Good Risk Management owes much to 'sati' and 'panya'

Walter Wriston, former chairman and CEO of Citibank, defined "banking business" as "the business of managing risk".

Although a recognition of risk management and its relevance to banking business has been made since the time of Walter Wriston back in the 1960s, not much progress concerning sophisticated risk management has been employed up until the last decade.

Developed with an objective of determining how much capital banks need to put aside to guard against uncertainty, Basel II has been recognised as the most quantitative and sophisticated risk-management regulatory framework so far.

Featuring in Basel II, risk measurement is, by and large, the essence of modern risk-management practices. Providing that risk is measured in monetary terms, the calculation of both risk-adjusted return and risk-adjusted capital enhances the risk manager's ability to effectively monitor and manage risk.

Notwithstanding its sophistication and complex utilities, there are still several pitfalls and limitations in measuring risk by employing complex mathematical and statistical models.

Firstly, as the model is getting more complex, senior management is less likely to fully comprehend the essence as well as the operation of such a model. Hence, the benefits intended by this complex risk modelling can be limited.

Secondly, a risk model is only a proxy of the real physical world. A model cannot comprehensively capture and envisage all possible events. For example, the "99% confidence level" is often used in the Value at Risk (VaR) model. This means there is a 1-per-cent chance that the model has not accounted for.

Thirdly, a model is often constructed on past data or ordinary items/events that we have experienced. Recalling Nassim Taleb's black swan theory, most people ignore "black swan" because they have not seen one. This analogy is made to the "unexpected rare events" that most people disregard.

LTCM is a case in point. LTCM was a hedge fund set up by two Nobel Prize-winning economists. Their company had developed complex mathematical models for trading financial instruments. In 1998, it was at the brink of default and needed a US$3.5-billion (Bt118 billion) rescue package organised by the Federal Reserve Bank. One of the key reasons was that LTCM's trading model failed to predict the ruble crisis that resulted in the default of Russian government bonds.

In sum, the sophistication

of risk management and complex models has come very far since Walter Wriston's time. However, amid all these quantitative complexities, one may have to return back to basics and rely on a simple analytical tool such as common sense. Through common sense, we can refrain from:

a) Things that we could not and do not truly understand. For example, what is a CDO?

b) Things that are too good to be true. For example, a CDO that received the same rating as an ordinary debt instrument and yet featured an additional yield of 50 basis points.

Emphasising a return to basics, two old Buddhist words, "sati (mindfulness)" and "panya (wisdom)", provide a good analogy. When "panya" goes too far without enough "sati", things can really go wrong. "Sati" and "panya" must be kept in balance and harmony.

As a final remark, though risk management is heavily embedded with complex mathematical and statistical models and formulas, common sense must not be forgotten in this business of managing risk.

Yokporn Tantisawetrat is senior executive vice president and chief risk officer at Siam Commercial Bank