Risk Analysis Needs a Broader Brush

Financial News, August 27, 2001 | Go to article overview

Risk Analysis Needs a Broader Brush


Country risk assessment is once again on the international financial radar screen due to its starring role in the Basel Committee's controversial proposals for a new Capital Accord.

Behind this is the natural desire to avoid a repetition of the effects of the Mexican, Asian, Brazilian and Russian banking crises between 1994 and 1998. This year we have seen crises first in Turkey and now in Argentina, which may well have knock-on effects in Chile, Uruguay and, most worryingly, Brazil.

Events related to country-specific risks have been central causes in all these crises. Government policy and legislation and, more often, plain politics, are always prime factors determining economic stability and, more than in any other part of risk management, perception of country and political risk in a foreign and often remote jurisdiction plays an important role in international investment decisions, whether justified or not.

For Basel, the issue is whether international banks' own internal ratings systems are sufficiently effective for supervisory purposes, and to what extent external sources - primarily ratings agencies - can and should be relied upon for country risk analysis. Both approaches are too limited.

There has never been any clear agreement on the best way for lenders, investors, acquirers or traders to properly assess how such country and political risk events come about, and how they interact and determine the more financial risks. Historically, country and political risk analysis has often been regarded as a non-financial issue that tends to take a back seat to economic, market and operational risk assessment.

There is a wide disparity in banks' approaches. The most experienced and sophisticated lenders have developed their own methodologies: for instance, about 60% of the Institute of International Finance member banks use country risk ratings to determine economic capital allocations. There is, however, a widespread tendency to rely on quantitative techniques and measures that often fail to take proper account of the mercurial nature of government. Not surprisingly, financial professionals gravitate towards risk measures expressed in familiar terms; unfortunately, politics and society rarely conform.

Indeed, many banks admit that they have been surprised by the apparent speed of the loss of market liquidity in some countries, while their own internal systems had failed to provide sufficient warning of impending disasters. …

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