Coca_Cola_Evaluation

Risk Management Techniques Introduction In a growing turbulent business environment, managing risks which are termed as ‘future losses’ remain critically important. As a Risk Manager my duties towards the bank are to minimize the potential losses or risks involved in day to day transactions. The critical factors would be to measure and monitor risk across all portfolios of the Bank while working in tandem with the Asset / Fund Managers and Client Account Managers to enhance the knowledge base of the bank updated with daily activities. Key functions and role of a Risk Manager includes: • Enhancing Bank’s wide framework for measuring, monitoring and evaluating the credit, operational and market risks. • Ensuring consistency of risk policies across the Bank management. • Execution of the decisions made by the risk management functions. • Effectively monitor and report the risk exposure to risk committees and senior management • To oversee the due diligence team which evaluates the credit applications of business departments and ensure the efficient and sound credit approval process. Commercial banks are predominantly in the risk business. Whilst providing financial services, they face various kinds of financial risks. Market players seek the services of these banks because of their ability to provide funding, market knowledge and expertise. They generally act as a principal in the transaction as their own balance sheet is used to facilitate the transaction and risks. However the bank is not always responsible for these risks and mitigates the risk by restricted business practices and involving third parties. Risk management has evolved gradually with dramatic changes in the communication channels required to effectively manage the constant changing risks a firm faces. Risk management as it exists today is distinctly different from a decade ago, it has progressed from dealing primarily with risks inside a company to an approach that integrates the risk management function into the broader strategic objectives of the firm. One of the most prominent changes that have occurred involves the scope of risks addressed and the increased sophistication of financing methods utilized by risk managers. However, the broadening scope of risk management also has been accompanied by an evolution in the role that risk communication plays relative to the past. Risk communication remains vital to a successful risk management program which is evident seeing the growing number of stakeholders. Not only have the quantity of information, the quality of information, and the parties involved in communication changed, but there is a general recognition that risk communication itself is an important tool in effectively managing risk. As newer risk-financing options are being developed, the risk management function also is being transformed into a more collaborated approach with other management functions within the firm. Increased regulations over risk management expanded the need to coordinate with corporate counsel. The public’s demand for more direct communications regarding such risks as defective products, professional malpractice, and environmental damage increased the importance of coordination with marketing and public relations functions. Also, the greater sophistication in risk-financing instruments often led to greater involvement with the board. In order to maximize value, corporations must recognize the effect of their activities on customers, suppliers, and employees. The importance of a Risk Manager within a corporation has become more than just successful interaction with the insurance market. To be effective, risk managers need to communicate effectively with managers and others throughout the company in order to understand all of the risks faced by the company, design risk reduction programs, and implement insurance and non-insurance risk-financing techniques. Communication has become more important than ever before. While the systems and activities begun in the first generation continued, the risk manager’s job now requires a substantial commitment to managing risks that crop up from relationships with external stakeholders. Reasons of Risk Management Few of the major reasons of risk imbalance are Asymmetric information causing Adverse selection. Asymmetric Information is a case where one party in a deal or a transaction has higher or superior information compared to the other party. It often happens in transactions where the seller knows more than the buyer about the transaction details, although the reverse can happen as well. This could be a high risk situation because one party can take advantage of the other party’s lack of knowledge and information regarding the transaction. With globalization and increased advancements in technology, asymmetric information has been on the decline due to ease in access to all types of information. Asymmetric information refers to a case where the buyer and the seller have an imbalance in the information about each other and / or the transaction details. Information Asymmetry can lead to two main problems: 1. Adverse selection- immoral behavior that takes advantage of asymmetric information before a transaction. For example, a person who is not be in optimal health may be more inclined to purchase life insurance than someone who feels fine. 2. Moral Hazard- immoral behavior that takes advantage of asymmetric information after a transaction. For example, if someone has fire insurance they may be more likely to commit arson to reap the benefits of the insurance. Moral hazard means that people with insurance may take greater risks than they would do without it because they know they are protected, so the insurer may get more claims than it bargained for Types of Risks Risks in a commercial bank would be encountered in many forms, from the risks associated with specific products of the bank to operational risks and risks associated with a given market or stock. Product or fund risk is the risk associated with choosing a particular investment product or fund. It is of vital importance to know the funds specification setting out the parameters within which the portfolio manager can invest. An in house research team which specializes in studying the particular industry or company is very essential apart form third party analysts which would provide the investors with a clear view of the investment scenario. Operational risks are associated with individual investment houses and their business processes. Operational risk is associated with the problems of accurately processing, settling, and taking or making delivery on trades in exchange for cash. Fund managers should not be allowed to expose their funds to unnecessary risk by investing in assets outside the remit of the fund specification. There should be a well developed and efficient Controls & Compliance function which promotes transparency in investments. Their independent monitoring provides comfort to investors that fund specifications will be appropriately controlled. Market & stock specific risks are those associated with individual investment markets and shares which all investment managers aim to control through effective asset allocation and stock selection. To reduce the potential risk associated with specific companies, there should be a dedicated comprehensive research team to minimize the potential risk associated with investing in certain companies. Credit riskarises from non-performance by a borrower. It may arise from either an inability or an unwillingness to perform in the pre-committed contracted manner. This can affect the lender holding the loan contract, as well as other lenders to the creditor. Therefore, the financial condition of the borrower as well as the current value of any underlying collateral is of considerable interest to its bank. Counterparty risk comes from non-performance of a trading partner. The non-performance may arise from counterparty’s refusal to perform due to an adverse price movement caused by systematic factors, or from some other political or legal constraint that was not anticipated by the principals. Diversification is the major tool for controlling nonsystematic counterparty risk. Counterparty risk is like credit risk, but it is generally viewed as a more transient financial risk associated with trading than standard creditor default risk. Liquidity risk can best be described as the risk of a funding crisis. While some would include the need to plan for growth and unexpected expansion of credit, the risk here is seen more correctly as the potential for a funding crisis. Such a situation would inevitably be associated with an unexpected event, such as a large charge off, loss of confidence, or a crisis of national proportion such as a currency crisis. Legal risks are caused by new statutes, tax legislation etc which can upset previous established transactions into contention even when all parties have previously performed adequately and are fully able to perform in the future. Cases Some examples would be: The tendency of those in dangerous jobs or high risk lifestyles to get life insurance. A situation where sellers have information that buyers don't (or vice versa) about some aspect of product quality. In order to fight adverse selection, insurance companies try to reduce exposure to large claims by limiting coverage or raising premiums. A risk manager may have an assignment for an organization to arrange a prospectus liability policy to protect the exposures arising from their proposed flotation on the London Stock Exchange. The flotation which may be of a large capital would need the risk manager to insure the IPO in appropriate limits to protect the company, the directors and the selling shareholders (CVC). It would cover a certain period of time frame thereby protecting the company from any market risks and enable the board to make a clean exit from the company. Tools and Implementation After researching on the techniques employed by leading firms through primary research, there is a specific approach which emerges from an examination of large-scale risk management systems. The management of the banking firm relies on a sequence of steps to implement a risk management system. These can be identified as: 1. Standards and reports 2. Position limits or rules 3. Investment guidelines or strategies 4. Incentive contracts and compensation. In general, these tools are established to measure exposure, define procedures to manage these exposures, limit individual positions to acceptable levels, and encourage decision makers to manage risk in a manner that is consistent with the firm's goals and objectives. Further elaboration on these steps throws more light on the techniques. Standards and Reports The first of these risk management techniques involves two different conceptual activities, i.e., standard setting and financial reporting. Managing underwriting standards, risk categorizations, and standards of review are all traditional tools of risk management and control. Consistent evaluation and rating of exposures of various types are essential to understand the risks in the portfolio, and the extent to which these risks must be mitigated or absorbed. The standardization of financial reporting is important, third party audits, regulatory reports, and rating agency evaluations are also essential for investors to gauge asset quality and firm level risk. Position Limits and Rules Another technique for internal control of active management is the use of position limits, and / or minimum standards for participation. In terms of the latter, the domain of risk taking is restricted to only those assets or counterparties that pass some prespecified quality standard. Then, even for those investments that are eligible, limits are imposed to cover exposures to counterparties, credits, and overall position concentrations relative to various types of risks. While such limits are costly to establish and administer, their imposition restricts the risk that can be assumed by any one individual, and therefore by the organization as a whole. In general, each person who can commit capital will have a well-defined limit. This applies to traders, lenders, and portfolio managers. Summary reports show limits as well as current exposure by business unit on a periodic basis. In large organizations with thousands of positions maintained, accurate and timely reporting is difficult, but even more essential. Investment Guidelines and Strategies Investment guidelines and recommended positions for the immediate future are the third technique commonly in use. Here, strategies are outlined in terms of concentrations and commitments to particular areas of the market, the extent of desired asset-liability mismatching or exposure, and the need to hedge against systematic risk of a particular type. The limits described above lead to passive risk avoidance and/or diversification, because managers generally operate within position limits and prescribed rules. Beyond this, guidelines offer firm level advice as to the appropriate level of active management, given the state of the market and the willingness of senior management to absorb the risks implied by the aggregate portfolio. Such guidelines lead to firm level hedging and asset-liability matching. Incentive Schemes These are schemes wherein the management enters into incentive contracts with the Managers and make risk based compensations. However, such incentive contracts require accurate position valuation and proper internal control systems. These tools include position posting, risk analysis, the allocation of costs etc are complex in nature. Well designed systems align the goals of managers with other stakeholders in a most desirable way. Conclusion Apart from the basic risks involved, commercial banks have many other issues like frauds within the employees etc. The industry is emerging with a higher level of risk management techniques compared to the ones used in the past. Yet, there is significant room for improvement. The risk management techniques reviewed here are not the average, but the techniques used by firms at certain niche of the market. The risk management approaches at smaller institutions are less precise and analytic. However, the techniques used by majority of firms that set the industry standard could do some improvement. Each bank must apply a consistent evaluation and rating scheme to all its investment opportunities in order for credit decisions to be made in a consistent manner and for the resultant aggregate reporting of credit risk exposure to be meaningful. To facilitate this, a substantial degree of standardization of process and documentation is required. This has lead to standardized ratings across borrowers and a credit portfolio report that presents meaningful information on the overall quality of the credit portfolio. All credits with the bank should be monitored at regular intervals to ensure the accuracy of the rating associated with the lending facility. Any kind of material change with the borrower or the facility itself, such as a change in the value of collateral or increase in stock prices will change the whole equation and hence a new valuation would be required. Thus following these steps would ensure the quality of credit portfolio to be consistent. Bibliography & References Jorion, P., Value at Risk: The New Benchmark for Control Mar ket Risk, Irwin Professional Publications, Illinois, 1997. Phelan, M. “Probability and Statistics Applied to the Practice of Financial Risk Management: The Case of JP Asymmetric Information in Financial Markets: Introduction and Applications. Ricardo Bebczuk (Ed.); Cambridge University Press, Cambridge, 2003 Morgan’s RiskMetrics ,” Journal of Financial Services Research , June 1997. TM Saunders, A. Financial Institutions Management: A Modern Perspective , Irwin Publishers, Illinois, 1996. Santomero, A. “Financial Risk Management: The Whys and Hows,” Journal of Financial Markets, Institutions and Investments, 4, 1995. Skipper, H and Jean Kwon, W, Perspectives in a global economy, Risk Management and Insurance, May 2007. B.Crabtree, Aon Consulting, personal communication, March 3, 2008