Risks and Challenges to the Banking Institutions - Assignment Example

?Financial Risk Management Introduction Money lending in different forms has always taken place in the history of mankind. Money lenders of some formor the other have existed in the market over long ancient years. In the beginning of the twentieth century, modern industry required a state regulated banking system (Hammonds, 2006). In the current financial framework, the central bank of a nation sets all the monetary policies for the economy. All the other commercial banks work under the rules and regulations of the central bank. Growth and economic development in a nation requires excessive investments, these are financed by the financial bodies in an economy. The banking and financial institutions of a country are responsible for the development and progress of different sectors in the economy. They mobilize household savings and lend it to the potential investors in a country. Investments made in the business corporations help them to expand and generate more employment opportunities in a country. Thus, financial institutions and banks play a pivotal rule in the progress of a nation (Saunders and Cornett, 2011). Figure 1: Classical Banking Model (Source: PPT) Figure 1 above depicts the simplest version of banking model in an economy. However the primary task of these institutions also constitute in offering loans to only the worthy borrowers. Rise in the threshold of bad debts result in acute loss of all the related economic entities. Thus, controlling credit, interest and operational risk is one of the most important tasks conducted by all financial institutions. However, the actual framework of banking system in an economy is more complex, this takes into account the market securities and banking risks involved in lending operations (ECB, 2011). Figure 2: Securitization Model of Banking (Source: PPT) Figure 3: Optimization Model (Source: PPT) Risks and Challenges to the Banking Institutions The modern banking and financial institutions have faced several challenges and risks in its process. One of the primary challenges is to introduce mobile banking as regular mode in all banking activities. They have executed several operations to stimulate growth in an economy, sustaining profit levels in an environment with low interest rates etc. They have taken active measures to enhance capital quality and improve capital surplus. Modern banks have tried their best to enrich customer relationship along with restoring public confidence regarding industry. In the recent years the managers of the financial institutions are giving high importance in risk managements. In 1970’s large sums of loans were offered by the financial institutions to different business enterprises in the Eastern bloc, Latin American and less developed economies, but in 1980’s it was found that many borrowers were unable to pay back their loans in time. Government in many economies have introduced the tool of Sovereign Debt Ceiling. By this rule, the borrowers are forced to be defaulters even though they comprise strong credit rating. The global financial instability is increasing with time. Financial crisis in most of the developed and developing economies have increased the credit risks faced by the banking and financial institutions. Many developed economies are suffering from huge debts and failed projects are demanding implicit bail outs from the government. Figure 4: Emerging Market Risks (Source: IMF, 2011) The above cob wed model explains the increased market risks faced by banking and non banking financial institutions in the modern era. Banks and financial institutions deal with different currencies in different economies thus they are often exposed to exchange rate fluctuation risks. They also suffer from high price volatility risks. Interest rate risks faced by the commercial banks are of different types. Repairing risks are also known as the maturity risks, these are the risks that arise due to the inverse relationships between bond prices and interest rates in the market. Basis risks are the ones that arise due to the difference between the short and long run yield curves that depict same maturity for different financial instruments. Yield curve risk is the risk that arises due to the prices and slope change of the yield curve. When the asset and liability is matched together having same durations of maturity but different in terms of cash flows. Yield curve risks are analyzed with the help of maturity risk spread methodology. Change in duration of assets and liabilities due to change in interest rates generates Option risks. Gap, scenario and stimulation models are the models that help in measuring interest rate threats (Keefe, Fournier and Torys, 2003). Thus, accessing credit quality as well as sovereign risk is highly important in the modern days. Market data may also be used by the banking and financial institutions to access risk associated with lending operations. The central bank of a country trades with government bonds in its open market operations. This helps to regulate the supply of money in the economy. Bond prices are inversely related to interest rates and thus, it becomes important for the banks to forecast the possible risks associated with interest rate changes. The most common approach used to access interest rate risk in the duration and convexity approach. It helps to analyse the change in interest rate of a portfolio of bonds with the help of duration, this is the first mode of approximation. The second approximation approach to find interest rate risks is the convexity technique. The traditional formula used to measure the duration of a security is: Duration= V- - V+/2V0 (y); V0= current bond price. V-= the estimated price of bonds, if the interest rate falls with time. V+= the estimated price of bonds, if the interest rate rises with time. D(y) = the change in interest rates. The duration approach is based on the principle of single interest rate that is also popularly known as the flat yield curve. However, this method makes no hypothesis about the structure of the securities. In case of convexity, if the vale comes in positive, then the gain is more than the loss associated with changes in interest rates. The situation is just the opposite if the convexity value comes negative. Figure 5: Convexity Approach (Source: PPT) The above graph graphically depicts the convexity approach to estimate interest risks. Risks are formulated out of market uncertainties. In the current era, state of economic affairs are highly volatile, thus controlling and predicting the negative uncertainties has become one of the pivotal task for all the financial institutions in an economy (Gajek, Ostaszewski and Zwiesler, 2005). (Source: PPT) These are the types of catch phases used my modern banking authorities. Pricing Profitability and Credit Risk in Lending Commercial banks offer certain rates of interest to the depositors. Higher the duration and value of deposit, higher is the interest offered to the depositors. The banks mobilize the total deposits and lend it to the different investors demanding money. The investors are required to pay a certain rate of interest on the borrowings offered by the banks. However, for any bank the lending rate is greater than the borrowing rate. The difference between the lending and borrowing rates marks the profit margins for commercial banks in lending operations. The interest charged or offered is always higher for high valued financial transactions. The profit generated by the commercial banks is directly proportional to the scale of operations. Profit maximizing of a banking institution is not its revenue maximizing limit. The commercial banks must analyze their optimal lending capacity that shows the best profit subject to the given constraints like credit risks. The banking institutions demand for certain collateral securities in for the loans offered by them. The value and worth of the collaterals demanded is directly proportional to the probability of defaults in a lending operation. Modern commercial banks also trade with derivatives and other forms of assets in the economy (Seagal, 2013). Operational Risk Operational risks are the risks involved in the internal working of banking systems. These risks are associated with the people, process and system in banking operations. Fraud, legal and environmental risks associated in the working of a bank is also included in the category of operational risk in banking system. Figure 6: Level 1 and 2 Category of Operational Risks. (Source: PPT) The above schedule depicts the different variations of operational risks in business organizations. The costs associated with such risks are pricy for a bank. However, there are various quantitative approaches to control the operational risks in a bank. These are the Basic Indicator Approach (BIA), The Standardized Approach (TSA) and Advanced Measurement Approach (AMA). The BIA makes the banks set a goal to achieve a gross profit of at least 15% in three years. The TSA is the average summation of three years regulatory capital charges. AMA is the method that deals with scenario analysis and internal loss modelling. The scenario analysis involves identifying the operational risks, helps to form parameters that recognise the capital risks and uses a Monte Carlo simulation in its process (GARP, n.d.) Figure 7: Monte Carlo Stimulation Process (Source: PPT) The graph above explains the quantitative approach to measure operational risk. Here, the historical data of scenario analysis is used and the Cox-Poison method is incorporated to access the average loss in frequency due to an operational problem. Lognormal distribution is used to measure the mean and standard deviation of the internal and external historical data of scenario analysis (BIS, n.d.) Figure 8: Differed Quantitative Approached to Access Operational Risks (Source: PPT) The above diagram shows the three formulas required to measure operational risks. However, operational risk can also be accessed qualitatively. Figure 9: Qualitative Assessment of Operational Risk (Source: PPT) Measuring operational risk qualitatively is time consuming and a non scientific method, so can often give out wrong conclusions. There are various other approaches used to measure operational risks, these are correlation analysis, questionnaire analysis, etc. Market Risks Market risk faced by the banks generates negative uncertainties from changes in the market conditions. Market volatility and interest rate risks, currency and commodity price risks etc, are different types of market risks faced by the banks in the modern economic system. The current market is highly volatile in the economy, thus fluctuations in prices of both commodities and derivatives is obvious, so it becomes important for the banking institutions to control the market risks affecting its financial transactions. There are various ways to measure the extent of risks associated in the markets. Value at Risk (VAR) is the most traditional approach used to measure the market risk. The banking as well as the other financial institution use VAR to introduce short term risk management methods in their operations (Manganelli and Engle, 2001). This approach helps to estimate the probability of negative uncertainties in the portfolio trading activities of financial institutions. The VAR model assumes the portfolio market to be normally distributed. It shows the maximum possible change in the value of a portfolio of financial apparatus given the probability over the time. Figure 10: VAR Model (Source: PPT) The above graph shows a VAR model, where x% shows the confidence interval that signifies that the change in the price of the portfolio would be -.5 to +.5 variable forms the desired expected mean change. The two tails of distribution shows the critical regions (100-x) % where losses are exactly negative to the gains from market-to-market operations. The gains or losses follow independent normal distributions. One day VAR =.233(Standard Deviation), T Day VAR= SqRoot T times one day VAR. The VAR model helps to access the total risk associated by only a single number. It is simple to calculate and easy to understand. Economists generally use linier models to calculate VAR. The VAR models can be broadly classified into three major categories; parametric, nonparametric and semi parametric. VAR model not only helps in risk management but also helps in estimating the performances of the risk takers and access the requirements of regulations in the work of financial institutions. The parametric models like Risk matrices, Generalized Autoregressive Conditional Heteroscedasticity (GARCH) etc. help to forecast the different changes in the prices. The non parametric models based on historical stimulation that focuses on the principle of rolling windows. The modern semi parametric approach helps to analyse the VAR on the basis of Extreme Value Theory (Alexander, 2009). Credit Value Adjustment Counter Party Credit Risks (CRR) are the risks that arise when counterparty defaults before the final cash flow transaction is over. If the portfolio of transactions comprise of positive economic value at the time of the default then the financial institution suffers from economic losses. The credit risks associated with simple lending operations are unilateral in nature, where only the lending bank suffers from the loss. CRR creates bilateral risks, where the market value of the transactions can affect either counterparty positively or negatively. Figure 11: Interest Rate Risk in Counter Party Transactions (Source: PPT) Credit Value Adjustment (CVA) adjusts a value that enumerates the creditworthiness of the counterparties in a financial transaction. The CVA method has been modified over time; the advanced form of CVA can only be utilized by the banks that have the IMM approval. The approval is granted for reducing the possibility of counterparty credit risks (Mehta et al., 2012). Figure 12: Advance CVA Working (Source: PPT) This process can only be utilized by the banks that can assign specific risks in the VAR models for bonds. CRR credit risks have increased with the rise in global financial crisis. The banks have taken active measures to minimize such over the counter risks; CVA is used by them to facilitate pricing and management operations. The traditional CVA method includes only the component of risk that is involved in the counter transactions. The new CVA approach takes into account both loss and risk in these uncertain transactions. Along with the difference of the risk free and actual value of the portfolio, the loss is calculated with the VAR models and multiplied with it. Basel Three Approach of Risk Management The Basel Committee attempts to make the banking sector more stable. The Liquidity Coverage Ratio introduced by the banking sector helps in reducing the short term liquidity risks of the commercial banks. It assures that the commercial banks have enough cash reserves to pay off its short term liabilities at the end of every month. The extent of the financial instability is increasing rapidly with time. Stock market fluctuations have become almost indispensible, in the current economic conditions. At this juncture the access of surplus or adequate liquid fund is essential for the banks to help them absorb the different fluctuations of the economic system. A situation of crisis or financial scarcity in the banking sector immediately spills over to the real sector of the economy. Thus, sufficient liquidity coverage ratio ensures that the crisis in the financial sector will not create much spill over effect in the real economy. The Global financial crisis of 2007 to 2008 has shown that many banks had adequate fund with them but could not pay back the short term liabilities. This is because the banks did not manage the fluid resource efficiently. At the beginning of 2008, the Sound Liquidity Risk Management and Supervision Principles were introduced by the Basel Committee provided guiding rules that helped the commercial banks reduce the probability of liquidity risk in the short run. National Trust Banking Corporation Report The National Banking Corporation, in order to conduct a self reliant and sustainable banking system considers both the internal and external factors that may affect its operations in the long run. Liquidity management is the primary concern for the bank. The proportion of liquidity risk in the bank must be low, this may be done by acquiring reliable assets and diversified portfolio. The bank must have proper capital adequacy management and should also try to accumulate fund at low cost. The bank should ensure that the cash inflow is more or at par with the fund outflow, this will make the bank rich in terms of liquid resources. In the current uncertain financial market, it is very important for a bank to analyze its risk and potentials. Considering the three exhibits of the national trust banking corporation, the next context of the essay will consider the traditional liquidity ratios of the bank. These ratios are matrices that analyze the ability of a company to pay back its short run debt obligations. The higher the value of the liquidity ratio, the better it is for the organization. A high value of liquidity ratio depicts that the probability of the bank to pay back its short term debts is high. The standard liquidity ratios are the current ratio, quick ratio and the operating cash flow ratio. Creditors nowadays are highly concerned with the ability of a bank to pay back its short term loans by converting its liquid assets into cash. Current ratio= current assets/current liabilities. The higher the value of the current ratio, the better is the ability of the company to pay back its short term obligations. Quick ratio= (current assets-inventories)/liabilities. Quick ratio is a better measure to analyze the company’s short term financial strength. It excludes the inventories from the current assets. During short term crisis, it often becomes difficult for a bank to sell its inventories and get cash in return. Thus, current ratio sometimes overestimates the short term economic strength of a financial organization. The most conservative form of liquid ratio is the Cash ratio. Cash ratio= {cash + marketable securities}/Current Liabilities. This measure not only includes the firm’s cash content, but also enumerates the investments made by the firm that the firm easily may convert into cash at the time of short term debt payments. The higher the cash ratio for a company, the better it is for the organization. Operating cash flow ratio= Cash flow from operations / current liabilities. The way a company pays of its regular expenses, is also a good indicator of the liquidity strength of the company. The Liquidity ratios of the National Trust Bank are:- Current Ratio Schedule Amount Total Current Assets 2010 229152 Total Current Liabilities 2010 270561 Current Ratio 2010 0.85 Total Current Assets 2011 270752 Total Current Liabilities 2011 294620 Current Ratio 2011 0.92 (Source: Authors Creation) Figure 13: Current Ratio 2010-2011 (Source: Authors Creation) The above schedule and graph shows the current ratio of the bank from 2010 to 2011. If a bank has a current ratio less than 1 then it signifies that the short run financial strength of the bank is not very good. For every one dollar debt the bank will be able to pay back less than one dollar. However, considering the balance sheet of 2010 to 2011, the current ration of the National Bank has improved from 0.85 to 0.92. Thus, the short term financial strength of the bank has improved. This organization is a non manufacturing company, so it is assumed that it does not have any significant value for inventories. Thus, the current and quick ratios will be almost same for the National Trust Banking Corporation (BIS, 2012). Cash Ratio Schedule 2010-2011 Years 2010 2011 Total of Cash and Marketable Securities 165170 134063 Current Liabilities 270561 294620 Cash Ratio 0.61 0.46 (Source: Authors Creation) Figure 14: Cash Ratio 2010-2011 (Source: Authors Creation) Considering the above schedule and graph it is clear that unlike the current and quick ratios, the Cash ratio of the bank has fallen from 0.61 to 0.46. This shows that the overall derivative investment business of the bank has fallen from 2010 to 2011. The Basel Committee in its approach, instructs the National banking Corporation to maintain adequate fund to pay back its short term debts. The three exhibits show that the liquidity ratios of the bank are not very good. The current ratio has been lower than 1, this shows that the bank would not be able to provide payments for all its short term liabilities. A low level of current and quick ratio for the bank will made it loose the confidence of its creditors. Although the threshold of current ratio and quick ratio has improved, the level of cash ratio for the back remains low. The falling trend of cash ratio emphasizes the fact that the bank is making fewer investments in the derivative market. Proper liquid fund management ensures that a commercial bank must diversify its portfolio in different types of securities. The low investment of the bank in the securities market may occur because of rising uncertainties in the derivative market. In 2012 JPMorgan Chase bank has suffered a huge derivative loss; this has made the total speculative market uncanny for investments. The recessionary trails in the market have made speculative investments more risky and scare. The circulation of money in the global market has fallen. The low level of liquid fund is due to the current economic crisis in the world. However, considering the Sound Principles, the central banks of both the U.S. and Euro Zone have introduced the tool of Quantitative Easing. The banks are offered loans at almost 1% interest in return of valuable government bonds (BIS, 2013). These tools are helping commercial banks to get access to more liquid fund and make their banking system more stable. The National Banking Corporation should take such opportunities and reduce its liquidity risks (Davis and Zhu, 2004). Reference List Alexander, C., 2009. Market Risk Analysis, Value at Risk Models. New Jersey: John Wiley & Sons. BIS, 2012. Basel III counterparty credit risk and exposures to central counterparties - Frequently asked questions. [pdf] Available at [Accessed 3 September 2013]. BIS, 2013. 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