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Business Master Dissertations
2014 Management of financial risks in social security institutions in Tanzania: a case study of the LAPF pensions fund
Rotente, Bhoke John
The University of Dodoma
Rotente, B. J. (2014). Management of financial risks in social security institutions in Tanzania: a case study of the LAPF pensions fund. Dodoma: The University of Dodoma. http://hdl.handle.net/20.500.12661/723 Downloaded from UDOM Institutional Repository at The University of Dodoma, an open access institutional repository. MANAGEMENT OF FINANCIAL RISKS IN SOCIAL SECURITY
INSTITUTIONS IN TANZANIA: A CASE STUDY OF THE LAPF
PENSIONS FUND
By
Bhoke John Rotente
Dissertation Submitted in Partial fulfillment of the Requirement for the Award of the Degree of Master of Business Administration of the University of Dodoma
The University of Dodoma
October, 2014 CERTIFICATION
The undersigned certifies that has read and hereby recommends for acceptance by the
University of Dodoma dissertation entitled: “Management of Financial Risks in Social
Security Institutions in Tanzania: A Case Study of LAPF Pensions Fund” in partial fulfilment of the requirement for the Degree of Masters of Business Administration of the
University of Dodoma.
…………………………………….
Dr Mark Paul Diyammi
(SUPERVISOR)
Date ………………………………
i DECLARATION AND COPYRIGHT
I, Bhoke John Rotente do hereby declare to University of Dodoma that this dissertation is a result of my own original work and that it has not been submitted for any degree award in any university for the award of the Degree of Masters of Business Administration of the
University of Dodoma.
Signature…………………………
No part of this dissertation may be reproduced, stored in any retrieval system, or transmitted in any form or by any means without prior written permission of the author of the University of Dodoma.
ii ACKNOWLODGEMENT
With the deepest gratitude I wish to thank every person who has come into my life and inspired, touched and illuminated me though their presence.
I am deeply indebted to Dr Mark Paul Diyammi my principal supervisor. He undertook the last of guiding me from the initiation of the study during its execution through to the final write up of the Dissertation. The constructive criticism suggestions and encouragement motivated me to hard work.
I am grateful to my parents (Mr. and Mrs John Rotente). They invested the little they had in my life. I know a good number of friends who were academically excellent but were never sent to school, may God bless both of them.
Special thanks go to my husband (Elinisaidie Mlay) who encouraged, financed and even tolerated me during difficult moments which faced as a family, without forgetting my lovely daughter (Rosemary) who missed my presence and support during my studies.
For generously sharing their wisdom, love and divinity, I pay homage to appreciation to the LAPF Pensions Fund staffs in responding during data collection. May the Almighty
God bless them all.
Lastly but equally important, I like to express my sincere thanks to all friends and unnumbered people who actually deserved a mention because they made their contribution in one way or another to make this report a success.
iii DEDICATION
This study dedicated to my husband (Elinisaidie Mlay) who encouraged, financed and even tolerated me during difficult moments which faced as a family, without forgetting my lovely daughter (Rosemary) who missed my presence and support during my studies.
iv ABSTRACT
This study examined the Management of Financial Risks in Social Security Institutions in Tanzania: Specifically it aimed to identify financial risks facing LAPF in its operations, to find out the measures being taken by LAPF in managing the financial risks and to examine the effectiveness of the existing measures being taken by LAPF in managing the financial risks.
A sample of 40 respondents was made use of and these were randomly obtained from LAPF in Dodoma. The researcher used both primary and secondary sources in collecting data. Data were collected using instruments like questionnaires, interviews and observation. The statistical package for social science (SPSS) was used for management of data and analysis. In this study the theories pertaining to financial mechanism used by LAPF FUNDS was established to familiarize the reader with paradigms, frameworks and approaches.
The findings reveal that the study that Social Security Institutions are subject to different types of risks in respects of their liabilities, earning, structural changes in the economy, unemployment, disability, the future growth in the cost of health care and general improvement in longevity for the whole population. The study as well finds out that LAPF encounters different financial risks in their operation, namely: -liquidity risk, market risk, credit risk, litigation risk, regulatory, operation and policy risks and political risks. According to findings, liquidity risk is the most serious risk affecting financial risks followed by operational risk. Different measures have been employed by LAPF to mitigate financial risks.
The study recommends that the government should make sure that, each social security institution establishes an independent risk management unit to oversee the management of risks in their operations. Reports from the auditors and the actuary should be made publicly available. LAPF should make use of financial derivatives as an investment management instrument to manage and hedge risks. Appropriate risk management structures should be put in place to govern the use of derivatives, and compliance with these structures should be carefully monitored. LAPF should ensure that their staffs have appropriate expertise and training on key risk indicators and the importance of risk+
management.
v TABLE OF CONTENTS
CERTIFICATION ...... i DECLARATION AND COPYRIGHT ...... ii ACKNOWLODGEMENT ...... iii DEDICATION ...... iv ABSTRACT ...... v TABLE OF CONTENTS ...... vi LIST OF TABLES ...... xii LIST OF FIGURES ...... xiii LIST OF APPENDICES ...... xiv LIST OF ABBREVIATIONS AND ACRONYMS ...... xv
CHAPTER ONE ...... 1 INTRODUCTION AND BACKGROUND TO THE STUDY ...... 1 1.0 Introduction ...... 1 1.1 Background to the Study ...... 1 1.2 Statement of the Problem ...... 5 1.3 Objectives of the Study ...... 6 1.3.1 General Objectives ...... 6 1.4 Research Questions ...... 7 1.5 Significance of the Study ...... 7 1.6 Limitation of the Study ...... 8 1.7 Delimitation of the Study ...... 8 1.8 Summary and Organization of the Study ...... 8
CHAPTER TWO ...... 10 LITERATURE REVIEW ...... 10 2.0 Introduction ...... 10 2.1 Definition of Key Terms ...... 10 2.1.1 Concept of Social Security ...... 10 2.1.2 Concept of Risk ...... 12 2.2 Types of Risks ...... 12 2.2.1 Equity Risk ...... 12
vi 2.2.2 Interest Rate Risk ...... 12 2.2.3 Hedging Interest Rate Risk ...... 13 2.2.4 Currency Risk ...... 13 2.2.5 Commodity Risk ...... 13 2.3 Risk Management ...... 13 2.3.1 Risk Avoidance ...... 14 2.3.2 Risk Reduction ...... 14 2.3.3 Risk Retention ...... 15 2.3.4 Risk Transfer ...... 15 2.4 Empirical Literature Review ...... 16 2.4.1 Social Security System and Its Objectives in Tanzania ...... 16 2.4.2 Lack of Mechanism for Portability of Benefit Rights ...... 16 2.4.3 Social Security Benefits ...... 16 2.5 Difficulties Managing Pension Reserve Funds ...... 17 2.5.1 Lack of Investment Opportunities ...... 18 2.5.2 Issues Specific to the Defined Benefit Schemes ...... 18 2.5.3 Public Service Pension Obligations ...... 19 2.5.4 Provident Fund Difficulties ...... 20 2.5.5 Pension Portability ...... 20 2.5.6 Funds Regulation ...... 21 2.6 Challenges in the Social Security System ...... 21 2.6.1 Weakening of Informal Social Protection System ...... 22 2.6.2 Limited Growth of the Formal Employment ...... 23 2.6.3 Reduced Access to Social Services ...... 23 2 6.4 Low Levels of Income ...... 23 2.6.5 Declaration of Low Insurable Earnings ...... 23 2.7 A General Theory of Financial Risk ...... 24 2.7.1 Actuarial Approaches to Risk ...... 24 2.7.2 Expected Utility ...... 25 2.7.3 Anomaly and Paradigm Shift ...... 25 2.7.4 Neural Mechanics of Physical Risk ...... 26 2.7.5 Observations by Adam Smith ...... 26 2.7.6 Observations by John Maynard Keynes ...... 28 2.7.7 Observations by von Neumann and Morgenstem ...... 30 2.7.8 Observations by Maurice Allais ...... 32
vii 2.7.9 Observations by William Sharpe ...... 33 2.7.10 Attempted Generalisations of Expected Utility ...... 33 2.7.11 Absence of an Unambiguous Basic Measure of Risk ...... 34 2.7.12 Myopic Loss Aversion ...... 35 2.7.14 A ―Risk Equals Uncertainty‖ Paradox ...... 36 2.7.15 The Other St Petersburg Paradox ...... 37 2.7.16 Extreme Value Theory and Financial Risk Management ...... 38 2.7.17 Extreme Value Theory in Risk Management ...... 40 2.7.18 Liquidity at Risk ...... 42 2.7.18 Scenario Analysis-Based Contingency Plans ...... 42 2.7.19 Diversification of Liquidity Providers ...... 43 2.8 Financial Institutions ...... 43 2.9 Risk in Financial Services ...... 44 2.9.1 Why Does Risk Matter? ...... 44 2.9.2 Risk Mitigation Approaches ...... 45 2.9.3 Taxonomy of Financial Institutions, Services, and Risks ...... 49 2.9.4 Basic Financial Services ...... 50 2.9.5 Risks in Providing Financial Services ...... 53 2.9.6 When to Practice Risk Management ...... 57 2.9.7 Understanding the Differences between Institutions ...... 58 2.9.8 Requirements for Active Risk Management Techniques ...... 60 2.9.9 Derivatives ...... 63 2.9.10 Empirical Findings on Derivatives ...... 64 2.9.11 Why Do Smaller Firms with Less Diversifiable Risk Choose Not to Use Derivatives? ...... 64 2.9.12 Risk Management Procedures ...... 65 2.9.13 Measures to Combat Financial Risks ...... 66 2.9.13.1 Actuarial Valuation ...... 66 2.9.13.2 Hedge ...... 66 2.9.13.3 Derivatives ...... 67 2.9.13.4 Diversification ...... 67 2.10 Research Gap ...... 68 2.11 Conceptual Framework ...... 69 2.12 Summary ...... 70
viii CHAPTER THREE ...... 71 RESEARCH METHODOLOGY ...... 71 3.0 Introduction ...... 71 3.1 The Area of Study and its Description ...... 71 3.1.1 Population and Units of Inquiry ...... 74 3.2 The Research Design ...... 74 3.3 Sample and Sampling Procedures ...... 75 3.4 Data Collection Procedures ...... 76 3.5 Data Collection Methods ...... 77 3.6 Data Collection Instruments ...... 78 3.6.1 Questionnaires ...... 78 3.6.2 Interview ...... 79 3.6.3 Observation ...... 79 3.6.4 Documentary Source ...... 79 3.6.5 Internet ...... 79 3.7 Data Analysis and Presentation ...... 80 3.8 Validity and Reliability ...... 81 3.9 Ethical Issues and Consideration ...... 82 3.10 Summary ...... 83 CHAPTER FOUR ...... 84 DATA ANALYSIS, DISCUSSION AND INTERPRETATION ...... 84 4.0 Introduction ...... 84 4.1 Specific Observation ...... 84 4.2 Study and Response Rate ...... 84 4.3 Respondents Background Characteristics ...... 85 4.3.1 Respondent‘s Ages ...... 86 4.3.2 Education Level of Respondents ...... 87 4.3.3 Respondents Working Experience ...... 88 4.4 Descriptive Analysis and Findings ...... 89 4.4.1 Financial Risks in LAPF Pensions Fund ...... 89 4.4.2 Liquidity Risks ...... 90 4.4.3 Market Risks ...... 91 4.4.4 Credit Risks ...... 92 4.4.5 Litigation Risks ...... 93 4.4.6 Regulatory, Operational and Policy Risks ...... 94
ix 4.4.7 Political Risks ...... 95 4.4.8 Risk Management is carried Out by Management under the Supervision of the Investment Committee ...... 97 4.5 Measures Taken By LAPF to Combat Financial Risks...... 98 4.5.1 Actuarial Valuation ...... 98 4.5.2 Market Rent ...... 99 4.5.3 Loan Deposit Ratio ...... 99 4.5.4 Daily Movement of Exchange Rate ...... 99 4.5.5 Risk Management Guidelines ...... 100 4. 6 Effectiveness of the Measures Being Taken By LAPF in Managing the Financial Risks ...... 100 4.6.1 Priorities in Managing Financial Risks ...... 100 4.6.2 Effectiveness of Managing Financial Risks ...... 102 4.6.3 Uses of Value at Risk (VaR) in Managing Market Risk ...... 103 4.6.4 Impact of Financial Risk to Social Security Institution Operations ...... 104 4.6.5 Increase Legal Fees and Reputation Problem ...... 104 4.6.6 Market Rent ...... 105 4.6.7 Loan Deposit Ratio ...... 105 4.6.8 Daily movement of Exchange Rate ...... 106 4.6.9 Risk Management Guidelines ...... 106 4.7 Measures Being Taken By LAPF in Managing the Financial Risks ...... 106 4.7.1 Effectiveness of Managing Financial Risks ...... 107 4.7.2 Uses of Value at Risk (VaR) in Managing Market Risk ...... 107 4.7.3 Level of Risk Management Policy Implementation ...... 108
CHAPTER FIVE ...... 110 CONCLUSIONS AND RECOMMENDATIONS ...... 110 5.0 Introduction ...... 110 5.1 Summary of the Findings ...... 110 5.1.1 Financial Risks Faced LAPF ...... 111 5.1.2 Measures Taken by LAPF to Combat Financial Risks ...... 111 5.1.3 Effectiveness of the Existing Measures ...... 111 5.2 Conclusion ...... 111 5.3 Recommendations ...... 112 5.3.1 Recommendations to the Government ...... 112
x 5.3.2 Recommendations to LAPF Management ...... 113 5.4 Areas for Further Studies ...... 114 REFERENCES ...... 115 APPENDICES ...... 120
xi LIST OF TABLES
Table 2.1: Firm Level Risk Mitigation Approaches ...... 49 Table 4.1: Respondents‘ Rate in Percentage Wise ...... 85 Table 4.2: Effectiveness of Managing Financial Risks ...... 102
xii LIST OF FIGURES
Figure 2.1: Map of Dodoma Region ...... 73 Figure 4.1: Respondents‘ Rate ...... 85 Figure 4.2: Respondents‘ Age Distribution ...... 87 Figure 4.3: Respondents‘ Education Level ...... 88 Figure4.4: Working Experience ...... 89 Figure 4.5: Liquidity Risks ...... 90 Figure 4.6: Market Risks ...... 91 Figure 4.7: Credit Risks ...... 92 Figure 4.8: Litigation Risk ...... 94 Figure 4.9: Regulatory, Operational and Policy Risk ...... 95 Figure 4.10: Types of Risk Facing LAPF ...... 96 Figure 4.11: Risk Management Is Carried Out By Management Under The Supervision of Investment Committee ...... 97 Figure 4.12: Priorities in Managing Financial Risks in LAPF ...... 101 Figure 4.13: Management of Market Risk Using Value at Risk (VaR) at LAPF ...... 104 Figure 4.14: Risk Management Policy Implementation ...... 109
xiii LIST OF APPENDICES
Appendix I: Questioners for the Respondents ...... 120
xiv LIST OF ABBREVIATIONS AND ACRONYMS
CAG Controller and Auditor General CAPF Capital Asset Pricing Model CEOs Chief Executive Officers EE’S Employee‘s ER’S Employer‘s FDRS - Fixed Deposit Receipts GEPF Government Employees Provident Fund ILO International Labour Organization ISSA International Social Security Association LAPF Local Authorities Pensions Fund NGOs Non Governmental Organizations NHIF National Health Insurance NPV Net Present Value PFs Pensions Funds PPF Parastatal Pension Fund PSPF Public Service Pension Fund R.E Revised ROCE Return on Capital Employed ROI Return on Investment SMART Specific, Measurable, Attainable, Realistic and Time Bond SPSS Statistical Package for Social Sciences SSI Social Security Institutions SSLP Specified State Leaders Pensions Scheme SSS Social Security Schemes URT United Republic of Tanzania ZSSF Zanzibar Social Security Fund
xv CHAPTER ONE
INTRODUCTION AND BACKGROUND TO THE STUDY
1.0 Introduction
The chapter pulls its attention on “Management of Financial Risks in Social Security
Institutions in Tanzania: A Case Study of LAPF Pensions Fund in Dodoma Municipality.”
Included are the statement of the problem, purpose of the study, objectives of the study, the specific objectives of the study, research questions, significance of the study, assumptions of the study, scope of the study, delimitations of the study and winds up with the organization of the thesis.
1.1 Background to the Study
More than a third of the world population lives under extreme conditions of poverty and deprivation. These are typically people found in remote areas with difficult access to markets and institutions, not educated, with poor health, employed in jobs with little security and inadequate access to productive assets. Such characteristics make the poor to shocks caused by life cycle changes, economic reforms and other types of events such as illness or bad weather conditions. The vulnerability of the poor to socio-economic shocks can be reduced by policies that protect their livelihoods, increase their human capital and assist them in times of crises. However, despite the need of social security policies, it is not immediately clear that developing countries are able to implement programmes of social security (Radian, 1980, Newbery and Stern, 1987, Justino, 2003).
System of socio-economic security was introduced in Europe in the late 19th century.
These were slowly implemented in most countries during the early 20th century and
1 consolidated after the Second World War. These programmes were established as means of improving the wellbeing of the poor reduce inequality within society and conciliate different social demands, thus avoiding the social and political conflicts which necessarily arose as capitalist forms of production evolved in the industrialised countries. Two of the most influential examples were the United States Social Security Act and the Social
Security programme implemented in the UK, summarised in the Beveridge Report. These programmes established the basis for modern forms of security, defined by the
International Labour Organisation (ILO) as ―the protection which society provides for its members through a series of public measures against the economic and social distress that otherwise would be caused by stoppage or substantial reduction of earnings resulting from sickness, maternity, employment injury, invalidity and death; the provision of medical care; and the provision of subsidies for families with children‖ (ILO,1984).
Most social protection policies in developing countries will almost certainly be concerned with reducing vulnerability and unacceptable levels of deprivation. The extent of poverty and destitution in most developing countries would, however, make typical post-shock social security benefits of the type implemented in industrialised countries too costly to put into practice must, consequently, be extended not only to that of a ‗safety–net‘, but, more importantly, to ‗prevention‘ against increase in deprivation and the ‗promotion‘ of better chances of individual development (Guhan, 1994). In this sense, social protection policies are not only addressed to negative outcomes of development but would also promote more equal opportunities amongst all population groups, thereby reducing the likelihood of negative outcomes. the focus of social security policies in developing countries should thus be on the reduction and mitigation of structural forms of vulnerability and on the implementation of ways of coping with all type of risk (Norton, Conway and Foster, 2001;
2 Kabeer, 2002) and be integrated within the overall development strategy of the country rather than implemented as individual programmes.
Well-designed social security policies can contribute to a better environment for economic growth in Tanzania. And whole of Sub Saharan Africa It would be erroneous to think that social security is a luxury to be afforded only when growth has taken place or when countries have reached a certain level of per capital income. The fact is that there is a mutually reinforcing relationship between economic growth and society‘s ability to deal with the consequences of social and economic uncertainty. Adequate frameworks to deal with uncertainty will help improve the allocation of resources and hence contribute to economic growth. At low income levels there are substantial market imperfections that prevent people from dealing adequately with risks, and this determines the type of activities they undertake and the efficiency of their investment. However, it would also seem unwarranted not to take into account the limitations that the level of income imposes on the ability of government to effectuate transfers across groups. As income increases, it is easier for governments to tax and transfer resources to help the less fortunate deal with the results of economic uncertainty. Disregard of the budgetary effects and limitations will have harmful effects (Barbone and Sanchez, 1999).
Much of the literature on social security in Tanzania has defined social security as the protection provided by society to its members through public measures against the economic and social distress which otherwise would be caused by the stoppage or reduction of earnings arising from contingencies (Haule, et al., 1994). Examples of contingencies which could cause economic and social distresses include sickness, employment injury and occupational disease, maternity, old age, invalidity, death and unemployment. It overemphasizes the role of the public sector and the related net costs and expenditures while overlooking social security as an investment in human capital. It also
3 provides limited guidance to effective poverty alleviation. Most people in Tanzania are faced with insecurity caused by chronic or structural poverty: This insecurity arises mainly from insufficient economic development. But the removal of chronic social insecurity faced by the poor does not remove the social insecurity associated with risks emanating from conventional contingencies such as loss of employment, disability, old age and death
(Mchomvu, 2002)).
The fundamental social security needs of the poor in Tanzania are the result of chronic or structural poverty and only secondarily of conventional social insecurity. An attempt to define social security should therefore take into account both the conventional definition as well as the basic needs definition of social security which portrays the situation in
Tanzania. Holzmann and Jorgensen (2000) offer such a definition. According to them, social security consists of "public interventions to assist individuals, households and communities better manage risk and to provide support to the critically poor". Underlying this definition is the idea that social security is both a springboard and a safety net for the poor. It regards social security as an investment in human capital and focuses more on the causes than on the symptoms of poverty. Finally, this definition considers individuals, households and communities as vulnerable to multiple risks from different sources, both natural and man-made (Mchomvu, op.cit.).
Currently, there are five major formal institutions that provide social security protection in Tanzania. These are the National Social Security Fund (NSSF) offering social security coverage to employees of private sector and non-pensionable parastatal and government employees, the Public Service Pension Fund (PSPF) providing social security protection to employees of central Government under pensionable terms, Parastatal Pension Fund (PPF) offering social security coverage to employees of the both private and parastatal organizations, the LAPF Pensions Fund (LAPF) offering social security coverage to employees of the Local Government and from all economic sectors and the National Health Insurance Fund (NHIF) offering health insurance coverage to pensionable
4 employees of central government and Government Employee Provident Fund(GEPF) offers pension services to Government employees on contract not under pensionable terms.
1.2 Statement of the Problem
Increased capital flows, rapid dissemination of information and faster transfers of funds have all served to increased markets risks. Deregulation of capital flows in the worlds emerging economies has been the main catalyst for globalization, when un-checked growth of capitalism, poor accounting standards and inefficient financial intermediation precipitated some major credit crises (Diermeirer and Solnik, 2001).
Recently global trends in financial markets have increased many types of operational risks.
The concentration of key financial services into a single geographical location increases operational risks arising from damage to physical assets. Financial Institutions now offer highly structured products having access to a wide range of asset classes across the world and the complexity of these financial instruments highlights several types of operational risks. With less transparency in the trading and new and complex systems, system risks increased, products and business practice risks increased because of the danger of mis- pricing and mis-selling these products, and human risks in general increase because only a few experienced people understand the systems and products (Alexander, 2003).
While new financial instruments(such as derivatives), new participants (e.g hedge funds), and new technologies (like electronic trading), typically have improved the information, efficiency of markets and have facilitated the matching of savings with investment opportunities, they also changed the speed with which new information is incorporated into prices, often giving little time to institutions to adjust to new information before they see their financial soundness imperilled by new balance sheet weakness. Financial institutions in Tanzania invest substantial amount of their fund into financial markets. These
5 investments are government securities (Treasury bonds, Treasury bills and Government stocks), fixed deposits, Real estates and Loans. These types of investments are exposed with financial risks which affect their liquidity position which result into uncertain for them to settle their obligations (Carey, 2007). Accordingly, this study intended to determine the management of financial risks in social security institutions and suggest the ways of managing financial risks.
According to survey conducted by Deloitte (2008), risk management is not fully integrated throughout social security institutions in Tanzania. About 51% of the institutions surveyed had not completely or substantially incorporated responsibilities for risk management into performance goals and compensation decisions for senior management. Only 36% of the institutions had an enterprise risk management (ERM) program, although another 23% were in the process of creating one.
LAPF as other social security institutions established risk management framework in 2008 to provide guidance to the management in the mitigation of risks within the fund. Although
LAPF has a mechanism of managing risks, there is no clear evidence that the fund is efficient in mitigating risks. Therefore this study was intended to assess the effectiveness of managing financial risks in SSIs in Tanzania using a case of LAPF.
1.3 Objectives of the Study
1.3.1 General Objectives
The main objective of the study was to assess the management of financial risks facing the social security institutions of Tanzania with evidence from LAPF.
1.3.2 Specific Objectives
6 Specifically this study aimed at:
i. To identify financial risks facing LAPF in its operations.
ii. To find out the measures being taken by LAPF in managing the financial risks.
iii. Examine the effectiveness of the existing measures being taken by LAPF in
managing the financial risks.
1.4 Research Questions
The study aimed at answering the following questions:
i. What financial risks are currently facing Social Security Institutions in
Tanzania?
ii. What are the impacts of financial risks to Social Security Institutions
operations?
iii. How effective are Tanzania‘s Social Security Institutions in managing financial
risks?
1.5 Significance of the Study
To the Host Organization; the study gives out financial risks in social security institutions and suggested the ways of managing these financial risks. Whilst to the researcher, the study provided with her practical experiences on the field of work and has helped the researcher in the partial fulfilment for the award of Master of Business Administration.
Eventually, the study acts as a stimulus to other researchers to conduct further studies to the topic under study. And will contribute to available literature on Social Security Funds in the market where many Social Securities are now emerging.
7 1.6 Limitation of the Study
The researcher faced problems relating to data collection and questionnaires since exercise was limited to LAPF Head Offices, some of the headaches were the availability of data, centralization of the finance department and availability of staff with knowledge of financial management. The researcher did not get sponsors to cover the cost which were involved. These include the cost of buying laptop, printing costs and secretarial costs. Thus the researcher had to meet his own pocket thus financed through rising from the Savings and Credit Society, employer and friends.
1.7 Delimitation of the Study
The expected results will be used by the Management of the LAPF Pensions Fund, academicians, professionals, employees of LAPF and other stakeholders without any limit.
1.8 Summary and Organization of the Study
This investigation is made up of five chapters. The first Chapter provides the preliminary information of the research and wide-ranging background of the study, statement of the setback, set of objectives, research questions, as well as, importance of the study. The second Chapter presents theoretical and empirical reviews of literature on an assortment of aspects concerning decentralisation and local governance, it points out the gaps in the prevailing situation that necessitated the need for the present study. Chapter third provides a detailed description regarding methods and techniques that the study employed in collection, organization and analysis of data.
While, the fourth and fifth chapters stand for data presentation, analysis and discussions in response to the research questions herein. These two chapters reflected the thematic
8 categorization to topics or major issues carried within specific objectives of the study.
Consequently, in chapter two a detailed examination and analysis of the nature of
Management of Financial Risks in Social Security Institutions in Tanzania, specifically the
LAPF Pensions Fund, will be attempted. Chapter five depicts the summary, conclusion and recommendations of the study. Conclusively, the following chapter of the study (Chapter
Two) focuses on Literature Review.
9 CHAPTER TWO
LITERATURE REVIEW
2.0 Introduction
This chapter defines the important concepts and terms related to the research topic. It is an organized collection of references, or citations. It helps the researcher develop a good understanding, insight and right trends regarding similar subject. The chapter focuses on introduction, theoretical literatures review that includes description of concepts and theories, empirical analysis, conceptual framework, Research gap and its conclusion.
2.1 Definition of Key Terms
2.1.1 Concept of Social Security
The concept of social security is as old as human life. For example Africa, elders and invalid were taken (care) of family members. Also efforts were made to assist the affected people in events of contingencies of nature. Mkullo (2000)), refers to it as the informal social security, which had no reserve funds. The International Labour Organization (ILO) defines social security as ―the protection‘‘ which society provide for its members through a series of public measures against economic and social distress would have been caused by stoppages or substantial reductions of earnings resulting from sickness, unemployment
,invalidity ,old age, death and so on (ILO,1994).
Social security may be defined as any programme of social protection established by legislation, or any other mandatory arrangement, that provides individuals with a degree of income security when faced with the contingencies of old age, survivorship, incapacity,
10 disability, unemployment or rearing children. It may also offer access to curative or preventive medical care. As defined by the International Social Security Association, social security can include social insurance programs, social assistance programs, universal programs, mutual benefit schemes, national provident funds, and other arrangements including market-oriented approaches that, in accordance with national law or practice, form part of a country's social security system (http://www.issa.int/aiss/Topics/About- social-security). Furthermore, social security means any kind of collective measures or activities designed to ensure that members of society meet their basic needs and are protected from the contingencies to enable them maintain a standard of living consistent with social norms.
The social security concept has been changing with time from the traditional ways of security to modern ones. As societies became more industrialized as a result of industrial revolution in the 19th century and more people became dependent upon wage employment, it was no longer possible to rely upon the traditional system of social security. The negative impact of industrialization and urbanization attracted the attention of policy makers to formalize social security system that addressed the emerged social issues. Social security is defined in its broadest meaning by the International Labour Organization (ILO) as: "The protection measures which society provides for its members, through a series of public measures against economic and social distress that would otherwise be caused by the stoppages or substantial reduction of earnings resulting from sickness, maternity, employment injury, unemployment, disability, old age, death, the provision of medical care subsidies for families with children.‖
11 2.1.2 Concept of Risk
Risk is a concept that denotes the precise probability of specific eventualities. Technically, the notion of risk is independent from the notion of value and, as such, eventualities may have both beneficial and adverse consequences. However, in general usage the convention is to focus only on potential negative impact to some characteristic of value that may arise from a future event (Tapiero, 2004).
2.2 Types of Risks
2.2.1 Equity Risk
It is a risk that one's investments will depreciate because of stock market dynamics causing one to lose money. The measure of risk used in the equity markets is typically the standard deviation of a security's price over a number of periods. The standard deviation will delineate the normal fluctuations one can expect in that particular security above and below the mean, or average. However, since most investors would not consider fluctuations above the average return as "risk", some economists prefer other means of measuring it (Tapiero, op.cit.).
2.2.2 Interest Rate Risk
The term is defined as a risk (variability in value) borne by an interest-bearing asset, such as a loan or a bond, due to variability of interest rates. In general, as rates rise, the price of a fixed rate bond will fall, and vice versa. Interest rate risk is commonly measured by the bond's duration it (Tapiero, op.cit.).
12 2.2.3 Hedging Interest Rate Risk
Interest rate risks can be hedged using fixed income instruments or interest rate swaps.
Interest rate risk can be reduced by buying bonds with shorter duration, or by entering into a fixed-for-floating interest rate swap it (Tapiero, op.cit.).
2.2.4 Currency Risk
The term is a form of risk that arises from the change in price of one currency against another. Whenever investors or companies have assets or business operations across national borders, they face currency risk if their positions are not hedged. Transaction risk is the risk that exchange rates will change unfavorably over time. It can be hedged against using forward currency contracts it (Tapiero, op.cit.).
2.2.5 Commodity Risk
This refers to the uncertainties of future market values and of the size of the future income, caused by the fluctuation in the prices of commodities.[1] These commodities may be grains, metals, gas, electricity etc. A Commodity enterprise needs to deal with the following kinds of risks it (Tapiero, op.cit.).
2.3 Risk Management
It is the identification, assessment, and prioritization of risks followed by coordinated and economical application of resources to minimize, monitor, and control the probability and/or impact of unfortunate events. Risks can come from uncertainty in financial markets, project failures, legal liabilities, credit risk, accidents, natural causes and disasters as well as deliberate attacks from an adversary. Several risk management standards have been
13 developed including the Project Management Institute, the National Institute of Science and Technology, actuarial societies, and ISO standards. Methods, definitions and goals vary widely according to whether the risk management method is in the context of project management, security, engineering, industrial processes, financial portfolios, actuarial assessments, or public health and safety (Crockford and Neil,1986).
2.3.1 Risk Avoidance
This includes not performing an activity that could carry risk. An example would be not buying a property or business in order to not take on the liability that comes with it.
Another would be not flying in order to not take the risk that the airplanes was to be hijacked. Avoidance may seem the answer to all risks, but avoiding risks also means losing out on the potential gain that accepting (retaining) the risk may have allowed. Not entering a business to avoid the risk of loss also avoids the possibility of earning profits (James,
2003).
2.3.2 Risk Reduction
Also James (2003), Enterprise Risk Management: From Incentives to Controls. John Wiley defined risk reductions as it involves methods that reduce the severity of the loss or the likelihood of the loss from occurring. For example, sprinklers are designed to put out a fire to reduce the risk of loss by fire. This method may cause a greater loss by water damage and therefore may not be suitable. Halon fire suppression systems may mitigate that risk, but the cost may be prohibitive as a strategy. Risk management may also take the form of a set policy, such as only allow the use of secured IM platforms (like Brosix) and not allowing personal IM platforms (like AIM) to be used in order to reduce the risk of data leaks.
14 2.3.3 Risk Retention
Risk Retention involves accepting the loss when it occurs. True self insurance falls in this category. Risk retention is a viable strategy for small risks where the cost of insuring against the risk would be greater over time than the total losses sustained. All risks that are not avoided or transferred are retained by default. This includes risks that are so large or catastrophic that they either cannot be insured against or the premiums would be infeasible.
War is an example since most property and risks are not insured against war, so the loss attributed by war is retained by the insured. Also any amount of potential loss (risk) over the amount insured is retained risk. This may also be acceptable if the chance of a very large loss is small or if the cost to insure for greater coverage amounts is so great it would hinder the goals of the organization too much (Mittal, 2009).
2.3.4 Risk Transfer
Risk transfer as the terminology of practitioners and scholars alike, the purchase of an insurance contract is often described as a "transfer of risk." However, technically speaking, the buyer of the contract generally retains legal responsibility for the losses "transferred", meaning that insurance may be described more accurately as a post-event compensatory mechanism. For example, a personal injuries insurance policy does not transfer the risk of a car accident to the insurance company. The risk still lies with the policy holder namely the person who has been in the accident. The insurance policy simply provides that if an accident (the event) occurs involving the policy holder then some compensation may be payable to the policy holder that is commensurate to the suffering/damage (Van Deventer, et al., 2004)).
15 2.4 Empirical Literature Review
2.4.1 Social Security System and Its Objectives in Tanzania
According to National Bureau of Statistics, 2001, National Labour Force Survey, 1999,
Social security in Tanzania covers a wider variety of public and private measures meant to provide benefits in the event of the individuals‘ earning power permanently ceasing, being interrupted, never developing, being unable to avoid poverty, or being exercised only at an acceptable social costs. The major domains of social security are: poverty prevention, poverty alleviation, social compensation and income distribution. Many issues relating to social security are sensitive, as they touch on the material interests of organized workers and the unorganized poor as well as insurance industry and employer organizations.
2.4.2 Lack of Mechanism for Portability of Benefit Rights
There is no established mechanism that can allow benefit rights of a member to be transferred from one scheme to another. This results in employees losing some of their benefit rights when they move from one sector to another (National Labour Force Survey, op.cit.).
2.4.3 Social Security Benefits
In some of the Tanzania‘s social security schemes, members‘ benefits are not rights but privileges. Normally, members lose some of their benefits if they leave employment before attainment of their pensionable ages. In other circumstances, members‘ benefit rights are determined by the employers depending on the nature of termination (National Labour
Force Survey, op.cit.).
16 2.5 Difficulties Managing Pension Reserve Funds
Most Pensions Funds in Tanzania, and Sub-Saharan Africa Provident or otherwise, have generated surplus resources. Management of these reserves has proven problematic and has contributed to existing and forthcoming difficulties. There are multiple reasons why management of funds has been difficult. To begin, governments have had a considerable degree of say on how pension surplus funds are utilized. In almost all countries, government has either borrowed or appropriated resources from the pension funds. As a consequence, in many cases the interest rates were below market returns, and in some cases below inflation rate. Countries are finding it increasingly necessary to clarify the accounts between the government and the pension funds (Barbone and Sanchez, et al.,
1999).
Besides, the direct use of resources by the public treasury, governments have also directed pension funds to invest in specific projects or companies. These investments have not always been fortunate. There have also been problems with the decisions of fund management regarding where to invest. A favourite area of investment has been real estate.
Problems in this area have come from inflated purchase prices and high construction costs.
The end result has been that pension funds are not adequately funded. This shows up and poses different problems in provident funds and in defined-benefit arrangements. In provident funds, the impact of fund mismanagement falls on the contributors. Thus, the returns to investment that are credited are often below the market rate of return. Even so it may be that not enough funds are available to cover the obligations in the books to beneficiaries—the sum total of savings plus the returns. In this case the provident fund itself is unfunded. In cases like Kenya and Uganda, the extent to which provident funds can actuarially cover their obligations to the beneficiaries depends on successfully finishing on-going real estate projects and the returns to previous real estate investments.
17 The problems that follow in defined benefit schemes are slightly different. Poor reserve fund management will affect the extent to which the funds are balanced, but not necessarily the benefits extended to the beneficiaries, at least in principle. The fact is however, that loss in reserves ends up pressuring an increase in the level of the contributions or lowering benefits indirectly, such as failing to adjust pensions for inflation, or adjusting them too late (Barbone, et al., op.cit.).
2.5.1 Lack of Investment Opportunities
The problems with the management of pension reserve funds do not arise exclusively from bad governance. It has also been the case that over the last decades investment opportunities have been very limited. It appears, in fact, that investment returns in the sub- continent have been low if not negative over the last decades. The profitability crisis and the crisis of the financial sector have not been any less dramatic than the social security crisis. The result has been a loss of credibility in both the public and private sectors
(Barbone, et al., op.cit.).
2.5.2 Issues Specific to the Defined Benefit Schemes
Defined benefit schemes as found in Tanzania face their own specific problems. These systems, as mentioned, combine pension and non-pension benefits, and pension contribution rates have been low, as pointed out above. Initially, these schemes generated operating surpluses. Over time, however, pension obligations have grown faster than contributions. This may appear odd in countries with young populations and fast growing economically active populations. However, the demographics of the formal pension systems are considerably different from the population at large. The number of beneficiaries contributing to the formal pension funds stagnated over the last decade, while
18 the average age of its membership increased. As a consequence, the ratio of beneficiaries over contributors increased dramatically over time, resembling the characteristics of a quickly maturing pension system. It is likely that this situation would worsen in the near future, as membership in the formal pension systems is still linked to public sector employment and civil service reforms and privatization are slowing or even reducing the employment provided by the public sector and its institutions.
Over the longer term, much will depend on the evolution of the formal sectors as economic recovery gets underway. So far the solution has been to redirect resources from other benefits to pay for pensions. A more considered approach will have to include rethinking the level of other benefits, reaching an understanding with government on the outstanding obligations and the form of payment, and, most importantly, taking measures to improve governance and performance before committing to increase pension contribution rates (Barbone et al., op.cit.).
2.5.3 Public Service Pension Obligations
Social security and pension obligations for public employees raise important problems of their own. When there are independent pension systems for public employees, a problem has been that governments did not pay their contributions, thus the fact appropriating the surplus that would have been generated. With pension funds in problems, it is necessary to clear the accounts between the government and the funds, and agree on mechanism for reimbursement. In the absence of a public pension fund, all of the current obligations fall on the budget. The end result has been that the payments for pensions have been increasing. This has been further accelerated by retrenchment. Additionally, civil service reforms have implied substantial salary increases, leading to higher pension outlays now and in the future. This has led some countries to try and set new public pension funds.
19 Salary increases have been used to allow employees to contribute to the funds. Uganda is going through this process now (Barbone, et al, op.cit.).
2.5.4 Provident Fund Difficulties
Some of the problems with provident funds have already been mentioned. The consequence of administrative and financial mismanagement falls on the beneficiaries.
Low pension benefits made the contribution seem like a tax. The result has been the tendency to move away from defined benefit schemes. It is clear that the beneficiaries did not have the mechanisms to monitor management and the government. An option would have been to allow employees and/or employers to exit and form complementary or substitute funds. While this could have been possible (it has happened in other countries outside Africa with provident fund designs) it did not happen to a significant extent. In some countries, like Uganda, the public pension fund successfully argued against these options (Barbone, et al., op.cit.).
2.5.5 Pension Portability
In most countries under review, movement from one pension system to another is likely to imply a loss of pension benefits. This results from two facts. Usually it takes a long-time to be eligible for a pension. Also, countries do not have provisions allowing contributors to carry benefits from one pension system to another. The most obvious example is when moving from the public to the private sector or vice-versa. Unless the contributor has met the minimum years of work to qualify for a pension, movement will imply a loss, since often the person can only take his/her contributions and not the employer‘s. There are other examples. Movement across countries, as in East Africa, will imply loss of accrued benefits. Portability is also important in company pension schemes. Movement from one
20 pension to another will imply a loss of pension benefits, when the employee can only take its contribution and not the employer‘s. Lack of pension mobility then becomes a mechanism to retain labour (Bender, et al., 2013).
2.5.6 Funds Regulation
There is very limited experience in pension regulation in Sub-Saharan Africa. Public pension schemes are subject to the laws that created them. The Ministries of Labor and
Finance often exercise oversight. Private pension funds often fall under the jurisdiction of insurance regulators. Pension specific regulation has recently been introduced in Kenya. In
French-speaking Africa, CIPRES plays the role of a regulator, but is still in a developing stage. The pensions fund regulatory authority has been established since 2008 but not effective start its operations (Barbone, et al., op.cit.). Establishing legislations of the current social security institutions have provisions that conflict in terms of operations.
2.6 Challenges in the Social Security System
According to National Bureau of Statistics, 2001, National Labour Force Survey,1999 highlighted the challenges faced in many African countries continues to building up of credible and sustainable social security institutions, anchored on a clear concept of equity and supported by rules of the game that assure adequate governance. Development of a broad approach to social security that includes all persons both inside and outside the formal system can only be developed gradually and as a result of the efforts countries undertake to design and implement new social protection schemes (National Bureau of
Statistics, 2001).
The initial focus will in most cases be on the reform of formal social security arrangements, to an extent greater than is probably warranted. But, there is hardly any
21 choice given the current difficulties with formal social security systems. In doing so, it is necessary to proceed gradually and by taking careful stock of the existing situations. Social security reform is a difficult area of social policy, since the entitlements it creates are difficult to reverse later on, and long-term effects are difficult to visualize without the support of detailed technical analysis. Solutions that may appear attractive in the short- term can end up having very negative long-term effects.
Countries must avoid at all costs strategies that cannot be sustained over time. Improving social protection for the informal and traditional societies is going to take time, as it requires identifying mechanisms that are tested and feasible. This can only be done by using the lessons that will be gathered from the multiplicity of efforts to improve social protection coverage in the continent. Overtime, it is likely that the problems with the elderly in the informal sector will increase. By then, hopefully the mechanisms will be in place to allow societies to supply them with adequate protection (National Bureau of
Statistics, op.cit.).
2.6.1 Weakening of Informal Social Protection System
Socio-economic developments taking place in Tanzania have resulted into a slow but steady disintegration of the kinship or family-based social support systems on which the majority of Tanzanians have depended for protection against contingencies.
Economic hardships have made it difficult for individuals, families and/or kin members to provide assistance to each other in time of crisis and need. The high rate of urbanisation has also taken its toll on traditional social protection systems. There has been increasing fragmentation with families becoming more dispersed thereby eroding the capacity of extended families to function as social safety nets (National Bureau of Statistics, op.cit.).
22 2.6.2 Limited Growth of the Formal Employment
Public sector reforms have resulted into retrenchment of workers, freezing employment in the public sector and privatisation of public enterprises. These have led to increased unemployment, which in turn has forced more people to resort to employment in the urban informal sector where earnings are often inadequate and/or uncertain. There is however a limited growth in employment in the private sector (National Bureau of Statistics, op.cit.).
2.6.3 Reduced Access to Social Services
Despite the deliberate measures by the government to improve provision of social services to the public, considerable part of the population has either limited or no access to services.
In some instances, cost sharing in the provision of social services has reduced the capacity of the people to access the services (National Bureau of Statistics, op.cit.).
2 6.4 Low Levels of Income
Incomes for the majority of the people in Tanzania are generally inadequate to meet their basic requirements and save for future use (National Bureau of Statistics, op.cit.).
2.6.5 Declaration of Low Insurable Earnings
Some employers provide remunerations composed of basic salaries and allowances, while deductions for social security are based on basic salaries only, leading to lower benefits from social security institutions upon retirement (National Bureau of Statistics, op.cit.).
23 2.7 A General Theory of Financial Risk
2.7.1 Actuarial Approaches to Risk
Actuaries first came to prominence as financial experts through their ability to measure and manage mortality risk in the life assurance and pension fund contexts. The foundation work for this expertise was the empirical investigation set out in Halley, (1696), which describes the construction of the first scientific life table. Some actuaries then applied their mathematical and practical skills to general insurance and in process developed a new ―risk theory‖ covering loss functions and the probability of ruin (Sortino and Satchell, 2001).
The actuarial profession responded to the upsurge in interest in financial risk during the
1980s by setting up AFIR (Actuarial Approach for Financial Risk) as the finance section of the International Actuarial Association. However, although AFIR has now been in existence, and running international colloquia, for more than ten years, no dominant single approach to financial risk has emerged. Instead, colloquium papers have typically reflected a wide spectrum of approaches to risk, with papers following the risk methodologies of financial economics tending to become more frequent over recent years (Clarkson, 1996).
This absence of a dominant single approach to risk is reflected in influential actuarial textbooks such as Daykin, et al., (1994) and Booth, et al., (1999). Various different approaches to risk are shown as being appropriate in different application areas, but there is little conceptual cohesion between the different approaches. A very desirable attribute of any new theory of financial risk will accordingly be a sufficiently high degree of generality to allow all useful existing risk methodologies to be regarded as important special cases
(Clarkson, op.cit.).
24 2.7.2 Expected Utility
The expected utility approach pioneered by Bernoulli, (1738,1954) developed along rigorous mathematical lines by von Neumann and Morgenstern (1944) is one of the cornerstones of present day economic science and is perhaps the most widely used theoretical framework for human choice under conditions of uncertainty and risk.
As will be described in detail below, not only has utility theory been severely criticised by many eminent economists, but its predictions are in many well documented cases markedly inconsistent with observed real world behaviour. There is accordingly considerable doubt as to whether utility theory can mirror the deliberative thought processes of reasonable individual (Sortino and Satchell, 2001).
2.7.3 Anomaly and Paradigm Shift
In the physical sciences, there have been many important instances of revolutionary new theories displacing familiar old theories when, despite considerable effort and ingenuity on the part of their adherents, these old theories cannot be made accurate enough in their explanation of certain features of observed behaviour. The classic example was the
Copernican Revolution in astronomy, when the old system - predicated on the wrong causal mechanism of the earth being the centre of the universe - was replaced by the new system in which all planets orbit around the sun No less radical a change of world view may be needed in the search for a new and better theory of financial risk. In particular, some of the seemingly innocuous axioms of ―rational behaviour‖ may have to be modified or abandoned completely (Clarkson, op.cit.).
25 2.7.4 Neural Mechanics of Physical Risk
The starting point in the derivation of the new theory is the recognition that in the assessment of risk of any type the human mind acts as an analogue computer rather than as a digital computer, with the strength of the risk perception neural response being determined almost instantaneously at a subconscious level rather than as a time-consuming quantitative computation. A corollary is that the neural mechanics of financial risk, where the unwanted outcomes are financial distress or financial ruin at the personal or corporate level, will be identical to the neural mechanics of physical risk, where the unwanted outcomes are injury or death. Since everyday experience provides a vast amount of observational data as to how the human mind assesses and manages physical risk, it should be possible to construct in the first instance a theory of physical risk and then to translate this into a theory of financial risk (Clarkson, op.cit.).
2.7.5 Observations by Adam Smith
2.1.1 In his ―Wealth of Nations‖, Smith, (1776, 1976) observes how the ―absurd presumption in their own good fortune‖ on the part of most people leads to behaviour that is blatantly inconsistent with the ―rational behaviour‖ cornerstone of present day economics: ―The chance of gain is by every man more or less over-valued, and the chance of loss is by most men under-valued‖ (Sortino and Satchell, 2001). Smith cites the popularity of lotteries, where the expected payout is always well below the price of a ticket, as a classic example of the overvaluation of gains. It is salutary to note that in
January 1999 the Chairman of the U.S. Federal Reserve used the phrase ―lottery mentality‖ in connection with his ―irrational exuberance‖ warning that the aggregate market capitalisation of interest-related stocks was vastly in excess of what could be justified by the likely aggregate future profits of the industry. Also, in the first week of January 2000
26 when major stock markets experienced sharp setbacks after the ―new millennium‖ euphoria of December 1999, the Governor of the Bank of England warned that it was very easy for stock markets to become seriously overvalued (Sortino and Satchell, 2001).
As his flagship example of how most people undervalue risk as a result of ―thoughtless rashness and presumptuous contempt‖, Smith cites the failure of many people to insure against serious wealth-destroying hazards such as fit and shipwreck, even although appropriate insurance cover is often readily available at reasonable cost. He also refers to a
―nice calculation‖ on a probabilistic basis whereby risk may be reduced to an acceptable level through what would today be called self-insurance (Clarkson, op.cit.).
‗When a great company, or even a great merchant, has twenty or thirty ships at sea, they may, as it were, insure one another. The premium saved upon them all may more than compensate such losses as they are likely to meet with in the common course of chances‖
(Clarkson, op.cit.). This provides the first pointer towards a new theory of risk, namely that risk cannot be eliminated completely but must be brought down below some small value that is deemed acceptable in all the circumstances (Clarkson, op.cit.).
Smith begins his discussion of the determinants of wages and profit by observing that the theoretical state of equilibrium that would result from every man‘s self interest to ―seek the advantageous and to shun the disadvantageous‖ does not in fact occur, largely because of factors that exist only ―in the imaginations of men‖. This is perhaps the first documented evidence of what might today be called ―systematic irrationality‖ (Clarkson, op.cit.).
In the context of commodity prices (of which stock market prices are perhaps the most important present day examples), Smith observes that, rather than always being close to what he called their ―natural‖ (or equilibrium) value, the observed market prices often
27 differ markedly from these ―natural‖ prices:.―The natural price, therefore, is, as it were, the central price, to which the prices of all commodities are continually gravitating. Different accidents may sometimes keep them suspended a good deal above it, and sometimes force them down even somewhat below it. But whatever may be the obstacles which hinder them from settling in this centre of repose and continuance, they are constantly tending towards it. Smith discusses the annual prices of corn, the most important commodity several hundred years ago, to illustrate the general behaviour of commodity prices. It is instructive to note that his numerical approach of using I0-year moving averages as reference values is identical in principle to the Mean Absolute Deviation analysis of stock market prices described in Plymen & Prevett (1972) and Clarkson (1978,198l).
In his ―History of Astronomy‖, Smith (1795, 1980), when setting out his objectives for the study of philosophy (what we would now call science), comments on an often overlooked
―overconfidence‖ facet of human behaviour, namely the (often wrong) presumption that currently accepted theories in a particular field of human endeavour always represent the best that will ever be available:
―Let us endeavour to trace philosophy, from its first origin, up to that summit of perfection to which it is at present supposed to have arrived, and to which, indeed, it has equally been supposed to have arrived in almost all former times‖.
2.7.6 Observations by John Maynard Keynes
In Chapter 12 of Keynes (1936) it is observed that there are not, in reality, two separate factors affecting the rate of investment, namely expected return and perceived risk in terms of the ―state of confidence‖; confidence effectively dominates whether investment will be contemplated or not. In other words, no matter how attractive the expected return,
28 investment will not be contemplated unless the probability of failure (however defined) is acceptably low. Keynes also observes that a purely quantitative approach is the exception rather than the rule: ―Most, probably, of our decisions to do something positive, the full consequences of which will be drawn out over many days to come, can only be taken as a result of animal spirits - of a spontaneous urge to action rather than inaction, and not as the outcome of a weighted average of quantitative benefits multiplied by quantitative probabilities.‖ Keynes uses a geometry metaphor to emphasise what he saw as the serious limitations of the then current axioms of economic science:
―The classical theorists resemble Euclidean geometers in a non-Euclidean world who, discovering that in experience straight lines apparently parallel often meet, rebuke the lines for not keeping straight - as the only remedy for the unfortunate collisions which are occurring. Yet, in truth, there is no remedy except to throw over the axiom of parallels and to work out a non-Euclidean geometry. Something similar is required today in economics‖
(Keynes, 1921).
This provides a second pointer towards a new and better theory of risk: since the dominant scientific paradigm is the one-dimensional expected utility approach, we should in the first instance attempt to find a two-dimensional approach where expected utility can be regarded as a (possibly inaccurate) special case (Keynes, 1921). In his much earlier
―Treatise on Probability‖ Keynes (1921) suggests various ways in which to achieve better understanding of how the human mind perceives probability and risk. In particular, he is strongly distrustful of the marginal utility of wealth approach that Daniel Bernoulli (1738,
1954) relied upon to ―solve‖ the famous St Petersburg Paradox, and observes that what might be called tacit knowledge, especially regarding Peter‘s ability to pay Paul and the enormous risk of Paul incurring a serious loss, leads to considerable ―psychological doubt‖ which makes a purely mathematical approach difficult (Keynes, 1921). ―We are unwilling
29 to be Paul, partly because we do not believe Peter will pay us if we have good fortune in the tossing, partly because we do not know what we should do with so much money or sand or hydrogen if we won it, and partly because we do not think it would be a rational act to risk an infinitely larger one, whose attainment is infinitely unlikely. When we have made the proper hypotheses and have eliminated these areas of psychological doubt, the theoretical dispersal of what element of paradox remains must be brought about, I think, by a development of the theory of risk.‖ Keynes also suggests an extension of the second maxim of Jacques Bernoulli (an uncle of Daniel), which states that we must take into account all the information we have:
―But should this maxim not be reinforced by a further maxim that we ought to make the weight of our arguments as great as possible by getting all the information we can? . . . .
But there clearly comes a point when it is no longer worthwhile to spend trouble before acting, and there is no evident principle by which to determine how far we ought to carry our maxim of strengthening the weight of our argument.‖
Keynes discusses instances of where the human mind appears to ignore the risk when it is below some very small value, and cites an interesting observation by the French philosopher Buffon (1777) ―I am thinking of such arguments as Buffon‘s when he names l/10,000 as the limit, beyond which probability is negligible, on the grounds that, being the chance that a man of 56 taken at random will die within a day, it is practically disregarded by a man of 56 who knows his health to be good.‖
2.7.7 Observations by von Neumann and Morgenstem
In von Neumann & Morgenstem (1944), the foundation work of modem utility theory, it is assumed that human choice under conditions of uncertainty and risk is based on ―rational
30 behaviour‖ as defined by a set of seemingly innocuous utility axioms. Even the authors themselves had serious doubts about the validity of certain of the axioms, particularly
(3:C:b), but they concluded that this, axiom was ―plausible and legitimate, unless a much more refined system of psychology is used than the one now available for the purposes of economics‖.
The authors also observed that ―the common individual, whose behaviour one wants to describe, does not measure his utilities exactly but rather conducts his economic activities in a sphere of considerable haziness.‖ Despite this admission that ―rational behaviour‖ as defined by their utility axioms was more likely to be the exception rather than the rule in the real world, they expressed their belief that at some future date the benefits of their utility approach might be significant von Neumann & Morgenstem, (1944).
―Once a fuller understanding of economic behaviour has been achieved with the aid of a theory which makes use of this instrument, the life of the individual might be materially affected.‖Many eminent economists of the day, such as Friedman, Malinvaud, Samuelson and Savage, were highly critical of the von Neumann & Morgenstem utility axioms.
However, mathematicians with no practical experience of economics tended to brush these criticisms aside, as exemplified by the highly favourable review in the Bulletin of the
American Mathematical Society (Sortino, and Satchell, 2001). ―Posterity may regard this book a one of the major scientific achievements of the first half of the twentieth century.
This will undoubtedly be the case if the authors have succeeded in establishing a new exact science - the science of economics. The foundation which they have laid is extremely promising‖ (Clarkson, op.cit.). In the Preface to the Third Edition, von Neumann &
Morgenstem brushed aside all criticism of their approach, claiming that they had ―applied the axiomatic method in the customary way with the customary precautions‖.
31 2.7.8 Observations by Maurice Allais
By far the most powerful attack on the highly mathematical approach of utility theory was from Allais, (1953) who argues that there is no single-valued function (such as a value of expected utility) which can provide an accurate guide as to how deliberative choices are made by ―reasonable‖ men. He accordingly concludes that the expected utility maxim cannot be regarded as the criterion of rational behaviour. The now famous ―Allais
Paradox‖ is a counterexample Allais used to support his rejection of the expected utility maxim. When given the choice between receiving film with certainty or of receiving ml,
£lm and £5m with probabilities of 0.01, 0.89 and 0.1 respectively, most subjects choose the former, but when given the choice between receiving nil or £lm with probabilities of 0.89 and 0.11 respectively or of receiving nil or £5m with probabilities of 0.9 and 0.1 respectively, most of the same subjects choose the latter. Such a combination of choices is inconsistent with any expected utility function. Reference will be made at the end of this section to the following similar but less contrived choice. A businessman has sought your actuarial advice as to whether or not he should put his entire working capital of £lm at risk for a business opportunity which will lead either to a profit of £80, 000 with probability
0.95 or to a loss of all £lm of his working capital with probability 0.05, giving an expected profit of £26, 000.In his Nobel Lecture, given on 9 December 1988, Allais (1989) suggests that his paradox demonstrates what he calls ―the preference for security in the neighbourhood of certainty‖, This is a facet of prudential human behaviour that is (to use the phraseology of von Neumann & Morgenstem) ―far more refined‖ than the ―rational behaviour‖ assumptions on which expected utility is based.
Allais, (1954) draws attention to the very serious dangers of building an apparently rigorous mathematical theory on simplifying assumptions that have no real world relevance, and accordingly he suggests that only those who have extensive practical
32 experience gained over a period of many years should attempt to formulate economic models.
2.7.9 Observations by William Sharpe
Sharpe, (1970) investigates utility theory as a plausible framework for the implementation of the Markowitz, (1959) mean-variance approach to portfolio selection, and observes that, of the various possible utility curves that have been proposed, ―Only one is completely consistent with choices based solely on expected return and standard deviation of return: the assumption that utility is a quadratic function of wealth‖. However, on investigating the implications of using a quadratic utility function, he discovers some serious inconsistencies and draws the following conclusions: ―In some instances, investors will be concerned with more than the expected return and standard deviation of return. In such cases a quadratic utility curve will imperfectly approximate an investor‘s actual utility curve. If portfolios with radically different prospects are considered by an investor, too much reality may be omitted if his decision is assumed to depend only on expected return and standard deviation of return.‖ Despite these serious inconsistencies, Sharpe suggests that the use of a utility curve may still be justified if it is assumed that investors choose amongst portfolios of roughly similar risk. However, in many suggested applications of utility theory, such as whether or not to insure against the risk of a serious financial loss, the risk levels of the scenarios being compared differ enormously (Sortino and Satchell, op.cit.).
2.7.10 Attempted Generalisations of Expected Utility
Until the late 1970s, most economists believed that agents were rational and that expected utility provided a highly satisfactory framework for human choice under conditions of uncertainty and risk. However, by the early 1980s the voluminous experimental evidence
33 of axiom violations that had been published over the previous decade, particularly by
Kahneman & Tversky (1979) and Grether & Plott (1979), forced economic theorists to attempt to build more complex new theories that could give a better explanation of real world behaviour. Anand, (1993), Machina (1987) and Quiggin (1993) have been especially prolific in fit of all documenting axiom violations (particularly in the areas of
―independence‖ and ―transitivity‖) and then suggesting more and more complex general & d axiomatic approaches.
The situation is reminiscent of the failure of Ptolemaic astronomy and its eventual replacement by the Copemican system. Despite numerous attempted generalisations down through the centuries, and its latterly horrendous complexity, the Ptolemaic system could not be made accurate enough to achieve its primary objective, namely to provide a practical framework for safe navigation around the world. Also, the Ptolemaic system was predicated on the totally erroneous belief that the earth was the centre of the universe; the
―rational behaviour‖ belief of mainstream economic science in general and of expected utility theory in particular may similarly be seen at some future date as having been no less erroneous (Clarkson, op.cit.).
2.7.11 Absence of an Unambiguous Basic Measure of Risk
In virtually all branches of science where a mathematical approach is attempted, an unambiguous basic measure of key attributes is a necessary condition for the subsequent successful development of a body of theory which can accurately describe real world behaviour. In particular, we need to be able to make unambiguous statements along the lines of ―the value in the case of A is twice the value in the case of B‖ (Clarkson, op.cit.).
34 No such unambiguous basic measure exists for financial risk. In particular, standard deviation of return and variance of return are both used as a measure. However, if the standard deviation in the case of A is twice that for B, the variance for A is four times that for B. What is the ―true‖ value of risk for A as a multiple of that for B? The probability of ruin is also used as a measure of risk, but there is no obvious link between this
―nonparametric‖ measure and a ―parametric‖ measure such as variance. Furthermore, the
Risk Assessment and Management for Projects (RAMP) methodology, which has been put forward jointly by the UK actuarial profession and the Institution of Civil Engineers as a basic framework for practical risk management, does not incorporate an explicit numerical measure of risk. Can such an apparently informal approach be regarded as ―scientific‖
(Clarkson, op.cit.).
2.7.12 Myopic Loss Aversion
Any financial disadvantage resulting from the fit three of these four behavioural traits could be mitigated to a considerable extent by the availability of more detailed information, presented in as impartial a manner as possible. Myopic loss aversion, however, is a much more deeply in gained wealth-destroying behaviour trait. A classic physical risk example is a refusal to fly for either business or pleasure purposes, despite the existence of vast amounts of statistical evidence showing that going by car is vastly more risky, in terms of deaths per passenger mile, than flying with a recognised airline
(Clarkson, op.cit.).
The classic financial risk example is a preference on the part of many investors for long- term investment in bonds rather than equities, despite very strong evidence that the likelihood of equities outperforming bonds increases to near certainty as the investment
35 horizon increases. This equity versus bond question is discussed in detail in Section 6
(Clarkson, op.cit.).
2.7.13 The Tversky Paradox
Tversky, (1978) questions the absolutely fundamental assumption that individuals are
―risk-averse‖ in the generally accepted sense of preferring, for a given expected value, the choice which involves the lowest uncertainty of return, as measured, for example, by the standard deviation or variance of return. If investors have the choice between a gain with certainty of £85,000, or an 85% chance of gaining £l00, 000 and a 15% chance of gaining nothing, most will choose the former, certain, outcome, which is consistent with standard theory Suppose now that investors have a choice between losing £85,000 with certainty, or an 85% chance of losing £l00, 000 and a 15% chance of losing nothing. Most people will
―gamble‖ and choose the latter, which is inconsistent with standard theory. Tversky,
(1990)
2.7.14 A “Risk Equals Uncertainty” Paradox
An insurance company with assets at present of 100 requires assets at some future date of
110 or more to achieve what it regards as a satisfactory return on capital, and will be insolvent if assets have a value of 105 or less at that future date. The company can invest either in asset class A which will give 105 with certainty, or in asset class B which will give 110 or 115 with equal probability. The paradox here is that textbooks on stochastic calculus as applied to finance, such as Lamberton & Lapeyre, (1996), define asset class A as the ―risk-free‖ asset and asset class B as ―risky‖, in that it involves an uncertain outcome. Common sense shows that it is an asset class, that is (pathologically!) risky,
36 whereas asset class B is risk-free in that the criterion of a satisfactory return on capital is achieved with certainty. REF Frank Alphonse Sortino, Stephen Satchell - 2001.
2.7.15 The Other St Petersburg Paradox
2.12.1 Bernoulli (1738, 1954) applies the logarithmic utility approach that he used to
―solve‖ the St Petersburg Paradox to the case of merchant shipping goods from St
Petersburg to Amsterdam. He can sell his cargo for 10,000 ducats if the ship arrives safely, but there is a probability of 0.05 that the ship and cargo are lost at sea, with the requisite insurance cover being available for a premium of 800 ducats, which the merchant regards as outrageously high. Bernoulli asks what other wealth the merchant should possess for it to be rational for him to choose not to insure. Bernoulli obtains the answer of 5,843 ducats, and is very pleased with his approach: (Samuelson, op. cit.). ―Though a person who is fairly judicious by natural instinct might have realized and spontaneously applied much of what I have here explained, hardly anyone believed it is possible to define these problems with the precision we have employed in our examples. Since all our propositions harmonize perfectly with experience it would be wrong to neglect them as abstractions resting on precarious hypotheses‖ (Samuelson, op. cit.).
Taking one ducat as being equivalent to £100, this example is identical to that at the end of
Section 2.4.2. namely whether or not a businessman should put his entire working capital at risk for a business opportunity which will lead either to a profit of £80,000 with probability 0.95 or to a loss of all £lm of his working capital with probability 0.05, giving an expected profit of £26,000. Even with other wealth of around £600,000, the equivalent of Bernoulli‘s computation, most actuaries would strongly discourage the businessman from taking up the opportunity. The obvious corollary is that Bernoulli‘s logarithmic utility approach must after all be based on ―precarious hypotheses‖ (Samuelson, op. cit.).
37 2.7.16 Extreme Value Theory and Financial Risk Management
Mandira Sarma, (2002) defined Financial risk management is about understanding the large movements in the market values of asset portfolios. The conventional approach of estimating market risk measures deal in assuming a Gaussian distribution for the innovations of the return series. This approach may lead to faulty risk measures if the innovation distribution is non-Gaussian, which is often the case for financial series.
The paper uses extreme value theory to explicitly model the tail regions of the innovation distribution of the return series of a prominent Indian equity index, the S & P CNX Nifty.
He find out that the lower tail of the Nifty innovations behaves very much like the lower tail of the standard Gaussian curve, while the upper tail has significant "tail thickness".
This inherent asymmetry and the existence of tail-thickness can provide valuable information to the risk manager. The EVT-based tail quintiles have been used to make daily forecasts of Value-at-Risk for the portfolio under consideration at 95% and 99% levels for a long and a short position in the Nifty portfolio. These forecasts are found to be providing statistically sound risk measures for the portfolio under consideration
(Samuelson, op. cit.).
Mandira Sarma, (2002) also defined Value-at-Risk (VaR) is widely used as a tool for measuring the market risk of asset portfolios. It quantifies in monetary terms the exposure of a portfolio to the market fluctuations. It is defined as the maximum monetary loss of a portfolio such that the likelihood of experiencing a loss exceeding that amount, due to its exposure to the market movements, over a specified risk horizon is equal to a pre-specified tolerance level (Samuelson, op. cit.).
38 Extreme value theory (EVT) deals with the study of the asymptotic behaviour of extreme
(maxima and minima) observations of a random variable. Financial risk management is all about understanding the large movements in the values of asset portfolios. It essentially deals with the analysis of the tail regions of the distribution of changes in the market value of the portfolio. Extreme value theory, by dealing with only extreme observations, can provide a better treatment to the estimation of tail quintiles like VaR. In conventional techniques of measuring risk, inferences about the tail region are made after estimating the entire return distribution. In such an approach, the observations in the interior of the distribution dominate the estimation process and since extreme observations consists only a small part of the data, their contribution in the estimation is relatively smaller than the observations in the central part of the distribution. Therefore in such an approach the tail regions are not accurately estimated Mandira, (2002).
Extreme value theory, on the other hand, focuses primarily on analysing the extreme observations rather than the observations in the central region of the distribution. The theory provides robust tools for estimating only the tails by making use of the available data. Tail quintiles like VaR can be estimated more accurately by using EVT than the conventional approaches.
Another appealing aspect of EVT is that it does not require making a priori assumption about the return distribution. The fundamental result of extreme value theory, known as the
―external types theorem", identifies the possible classes of distributions for movements of the extreme returns irrespective of the actual underlying return distribution. This extremely powerful result of the extreme value theory makes the VaR estimation process free from any a priori assumption about the portfolio return distribution. Moreover, EVT based methods inherently incorporates separate estimation of the upper and the lower tails, and thereby emphasises the necessity to treat both the tails separately due to possible existence
39 of asymmetry in the return series. This becomes important when estimating VaR measures for long and short positions. A conventional model of VaR estimation treats both the tails symmetrically and hence VaR for the long and short positions are assumed to be equal in magnitude.
Mandira Sarma in his paper uses the recent developments of extreme value theory to analyse the tails of the innovation distribution of the Nifty returns. Using the Peaks-Over-
Threshold" (POT) model (McNeil and Frey, 1999) we estimate the tail regions of the innovation distribution of the Nifty returns. We find that the lower tail of the Nifty innovation behaves very much like a Gaussian tail whereas the upper tail behaves significantly different from that of a Gaussian tail. The upper tail is found to exhibit significant ―tail thickness" which indicates existence of asymmetry in the innovation distribution. The existence of asymmetry and the tail thickness in the innovation distribution provides valuable information while estimating risk measures based on tail quintiles.
2.7.17 Extreme Value Theory in Risk Management
There are two broad categories of approaches which uses the results of the extreme value theory while estimating market risk of financial assets. The first among them, known as the
`Block Maxima Model (BMM)' utilises the `extremal type‘s theorem' to model the distribution of extreme (largest or smallest) observations collected from non-overlapping blocks of fixed size from the data. Then the `generalised extreme value' distribution is fitted to these block extrema. This distribution would reflect the behaviour of very high profits (in case of maxima) and very high losses (in case of minima) from the portfolio.
40 For example, suppose the data consists of the daily returns of a particular portfolio and we are interested to analyse the lower tail of the portfolio return distribution. In this case, the
BMM approach would involve the fitting of the GEV distribution H (x) to the minimum observations collected from non-overlapping blocks over the entire sample. If the block size is 25 (a month), the 5th percentile of this distribution would give the magnitude of the daily loss that can be expected with probability 0.05, which is the daily loss level that one can expect to face once in 20 months. Such a value is known as the `stress loss' with probability 0.05.
Longin, (2000) develops a method for VaR estimation using the BMM approach. He develops a formula for VaR estimation by relating the distribution of the extremes and the distribution of the underlying returns in terms of the parameters of the `generalised extreme value' distribution. This approach can be used even for stationary non-iid time series by estimating an additional parameter called the `external index'4. The above measures of market risk are essentially unconditional. These measures are constant over the forecast period, and do not incorporate the changing time series dynamics of the underlying returns.
The second approach, known as the `Peaks-Over-Threshold (POT)' model, attempts to estimate the tails of the underlying return distribution, instead of modelling the distribution of extremes as in the BMM approach. In the POT model, a certain threshold is identified to define the starting of the tail of the return distribution. Then the distribution of the
`excesses' over the threshold point is estimated.
There are two approaches of estimating the `excess' distribution, viz. the semi-parametric models based on the Hill estimator (Danielsson and de Vries, 1997) and the fully parametric model based on the Generalised Pareto distribution (GPD) (McNeil and Frey,
41 1999). The Hill estimator based approach is limited in its application as it requires the assumption of fat tails of the underlying return distribution. On the other hand, the GPD version is applicable to any kind of distribution, fat-tailed or no. This approach utilises the
Pickands-Balkema-deHaan theorem to fit a generalised Pareto distribution to the excesses over specific thresholds.
2.7.18 Liquidity at Risk
Greenspan, (1999) discusses management of foreign exchange reserves. The Liquidity at risk measure is suggested. A country's liquidity position under a range of possible outcomes for relevant financial variables (exchange rates, commodity prices, credit spreads, etc.) is considered. It might be possible to express a standard in terms of the probabilities of different outcomes. For example, an acceptable debt structure could have an average maturity--averaged over estimated distributions for relevant financial variables-
-in excess of a certain limit. In addition, countries could be expected to hold sufficient liquid reserves to ensure that they could avoid new borrowing for one year with certain ex ante probability, such as 95 percent of the time.
2.7.18 Scenario Analysis-Based Contingency Plans
The FDIC (Federal Deposit Insurance Corporation) discuss liquidity risk management and write "Contingency funding plans should incorporate events that could rapidly affect an institution‘s liquidity, including a sudden inability to securitize assets, tightening of collateral requirements or other restrictive terms associated with secured borrowings, or the loss of a large depositor or counterparty.". Greenspan's liquidity at risk concept is an example of scenario based liquidity risk management (Greenspan, 1999).
42 2.7.19 Diversification of Liquidity Providers
If several liquidity providers are on call then if any of those providers increases its costs of supplying liquidity, the impact of this is reduced, the American Academy of Actuaries wrote "While a company is in good financial shape, it may wish to establish durable, ever- green (i.e., always available) liquidity lines of credit. The credit issuer should have an appropriately high credit rating to increase the chances that the resources will be there when needed‖ (Greenspan, 1999).
2.8 Financial Institutions
George and Santomero (1997) explained that financial institutions exist to improve the efficiency of the financial markets. If savers and investors, buyers and sellers, could locate each other efficiently, purchase any and all assets costless, and make their decisions with freely available perfect information, then financial institutions would have little scope for replacing or mediating direct transactions. However, this is not the real world. In actual economies, market participants seek the services of financial institutions because of the latter's ability to provide market knowledge, transaction efficiency, and contract enforcement. Such firms operate in two ways. They may actively discover, underwrite, and service investments made using their own resources, or merely act as agent for market participants who contract with them to obtain some of these same services. In the latter case, investors assemble their portfolios from securities brought to them by these same firms.
In light of the two ways in which institutions may operate in the financial sector, several issues immediately arise. First, when and under what circumstances should these firms use their own resources to provide financial services, rather than offering them through a
43 simple agency transaction? Second, to the extent that such services are offered through the use of the institution‘s own resources, how should it be managing its portfolio so as to achieve the highest value added for its stakeholders (Gertler, 1988), Herring and
Santomero (1991).
2.9 Risk in Financial Services
George and Santomero (1997), discussed the place of risk and risk management in the financial sector with the two key issues, viz., why risk matters and what approaches can be taken to mitigate the risks that are an integral part of the sector‘s product array.
Understanding these two issues leads to a greater appreciation of the nature of the challenge facing managers in the financial community. Specifically, it explains why managers wish to reduce risk, and approaches taken to mitigate something that is an inherent part of the financial services offered by these firms.
2.9.1 Why Does Risk Matter?
According to standard economic theory, firm managers ought to maximize expected profits without regard to the variability of reported earnings. However, there is now a growing literature on the reasons for managerial concern over the volatility of financial performance, dating back at least to 1984. (Stulz, 1984) was the first to offer a viable economic reason why firm managers might concern themselves with both expected profit and the variability around this value. Since that time a number of alternative theories and explanations have been offered to justify active risk management, with a recent review of the literature presenting four distinct rationales.
In Santomero (1995) these include: managerial self-interest, tax effects, the cost of financial distress, capital market imperfections. In each case, the volatility of profit leads to
44 a lower value to at least some of the firm‘s stakeholders. In the first case, it is noted that managers have limited ability to diversify their investment in their own firm, due to limited wealth and the concentration of human capital returns in the firm they manage. This fosters risk aversion and a preference for stability. In the second case, it is noted that, with progressive tax schedules, the expected tax burden is reduced by reduced volatility in reported taxable income. The third and fourth explanations focus on the fact that a decline in profitability has a more than proportional impact on the firm‘s fortunes. Financial distress is costly and the cost of external financing increases rapidly when firm viability is in question.
Any one of these reasons is sufficient to motivate management to concern itself with risk and embark upon a careful assessment of both the level of risk associated with any financial product and potential risk mitigation techniques. In fact, the most well-known textbook in the field, Smith, Smithson, and Wilford (1995), devotes an entire chapter to motivating financial risk management as a value enhancing strategy using the arguments outlined above.
2.9.2 Risk Mitigation Approaches
Accepting the notion that the volatility of performance has some negative impact on the value of the firm leads managers to consider risk mitigation strategies. There are three generic types: risks can be eliminated or avoided by simple business practices, risks can be transferred to other participants, and, risks can be actively managed at the firm level.
In the first of these cases, the practice of risk avoidance involves actions to reduce the chances of idiosyncratic losses by eliminating risks that are superfluous to the institution's business purpose. Common risk avoidance actions, here, are underwriting standards,
45 hedges or asset-liability matches, diversification, reinsurance or syndication, and due diligence investigation. In each case, the goal is to rid the firm of risks that are not essential to the financial service provided, or to absorb only the optimal quantity of a particular kind of risk. What remains is some portion of systematic risk, and the unique risks that are integral to an institution's unique business franchise. In both of these cases, risk mitigation remains incomplete and could be further enhanced. In the case of systematic risk, any systematic risk not required to do business can be minimized. Whether or not this is done is a business decision that can be clearly indicated to stockholders. Likewise, in the case of operational risk, these risks of service provision - including fraud, oversight failure, lack of control, and managerial limitations - can be addressed.
Aggressive risk avoidance activities in both these areas will constrain risk, while reducing the profitability from the business activity. Accordingly, the level of effort focused on reducing these risks can be communicated to shareholders and cost-justified. There are also some risks that can be eliminated, or at least substantially reduced through the technique of risk transfer. Markets exist for the claims issued and/or assets created by many of these financial institutions. Individual market participants can buy or sell financial claims to diversify or concentrate the risk in their portfolios. To the extent that the financial risks of the assets created or held by the financial firm are understood by the market, they can be sold in the open market at their fair market value. If the institution has no comparative advantage in managing the attendant risk, there is no reason for the firm to absorb and/or manage such risks, rather than transfer them. In essence, there is no value-added associated with absorbing these risks at the firm level (Santomero and Trester, 1997, Berger and
Udell, 1993).
However, there is another class of assets or activities where the risk inherent in the activity must and should be absorbed by the firm. In these cases, risk management must be
46 aggressive and good reasons exist for using further resources to manage firm level risk.
These are financial assets or activities that have one or more of the following characteristics. First, the equity claimants, or others for whom the institution has a fiduciary interest, may own claims that cannot be traded or hedged easily by the investors themselves. For example, defined benefit pension plan participants can neither trade their claims nor hedge them on an equivalent after-tax basis.
A similar case can be made for policies of mutual insurance companies which are complex bundles of insurance and equity. Second, activities where the nature of the embedded risk may be complex and difficult to reveal to non-firm level interests, this is the case in institutions such as banks, which hold complex, illiquid and proprietary assets.
Communication in such cases may be more difficult or expensive than hedging the underlying risk. (This point has been made in a different context by both Santomero and
Trester (1997) and Berger and Udell (1993).
Moreover, revealing information about customers or clients may give competitors an undue advantage. Third, moral hazard may exist such that it is in the interest of stakeholders to require risk management as part of standard operating procedures. For example, providers of insurance, e.g., the FDIC, can insist that institutions with insured claims follow appropriate business policies. A fourth reason for institutional risk management is that it is central to its business purpose.
An index fund invests in an index without hedging systematic risk. A security dealer engaged in proprietary trading and arbitrage will generally not be fully hedged. In all of the above circumstances, risk is absorbed and risk management activity requires the monitoring of business activity risk and return. This is part of the cost of doing business since it absorbs management attention.
47 This view of risk mitigation is summarized in Table 1. The risks inherent in the industry are divided into the three categories we suggest, and the techniques of control as well as the goals of risk management for each group are enumerated. The communication challenge of informing stakeholders of the reasons for risk management activity is also reported for each risk category.
With legitimate institutional risk management rationales defined and outlined, non- economic or redundant risk management practices can also be identified. These practices are associated with reducing risks through ill-considered hedges or through inappropriate diversification. Consider a recent example. During the 1980s a number of companies diversified into unrelated businesses. This was an attempt by their managements to break out of the cyclical nature of the profitability inherent in their basic franchise. Regardless of outcome, these investments could not help shareholders unless management had valuable skills in these areas. Clearly, without such skills, owners of the firms‘ stock could make such investments on their own.
48 Table 2.1: Firm Level Risk Mitigation Approaches
Risks to be e avoided Risks to Risks that must /eliminated transferred be actively managed Risk 1.Reduce chance of 1.Buy/sell 1.Act as agent for Avoidance idiosyncratic losses financial others Goals arising from business claims who cannot activities to diversify or hedge/trade 2.Shed superfluous risks concentrate 2.Protect proprietary by devoting resources to portfolio knowledge risk avoidance risks 3.Disclosure 3.Absorb only optimal 2.Sell assets complex or quantity of particular with risks not legal risk which the firm 4.Avoid moral has no hazard clear 5.Key element of competitive business advantage in purpose managing
Techniques of •Due diligence •Sale •Active risk Risk Control •Diversification •Syndication management •Matching •Derivative •Hedging hedging
Risk •Minimize non-relevant •Concentrate •Center firm on Management risk on risks in distinctive Goals •Control and protect which firm has competency profitability competitive •Control and protect advantage profitability
Communicati •Control justified risk •Cost justify •Communicate risk on avoidance practices business management Challenges activity after objectives risk •Communicate risk transfer management competency •Develop a track record
Source: LAPF Risk Management Policy
2.9.3 Taxonomy of Financial Institutions, Services, and Risks
George and Santomero (1997), Subdivided risk mitigation strategies into the three categories above, i.e., avoidance, transference, and active firm-level risk management, is conceptually useful. However, applying this classification to the full array of financial
49 institutions and their activities is somewhat more difficult. Accordingly, in this section we will present taxonomy of the services provided by the various members of the financial sector and the different types of risks that are part of the process.
We begin with the realization that a wide variety of organizations qualify as financial institutions. These include depositories (banks, thrifts, and credit unions), insurance companies (life, property and casualty, auto and health), investment companies (open-and closed-end funds,), pension funds (defined benefit and defined contribution), origination firms (insurance and security brokers, investment management companies, and mortgage bankers), market makers (specialists, dealers and reinsurance companies), exchanges
(stock, insurance, and derivatives), clearing houses, and a set of largely unregulated firms, finance companies of various sorts (consumer and commercial, captive and lease finance, and pawn brokers).
Some of these financial institutions act as principals, while others are agents for investors in transactions. Some institutions actively assume systematic and unsystematic risks, while other similar firms eschew risk altogether. What they have in common is their business focus on transacting the financial instruments generated by economic activity. To some extent, each type of institution provides one or more distinct financial services to facilitate the flow of funds between savers and investors in an economy.
2.9.4 Basic Financial Services
George and Santomero (1997), highlighted the services provided by the set of institutions above can be separated into six distinct activities. These are origination, distribution, 99 packaging, servicing, intermediating, and market making. (we distinguish here between the basic financial services offered by financial institutions and the six core functions outlined
50 by Merton (1993) and Merton and Bodie (1995) that a financial system provides. In our view, institutions providing the basic services that we define will create a financial system that provides core functions as defined by Merton).
A Brief Discussion Illustrates Each Service
Origination involves locating, evaluating and creating new financial claims issued by the institution's clients. The originator first assembles and evaluates information concerning the transaction. On the one hand, if the originator plans to maintain ownership of the new asset, it must set its own standards of acceptable risk and return for it to act as principal, as well. On the other hand, if the originator plans to act as an agent and sell the product, it must abide by the underwriting standards of other principals. An example of the latter is a mortgage banker that must originate mortgages in conformance with agency standards to sell such mortgages into an agency sponsored pool of mortgages (George and
Santomero1997).
Distribution is the act of raising funds by selling newly originated products to customers that have the resources available to finance them. This activity can be conducted as either a brokered transaction or with the institution acting as principal. In the former, newly originated assets are placed with investors who directly remit to the issuing firm. The financial institution never takes ownership of the asset in question, but merely facilitates its placement into a third party's portfolio. In the latter, the initiating institution purchases the originated assets and sells or distributes them from its own inventory. Most retail sales are made on a brokered basis, while institutional distribution is most frequently conducted with an institution acting as principal (George and Santomero, op.cit.).
51 Servicing involves collecting payments due from issuers and paying the collected funds to claimants. In addition, a servicer maintains payment records, monitors contracts, and pursues action in defaults. In less developed economies, this aspect of financial service provision is relatively invisible. Most assets are originated and held by the same institution, particularly in the fixed income area. Accordingly, the customer service aspect of lending is less obvious. In developed economies, servicing is seen as a distinct business activity in the financial markets (George and Santomero, op.cit.).
Packaging is a relatively recent activity. It involves the collection of individual financial assets into pools, and possibly the decomposition of the cash flow from such assets again into different types of financial claims. Such repackaging of financial flows is done with an eye toward increasing liquidity or tailoring cash flows for specific customers. For example, securitizing mortgages creates a liquid market for residential mortgages in agency sponsored pools, while a REMIC divides the principal and interest flows from the pools into different classes of bonds (George and Santomero, op.cit.).
Intermediating involves the simultaneous issuance and purchase of different financial claims by a single financial entity. It occurs when an institution purchases one type of financial instrument for its own account and finances the transaction by issuing a claim against its own balance sheet. Three types of such financial intermediation activity are common. These are: (i) insurance underwriting whereby the issuer assumes the policy's contingent liability, (ii) loan underwriting, whereby the intermediary uses its own resources in extending credit to a borrower, and (iii) security underwriting which involves buying securities as principal to distribute to investors (George and Santomero, op.cit.).
Market making is an activity involving the buying and selling of identical financial instruments by a dealer. The market making firm is usually, but not always, a principal in
52 the transaction. A market marker acts as an intermediary when it finances inventory by issuing its own claims, e.g., security underwriting. Gains and losses associated with the change in inventory value accrue to the market maker's financial benefit or loss. Recently, several commercial auction firms have made markets for loans as the seller's agent. In this case, buyers and sellers take principal risks and the auctioneer gets a commission, acting more as an agent for bringing together buyers and sellers than as a market maker. It is important to distinguish between principal and agency activities in all of these services.
The risks and incentives are quite different.
A principal commits capital and risks both time and money. The capital requirements of this business can be substantial. A principal owns a portfolio and suffers from systematic and idiosyncratic risks. Quite differently, an agent works for someone else and risks time alone. In an agency business, investment of capital is modest. The risks are wholly idiosyncratic (George and Santomero, op.cit.).
2.9.5 Risks in Providing Financial Services
George and Santomero (1997), Identifies the risks associated with the provision of financial services differ by the type of service rendered. In general, the first four services, namely, those of originators, distributors, services and packagers are provided more or less on an agency basis. These services facilitate market access for buyers and sellers of financial instruments and provide little risk to the service provider. The last two, intermediation and market making, however, are largely principal businesses. In essence, these activities place a principal and his capital between direct trades by buyers and sellers.
It is in these areas that the financial institution retains the bulk of the risk of the service provided, and where effective risk management is most crucial. Neither an intermediary
53 nor a market maker will be perfectly hedged against all risks, and thus, its investors will bear an array of financial risks associated with the institution's activities.
Taxonomy of such risks will be helpful. The risks borne by these financial institutions can be broken into five generic types: systematic, credit, counterparty, operational, and legal.
See Table 3. Briefly, we will discuss each of these risks facing the institution.
Systematic risk is the risk of asset value change associated with systemic factors. As such, it can be hedged but cannot be diversified completely away. In fact, systematic risk can be thought of as diversifiable risk. Financial institutions assume this type of risk whenever assets owned or claims issued can change in value as a result of broader economic conditions. As such, systematic risk comes in many different forms. For example, as interest rates change, different assets have somewhat different and unpredictable value responses. Energy prices affect transportation firms' stock prices and real estate values differently. Large scale weather effects can strongly influence both real and financial asset values for better and worse. These are a few types of systematic risks associated with asset values.
Some financial institutions decompose systematic risk more finely. Institutions that have substantial balance sheet reactions to specific systemic changes may try to estimate the impact of these particular systematic risks on performance, attempt to manage them, and thus limit their sensitivity to variation in these diversifiable factors. Accordingly, many institutions heavily involved in the fixed income market attempt to track interest rate risk closely and more rigorously than those that have little rate risk in their portfolios.
(Commercial banks are a clear example of such institutions. Therefore, they have devoted considerable energy to interest rate risk management (Esty, Tufano and Headly, 1994,
Santomero, 1997).
54 They measure and manage the firm's vulnerability to interest rate variation, even though they cannot do so perfectly. Likewise, international investors are aware of foreign exchange risk and try to measure and restrict their exposure to it. (Jesswein, Kwok, Folks
(1995). In a similar fashion, investors with high concentrations in one commodity need to concern themselves with commodity price risk and perhaps overall price inflation, while investors with high single industry investments monitor both specific industry concentration risk and the forces that affect the fortunes of the industry involved.
Credit risk arises from non-performance by a debtor. It may arise from either an inability or an unwillingness to perform in the pre-committed contracted manner. This can affect the lender who underwrote the contract, other lenders to the creditor, and the debtor's own shareholders. Credit risk is diversifiable but difficult to hedge perfectly. This is because most of the default risk may result, in fact, from the systematic risk outlined above. The idiosyncratic nature of some portion of these losses, however, remains a problem for creditors in spite of the beneficial effect of diversification on total uncertainty. This is particularly true for creditors that lend in local markets and take on highly illiquidity assets. (Accordingly, lending institutions actively manage their credit portfolios. See
Morsman (1993) or Babbel and Santomero (1997) for a presentation of the techniques used by the banking and insurance industry respectively).
Counterparty risk comes from non-performance of a trading partner. The non- performance may arise from counterparty‘s refusal to perform due to an adverse price movement caused by systematic factors, or from some other political or legal constraint that was not anticipated by the principals. Diversification is the major tool for controlling non-systematic counterparty risk.
55 Counterparty risk is like credit risk, but it is generally considered a transient financial risk associated with trading, rather than a standard creditor default risk associated with an investment portfolio. Counterparty‘s failure to settle a trade can arise from many factors other than a credit problem (Santomero, 1997) for a discussion of how banks manage counterparty risk).
Operational risk is associated with the problems of accurately processing, settling, and taking or making delivery on trades in exchange for cash. It also arises in record keeping, computing correct payment amounts, processing system failures and compliance with various regulations. As such, individual operating problems are small probability events for well-run organizations, but they expose a firm to outcomes that may be quite costly
(Santomero, 1997).
Legal risks are endemic in financial contracting and are separate from the legal ramifications of credit, counterparty, and operational risks. New statutes, court opinions and regulations can put formerly well established transactions into contention even when all parties have previously performed adequately and are fully able to perform in the future. For example, the bankruptcy law enacted in 1979 created new risks for corporate bondholders. Environmental regulations have radically affected real estate values for older properties as well. A second type of legal risk arises from the activities of an institution's management or employees. Fraud, violations of securities laws, and other actions can lead to catastrophic loss, as recent examples have demonstrated (Santomero, 1997).
All financial institutions face these risks to some extent. Non-principal or agency activity primarily involves operational risk primarily. Since institutions in this case do not own the underlying assets in which they trade, systematic, credit and counterparty risk accrues directly to the asset holder (Santomero, 1997).
56 If the latter experiences a financial loss, however, legal recourse against an agent is often attempted. Therefore, institutions engaged in only agency transactions bear some legal risk, if only indirectly. Our main interest, however, is in the businesses which the institutions participate as principals. In these activities, principals must decide how much business to originate, how much to sell, how much to contract to agents, and how much to finance and manage themselves. Principals must weigh both the expected profit and the various risks enumerated above to assure stockholders that the result achieves the stated goal of maximizing shareholder value. The result of this exercise will permit a wide range of financial institutions to co-exist (Santomero, 1997).
2.9.6 When to Practice Risk Management
George and Santomero (1997) differentiate the REMIC (a real estate mortgage investment conduit) and commercial banking firm is stark. The debt and equity claims issued by both the REMIC and the commercial banking firm are risky in almost any sense. Yet, in the case of the REMIC, investors buy the instruments and seldom hold the intermediary accountable for the ex post performance of the instruments it issues. The trustee, as fiduciary for the regular and residual interest holders, monitors the servicer and foreclosure firm for a fee. However, the trustee is not held liable for market performance. From a theoretical standpoint, the REMIC is the ultimate passive intermediary. Conversely, active management is a critical part of the commercial bank's activity. It originates and manages illiquid assets that have imprecise values in the open market. These assets' values change over time, as do the assets themselves. Unlike the REMIC, the bank has no predetermined life span or asset replacement constraints (George and Santomero, 1997).
57 2.9.7 Understanding the Differences between Institutions
The difference between a REMIC and a banking intermediary is the transparency and permanency of the organization's investor interests. An investor in a REMIC can obtain a very detailed description of the assets, contracts, and payment schemes for regular interests. The rules for operation are quite clear. Thus, unexpected events that severely affect the REMIC's value are many, but they do not lead to questions of confidence or competence on the part of the trust .In a typical actively-managed financial firm, however, such information is not available to anyone but management, due to the uncertainty concerning the economic value of financial claims. Either because of tied-in product composition, as in the case of insurance products, or because of ambiguity in underlying asset value, pricing these assets and therefore shareholder value, is problematic for the intermediary.
In addition, the extent of dynamic asset change and the rules followed for such portfolio adjustment are rarely communicated, nor are they subject to monitoring, due to the features of the assets held. From the above, one may be able to generalize from the distinctions between these two institutional type. For simplicity, allow institutions to be transparent, translucent, or opaque in information and either active or passive in operation. We can fill in categories with different institutions. Discretionary risk management activity is concentrated in the actively managed opaque institutions. These are clustered in the top right-hand corner Bodie, et al., 1992).
On the other hand, transparent institutions with rather passive investment strategies are located in the lower left corner. In these institutions, rules substitute for management.
Institutions also exist at the other extremes. In the upper left hand corner actively managed institutions such as open end mutual funds can be found. These entities are fully
58 transparent, but actively managed in a manner clearly defined by their prospectus. These institutions limit risk management to eliminating unnecessary risk in a manner outlined in
Section 2 above.
They shed nonessential risk at the same time that they seek those risks essential to the value-added activity. At the other extreme, agency mortgage pools flourish, but only with implicit government guarantees. The opaqueness of these portfolios makes the institutions' asset value uncertain, and only through credit enhancements can the investor be convinced of the timeliness of future cash flows. Institutions can also flourish in the interior of this two dimensional space. Horizontally, this region is referred to as translucent because some knowledge is available, but it is often not timely, nor wholly credible (Bodie, et al., op.cit.).
Vertically, the intermediate region can be dimensioned by the portfolio turnover rate, which increases as one moves from a purely passive portfolio to a more actively managed one. For institutions in this intermediate range, a substantial amount of energy is spent on communicating with stakeholders, and to presenting clear statements of investments or investment policy. These actions should be seen as attempts to clarify the position of the institutions and perhaps move the institutions to increase transparency. At the same time, fees associated with intermediation services tend to be correlated with the extent of active management. For example, index funds generally carry lower management fees than either actively managed investment funds or depository institutions. In part, this is because the latter have higher operating costs, associated with more portfolio transactions and a higher turnover rate (Bodie, et al., op.cit.).
However, it is also due to the presumed greater value-added provided by these managers.
Discretion is given because of their expertise in their chosen market, and their associated
59 reputation for supra-normal performance and skill in active risk management. (The ability of fund managers to provide such services has long been debated (Treynor, 1966, or more recently Bodie, et al., 1992). In essence, one of the value-added activities performed by management is the control of risk at the firm level, so as to increase portfolio value to stakeholders.
2.9.8 Requirements for Active Risk Management Techniques
Thus far it has been argued that risk is an essential ingredient in the financial sector, and that some of this risk will be borne by all but the most transparent and passive institutions.
In short, active risk management has a place in most financial firms. In light of this, what techniques can be used to limit and proactively manage risk? And, what are the necessary procedures to implement in order to adequately manage the risks which have been identified as the responsibility of firm management? The answers to these questions are straightforward and are the issues to which we now turn. If management is going to control risk; it must establish a set of procedures to obtain this goal. In the financial community this is referred to as a firm-level risk management system. Its goal is to measure and manage firm level exposure to various types of risks which management has identified as central to their franchise. For each risk category, the firm employs a four-step procedure to measure and manage firm level exposure. These steps include: standards and reports, position limits or rules, investment guidelines or strategies, incentive contracts and compensation.
In general, these tools are established to accurately define the risk, limit exposure to acceptable levels, and encourage decision makers to manage risk in a manner that is consistent with management's goals and objectives. To see how each of these four steps of
60 a risk management system achieves these ends, we elaborate on each part of the process below:-
(i) Standards and Reports
The first step of these control techniques involves two different conceptual activities, i.e., standard setting and financial reporting. They are listed together because they are the sine qua non of any risk management system. Underwriting standards, risk categorizations, and standards of review are all traditional tools of risk control. Consistent evaluation and rating of exposure is essential for management to understand the true embedded risks in the portfolio, and the extent to which these risks must be mitigated or absorbed.
The standardization of financial reporting is the next ingredient. Obviously, outside audits, regulatory reports, and rating agency evaluations are essential for investors to gauge asset quality and firm-level risk. These reports have long been standardized, for better or worse.
However, the need here goes beyond public reports and audited statements to the need for management information on asset quality and risk posture. Such internal reports need similar standardization and much more frequent reporting intervals, with daily or weekly reports substituting for the quarterly GAAP periodicity.
(ii) Position Limits and Rules
A second step for internal control of active management is the establishment of position limits. These are imposed to cover exposures to counterparties, credits, and overall position concentrations relative to systematic risks. In general, each person who can commit capital has a well defined limit. This applies to traders, lenders, and portfolio managers. Summary reports to management show counterparty, credit, and capital exposure by business unit on a periodic basis. In large organizations with thousands of positions maintained and
61 transactions done daily, accurate and timely reporting is quite difficult, but perhaps even more essential.
(iii) Investment Guidelines
Third, investment guidelines and strategies for risk taking in the immediate future are outlined in terms of commitments to particular areas of the market, the extent of asset- liability mismatching or the need to hedge against systematic risk at a particular time.
Guidelines offer firm level advice as to the appropriate level of active management - given the state of the market and the willingness of senior management to absorb the risks implied by the aggregate portfolio. Such guidelines lead to hedging and asset-liability matching. In addition, securitization and syndication are rapidly growing techniques of position management open to participants looking to reduce their exposure to be in line with management's guidelines. These transactions facilitate asset financing, reduce systematic risk, and allow management to concentrate on customer needs that centre more on origination and servicing requirements than funding position.
(iv) Incentive Schemes
To the extent that management can enter into incentive compatible contracts with line managers and make compensation related to the risks borne by these individuals, the need for elaborate and costly controls is lessened. However, such incentive contracts require accurate position valuation and proper cost and capital accounting systems. It involves substantial cost accounting analysis and risk weighting which may take years to put in place. Notwithstanding the difficulty, well designed compensation contracts align the goals of managers with other stakeholders in a most desirable way (Jensen and Meckling (1976), and Santomero (1984) for discussions of the shortcomings in simple linear risk sharing
62 incentive contracts for assuring incentive compatibility between principals and agents. In fact, most financial debacles can be traced to the absence of incentive compatibility, as the case of deposit insurance illustrates.
2.9.9 Derivatives
Peter R. Crabb, Financial Risk Management: The big and the small (September 2003), writes on derivatives. Options and futures derive their value from other financial assets.
Such assets are called derivatives. A derivative is any financial contract whose value is dependent upon the value of some underlying asset. Derivatives can be used to reduce risk
(hedge) or take on risk (speculate). For financial risk management purposes, we are only concerned with hedging; speculating is not the job of the business manager. To many,
―derivatives‖ is a four-letter word. Businesses both large and small have seen the problems that reckless use of derivatives can cause.
In the early 1990s Procter and Gamble Corporation lost over $100 million through speculative use of interest rate derivatives. In discussing the loss, P&G Chairman Edwin L.
Artzt said "Derivatives like these are dangerous and we were badly burned. We won't let this happen again"(Wall Street Journal. (Eastern edition) New York, N.Y.: Apr 13, 1994. pg. A3) In the same year Gibson Greetings Inc. said it incurred a $3 million loss as a result of "unauthorized" interest-rate swaps involving "aggressive forms of derivatives." Both very large and medium sized firms have incurred large losses from the improper use of derivatives; the small firm could never survive such a loss. So, we know that derivatives should not be used without ―authorization‖ or ―aggressively‖. That is, firms should not speculate with derivatives. But should the small firm use derivatives to hedge risks? If the firm is to be profitable, it must exploit the valuable opportunities it faces. This in no doubt involves risk. Firms, therefore, should avoid risks that are not profitable so that it can take
63 on the risks that are. Derivatives can be used for this purpose, but the firm must have a strong process in place to assure it is actually hedging, and not speculating.
2.9.10 Empirical Findings on Derivatives
Numerous academic studies have sought to answer why firms use derivatives. Support has been found for each of the theoretical hedging motives discussed above (see for example
Bailly, et. al. (2003) Gay, et. al. (1998), Geczy, et. al. (1997), Graham and Rogers (2002), and Nance et. al. (1993)). Surprisingly though, is the consistent finding in these studies that the use of derivatives is positively correlated with firm size. This finding suggests that the firms less likely to need derivatives as a hedging tool, because they have the opportunity to diversify in the manner of McDonald‘s Corporation, is the most likely to use it. Proctor &
Gamble is a multi-billion firm with operations around the world and in numerous product offerings, but according to the empirical research, P&G is likely to have numerous derivative positions and Gibson Greetings is unlikely to use derivatives.
2.9.11 Why Do Smaller Firms with Less Diversifiable Risk Choose Not to Use
Derivatives?
Many answers to this question have been proposed, but two stand out. First, derivative use is often seen as a sophisticated process that requires an advanced academic degree, usually in mathematics. This is more likely to be true when the firm faces many risk exposures: currency values, commodity prices, interest rates, etc. Second, the costs of deciding upon and setting derivative positions may be high. These costs include both monetary investments in advisor and broker fees and the time management must devote to the process. Smaller firms are unlikely to have the managerial resources available to devote to the process. Large corporations often employ a full-time risk manager to identify and
64 analyze possible loss exposures. Is risk management therefore out of the question for the small business manager? Is the small firm not only unable to diversify, but also unable to transfer risks by taking derivative positions? To answer the question, I next look at the risk management systems in place a three sample firms.
2.9.12 Risk Management Procedures
Crabb, (2003) identifies procedures for risk management any risk management program should include the following four steps: A strategic decision for managing financial price risk must exist. As always, financial operations should support business operations, not the other way around. Examples of such strategic purposes include the need to create good managerial incentives, supporting research investments, and supporting capital investments. These purposes are consistent with the objective of serving the company by allowing it to avoid risks that are not profitable so that it can take on the risks that are
(Crabb, 2003).
The full economic exposure must be identified. After identifying a market price risk such as foreign currencies or interest rates, the firm must identify if there are any natural offsetting positions in its operations. In this manner, the firm is using the benefit of diversification if it exists. Only derivatives that match the risk exposure should be used.
The company must choose a specific derivative instrument to manage a specific type of risk. Risks affecting cash flow from operations are often best managed with options, because cash flows are hard to predict. More predictable asset positions can frequently be managed with forwards and futures (Crabb, 2003).
Speculation in derivatives should never take place within the firm. Taking positions in derivatives is generally easy and inexpensive, and when using derivatives, a firm‘s
65 exposure to financial price risk can quickly rise, instead of falling, without the proper controls. It is therefore imperative that the firm monitor its derivative positions frequently and measure risks accurately. Monitoring by an outside entity such as the firm‘s bank and its auditors is helpful. Further controls, such as setting specific time frames for hedge positions, can also help the firm avoid losses in derivative markets. By duplicating these big-firm practices small firms can improve their businesses through financial risk- management (Crabb, 2003).
2.9.13 Measures to Combat Financial Risks
There are four main measures in dealing with financial risks namely actuarial valuation, hedge, derivatives, and diversification (Shannon, 2002).
2.9.13.1 Actuarial Valuation
An actuarial valuation of a retirement plan is an estimate of a plan's financial position at a specific point in time. During a valuation, an actuary takes a ―snapshot‖ of the membership as of a given date to determine the plan‘s liabilities and funded status.
An actuarial valuation projects the expected cash flow of plan members‘ benefits.
Actuarial projections are derived from a combination of judgement and mathematical models, based on assumptions about the likely occurrence of future events that affect the outcome and duration of pension benefits (Boorack, 2008).
2.9.13.2 Hedge
A hedge is a form of risk compensation using a counter-trade or covering transaction designed to offset an existing or potential risk position by eliminating or diminishing the
66 element of risk (in particular, price, interest rate or exchange rate risk) (Kahan & Rock,
2007).
Hedgers are parties at risk with a commodity or an asset, which means they are exposed to price changes. They buy or sell futures contracts in order to offset their risk. In other words, hedgers actually deal in the commodity or financial instrument specified in the futures contract. By taking a position opposite to that of one already held, at a price set today, hedgers plan to reduce the risk of adverse price fluctuations—that is, to hedge the risk of unexpected price changes (Virtual University of Pakistan, 2008).
2.9.13.3 Derivatives
A derivative is a financial instrument - or more simply, an agreement between two people or two parties - that has a value determined by the price of something else (called the underlying).It is a financial contract with a value linked to the expected future price movements of the asset it is linked to - such as a share or a currency (McDonald, 2006).
A financial derivative is a tool which derives its value from an underlying asset, where the asset can be anything that exists as a tradable entity. This value is derived on the future expectation of the asset price movement to be experienced by the investors involved in the transaction of the particular asset. Derivatives, as risk management tools, can only spread or distribute the risk of price movements rather than reducing any risk that is associated with the future change in price of the underlying asset (Bryan and Rafferty, 2007).
2.9.13.4 Diversification
Diversification in finance means reducing risk by investing in a variety of asset If the asset values do not move up and down in perfect synchrony, a diversified portfolio will have less
67 risk than the weighted average risk of its constituent assets, often less risk than the least risky of its constituents (Sheffrin, 2003). The insurance principle illustrates the concept of attempting to diversify the risk involved in a portfolio of assets (or liabilities). In fact, diversification is the key to the management of portfolio risk, because it allows investors; significantly to lower portfolio risk without adversely affecting return (Virtual University of Pakistan, 2008).
2.10 Research Gap
This related literature on the management of financial risks in social security institutions in the developed countries is largely conducted than there in developing countries. Besides, certain scholars such us (Alexander, 2003) whose work was ―The Present and Future of
Financial Management‖ focuses on transparency in the trading and new and complex systems. He confirms that products and business practice risks increases because of the menace of mis-pricing and mis-selling these products, and human risks in general increase because only a few experienced people understand the systems and products.
The reviewed literature found to have conflicting ideas. The reviewed literature did not tell precisely the position of management of financial risks and its circumstances. They also failed to tell us on what situation can turn out to be a exposure to institutions Security. The study has focused on removing those gaps by finding a clear answer towards those areas.
Consequently, this study contributes to existing research literature and at the same time provides employers, policy makers and other stake-holders relevant information on how this domain can contribute to social economic welfare.
68 2.11 Conceptual Framework
Structured from a set of broad ideas and theories are conceptual framework that help a researcher to properly identity the problem they are looking at, frame their questions and find suitable literature. A conceptual framework is thus a tool researchers use to guide their inquiry in terms of identifying research variables, and clarifying relationships among the variables (Smyth, 2004). In this study, security risk management analysis is a complex area. It encompasses four aspects namely risk assessment, risk mitigation, security best- practice, and security technology. There are many research groups behind the development of security risk management study such as risk modelling, risk assessment analysis, intrusion detection, and forensic investigation as shown in Figure 2.1.
Figure 2.1: Security Risk Management
Source: Adopted from Nayot Poolsappasit, 2010
69 2.12 Summary
The chapter has provided the study overview, in introduction, definition of key concept, types of packaging material, consumer preference and the functional of packaging. While the subsequently chapter (Chapter III) focuses on the methodology of the study.
70 CHAPTER THREE
RESEARCH METHODOLOGY
3.0 Introduction
This chapter describes the procedures that were followed in conducting the study. It gives details regarding research design, population of the study area, sample and sampling techniques, a description of data collection instruments that were used, as well as the techniques that were used to analyze data. The study took place at LAPF Pensions Fund
(LAPF) headquarters in Dodoma region.
3.1 The Area of Study and its Description
Dodoma Region lays at 40° to 70° Latitude South and 350° to 370° Longitude East it is a region centrally positioned in Tanzania and is bordered by four regions namely; Manyara in the North, Morogoro in the East, Iringa in the South and Singida in the West. Much of the region is a plateau rising gradually from some 830 meters in Bahi Swamps to 2000 meters above sea level in the highlands north of Kondoa.
The region was established in 1963 consisting of three rural districts and one Township
Authority. To date, Dodoma region has four rural districts and one urban District namely;
Dodoma-Rural, Kondoa, Mpwapwa, Kongwa and Dodoma Urban. The region is the 12th largest in the country and covers an area of 41,310 sq. km equivalent to 5% of the total area of Tanzania Mainland. Based on the growth rate of 2.4 percent and taking 1988 as a base year, the current (2012) Regional population is estimated at 1,735,000 Dodoma Urban
280,781 whereby male 135,094 and female 145,688 latitude of -6,1833(650‘59.988‖S) and
71 longitude of 357500 (3545‘0.000‖E) and it have altitude of 1032 m above the sea level. It coordinates are 6o0‘0‖E in DSM (degree minutes second) or -6 and 36 (in decimal degree).
The study was conducted in Dodoma it is managerially divided into one parliamentary constituency, 4 divisions, 37 wards, 39 villages, 100 mitaa and 222 hamlets. While the original inhabitants of the District are believed to be the Wagogo and Warangi there are now a quite good amount of mixed tribes from neighbouring regions; this is due to trade and cultural relationships in the area. According to the population and housing census of
2012, Dodoma District had 410,956 people of which male are 196,487 and females
211,469 with the households‘ size growth of 4.4. The number of households is
93,339.Growth rate is 2.7% Economic activities carried at Dodoma Urban are agriculture, fishing activities, trading and industries activities. The Figure 2.1 indicates the locality of the area of the study.
72 Figure 2.1: Map of Dodoma Region
D O D O M A U R B AN D IS TR IC T
H O M B O LO
#S M s is i N G a w a y e
#S #S H o m bo lo m a k u lu
M k o y o C H IH AN G A #S
C h ih a n g a #S
#S Z e p is a H o m bo lo b w a w a n i #S
#S M c h e m w a M z a k w e #S #S lo o N za s a b m M B A LA W AL A M AK U TU P O R A o H #S e V e y u la ak #S L M b a la w a la #S
M S A LA TO Ip a la
M s e m b e ta #S M s a l a t o #S #S #S K it e le la #S Lu g a l a IP A LA C h a h w a #S C h ig on g w e M IY U JI M a h o m a n y ik a M a h o m a m a k u lu #S #S #S V ik o n je N a la M p a m a a #S #S #S #S M iy u ji N AL A N d a c h i N ZU G U N I
#S M t u m b a N zu g u n i #S #S S w a s w a
ZU Z U Zu z u Ih um w a M TU M B A #S D O D O M A #S Y# D o do m a m a k u lu
#S K IK O M B O M ic h e s e #S #S #S Iy u m b u C h id id im o K Ik o m b o
#S #S M k o n z e N ty uk a #S M a p in d u zi N k o n g 'o n h a #S
#S M K O N ZE TAM B U K AR E L I #S C h ol ol o C h is ic h ili M b a b a la 'A ' #S N G H O N G 'O N H TA
#S
M B A B A LA #S M a t u m b u lu D O D O M A U R B A N D IST R I C T M b a b a la 'B ' #S # #S Y D IS T R IC T H E A D Q U A T O R S
C h izo m o c h e #S D IV IS IO N H E A D Q U A T O R S
#S #S V IL L A G E C E N T E R M p u n g uz i D O D O M A M J IN I D IV IS IO N H O M B O L O D IV IS IO N M P U N G U Z I K IK O M B O D IV IS IO N
#S Z U Z U D IV IS IO N N k u la b i R A I L W A Y M A IN R O A D M IN O R R O A D 26 A U G O S T 2 00 8 W A R D B O U N D A R Y 10 0 00 0 10 0 00 20 0 00 K ilo m e te r s D IV IS IO N B O U N D A R Y B y:LA N G IB O L I,M .J (B D E P M II: IR D P 2 00 8 ) D IS T R IC T B O U N D A R Y
Source: Dodoma Urban Profile, 2014
73 The study was conducted at LAPF Head Quarter located at Mtendeni Street at Dodoma
Municipality. It was also extended to four department i.e Member Services, Finance,
Planning and Investment and Internal Audit.
3.1.1 Population and Units of Inquiry
The target population was the LAPF Pensions Fund (LAPF) and these include officers, senior officers, principle officers, managers at middle level and managers at strategic level.
3.2 The Research Design
A research design is the strategy for a study as well as plan by which the strategy is to be carried out. It specifies the methods and procedures for collection, measurements and analysis of data (Emory and Cooper, 1997). The study adopted an exploratory design.
According to Crawford (1997), exploratory research has the objective of giving a better understanding of the problem. This includes helping to identify the variables, which should be measured within the study. When we have little understanding of topic we find it impossible to formulate hypothesis without some exploratory research. The techniques of exploratory research includes review of secondary sources of data, informal interviews and focus groups interviews, Exploratory research finds out what is happening by seeking new insights, asking questions and assessing phenomena in a new light.
Qualitative as well as quantitative data were collected. Quantitative data were required to show how studies variables relate to each other while qualitative approach was applied to enable researcher to seek the informant‘s perspectives, meanings and implications, also to explain the data that are in quantitative form.
74 The case study approach was applied for conducting this research. The case study method is a technique by which individual factor whether it is an institution or just an episode in life of an individual or a group is analysed in its relationship to any other group (Kothari,
2002).
Case study was preferred mostly, rather than other field research because it provides an intensive and integrated investigation of definitive unit, such as a specific social institutions, work place or department in search for comprehensive information on a distinct phenomenon (Good, 1966). Unlike survey research, case studies are more exhaustive and reliable (VanDalen, 1979). This approach was appropriate as it considered aspects which will reveal that the mismanagement of financial risks is due to poor management and other reasons. In creating the case study, several types of data were collected including general data about social security industry in Tanzania and specific data about risk management made by LAPF. These data includes: income from investment, financial risk management and corrective measure taken input some important words.
3.3 Sample and Sampling Procedures
Respondents were taken from all the four (4) categories selected which are responsible for financial risks at LAPF. These are: Finance department, Internal Audit department,
Members Service department and Planning and Investment department. The researcher used purposive sampling technique to select the appropriate respondents from LAPF staff within the selected departments. This sampling technique enabled the researcher to acquire the right and intended information.
Quota sampling technique was used to ensure that we get representative from various areas
Quota sampling is a judgmental sampling in nature with constrains that a sample includes a
75 minimum number of representatives from each specified subgroup in the population
(Aaker at al,. 2002). With this sampling method, the most accessible individuals are the ones who are included in the sample (Millward, 2004). The method is less costly, convenient and can be set up very quickly (Saunders, 2004). Quote sampling was selected purposively.
3.4 Data Collection Procedures
Before data collection, the questionnaire and the rest of the data collection tools like the interview was conducted and the questions are presented by English language. This is because English language is common language to the respondent especially the customer of wine product because the buyer is in the level of educated. However, for in-depth interviews and focus group discussions the researcher used Swahili as the majority of the respondents use these languages. The questionnaire was tested and later adjusted accordingly before data collection.
The first thing that was done after reaching to those three regions was to introduce to the authorities, signing visitor‘s books and permission was granted to undertake the research.
The research assistants were all trained in order to collect data systematically. After administering the questioners, they were all collected and placed in one box. They were, then, all crosschecked for apparent mistakes and unclear signals, and numbered for easy computerization and identification of each respondent with his/her respective questionnaire.
Those respondents found comfortable in writing and reading were asked to fill the questionnaires themselves. But other respondents were not able to write and read and for
76 that matter structured interview where the interviewers filled the questionnaires themselves were employed.
3.5 Data Collection Methods
In this part of the research methods, the researcher presents techniques that were used in data collection and how they were utilized. Methods used for data collection are interviews, questionnaire, panels, observations, documents and many others. The methods are then categorized into two streams which are qualitative and quantitative.
As already stated, this study has an approach that uses mixed methods. It is for this reason that there was quantitative data collected together with qualitative data. While for quantitative data, there was use of a structure for qualitative data there was use of in-depth interviews.
For quantitative data, a structured questionnaire was administered in English language to the respondents. Each respondent was approached personally by the interviewer.
Questionnaire was introduced and after permission from the interviewee, one question after another was read, a response was given, and recorded on the questionnaire sheet. The questions were translated in Swahili since it might decrease the risk of misunderstanding
(Brayman, 2007.
For qualitative data, the in-depth interviews and focus group discussion (FGDS) were used.
In-depth interviews were conducted to a selected number of customers of wine product both women and men. The interviews conducted were semi-structured in nature meaning that the content of interview to a certain extent was determined prior to the interview. The respondents were approached, explained the purpose of the research and the content of the upcoming interview, consent was given after which the interview took place. In order to
77 make sure that the inter views covered all of the important topics, an interview guide was developed to guide the process, however, the researchers did not strict themselves to the interview guide.
All interviews were conducted with only one respondent at ago. For the FGD, the respondents were collected and the discussion was conducted in out of the office. All interviews and the FGD were conducted in Kiswahili this was done in order to avoid a risk of misunderstandings and limiting the respondent‘s language. This is in accordance with
(Bryman, 2007) who suggests that interviews should be conducted in the respondent‘s primary language since the communication is likely to be more effective. In addition to the interviews, the study also made intensive use of secondary information and this consisted of books, reports, articles, conference papers and the website by using suitable phrase and search words.
3.6 Data Collection Instruments
The researcher used both primary and secondary sources in collecting data. Primary data were collected using instruments like questionnaires, interviews and observation.
Secondary data were collected by using instruments like Internet, documents, books and reports.
3.6.1 Questionnaires
This is a series of questions prepared and distributed to different people who were selected as a sample. The methodology provides more information because anonymity attracts respondents to answer the questions (Babbie, 1983). English questionnaires were prepared differently according to the role and responsibilities of each key act at this study. The questionnaires were administered to, LAPF staffs, who are responsible treasury
78 management and estate management of LAPF. These questionnaires aimed to explore the financial risks in the operations of fund.
3.6.2 Interview
The researcher conducted interviews in order to gather more information about financial risks at LAPF. The interviews were conducted to the staffs of LAPF which are mainly responsible for treasury management, Estate management, Members Services department and internal audit department.
3.6.3 Observation
This is a technique/method of collecting information without letting the observed know that there is someone observing him/here (Babbie, 1983). The researcher observed how the financial risks occurred and its impacts.
3.6.4 Documentary Source
Documents related to the topic of the study were highly consulted for the purpose of soliciting more information. These documents include: LAPF annual financial reports,
LAPF Act, LAPF Investment Policy and LAPF Risk Management Policy.
3.6.5 Internet
The researcher obtained information from various websites. The information provides a wide knowledge about financial risks and the ways of managing them.
79 3.7 Data Analysis and Presentation
Data analysis and presentation is process of inspecting, cleaning, transforming, and modelling data with the goal of discovering useful information, suggesting conclusions, and supporting decision making. Pallant, (2007) stated that, in a research process the data analysis method has its own part. The letter, assimilate evidence in order to obtain answer to the research questions, Kothari (2002). The researcher will analyze item-to-item putting into account the importance of each item under the study. Data analysis will constitute data from publications.
To pave a way for smooth analysis, collected raw data were processed. The key activities in data analysis are editing, coding, classification and tabulation of collected raw data
(Adam, 2008). Data entry which aims at converting gathered data to a minimum for viewing and tabulation is also a part of data processing (Bhattacharya, 2003).
To secure quality standard of data for analysis editing was done to remove errors and omissions on the collected data. According to (Kothari 1990), editing is done to ensure that the data are accurate, consistent with other fact gathered, uniformly entered, as completed as possible and have been arranged to facilitate coding and tabulation. Coding which involve assigning numerals to responses enable a researcher to enter the data quickly using numeric keypad of a keyboard and with few errors (Saunders, 2004). Coding facilitated efficient analysis as it helped to reduce bulkiness of responses to manageable one and hence the possibility of making errors during data entry was minimized.
Data entry and analysis were done by using SPSS. Quantitative data from the questionnaire was coded and entered in the SPSS program. With the SPSS, there was use of descriptive statistics in order to determine the different percentages of the respondents. There was
80 importing of data from SPSS to Microsoft word for drawing Pie charts, tables, line graphs and histograms. In order to make different comparisons, the means were used.
Qualitative data was analyzed with the use of content analysis, a method that examines artifacts of social communication, which included written documents or transcriptions of recorded verbal communication such as interviews and field notes (Van, 1995) was key to this study. The different in-depth interviews and FGD were transformed into free-flowing summaries in order to condense the information for looking for special characteristics of messages relating to the issue of packaging. The results obtained are presented in different forms such as tables, figures, percentages and narrative notes. Pie charts, line and bar graphs diagram are used for easy interpretation and understanding of the research findings.
3.8 Validity and Reliability
Validity is the extent to which a test measures what it claims to measure. It is vital for a test to be valid in order for the results to be accurately applied and interpreted (Kendra,
2009). Reliability is the extent to which results are consistent over time. Results are referred to as reliable if the same results can be reproduced under a similar methodology then the research instruments are considered to be reliable. To achieve reliability and validity, the following steps was followed:
The first step was on the selection of respondents. The selection of the respondents was based on the established sampling procedure for the quantitative data; for the quantitative data, respondents were selected based on opportunity to learn.
The second step was on the data collection. Since data was collected by several interviewers, these were trained on how to use the data collection tools. There was possibility of triangulation on the data collected because of the different types of data
81 collected, on the one hand, and the repetitiveness of the same questions, on the other hand.
With a high degree of stability on the data, then there is a high degree of reliability, implying that the results are repeatable.
Under this step, data was collected using multiple methods (questionnaire, interviews and
FGD) and from different units of analysis. This helped to capture evidences from different angles and thus improved validity of data and information obtained. Third step was referred as data computerizations. The quantitative data collected was computerized in order to avoid unnecessary loss of data and conduct more precise analysis with the use of computer software. Pilot test on the questionnaire was done after which some versions were made to eliminate ambiguities in the questionnaire.
3.9 Ethical Issues and Consideration
During the study, the researcher adhered to human rights national policies and paid attention to rules and regulations. That is, the data were collected after clearance to carry out the research study was obtained from the University of Dodoma,
Other consideration was about Informed Consent of Respondents and Confidentiality. In the study area, friendship with the respondents was reached in order to inquire about their consent. The respondents were assured in advance that the information they provided would be kept confidential and private would be used only for the research purpose. In effecting human rights, the respondents were free to pull out at any time during data collection and during interview sessions.
82 3.10 Summary
The part has presented the practical procedures for this study. It has presented the research design based on the ethno methodological and mixed methods approaches. While due to its embedment in the ethno methodological approach the study makes use of the case study, it collects quantitative and qualitative data, on the one hand, and analyses the data with the use of statistics and content analysis, on the other hand. The chapter has winded up with the issues related to validity and consistency, coming chapter (Chapter IV) discuses about the presentation and discussion of the result.
83 CHAPTER FOUR
DATA ANALYSIS, DISCUSSION AND INTERPRETATION
4.0 Introduction
In this chapter the data which were collected through questionnaires, interviews and observations have been presented and analyzed. The researcher presents the facts which were obtained during the study. The findings which were set forth are originated from the data collected edited and coded for the purpose of completeness and accuracy and have been classified into meaningful relationships to indicate what it means in the context of the research report. The results which are being presented in this chapter should be viewed in consideration of the scope and limitations of the study pointed out in the early chapters.
4.1 Specific Observation
In this chapter, response rate has been dealt with first, followed by the characteristics and findings from Management, staff, followed by characteristics and findings from all departments‘ staff.
Frequency distribution was used to organize data, to give meaning to the response rates and facilitate insight. In relevant tables the frequency distribution of responses has been arranged by occurrence from the highest to the lowest obtained from the responses.
Furthermore, tables, graphs and charts were drawn using excel.
4.2 Study and Response Rate
The sample studied were forty in total which contained four groups of people; Finance,
Internal Audit, Member Service and Planning and Investment staff. Out of forty
84 questionnaires distributed and all forty were collected, this represents rate of 100% as summarized in the figure.
Figure 4.1: Respondents’ Rate
Respondents' Rate (N=40) 18 18 16 14 12 12 10 8 8 6 Respondents' Rate (N=40) 4 2 2 0 Member Finance Planning Internal Service and Audit Investment
Source: Research Field Data, 2014
4.3 Respondents Background Characteristics
It is important to describe the characteristics of the respondents in terms of response. These characteristics influence their opinions/responses to different data collection instruments.
The respondents were from four different departments namely, 18 from planning and investment department (45%), 8 from finance department (20%), 12 from member‘s services department (30%) which includes staff from four different LAPF‘s zone offices
(49%), 2 from internal audit (12%) This distribution is summarized in the following table.
Table 4.1: Respondents’ Rate in Percentage Wise
Departments Number of Respondents Percentage (%) Member service/Operations 12 30 Finance 8 20 Planning and Investment 18 45
85 Internal Audit 2 5 Total 40 100 Source: Research Field Data, 2014
4.3.1 Respondent’s Ages
As shown in figure 4.2, majority of respondent‘s age ranged between 26 and 35 years.
They were fifteen and marking 37.5 per cent of total number of respondent from selected sample. The second frequently occurring age group was ranging between 36 and 45 years, they were 13 respondents that make up 32.5 per cent of the sample. The third of the respondents were ranging between 46 and 55 that make up twenty per cent of the respondent and lastly were ranging between 55 and 60. The age structure shows that LAPF is mostly composed of a highly energetic workforce that may indicate its vision to adapt to the rapidly changing business climate in the country. Furthermore, this age structure is suitable for the research as the employees studied are more likely to stay in the organisation for a long time; they have very important role for its future performance.
86 Figure 4.2: Respondents’ Age Distribution
Age Distribution
10% 4
37% 20% 15 8 26-35 36-45 46-55 55-60
33% 13
Source: Research Field Data, 2014
4.3.2 Education Level of Respondents
Most of the respondents that were sampled are undergraduates that have a degree. Out of the forty respondents twenty five had a degree making up 62.5 per cent of total respondents. Diploma respondents were only one equivalent to 2.5 of the sample size and those with higher qualifications, mostly were four making 10 per cent. And there were ten respondents who were equivalent to 25 per cent. This shows that LAPF base of qualified staff.
87 Figure 4.3: Respondents’ Education Level
Diploma ACCA/CPA/CSP 2% 10% Respondents' Education level 1 4
Graduate 25% 10
Undergraduate 63% 25
Source: Research Field Data, 2014
4.3.3 Respondents Working Experience
The researcher wanted to know distribution of working experience in order to know the quality of responses justified with the inputs made to the research. The distribution table shows that most of the respondents lie between 6 to 10 years equivalent to 55 per cent which have adequate experience to provide relevant responses to the research.
As indicated in figure 4.4, majority of the respondents fall in class of working experience between 6 – 10 years which is 55 per cent of all respondents. Another group of the respondents lies within a working experience of 1-5 years which scored 25.0 per cent of total respondents. The group ranging from 11- 15 years seems to be of much important to the study because they have long working experience.
88 Figure4.4: Working Experience
Source: Research Field Data, 2014
4.4 Descriptive Analysis and Findings
4.4.1 Financial Risks in LAPF Pensions Fund
The first objective of this study was to identify financial risks which are currently facing
LAPF in its operations. Therefore this section presents the different issues on liquidity risk, market risk, credit risk, litigation risk, regulatory, operation and policy risks and political risks from 2004/2005 to 2011/2012. The section responds to the questions: what are the liquidity, market, credit, litigation regulatory, operation and policy and political risks facing LAPF from 2004/2005 to 2011/2012?
89 4.4.2 Liquidity Risks
Respondents from member‘s service department highlighted the possibility of liquidity risk in the future. About 85% revealed the availability of the liquidity risks at LAPF. It is the risk of which the risk of the Fund failing to meet obligations when they are due. Liquidity risk may also arise from inability to sell financial assets quickly at close to its fair value.
The LAPF is exposed to daily calls on its available cash for benefit payments and other administrative expenses. The Fund manages liquidity risk by maintaining a pool of short term placements with banks which is adequate to meet its obligations for benefit payments as well as investment commitments and administrative expenditure. The Fund carries out weekly cash flow projection which discussed by Management Investment Committee for
Investment decisions. Main source of funds include monthly pensions contributions, maturities from investment and investment income.
Figure 4.5: Liquidity Risks
Not Effective Extremely Effective 12 7 29% 17%
very Effective 21 52.5%
Extremely Effective very Effective Not Effective
Source: Research Field Data, 2014
90 4.4.3 Market Risks
Market risk is the risk that the value of an investment will decrease due to moves in market factors. The four standard market risk factors are: Equity risk, the risk that stock prices will change, interest rate risk, the risk that interest rates will change, currency risk, the risk that foreign exchange rates will change and commodity risk, the risk that commodity prices
(e.g. grains, metals) will change. About 70% of respondents revealed that, market risks are among the emerged risks types that affect the pension‘s Fund. The researcher observed that the Fund generates foreign currency from rental income which is invoiced in USD to preserve the value and return of its investment properties due to persistent depreciation of the Tanzanian shilling against the major currencies. Funds generated from rental collections are maintained in placements/investments denominated in foreign currencies.
Figure 4.6: Market Risks
MARKET RISKS
18 16 14 12 10 8 6 4 2 0
Extremely Effective very Effective Not Effective
Extremely Effective very Effective Not Effective
Source: Research Field Data, 2014
91 4.4.4 Credit Risks
Credit risk refers to the probability that an asset or loan becomes irrecoverable due to a default or delay in settlements. The study found that, the Fund‘s main financial assets are in Government securities, corporate debt securities, bank placements and real estate.
Significant portions of the investment of the Fund are in government securities. The Fund has an Investments Policy which guides investment activities in order to mitigate credit and other risks associated with the investment function. The findings show that, the Fund provides credit facilities to different organisations such as TANESCO, SACCOS and other businesses. Also, it provides credit to their staff. The consequences can be severe with a decline in the value of a bank‘s assets. About 70% of respondents revealed that, the Fund is in position to experience the occurrence of credit risk.
Figure 4.7: Credit Risks
Credit Risks
Not Effective Extremely Effective 12 12 30% 30%
Extremely Effective very Effective Not Effective
very Effective 16 40%
Source: Research Field Data, 2014
92 4.4.5 Litigation Risks
Litigation exposure can result from either Fund-initiated or third-party-initiated litigation.
Fund-initiated litigation occurs when LAPF management initiates legal proceedings. Such legal actions enforce contract rights, including loan and lease covenants; recover debts or obligations owed to the bank; foreclose on property in which the bank holds a security or ownership interest; or recover damages caused by insiders or third parties. In some cases, fund-initiated litigation gives rise to countersuits. Third-party-initiated litigation occurs when an action has been threatened or commenced against the fund. Third-party-initiated litigation may involve allegations of errors, omissions, violations of law, damages, or personal injury caused by the Fund, its management, or staff. The findings revealed that, there is outstanding debt of TZS 1.849 billion owed to M/S G.K Hotels & Resorts and the case is in the court. The recoverability of these amounts is in doubt (LAPF, 2008). In this situation, there is a possibility of Fund to lose case and get the loss of TZS 1.849 billion which could be used for investment or paying member‘s claims.
93 Figure 4.8: Litigation Risk
Litigation Risk
Not Effective 7 Extremely Effective 17.5% 12 30%
very Effective 21 52.5%
Extremely Effective very Effective Not Effective
Source: Research Field Data, 2014
4.4.6 Regulatory, Operational and Policy Risks
About 80% of respondents revealed the likelihood of operational risks at LAPF. This can take many different forms like computer failure, mistakes in record-keeping, poor compliance of members/employers with earnings declaration and contribution payment, inaccurate allocation of expenses between branches, inadequate staffing to maintain operations satisfactorily, for example because of recruitment problems or uncompetitive salaries, strikes and other staff unrest, weak management; fire, earthquake, hurricane or flood, fraudulent transactions, hostile hacking into the main computer database; failure to implement an element of the legislation; failure to warn insured persons of an impending change in coverage or benefit accrual; unexpected fiscal liabilities; failure of risk controls on delegated authorities; poor risk management (Cardinale et al, 2005).
94 Further pension schemes also face the background risks in the form of regulatory, operational and policy risks (Wiley, 2005). Throughout the world, governments change the tax treatment of pensions as well as the definitions of liabilities in ways which can be quite costly for pension scheme sponsors. In Tanzania tax laws are changing every year and create more complications on pensions fund investment return in terms of Value Added
Tax (VAT) return, withholding taxes, rental taxes and others taxes. For example LAPF Act exempts them from paying corporate tax but there is not such exemption in Income Tax
Act 2004.
Figure 4.9: Regulatory, Operational and Policy Risk
RESPONDENTS (Regulatory/compliance)
Extremely Not Effective Effective 7 7 17.5% 17.5%
26 65%
Source: Research Field Data, 2014
4.4.7 Political Risks
About 57% of the respondents revealed that the Fund is not independent from Political decisions. Most of the time the government directs the Fund to invest on certain activities even though the return is not viable, for example, the constructions of social infrastructures such as schools, hospitals, bridges etc. e.g constructions of parliament
95 chambers and University of Dodoma. These activities took huge pensions funds and their payback could take more time than the required rate of return. If the Fund can invest these monies somewhere else, like fixed deposit in banks, they could get return above the one provided by government.
The figure below shows the summary of the financial risks available at LAPF, ranking by percentages of respondents.
Figure 4.10: Types of Risk Facing LAPF
Types Of Risk Facing LAPF
Political 12% Liquidity 18%
Litigation 12%
Operational Regulatory/Compli 16% ance 14%
Credit Market 14% 14%
Source: Research Field Data, 2014
The above figure 4.10 shows the frequency of risks facing LAPF in its operation.
According to respondents, liquidity risk is among the most affecting risks followed by operation risk.
96 4.4.8 Risk Management is carried Out by Management under the Supervision of the
Investment Committee
Results of analysis in figure4.11 showed that 37.5 percent of the respondents totally agreed that risk management is carried out by management under the supervision of the committee and the other 37.5 per cent were partially agreed to the questions only 8 respondents who were equally to 20 percent were partially disagree and the rest 5 percent were not sure if the Risk Management is carried out by management under the supervision of the investment committee
Figure 4.11: Risk Management Is Carried Out By Management Under The
Supervision of Investment Committee
Totally Disagree 2 5% Partially Disagree 8 20% Partially Agree 15 37.5%
Totally Agree 15 37.5%
Totally Agree Partially Agree Partially Disagree Totally Disagree
Source: Research Field Data, 2014
97 4.5 Measures Taken By LAPF to Combat Financial Risks
The second objective of this study was to identify the existing measures taken by LAPF to combat financial risks. This section presents ways used by LAPF starting with, actuarial valuation, followed by market rent. Furthermore, the section presents loan deposit ratio and daily movement of exchange rate as measures to combat financial risks. Lastly, the section describes how LAPF uses risk management guidelines as a way of managing financial risks. The section responds to the following questions: How does LAPF employ actuarial valuation, market rent, and loan deposit ratio, daily movement of exchange rate and risk management guidelines to effectively manage financial risks.
4.5.1 Actuarial Valuation
This is the process which involves assessing the current level of funding of the scheme by comparing scheme assets with liabilities accrued to the date of valuation and to determine the level of contributions that need to be paid in future to achieve the level of funding necessary to pay out the benefits promised. LAPF as social security institution is required to carry out actuarial valuation after every three years. This helps to identify the funding ability of the social security institutions and act as the alerting tool to know if the fund has ability to pay all its obligations or not. For example, according to the actuarial valuation report of LAPF done in December 2003, additional funding requirement was determined to be TZS 107.30 billion at 30 June 2005, to enable all the existing members in the scheme to qualify for pensions, if they contribute for a minimum of 15 years and have reached the retirement age. The Government of Tanzania agreed to inject in full the additional funding in equal instalments over a period of 10 years from the 2007/08 financial year. The Fund started receiving equivalent monthly instalments from July 2007 (LAPF, 2008).
98 4.5.2 Market Rent
LAPF like other social security institutions in Tanzania invests a huge capital on real estate, that is, they own several buildings as investment properties. They are leasing these buildings at market rent in order to obtain the expected return. The question they should answer, is the rent a market rent? The findings show that, LAPF charges market rent in investment properties in Dar es Salaam only, but they do not charge market rent in
Dodoma buildings.
4.5.3 Loan Deposit Ratio
Loan deposit ratio is the amount of a bank‘s loans divided by the amount of its deposits at any given time. The higher the ratio, the more the bank is relying on borrowed funds, which are generally more costly than most type of deposits. Although LAPF does not provide loans to customers as banks do, they invest in fixed deposit in other financial institutions like banks. The findings revealed that, LAPF calculates loan deposit ratio frequently to determine the position of lending to other financial institutions or government.
4.5.4 Daily Movement of Exchange Rate
The interview conducted to treasury manager revealed that, LAPF has established the mechanism to monitor and measures the daily movement of exchange rates. Others respondents from finance department supported that the fund has established measure to monitor the daily movement of the exchange rates. They fix the daily exchange rates in which their customers will transact their business operations.
99 4.5.5 Risk Management Guidelines
The information obtained from internal audit department revealed that, LAPF established risk management framework in 2008 in which it involves an understanding and appraisal of the Fund‘s external relationships, its own internal and organizational environment in which the stages of the risk management process are followed. In analysing risks facing the
LAPF, the following procedures are adhered to, Risk identification, Risk measurement,
Risk control and Risk monitoring. However, the current situation is that, LAPF does not fully implement this risk management framework.
4. 6 Effectiveness of the Measures Being Taken By LAPF in Managing the
Financial Risks
The third and last research objective of this study was to examine the effectiveness of the existing measures being taken by LAPF in managing financial risks. The section assesses by comparing priorities given in managing each type of risks. The section also assesses the effectiveness in managing each type of risk. Moreover, this section examines how LAPF uses Value at Risk (VaR) in managing market risk. Lastly, under this section, risk management policy implementation is addressed. The questions answered by this section include: which risks are given higher priority than others? How effectively is each risk is managed? How is value at risk used in managing market risk and to what extent has risk management policy been implemented?
4.6.1 Priorities in Managing Financial Risks
The findings revealed that LAPF has made great efforts to develop different measures to manage risks in their operations. The measures adopted are: - actuarial valuation, market rent, loan deposit ratio, daily exchange rate and establishment of risk management
100 framework. According to information obtained from the respondents, i.e. LAPF staff and reviewed documents, LAPF mitigate differently the following types of risks; the following table shows the ranking of efforts employed by LAPF to manage different type of risks.
Figure 4.12 below show the percentage of priorities of managing financial risks at LAPF.
Figure 4.12: Priorities in Managing Financial Risks in LAPF
Priorities in Managing Financial Risks in LAPF Liquidity 1 86% Credit 0.8 71% 71% 57% 57% Market 0.6 43% 43% 0.4 Regulatory/compliance
0.2 Litigation 0 Business continuity/IT security Operational
Source: Research Field Data, 2014
According to the findings above, LAPF has engaged in risk management procedures to control/manage the above types of risks. The findings show that, liquidity risks takes a high priority (86%) of management effort compared to other risks. It means LAPF employs more efforts to control liquidity risks such as funding strategy and diversification of funding sources and investment opportunities. Market risks such as interest rates risks, currency risks as well as commodity and equity risks and credit risks take about 71% of the
LAPF efforts of risk management. Other types of risks take little concern on management and controls.
101 4.6.2 Effectiveness of Managing Financial Risks
The effectiveness of managing financial risks is assessed in three areas, namely: - extremely effective, very effective and not effective. Except business continuity/IT security, all types of risks are not extremely effectively managed. Business continuity is not effectively managed simply because of lack of integration among their risk systems.
Respondents interviewed rated the LAPF as being very effective at managing liquidity and litigation risks (57%), credit risk, regulatory/compliance, market business continuity/IT security and operational risks (43%).
LAPF is not effective in managing IT security (57%) and market risk (43%). The importance of managing these risks is expected to continue to grow because of the numerous recommendations after the establishment of social security regulatory authority in 2008 and the establishment of risk management framework.
The following table 4.2 provides the summary the level of effectiveness of managing financial risks at LAPF.
Table 4.2: Effectiveness of Managing Financial Risks Types of Risks Level of Effectiveness of Risk Management as the Percentage of Respondents Responses Extremely Effective Very Effective Not Effective Liquidity 14% 57% 29% Credit 29% 43% 29% Market 14% 43% 43% Regulatory/compliance 14% 43% 14% Litigation 29% 57% 14% Business Continuity/IT 0% 43% 57% Security Operational 29% 43% 29% Source: Research Field Data, 2014
102 4.6.3 Uses of Value at Risk (VaR) in Managing Market Risk
Value-at-Risk (VaR) is widely used as a tool for measuring the market risk of asset portfolios. It quantifies in monetary terms the exposure of a portfolio to the market fluctuations. It is defined as the maximum monetary loss of a portfolio such that the likelihood of experiencing a loss exceeding that amount, due to its exposure to the market movements, over a specified risk horizon is equal to a pre-specified tolerance level (Sarma,
2002). Market risks include equity, interest rate, currency and commodity risks.
In determining the use of Value at Risk in managing financial risks by LAPF, most of respondents revealed that greater percentage of the assets of LAPF are not covered by
Value at Risk. Value at Risk helps to understand what you should expect to happen on a daily basis in an environment that is roughly the same. Value at Risk measures formed a key barometer for most firms in understanding their sensitivity to changes in market conditions. In LAPF, VaR does not carry equal significance compared to other financial institutions. LAPF does not establish VaR in their operations, they are not aware of its functions and significance in risk management.
The table below shows the classes of assets covered by Value at risk in LAPF. The findings show the low proportions of assets are covered by value at risk. These are fixed income, foreign exchange, equity and asset backed securities and structured products
(29%) while others are below.
The level of implementation of risk management policy at LAPF is summarised by the following and Figure 4.13.
103 Figure 4.13: Management of Market Risk Using Value at Risk (VaR) at LAPF
NUMBEROF RESPONDENT (N=40)
100% 14% 14%0% 14%0% 14% 14% 14% 14% 29% 29% 29% Not covered and no plans to 57% 57% 43% 14% 50% 43% 14% 43% 43% 43% Not covered but plan to 29% 29% 29% 29% 14% 14% 14% 0% Somewhat covered
Extensively covered
as the the of percentage respondents as Level of uses of Value at ofValueat (VaR) of uses risk Level
ASSET CLASSES
Source: Research Field Data, 2014
4.6.4 Impact of Financial Risk to Social Security Institution Operations
The second objective of this study was to identify impact of Financial Risk to Social
Security Institutions Operations. This section presents the impacts face LAPF which were
Increase Legal and Reputations problem, Decrease in funds due to inflations, reduce competitive edge in the SSI, Delay in the Introduction of New benefits and Reduce Return on Investment
4.6.5 Increase Legal Fees and Reputation Problem
This is the process which involves assessing the current level of funding of the scheme by comparing scheme assets with liabilities accrued to the date of valuation and to determine the level of contributions that need to be paid in future to achieve the level of funding necessary to pay out the benefits promised. LAPF as social security institution is required to carry out actuarial valuation after every three years. This helps to identify the funding
104 ability of the social security institutions and act as the alerting tool to know if the fund has ability to pay all its obligations or not. For example, according to the actuarial valuation report of LAPF done in December 2003, additional funding requirement was determined to be TZS 107.30 billion at 30 June 2005, to enable all the existing members in the scheme to qualify for pensions, if they contribute for a minimum of 15 years and have reached the retirement age. The Government of Tanzania agreed to inject in full the additional funding in equal instalments over a period of 10 years from the 2007/08 financial year. The Fund started receiving equivalent monthly instalments from July 2007 (LAPF, 2008).
4.6.6 Market Rent
LAPF like other social security institutions in Tanzania invests a huge capital on real estate, that is, they own several buildings as investment properties. They are leasing these buildings at market rent in order to obtain the expected return. The question they should answer, is the rent a market rent? The findings show that, LAPF charges market rent in investment properties in Dar es Salaam only, but they do not charge market rent in
Dodoma buildings.
4.6.7 Loan Deposit Ratio
Loan deposit ratio is the amount of a bank‘s loans divided by the amount of its deposits at any given time. The higher the ratio, the more the bank is relying on borrowed funds, which are generally more costly than most type of deposits. Although LAPF does not provide loans to customers as banks do, they invest in fixed deposit in other financial institutions like banks. The findings revealed that, LAPF calculates loan deposit ratio frequently to determine the position of lending to other financial institutions or government.
105 4.6.8 Daily movement of Exchange Rate
The interview conducted to treasury manager revealed that, LAPF has established the mechanism to monitor and measures the daily movement of exchange rates. Others respondents from finance department supported that the fund has established measure to monitor the daily movement of the exchange rates. They fix the daily exchange rates in which their customers will transact their business operations.
4.6.9 Risk Management Guidelines
The information obtained from internal audit department revealed that, LAPF established risk management framework in 2008 in which it involves an understanding and appraisal of the Fund‘s external relationships, its own internal and organizational environment in which the stages of the risk management process are followed. In analysing risks facing the
LAPF, the following procedures are adhered to, Risk identification, Risk measurement,
Risk control and Risk monitoring. However, the current situation is that, LAPF does not fully implement this risk management framework.
4.7 Measures Being Taken By LAPF in Managing the Financial Risks
The third and last research objective of this study was to examine the effectiveness of the existing measures being taken by LAPF in managing financial risks. The section assesses by comparing priorities given in managing each type of risks. The section also assesses the effectiveness in managing each type of risk. Moreover, this section examines how LAPF uses Value at Risk (VaR) in managing market risk. Lastly, under this section, risk management policy implementation is addressed. The questions answered by this section include: which risks are given higher priority than others? How effectively is each risk is
106 managed? How is value at risk used in managing market risk and to what extent has risk management policy been implemented?
4.7.1 Effectiveness of Managing Financial Risks
The effectiveness of managing financial risks is assessed in three areas, namely: - extremely effective, very effective and not effective. Except business continuity/IT security, all types of risks are not extremely effectively managed. Business continuity is not effectively managed simply because of lack of integration among their risk systems.
Respondents interviewed rated the LAPF as being very effective at managing liquidity and litigation risks (57%), credit risk, regulatory/compliance, market business continuity/IT security and operational risks (43%).
LAPF is not effective in managing IT security (57%) and market risk (43%). The importance of managing these risks is expected to continue to grow because of the numerous recommendations after the establishment of social security regulatory authority in 2008 and the establishment of risk management framework.
The following table provides the summary the level of effectiveness of managing financial risks at LAPF.
4.7.2 Uses of Value at Risk (VaR) in Managing Market Risk
Value-at-Risk (VaR) is widely used as a tool for measuring the market risk of asset portfolios. It quantifies in monetary terms the exposure of a portfolio to the market fluctuations. It is defined as the maximum monetary loss of a portfolio such that the likelihood of experiencing a loss exceeding that amount, due to its exposure to the market
107 movements, over a specified risk horizon is equal to a pre-specified tolerance level (Sarma,
2002). Market risks include equity, interest rate, currency and commodity risks.
In determining the use of Value at Risk in managing financial risks by LAPF, most of respondents revealed that greater percentage of the assets of LAPF are not covered by
Value at Risk. Value at Risk helps to understand what you should expect to happen on a daily basis in an environment that is roughly the same. Value at Risk measures formed a key barometer for most firms in understanding their sensitivity to changes in market conditions. In LAPF, VaR does not carry equal significance compared to other financial institutions. LAPF does not establish VaR in their operations, they are not aware of its functions and significance in risk management.
The table below shows the classes of assets covered by Value at risk in LAPF. The findings show the low proportions of assets are covered by value at risk. These are fixed income, foreign exchange, equity and asset backed securities and structured products
(29%) while others are below.
The level of implementation of risk management policy at LAPF is summarised by the following table.
4.7.3 Level of Risk Management Policy Implementation
According to findings, LAPF has developed risk management policy since 2008. Roughly three quarters of respondents revealed that, LAPF had either substantially or not implemented the work required to identify operational risk types and standardize documentation of processes and controls. LAPF had made less progress in these areas.
Less than half of the respondents said work was either fully or substantially implemented for developing methodologies to quantify risks, for rolling out a formal training program
108 for operational risk, and for creating metrics to monitor operational risk types. Clearly, developing methodologies and metrics for operational risk has proven to be a major challenge for LAPF.
Figure 4.14: Risk Management Policy Implementation
80% 71% 72% 70% 60% 50% 43% 43% 37% 40% Full 29% 29% 29% Implemented 30% 22% 20% 14% 14% 14% Substantially Implemented 10% 0% 0% 0% 0% Not Implemented
Source: Research Field Data, 2014
4.8 Summary
Irrefutably and exactly speaking, the chapter has discussed the examination of data and presentation of the research findings. It inaugurate with Demographic silhouette of the
Study Population pursued by the investigation of objectives of the study, at the same time as the subsequent chapter (Chapter Five) portrays the synopsis, conclusion and recommendations for the further area concerning the same observable fact.
109 CHAPTER FIVE
CONCLUSIONS AND RECOMMENDATIONS
5.0 Introduction
The study pointed out that, financial institutions in Tanzania invest substantial amounts of their funds into financial markets. These investments are government securities, fixed deposits with banks, real estates and loans. These types of investments are exposed to financial risks which affect their liquidity position and result into uncertainty for them to settle their obligations. This study therefore, aimed at examining the effectiveness of managing financial risks in social security institutions through identifying the financial risks facing LAPF in its operations, the measures taken by LAPF to combat financial risks and examining the effectiveness of the existing measures being taken by LAPF in managing the financial risks. The study portrays a summary of the findings, a conclusion, recommendations, limitation of the study and eventually study suggests the areas for further study.
5.1 Summary of the Findings
This section summarizes the major findings of the study. The section starts by presenting a summary of the findings on financial risks facing LAPF in its operations, followed by a summary on the measures taken by LAPF to combat financial risks, and finally, the section summaries the issues related to the effectiveness of the existing measures being taken by
LAPF in managing the financial risks.
110 5.1.1 Financial Risks Faced LAPF
LAPF encounters different financial risks in their operation, namely: - liquidity risk, market risk, credit risk, litigation risk, regulatory, operation and policy risks and political risks. According to findings, liquidity risk is the most serious risk affecting financial risks followed by operational risk.
5.1.2 Measures Taken by LAPF to Combat Financial Risks
LAPF has employed more efforts to combat financial risks, namely: - actuarial valuation, market rent, loan deposit ratio, daily movement of exchange rate, and risk management guidelines. However, LAPF does not fully implement its risk management guidelines.
5.1.3 Effectiveness of the Existing Measures
Different measures have been employed by LAPF to mitigate financial risks. Priorities of managing these risks differ from one type of risk to another, for example, liquidity risks get more attention than others. Also LAPF does not efficiently use Value at Risk (VaR) measure to manage market risk. Lastly, risk management policy has been established but is not yet fully implemented.
5.2 Conclusion
The study aims to (i) Identify the financial risks facing LAPF Pensions Fund in its operations (ii) Identify measures taken by LAPF to combat financial risks and (iii)
Examine the effectiveness of the existing measures being taken by LAPF in managing the financial risks. It is found that, LAPF has been facing different financial risks, namely: - liquidity, market risk, credit risk, litigation risk, regulatory, operation and policy risks and
111 political risks. LAPF also has employed different measures to combat these financial risks which are; actuarial valuation, market rent, loan deposit ratio, daily movement of exchange rate, and risk management guidelines and finally, LAPF has established risk management guidelines but has not yet fully implemented them.
5.3 Recommendations
Social security institutions are subject to different types of risks in respect of their liabilities, earning, structural changes in the economy, unemployment, disability, the future growth in the costs of health care and general improvements in longevity for the whole population (Daykin, 2004). Therefore, for this case, risk management is inevitable for social security institutions. The following are recommendations for effective risk management in social security institutions.
5.3.1 Recommendations to the Government
The government should make sure that, each social security institution establishes an independent risk management unit to oversee the management of risks in their operations.
Such a setup could be in a form of risk manager, committee or department depending on the size and complexity of the institution. The government should also make sure that, there is effective audit in social security institutions at least annually and should every year or two be subjected to actuarial valuation and review to assess the future commitments and the adequacy of expected income, having regard to the assets of the scheme. Reports from the auditors and the actuary should be made publicly available.
112 5.3.2 Recommendations to LAPF Management
LAPF should make use of financial derivatives as an investment management instrument to manage and hedge risks (e.g., to reduce exposure to currency fluctuations). However, unhedged positions in derivatives can expose the investing institution to significant risk.
Appropriate risk management structures should be put in place to govern the use of derivatives, and compliance with these structures should be carefully monitored.
The investment policy of LAPF should be based on prudent person principles and appropriate quantitative restrictions. It should take into account the following concepts: - risk management, diversification and dispersion, matching assets and liabilities, including considerations of duration and maturity, currency matching; and performance measurement and monitoring. In establishing the investment policy and strategy, the governing bodies of the social security scheme and of the investing institution should determine the degree of risk and risk tolerance the scheme is able to sustain. Factors such as the volatility of contributions and assets should be considered along with the financial objectives. The governing bodies of the social security scheme and of the investing institution should have a sound understanding of the scheme's obligations, the purpose of the investments, and the appropriate mix of assets required to ensure the scheme's financial sustainability.
LAPF should ensure that their staffs have appropriate expertise and training on key risk indicators and the importance of risk management. Staff should be trained on how to identify and measure risks in the Fund and how to treat or reduce the impact of risks through risk management program.
113 5.4 Areas for Further Studies
The study covered a narrow area of financial risk management at LAPF, it is suggested that
more and further research be undertaken in the following areas:-
i. Operational risks management in social security institutions, ii. Whether investments returns of pensions fund are relevant to the cost of investment (
the relationship between return and investment in pensions fund in Tanzania), iii. Real estate risks management in Tanzania. iv. Financial risks management in Tanzania v. It is also recommended to undertake studies on the above mentioned area using survey
approach in order to cover wider area.
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119 APPENDICES
Appendix I: Questioners for the Respondents
Dear Respondents,
I, Bhoke John Rotente, am a student from the University of Dodoma pursuing Master of
Business Administration. I am conducting a research as a partial fulfilment for the MBA.
This data is purely for academic purposes as part of the requirements to attainment of the said degree. Participation is purely voluntary and the researcher will purely observe confidentiality while analyzing the information provided. This questionnaire is simply for the purpose of collecting data for my research.
In order for the organization to improve the quality of its packaging and satisfy customers‘ needs, I kindly beg you to respond to the questions to the best of your knowledge and I beg to free yourself in answering this questions. The information gathered will be used solely for academic purpose only and not otherwise.
A: Profile of the Respondents
The information requested will enable the researcher to make meaningful interpretation of the data obtained.
(Please tick your responses to the following questions).
1. What is your name (Optional)
…………………………………………………….
120 2.Gender of the Respondents a. Male [ ] b. Female [ ] 3.What is your level of Education? a. Secondary (O‘ Level) [ ] b. Secondary (A‘ Level) [ ] c. Diploma [ ] d. Undergraduate [ ] e. Graduate [ ] f. CPA/ACCA/CSP [ ] 4. Please indicate which of the following age groups you belong. a. 18-25 years [ ] b. 26-35 years [ ] c. 36-45years [ ] d. 46-50 years [ ] e. 51 years [ ] 5. For how long have you been working with your organization?
a. 1-5years [ ] b. 6-10 years [ ] c. 11-15 years [ ] d. 16-20 years [ ] e. 21 years and above [ ]
6. Please indicate you are from which department?
a. Member Services Department [ ] b. Finance Department [ ] c. Planning and Investment Department [ ] d. Internal Audit Department [ ]
121 SECTION II 7. Are there any defaulters in the Fund operation? a. Yes [ ] b. No [ ] c. Not Sure [ ] 8. Do the following count as the main defaulters of the Fund? a. Defaulters in remittance contributions [ ] b. Defaulters in Repayment Loans (SACCOS ) [ ] c. Payment of Government LOANS [ ] d. Rent Payment [ ] e. All of the above [ ] f. Not sure [ ] 9. Is it true that the main source of the Fund coming from any of the following? a. Employees Monthly contributions [ ] b. Maturities from investment [ ] c. Investment income [ ] d. All of the above [ ] e. Not sure [ ] 10. Which measures are taken by the Fund to manage defaulters? a. Paying the Principle with Penalties [ ] b. Negotiation/waiver /Dialogue [ ] c. Institute Legal Measures [ ] d. Constant follow up [ ] e. Introduce special Unit (Estate) [ ] f. Guarantee on Loans [ ] g. Selective on investment [ ] h. Screening of borrowers [ ] i. Strengthening Financial Policies [ ] j. All of the above are true [ ] k. Not sure [ ]
122 10. Do you know any of the following financial risk that affects development
of the Fund? ( √ on the right answer)
a. Credit Risk [ ] b. Liquidity Risk [ ] c. Market Risk [ ] d. Interest rate risk [ ] e. Foreign exchange risk [ ] f. Regulatory/ compliance risk [ ] g. Litigation risk [ ] h. Business continuity/IT security risk [ ] i. Operational risk [ ] j. Model risk [ ] k. All of the above [ ] l. Others [ ] 11. If you agree on the above question which of the following impact face the
Fund?
a. Increase Legal Fees and Reputation problem [ ] b. Decrease in funds due to inflations [ ] c. Reduce competitive edge in the SSI [ ] d. Delay in the introduction of New benefits [ ] e. Reduce Return on Investment [ ] f. All of the above [ ] m. Not sure [ ]
123 12. What types of risks does LAPF attempt to manage? ( √ on the right
answer)
n. Credit Risk [ ] o. Liquidity Risk [ ] p. Market Risk [ ] q. Interest rate risk [ ] r. Foreign exchange risk [ ] s. Regulatory/ compliance risk [ ] t. Litigation risk [ ] u. Business continuity/IT security risk [ ] v. Operational risk [ ] w. Model risk [ ] x. All of the above [ ] y. Others [ ]
Does the Fund hedge any fund ?
a. Totally Agree [ ]
b. Partially Agree [ ]
c. Partially disagree [ ]
d. Totally disagree [ ]
e. Not sure [ ]
124 13. Is it true that the Risk Management is carried out by management under
the supervision of the investment Committee which is guided by policies approved
by the Board of Trustees?
a. Totally Agree [ ]
b. Partially Agree [ ]
c. Partially disagree [ ]
d. Totally disagree [ ]
e. Not sure [ ]
14. Does the Fund use the following measures/strategies to minimise credit
risk?
a. Set limits on different categories of investments [ ]
b. Set exposure limits for each bank where it makes placements of the fund [ ] c. All of the above a and b are true [ ]
d. Not sure [ ]
Does LAPF have approved enterprise risk management framework or enterprise risk management policy?
a) Yes, approved at the board level
b) Yes, approved at the risk management committee level
c) No, however our framework and policy are in draft
d) No, but plan to have at the board or risk management committee level
125 15. How effective do you think your organization is in managing the following risks? (√ Tick the appropriate answer)
TYPES OF RISK Extremely Very Not Effective Extremely Effective a. Liquidity b. Credit c. Market d. Regulatory/Compliance e. Litigation f. Business Continuity/IT security g. Operational h. Model Risk i. others
16. How satisfied are you with your current risk management systems in the following areas? (√ Tick the appropriate answer)
TYPES OF RISK Extremely Very satisfied Not satisfied satisfied a. Market Risk b. Credit Risk c. Liquidity Risk d. Operational risk e. Economic capital calculation and reporting f. Compliance management g. Collateral management h. Enterprise risk
126 17. To what extent are the following operational risk management methodologies developed at LAPF? (√ Tick the appropriate answer)
Well developed Somewhat Not developed developed a. Risk assessments b. Internal loss eventdata/database c. Key risk indicators d. Casual event analysis e. Scenario analysis f. External loss event database g. Scorecards h. Capital modelling 18.
127 19. To what extent has LAPF implemented the following aspects of operational risk management? (√ Tick the appropriate answer) Fully Substantially Not implemented implemented Implemented a. Identifying risk types b. Standardizing documentation of processes and controls c. Gathering relevant data d. Developing methodologies to quantify risks e. Roll out of a formal operational risk training program f. Creating metrics for monitoring each types of operational risk
20. To what extent does your Value at Risk (VaR) analysis cover the following asset classes? (√ Tick the appropriate answer)
Extensively Somewhat Not Not covered covered covered covered, but no plan but plan to to a. Fixed Income b. Foreign exchange c. Equity d. Asset-backed securities and structured products e. Credit derivatives f. Commodity g. Catastrophe or other event driven instruments
128 21. How much of a concern are the following issues with your risk management information technology systems? (√ Tick the appropriate answer)
Major Concern Minor Concern a. Lack of integration among system b. Lack of flexibility to extend the current system c. Inability to integrate analytics from multiple risk systems d. Lack of product coverage e. Lack of performance for more frequent and timely reporting f. High cost of maintenance and vendor fees g. Lack of integrated risk and finance reporting for economic capital optimization h. Out-of date methodologies i. Inability to source required functionality from a single vendor j. Inability to capture increasing volumes k. Lack of aggregation of trading and banking books
129