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Back to Basics - Hari Misra, Editor-in-Chief, Finsight Media

Back to Basics - Hari Misra, Editor-in-Chief, Finsight Media. Words and World (First Dilemma of Modeling). Words model Reality Words take different meanings in different contexts Different disciplines use words in specialized way –The Origin of Jargon

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Back to Basics - Hari Misra, Editor-in-Chief, Finsight Media

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  1. Back to Basics - Hari Misra, Editor-in-Chief, Finsight Media Risk & Compliance Annual Summit March 9, 2007

  2. Words and World (First Dilemma of Modeling) Words model Reality Words take different meanings in different contexts Different disciplines use words in specialized way –The Origin of Jargon Words, however, fail to explain the connection between Reality and themselves –First dilemma of modeling Risk & Compliance Annual Summit March 9, 2007

  3. Words and World (First Dilemma of Modeling) Market Share = (Average IQ of Staff / 100) * (desktops/staff) * (branches/ total branches of all banks) Risk & Compliance Annual Summit March 9, 2007

  4. Jargon (Language of the Specialists) Jargon owes its origin to the attempts of modeling reality by assigning specialized meanings to commonly used words.  “Each new point of view calls forth a revolution in nomenclature” -- Friedrich Engels ‘Value at Risk uses parametric normal distributions which fail when modeling fat tails as observed in high-severity low-frequency events for which Extreme Value Theory is a good modeling technique since it uses generalized Pareto distribution. Enterprise wide risk management is essential since it enables you to take into account the correlations that risk silos fail to capture.’ Risk & Compliance Annual Summit March 9, 2007

  5. ‘RISK’ in Risk Management Force= mass * acceleration Risk (of a class of events) = (Probability of occurrence) * (Impact on Occurrence) By definition, Risk is a ‘measure’ of possible loss on account of one type of events (like interest rate movements, changes in currency exchange rates). Risk & Compliance Annual Summit March 9, 2007

  6. Financial Risks Despite quantitative definition, all financial risks are not measurable with equal ease. Easily Measurable Interest rate risk Foreign exchange risk Liquidity risk Asset pricing risk (market risk) Credit risk Not Easily Measurable Strategic risk Technology risk Reputation risk Compliance risk Modeling risk Operational risk What is the differentiating factor between measurable and ‘not-so-easily-measurable’ risks? Risk & Compliance Annual Summit March 9, 2007

  7. Risk Measurement (Modeling) Each Risk is characterized by unique attributes Modeling is a measurement (or estimation) technique Models are simplified and approximate representation of Reality Models are based on certain assumptions Models use known and proven techniques Risk & Compliance Annual Summit March 9, 2007

  8. Common Assumptions Future course of events will be similar to past trend Actions based on risk models will not significantly alter the risk that is being measured Sufficient and accurate data is available or can be collected Event types are mutually exclusive Risk & Compliance Annual Summit March 9, 2007

  9. Interdependencyof Financial Risks Classification of financial risks as credit, market or operational makes these risks appear independent A few examples of risk interdependency --- interest rate and credit default probability --- credit default and liquidity --- frauds relating to credit origination process Risk & Compliance Annual Summit March 9, 2007

  10. In Practice…….. Understand the key assumptions, limitations, and relevance of risk measurement models to your business Let Specialists handle the intricate details Use cost-benefit approach to decide the degree of sophistication in your risk management process Risk & Compliance Annual Summit March 9, 2007

  11. Why Measure Risk? Load risk cost to price Ascertain Efficiency of Controls Factor Risk in performance measurement Remain Solvent Compliance to Regulatory Requirements Risk & Compliance Annual Summit March 9, 2007

  12. Regulation Banking is highly leveraged Banks are tightly interconnected financially (Systemic Risk) Regulator’s chief goal is to ensure stability of the banking system Compliance to regulatory capital requirement under Basel II is driving risk measurement initiatives Risk & Compliance Annual Summit March 9, 2007

  13. Compliance Basel II, Anti-Money Laundering, MIFID, Sarbanes-Oxley, REG-NMS, IAS/IFRS,….. ….and many others. Most compliance requirements emerge from Conflict of Interest Risk & Compliance Annual Summit March 9, 2007

  14. Conflict of Interest Conflict has its roots at genetic level Conflict, like risk, cannot be eliminated Conflict of Interest : In the mind of individual Conflict of Interest : Principal –Agent Conflict of Interest: Between groups, organizations Risk & Compliance Annual Summit March 9, 2007

  15. Arbitrage Opportunities Better risk management to reduce regulatory capital, offer competitive pricing and to control operational losses Integrating risk, compliance and CRM data collection to avoid duplication of effort Risk & Compliance Annual Summit March 9, 2007

  16. Thank You Risk & Compliance Annual Summit March 9, 2007

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