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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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slide1

Back to Basics

- Hari Misra, Editor-in-Chief, Finsight Media

Risk & Compliance Annual Summit

March 9, 2007

words and world first dilemma of modeling
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

words and world first dilemma of modeling3
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

jargon language of the specialists
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

risk in risk management
‘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

financial risks
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

risk measurement modeling
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

common assumptions
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

interdependency of financial risks
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

in practice
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

why measure risk
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

regulation
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

compliance
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

conflict of interest
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

arbitrage opportunities
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

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Thank You

Risk & Compliance Annual Summit

March 9, 2007