Risky Business: DNA, 3rd April 2008

Companies need strong risk practices to shield themselves from sudden crises elsewhere

Situation A. A large Indian engineering firm has a risk mitigation policy in place and decides to hedge its raw materials price risk on the LME (London Metal Exchange). Typically, one does it when prices are on the upswing, as the input costs would shoot up in case prices move up. By buying at a fixed price, one is buffered against an adverse price movement. However, one bargains that prices will not fall and takes positions accordingly. However, prices of some metals crash suddenly due to market conditions, and the company has to book losses of about Rs200 crore.
Situation B. A large private bank with sophisticated risk management tools goes in for some persuasive investments in credit default swaps (CDS). A CDS is basically an instrument where the owner of the asset passes on the risk of a default to a third party in return for a fee. This is a sound strategy. Now, from nowhere, there is a sub-prime asset crisis in the USA, leading to an increase in the spreads on CDS in general. Higher rates mean lower value of the asset. The bank, which has a $2.2 billion exposure to credit derivatives, though not related to the sub-prime crisis, faces a notional loss when the portfolio is valued at current prices, which in financial parlance is called mark-to-market. There is a loss of Rs1000 crore that has to be shown based on sound accounting practices.
What is one to make of these two situations which are different yet similar? The first point to be understood is that the world is getting flat and no one can insulate themselves from what happens in other countries, especially the USA.
The second is that Indian companies are suave and are making use of the most sophisticated asset classes like CDS or maybe even CDOs (collateralised debt obligations). While the world of finance provides these opportunities, banks need to have their risk mitigation processes in place and follow the early warning systems. The signal given last year should have prompted the bank to unwind positions, which was not done.
The third is that even hedging decisions can go wrong, and hence an instrument such as commodity hedge on LME can go awry when conditions change dramatically. The commodity cycle needs to be understood well and companies should enter the market as hedgers and not traders as it could have been in this case.
The fourth is the fact that we are gradually seeing more transparency in the operation of companies in both the financial and commodity-related fields, which cover virtually 80 per cent of industrial and service activity in the organised sector. These losses would otherwise have gotten hidden in the font 6 notes to accounts in the balance sheet, thus escaping public scrutiny.
The question that can be posed is: why have things failed suddenly? The globalisation part of the story is the clue, and the intrinsic risk in the instruments being used is the other part. Derivatives have become complex instruments as the original parties in a deal disappear in the maze, as happened in the sub-prime crisis. Therefore, monitoring the underlying asset becomes difficult.
Do these stories indicate a systemic crisis that is lurking around? Definitely no, as what has been seen today is a risk which is attached to every business. Rigorous stop-loss rules need to be drawn up and followed in order to cap potential losses in these instruments. Derivatives such as CDS evidently need to be monitored better, given that it is felt that there are several large public sector banks which have similar exposures. These losses need to be tackled head-on and structures need to be built to eschew them in future.
Lastly, what is an investor to make of these episodes? There is a need to recognise that the risks involved with businesses diversifying into new areas would always be there. Conventional policies do not deliver extraordinary results, and when institutions are in the pursuit of shareholder value, such risks are a corollary.
Some simple rules could go this way. Commodity-based business will always be prone to price shocks and unless the companies are strong in their risk practices and swift to anticipate and take cues quickly, there will always be a lingering doubt. The same holds for the financial sector, where financial innovations also have their consequences which should be understood. More importantly, companies need to be more open with their disclosures so that investors are aware of the risks being taken.