Risk management is back: the financial crisis and the Asian banking perspective
The financial crisis has created profound and widespread trauma. Across the financial services business, the certainties of the boom times have crumbled and the old business models have been destroyed. One of the most critical failings before the crash was that asset prices became increasingly irrational, divorced from fundamental risk. Asian banks, in particular, are waking up to the fact that far more robust and sophisticated risk management strategies are essential in the future. But lack of experience and understanding of advanced risk mitigation techniques threatens to leave them at a disadvantage compared with international competitors.
Before the crisis, risk management was towards the bottom of the priority list for many banks in Asia. Business was plentiful. Very often, risk management was compromised for the sake of revenue generation. The risk implications of subordination were overlooked. Covenants were too lax, and pricing no longer reflected underlying risk: pricing became simply a function of market liquidity.
As liquidity started to tighten at the beginning of the crisis, banks began to realise that they needed alternative funding solutions. At the same time, they sought to manage risk to preserve the strength to compete in their chosen sectors. Those who lacked adequate risk management tools struggled to provide the appropriate level of support to their clients, and lost significant market share. The lessons are now being learned, painfully. Risk management and risk mitigation are now firmly back on the agenda. In many Asian markets, this means that banks are having to get up to speed with contemporary techniques for managing counterparty risk which they have not previously had to master.
Risk participation, for example, is steadily gaining greater acceptance in the Asian banking context. Risk participation enables the transfer of risks between banks, and between banks and clients, for a fee. It facilitates the acceptance and mitigation of trade-related risk, and supports the provision of cross-border trade services to customers. Banks are increasingly turning to risk participation as a method of transferring non-documentary payment risk to another institution either on a funded or unfunded basis. However, a number of challenges remain.
Risk participation agreements are over-the-counter (OTC), bilateral agreements between two parties. As a consequence, various forms of agreement have been developed, which creates inconsistency, uncertainty and a lack of standardised terms and conditions. Negotiation and finalisation of risk participation agreements can take a lot of time and rack up significant legal costs. Non-standardisation also inhibits general agreement on accounting treatment and policy. The lack of clarity and consistency complicates the issue of regulation from central banks’ perspective.
However, the industry is responding to the need for change. One of the latest developments is the introduction of a new Industry Master Participation Agreement (IMPA) endorsed by the Bankers Association For Finance and Trade (BAFT) to facilitate the buying and selling of country and bank trade-related risk. The new IMPA provides a standardised document template to ensure the simplification of documentation exchanges between banks and reduce legal costs by minimising redundancies and excessive bilateral discussions.
Recently, J.P. Morgan developed a Shariah-compliant Master Risk Participation Agreement (MRPA), which will enable our Islamic financial institution clients to participate in J.P. Morgan-originated transactions. This agreement – the first of its kind in the market – will allow our clients to access a diversified book of trade finance investments originated in J.P. Morgan’s global Trade Services group, by giving them access to assets from different regions and trade asset classes. The MRPA will enable clients of Islamic financial institutions to participate in both funded and unfunded traditional trade finance transactions originated by J.P. Morgan’s Treasury Services business. The MRPA was developed with J.P. Morgan’s Shariah advisor and has received the relevant Shariah approvals.
One of the impacts of the crisis was that claims on insurance rose along with financial defaults. A few insurers faced challenges in providing cover for bank counterparty risks. Insurance remains a fundamental tool in the risk management portfolio. Since the financial crisis, though, insurance premiums are extremely high for new policies. Choosing a financially strong and sound insurer is essential. Equally important, however, are the details of the policy cover, the relevant claims history and residual retentions and excesses. Since insurance may require the insured party to perform certain obligations to ensure protection remains valid, it is important to negotiate the appropriate language in each policy, specific to the requirement.
Many banks have realised the value of partnerships with multilateral agencies such as the Asian Development Bank (ADB) and the International Finance Corporation (IFC). These agencies have been playing an active role in promoting regional and global trade with the introduction of various programmes to help banks with their transactions. These multilateral agencies – with the backing of the World Bank – provide a much higher degree of protection and assurance to financial institutions. To the best of our knowledge, there has not been a single claim or default under the trade finance facilitation programme to date. While initial due diligence and documentation can be cumbersome and time consuming, these multilateral agency programmes provide banks with an alternative to managing counterparty risk, and improve deal parameters and risk profile.
The tools for sophisticated and effective risk mitigation and transfer are out there. In the post-crisis world, how well they are incorporated into a bank’s operating model can make a big difference between success and failure. Asian banks have traditionally been slow to embrace the latest techniques. Partnerships with innovative global players with strong balance sheets can help bring those techniques into the Asian banking sector to the benefit of all parties.