spikegifted.net - Risk Management

Other types of risks: What's leaking? Country risk, Political risk, Concentration risk, Issuer risk

We have covered a great number of risk areas: market risk, credit risk, operational risk, legal and regulatory risks, reputation and underwriting risks and systemic risk. In all, we've covered nearly every major type of risk financial institutions can be exposed to. However, there're additional types of risks that risk managers have identified. There is a good reason why I haven't cover each of these specifically: These risks are not distinct - they're in effect combination of different risk categories that have been previously mentioned or they are taken care of in such a way that the risks are 'distilled' down the one of the other risks. While I'm not suggesting that they are not important, as they clearly are, they are not necessarily the primary concern for risk managers like the other risk categories mentioned earlier. I shall briefly cover these risks for the sake of completeness.

Country Risk: For any given country, there is a certain risk factor attached to it. This risk factor is a combination of the country's economy, level of sophistication in legal and regulatory developments and accounting principles, political stability and other factors. The higher the risk factor, the more capital is being put at risk - to put simply, to conduct the same level of business activity in countries like Russia or China as to the US or Germany, an institution will be putting significantly more capital at risk. Country risk is the combination of all risk exposures into "one magic number" - The riskier the country, the lower that number is likely to be or if the "one magic number" is the same for all countries, the countries with higher risk factors will translate to lower level of business activities due to higher risk weighting. For countries that has huge growth potential (like China, Russia and India), the desire to gain market shares at early stages of development is finely balanced by the levels of country risk an institution is willing to be exposed to. It is a constant battle between business areas and those who determine and calculate country risk to ensure that the desirable level of business is being done without overly exposing the firm.

Political Risk: Since it is desirable to limit an institution's exposure to country risks from certain less developed states, we need to look at ways to 'hedge out' these exposures. One of the reason that less developed states are riskier is due to their legal and political structures and political risk arises when the client or counterparty fail to perform not due to circumstances of their choosing, e.g. the imposition of a currency moratorium or nationalization of industries. Political risk insurance (PRI) is one of ways employed to ensure that the business is being done without assuming massive country risk exposure. PRIs are usually provided by specialist organizations like international development agencies and specialist insurance companies. These organizations, in turn, usually have strong credit rating or are subsidiaries of organizations that are highly rated. Therefore, political risk, a risk category that is close to impossible to calculate and even more difficult to hedge out, is transformed to become counterparty risk and legal risk. The counterparty risk is usually easily assess, but the legal risk tends to be very difficult to judge for these organizations are unlikely to assume risk without consideration. The legal trigger for payout are usually highly ambiguous and claims tend to be drawn out and costly.

Concentration Risk: While country risk looks at total exposure to a particular country, concentration risk performs a similar function on an industry type or groups of industry or even a group of companies. One of the prime example is banks operating in less developed countries like Russia and Kazakhstan. The dominant industries in these countries are mineral extraction and oil & gas. It is therefore logical that the largest exposure banks in these countries will be to these industries - lending (short- and long-term), trade finance, foreign currency transactions, etc. This type of concentration is unavoidable and risk managers will be keen to reduce the proportion of exposure to these industries by encouraging business developments in other sectors of the economy. However, progress is slow and it is often a vicious circle - the better the performance of an industry, the higher the need for finance and hence more money poured into the sector to support growth. Another example of concentration risk, and this case is avoidable, is the 'tech bubble' which was a phenomenal in the late 1990s. Partly driven by the low interest rate growth environment, partly driven by believe of 'productivity gain' through the deployment of sophisticated information technology and finally believing in optimistic market sentiment will persist, TMT (telecoms, media and technology) companies share prices running sky-high and ambitious growth plans were envisaged and these were in turn financed by banks and investors believing their fantastic growth stories. Well, the 'tech bubble' burst - first led by internet sector, moving on to other technology sectors and telecoms and finally the media sector succumbed. Banks and investors were left with huge exposures to these sectors. Those who made good living lending and holding these companies' stocks and bonds were left with a big hole in the balance sheets (due to write-offs and unrealized losses). Can these losses be avoided? The obvious answer (ie. yes) is probably not the right answer - financial institutions were competing against each other to gain businesses in these sectors and the herd mentality drove them to taking more and more risk and the overall market optimism blinded even the professionals. For many different reasons, banks and other financial institutions are driven by the need to enhance shareholders' value and not being in the thick of a growth sector is often seen as not doing the best for the shareholders. It is another vicious circle. However, those institutions with good risk management would have pegged back their exposure - promoting other products that would satisfy their clients' needs without increasing, or even reducing, the institutions' exposure to the sector. In the end, those who didn't do that ended holding the ball when music stopped and others have the resources to explore other opportunities.

Issuer Risk: At a simplistic level, issuer risk is very similar to concentration risk. Concentration risk deals with exposures that makes up significant parts of the institutions' balance sheets - either on a sector basis or on a single entity basis - and it can be argued that issuer risk is concentration risk in the latter form. However, risk managers look at issuer risks even when they are not large enough to constitute 'concentration'. Issuer risk is the sum total of all the risks across all products that an organization is exposed to a particular obligor. The one obligor rule is one that originates from credit risk where exposures of subsidiaries of a particular company is brought up through the corporate group structure to the head company. Therefore, what appears to be a series of small exposures to a group of entities can actually mean a large exposure after all the risks to various subsidiaries are totaled up. This is another method risk managers employ to check against concentration.

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