Mr Erçel discusses financial risk and its management  (Central Bank Articles and Speeches, 8 Apr 1999)
Central bank: tcmb | Type: speech | Date: 1999-04-19

## Mr. Erçel discusses financial risk and its managementAddress

by

the

Governor

of

the

Central

Bank

of

the

Republic

of

Turkey,

Mr.

Gazi

Erçel,

at Sixth Annual Global Finance Conference, Bilgi University, Istanbul, on 8 April, 1\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_,GLYPH DPGLYPH SOHDVHGGLYPH WRGLYPH EHGLYPH KHUHGLYPH WRGD\GLYPH IRUGLYPH DGLYPH NLQGGLYPH LQYLWDWLRQGLYPH RIGLYPH *OREDOGLYPH )LQDQFHGLYPH $VVRFLDWLRQGLYPH DQGGLYPH łVWDQEXOGLYPH %LOJL University.

Today I like to discuss financial risk and its management which are one of the hot the international financial circles.The 1980s and 1990s witnessed a major transformation in the international financial markets advent of more complex and dynamic transactions have substantially increased uncertainties marketplace,

and,

in

today's

environment,

dominated

by

a

dynamic,

aggressive

financial

se industry, market participants are exposed to greater financial risks than before.

Of course several reasons for these changes.The first reason is the globalization of the international markets.

Markets all over the world a consolidated into a vast world market as obstacles to the free movement of capital are gradual removed.

This can be seen in the present global crisis, which arose because problems occurring region of the world promptly made themselves felt by markets and investors in other regions.Another

reason is that the international markets

have

become

much

more

volatile.

Volatility means the fluctuation of market prices and ratios, is one of the principal sources of financial market volatility increases, market participants are exposed to greater uncertainty--and greaterStill

another

change

of

conditions

in

the

international

markets

is

the

appearance

of

new

f investment

with

very

complex

structures.

The

great

variety

of

these

investment

tools

has

le development of still others, like derivative instruments, aimed at reducing the degree of risk associated with several financial transactions.

Derivative instruments are being more and more widely use hope of reducing risk in the financial markets, but the losses coming from derivative operations begun to increase.The worldwide increase in the supply of loanable funds has also played an important part in the of financial risks.

This surge, in combination with greater uncertainties, has caused much gre due to the materialization of financial risks.

In the 1990s especially, such losses have frequefrom financial scandals.

The recent collapse of 'Long-Term Capital Management' has clearly shown not even having Nobel-prize winning managers can always reduce the risk.Finally, one of the principal reasons for the increase in financial risks is to be found in intensity of international competitiveness.

Credit risk in particular has become more complica the banking sectors of developed and emerging market countries began to compete in the same a and since the larger banks began to compete intensively against non-bank financial institutionsEvery one of these developments has fundamentally affected national and international banking sy More effective risk management by banks and other financial institutions has become vital for pr the financial stability of both domestic and international markets.

The changes I have just desc that market

participants and departments responsible for financial control, and also portfolio managers, are often unaware of some of the risks to which their institutions are exposed.For

all

these

reasons,

the

sound

measurement

of

financial

risks

and

methods

for

their

e management have become an absolute necessity.

It is also important to make regular announcemen information on which market participants can base sound decisions about a bank's financial stand risk structure.

It is well known that markets have a natural disciplinary mechanism which rewa that

manage

their

risks

effectively

and

penalize

banks

that

show

themselves

to

be

risky.

Ev knows

that

the

successful

operation

of

this

mechanism

depends

on

the

regular

disseminatio information making banks and the banking system transparent and allows market participants to ar sound decisions.In an environment that is home to all these kinds of activity, the task of maintaining the national and international banking systems has come to require new arrangements and dispositions banking sector.

To lead the way for progress in this area, a committee was established, led by for International Settlement (BIS) and made up of central banks and banking supervisors from s countries.

Almost all of the proposals that ultimately originated in the work of this 'Basle have been adopted for the banking systems of many countries, even though the Committee has no po to apply sanctions.One of the first accomplishments of the Basle Committee was a study of banks' capital adequacy. in 1988, under the title 'International Convergence of Capital Measurement and Capital Standards report was soon endorsed by many countries.

Also known as the 'Basle Capital Accord,' the studyaccount of credit risk.

Although the variety of risks in the international markets is increasing still the most significant risk category for banks.Credit risk means the probability of defaulting on one's obligation to the other party in any tra As I already mentioned, the growth of competitiveness in the international credit markets in rec the active participation of non-bank financial institutions in these markets, and borrowers' r capital markets for loans at lower cost, have all brought about a considerable narrowing of prof in credit transactions.

This has forced the banks to make more loans in order to have a competi But they have encountered credit problems due to adverse developments in the economic and fina conditions.

All these developments have resulted in the design of new methods for more effe evaluating the risks and yields of credit transactions.

Besides creating credit rating models f banks,

these

efforts

have

produced

analytical

methods

calling

for

intensive

data

analysis retrospective analysis of credit losses, models of bankruptcy probabilities, and stress tests.Effective management of the credit risks of banks and determining how much capital must be held a contingencies that could arise from such risks are very important for the soundness and stabil banking sector.

The 1988 Basle Capital Accord that I mentioned earlier was the fruit of the work to this aim.

The Accord targets a bank's capital holdings as a proportion of the credit risk balance-sheet and off-balance-sheet business.

For this purpose, investment instruments were c into

five

main

categories

according

to

their

risk,

and

a

risk

coefficient

assigned

to

each

g weighting formula for asset risk was intended to determine the capital

coverage needed

for

a exposure to credit risk.But this arrangement dating from 1988 proved ineffective against newer developments emerging du the last decade, and work continues particularly at the BIS on how to reduce credit risk.Besides credit risk, the main risk categories that have been identified in transactions and ma as Market risk,

Exchange rate risk,

Interest rate risk,

Liquidity risk,

Operational risk, Legal risk,

Hedging risk,

Systemic risk.I do not intend to go into the details of all these categories of risk.

Of special interest, improvement

of

systems

and

techniques

that

aim;

to

reduce

these

risks

by

means

of

informa technology.

Once the risk is identified, measuring it accurately is generally accepted as thepreventing it from happening.

The rapid progress of information technology

in recent years has new risk measurement models to aid in the measurement of market risk.The most widely accepted of these is the 'Value-at-Risk' model, called 'VaR' for short.

VaR maximum loss that can occur in the value of a portfolio having a certain investment horizon certain

probability.

Since

it

is

a

simple

and

clear-cut

concept,

the

VaR

model

is

widely measuring market risk.

It permits comparison of the market risk of different investment instru that portfolio performance can be evaluated in terms of the risk undertaken.

Especially for market risk to determine capital adequacy, this model has become a necessity in many countrie financial institutions.Another method widely used for measuring market risk is 'Scenario Analysis'.

Scenario Analysis technique used to see how the value of a portfolio would be affected by various probable cha market conditions.A last widely used method for measuring risk is the 'Stress Test' method.

The Stress Test is estimate how the value of a portfolio would be affected by large, unexpected fluctuations in the such as have been observed during the global crisis which is still with us.

Though similar to Analysis, the Stress Test mainly aims to predict the maximum value that would be lost by a po under

certain

extraordinary

market

conditions.

The

success

of

this

method

depends

on

succes predicting market conditions.Now let me touch briefly on risk management in Turkey's banking sector.

From the risk managem standpoint, we are well supplied with well-developed methods for managing risk and supervising th that we do accept.As to the financial standing of Turkey's banking sector, Turkish banks have achieved a level of and institutional development not to be underestimated.

But besides these strengths, there ar threats to the well-being of the Turkish banking sector which should be mentioned.

Turkish ban mostly exposed to credit risk, liquidity risk, interest rate risk, and foreign exchange risk.

Th when

there

is

no

global

crisis

or

macroeconomic

risks

stemming

from

political

uncertainty.

I mention

that

all

these

different

kinds

of

risk

have

been

thoroughly

monitored

by

the

supe authorities, who put preventive measures in place before the effects of any problems that wer could threaten financial stability.

Under this regulatory system, the banks must submit annual,and

even

daily

financial

data

to

the

Central

Bank

and

the

Treasury.

And

besides

frequent

f evaluations of banks by off-site examiners, on-site examinations are conducted to verify the accu reliability of the data reported and clarify any special issues found during off-site examinationLet me conclude my remarks by underlining once again how important it is to assess, manage, and r financial risks to ensure a sound financial system.

A sound economy must be based on well-funct real and financial sectors, and there can be no doubt that, in times to come, we will have to giv thought to reducing financial risks and keeping them from interfering with the proper functioni system.

If competition, volatility, globalization, and stresses threaten to pressure the banking resorting to bad risk-taking practices, the responsible authorities and supervisors must take wha are necessary to restore financial stability.