Money and finances

Business lines

A bank or fund is usually the sum total of several business lines. Each of these business lines has an associated risk to its assets that Basel II wishes to label Beta or Gamma. The total risk exposure can be summed as the total of the risk-weighted assets. Thus, best practice in one department does not mean it translates into a bank’s best practice.
We have defined the risk appetite to risk offer relationship in another line of our Loss Database that evolves into a Basel II compliant system. A standard-certified risk-taking bank will have higher regulatory capital assigned because its risk management processes and system are adequate, but not extremely sophisticated. An advanced-certified risk-taking bank will have lower regulatory capital allocated because its risk management is highly developed and is evaluated as a lower overall risk. The risk of losses increases, and this should be reflected in the Beta or Gamma risk weight.
The long-term investors can almost be in danger of extinction under the rush of the incoming speculators. More traditional wealth-creation business lines involving “hard” assets and less turnover or “churn” attract lower comparative costs and risk.
Moreover, under the advances of the Internet and online dealing, we have the increased presence of naive traders in the jungle. For such a public, there are a score of animals that can seek to prey upon such victims; smart operators, banks and brokers can play the role of scavengers. These people may be naive gamblers, even more tempted by margin trading and buying highly leveraged derivatives contracts, even with borrowed money. Thus, there is little in the way of risk management to protect us – a fool and his money are easily parted. There are other methods in risk management for the investors from the traditional ones offered, they are:

• risk avoidance
• risk retention
• risk reduction (e.g. diversification)
• risk hedging
• transfer of risk.

Maybe fund managers and bank professionals have too much information at times. It is a mess and too much to process efficiently. Everyone is perennially too busy. They do not have enough useful data to make the best investment decisions. Risk management is partly the presentation of useful and readable information, then the translation into action and concrete risk countermeasures. So, in the absence of a clear solution, they take Occam’s Razor for a business decision. Stated very simply, if there are two or more choices, then the simpler and better option is likely to be one that offers the least line of resistance. Thus, when confused, call in the experts and dump the problem (or risk) on them.

The credit ratings procedure

The credit raters are not to blame as such; they only review the data and aspects of a company presented. It is a consensual process, in that the agencies do not barge in uninvited, nor do they pay surprise visits. The company visited pays for the inspection, or it may have been requested and funded by a party intending on buying a large stake or take-over.
If the firm wishes to hide or misrepresent the truth, then it is difficult for the rating agency to find out the accurate picture. The rating agency may be given a short time of a day or less to make an inspection of the company. More complex inspections can take a bit more time on site. Follow visits may be done in one or two hours some time or years later. Such visits can be rather superficial inspections, depending upon the conditions, but time is tight and the extent of cover-up would be difficult to spot in many cases. So, deep information is unlikely to be revealed where intent of deception remains.
Nevertheless, many unbiased analyses are made by the credit raters where a “favourable assessment cannot be bought”. Rating agencies disagree more often on banks and insurance companies. The strength of a balance sheet in a financial company can be difficult to assess, even after several on-site visits.
Where the subject field is broader, there is likely to be even more room for controversy and disagreement. Sovereign, market, interest rate or currency risk carry a lot of attention. The room for surprise is quite large. The rouble’s dramatic devaluation in 1998 or the Argentinean peso in 2001 reflect how experts can get it wrong.
Yet, banks and financial institutions cannot blame the credit-ratings agencies. This former get-out clause is further closed where the banks themselves choose to gauge their own risk rating under the Basel II AMA (Advanced Measurement Approach) or IRB (Internal Ratings Base) system proposals. Yet, the blame for a bad investment decision cannot reasonably be laid at the door of the raters. Caveat emptor clearly states that caution had to be exercised by the buyer, and no ratings agency forced investors into Argentina or WorldCom.
Frankly, it is not the job of the rating agencies (Moodys, S&P, Fitch) to be the world corporate police officers. All they do is survey past data and monitor news releases or pay a short visit to the companies themselves. The ultimate decision on investing money after the assessment of fundamental enterprise risk rests with the owner of the capital of the person who is mandated to make the choices. The passing the buck:
“I only made the decision because the credit-raters told me it was a good company”, is an insufficient excuse. To say anything less would be cowardice, and chicken capitalism thrives.
Business investment decisions must be made by the investor, resting upon a straightforward train of processes:
1. Formulate business plan.
2. Marry risk appetite to risk offer.
3. Manage reputational risk/due diligence.
4. Risk support/risk monitoring.
Not only is risk appetite directly linked to risk offer, but risk appetite is also covered by regulatory capital. Risk support means that the danger of capital becoming inadequate to cover expected losses automatically signals an alert to the bank. What we have created is a web-based system for warning of banking danger areas.
The spectre for shouldering risk increases under the latest Basel II standards where “higher rated” banking and financial institutions choose to rate their own risk under AMA (Advanced Measurement Approach) or IRB (Internal Ratings Base). This essentially means that the banks will develop their own ratings systems (geared towards showing that they are lower risk banks) and justify their models to the regulators. Naturally, it would be in the banks’ best interests to portray themselves as lower risk to the regulators and the credit-ratings agencies. It is going to be very interesting what sort of assumptions and theories underpin their models.

CREDIT RATINGS

Credit ratings are just one of the benchmarks of banking and fund management industrial standards. They are a good attempt to protect against potentially wayward performance in the financial markets, but they represent only one technique. They provide a short single figure or code e.g. AA, B
The research figures distilled into one succinct summary may be fine for a university, but it can be dangerous when looking deeply into market investments. Risk management systems embody the knowledge or assumptions of industrial best-practice norms that have been built up over the years. Thus, the up-to-date credit rating of counter-party firms are essentially a reactive move to risk-monitor companies, quite possibly using data that might be up to 12 months old. Also, bank decision makers may take the individual ratings and amalgamate them, thus losing data accuracy or granularity. This introduces risk of its own.
There are real dangers about using credit ratings as a proxy for full-scale risk management, of which due diligence is just one tool. When the ratings are up to date and accurate, they work well in defining an extent of risk attached to a company or investment. If not, they can fail you. Credit-rating agencies used in the risk management exercise can be late or irrelevant where the search is done post facto, i.e. the decision has essentially been made and all that is needed is a rubber stamp. The process of estimating the risk from past data reflects the subjectivity of credit ratings published. Where balance sheets and similar audit data are used, we are imposing two layers of subjectivity. This error is increased where the published information is out of date. Thus, you have distilled a mass of complex (and sometimes dubious data) into one single figure or grade. This sifting process can have inherent faults at play to provide a misleading result.

Looking Deeper into Levels of the Rate of Change Indicator

The rate of change oscillator conveys a good deal of information in and of itself, but it provides more information if the time is taken to study the market action that errated the current reading.
More specifically, each day’s new rate of change indicator level actually involves two variables: the current day’s change in price level and dimction of movement, and the level and direction of the price movement of the day that is being removed from the calculation being made.
If the day being removed was a day of market decline, rate of change measurements will turn upward even if today shows no gain in price, for as long as it shows lesser loss than the day being removed. Therefore, if weaker market periods are being eliminated from rate of change calculations, rate of change levels tend to rise easily, often before price trends tum upward. If today happens to be a rising day and the day eliminated from the calculation was a falling day, rate of change measurements might rise rapidly.
Conversely, if the days being removed from your calculations were days of market advance, it will be more difficult for your rate of change indicator to gain ground. During strong market periods, rate of change indicators are likely to track sideways, but at relatively high levels. It might appear at such times that negative divergences are taking place, but if you examine the data stream carefully, you might notice that the stock market is not really weakening at all and that, in fact, the ability of its rate of change readings to remain high is a sign of strength.
Let’s go back to our data September was a period of sharply declining stock prices, so rate of change levels rose quickly in October, even prior to price gains of any significance. Not until the turn of the month into November were the days being eliminated in the calculations rising market days. Rate of change measurements remained flat, though high for several weeks. The inability of rate of change measurements to advance further was, in this instance, not a sign of market weakness, but rather simply a reflection of the ongoing strength that had been maintained over several weeks.
Relative strength readings did not seriously begin to fail until the end of 2001, when, after a dip, prices rose to new highs while rate of change measurements clearly failed to do so. Prices and rate of change measurements declined simultaneously early in 2002, the decline preceded by the negative divergence that had developed between December 2001 and January 2002.
The first dip down in early December, accompanied by declines in the rate of change indicator, was not necessarily indicative of a more negative market climate. Even the strongest market advances have periods of consolidation. You might notice that at no time did rate of change levels decline below 0 during December. However, a negative divergence, with more bearish implications, did develop at year end.
What made tlh negative divergence more significant than the flattening of the rate of change indicator during October and November? Well, for one thing, rate of change readings were no longer tracking at high levels, declining to near the zero line. For another, patterns of price movement had changed, with price trends flattening. As a third consideration, there was very little time between the time that the rate of change failed to reach new peaks that would have confirmed new highs in price, and the rapid turndown in price levels from the early January peak.
Again, declines in rate of change readings and the presence of negative divergences are more significant if they are accompanied by some weakening in price trend. Double-top formations in price (two peaks spaced a few days to a few weeks apart) accompanied by declining double top formations in rate of change measurements can be quite bearish.
Conversely, rising patterns in rate of change measurements are more significant if they are confirmed by a demonstrated ability of the stock market to turn upward. Double-bottom stock market formations, spaced a few days to a few weeks apart, accompanied by rising rate of change readmgs often provide excellent entry points.