Risk Management within Banking


2.1 Defining Financial Risks

Financial risks in the banking sector are the odds that the result of an act or result could bring up unfavorable impacts. Such impacts could either cause direct loss of earnings or capital or may result in limitations on bank’s capacity to meet its business targets. According to the State Bank of Pakistan (2004) such events cause a risk as they can influence a bank's capacity to perform its ongoing business or to take advantage of opportunities to advance its business

2.2 Definition of Financial Risks as Per Basel II

Financial risk management has been defined by the Basel Committee (2001) as a ‘sequence of four processes: the identification of events into more or broad categories of market, credit, operational and ‘other’ risks and specific sub-categories; the assessment of risks using data and a risk model; the monitoring and reporting of the risk assessments on a timely basis; and the control of these risks by senior management.

2.3 Distinction between Risk Management and Risk Measurement?

According to Suren Markosov (2001) risk measurement is a key part of the general risk management process, but it's only one of the parts. Key parts also include defining risks, setting policy risk limits and guidelines, and taking action when those limits are threatened of being breached. Risk management is as much about people, procedures, and communication, as it is about quantitative methods involved in risk measurement.

Risk measurement, however, is important to the success of the risk management process. Part of the risk measurement task is to guarantee that the risk measures being used are suitable to the nature of the risks, so the necessary choices for risk measures need to be made.

2.4 Why do Banks manage Risks?

The analysis of risk management reported in Santomero (1995) gives us a lists of dozens contributions and at least four separate rationales considered for active risk management. These include ‘managerial self-interest, the non-linearity of the tax structure, the costs of financial distress and the existence of capital market imperfections.’

According to Laurence H Meyer (2000) risk is a fundamental part of the banking business and it is not amazing that banks have been using risk management ever since there have been banks and without which the industry could never have survived and the only change is the level of sophistication now needed to reflect the new complex and rapid moving environment.

As stated by Laurence H Meyer (2000), risk management is in fact expensive in both resources and in institutional disturbance and the cost of delaying or avoiding proper risk management can be extreme: failure of a bank and possibly failure of a banking system.

2.5 Determinants of Risks

When banks are exposed to risk, this implies that they are vulnerable to financial distress and failure. Determinants of risk are thus causes of problem bank failure. The common causes of bank failure are:

  • Management

Accounting deficiencies, poor response to change, over-gearing, over trading and large projects; all are reasons which affect capabilities of management.

  • Asset quality

Loan and advances comprise a substantial portion (50%-80%) of commercial banks’ total assets. “Asset quality is the most important determinant of bank risk exposure” as pointed out by Hefferman (2000), Gonzalex-Hermossilo (1999), and Hardy (1998). The asset quality of a bank is affected by various factors such as, over concentration, insider lending and political loans.

  • Capitalization

A bank can either maintain its capital adequacy ratio by increasing its capital or reducing of adjusted risk assets. The prime objective of this control is to protect depositors. However Blum (1998) found that with the incentives for asset substitution, capital adequacy requirements may actually increase risk. In Mauritius the BOM has adopted a capital adequacy ratio of 10% to match international standards.

  • Fraud

Fraud is one of the key determinants of risk. However it is closely related with the management competence that some fraudulent activities. The BCI and Barings Bank are good examples.

2.6 How Are Risks Managed?

As pointed out by Anthony M. Santomero (1997) there need to be essential procedures that must be put in place to carry out satisfactory risk management. Various ways are used to limit and manage the different types of risk and the management of the bank relies on a series of steps to put into operation a risk management system. These are as follows:

2.6.1 Standards and reports,

2.6.2 Position limits or rules,

2.6.3 Investment guidelines or strategies,

2.6.4 Incentive contracts and compensation.

2.6.1 Standards and Reports

According to Hodgson (1999) ‘underwriting standards, risk categorisations, and standards of review are all traditional tools of risk management and control and consistent evaluation and rating of exposures of various types are essential to understand the risks in the portfolio, and the degree to which these risks must be mitigated’. The consistency of financial reporting is the important. Audits, regulatory reports, and rating agency, evaluations are necessary for investors to measure asset quality and firm level risk.

2.6.2 Position Limits and Rules

The use of position limits, and minimum standards can be categorized as a second method for internal control of active management. According to Santomero (1995) ‘risk taking is restricted to only those assets or counterparties that pass some pre-specified quality standard and limits are compulsory to cover exposures to counterparties, credits, and overall position concentrations relative to various types of risks’. While such limits are costly to set up and control, their imposition restricts the risk that can be assumed by any one individual, and therefore by the organization as a whole.

2.6.3 Guidelines and Strategies

Guidelines are the third technique commonly in use. Cummins et al (1998) ‘provide that under this means of management control, strategies are shaped in terms of concentrations and commitments. 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 combined portfolio’.

2.6.4 Incentive Schemes

According to Cummins et al., (1998) ‘banks can enter incentive compatible contracts with line managers and make compensation linked to the risks assumed by these individuals, and then the need for complex and costly controls is decreased’. Incentive contracts require precise position valuation and proper internal control systems.

  • Strategies Used By Banks To Manage Risks
  • Interest Rate Risk

All banks face interest rate risk. This type of risks occurs when long term mortgages are funded by short term deposits. According to Ron Feldman and Jason Schmidt “Interest rate risk is like the “blood pressure for banks and is vital for their survival.”

Furthermore, according to the Basel Committee (2001) “interest rate risk is the exposure of a bank’s financial condition to adverse movements in interest rates. Accepting this risk is a normal part of banking and can be an important source of profitability and shareholder value.”

According to the Bank of Jamaica (2005) ‘each banking institution needs to establish explicit and prudent interest rate risk limits, and ensure that the level of interest rate risk exposure does not exceed these limits and Interest rate risk limits need to be set within an institution’s overall risk profile, which reflects factors such as its capital adequacy, liquidity, credit quality, investment risk and foreign exchange risk’.

Gap analysis, duration analysis and stimulation models are interest rate risk measurement techniques used by the Bank of Jamaica (2005). And according to the same bank ‘each technique provides a different perspective on interest rate risk, has distinct strengths and weaknesses, and is more effective when used in combination with another’.

Gap Analysis

A simple gap analysis measures the difference between the amount of interest-earning assets and interest-bearing liabilities (both on- and off-balance sheet) that reprice in a particular time period.

Duration Analysis

Duration measures the relative sensitivity of the value of these instruments to changing interest rates, and reflects how changes in interest rates will affect the institution’s economic value.

Simulation Models

Simulation models are used to analyse interest rate risk in a dynamic context. They evaluate interest rate risk arising from current and future business and provide a system to assess the effects of strategies to boost earnings or decrease interest rate risk.

  • Foreign Exchange Risk

According to the State bank of Pakistan it is the current risk to earnings and capital arising from negative movements in currency exchange rates. It refers to the impact of adverse movement in currency exchange rates on the value of open foreign currency position.

The use of hedging techniques by the Bank of Jamaica is one means of managing and controlling foreign exchange risk. Many financial instruments can be used for hedging purposes, the most commonly used, being derivative instruments. Examples also include forward foreign exchange contracts, foreign currency futures contracts, foreign currency options, and foreign currency swaps.

  • Credit Risk

Dr.Adem Anbar (2006) claimed that credit risk is the oldest and the most important risk which banks are exposed to and importance of credit risk and credit risk management are increasing with time because of reasons like economic crises and stagnation and company bankruptcies.

For the Norinchukin Bank in Japan (2006), transactions involving credit risk are one of the most important and strategic sources of earnings. In addition to assessments of the risks present in individual loans and other assets, the bank conducts comprehensive risk management from the perspective of its overall credit risk portfolio.

While frequently strengthening its credit analysis capabilities, the Norinchukin Bank conducts expert checks on the standing of borrowers, taking due account of their characteristics as cooperatives, private corporations, public entities, or non-residents. To conduct credit analysis on private corporations and public corporations, the Norinchukin Bank has established the Credit Risk Management Division, which is separate from the Corporate Business Management & Strategy Division, to prepare credit analyses by industry, drawing fully on the expertise the bank has historically acquired.

Based on estimates of the total credit extended, the Norinchukin Bank uses information related to credit risk— such as rating transition ratios that measure the probability of rating changes and are computed based on background history and future business prospects, default ratios by rating, recovery ratios in the event of default and correlations among the creditworthiness of corporations and other entities to conduct tens of thousands of simulated scenarios, under various assumptions regarding defaults and rating changes for its customers and their products—to determine the distribution of potential losses.

  • Liquidity Risk

According to the Bank of Mauritius liquidity risk is the risk that could occur if an institution does not have enough funds accessible to meet all its cash outflow obligations as they become due. Liquidity risk management ensures that funds will be available at all times to honour the institution’s obligations.

Banks use a variety of ratios to quantify liquidity which are as follows:

Cash Flow Ratios and Limits.

One of the main sources of liquidity risk arises from a bank's failure to pay a maturing liability. Cash flow ratios and limits attempt to measure and control the volume of liabilities maturing during a specified period of time.

Liability Concentration Ratios and Limits.

Liability concentration ratios aid to avoid a bank from relying on too few funding sources. According to the Bank of Pakistan (2005) ‘limits are usually expressed as either a percentage of liquid assets or an absolute amount and sometimes they are more indirectly expressed as a percentage of deposits, purchased funds, or total liabilities’.

Balance Sheet Ratios.

‘Total loans/total deposits, total loans/total equity capital, borrowed funds/total assets’ are examples of common ratios used by the Bank of Pakistan to monitor current and potential funding levels.

  • Empirical Evidence On Financial Risk Management Techniques
  • Credit Risk Management

Credit operations are traditionally the main source of income as well as risks for banks. Ramon Moreno in 2005 carried out an analysis of market central bank participants.

It was found that 40% of the respondents to his survey cited credit to household as an important source of credit risk. According to Moreno (2005), a distinct increase in credit to the household sector has altered risk exposures and he also found that in some countries there is significant credit risks on the banking book associated with asset price fluctuation for example lending for residential real estate accounts for around 25% of total loans in Hong Kong and Korea, around 19% in Hungary, Poland and Israel, but lower in Colombia and Mexico.

Another study carried out by Santomero (1997) found that banks usually use a credit rating procedure to assess investment opportunities in order to make credit decisions in a reliable manner and to limit credit risk exposure. It was found that the credit quality report signals changes in expected loan losses.

Also many banks are developing concentration reports and indicating sectorwise composition of the loan portfolio. Moreover the credit risk survey study done in the Turkish Banking sector by Dr Adem ANBAR, found that there is main quantitative credit risk measurer. There are the expected loss (EL), unexpected loss (UL) and credit value at risk (CVAR). Although these credit risk measures are used for measuring credit risk of one asset, particularly they are used for measuring portfolio credit risk. Only 35% of the bank used these measures.According to Dr Anbar, 30% of the banks said they measured credit risk using a portfolio credit risk model and software developed mostly by them.

Furthermore 95% of the bank used internal credit rating system and a credit scoring model in credit risk analysis. This technique was used to determine credit limits, to determine problematic credit and credit risk measurement.

According to the study there are 3 approaches in Basel II for credit measurement. These are Standardised Approach (SA), Foundation Internal Ratings Based Approach (FIRBA), and Advanced Internal Rating Based Approach (AIRBA). It was found that 60% of the banks used the first method and 20% the FIRBA and 20% the AIRBA.

Dr Anbar found that in general the tools which are used by Turkish banks are collateral, credit limits and diversification but they don’t use methods like loan selling, securitization, credit insurance for transferring credit risk. One reason for that was that these types of methods haven’t been developed in Turkish sector yet.

  • Interest Rate Risk Management

According to Santomero (1997) institutions that do not have active trading businesses, value-at-risk has become the standard approach. Many firms use this model but in some cases it is still in an implementation process.

According to his analysis, commercial banks tend not to use market value reports and guidelines but rather, their approach relies on cash flow and bank values. This system has been traditionally been known as the GAP reporting system. According to Hempel, Simonson and Coleman (1994) this system has been supplemented with a duration analysis.

Most banks, however have attempted to move beyond this gap methodology, they have concluded that the gap and duration reports are static and do not fit well with the dynamic nature of the banking market.

Furthermore, according to the survey, many banks are using balance sheet simulation models to find the effect of interest rate variation on reported earnings overtime. This system requires relatively informed repricing schedules as well as estimates of prepayments and cash flows. Officers make use of cash, futures and swaps to reduce this risk.

  • Foreign Exchange Risk Management

Not all banks are active Participants in dealing with foreign exchange risk; some banks view this activity as being beyond their franchise. Most active banks have large trading accounts and multiple trading locations, thus the importance of foreign exchange risk.

Most of the respondents to the survey carried out by Ramon Moreno (2005) expressed no concerns about this type of risk. Although there is direct currency exposure, while in some cases loss is significant due to currency risk. For example in Turkey banks have small open positions that do not require additional capital, so exchange rate risk is much lower than in the period before the 2000-01 crisis.

According to Santomero (1997) limits are the key elements of the risk management systems in foreign exchange trading. In many banks the derivation of limits tended to be an imprecise science. Other banks, however, do attempt to derive the limits using a method analytically similar to an approach used in the area of Interest Rate Risk Management. According to the survey in some banks stress testing are done to evaluate the potential loss associated with changes in the exchange rates.

  • Financial risks management in other sectors:
  • The Insurance Sector

The financial risks that insurance companies face are different from other institution as the insurance field is concerned with risk element in all its form.

Borwick, (2003) claimed that the insurance business represents the trading of risk profiles Insurance companies do use portfolio approach, i.e. they do not place “all their eggs in the same basket” (Hogarth, 2002). In the process of providing insurance and other financial services, they are faced with various kinds of actuarial and financial risks (Cummins et al, 1998).The risk that are found in an insurer’s product sales, i.e. those already in the products sold to clients to protect against actuarial risk are not all accepted by the insurer itself as stated by Oldfield and Santomero (1995).

The risks associated with the provision of insurance services differ by the types of services offered by the insurance companies. Actuarial risk is the most important risk that an insurance company faces. Actuarial risk is exclusive to the insurance industry.

Actuarial is the risk that emanates from the raising of funds through the issue of insurance policies. According to a study done by KPMG in 2002, it has been found that this risk which is the main risk faced by an insurer means that the insurer has either obtained too little premium for the risks it has agreed to underwrite and has not sufficient funds to invest and pay claims.

The insurer is also faced with systematic risk (Market risks) i.e. interest rate risk, basis risk and inflation risk (Santomero and Babbel, 1996). Insurers try to hedge against these risks to control the sensitivity of their financial performance. And of course like banking institutions, insurance companies are faced with credit risk and liquidity risk.

But the biggest difference is that insurance companies can use reinsurance to alleviate risks. Reinsurance can be defined as the transfer of risks from an insurer to a reinsurer (Hole and Shah, 2004). In general, every insurance company has a limit to the risk it is capable to assume in accordance of an individual policy. So, if the insurance company finds that it has entered into a policy with an expensive proposition for it, it will try to reduce the probability of any possible loss and thus giving up the contract by way of reinsuring a portion of risk with another insurer (Gupta and Gupta 1994).

  • Investment Companies

Investors take greater risks to achieve greater returns. Investments companies have almost the same types of financial risk (i.e.), interest rate risk, foreign exchange risk, credit risk and liquidity risk. There are two additional financial risks that an investment company will come across which are as follows:

  • Inflation risk is the risk that the money one invests will buy less in the future because prices of consumer goods rise. When the rate of inflation increases, investments have less purchasing power.
  • Reinvestment risk is the risk that reinvested money will fetch returns lower than those earned before reinvestment.

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