Risk management in the polish financial system

1.2 Economic risk versus state risk 8 1.2.1 State systemic risks 8 1.2.3 Tax risk from the perspective of the state 2.1.1 The operation of a financial system and the influence it exert

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Risk Management in the Polish Financial System

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Library of Congress Cataloging-in-Publication Data

Raczkowski, Konrad

Risk management in the Polish financial system : a systemic approach/

Konrad Raczkowski, Marian Noga, Jarosław Klepacki

pages cm

1 Finance – Poland 2 Financial institutions – Poland 3 Risk

management – Poland I Noga, Marian II Klepacki, Jarosław III Title

HG186.P7R33 2015

332.09438—dc23 2015018871

1.2 Economic risk versus state risk 8

1.2.1 State systemic risks 8

1.2.3 Tax risk from the perspective of the state

2.1.1 The operation of a financial system and the

influence it exerts on economic growth 47

2.1.2 Interaction between financial institutions 59

2.1.3 Protection of financial stability –

macroprudential policy goals and tools 61

2.2.1 Prevention of individual bankruptcy

2.2.2 Depositor protection 91

2.3 Comprehensive assessment of the financial situation

3 Management of Financial Stability Risk 100

3.4 Transfer of banking risk into the financial system 124

3.5 Reorganization of legal risk management processes 131

4 The Risk of Investing in Financial Instruments 138

4.1 Types of financial instruments 138

4.1.1 Money market instruments 146

4.1.3 Equity instruments 155

4.1.4 Derivative instruments (derivatives) 160

4.2 Investment risk involved in equity financial

4.2.4 Risk of total value loss 176

4.3 The risk of investing in debt instruments 177

5.1 Stock exchange investment style 186

5.2 Risk of investment strategies 191

5.3 Risk of other strategies 2015.3.1 Opportunistic strategy 202 5.3.2 Buy and hold strategy 204 5.3.3 Market timing strategy 206 5.3.4 Behavioral strategy 207 5.3.5 Dollar cost averaging strategy 209 5.3.6 Current yield strategy 214 5.3.7 Ratio investment strategy 216 5.3.8 Capital preservation strategy 218 5.3.9 The Benjamin Graham strategy 219 5.3.10 Fixed structure strategy 222 5.3.11 Constant proportion strategy 225 5.3.12 The black swan strategy 227

List of Figures

1.1 The influence of the socioeconomic system on

1.2 Profitability of ten-year government bonds in Poland 15 1.3 The population of Poland by functional age groups

1.4 Overall risk involved in the financial system 19

1.6 Overall and primary balances of national and local

1.7 The total tax burdens in EU Member States in 2014 31

2.1 A functional model of the transformation of a

financial crisis into a crisis of the real economy 55 2.2 Model of the system of interactions among financial

3.1 Comparison between systematic and systemic risk 110 3.2 The dynamics of the GDP of Poland and Germany 111 3.3 New European architecture of financial supervision 119 3.4 Types of bank risk in the area of finance 126 3.5 Model of credit risk transfer 129 3.6 Financial risk according to the Bank for International

4.1 Classical investment areas and the scales of

4.2 Juxtaposition of changes to the reference rate in

5.1 Changes to WIG over the last 30 years 193 5.2 Changes to WIG20 over the last 30 years 193

5.4 Prices of shares of Volkswagen AG between

5.8 KGHM share price, the purchase price averaging

strategy, diversification in time 210 5.9 KGHM share price, the purchase price averaging

strategy, diversification in the price in an uptrend 211 5.10 KGHM share price, the purchase price averaging

strategy, diversification in the price in a

5.11 Changes to stock prices 215 5.12 Changes to the WIG index and profitability of Polish

5.13 Behavior of the WIG20 index and the profitability of

ten-year government bonds between 2006 and 2014 223 5.14 Behavior of the S&P 500 Index and the profitability

of ten-year German government bonds between

List of Tables

1.1 Exemplary juxtaposition of the basic components of

1.2 Estimated indicators for comparison of the main

economic perspectives, according to the OECD,

1.3 Basic risk assessment scale of rating agencies 12 1.4 European Union Member States rating for March 1, 2013 13 1.5 Taxonomy of global risk according to the

1.6 The foundations underlying operational tax risk

1.7 Revenue, expenditure, and debt in the public finance

sector in Poland in the years 2006–2019 28 1.8 Affiliation of companies conducting business in

Poland based on confidential tax agreements concluded in

1.9 Tax burdens and tax optimization of the most profitable

2.1 Assets of financial system in relation to GDP in selected

countries from Eastern and Central Europe and from

2.2 Assets of Polish financial institutions during 2005–2015 50 2.3 Number of financial institutions in Poland between

2.8 Efficiency of classification of systems by D Hadasik

2.9 Efficiency forecasts of systems by D Hadasik for

2.10 Creation of credit money by commercial banks 81 2.11 Ratings of Polish banks according to Moody’s,

2.12 Selected balance sheet items in Polish banking sector 83 2.13 Results of assessment of resistance of banks to

Preface

The classic understanding of supply and demand, that is, typical forces stirring free market economies, is nowadays more and more commonly identified as the need to seek financial stability and security It is quite a practical approach, considering that neoliberal ideology, which had been spreading for many years as part of neoclassical economics, provided the directions for socioeconomic transformations Eventually, it has led to many financial crises and the financialization of the economy, which not only caused the financial market to become a major creator of the GDP

in many countries and thus tied the institutional domain of the state

to it, but also, due to an increase in its importance, generated systemic risk that exerts an overwhelmingly strong influence In the period of unification, globalization, and practically limitless possibilities for the transfer of capital, a completely new phenomenon has emerged: an inte-grated worldwide capital market On the one hand, nearly all sources

of broadly defined economic freedoms meet here On the other hand,

it is full of state-of-the-art mechanisms, relationships, correlations, and threats on top of that The role of an individual economy in such a system of correlations has never been as minor as it is now The transfer and diagnosis of risks have never been so imprecise before This dramati-cally changes the conditions for making investment, as risk has become inseparable and the possibilities of dispersion are often blocked

In consequence, the generating of theoretical models up to now subsequent attempts at incorporating them into the rapidly changing reality are vastly insufficient The example of continually refined systems

of financial supervision, which are either overregulated at some point

in time or are devoid of control and supervision mechanisms at other times, is a perfect illustration of the situation Therefore, it is becoming inevitable that a different perspective on these phenomena should be adopted – a perspective that is not only provided by researchers and theoreticians but also, and perhaps most importantly, one that is real and practical, a perspective that physically exists

Economic crises have always been arising, and they always will

be However, the fundamental problem in the contemporary global economy has to do with countering the transformation of a financial crisis into an economic crisis, and not only in one country or region but

all over the world As is widely recognized, a financial crisis will arise if one of the three possible economic scenarios unfolds: a run on banks (a crisis in the banking sector), an attack on a national currency and its purchase power (a national currency crisis), or an increase in interest rates applied to bonds in a given country (i.e., a transformation of stable assets into “junk” bonds – a sovereign debt crisis)

If it were possible to limit a financial crisis so that it affected solely the financial system, then it would not lead to an economic crisis in a country and in the whole world later on The relevant literature offers such a possibility, but world history – from the 20th and 21st centuries – has not registered any such occasion This is why theoretical economists have been looking for the causes of the transformation of a financial crisis into an economic one As far as the economy is concerned, we have observed that insufficient attention is paid to systemic risk, which

is a principal contributor to economic crises The following monograph

is devoted to this very fundamental problem of the contemporary global economy It is, as we acknowledge, a bold but realistic undertaking to study systemic risk For the purpose of attaining our goals, we define a financial system in simple terms as part of an economic system, which allows money to circulate across the economy We wish to stress that an abundance of different definitions of a financial system may be offered, but taking into account that the Polish financial system is composed out of ten groups of entities, it is virtually impossible to provide a single definition of a financial system that would suit everyone Certainly, while deliberating on various aspects of the financial system throughout the book, we will be adding different elements to the above-mentioned working definition; however, it will never contradict the accepted claim that a financial system is part of an economic system, which allows money to circulate across the economy

The purpose of this book is to present possibilities for managing risk

in the Polish financial system In particular, a map of risk in the Polish financial system 2015+ serves to achieve this aim by way of indicating the wide institutional and market frames, principles, and prospects

of exposure to risk and risk dispersion We put forward a hypothesis that risk management in the Polish financial system is necessary and possible if the principles of an appropriately formulated micro- and macroeconomic policy that is able to prevent the increase in systemic risks are observed From the point of view of the government, it should take place by way of consistent and effective implementation of a well-designed public policy oriented especially toward fiscal and monetary policies From the perspective of households and companies, it should

be perceived as a capability of getting to know the risk of daily life in order to skillfully (and to the accompaniment of lower information asymmetry) take action in terms of planning, organizing, and control-ling with respect to given socioeconomic activity

The book that we present consists of five chapters, each preceded by

a short introduction and followed by a conclusion Chapter 1 ates on national systemic risk management and presents an approach to those processes both in terms of real and regulatory socioeconomic proc-esses A depiction of tax risk (which is of such immense importance from the point of view of both a person conducting a business and the state – elimination of a legal loophole) is a valuable addition to those delibera-tions The stability of the Polish financial system and the involved risk are presented in Chapter 2 The micro- and macroprudential policies are illustrated here along with the assessment of the stability of the Polish financial system An addition and extension to that is Chapter 3, which

deliber-is concerned with financial stability rdeliber-isk from a managerial tive It discusses the principles of effective supervision with a systemic approach The next two chapters, that is Chapters 4 and 5, present the current risk involved in investing in financial instruments and the risk

perspec-of strategic investing in stock exchange A considerable cognitive merit for investors (but not only them) is the presentation of practical refer-ences of the explored strategies in relation to exposure to risk

The book is meant both for practitioners from all the sectors of the economy, especially those interested in financial risk, as well as students

in Bachelor’s, Master’s, or Doctoral programs who would like to widen their knowledge on risk management in finance

We hope that this book will satisfy the readers’ expectations by proving that risk dispersion is not always possible and that the forms of risk management and the processes involved should be understood so that they can become part of our everyday activity, which we will then undertake with full awareness at the least

Introduction

In order to manage systemic risk in an organization, such as a state, three points of reference must be established, that is a micro-organizational (households, companies), a macro-organizational (the state institutional system, the socioeconomic system of a country), and a mega-organizational one (global relationships) The most impor-tant in this case is the macro-organizational point, as looking at the executive of the state institutional system allows to assume a holistic perspective on risk within the framework of shaping the immediate systemic environment and neutralizing the threats posed by a distant systemic environment In turn, any human activity, especially if related

to trade, is connected with taking risks and the possibilities of incurring potential losses, particularly in legal and financial terms There is also a global perspective on top of that, which should not only be taken into account but perpetually born in mind as it may pose both opportunities and threats This is because every type of risk, systemic or incidental

in nature, assumes its own significance or generates cyclical or stable costs that must be incurred in order to regain the efficiency of operation chiefly in economic terms

The nature of any risk is always dynamic, irrespective of the fact that it might remain stable at some points in time As far as manage-ment is concerned, it must first be identified, and subsequently its real

or estimated weight must be defined, which will make regular control possible and allow the adoption of appropriate security measures Next, human skills must be used in a broad-minded way and not merely on

an individual, sector-, or department-based scale Therefore, this chapter presents an introduction to the abundance of approaches that one might

1

National Systemic Risk

Management

take to systemic risk, while at the same time showing how to achieve a compromise between exposition to risk and its aversion when it comes

“the objectified uncertainty as to the occurrence of an undesired event

It varies with the uncertainty and not with the degree of probability” (Willet, 1951) In the seventies, risk and its management were directed

at incidental and credit risks; in the eighties, market risk was added; and in the nineties, operational, strategic, and financial risks were also being developed (Cican, 2014, 280) If, in turn, we refer to the deci-sion theory in its classical form, the greater the dispersion around the expected values of variance distribution of profit and loss, the higher the risk (Kubińska and Markiewicz, 2012, 45) Whereas risk management is intended to make people conscious of what risk is involved in a given activity so that it can be managed, from the perspective of an individual (household), a state institutional system, and a company, it is supposed

to improve financial results and bring about conditions that will allow

to keep loss at a level not higher than specified earlier (Dziawgo, 2011, 314) The best principle of risk management in history was written down

in the Code of Hammurabi (about 1772 BC) It read, “If a builder build

a house for some one, and does not construct it properly, and the house which he built fall in and kill its owner, then that builder shall be put to death” (Taleb, 2015, 244) The death penalty mentioned in this passage might as well be replaced by money damages, if its amount would in fact compensate for the incurred loss (although it is hard to claim that any amount of money could be a substitute for the life of a person)

Risk has many synonyms, and is interdependently related to many terms, such as chance (the positive aspect of risk), systemic risk (common for a given group), unique risk (specific), shock (negative or positive change that may be either evolutionary or unpredictable), exposure to risk (shocks and vulnerability to risk), susceptibility (to losses generated

by negative shocks), resistance to shocks, crisis (emerging under the impact of the negative effects of risk), and uncertainty about the future (World Development Report, 2014, 61)

In general, risks may be categorized as follows:

according to the categories of decisions made for the purpose of a)

achieving goals (risk as uncertainty with respect to future events or the outcomes of decisions), and the results brought about by those decisions may either be loss or profit,

according to the sources of risk (uncertain information or a decision b)

made on the basis of a not optimal choice),

according to the manifestations of risk (deviation from the expected c)

value of the goal that has been set),

according to probabilistic or statistical measures as the subjective d)

probability of one-time events (including ones that have never taken place) (Tyszka and Zaleśkiewicz, 2010, 58–60)

The risk involved in an individual’s actions is always to some extent dependent on the external environment and may be examined from the perspective of numerous overlapping correlations that eventually affect decisions (Figure 1.1)

In this system, an individual (a human being) will always receive the necessary support, starting from a household, which protects its members and has the possibility of making use of the combined total resources, through companies, which ensure income and allow the absorption of shocks, to the state, which, through to an institutional system, is capable of exerting local, national, or international influence and serves as the last resort in ensuring that the fundamental rights are observed (World Development Report, 2014, 19)

The dimensions of risk management, from the broad to the very specific ones, may be presented as follows (Improving the Management , 2011, 5):

risk management (organizational principles, effective risk prediction): a)

placing an emerging strategy of risk management within the

●

framework of organizational strategic decision-making,

explaining the roles and responsibilities of the particular members

●

of an organization

risk culture (an active culture of risk management oriented at b)

super-vision, absorption, and assessment of information):

developing incentives to exercise supervision and prizes,

training and developing the potential for/capabilities of:

with the chief interested parties,

working and cooperating with others for the purpose of

under-●

standing the problems and threats that arise

adaptation planning and management (stress placed on d)

communi-cation and identificommuni-cation of risk):

predicting and preventive preparation in case of adverse effects,

●

drawing up of a list of options and priorities in order to ensure

●

flexibility and a possibility to change a decision,

formulating a strategy for resistance and response to the emerging

insurance, advanced age;

• Help and support

• Family ties;

• Collective activity

The enterprise sector

• Work and income

The financial system

• Insurance and credits

Individual risk management (everyday life risk)

The international community

(resources, global rules, coordination, experience)

Figure 1.1 The influence of the socioeconomic system on individual risk

management

Source : World Development Report, Risk and Opportunity – Managing Risk for Development,

World Bank, Washington 2014, p 19

stabilization and reduction across time by way of dispersion However, not all such factors may be stabilized or dispersed, and reduction in the level of accompanying uncertainty may also have a merely subjective character, if there are no sufficient grounds for objective appreciation The unexpected character of certain events is rather a consequence of insufficient knowledge on a given subject But why is it that having,

as we believe, quite extensive knowledge, we are still surprised by the lack of certainty, if we are empirically proven wrong (Hadyniak, 2010, 13–14)?

Since J von Neumann and O Morgenstern elaborated on the

D Bernoulli’s expected utility principle, this rule has governed sions involving risk, as it offered guidelines on which path to choose Further development of this theory on the basis of experiments that were conducted has led to the formulation of the so-called conventional theory (Kopańska-Bródka, 2012, 133–134) “These theories study the preference relationships inevitable to explain the sources of inconsisten-cies with the independence axiom In such extensions, the axiom system

deci-of the theory deci-of expected utility is accepted However, the functional on

a set of risky decisions is not an expected value but a decision-weighted transformation of the utility of possible outcomes This new principle has not led to such inconsistencies as the principle of expected value maximization” (Kopańska-Bródka, 2012, 134) Nevertheless, even these theories did not prove quite useful, which led to the development of alternative theories known as unconventional ones as well as prospect, dual, or generalization theories In general, each instance of strategic decision-making should be – from the point of view of the state or the market – dependent on the mutual infiltration and complementation of prescriptive and descriptive approaches (i.e., the so-called conventional and unconventional ones), which would mean taking into account individual reasonableness associated with the subjectivity of the act of making a choice (Kopańska-Bródka, 2012, 134, 146–147)

Therefore, a taxonomy of the threats and risks to macroeconomic growth, which must be taken into consideration when making strategic decisions, especially related to finances, includes the following units that may be examined from the perspective of insurance companies, corpo-rations, financial risk managers, and political decision-makers (Coburn

A certain mood of the decision-maker can affect their decisions that are made in uncertain conditions Research conducted by A Bassi,

R Colacito, and P Fulghieri demonstrates that even the weather can exert an influence on risk aversion By affecting people’s moods, good weather encourages the taking of risk, while bad weather increases the propensity for averting risk The results of this research are particularly important in the making of strategic decisions involving risk in the context of investment behavior and the dynamics of the rate of return

on assets (Bassi et al., 2013, 1844–1845)

1.2 Economic risk versus state risk

1.2.1 State systemic risks

State risk is closely related to the cognitive purpose of economics regarding the explanation of agentic actions taken as part of doing busi-ness, that is, the “production and exchange of various goods and deter-mination of the frequency of spontaneously repeated production and distribution processes” (Klimczak, 2013, 15) This is associated with the cognitive purpose of risk that is relevant for any dimension of individual and institutional activity of not only the citizens or residents of a given country but also of the whole global society, which directly or indirectly shapes the level of international and state risk

Naturally, the state must investigate risk with reference to various gories of system failures that occur in all parts of the state and not only

cate-in its cate-individual and often selective elements (Kaufman and Scott, 2003, 371) This type of risk is characterized by risk fragmentation and may be transferred to other areas of the state as a system, and even slight (and seemingly meaningless) fragments indirectly contribute to the far-reaching consequences of a failure In addition, systemic risks pose difficulties in regaining balance after a shock (Goldin and Mariathasan, 2014) W.A Rowe sees risk as a negative consequence of a given event (Rowe, 1977), which is consistent with the views held by J Sinkey, who claims that risk manifests itself through an unexpected change in events and that it is concerned with the uncertainty connected with some event (Sinkey, 1992) B Shanmugan believes that political risk may influence (and it usually does) the profita-bility of global ventures and that the lack of foreign exchange reserves in the process of external debt management is the main reason behind the emer-gence of risk that a given state will face (Shanmugam, 1990) Therefore, as

T L Brever and P Rivoli put it, economic, political, and financial factors are key in the assessment of risks with which a given state is posed (Brewer and Rivoli, 1990, 357–369) These factors are based on both short- and long-term variables that reflect the political system of a country as well as the fundamentals of the economy, which are treated as priorities by investors when it comes to making investment decisions (Sari et al., 2013, 5)

It may thus be stated that there are three factors among 22 variables that are of cardinal importance for a state as far as risk estimation is concerned, that is,

a) the economic factor – GDP per capita, annual inflation rate, the real

GDP growth rate, government budget balance as a percentage of the GDP, and balance of trade as a percentage of the GDP,

b) the financial factor – external debt as a percentage of the GDP, stability

of currency exchange rate, external debt servicing (percentage of the GDP), net liquidity, and balance of trade as a percentage of export, and

c) and the political factor – stability of the government, external and

internal conflicts, socioeconomic conditions, investment profile, the presence of the army in politics, corruption, ethnic, and reli-gious tensions, the level of democracy, the level of bureaucracy, the legal system (Hoti, 2002, 1–61)

Simultaneously, a randomized study by B.K Asiri and R.A Hubail conducted with a group of over 70 countries based on a period between

2006 and 2011 shows that political risk exerts a powerful influence on the evaluation of a given country as a whole Additionally, rating agencies use GDP per capita and gross capital formation as the basic points of refer-ence in estimating the overall risk that a state faces (Table 1.1) The ratio

of external debt to export and the rate of economic growth must also be included within this group (Asiri and Hubail, 2014, 65)

Economic perspectives reflecting risk or lack of it may be compared

in all types of business reviews (and they are) One of those is offered

by the Organization for Economic Co-operation and Development (OECD) It evaluates positive changes as well as risks and the weight of threats, especially in terms of accommodative monetary policy, financial stability, and systemic challenges The four basic comparison measures (but naturally not the only ones) for a given country are GDP growth (in percentages), unemployment rate (percentage of labor force), debt of the

Table 1.1 Exemplary juxtaposition of the basic components of risk assessment for a

given state (on the example of data for Poland)

Political

stability*

55.29 69.71 77.51 80.09 83.02 83.96 83.41 78.67 Gross capital

Notes : *Political stability/no aggression/terrorism; **accumulation of the national capital over a

specified period of time; ***Nominal GDP (in current prices in PLN)

Source: drawn up by the authors on the basis of data obtained from the World Bank, October,

2014

public sector (percentage of the GDP), and inflation expressed with the consumer price index (CPI in percentages) – Table 1.2

Assessment of the credibility of a given state (similarly to assessment

of economic entities) is controversial and does not always reflect the real condition of the entity undergoing assessment, which was clearly demon-strated by the last financial crisis As a result of considerable exposition

to risk due to subprime lending, banks were forced to take out short-term loans from the market in order to finance risk assets and, so to say, estab-lished the risk assets in effect It has also been proven that financial insti-tutions, or in fact their employees, are motivated to achieve effectiveness and increase the efficiency of financial operations, which they carry out

by way of exploiting the defects and loopholes in the internal control system Thus they cause excessive exposure to risk, which if not alleviated, may lead to dual losses – of the client and the institution – and to bank-ruptcy of both at the extreme This happens because managers responsible for managing risk do not have real knowledge and their function mainly comes down to exercising control over the rules and standards established

by supervisory agencies, and often purely on paper Exposure to risk is controlled by people holding operational commercial positions and the management department of a bank instead of people who could exercise control from the perspective of risk management, that is, with full partici-pation of the management department and within flexible and not rigid frames (Kashyap et al., 2008, Ellul and Yerramilli, 2013, 1758–1759 ff.) It is thus not surprising that such a state of affairs regarding the whole financial

Table 1.2 Estimated indicators for comparison of the main economic

perspec-tives, according to the OECD, relevant for risk management

Indicator (%)

2014 2015 2016

Poland

The Euro Area Poland

The Euro Area Poland

The Euro Area

Note : *at constant prices

Source: compare your country – OECD Economic Outlook, Paris, November 2014

system is associated with huge systemic risk and fundamental instabilities often caused by the markets themselves Indeed, the risk of instability and bankruptcy is growing if all the participating institutions on a given market make the same mistakes (Boot, 2014, 129–131) This is true both for a bank-oriented financial system and a capital market-oriented one (see Flejterski and Solarz, 2015, 79–80)

Furthermore, managers predominantly concentrate on the capital market even though they should pay greater attention to the clients and the product market with which they deal (Chen et al., 2012, 739)

It has also been demonstrated that a tendency to take risk will have

a more profound influence on decision-making if the decision-maker has to make a decision without having access to complete information Nevertheless, both persons prone to taking risks and those who would rather not take risks take the same risk when they had a chance to access information about threats Hence, if no information on threats and risk

is available, decisions are made on the basis of trusting intuition and will

be different depending on personal dispositions and experience of the decision-maker (Meertens and Lion, 2011, 654)

It was indeed the very banking environment in which – according to R.M Stultz – absolutely no identification or measurement of risk, no monitoring or management of risk, and even a lack of crucial communi-cation of exposures to risk to top-level management were revealed (Stulz,

2008, 58–67) Rating agencies distorted their ratings of numerous tutions or even countries, and in many cases did not just fail to predict what was going to happen but created systemic threats by not issuing warnings Although they did not fulfill their role, it is currently in their hands, especially as far as countries still suffering from the consequences

insti-of the last financial crisis are concerned, to lower the rating insti-of a given country, which might produce distinctly negative consequences for its whole economy This is because financial institutions respond almost immediately to any new ratings – especially the negative ones – by way

of making specific decisions that directly contribute to an increase in the demand for debt financing of a given state or lead to a rise, sometimes significant, in the cost of financing loans It is also meaningful that the European Securities and Markets Authority not only monitors the finan-cial markets in Member States but also watches the activity of rating agencies This is because they cannot let rating agencies create separate model economic entities based on a methodology of research that is subjective, if not downright ignorant of the reality, as they used to do before the financial crisis J Boatright, who studied the ethics of finan-cial management, is right in this respect Anyone who was supposed

to deal with the stabilization and protection of the whole financial system (and perhaps the rating agencies in particular) shares respon-sibility for this state of affairs and for a false sense of security that was created (Boatright, 2011, 145–170) Rating agencies did not see the real risk involved in granting mortgage loans in the United States, and their assessment turned out to be ten times lower than the actual exposure to risk (McDonald and Robinson, 2009, 164)

Currently, there are over 80 rating agencies in the world, and new ones are established every now and again However, about 94 percent of the global market is rated by three agencies, the oldest ones – Moody’s, Standard & Poor’s (S&P), and Fitch (Competition and Credit Ratings Agencies, 2010, 12) (Tables 1.3 and 1.4)

Ratings are much more complex and have assessment categories that refer both to the national currency and the foreign one (Table 1.4) Estimation of risk in a given country is intended to prevent an economic crisis by forecasting that it is approaching It is possible, however, that neither recession nor economic growth forecast will come true Nonetheless, preparation of a correct forecast in the first case (of a recession) allows the achievement of a macroeconomic effect through the possibility of the adoption of preventive measures by the govern-ment Simultaneously, microeconomic effects are produced as well since entrepreneurs are offered a possibility of diversifying their business port-folios, eliminating some portion of risk, and taking anticipatory action before the possible economic downturn (Korol, 2010, 75)

Table 1.3 Basic risk assessment scale of rating agencies

S&P rating

Moody’s rating Fitch rating

Credibility level Level

Investment (no or certain risk)

AA+, AA, AA– Aa1, Aa2, Aa3 AA+, AA, AA– Very high

A+, A, A– A1, A2, A3 A+, A, A– High

BBB+, BBB, BBB- Baa1, Baa2,

Baa3, Baa4

BBB+, BBB, BBB-

GoodBB+, BB, BB– Ba1, Ba2, Ba3 BB+, BB, BB– Speculative

Noninvestment level (high risk)

B+, B, B– B1, B2, B3 B+, B, B– Very

speculativeCCC, CC, C,

RD, D

Caa1, Caa2, Caa3, Ca

CCC, CC, C,

RD, D

Serious risk – insolvency

Source: drawn up on the basis of the methodology of rating agencies – S&P, Moody’s, and

Fitch

Many organizations and entities deal with the measurement of risk of

a given country, and the most popular are (Erb et al., 1996, 29–30, Rao,

S&P perspective

Moody’s rating

Moody’s perspective

Fitch rating

Fitch perspective

The Czech

Republic

Source: drawn up by the authors on the basis of data from Sovereign Credit Ratings: S Roger,

A Sedghi, J Burn-Murdoch, Credit ratings: How Fitch’s, Moody’s, and S&P rate each country, The Guardian , London 2013

BERI – Business Environmental Risk Intelligence,

cross-border transactions, geopolitics, and macroeconomics), CRIS – Control Risk Information Services,

that measures the six dimensions of the government in a given state

A rating of a given state directly translates into interest rates placed on ten-year government bonds, where lower profitability attests to a better position of the economy of a given country and is associated with a lower budget deficit, as well as lower debt servicing costs In February 2015, Poland recorded the lowest (in recent years) profitability of Treasuries at 2.19 percent (Figure 1.2)

Simultaneously, the profitability of ten-year bonds was richly varied

in the European Union (EU) in the same period (November 2014)

It was high in risky states, such as Greece (7.26 percent) or Cyprus (6 percent), or very low, such as in Germany (0.79 percent), Luxembourg (0.87 percent), Finland (1.01 percent), the Netherlands (1.03 percent), or Austria (1.10 percent) (Long term government , Eurostat)

For the first time since 1989, Poland in July 2014 recorded deflation connected with a rather short-lived phenomenon of a decrease in prices, which accompanied the economic downturn in some states in the Euro area (as well as the Russian embargo imposed on the import of Polish foodstuffs and agricultural products), and no cost and demand pressures Deflation would pose a threat if it continued for a long time, as it would lead to a general decrease in prices of consumption goods and services, which would also bring about other accompanying phenomena (Raport

contrib-be taken One might even say that a decrease in mean inflation rates is correlated with the openness of the capital market to financial globali-zation (Devereux et al., 2014, 921–957) and thus to taking a global perspective on risk

Figure 1.2 Profitability of ten-year government bonds in Poland (%)

Source : drawn up by the authors on the basis of data from the OECD for: Graph: Long-Term

Government Bond Yields: 10-year: Main (Including Benchmark) for Poland, Fred Economic Data, Federal Reserve Bank of St Louis, from March 1, 2015

It does not, however, appear that deflation will last longer in Poland,

or follow a cyclic pattern, which makes it possible to believe that within

a few coming years, inflation will be kept at a low or very low level, even below the target inflation set by the National Bank of Poland (NBP) One of the serious risks for any state, which should be taken into account when adopting the systemic perspective, is the population, which is connected with the rate of population growth and interrelated with the proportions of functional working-age groups and the post-productive age group (of retired people) In January 2014, the global population exceeded 7.1 billion people, and forecasts predict that in

2050, there might be 9.3 billion inhabitants on Earth (World Population Prospects , 2011)

Between 2015 and 2050, the world will undergo profound graphic changes that will certainly affect risks and the possibilities related to them China, which is populated by 1.36 billion people

demo-in 2015, will have a similar number of people demo-in 2050 (1.30 billion); however, it is estimated that the number of people in India will rise from 1.25 billion in 2015 to 1.65 billion in 2050 At the same time, Russia and Japan will no longer be considered as two of the ten biggest coun-tries in the world in terms of population as their place will be taken by Ethiopia and the Philippines Extensive changes will occur because the population growth is the fastest in Africa now, especially in countries such as Uganda, Niger, Ethiopia, or Burkina Faso In contrast, negative population growth will be observed in nearly 30 countries, and the most threatened are Moldavia, Bulgaria, Estonia, Latvia, and Ukraine (Stein,

2014, 26–27)

From such a perspective, the population of Poland by functional age groups will face the long-term and systemic demographic risks associ-ated with an aging population, which will most probably lead to socio-economic tensions in the near future and destabilize public finances

to some extent If systemic risks are not eliminated through, among other strategies, shaping a profamily policy oriented toward increasing the replacement rate; lowering the unemployment rate; reforming the pension system (especially by eliminating numerous privileges origi-nating from the previous political regime); and creating the founda-tion for an innovative economy – and not merely in name, but a really innovative one – then the population of Poland will have decreased

by almost 4.5 million people by 2050; the number of the working-age population will have gone down by 2.8 million; and the number of pensioners above the age of 75 will have increased by as many as 6.25 million (Figure 1.3)

The basic problem from the perspective of the financial system is the threat of upsetting the cross-generation transfer of incomes and economic growth The issue is that it will not be possible to stabilize a budget and carry through with indexation or even maintain the same level of pensions if there is no high productivity and economic growth at the same time (i.e., the GDP at least 3 percent and productivity 2.9 percent –

up to 2025 After this period, both the GDP and productivity ought to increase significantly [Ochocki, 2012, 15], if we are to talk about a rela-tive stabilization of the rate of potential cross-generation support at all) However, perhaps the lack of prospects for a new baby boom will result

in changes on the labor market, and it will be much easier to find a job

38,419,0046,876,311

24,409,70115,164,810

9,244,8917,132,9925,728,495

23,892,1748,798,335

26,619,8516,070,658

2,697,2231,560,083701,194

33,950,5634,963,362

19,047,7399,331,049

9,716,6909,939,4624,120,477

16,130,29313,699,79318,732,59311,097,4935,616,7873,537,5032,071,817

0 10,000,000 20,000,000 30,000,000 40,000,000 50,000,000Total

2014

and the level of unemployment will spontaneously go down But then

we will be faced with the problem of staff shortages, and we will need

to attract employees from other countries, which will change the social structure of Poland as a nation

For this reason, systemic risks in a country may be referenced to the taxonomy offered by the World Economic Forum (Table 1.5)

All the risks enumerated above exert a direct or indirect influence on the financial system in a given country They may open up opportuni-ties, especially if another country is affected by them, but they may also pose threats When the situation is relatively stable, the most important

Table 1.5 Taxonomy of global risk according to the World Economic Forum

economic State financial policy collapse

Collapse of important mechanisms and financial institutionsThe influence of an increase in prices of oil on the economyCollapse or short-term failure of the critical infrastructureHigh structural unemployment

Currency crisis

environmental Natural disasters (geological or related to weather anomalies, etc.)

Ecological disasters caused by human activity (oil leakages, radioactive contamination, etc.)

Loss of biodiversity, collapse of land and marine ecosystemsClimate changes (connected with the global warming, among other things)

Water crisis (depletion of freshwater resources)

political Downfall of world authorities

Political crisis in countries of high geopolitical importanceLarge-scale terrorist attack

Corruption

Escalation of organized crime

Development of weapons of mass destruction

Regional conflicts between countries

social Food crisis

Risk of epidemic

Unstable social or political situation

Uncontrolled urbanization

technological Collapse of information infrastructure and network

Terrorist attack on information infrastructure

Data theft on a massive scale

Source: Global Risk 2014 Ninth Edition, World Economic Forum, Geneva 2014, pp 11–12

group of risks from the perspective of Poland is certainly economic risks connected with the collapse of the financial policy It is difficult, however, to consider these risks and the influence they exert separately without taking into account their relationships with mutual levels of corruption, organized crime, regional conflicts between nations – which belong to the category of political risks – or others included in the cate-gories of social, technological, or environmental risks

It may thus be assumed that a financial system is “the collection of markets, institutions, laws, regulations, and techniques through which bonds, stocks, and other securities are traded, interest rates are determined, and financial services are produced and delivered around the world” (Rose and Marquis, 2011, 3) However, a definition formulated in such a way is incomplete as it does not take into consideration public finances as the basis of the state fiscal policy that shapes the monetary policy in turn

Hence, we assumed that a financial system is part of an economic system, which allows money to circulate in the economy , and that risk present in this

system may be depicted with the following diagram (Figure 1.4)

Risk involved in the financial system

Political risk Financial risk Economic risk

Economic system

Key risks

Everyday life risk Limited insight to and prognosis of potential scenarios

Other risks interdependent on subjective uncertainty

Social risk Environmental risk Technological risk

Figure 1.4 Overall risk involved in the financial system

Source : drawn up by the authors

In such a general diagram of risk involved in the financial system, the manner of money circulation is open It circulates among (the finan-cial, commodity, or resources) markets, households, enterprises, and the institutional sphere, symbolically represented as the government, which holds the executive power Key risks are concerned with political, finan-cial, and economic factors, which are also shaped by other risks that are interdependent on subjective uncertainty

1.2.2 Economic risk

Generally speaking, three categories of risk may be discerned as far as business activity (undertaken by companies) is concerned, and each requires an individual approach (Kaplan and Mikes, 2012, 55):

a) Internal business risk – does not contribute to the emergence of any

strategic advantages The risk is limited by way of adopting an tive approach In an integrated model of culture and conformity, it

effec-is necessary to come up with extreme systemic principles and tions, a common mission, values, standard procedures, and exercise control (in a form of an audit as well) The role of the management

solu-is to coordinate, supervsolu-ise, and correct the control mechansolu-isms, treating risk management as an independent function,

b) Strategic risk – is considered while taking into account all the

possible major strategic turning points in order to reduce the ability that it will be incurred and the costs it may bring about A model approach is based on a discussion of threats to strategic goals with respect to a map of the probability and impact of a given risk, and allocation of resources It is intended to reduce the risk of the occurrence of critical events and develop key risk indicators within

prob-a scorecprob-ard The mprob-anprob-agement stprob-aff responsible for mprob-anprob-aging risk should hold regular meetings and reviews of risk, as well as offer support in developing risk-related initiatives and act as independent initiators and experts,

c) External risk – which consists of the so-called external threats not

subject to control – should be managed so that its possible quences and costs will be effectively reduced before running the risk

conse-at all This can be done through forecasting: simulconse-ation games, risk assessments, stress testing, and scenario planning The task of the management staff is to mount exercises in various planning proc-esses, analyses, or scenario planning, and supplement the team-work strategy as part of independent initiatives and the exercises mounted

The essence of risk management is such a selection of methods and techniques of action that will lead to a reduction in the level of risk affecting a given entity by way of communication that is intended to identify, analyze, plan, track, and control the risk (Zawiła-Niedźwiecki,

2013, 73)

Each economic entity is exposed to risk that is posed by two groups of factors (Śliwiński, 2002, 55):

a) external factors , that is, the environment of a company (economic

trends and tendencies on the global markets, state economic and fiscal policies) and the micro environment (trends in a given sector

in which a company operates, the financial power of the tion, the capabilities of suppliers, and clients),

b) internal factors , that is, resources owned by a given entity (both

tangible and intangible) and their use in strategic and operational activity

Any business, or business trade in broader terms, may be placed within the interdependent prospectives of awareness of risk or awareness of responsibility (Brinkmann, 2012, 567 ff.) Economic risk is associated with uncertainty about generating profit by a given entity, lack of knowl-edge about the situation on the market or, more broadly, the market conditions themselves (Szkutnik, 2010, 29) Simultaneously, one should note, in line with the confirmed studies by M Mazzocco as well as E Jouini, C Napp, and D Nocetti (Mazzocco, 2004, 1169–1182, Jouini,

2013, 411–428), that an increase in tolerance of risk shown by a given person in a group may lower the group’s collective level of risk toler-ance Thus, risk distribution among groups and individuals and among individuals experiencing different levels of risk is a fact As a result, when running a business, it is important who manages certain business processes and what is their propensity for taking risk, as it either directly lowers or raises risk aversion, depending on individual preferences However, uncertainty brings about different qualitative consequences than risk as far as business activity is concerned Greater uncertainty intensifies fast learning processes and entails increased assiduity of the managers themselves (He et al., 2014, 206–225)

As demonstrated by the study by G Loomes and G Pogrebna, nation of attitudes to risk requires the application of such a procedure

exami-of participant priming, which is suited to the type exami-of decisions being investigated Sometimes it might require that several question vari-ants be asked, which will de facto reduce the observational error, or

the adoption of an additional procedure may turn out to be not only helpful but also increase the sensitivity of risk parameters estimation Simultaneously, it is a challenge to refer to the stochastic character of human decision-making and build process models so that they will

be adjusted to the reactions that such decisions produce (Loomes and Pogrebna, 2014, 592)

In an economic environment, risk is aggregated (combined), and entities – participants in business trade – show different risk tolerance At the same time, risks may be categorized into three groups, which are related

to the market, the operational dimension, and events (Figure 1.5)

Taking the above into account, we can say that economic risk may be defined as a measurable uncertainty in business activity, which is dependent

on the propensity interpretation of events by the decision-maker within the frequency and probability of conditional socioeconomic processes The

propensity interpretation included in the above-mentioned definition

Commodity prices risk

Risk of withdrawal of capital

Currency risk

Interest rates risk

State risk

Organizational risk Systemic risk Business trading risk Embezzlement risk Tax optimization risk

Political risk Regulatory risk Risk of a natural or civilizational disaster

Frequency Conditional probability of

occurrence of events Propensity interpretation

Expected results and events

Figure 1.5 Economic risk

Source : drawn up by the authors on the basis of business bankruptcy risk: T Korol, Systemy

ostrzegania przedsiębiorstw przed ryzykiem upadłości [Warning Systems against Risk of Insolvency], Wolters Kluwer business, Warsaw (2010, 68)

is concerned with the propensity theory put forward by K.R Popper, which proposes that a decision-maker conditioned by a subjective inter-pretation of events may make use of objective propensities (Popper,

If we look closely at contemporary business trading, which is often devoid of rules and is interested in achieving its own goals exclusively, the proposition by A Congleton that corporations may treat their social mission similarly to how a hospital or a university might treat it appears to be nothing more than a utopian idea (Congleton, 2014, 171) Although it is unrealistic, it does happen in individual cases

H Dellas and A Fernandes should also be mentioned at this point

as they used the general equilibrium model to prove that the tion of financial limitations among companies increases competition

allevia-in the sectors dependent fallevia-inancially (low Lerner allevia-index), even though other indicators may suggest otherwise Thus, all the risks present on the financial market, including crises in particular, may have an adverse effect on competition on the product market, especially in terms of costs (Dellas and Fernandes, 2013, 269–288) This is likewise true in the case

of banks, for which the Lerner index measures interbank competition by estimating their market power, including their impact on whole coun-tries as well It turns out that high-income countries, the so-called devel-oped countries, especially the OECD ones, have lower market force of banks (0.0955) as opposed to African (0.1814) or Islamic banks (which have the highest Lerner index of all the categories, i.e., 0.2034), which may be related to the transparency of the institution’s activity or finan-cial liberalization (Coccorese, 2014, 84–85)

It is worth noting and highlighting that an increase in uncertainty during economic downturn and recession contributes to a decrease in production in the first year by 3 percent, which is connected with a temporary halt in investment processes, employment of new staff, or activation of new saving processes The situation quickly returns to

normal in the second year (Bloom, 2014, 169), which allows risk sion in the whole economy, as long as all entrepreneurs act in this fashion, of course

1.2.3 Tax risk from the perspective of the state and the economy

Another type of economic risk is tax risk, which may be divided into two categories:

a) Corporate tax risk – which concerns the understatement of tax

liabili-ties either erroneously or on purpose (both in line with the law in

a given place and time – tax optimization – or to illegally evade taxation) This may lead to the necessity of incurring additional expenses, loss of financial liquidity, or even bankruptcy, if an audit turns out positive and a final court decision is pronounced,

b) State tax risk – which is connected with the creation of a tax gap

by companies and households, and which consists in reducing the tax base in a hybrid manner, that is, legal and illegal, or defrauding the financial benefits of the state budget by way of tax return (most usually VAT in the intra-Community trade), which influences the final amount of contributions to the budget and the state budget deficit, as well as the public debt

Common categories of tax risk that affect (to a varied extent) both ties conducting business activity and tax offices controlling business trading are as follows:

a) transfer prices – defined as “prices at which an enterprise transfers

physical goods and intangible property or provides services to ciated enterprises” (Communication from the Commission to the Council, 1990) The most popular methods of price estimation are the comparable uncontrolled price method (for a given entity and associated enterprises), resale price method (defining the margin

asso-of resale price), reasonable margin method, the so-called plus method (setting prices for the sale of rights and goods, and rendering services), and as the last resort, the transactional profits method (estimation of income on the basis of expected profit based

cost-on divisicost-on of profits or net transacticost-onal margin) (Ordinance of the Minister of Finance of September 10 , 2014),

b) indirect taxes – an element of constant risk, especially in

intra-Community trade and involuntary participation in “carousel” tax fraud (business risk) and which is also connected with defrauding

unduly paid tax of the state budget by way of wrongful tax return (state risk),

c) a large increase in tax risk and controversy – with regard to the

busi-ness activity of a given entity on the emerging markets, especially in China, India, and Brazil,

d) reputational risk (i.e., risk of loss of reputation in the eyes of a client

or the taxman, especially if immoral tax behavior or illegal iors are widely publicized by the media),

e) legislative risk (associated with chaos, overregulation, and

simultane-ously with an inconsistent interpretation of the provisions of tax law – not suited to global trade practices, especially in e-commerce and regarding intangibles),

f) law enforcement risk (concerned with the fact that in consequence of

a large number of instances of tax fraud, tax administrations do not keep up with implementing effective control mechanisms, which may on the one hand strengthen unfair competition in the case

of crime in a given sector and when no perpetrator is detected or punished and on the other hand lead to an increasingly aggressive attitude of tax authorities toward enforcement of tax law, even with lack of proof of perpetration and despite top-down pressures),

g) operational tax risk – connected with the inside of an organization

and caused by employees, technology, or initiated and supervised processes 1

In every management process the weakest spot is the human, nology, or the process itself; therefore, eight foundations of basic oper-ational risk management relevant for a state, as an organization, and enterprises must be presented 2 (Table 1.6)

One of the most significant and, in fact, fundamental issues related

to financial risk management in a country is the general condition of public finances Public finances allow formulation of the whole socio-economic policy through the sustainable satisfaction of citizens’ needs and the creation of opportunities for broadly defined business and innovation The debt of national and local government institutions (the so-called excessive debt procedure [EDP]) amounted to over PLN 830.2 billion in the middle of 2014, and if it had not been for a drop resulting from a reform of the pensions system and redemption of public debt securities, it would have risen A similar trend can be observed for state public debt, which amounted to PLN 793.6 billion in an analogous period (Zadłużenie sektora finansów , 2014, 1–3) High risk is posed

by the fact that 58 percent of public debt is owned and handled by foreign