How to navigate in financial storms

New book offers a practical approach to financial risk management in emerging markets

By Ann Moline

The world of business is a world of risks, both large and small. Risk-taking practically defines entrepreneurship. In developing countries, where financial crises tend to be more frequent, the ability to manage risks is a particularly crucial item in an executive’s portfolio. But while financial landmines are plentiful, well-conceived strategies to manage them are generally scarce.

In simple terms, a risk-management system strives to find a balance between protecting an institution’s capital and investing that same capital to achieve maximum profitability. In developing countries, just as in industrialized ones, financial risk management is crucial because it helps to ensure the viability of key financial institutions, both public and private. A strong, stable banking system, for example, will minimize the impact of downturns for the economy as a whole, enabling a faster recovery during volatile periods.

In designing a risk-management strategy, each institution must make an evaluation of the amount and type of risk it is willing to assume in order to obtain a given return on its investments. This evaluation involves a complex analysis of numerous factors—a process that can be especially demanding in developing countries where the extent, variety and availability of financial information is limited. Now, for the first time, a handbook is available in Spanish as well as English that is aimed at helping businesses and financial companies with this process. Financial Risk Management: a Practical Approach for Emerging Markets, published by the IDB, offers step-by-step guidance for private sector managers who want to incorporate this crucial concept into their portfolio management framework.

The book, which was a joint project with the Spanish bank Santander, combines theory and practice. It is designed to help guide managers in setting up risk-management systems.

In the interview below, Kim B. Staking, IDB principal financial institutions specialist and co-author of the new book, discusses the importance of financial risk management and why firms in emerging markets need to develop strategies specific to their needs.

IDBAmérica: From a macroeconomic perspective, how does implementing a financial risk-management strategy help a developing nation?

Good financial risk management can help to eliminate the "boom-bust" cycle that is so characteristic in Latin America. By lessening volatility, it will mitigate the impact of an economic downturn. It will help to prevent throwing the entire banking system into crisis, accelerating the downturn, forcing cuts in social spending, and causing other problems.

IDBAmérica: How is the approach to financial risk management different in an emerging market?

An emerging market is not complete, that is, the instruments for taking positions or hedging risks may not exist or may not be liquid. There is also a higher level of transactional risk. For example, a European bank can hedge with a huge transaction in a matter of minutes. But in Latin America, what looks like the perfect hedge on paper may be impossible to carry out in real time. In fact, the transaction could take weeks. So, by the time you can complete the deal, things might have changed to the point that it is no longer a perfect hedge. It is definitely an art as well as a science. Financial managers have to be able to know what has to be done in a few weeks as well as right now. Having advanced information systems to support the strategy will be crucial, so that managers can understand the data, document it, and use it to accurately strategize.

IDBAmérica: How can a bank benefit from a financial risk-management strategy?

As banks get increasingly involved in highly complex financial instruments, such as derivatives, there is great potential for making money. On the other hand, should interest rates shift, for example, you can lose a great deal overnight. If you do not implement a system that helps to protect investments, you place your capital at significant risk. Even a small mismatch between assets and liabilities can rapidly eliminate your capital. If you as a bank are not well capitalized, regulators will look at you with greater scrutiny, and other institutions may not want to work with you. By efficiently managing your financial risks, you end up with a lower cost if capital and a higher level of profitability.

IDBAmérica: What other business opportunities does risk management offer banking institutions?

Once a bank manages its financial risks well, it can provide these same kinds of services to its customers. This opens up a whole new line of business for the bank: helping its customers protect their capital. The bank’s customers are not in the business of speculating on interest rates or foreign exchange rates, but often, they are forced to do so. By offering financial risk management as a service to customers, banks are encouraging economic development, because it allows entrepreneurs to concentrate on the things they do well. This boosts the local economy and helps create more complete financial markets.

Financial institutions in Latin America today are missing out on business opportunities to manage their customer’s financial risk.

IDBAmérica: This would appear to be common sense. Why the need for this book?

In developed markets, financial risk management is done all the time. Financial institutions are always looking for ways to use their capital as profitably as possible, while protecting it at the same time. This has become even more important with new instruments such as derivatives and options swaps. In Latin America, however, financial risk management is pushed more by regulators than by banks. It is not a financial institution-led process. A large part of the reason, we discovered, is that firms don’t have the information they need.

Senior bank managers in Latin America are very much aware of credit risk, inflation and liquidity risk, but are generally unable to hedge these and other risks. And, when aggressive, young MBAs begin introducing complex derivatives into their portfolios, senior managers often do not understand the risks, or even what it is that the MBAs are doing. It is more than just the math–they need to understand how to develop a risk-management culture, how to measure these risks. There is no emphasis on diversification in order to protect investments. While a good banker might have an intuitive understanding that this should be done, there is no tool to help create a systematic approach. And it is much harder to do so in an illiquid market, which is why it was so important to produce a book specifically aimed at such markets.

IDBAmérica: This sounds like a very ambitious proposition. Can banks implement the strategy gradually?

There is no question that there must be a heavy commitment of resources to do this correctly. There must be involvement at every level of bank management, as well as a financial commitment. Very few institutions in Latin America have taken the type of holistic approach that is needed. At the very least, a bank should gather the information necessary to diversify its own portfolio in order to manage its risk. However, a bank cannot do this partially, and then offer it as an instrument to customers. That is a recipe for disaster.

But it does not have to be done all at once. It can be done as a process. In the end, banks must compare [the cost of risk management] with the cost of not doing it.

Date posted: July 2001

Meet Kim B. Staking

IDB Publications website