Harun R Khan: Taking on risk - the sensible way
Keynote address by Mr Harun R Khan, Deputy Governor of the Reserve Bank of India, at the
CII "Confederation of Indian Industry" National Risk Management Summit 2015 on
"De-risking the Future of India Inc.", Mumbai, 10 February 2015.
* * *
The speaker deeply acknowledges the contributions of Shri. R Gurumurthy of the Reserve Bank of India.
Shri Suresh Senapaty, Shri Richard Rekhy, Shri Deepak Parekh, Smt. Greeta Varughese
other distinguished guests & invitees on and across the dais. This invitation to give an
address at this important CII event gives me a great pleasure. CII seems to have chosen a
very interesting theme for this national risk summit - "De-risking the future of India Inc." - I
am, of course, wondering why CII is thinking of de-risking the future of India Inc. though the
participants here would appreciate the fact that de-risking would also mean that they have no
business to be in "business".
Risk-return-retribution in a VUCAP world
All human enterprise, more so business activities essentially involve risk taking, in a bid to
earn the "reward" or "return" according to the risk-return trade-off. This relationship is,
however, far from simple as the reckless chasing of returns may result in unimaginable levels
of risks not only for the individual enterprise but also for the whole system. The risks posing a
threat to the financial and economic balance of the world today are far from being properly
managed and controlled. I understand that the prevailing evidence of continuing, if not
increasing, appetite, for fast returns is one of the major motivations behind the broad theme
for this seminar.
While developing my thoughts on the much used idea of the risk-return trade-off, I was led to
think of a missing "R" - Requital - in the risk-return conundrum. The tremendously forceful
human fascination for reward and the almost irresistible tendency to take or overlook risks in
that pursuit has, more often than not, resulted in inevitable retribution or requital, in the long
term.
In the present context, probably it is the zeitgeist that drives us crazy. Having seen the
massive impact of the global financial crisis, we may want to take a pledge to de-risk the
future. Peter Bernstein, the American financial historian, had an interesting perspective;
according to him, "Risk and time are opposite sides of the same coin, for if there were no
tomorrow there would be no risk. Time transforms risk, and the nature of risk is shaped by
the time horizon: the future is the playing field".1 Hence, our approach should be to ensure
risk compatibility over time rather than trying to de-risk the future. In fact, a fanatic
commitment to risk aversion could itself be a risk that businesses might face in any
postcrisis period.
May be that we need to strategize to meet the challenges of a VUCA world. Part of the
military vocabulary, it is an acronym for volatility, uncertainty, complexity and ambiguity, now
widely used to explain the vagaries of global economy and the financial markets. I would like
to add a P to this, which stands for perversity, making it VUCAP. That wouldn't be a misfit
given the nature of the contemporary global economy, financial markets and the army
interventions across the globe!!
We used to scorn high volatility in the past, but are now wary of low volatilities. We do worry
about uncertainties, but certainty brings complacency and makes us vulnerable. Are we all
really uncomfortable with complexity? Not sure. For some, complexity pays. And there is this
ambiguity in all these. The latest financial stability report released by the Reserve Bank of
India (December 2014) talked about "an ambience wherein weak growth prospects are still
considered benign for financial markets" for that would lend strength to the expectations that
ultra-easy monetary policies would continue; that, in a way is perversity. But then, that's the
world that we have to deal with.
I think it might be in Nature. Let's for instance take a look at the ancient Egyptian religious
thought, where the themes - viz., order, chaos and renewal - appear repeatedly. Every year
the Nile flooded, but then it renewed the fertility of the soil and helped a highly productive
farming industry that sustained the Egyptian civilisation. The global financial crisis, like every
other crisis, has provided us new lessons as also opportunities.
Having added a P here and an R there to put the broad theme of this seminar in perspective,
let me now turn to some specifics.
Business risk and regulatory dialectics
Being a regulator, I will start with the business community's concerns over legal and
regulatory risks. As I could see from your flyer, there is a slot to discuss this and a brief is
given thereunder. While it talked about increasing risks faced by companies arising from
complex regulatory enforcement and new legislation, it also pointed out, rightly, that, these
were brought upon due to the corporate scandals and breakdowns in the past few years.
This is also because organizations have been doing more business across boundaries than
ever; thus, adding global regulatory concerns to their local regulatory risks. So, we all
understand and appreciate the concerns here - both of the law enforcers and of those who
are subjected to these laws and regulations.
Oftentimes, we get to hear how difficult it is to do business in India. But multinationals, at
various points of time, have had similar concerns over doing business elsewhere too. At the
DLD technology conference in Munich recently, Nicolas Brusson, the co-founder of
BlaBlaCar, the French ride-sharing start-up, when questioned about the rationale in starting
his venture out of France with its 28 sets of laws and regulations, replied: "when you start
from France, everything looks simple". I am sure Indian companies that ventured overseas in
the last one decade or so may now vouch for these sentiments. In the current context, it may
make immense sense to seriously look at the "Make in India" pitch with the government
trying to do what it can.
We must understand that most of the times regulatory stance follows, rather than precede,
the excesses committed by the regulated entities or the overreach of the so called
selfregulatory mechanism. Their actions in fact emanate from the very nature of the wider
mandate that the regulators carry on their shoulders. In what is called as "regulatory
dialectics", financial market regulation is an endless process with both the regulator and the
regulated making alternative moves in terms of regulation, avoidance and re-regulation.2 This
must be true of other markets, too.
What guides the actions of regulators is the need to ensure smooth functioning and stability
of the markets that they regulate and not populism. In other words, as John Kay, the
Financial Times columnist, often says, crowd-pleasing is no substitute for wise judgement.
"That's why we prefer to entrust the navigation of a plane to a skilled pilot instead of using
the average of the opinions of the passengers", were his words of wisdom.
Use and misuse of credit
That brings me to a widespread concern of the regulators like the Reserve Bank of India
(RBI) over corporate leverage and the prevailing credit culture. One challenge that some
corporates might face, going ahead, is in terms of raising resources - not because of
nonavailability of resources, nor for lack of creditworthy business opportunities but because of
how the debtors respect their commitments as also an evolving thinking on "efficiency
imperative" in credit dispensation. It is very likely that the days ahead will experience
enhanced scrutiny of credit decisions of banks by depositors and tax payers, besides
shareholders. Is it all because of the deteriorating credit culture? We need to examine.
Banks form the backbone of our financial system and carry out an important function, viz.
reaching financial savings to those in need of it. Thus, credit is the other end of this
intermediation process and we all must understand the etymology of the word "credit" and
respect the semantics. The only way we address the situation is responsible use of credit.
As Governor Rajan has warned,3 there is an "uneven sharing of risk and returns in
enterprise, against all contractual norms established the world over - where promoters have
a class of "super" equity which retains all the upside in good times and very little of the
downside in bad times, while creditors, typically public sector banks in our context, hold
"junior" debt and get none of the fat returns in good times while absorbing much of the losses
in bad times".
Let us now look at the way "leverage" is assuming negative connotations. Leverage per se is
a necessary evil for businesses to grow. Why then corporate leverage is being quoted of late
as a concern for financial stability? Indian companies, no doubt, have come of age in terms
of building world class infrastructure projects, withstanding tough competition from global
players, and expanding their wings beyond national borders. While some have succeeded,
the ambitions of others have proved to be hubris. Their actions needed enormous resources,
which came from domestic and overseas financial markets though the ensued global
financial crisis (GFC), demand slump and currency volatility exposed them to unexpected
risks. Could they have seen all this ex-ante? Probably going ahead non-financial companies
may think of some kind of stress tests to assess their resilience to emerging risks, similar to
the approach adopted by financial sector industry, subsequent to the GFC.
Risks of unhedged forex exposures
Large scale unhedged foreign currency exposures are not only a threat for individual entities
but also a concern to the economic and financial system stability. While regulators certainly
will not like to micro manage what otherwise is a commercial decision, corporates need to
take care of the potential risks embedded in their unhedged currency exposures since they
might incur significant costs due to unexpected and sudden exchange rate movements. You
all might be aware of the recent decision of the Swiss National Bank that claimed a few
scalps while the victims cried foul.
On the other hand, as Governor Rajan had indicated some time back,4 borrowers get into a
trap at times of exchange rate appreciation which gives them a false sense of complacency
in terms of having higher equity due to rising asset prices. While we do have comfortable
foreign exchange reserves, there is a strong view that no amount of such reserves can
cushion extreme external shocks. That too here we are talking about nations. You can
imagine how vulnerable corporates can become if they have too much of foreign currency
exposures.
For those business entities that do not have a natural hedge, mere cost advantage in terms
of pure interest rate differential (without the hedge costs) should not be the guiding factor for
overseas borrowing. On the other hand, we also had this unpleasant experience, in the
aftermath of the financial crisis of 2008, when many Indian exporters who had entered into
complex derivative structures with banks suffering severe losses arising out of marking to
market of their derivative positions. This is why I said earlier that complexity benefits some
and hurts others. Hence corporates need to understand not only the risks they are assuming
but also the risks arising out of faulty "risk mitigation" processes. People in business should
therefore realise that adoption of risk management strategies is not meant for generating
additional earnings but is needed for protection of the projected income flows.
Last year when the US Fed indicated its intentions of tapering of quantitative easing (QE),
India, like many emerging market economies, particularly those with current account deficit
(CAD) came under severe pressure due to capital outflows. Several measures were taken to
address volatility in the foreign exchange market that included, among others, reduction in
limit for overseas direct investment (ODI) under automatic route from 400 per cent to 100 per
cent of the net-worth of an Indian entity as a macro-prudential measure though in genuine
cases requirements above the revised limits were considered under the approval route
besides many administrative measures aimed at curbing the opportunities for excessive
financial market activities. The Reserve Bank and the Government had to take a number of
measures to de-risk the national balance sheet; just to illustrate , the curbs imposed on gold
imports and opening of concessional swap windows for mopping up longer term foreign
currency resources through foreign currency deposits and borrowings by the banks.
With return of stability in the Rupee-Dollar exchange rate, restrictions with respect to
remittances under ODIs were largely withdrawn on July 01, 2014 and the limits under
automatic route for overseas investment were restored to 400 per cent of the net worth of the
Indian entity. In other words, the job of de-risking the corporate world sometimes is upon
macro prudential regulators like the RBI for the larger concerns that I had explained to you
earlier. Yet, I must also tell you that the dividing line between prudential regulation and micro
management is often thin.
Dealing with disruptive ideas and technologies
Let me now turn to another theme of discussion in this summit. This relates to the threats
posed by disruptive ideas and technologies and the risks in not being able to swiftly
appreciate the emerging challenges posed by the digital world. There is a perceptible
discomfort amongst a section of the business community with the rapidity with which the
world is changing as a result of disruptive ideas and technologies.
As per a PwC survey,5 60 per cent of the firms surveyed indicated "the speed of
technological change" as a threat to their growth prospects. On the other hand, the
manufacturing industry may be particularly worried about the fact that more and more talent
and resources are shifting their preferences to virtual platforms than to brick and mortar
manufacturing. The valuations seem skewed towards such initiatives, but let's not for a while
forget the fact that these disruptive initiatives do face their own set of risks and challenges,
what is more important, however, is that they are inevitable.
The attitude of de-risking doesn't go well with disruptive ideas and this gets clearer by
looking at the start-up culture that the US is known for and why that country stands apart and
enjoys leadership position amidst fast changing economic cycles and consumer preferences.
The recipe for success lies in transforming the businesses to be relevant in a post-industrial
digital world. For countries like ours we need to reassure that technologies would ultimately
improve job opportunities by augmenting inclusive growth - both quantitatively and
qualitatively - rather than taking them away and that they enhance the standard of living
rather than destroy it.
Coping with cyber threats
For the financial sector specifically, there is a need to look into the extant IT environment,
since there is a feeling that the IT infrastructure at most financial firms is fragmented and
inconsistent.6 The financial sector industry rests on trust and credibility, and increasing
cybercrime is threatening this basic premise. According to a report7 released by the British
Bankers' Association (BBA) in association with PwC, "defending and countering
cyberattacks whilst keeping up-to-date with evolving regulations and policy is a complex
challenge".
As you know, cybercrimes are getting sophisticated and nuanced. Their perpetrators could
be broadly categorised as "organised cyber criminals" and "enemy state agents". Motives
could be anything ranging from corporate espionage to intellectual property rights to
siphoning off funds. In all these, if we look at it seriously, the primary weapon is exploiting
vulnerabilities. While they cannot be easily wished away, the only way corporates can tackle
this is to be "proactive" about their "cyber resilience".
In the case of a data theft last year at one of the global investment bank, what was disturbing
was not the security breach per se but the fact that the hackers were inside their systems for
close to two months before being noticed! Corporates need to put in place a robust business
continuity management (BCM) plan (which is the broad theme of the last session of this
summit) and perform business impact analysis. No corporate can afford to brush these off as
trivial non-operating activities since the potential risks involve not only monetary loss but also
reputation and legal risk which can simply demolish established businesses.
A survey8 indicates that 41% of economic crime was committed by employees within an
organisation. How do we address this? Can we seriously think of examining the
incentivecompatibility structures at our companies? Since risk is inherent in every business, in the
absence of appropriate incentive compatibility structures, we may encounter behavioural
patterns leading to decision making processes that de-risk the individual rather than taking
the optimal decisions that would benefit the organisation. Such behavioural patterns may
lead to functional paralysis and at times, to explosive business disruptions within the
organisation.
We can even think of gender balance in decision making, the mostly ignored aspect of the
"inclusiveness" discussions. I am reminded of the famous response of Christine Lagarde to a
journalists' question. She said "had Lehman Brothers been Lehman Sisters today's economic
crisis would look quite different". That might be a quip, but we have seen the success of
Mohammed Younus who turned to women to make "micro finance" what it is today.
According to some research in behavioural finance, excessive risk taking in men has to do
with their body chemistry.
Optimism with caution
India is on the cusp of a great upsurge and business entities must ride the wave but they
should be mindful of the risks that they are assuming for themselves and for the system as a
whole. Macro-economic vulnerabilities facing our economy have significantly receded, thanks
to improvement in growth outlook, fall in inflation, sharp reduction in oil prices, recovery in the
external sector coupled with a bigger war chest of forex reserves, and a strong commitment
from the Government to contain fiscal deficit. This implies we are much better positioned
among our peer countries to cope with future uncertainties and vulnerabilities. Having said
that, we cannot afford to be complacent and that is why we want to be cautious in our
approach and want to be more certain than everyone else that our economy and financial
system do not have to repeatedly face many of these vulnerabilities.
In other words, at this juncture, India cannot afford to lose the greatest opportunity that it
possibly got over the last so many years, given its relatively strong position amongst
emerging market economies. On the other hand, with a political set up so attuned to the
concerns of the industry, the "Make in India" perspective offers a paradigm shift in terms of
Government-industry interaction.
Yet, a successful implementation of this paradigm requires asking some basic but
fundamental questions for each industry in terms of "What do I offer?", "What are my key
competencies?" and "What are my weaknesses?" Is it the cost control centric rather than
value addition centric approach of Indian industry that is to be addressed first? The term
"derisking" should mean finding one's own moorings, i.e., the sustainable USPs. A
manufacturing industry driven by cost minimization philosophy compromising on quality can
only be fleeting source of comfort.
Conclusion
Let me conclude with a few thoughts. The sustainable solution for risk mitigation lies, to a
great extent, in knowledge leadership. To progress from "me too" business models which are
all too vulnerable to disruptive onslaught from ever nimbler start-ups to "knowledge
leadership" is a significant leap. But India as a country has to make that leap in order to
develop sustainable source of leadership. And such leaps will have to be enabled at our
educational institutions, vocational or otherwise. More and more institutions of excellence
must be encouraged to serve as incubators for legions of technology breakthroughs.
The question we require to pose is what stops us from replicating such innovation centric
knowledge hubs. Knowledge leadership doesn't imply that Indian industry as a whole will be
insulated from churning. After all there is only one company common between the Dow
Jones index of the early twentieth century and twenty first century. It rather means that such
leadership will entail that for every loser in such an enterprise, there are multiple winners.
I wish you all the very best and hope you will have fruitful discussions on a broad range of
themes starting from "risk analytics" to "regulatory risks" to "digital forensics" to "risks from
work place of the future" and finally to "climate change and sustainability risks". I am sure
that at the end of the summit you will all arrive at a few workable strategies to manage your
business risks more efficiently.
Thank you all.