Banking Regulation and Risk - Assignment Example

July 2, Banking Risks Question There are different financial services’ risks. There is bank interest rate risk. The risk refers to there is a mismatch between the maturities of both the liabilities and assets. When the maturities of assets arrived earlier than the maturities of the liabilities, the risk is cancelled. To avoid this risk, the entity must ensure assets’ maturities will mature earlier than the liabilities’ maturities (Saunders & Cornett, 2011). Next, there is market risk. There risk occurs when there is risk in holding on to the bank’s assets and liabilities when there is a fluctuation among different related factors. The factors are rates of interest, rates of exchange, and the other prices. If the rates of the assets are higher than the rates of the liabilities, the entity is able to pay its liabilities on time. To avoid the risk, the entity must ensure the maturities of the assets occur earlier than the maturities of the liabilities (Saunders & Cornett, 2011). One such market risk involves risk of loss from stock market price fluctuations. A hypothetical example will clarify the concept. A Scottish college professor decides to invest some of his retirement money in Tesco Plc. On June 3, 2014, the Scotland- based professor invests in 1,000 shares of Tesco Plc in the London Stock Exchange. On June 9, 2014, the stock market price for each Tesco Plc share is £291.70. At 1,000 shares, the Scottish professor invests $201,700. After one month (July 8, 2014), news cropped up in the United Kingdom –based Telegraph news indicating one of the milk products of Tesco grocery was spoiled. The spoilage led to the hospitalization of 50 United Kingdom toddlers. Consequently, the news damaged the reputation of the United Kingdom –based Tesco Plc grocery chain. The London stock market investors responded. Many investors decided to divest their money from Tesco Plc. The divestment resulted to the high demand for the withdrawal of investor funds. The stock market price significantly dropped £271.70 per share. Consequently, the Scotland- based retired professor suffered from the market loss. Consequently, the market risk was realized when the professor generated a £ 10,000 market loss, (£291.70 - £ 271.70) x 1,000 shares. Third, there is credit risk. The risk occurs when there is a possibility that the loans or other liabilities will not be paid on time. This usually occurs when the debtor is in a state of financial difficulty. One such financial difficulty is when the debtor is forced into bankruptcy. When in bankruptcy, the debtor is not able to pay the maturing obligations or loans on time. Some banks resort to collecting the collateral assets as payment for the default in the loan payments. To avoid this risk, the entity must conduct a credit investigation. In addition, the bank or entity must avoid granting credits to risky customers by using the credit investigation as a basis for weeding out bankruptcy or near bankrupt current and future customers (Saunders & Cornett, 2011). The credit investigation will determine whether the loan applicant, credit line application or debt applicant will have enough cash to pay for the maturing liabilities on the payment date. The investigation’s affirming that the loan applicant is jobless will discourage approval of the loan application. In addition, the banks and other entities can require the loan applicant or credit line applicant to submit a mortgage as collateral for the loan or debt amount. For example, the loan applicant can attach his car as collateral for a £ 2,000 loan. When the debtor is not able to pay the loan amount on time, the creditor can go through the process of acquiring the debtor’s collateral, the debtor’s car, as full payment of his loan amount. This way, the credit risk is reduced to allowable levels. Fourth, there is off balance sheet risk. The risk occurs in relation to the bank’s assets or liabilities that are not included in the debtors’ financial statements. Specifically, the statement referred to is the balance sheet. The balance sheet contains both the assets and liabilities of the creditors and debtors. For example, the company may not include certain liabilities in the balance sheet in order to improve the financial statement picture of the entity. By not including some liabilities, the balance sheet will indicate a fraudulently higher than real stockholders’ equity amount. Avoid this risk, regular internal and external audits will deter, uncover, or stop off balance sheet items (Saunders & Cornett, 2011). A good example of off balance sheet risk is the infamous 2001 Enron Scandal. The Texas –based American company’s -management officers orchestrated the non-inclusion of several debts in the liabilities section of the balance sheet. The management officers included Mr. J. Skilling, Mr. A. Fastow, and Mr. K. Lay. The management officers connived and conspired with the external auditors, A. Anderssen, to present the fraudulent off balance sheet-based financial reports. After the discovery of the fraudulent activities, the stock market price of the Enron stocks dropped from the middle of the 2000 year’s $91 per share to a dismal $1 per share during the last quarter of 2001. Consequently, the withdrawal of the investors’ money forced Enron into bankruptcy during December of 2001. By not presenting all the company’s debts in the balance sheet, Enron was understating the true liability picture of the company. Consequently, the investors became unexpected victims of the Enron management officers’ fraudulent off balance sheet and other illegal activities. Aside from the fraudulent off balance sheet activities, Enron present fraudulently higher than real revenues (McLean, 2013). Fifth, there is foreign exchange risk. The risk occurs when there are significant fluctuations in the bank’s foreign currency exchange rates. The United Kingdom currency normally fluctuates in relation to other global currencies, including the United States dollar currency. This often occurs when the assets or liabilities are denominated in foreign currency. Then foreign currency translation is implemented, the rise or fall in the foreign current exchange rates will either generate a foreign currency translation loss or a foreign current translation gain. When a seller on July 1 sells a car and will receive payment in Japanese Yen, when the Sterling foreign exchange current value in relation to the Yen currency drops, the seller generates a foreign currency exchange loss, a possible risk. To avoid the risk, the company must sell when the foreign currency exchange rate trend generates a foreign current translation gain (Saunders & Cornett, 2011). An example will clarify the foreign currency risk concept. Assuming Mr. Brown of London’s west side bought a $2,000 product from a Texas company on July 3, 2014. The product was shipped from Texas to London using UPS global transport delivery. The current exchange rate on this date was $1.72 per U.K. pound. Mr. Brown’s debt on this date is $ 2,000. Converting the amount to pound is done as follows: $2,000/$1.72 = £ 1,162.79. The payment was to be made after 15 days from the date of purchase. The payment was to be made in U.S. dollars. After 15 days, the exchange rate had dropped from $1.72 per U.K. pound to $1.65 per U.K. pound. Consequently, Mr. Brown must pay the $2,000 on the 15th day. To get the $2,000 amount, Mr. Brown must pay out more United Kingdom pound currency. To be exact, $2,000/1.65 = £1,212.12. Mr. Brown generates a foreign current exchange loss of £ 49.33. This is arrived at by subtracting the £ 1,162.79 from the £ 1,212.12. Sixth, there is country (sovereign) risk. The risks occur when there are hindrances to the successful foreign country transaction. The risk occurs when certain restrictions prevent the bank’s successful payments to the foreign country lenders or foreign country investors. Likewise, certain interventions unfavourably affect the foreign country payments. Lastly, the foreign country may implement restrictions to the successful foreign country loan or investment payments. When the foreign country bans the entry of certain products due to protection policies, the entity stands to loss from the new ban on the product import. To avoid the risk, the entity must conduct researches to avoid the loss from the product entry protectionism ban (Saunders & Cornett, 2011). Seventh, there is technology as well as operational risk. The risk crops up when the current or future implementation of technology will not generate the bank’s expected cost savings. If the government requires the use of certain costly equipment, the entity is forced to purchase the costly equipment. However, the costly equipment may not generate enough revenues to recuperate the cost of the new equipment (Saunders & Cornett, 2011). Eight, there is liquidity risk. The risk occurs when the bank does not have enough assets available to pay for the maturing obligations on time. Consequently, the company is forced to liquidate its present assets at less than fair market value in order to pay the maturing obligations or loans. When the company’s 2014 current assets is £ 22,000 and the company’s 2014 current liabilities is £ 20,000, the company has an unfavourable 91 percent current ratio. This clearly shows that the company does not have enough current assets to pay its currently maturing current liabilities. To avoid the risk, the company must not generate liabilities that are higher than the total assets (Saunders & Cornett, 2011). Ninth, there is insolvency risk. The risk crops up when the bank does not have the needed capital investments needed to offset the unexpected asset value reduction. When the company’s inventories are reduced due to obsolescence, the company may not be able to generate net profit figures. To avoid this risk, the company must generate enough revenues to defray all costs and expenses incurred during one accounting period (Saunders & Cornett, 2011). Question 2 Leverage Concept. The leverage concept encompasses two inputs. The first input is loans. The banks and other entities need funds to generate the desired interest revenues and other bank revenue sources. The banks borrow money from other financial institutions. The entities who lend money to the banks are classified as creditors. In exchange for the lent money, the creditors generate loan interest revenues. Different entities present different loan interest amounts. When the creditors lend money to the banks and other entities, the creditors do not become owners of the borrowing entity. Creditors are assured of a fixed interest income over an agreed time period. The time period may cover one year, two years, five years, or even twenty years. Further, the banks and other entities must borrow just enough funds to ensure reaching the prescribed goals or objectives. The prescribed objectives may include high fixed revenues over several years. The prescribed objective may include generating an increasing net profit trend over several financial operating periods. The prescribed goal may include capturing a bigger share of the banks’ or entities’ market segment. Furthermore, the amount of loan is very important. With higher loan amounts, the company must pay higher loan interest amounts. However, the high loan amount will be able to generate the required higher revenue targets compared to applying for a small loan amount. Consequently, the higher revenues will contribute to higher net profits during the current and future financial operating periods. Moreover, the other leverage factor is investment. Individuals and entities with money and other assets can funnel their hard earned assets into the banks and other entities. The funneling of the money makes the individuals and entities investors. As investors, the individuals and entities are classified as part owners of the banks and entities. Further, the investors contribute to the decision making activities of the invested banks and other entities. The investors appoint some investors as board members. The board members manage the affairs of the banks and other entities. Management includes having a say on how the activities of the banks and entities should be done. Some of the investors are elected as chief operating officer, chief financial officer, President, chief financial officer. As owners of the banks and entities, the investors stand to gain or loss from their investments. If the banks or other entities do not generate enough revenues to cover the operating expenses of the banks and other entities, the investors will not receive their dividend incomes. Likewise, the investors may see their investment amounts go down the drain, disappear. This is the danger of being an investor. Table 1 Return on Equity                                                                 (A) Ratio   (B) Ratio       Return on equity = Net Income =   10,000.00 = 2   10,000.00 = 1.67       S.E   5,000.00   6,000.00                                       (A)   (B)       leverage = total liabilities =   5,000.00 = 1   5,000.00 = 0.83       Stock E   5,000.00   6,000.00                                                                           The above table clearly shows how the bank entity can use its leverage activities to improve its return on equity. The return on equity is arrived at by dividing the company’s net income by the company’s stockholders’ equity. The higher return on equity is a better ratio compared to a lower return on equity ratio. The leverage ratio is arrived at by dividing the bank’s total liabilities by the company’s stockholders’ equity. The best leverage ratio is 100 percent. A ratio that is lower or higher than the 100 percent ratio is less favourable compared to the 1000 percent leverage ratio (Saunders & Cornett, 2011). In the above table, the B portion shows that the bank entity’s leverage is 83 percent. Consequently, the same leverage ratio generated a 167 percent return on equity ratio. To improve the 1.67 return on equity ratio, the entity must increase its leverage ratio to the best ratio, 100 percent. To do this, the entity must invest an amount equal to the total liabilities amount. By investing the lower £5,000 stockholders’ equity, the entity’s new leverage (100 percent) generates the favourably higher return on equity. The new return on equity ratio is 200 percent (Saunders & Cornett, 2011). Table 2 Return on Equity 2                                                                 Ratio   Ratio       Return on equity = Net Income =   10,000.00 = 1.42857   10,000.00 = 1.67       S.E   7,000.00   6,000.00                                               leverage = total liabilities =   5,000.00 = 0.71429   5,000.00 = 0.83       Stock E   7,000.00   6,000.00                                                                           Further, the above table clearly shows the effect of increasing the bank’s stockholders equity investments. When the £6,000 stockholders’ equity is increased to £7,000, the 0.83 leverage will decrease to 0.71. Consequently, the current 1.67 return on equity unfavourably drops to the lower 1.43 ratio. Consequently, increasing the stockholders’ equity investments does not improve the return on equity ratio because the leverage, 0.83, had unfavourably declined to only 0.71 ratio (Saunders & Cornett, 2011). . Furthermore, the leverage ratio indicates that the company must rely on both loans and investments to generate revenues and profits. The company must not rely only on investments to generate profits. To rely on investments alone, the bank’s leverage is zero (0 liabilities divided by total amount of investments). Likewise, the company must rely on loans. The creditors may not grant credit terms to company having zero investments. The creditors may fear that the entity, bank, does not have enough investment-based assets to pay for the currently maturing obligations on their scheduled payment dates (Saunders & Cornett, 2011). Question 3 Asset securitization can be described as the transfer of assets from the original owner to the transfer vehicle. The vehicle issues a debt security. The debt security is backed by the assets. Banks and entities employ asset securitization in order to shift the assets’ credit risks to third parties. One of the third parties can be another bank. Another third party can be an insurance company. Another process is to invest in hedge funds. A hedge fund reduces the possible future losses. Further, the asset securitization process involves two parts. First, the originator bank or other entity transfers certain assets and liabilities to a reference portfolio. The picked assets and liabilities are taken out from the balance sheet presentation. Next, the vehicle purchases the reference portfolio. The vehicle, usually a bank or other financial intermediary, gives interest bearing securities to the originator. The originator sells the securities in the capital market. Capital market investors acquire the originator’s interest- bearing securities. Consequently, asset securitization is a different finance or fund source. Under the asset securitization concept, the credit risk is now shifted from the originator bank or entity to the capital market investors. Diagram 1 Asset Securitization                       Pool of Assets     Investor   Amount       Asset 1 £10,000 ---> A 70% £11,900.00       Asset 2 5,000 B 30% 5,100.00       Asset 3 2,000   100% £17,000.00       Total   £17,000                       The above diagram shows how asset securitization is done. The bank entity generates a pool of assets. The assets are composed of three different assets. Asset 1 is £ 10,000. Asset 2 is £ 5,000. Asset 3 is £ 2,000. By pooling the assets together, the bank encourages investors to invest on a certain percentage of the assets. The right portion of the diagram shows investor A preferring to invest in 70 percent of the entire asset pool. Consequently, investor A invests in £ 11,900.00 of the total pool assets. Next, Investor B decides to invest in only 30 percent of the entire pool. Consequently, investor B invests in a lower $5,100 amount of the total asset securitization pool of £ 17,000 (Apostolik, Donohue, & Went, 2008) . Diagram 2 Asset Securitization 2                                       Bond       Pool of liabilities   Creditor percentage Amount       Credit Card Debt £ 3,000   Brown 25% 7,000.00         Car loan debt £ 5000   Taylor 75% 21,000.00         Home Mortgage £20000   Total 100% 28,000.00         Total £28000                                                   Moreover, the above diagram shows the bank generating a pool of liabilities. The liabilities pool is composed of three liabilities. One liability is the £ 3,000 Credit Card liability. Another liability is the £ 5,000 car loan debt. A third liability is the £ 20,000 Home Mortgage loan balance. Consequently, two creditors lent money on the pool of liabilities. The pool of liabilities is classified as a bond. One creditor, Mr. Brown, lent £ 7,000 for a 25 percent acquisition of the total £ 28,000 bond total. In addition, Mr. Taylor lent £ 218,000 for a 75 percent acquisition of the total bond amount, £ 28,000. The bond amount is secured by the bank’s equivalent asset collateral. In case the bank is not able to pay the bond amount on time, both Taylor and Brown, the two creditors, can take the asset collaterals in exchange for the failed bond payments (Apostolik, Donohue, & Went, 2008) . During the 2008 crisis, the banks offered high rates of return on the collateralized debt liabilities. The high rates were pegged on the high interest rates expected to be collected from the housing loan and other debtors. However, the debtors were high credit risks. The borrowers were not able to pay their loans on time. Consequently, the creditors aimed to take the borrowers’ assets. However, the debtors filed for bankruptcy. Consequently, the debtors’ collateralized assets were not enough to pay for the maturing obligations on time. When the debtors filed for bankruptcy, the creditors, including banks, were not able to collect the loan amounts. Consequently, the creditors were forced to file for bankruptcy (Apostolik, Donohue, & Went, 2008) Question 4 The Basel II agreement was set up to remedy the effects of the 2008 economic crisis on the banking industry and affected stakeholders. The agreement sets a better alignment of the banks’ capital requirement standards. The agreement aligned the capital requirement to the possible bank risks. The agreement superseded the prior unsuccessful one size can fit all scenario bank scheme. The agreement was implemented in order to increase the public stakeholder’s confidence in the banking sector and other financial entity sectors. The 2008 depression affected several banks. Some banks sought government bailout. The US bank, Lehman Brothers Bank, filed for bankruptcy. The United Kingdom government acquired the bankrupt Northern Rock Bank. Moreover, there are three pillars of the Basel II agreement. Pillar 1 focuses on requiring banks and other entities to maintain a benchmark (minimum) amount to cover market risks, operations risks, as well as risks of credit. Pillar 1 implements a sophisticated to ensure successful internal risk management capacities as well as to compute for the required minimum capital amounts (Sironi & Resti, 2007) . Further, Pillar 2 focuses on the banks’ and other entities’ assessment of the full risk ranges. Likewise, the banks are required to ascertain the capital amount needed to hold the risks at bay. The bank’s adequate capital status and internal assessment issues are reviewed in order to assure above minimum capital amounts are held whenever suitable (Sironi & Resti, 2007) . Furthermore, Pillar 3 focuses on the bank and other entities ensure there is discipline in the banking market. Discipline is present whenever the risk disclosure standards are met. The bank disclosures include the capital adequateness aspect, risk profile aspect, as well the management of internal risk aspect. In terms of the areas relating to calculating the different banks’ market risk, operations risk, and regulatory capital risk, pillar 3 shows that different banks have different sophistication and exposure to risks leading to different disclosure benchmarks on the three areas (Sironi & Resti, 2007). . References Apostolik, R., Donohue, C., Went, P., 2008, Foundations of Banking Risk, London: Wiley McLean, B., 2013,. The Smartest Guys in the Room. London: Penguin . Saunders, A, Cornett, M., (2011). Financial Institutions Management: A Risk Management Approach. London: McGraw Hill. Siron, A., Resti, A., 2007, Risk Management and Shareholders’ Value in Banking: From Risk Measurement Models to Capital Allocation Policies, London: Wiley. Read More