by D.S.W. Andradi
ACA, ACMA Partner, SJ Associates

Turbulence has emerged arguably as the single most important facet, which characterises the modern financial world. In recent times, spectacular upheavals were experienced in the global financial markets.

For instance, high-profile financial institutions such as the Barings Bank, Sumitomo Corporation, BCCI, Daiwa, have collapsed in recent times.

East-Asian national economies including South Korea, Thailand, Indonesia, Malaysia (1997-1998), Russia (1999) and Brazil (1999), collapsed resulting financial crises.

Volatility has been observed in international capital markets including those of the developed economies such as the USA. The dot.com fever reflected in the USA’s NASDAQ index.

Financial markets of Sri Lanka, being closely integrated to the world economy and the international financial system, are by no means insulated form the turbulence in the global and regional financial markets. Further, domestic factors such as adverse movements in foreign exchange reserves, the widening fiscal deficits and the political and economic uncertainty resulting from the on-going military conflict, have also contributed towards volatility in our financial markets in Sri Lanka.

Definition of risk

When comprehending the basic concepts of risk management, the definition of `risk’ is important. Risk could be defined as the probability that the actual outcome would turnout to be different from the expected outcome.

Rapid changes in the business world invariably leads to risk and uncertainty. The level of risk increases exponentially with change.

The general human tendency is to perceive risk as something negative. This is natural because our mind generally tend to focus on the risks such as natural disasters, deaths, accidents, which only have a downside. But there are risks which have a upside as well as a downside. These are the risks which are associated with potential rewards.

Entreprenuership is an essential ingredient of business success. It could be argued that business enterprise is essentially about assuming risks. The saying goes , nothing ventures, nothing gained.

There is no reward without risk. After all, risk per se. cannot be considered to be a bad word. Risks which have an upside are in fact opportunities for gain.

The relationship of risk and reward is one of the central themes of modern financial theory. The higher the risk, higher is the reward or return expected by the entrepreneur. Further, the inclination to take risks also changes from person to person, company to company. The inclination to take risks is termed as the `risk appetite’.

Drivers of financial risks

Needless to say, turbulence and volatility in the financial markets result in financial risk and uncertainty. There are many factors which have to be considered about high volatility. Most of these factors are closely interrelated. Among the most significant factors are, the deregulation of financial markets, where state intervention in financial markets are reduced and market forces are allowed to operate more freely.

Internationalisation or the globalisation of financial markets allows financial crises to spread from one country to another very rapidly.

Impact of information technology is such that it enables enormous numbers of transactions to occur at tremendous speed.

Convergence of business, especially in financial services industry, which has resulted in commercial banks, in addition to their traditional banking practices, venture into leasing, development banking, investment banking, insurance and other services.

Deregulation, liberalisation and globalisation in most cases lead to the break up monopolies, paving the way for the intensification of competition.

Rise in the level of corruption world-wide, which is widely described by the term ``Crony Capitalism", refers mostly to bribery.

Corporate fraud continues to cause major concern in financial markets, a case in point being the well publicised case of Nick Leeson of Barings Bank.

Today, a whole host of sophisticated financial instruments and products such as tele-banking and e-banking have emerged.

Macro-economic factors such as fiscal deficits and foreign reserves and monetary policies of states, are also considered important when considering the area of financial risk.

Drivers of financial risk management

Turbulence in the financial markets continue to threaten the economic well being of the nations and the very survival of business organisations. This has brought about a world-wide clamour for sound financial risk management, along with the demand for transparency, accountability and responsible corporate governance. In fact, risk management is now perceived as a vital and integral part of good corporate governance.

For instance, the Turnbull report, which is the outcome of the latest working party on Corporate Governance in UK, recommends the placing of risk management in the agenda of the Board of Directors.

Among the major drivers of financial risk management (FRM) are; the pressure from the regulatory agencies interested in the stability of the international financial system, such as Central Banks, Securities Exchange Commissions and the Accounting Standard setters. Central Banks, under the guidance of the Basel Committee on Bank Supervision continue to introduce new regulations addressing risk management issues, Accounting standard setters such as the International Accounting Standards Committee (IASC) continue to show growing interest in the FRM, while addressing these issues in recent standards.

Another factor driving FRM is the pressure from international lending agencies, such as the World Bank and the International Monetary Fund, which are also interest in the stability of international financial systems. The banking crises in East Asian countries such as Indonesia and South Korea, which resulted mainly from enormous bad loans and `Crony Capitalism’ have lead to these institutions to pay special attention to the quality of loan portfolios and corporate governance.

Pressure for the investing community is also a factor which drives FRM. The initiatives of enlightened managers who are concerned about the survival and prosperity of their organisations, is also a driving factors, when financial risk management is considered.