. The primary components of a sound risk management process are: a comprehensive system for measuring different types of risk; a framework for governing risk taking, including limits, guidelines, and other relevant parameters; and an adequate management information system for monitoring, reporting and controlling risks. To achieve these goals, financial institutions are facing some immediate challenges. Conventional financial assets (equity, bonds, loans etc.) can be measured in a traditional accounting system (book or market valuation). However, swaps and other offbalance sheet contractual arrangements can not be incorporated in a similar value framework. The traditional accounting system is therefore not very suitable to identify risk allocations.
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Value at risk (VaR) is the most widely used risk management model. However, in extreme situations, VaR models do not function very well. That is why these models have been supplemented with “scenario” or “stress” testing. But this approach may not be adequate to control risks. An obvious limitation is that important extreme scenarios will be excluded from the analysis. For example, it seems doubtful that risk managers in their stress scenarios foresaw the extreme “LTCM 1998 episode” (Kimball, 2000). A fundamental limitation of the current generation of sophisticated risk management models is that they are based on the probability calculus of “a game against nature”. In other words, these risk management systems neglect strategic factors in the behaviour of market participants.
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Implications for Corporate Financial Risk Management Corporate financial risk management seeks to manage a company’s exposure to currencies, interest rates, energy, commodities and other factors driven by the financial market. It should be viewed as an ongoing process that continually evolves with the company as it encounters new and unforseen risks. However, in reality, many companies that have identified various risks in their businesses do not have formal risk policies or strategies in place to manage these risks within a corporate approved process (cf. Baldoni, 2001 and Jalilvand et al 2000). Many companies regard risk management as a series of unrelated transactions tied to a specific event or process. With this transactional approach to managing risk, one begins with a blank sheet of paper each time a new issue or problem arises, and then develops an independent solution for each disparate problem. After a time, this string of unrelated solutions themselves can become an exposure as the underlying risks shift. While the dangers of this kind of approach seem obvious, it is surprising how many companies rely on transactional approach. Clearly, companies would benefit from a process that is woven into their overall business strategies and management process. However, for senior management to help shape such integrated approaches to managing risk, they must be better informed about risk and its impact on the company. No doubt there will continue to be a need for unique and innovative risk management strategies and performance measurement methodologies. However, to unlock the true value and potential of the risk management process, we must continue the journey by going beyond current, silo-driven approaches. If we can apply and combine already developed techniques to equip senior management with a deeper, more comprehensive set of decision support tools, risk measurement and management processes can be elevated to their rightful status in the decision making process. Implications For Emerging Economies Emerging economies face more domestic vulnerabilities such as an over reliance on the exports of raw materials, inadequate bank supervision and capitalization, immature capital markets, and policy mistakes by governments etc. Consequently, emerging economies are more volatile than industrial countries4. In addition to domestic vulnerabilities, emerging economies also face risks from global factors beyond their control. First is the health of the global economy, which impacts both the price of commodities and the quantity of imports demanded from developing countries. Also, important are monetary policy and its effects on foreign exchange policy, as changes in developed country exchange rates can dramatically impact both the
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trade and capital accounts of developing countries. Changes in trade policy can also have tremendous impact on the fortunes of emerging markets. Raising tariff on imported goods and services or closing borders all together can devastate developing countries (Martins et al, 2001). Given these characteristics of emerging economies, one can see that the above implications for financial institutions and corporations do apply in emerging economies. Besides, due to the additional domestic uncertainties in emerging economies, financial risk management in emerging economies will face additional complications.
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The financial industry in emerging economies is often heavily regulated and thus many risk management products, which are available in developed economies, may not be available. At the mean time, the technological infrastructures for emerging economies are often lagging behind that in the developed economies. Thus financial risk management in emerging economies has a long way to go5. On the other hand, the awareness and willingness of companies in managing their risks has definitely increased in the emerging economies due to impact of events such as the Asian financial crisis. That is, the demand for financial risk management is increasing, especially in the past few years. Due to the great business potential, financial institutions from industrial economies are keen to explore the financial risk management in emerging economies. Thus the development of financial risk management in emerging economies will be likely at a fast pace. In sum, the emerging economies have to face the trends of financial risk management in the digital economy and thus face similar challenges. But the specific challenges faced by each emerging economies also depend on other factors such as the regulations on the financial industry and the technological infrastructure etc. Concluding Remarks In today’s digital economy, the financial industry is changing rapidly. We are facing an increase in the pace of financial innovations, a rapid expansion of cross-border financial transactions, the faster pace of transmitting shocks or mistakes throughout the international financial system and greater sensitivity on the part of financial market prices to changes in preferences. These changes in turn determine the trends of financial risk management in the future. Financial risk management will evolve at a faster pace: new risk management products will continue to emerge and the financial risk management system will continue to improve. Acknowledgement The author would like to thank Prof. Simon Gao for many useful comments and suggestions.
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Endnotes 1. For example, Fatemi and Glaum (2000) found that a large proportion of German firms (88% of the respondent firms in their study) use derivative instruments. 2. For example, an individual investor may use the protective put strategy to limit the possible loss in an investment. 3. VaR refers to the loss that can occur over a given period at a given confidence level, for details see Chance (2001).
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4. See Hausmann and Gavin (1996) who found the volatility of Latin American GDP Growth was at least twice as great as that in industrial economies over the 1970-1992 period. 5. For example, Lee (2001) claims that the Asian derivatives market is in the very early stages of development and Asia as whole is lagging behind its European counterparts in this sector as much as 10 years.
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References: Anonymous, 1999, Schools brief: the future of finance, The Economist, London, Dec 11, 71-72. Arak, M., Goodman, L.S. and Rones, A., 1988, Credit lines for new instruments: swaps, over-the-counter options, forwards and floor-ceiling agreements, Bank Structure and Competition, 437-56. Baldoni, R., 2001, Financial risk management: journey or destination? Directorship, June, 13-20.
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Balino, T.J.T., and Ubide, A., 2000, The new world of banking, Finance and Development, June, 41-44. Black, F. and Scholes, M.S., 1973, The pricing of options and corporate liabilities, Journal of Political Economy, May-June, 81(3), 637-54. Blommestein, H.J., 2000, The changing nature of risk and the challenges to sound risk management in the new global financial landscape. Financial Market Trends, March,171-194. Bruce, R., McKern, B., Pollard, I., and Skully, M., 1997, Handbook of Australian Corporate Finance, 5th edition, Butterworths. Chance, D.M., 2001, An introduction to derivatives and risk management, 5th edition, Harcourt. Dowd, K., 1998, Beyond value at risk, John Wiley & Sons. Fatemi, A. and Glaum, M., 2000, Risk management practice of German firms, Managerial Finance, Vol. 26 N0 3, 1-17. Gao, S., 2001, Strategic risk management and high-tech risks, The Proceedings of Risk Management Forum on the High-Tech Industry in Taiwan and the UK, May 2001, Taiwan. Grenville, S.A., 2000, Globalisation and the international financial architecture: writing (and righting) the rules, Reserve Bank of Australia Bulletin, July. Hausmann, R. and Gavin, M., 1996, Security stability and growth in a shock-prone region: the policy of challenge for Latin America. In Ricardo Hausmann and Helmut Reisen, eds., Security stability and growth in Latin America, OECD. Jalilvand, A., Switzer, J. and Tang, C., 2000, A Global perspective on the use of derivatives for corporate risk management decisions, Managerial Finance, Vol. 26 N0. 3, 2938. Jorgenson, D.W., 2001, Information technology and the U.S. economy, The American Economic Review, Vol 91 No.1, 1-31.
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Kimball, R.C., 2000, Failures in risk management, New England Economic Review, Jan/Feb, 3-12. Lee, J., 2001, Derivatives market yet to mature, Asia money, London, Vol.12, Issue 3, 36-38. Li, S., 2001, Some thoughts on managing e-commerce risks, Proceedings of the 2nd International We-B Conference, Edith Cowan University, 165-170. Martins, L.F., Petrov, C. and Kelly, J.M., 2001, Managing market risk for an emerging market debt portfolio, Journal of Portfolio Management, Vol. 27, Issue 2, 75-90.
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Merton, R.C., 1973, theory of rational option pricing, Bell Journal of Economics and Management Science, 4(1), 142-83. Scholes, M.S., 1998, Derivatives in a dynamic environment, The American Economic Review, Vol 88, No.3, 350-370. Smithson, C.W., 1998, Managing Financial Risk, A guide to derivative products, financial engineering and value maximization, McGraw-Hill. Tortoriello, B., 2000, Basel Proposal for a new capital adequacy framework, Banking Policy Report, New York, Jan 3. Zolkos,R., 2001, Alternative risk transfer tools growing in popularity, Business Insurance, Vol 35, Issue 20,16-19.