John Cyriac’s Blog

Operational Risk Management (ORM) is undergoing a transformation and it is widely getting recognised as a major area of risk for financial organisations. Major high street banks in the UK have already implemented BASEL II requirements for Operational Risk (OR) and now they are looking to reap more from their investments. There is a great emphasis on coordinated risk management and organisations have started adopting Enterprise Risk Management (ERM). The main objective for financial institutions in these efforts is to grow beyond compliance requirements and reap business benefits from their investments in OR. One such concept associated with reaping business benefits which is often considered as part of ERM is Risk Appetite. However, there is very little guidance available in the industry for applying the concept of Risk Appetite for OR. This study was conducted as an Action Research to provide a thought leadership in the area of Operational Risk Appetite (ORA). During this study, we initially analysed the regulatory landscape for OR and studied the way it is implemented in a major UK bank. We then conducted several interviews with senior decision makers to understand their views about ORA. Further to that, we conducted an industry-wide survey on the concept. We then supplemented these inputs with the study of existing research and academic articles in this area. The result of this study identifies the unique nature of ORA in comparison to Risk Appetite for credit or market risks. Therefore, we created a more appropriate definition for ORA. We then created an implementation framework for ORA.

John Cyriac’s article on Operational Risk Appetite in November 2008 Oprisk & Compliance

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My nine year old twin boys asked me the question - What is money really? Ofcourse they wanted to see if there is a simple way to buy more toys and sweets.

I am trying to answer 3 questions. 1) What is money? 2) Who creates money? 3) Who controls money and how they control it?

What is money?

Money is something with value. Everyone who uses a particular form of money must agree on that value, and agree to respect that value. Once a group of people agree on something to use as money, and on the value it carries, then a whole range of possibilities open up. Some uses are obvious, and were perhaps among the reasons why money was created. Others are less obvious, and reveal how different societies approach money in different ways. That is a philosophical definition of money.

Now let us illustrate that philosophical explanation with a real life situation.

You all know about the barter system. A fisherman exchanges fish to get wheat and vice versa. Barter system got into problems later, with its complexity and usage. People started using iron and other materials. But imagine the transaction with tonnes of iron to buy a piece of land. Gold was an easy choice. There is record of gold coin usage in ancient Greece during 560 BC. But again, we humans want simpler to use commodities. Then people started keeping their gold with goldsmiths and exchange the receipt they got.

Who creates money?

Later the goldsmiths realized that people seldom come back to collect their gold. So they started printing more receipts than there is gold. So for example, if there was 100 pounds worth of gold, instead of printing 100 pounds of receipts, they printed 1000 pounds of paper. Then they started giving out that paper to people and started charging interest on it. These goldsmiths or money changers are currently called banks. But today, truth is those receipts or bank notes are printed without those deposited gold. It is just paper and the value of a country’s currency is dependent on the public confidence of that country’s productivity. We as a society accept that the paper has value and we do transactions. Now you know who creates money.

How they control money?

The central banks create money and control money supply with interest rates. The amount of money in the economy (money supply) dictates the degree to which capital can be employed to employ people and generate economic activity (work in simple terms).

We live in a debt based society. Debt is used to control nations and the world itself.

What is the meaning of government debt?

Well, the government owes money to the bank. Have you considered how will it pay back the debt? It has to collect taxes and pay back.

If I own a house worth 100K and I owe the bank say 80K pounds, do you consider my situation okay? Now what if I own a house and I owe the bank say 1 million?

American national debt is more than 8 trillion USD. Every year there is a deficit of more than 800 billion in the US budget. It means, with every year passing, the American people owe 800 billion more to the Bank.

Some may say that wealth is siphoned off from the majority to the minority using the mechanism of the banking system - I don’t want to comment on the right or wrong of this view. If it didn’t work like this and on average we each had 2 kids (2 per couple) we would have a static population, and everyone would fairly quickly own their house and have limited motivation to work hard - so the debt based system does create the motive to make people work….

The Structural Analysis theory considers structural and economic differences between parties and the resulting power difference as the most important factor affecting success in negotiations. The theories of psychological influence provide a different approach and tactics for success in negotiations. This essay analyses the effect of power and influence in negotiations and proposes that ‘power is irrelevant in negotiation, only influence is relevant’.

This essay concludes that the relative power differences between negotiating parties is not relevant in deciding the outcome of a negotiation. A weaker party could win a negotiation using influence tactics over the other party even if it has more “aggregate power”. One should identify the favorable issues and the BATNA as per principled negotiation strategy and use influence tactics to arrive at a successful outcome. One can exert influence throughout the negotiation by asking the right questions to understand the interests of the other party and convince the perceived value of the suggested outcome for mutual benefit. Along with the strategy of using questions instead of statements, one can use the psychology of influence and achieve results in a negotiation.

Read the full essay here

This paper analyses the legal and financial aspects of investing in Wind Energy Projects in Kerala, India. Although the paper focuses on Kerala State, it can provide a basis for a framework to analyze the viability of wind energy projects in other States of India also. The paper starts with an overview of the wind energy sector in India and the scope for investors in the sector. It then outlines the various policies at the central government level, which forms the basis of State level regulations. The second section of the paper analyses the Kerala State level policies and administrative frameworks applicable for an Independent Power Producer (IPP) in the wind sector. The third section critically analyses the Kerala Model Power Purchase Agreement (PPA) and summarizes risk allocation depicted by the PPA. The fourth section of this paper considers a hypothetical wind energy project in Kerala using standard figures assumed in the PPA and related policies and conducts an investment appraisal. The paper concludes with a summary of findings from the legal and financial analysis.

Click here for a full analysis

Renewable energy (RE) is a growing area in India’s power sector. “India has an RE target of 10% (of total power supply) or 10,000 MW during 2003 to 2012”[1]. “The estimated potential of RE in India is estimated to be 80,000 MW”[2]. As of 2006, “5.5% (6050 MW) of installed power capacity in India is from RE”[3]. As of January 31, 2007, Indian RE installation rose to 9373 MW”[4]. This translates to a growth of more than 50% in a year.” By 2022, India is expected to have installed RE of 54,003 MW”[5]. By the tremendous growth rate already proved in the recent years, the target for 2022 looks achievable for India’s RE sector.

When it comes to RE from wind, “India is ranked fourth worldwide in terms of installed wind capacity and is set to advance markedly on its installed capacity figure”[6]. The wind capacity figures as of 2005 released by the Global Wind Energy Council are Germany (18,428 MW), Spain (10,027 MW), the USA (9,149 MW) and India (4,430 MW)[7]. “The cumulative installed capacity of grid-interactive wind power projects up to 31 March 2006 was 5382 MW. During 2006-07, 888 MW have been installed (up to 31 December 2006) and as per trends it is likely that a total of 1700 MW would be added during the year”[8]. This translates to a growth of more than 20% in a year. “By 2022, India is expected to have installed RE from wind energy of 40,000 MW”[9]. This target for wind energy also looks achievable by considering the achievements and growth shown by the industry in the recent years.

From the above figures and trends, it is clear that the wind energy sector which boasts around 75% of the total RE projections is the biggest RE investment opportunity in India compared to other sources of RE.

[1] Government of India (2006) Renewable Energy Policy.

[2] Ibid.

[3] ibid

[4] Ministry of new and renewable energy(2007) Annual Report 2006-2007.

[5] Ministry of new and renewable energy (2006) XITH PLAN PROPOSALS FOR NEW AND RENEWABLE ENERGY.

[6] Hauber, Grant(2007) Wind Energy Finance – Mobilising European Investment in the Indian Wind Sector.

[7] Adapted from Envis Centre on Renewable Energy and Environment (2006) Wind Energy Information.

[8] ^[8] Ministry of new and renewable energy(2007) Annual Report 2006-2007.

[9] Ministry of new and renewable energy (2006) XITH PLAN PROPOSALS FOR NEW AND RENEWABLE ENERGY.

The initial sections of this paper define Operational Risk (OR), discuss the rational for measuring OR and details of Basel II recommendations for OR mitigation. The case study section of this paper considers a sample UK financial institution and its existing initiatives and recommends certain changes for best practice OR Management implementation by leveraging the existing compliance function.

Click this link for the report
How to use Compliance Data for ORM

The compliance monitoring department of an FSA regulated institution is normally labelled as a “tick in the box” function. The true function of the compliance team is to minimize operational failures which can be as a result of fraud and mismanagement and can lead to financial loss for customers. Regulation is created to protect consumers and investors. With minor modifications in the process of data collection, the compliance monitoring can provide efficient data for operational risk management and CRD/Basel II compliance.

The compliance monitoring nexus: compliance and operational risk function in a financial institution

“The risks that blew up in the faces of boards at companies such as WorldCom, Enron, and Parmalat all come under the general category of operational risk.”

Most of the banking regulations are proposed to mitigate such operational failures. For example, “the Sarbanes-Oxley Act of 2002 (often shortened to SOX) is a legislation enacted in response to the high profile Enron and WorldCom financial scandals to protect shareholders and the public from accounting errors and fraudulent practices in the enterprise.”

The duty of compliance departments in financial institutions is to report adherence to various regulatory requirements to the corresponding regional regulator. However, as we see from the above example, most of the regulatory requirements came as a measure for institutions to mitigate operational risks.

Based on the above analysis, we can say that the underlying function of the compliance department in a financial institution is to mitigate operational risk. However, in most organisations, the compliance function is used for just “tick in the box” regulatory reporting.

Rational behind measuring Operational Risk - It could be meaningless to measure OR as per CAPM

The relationship between risk and return or downside and upside can be said as the yin and yang of the financial markets. So while considering to invest in the stock of a financial institution, its value is nothing but the “present value of its future cash flows adjusted for risk and that operational risk is a major source of earnings volatility for financial institutions”.

The Capital Asset Pricing Model (CAPM) is used as a standard to calculate the required return of an asset, which considers only the systematic risks. The risks, which are specific to a firm (unsystematic risks), are not considered in calculating the required return in the CAPM calculations as it is assumed that a diversified portfolio can nullify the effect of such risks.

Therefore, it is natural to question the logic behind measuring Operational Risk and assuming a capital charge, if the entire risk can be nullified by the shareholders by holding a diversified portfolio.

In addition, if we look at the first Basel Accord of 1988, it considered capital allocation by measuring market risk and credit risk alone.

So, why do we bother to measure Operational Risk?

“Operational loss events may serve as signals of poor management quality and operational controls, leading the market to reduce expectations of future cash flows.”

As per Basel II or Capital Requirement Directive(CRD), financial institutions need to assume a capital charge in relation to their Operational Risk. In addition, managing operational risk is good business judgement as it reduces the losses created by operational issues.

“Large operational risk-related financial services losses have averaged well in excess of $15B annually for the past 20 years, but this reflects only the large public and visible losses.” A major operational loss in a financial institution is endemic and affects investor’s confidence in markets.

Compliance Monitoring an integrated approach

Compliance monitoring is meant to be both proactive and reactive. It should collect data to prove the availability of controls and validations and it should also collect data relating to failure. In Operational Risk terminology, one could say that a compliance monitoring programme is collecting Key Risk Indicator and Loss Data.

So with minor changes in the presentation and the way data is collected by the Compliance Officer, it is possible to comply with the CRD/Basel II requirements and in doing so, create a meaningful programme to create an effective operational risk management programme.

There are new risks created because of the securitization transaction other than the traditional risks of failure of obligors meeting their obligations. In the US, mortgage backed issuance (MBS) amounted to $1.6 trillion in 2006. It is important to consider the risks in this type of investments rather than relying completely on the rating agencies.

If you are involved in investing in Asset Backed Securities (ABS) or in the issuance or generally interested to know the way in which the securitisation market works, see this analysis. Risk Analysis of an Asset Backed Security from an investor’s perspective

This is a case study on Asset Backed Securities (ABS) from an investor’s perspective. We will be considering the example of J.P Morgan Alternative Loan Trust 2006-S1, which is a Mortgage Backed Security (MBS), issued in the US. There are four major parts to this case study. The first part gives a historical overview of the ABS market and the importance of Mortgage Backed Securities (MBS) among them. The second part gives an overview of the ABS issue of J.P Morgan Alternative Loan Trust 2006-S1 and its overall compliance with Regulation AB. The third part identifies the disclosure items and transaction parties as per Regulation AB. The study ends with the fourth part, which gives an analysis of the major risks created because of securitization of the mortgage loans. The risk analysis is limited to the new risks created as a result of the securitization transaction without getting into details of the traditional risks of failure of obligors meeting their obligations.

Securitised1 transactions reached a total of $20 billion in 2006 compared to $6 billion in 2002 in Latin America, which is a rapid growth as per BIS September 07 quarterly report. But the average size of issues and their lack of secondary market liquidity are stated as reasons for grading it at infancy by the BIS report. But this trend of growth in securitisation suggests efficiency improvements in banks and financial markets as illiquid or risky assets are transformed into more liquid or less risky ones.

Latin American securitisation market evolved from a cross-border market prior to 1990s to a developed domestic market from 2003. Owing to the increasing political stability in the region securitisation has transformed from FFS in cross-border markets to ABS in the domestic market.  Also, CDO transactions has started in Latin America from 2006, but there is lot of room for progress as structured transactions are dominated by single asset classes like mortgages in Colombia, credit cards in Chile etc.

Latin American region still needs more legal frameworks for securitisation, more corporate information disclosure framework to assess credit risk. Also, conflict of interest associated with rating agencies, mortgage early repayments etc are some of the potential risks cited by the BIS report on Latin American securitisation. Recent experience of issues in the developed world in the area of securitisation can be a good indicator for Latin American securitisation in its earlier stages itself to implement the right infrastructure.
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1. Securitisation allows the issuance of securities through an off-balance sheet process involving a special purpose vehicle (SPV). Once the originator has selected a set of assets from its portfolio, they are then sold to an SPV. The SPV could be in an offshore location, if it is needed to avoid political risks. (These are called Future Flow securitisatons(FFS) where the future foreign currency receivables are transferred to the SPV outside the jurisdiction of the originator). Once the securities are issued, the interest and principal of the underlying assets are collected and managed by a “servicer” and rechannelled to investors through the SPV.

In a fully financially integrated world, real interest rates will be the same; investments with similar risks will provide the same return across the world. So in such a “one price holds” situation, money will flow to wherever be the maximum return. We are not there yet, but integration has progressed in a regional and global level in the past decade or so.
Regional financial integration increases economic growth and global integration reduces risk by diversification among less correlated macro economies. As the financial world is yet to be perfect, these benefits also come with potential risks also, for example a country can be affected by a financial crisis elsewhere.
September 07 BIS report cites the Chen et al (2006) study from 1994 to 2005 sample period to say that country specific factors are more important than sector specific factors in emerging markets. This is in contrast with US and European economies where sector specific factors are more important than the country specific factors. This shows that the emerging markets are still lagging in their level of integration compared to major markets. BIS report also suggests a stronger regional integration to advance a global integration considering the example of newer European members and their advanced stage of global integration via the regional integration by EU. Report also calls for more regional integration by regional financial centers and their collective action.

Covered bonds are unique in their dual nature of protection offered to investors. These are issued by banks which are liable for repayment and are backed by high quality mortgages¹ or loans to public sector. Investors have priority claim on the underlying assets. Covered bonds are considered as a high yielding² alternative to government bonds rather than an instrument to obtain exposure to credit risk.  Covered bonds are very different from ABS in many ways. Cover pools are used for improving credit worthiness and not as a means for getting exposure to underlying assets as in the case of ABS. Also, covered bonds have fixed rates whereas ABS have a floating rate and may pass defaults and early repayment directly to the investors. Jumbos (large issues of covered bonds) are traded in the secondary market which makes them more liquid than ABS. As per the September 07 BIS report, covered bond market has become one of the largest asset classes in the European bond market and the prominent source of finance for mortgage lending in the last decade. As of mid-2007, the outstanding amount of covered bonds has reached 1.6 trillion. 

More countries are beginning to have legislations on the covered bond market which covers stipulations like loan-to-value ratio (LTV). Also, the risk of bankruptcy of the originator poses issues like value of cover pool in that event and the possibility of their creditor’s trying to access the cover pool. These are not issues practically seen; as such a bankruptcy hasn’t yet happened. Also, the three rating agencies (Moody’s, S&P and Fitch) have differing methodologies to rate the risk in covered bonds. This adds to the difficulty of risk assessment.

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1.      Covered bonds are long term fixed rate instruments, so they are suited to refinance fixed rate mortgages.2.      Yields on covered bonds are lower than senior, unsecured loans of the same originator.