The Theory and Practice of Risk Management in Banks - Dissertation Example

?The Theory and Practice of Risk Management in Banks Introduction: There have been significant transformations in the operating environment in the global banking sector, during the last couple of decades. In the U.K. a significant rise in total assets has been observed ever since the 1990s. Furthermore, due to globalization and industrialization, transactions involving foreign exchange have also risen dramatically over the years. This has given rise to increased incidences of risk encountered by commercial banks world-wide. Commercial banks today operate in a highly risky environment, which are encountered by them, on an almost daily basis, during the process of their routine banking activities. There has been a major turbulence in the credit market which can be traced to the institutional changes brought about in the housing finance sector, in developed countries. Housing finance markets were deregulated, leading to a heighted competition in the credit lending market, and the integration of housing finance with the capital markets further worsened the crisis (Hoggarth & Pain, 2002). Also, the rapid development of technology brought about significant changes and played a key role in developing and strengthening the money market funds. The wide-scale use of technology further led to a global economic boom and helped in reducing the interest rates to a considerable extent. This increased the profitability of banks to considerable extent. Bank profitability is defined as a result of internal and external determinants (Short, 1979; Bourtke, 1989; Molyneux and Thornton, 1992; Demirguc-Kunt and Huizinga, 2000). Internal determinants include size, capital, credit risk, costs etc. There is a positive relationship between size and profitability of banks (Akhavein et al, 1997; Smirlock; 1985). It is also proposed that the size is an important internal determinant which influences the manner in which factors such as financial, legal and moral, affect profitability of banks (Demirguc Kunt, 1998; Maksimovic, 2002). Brief Background: As mentioned above, there have been significant transformations in the banking sector world-wide. In the U.K. these transformations include: the consolidation of the U.K. banking industry; the conversion of building societies into banks; as well as the influx of new entrants mostly comprising of non-financial institutions into the financial services market. After the introduction of the Building Societies Act, various building societies were converted into banks, while the rest of the building societies enjoyed unlimited commercial liberty under the Act. Changes such as these, added to the already competitive market. The banking sector was rapidly transforming during this period, following such changes. It was during the period 1991 – 1996 that the mergers and acquisitions increased drastically in the UK. The new entrants in the market comprised of non-financial institutions such as football clubs and insurance companies who were given authority to enter the retail market. Apparently, such drastic changes in the banking and financial services industry, in the U.K., gave rise to critical challenges, as the external environment in which the banks operate became increasingly concentrated. Banking regulation was relatively weaker, thus increasing the vulnerability of the sector, and significantly altering its power to address the risks faced by it. The case of Northern Rock: The bank which operated on Northern Rock, is one such glaring example of the vulnerability of the banking sector as well as the credit crunch which ensued such rapid transformations in the U.K. banking sector. This was the oldest running bank in the country, with over 150 years of business, however, its failure posed serious questions and left doubt regarding the effectiveness of the regulatory practices. The inefficacy of the regulatory practices coupled with the vulnerability of the bank, highlighted its inefficiency of responding to the crisis, hence services of the Bank of England were sought as a last resort. Serious concerns were raised with regard to the existing regulatory authority in the UK comprising of three regulatory bodies i.e., The Bank of England; the Financial Services Authority and the Treasury. Types of Risk: There are various types of risk faced by the banking sector globally. These include operational risk; financial risk, market risk, credit risk, quantitative risk, commodity risk, currency risk, project risk, technology risk etc among others. Banking institutions primarily have faced two fundamental types of risks so far. These include the risk of non-receipt of borrowed capital alternatively referred to as credit risk; and the risk of inability / failure to return the deposits, also known as liquidity risk (Gerhard, 2002). Credit Risk Management: The term credit risk management is defined as: the risk of default or reductions in market value caused on account of changes in the credit of issuers or counterparties (Duffie and Singleton, 2003). Basel (1999) defines credit risk management as “the potential that a bank borrower or counterparty will fail to meet its obligations in accordance with agreed term”. Credit risks is one of the most integral part of the banking system, and one of the most frequent type of risk, experienced in the banking sector. Banks are primarily in the lending business, and this involves recovering the amount lent, from the borrowers. According to Horcher (2005) credit failure is highly likely and inevitable “when an organization has accumulated large losses, owes many other counterparties or when its creditors or counterparties have financial difficulties or has failed”. It is believed to be one of the oldest and significant forms of risk faced by institutions operating in the financial sector (Broll, Pausch and Welzel 2002). According to Kaminsky and Reinhart, as cited by Jackson and Perraudin (1999) this is one type of risk which can threaten to completely erode a bank’s capital, forcing it into bankruptcy. The management of credit risk, hence is of utmost significance for all institutions operating in the financial services industry. The fundamental objective of risk management is to gain maximum possible ‘risk adjusted return’ through identification of credit risk which is inherent to their individual banking transactions, and try to curb the factors which are likely to threaten the bank’s functioning. This can be done by minimizing the credit risk exposure to a safer level. Credit risk management is one of the most critical aspects of risk management in banks, and plays a key role in the long-term functioning of any banking institution (Basel 1999). Types of Credit Risk: Credit risk, as has been established in the previous section, is one of the most recurring forms of risk experienced by banks globally. It is categorized into various types by various authors. The same is discussed in the following sections. There is a difference of opinion among researchers regarding the types of risks which can be categorized as a credit risk. For instance, according to Hennie (2003) there are three forms of credit risks, based on the type of borrowers which includes: corporate risk; consumer risk; and country risk. Culp and Neves (1998) on the other hand categorize credit risk into two types, based on the type of transaction i.e. default risk and resale risk. According to Horcher (2005), credit risk can be categorized into six distinct types which include: counterparty pre-settlement risk; concentration risk; default risk; legal risk; country risk; and counterparty settlement risk. Default Risk: This is the most basic type of risk often encountered in the banking business. It occurs when the borrower defaults in repayment of loans. In case of a default, the degree of risk involved is directly related to the amount of loan, which in some cases might be the entire borrowed amount. The probability of recovering the amount from defaulters, depends on the legal status of the creditors although, such a recovery is rare and highly unlikely. Persistent reoccurrence of such cases of default may lead to serious consequences, forcing the bank to apply for bankruptcy (Horcher, 2005). The case of American Trust Bank, Ga. Default risk is probably one of the most apparent and oft-encountered risk in the banking sector can be substantiated with the fact that recently, three banks were closed down in Georgia and Illinois thus, increasing the total count of bank failures to 14 in the year 2011. The American Trust Bank based in Roswell, Ga was seized by the Federal Deposit Insurance Corp., with $238.2 million in assets and @222.2 million in deposits; the North Georgia Bank of Watkinsville, Ga., with $153.2 million in assets and $139.7 million in deposits; and Chicago-based Community First Bank with $51.1 million in assets and $49.5 million in deposits (The Huffington Post, 2011). Counterparty Pre-Settlement Risk: Pre-settlement risk is the risk which is encountered on account of the probability that the counterparty is likely to default in the repayment of dues, after the contract has been signed. The bank has to suffer the consequences of unrealized gains, and the degree and extent of loss depends on the changes in market rates (Horcher, 2005). Counterparty Settlement Risk: Settlement risk refers to risk which is encountered in inter-bank transactions and entails a situation where one of the parties to the contract defaults in monetary payments or deliver assets to the other party, during the time of settlement. The delay in payment could however, be attributed to the differences in time zones (Casu, Girardone and Molyneux, 2006). According to Horcher (2005) the default in payment on account of differences in time zones occurs in cases of foreign exchange trading, where payment is typically made at different centers and the amount involved is huge. The Case of German bank, Bankhaus Herstatt: The German based Herstatt Bank, was a privately owned bank, which was closed down on June 26, 1974, by the German Authorities. The bank was highly active and mainly dealt with foreign exchange markets. Some of the bank's counterparties had paid large amount of Deutsche marks to the bank, although it had not yet received any dollars in exchange. Because of the time difference between the two countries, American markets had not yet opened for the day, when Herstatt made the payment. The closure of Herstatt triggered off a chain reaction in the financial markets and the entire banking industry was in panic and disrupted beyond control. Following the news of its closure the correspondent bank in New York, stopped all dollar payments to its customers, and refused to do so from their own account, until it received the counter value (Remolona et al., 1990; Hefferman, 1996). Country or Sovereign Risk: This type of risk occurs on account of various factors such as – deterioration of foreign social, political or economic conditions. Such deterioration leads to an adverse effect on the overseas transaction leading to a rise in sovereign risk. The concept implies that in such a situation, the government of respective countries, may exercise their right to declare debt to its external lenders as void or try to adjust the movement of profits, capital or interest owing to internal reasons such as economic or political pressure (Casu, Girardone and Molyneux 2006). In order to avoid any untoward incident in terms of huge financial losses, countries / governments usually tend to impose temporary or at times indefinite control on lending capital, as well as on cross border payments. This is because, in such a scenario, non-payment of dues on account of internal political or economic reasons, might lead to a financial crisis in the other country (Horcher, 2005). Identifying and Managing Credit Risks: Since credit risk is among the most frequently encountered risks in the banking and financial sector, identifying and managing such risks is of utmost significance for banks in order to avoid huge losses and minimize risk. According to Basel (1999) loans are one of the most apparent causes of credit risk, along with other factors such as financial instruments i.e., acceptances, inter-bank transactions, futures, guarantees, etc., make the banks vulnerable to credit risk. Thus the identification and complete eradication of factors or elements leading to credit risk is highly unlikely. Loans can be categorized into various types, such as consumer loans, commercial loans, industrial loans, real estate loans, as well as others. Some loans are made for a brief period of time such as commercial or industrial loans whose duration may last anywhere between a few weeks to a couple of years; while some loans take the form of mortgage loans such as in case of real estate loans, which differ greatly from consumer and industrial loans, in terms of size, amount as well as maturity. The risk of non-payment of dues i.e. credit risk is higher in case of bank loans as compared to any other forms of credit. However, over the years, the quality and regulations surrounding lending policies of banks has been questioned. This is mainly on account of failure and shutdown of banks in large numbers over the past few years. The credit risk on account of loans is universal in nature, and applies globally however, recently it has been observed that this type of risk has shifted to the developing nations, while the industrialized nations are facing problems due to commercial lending and credit risks associated with real-estate borrowings (Saunders and Cornett, 2006). According to Hennie (2003) credit risk on account of non-performing loans is also significantly higher. Non-performing loans refer to those loans which fail to generate income or gain monetary returns, and are classified as non-performing when the capital amount or interest due is left unpaid for more than 90 days, at a stretch. Needless to add, that non-performing loans play a major role in influencing the bank’s profitability and hence must be dealt with in an effective manner. The issue of non-performing loans can be attributed to the lending policies of the banks. The level or degree of a bank’s credit risk exposure is hence directly related to the quality of its lending decisions. Another significant cause of credit risk is the inter-bank transactions. Banks usually transfer huge amount of cash / money through wire transfer. The payments made to the wire transfer system, are provisional in nature, and are only settled during closing time. Thus, in case a major fraud is uncovered during the day, it may trigger a series of panic reaction across the whole network, leading to an immediate shutdown. This would cause the non-payment of promised dues to the counterparty bank, which in turn would fail to meet its payment commitments to other parties, thus leading to a serious causal reaction in the financial markets. This risk can be easily identified and dealt with by the respective banks, since the exchange of large amount of cash though wire transfer takes place during the day, and the same is not reflected in their balance sheets or any books of account. The non-recognition and non-acknowledgement of such a serious error / fraud, further leads to serious long-term consequences and prevents the banks from devising appropriate and effective methods of dealing with such routine forms of credit risks (Saunders and Cornett, 2006). Loan Commitments: This concept refers to the process whereby banks, make a formal offer, which includes all necessary terms and conditions regarding the repayment of loans, such as the interest rate, the amount to be borrowed, the maximum time allowed, etc. The credit risk in such cases exists in the setting of interest rates, formulated by banks on a loan commitment. In order to minimize risk, and mitigate losses, banks usually add a risk premium which in turn is calculated by taking into consideration various factors such as creditworthiness of the borrower. Thus, if the borrower gets caught in a financial difficulty making it difficult or impossible for them to return the dues the banks run a high risk of attracting heavy financial losses (Saunders and Cornett, 2006). According to Hennie (2003) irrespective of the transformations in the banking and financial sector, and the influx of various credit instruments followed by entry of non-financial institutions in the market, the threat of credit risk remains unchallenged. Credit risk continues to be one single reason behind heavy financial losses and even shut down of several small and large banks across the globe. This because, over 80 percent of a bank’s balance sheet is commonly associated with this characteristic trait of risk management. The discussion above further proves the significance of credit risk management in the banking sector. The primary objective of credit risk management is to help the banks to increase the risk adjusted return through credit risk exposure (Basel 1999a) and adjusting it to acceptable levels. Foreign Exchange Reserve Risks: Risk management in the area of foreign reserves in case of banks, is similar to the management of all other types of risk encountered by banking institutions world-wide, with respect to the consequences faced by them. These include written policies and procedures which lead to accuracy of assets and liabilities valuation; development and implementation of effective internal controls; the degree, size and type of accounting procedures and rules and regulations which are employed for valuation of assets and liabilities etc. among others (Enoch et al., 2002). Case Studies: The risk exposure of banks world-wide has risen dramatically over the years, and measures to implement effective policies and regulations are being implemented to upgrade their risk management abilities. The main focus of all the efforts made to mitigate risk, revolve around the introduction and implementation of strict practices to ensure that risks are reduce to the minimum possible extent. Some of the risk management practices of some international banks are discussed in the following section. The cases discussed include: Risk management practices at ECB (European Central Bank); and the foreign exchange reserves risk management, Hong Kong. European Central Bank: ECB is the central bank in Europe which manages the Euro. One of its key role comprises of ensuring that the purchasing power of Euro is maintained at a satisfactory level, at all times in order to maintain price stability in the Euro area. The ECB plays a major role in within the European banking sector – that of a key decision-maker as well as a coordinator. The Risk management segment of this bank looks after the regulations, policies and strategies with regard to managing risks and monitors the financial risks encountered by the bank (ECB, 2011). The Eurosystem is a unique structure, which entails a proper and effectively designed risk management system. In order to make the system more effective, the ECB with consultation of EMI (European Monetary Institute) and NCB, formed a framework whereby the ECB was centralized to lend more credibility and authority to the risk management policies and in order to ensure that the bank can function effectively and manage all financial operations within the Eurosystem. The Eurosystem acts as the central banking system of the euro area and comprises of the ECB and the NCB (national central banks). The Eurosystem is in fact a sub-set of the ESCB (European System of Central Banks) and is involved in key policy and decision making processes, which are framed to meet the common goals of the Eurosystem (ECB, 2011). The key reason behind the policy of managing risks centrally is to satisfy the primary objective of the Eurosystem - that of maintaining price stability and reduce risk. The principle of decentralization allows the ECB to manage and implement various key organizational decisions in the best interests of the ECB and for the Eurosystem as a whole. The ECB has express authority to execute plans or actions which are deemed important for the benefit of the Eurosystem. But risk management was considered as incompatible with the decentralized system, hence the decision was taken to centralize the system to minimize risks. Centralizing the risk management has led to various benefits in the form of ability to prevent any inability or failure on the part of the system to address issues which arise out of conflicts and the division of responsibilities (ECB, 2011). The ECB’s risk management division charter states that: It is required to offer organizational and administrative assistance and frame appropriate policies on risk management in order to transform the range of financial transactions conducted by the ECB or any of the 17 NCBs within the Eurosystem. Frame policies and strategies to address issues such as market or credit risk with respect to the financial transactions undertaken by the ECB; its investment options; and ensure that it is in sync with the monetary and foreign exchange policy framed by the ECB (ECB, 2011). The Risk management segment of the ECB comprises of two key areas. One for handling the risk management issues associated with application of monetary policy of operations within the Eurosystem, and the other for managing risk management issues regarding the foreign currency reserves of the funds managed by ECB. With a view to manage and organize the credit risk associated with monetary policy operations, the Eurosystem depends on the collateral offered by its counterparties. There is a special provision in the Eurosystem, mentioned in the Article 18, which ensures that the ESCB and ECB must cover any credit which is provided by the Eurosystem, and cover it with adequate collateral. The Eurosystem continues to apply a sophisticated collateral policy, which has become the key highlight of its entire risk management framework. Such a policy aims to achieve two key objectives – that of balancing the diverse practices implemented by the NCBs before the establishment of the monetary union and to existing diversities in the capital markets; the legal and institutional structures and other monetary and risk management policies of the EU member states. Management of Foreign Currency Reserves: The foreign currency reserves which are mainly invested in liquid assets are divided and shared by the 17 NCBs within the Eurosystem. The quantity of each division / share depends on the capital held by the NCBs. The ECB employs a dual level benchmark system for the management of foreign currency reserves, whereby each portfolio is given a strategic benchmark in accordance with the relevant currency. The key focus in such a bifurcation is on the long term investment. This is further supported by a tactical benchmark which is established and framed by the portfolio management department of the ECB, and enjoys a distinct existence which is separate from the Risk Management Division. The portfolio management divisions of NCBs who are otherwise involved in the management of the actual portfolios, are then allowed to assume positions within a preset band which in turn is based on a tactical benchmark (ECB, 2011). The Eurosystem also includes a separate division and a system for managing credit policies which limits the instruments, countries as well as issuers which the NCB may use. The department for risk management assesses and reports the adherence to rules and regulations, and ensures that the performance standards are met, by the NCB portfolio management team. Foreign Reserves Risk Management, Hong Kong The banks worldwide today, recognize and identify the risks associated with foreign exchange reserves which have posed several challenges to banks in the past couple of years. Banks are now aware that for the successful and effective management of foreign reserves, it is inevitable for them to understand and study the market situation and establish a risk management system which aims at developing and implementing policies and strategies to minimize such risks. If the performance standards established by the risk management department in banks, are strictly followed, then such risks can be easily avoided or minimized to a considerable extent. Furthermore, with the elimination or minimization of such risks, the banks may develop alternative strategies to improve and achieve their investment objectives and in the process regain consumer confidence in the monetary policies and measures of the government. The central banks are now increasingly adapting to the changing market dynamics by incorporating the best market practices along with their risk management practices in their respective countries. The innovations in the field of technology have made available a lot of sophisticated tools and techniques at the disposal of the banks, which can be used by them as tools for assessing, controlling and mitigating risks to a substantial extent. With regard to banks the effectiveness of risk management is measured with regard to performance attribution. In the case of the Hong Kong Monetary Authority (HKMA) the performance attribution is analyzed and categorized with regard to the overall asset allocation and return on portfolio. Principle 11 of the Basel Committee's core principle for effective banking supervision states that bank supervisors must be satisfied that the banks supervised by them have appropriate set of policies and procedure developed for assessing, analyzing and controlling the country risk as well as transfer risk, with respect to transactions related to international lending as well as other miscellaneous investment activities undertaken to maintain adequate levels of foreign reserves, as a risk management approach (HKMA, 2011). The Exchange Fund of Hong Kong (EFHK): The EFHK was established in the by the Currency Ordinance of 1935, and is involved in management of fiscal reserves ever since (HKMA, 2011). In 1976, under the government directives, the fiscal reserves were transferred to the Exchange fund. This was done to ensure that the fiscal reserves do not have to suffer exchange risks arising out of investments in foreign currency assets and to centralize the management of the Government's financial assets (KHMA, 2011). Furthermore the linked exchange rate system in Hong Kong, which was set up in the early 1980s can be seen as a response to the East Asian Economy Crisis which was triggered on account of shortage of currency, and hence also known as the currency crisis (Sheng, 1995). The Monetary base in Hong Kong includes components such as certificates of indebtedness – which were introduced as a measure against the risks associated with shortfall of banknotes; the aggregate balance of bank accounts maintained with the HKMA; as well as other outstanding amount. This system proved to be highly effective and helped the country to stabilize the Hong Kong dollar exchange rate. The same is controlled and supervised through automated systems, which intimate the officials regarding the rise and / fall in demand for HK dollars; or offers intimation regarding the weakening of HK dollar; information regarding the conversion rates; etc. Such a system helps the banks and the management unit responsible for managing and controlling risks, to keep abreast with up-to-date information via an all time access to vital information. Conclusion: Banking institutions like all other sectors, is currently operating in a highly uncertain environment which is characterized by heightened vulnerability of firms operating in this industry. The external as well as internal factors responsible are not only in-exhaustive but also difficult to be completely eliminated. The recent closure of banks in the developed countries is a glaring example of the high risks involved in operation and control of financial institutions. The industry is faced with newer and complex set of challenges like never before. The recent economic downturn, the credit crunch, as well as the weakening of the dollar triggered a series of uncontrollable events, hampering the profitability of some of the strongest players in the banking industry and completely shutting down many others. Some of the most recognized risks include the credit risks and risks of foreign currency reserves. The globalization and industrialization has increased the interaction of countries and facilitated better trade ties, thus involving huge amount of foreign exchange transactions. Risk management, hence is the only available tool to address the challenges faced by the highly volatile external environment, in order to sustain the profitability as well as the national economy. References: Akhavein, J.D., Berger, A.N., Humphrey, D.B., (1997). ‘‘The effects of mergers on efficiency and prices: evidence from a bank profit function’’. 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