Managing Financial Risk in a Volatile Global Environment

As Asian countries such as Korea and Thailand slowly recover from their financial collapse of some two years ago, the debate continues as to whether private sector financing or public sector support should be used to shore up the troubled economies of emerging-market countries. On December 9, 1999, Stanley Fischer, first deputy managing director of the International Monetary Fund (IMF), spoke to a room full of members at the annual New York City meeting of the Emerging Market Traders’ Association (EMTA) about his perspective on these issues.

Fischer offered up some current IMF strategies, which ranged from more intense “surveillance of economic policies and prospects” in member countries to increased private sector financing to emerging market nations. With an opposing opinion on the matter, the EMTA maintains that considerable private sector support of emerging market economies, followed by the rescheduling of bond payments, will simply drive the private sector from these same global markets.

In the past year, Pakistan, Ecuador, Romania and the Ukraine, have all experienced liquidity and solvency problems. According to

Anthony M. Santomero, director of the Wharton Financial Institutions Center, the private sector trading community should be concerned about the situation in these nations. He adds, however, that “the private sector has not much at risk in most of these countries, with the exception of the Ukraine.”

Still, as the IMF and the private sector work to resolve the financial difficulties in these nations, many are looking to the lessons to be learned from the 1997 Asian financial crisis and the resulting reforms called for to respond to the global economic turmoil. Certainly, the collapse of a number of Asian securities markets in the fourth quarter of 1997 and the subsequent ripple effect on the global financial marketplace remain a source of heated debate for industry experts, as well as those in the public sector.

The financial crisis appeared unprecedented in financial history. It spread like wildfire from the Malaysian, Thai and Indonesian financial markets to the Russian and Latin American monetary systems and finally to the faltering Greenwich, Connecticut-based Long-Term Capital Management hedge fund (LTCM). With government leaders and trading specialists looking for the root of the market instability, both have moved quickly to try to prevent a similar occurrence.

In an effort to understand the financial environment that led up to and followed this market upheaval, the Wharton Financial Institutions Center sponsored a roundtable last April entitled “The Measurement and Management of Global Financial Risk.” Co-sponsored by New York City-based Oliver, Wyman & Company, a panel of academics, financial consultants and risk managers from major trading houses convened in Philadelphia to discuss viable solutions to combat the ever-increasing trading risk from global markets.

Francis X. Diebold, a senior fellow with Wharton Financial Institutions Center, along with Santomero, highlight the salient points of the event in a companion paper to the conference, titled “Financial Risk Management in a Volatile Global Environment.”

Contrary to popular opinion, Diebold and Santomero describe the reactions by industry and government experts to the global financial crisis as “premature.” In April 1999, the President’s Working Group on Financial Markets sought to address the conditions that led to the collapse of LTCM. Among its recommendations, the group has proposed further disclosure of leveraged financial transactions by publicly traded companies and support for better controls on “offshore financial centers.”

The Counterparty Risk Management Group, represented by 12 international commercial and investment banks, followed up with recommendations in June 1999, hoping to address the situation within the private sector. Their conclusion: Increased sharing of information between financial competitors and additional evaluation of the “effects of leverage on market liquidity and credit risk” would serve as a buffer against global trading fluctuations.

Despite the corrective measures suggested by the public and private sector, Diebold and Santomero maintain that a firm understanding of the market crisis is needed before adequate responses can be determined. While the media and political pundits describe the global financial crisis as “extraordinary,” the historic volatility of both the Asian and Latin American securities markets should serve to dispute the notion. Although the authors note that the 40% drop in Asian markets in the fourth quarter of 1997 and the similar drop of Latin American markets in early 1998 “may have been viewed with surprise,” it could “not be viewed as statistically extraordinary.”

The financial crisis that first struck the Asian securities market, then Russian and Latin American markets and traveled westward to effectively cripple LTCM has left many to wonder about the linkage of the events. According to Diebold and Santomero, the excessive “spillover” of the decline in emerging markets sparked an aggressive search for the persons at the heart of the “contagion.” International hedge fund speculators, such as George Soros, continue to be identified as the cause of the financial turmoil by some foreign governmental bodies.

The historical evidence appears to show, however, that the “hedge funds were not dealing with pools of capital large enough to effectively disrupt an entire nation,” say Diebold and Santomero. The authors quickly dismiss the World Bank’s and IMF’s usual explanations of “poor macroeconomic policy, political corruption, and errant central banking” for the spread of the global financial problems. While pointing to “international trade linkages” as a more real cause of the crisis in Asia, Diebold and Santomero concede that these links are less defined outside the region. Further complicating the financial turmoil was the “failure to account for vanishing liquidity in times of crisis” and the need for additional understanding of the exploitation of competitors’ trading strategies.

Diebold and Santomero note that the financial industry should be more diligent in updating its risk management systems to adequately assess real-time trading exposures. The authors contend that the “complacency” of financial managers, overly confident from years of growth in the global securities market, has led many to underestimate the risks inherent in trading.

Santomero concedes that past profits made “it very easy to forget the risky financial environment.” Further, he adds that the current recovery in Asian markets “may reduce the pressure to fix fundamental problems.” Still, attributing a collapse or an exorbitant loss to a mere financial anomaly is not sufficient, and should suggest the inadequate nature of existing risk management practices and the need for more up-to-date computer systems to identify global trading exposures.

Diebold and Santomero sum up by saying that a failure to diligently update risk management systems and to better handle the risk inherent in trading will necessitate the push for further regulatory intervention into financial trading. Adds Santomero: “There is a very real concern that hedge funds will be further regulated.” Certainly, financial managers shy away from additional regulatory oversight, preferring to let market forces drive the market itself.

In principle, it appears that the IMF is hoping to encourage emerging markets to better manage their own economies, as well. Recently, the IMF’s Fischer noted that the organization is looking to ensure “that implicit or explicit guarantees do not shield the private sector from the consequences of unduly risky behavior.” Such pronouncements should lead the U.S. financial community to push for better risk management techniques to help insulate itself from the extreme volatility in these global markets.”

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