International Risk Management Systems of Advanced Bank - Essay Example

INTERNATIONALRISK MAGEMENT SYSTEMS OF ADVANCED BANKS By Name Course Instructor Institution City/State Date : International risk management systems of advanced bank Many firms manage their market risks by focusing on a short-term as a way of avoiding their portfolio losses on daily basis (Tschemernjak 2004, p.39). One of the best method of managing market risk is by the projection of the loss-and- profit distributions within short time, and the summary the information into single numerical like VaR (Chen & Ming 2013, p.1). Though many banks use VaR, it has numerous challenges ranging from modelling, reporting and data management (KRAUSE, 2003, p. 24). The Basel convention gave new insights in banking by outlining principles and guidelines that small and big banks can use to manage their risks. Most banks and firms strive to reach the independent status where they will be able to use their own tools to manage risks (Ojo 2010, p. 256). However, proper risk management is the responsibility of bank supervisors. They have to adhere to procedures and principles that Basel Committee recommends for proper banking. This paper, therefore, explains how bank supervisors can use the Basel approach to upgrade relatively small banks into large and independent banks that can adopt advanced approaches in their management. Market risks are the assets that a bank holds in its trading book relative to the assets in the banking book (Chen & Ming 2013, p.1). This enables the bank to realise losses based on trading position even when the obligor does not default. Off-the –shelf Standardised approach for market risks is similar to credit risk only that extremely liquid assets in firm’s trading book requires less capital than if they exist in the banking book (Tschemernjak 2004, p. 41). The most appropriate approach to banking is the Internal Models approach that has the VaR (value at risk). VaR refers to the soundness standard that banker’s measure in a day. For instance a bank may a VaR of 99% 1 day which means that each 1% of the expected outcome will lead exceed the VaR number (Chang et al 2013, p.1090 ). It is therefore possible to lose more than the VaR numbers and most banks keeps on proving this point. Basel II separates international banks into two distinct camps (Basel Committee on Banking Supervision 2006, p.250). One camp has the less sophisticated and smaller banks which uses the off-the shelf models. The second camp contains, advanced banks, uses their own tools of risk management for risk quantification. Bank supervisors have the task of proving to their banks that their risk management strategies or systems are effective. Banks can reach the advance status if they are capable to reach use less capital to support its business than the standardised banks (Ojo 2010, p.253). Banks have the obligation to use appropriate methodologies that enable them to manage all of their material market risks, identify where they come from whether from the desk, business or firm-wide (Chen &Ming 2013, p.1). VaR model identifies and also measures the risks that arise from all trading activities thus bank supervisors must integrate these activities in internal assessment of the capital status (Burchi 2013, p.287). The VaR model must be able to test the financial stresses in the firm. In the internal capital assessment, the process must be able to demonstrate that the bank must be able to achieve its goals using minimum capital while withstanding market shocks. The factors to consider include illiquidity, concentrated positions, non-linear productions, one-way markets and concentrated positions (Burchi 2013, p.287). In market risk, the Basel II recommends a set of procedures and policies for eligibility of the banks’ trading book (Basel Committee on Banking Supervision 2006, p.217). These policies are detrimental in ensuring integrity and consistency of the trading books. Bank supervisors must have the satisfaction that the procedures and policies that they use define boundaries that exists in the trading books. On the other hand, supervisors must also make sure that the transfer of positions between trading and banking books occur under limited circumstances (Basel Committee on Banking Supervision 2006, p.207). The supervision must also be able to advise the firm on the modification of procedure and principles that prove insufficient. This prevents the booking of positions that do not comply with the general principles of international banking. On the other hand, valuation is vital. Valuation of the adopted policies enable banks to enables the bank to deliver enough capital for hedging out the positions within ten days. Supervisors are up to the task of to identify if the banks have enough capital where their firms operate in concentrated market turn-over or when they have many position numbers (Basel Committee on Banking Supervision 2006, p.204). In addition, the supervisor has the obligation to react appropriately in the event of any shortfall. Moreover, the bank management must make sure that the firm has enough funds to meet the Basell II minimum capital requirement for covering stress testing results with the consideration of the international banking principles (Kosmidis & Terzidis, 2011, p.176). In market risk, the supervisors have the duty to determine if their banks have enough capital for meeting their trading activities. To reduce the shortfalls, the bank supervisors might advice banks to reduce exposure to risks and hold extra capital so that the capital resources will cover most of the pillars of international banking (Basel Committee on Banking Supervision 2006, p.210). Bank supervisors have a lot to do in ensuring that banks operate to their best in the international market. The supervisors must be transparent when carrying out their duties ad they must execute them in decent manner, with accountability (Basel Committee on Banking Supervision 2006, p.208). They should publicly avail the all the criteria that they use in reviewing internal capital assessments of the banks (Basel Committee on Banking Supervision 2006, p.10). For instance, when the capital needs of the bank fall above its minimum, the supervisor must be in a position to explain what went wrong and recommend the necessary actions for to salvage the situation. On the other hand, effective cross-border cooperation and communication is important for large banking co-corporations. Effective communication will entail continuous and close dialogue between supervisors and the bank industry participants. A practical and full basis corporation is vital for supervisors who operate in complex international banking (Basel Committee on Banking Supervision 2006, p.215). The communication framework for banking does not change all the legal responsibilities of all national supervisors when regulating domestic institutions. Home country supervisor has the duty to oversee the implementation of the Basel Committee Banking framework and the host country supervisors oversee operations of banking entities within their country (Kosmidis & Terzidis 2011, p.178). Where possible, all the supervisors must avoid operating in un-coordinated manner The market risk management in all international banks finds its basis from the Basel Basel Committee on Banking Supervision (Basel Committee on Banking Supervision 2006, p.217). The capital accord in this committee involves risk-weighted assets, factors of credit conversion, supple mental and core capital and market risks in banks trading books. On the other hand, there are different risk percentages for different banks. The Basel committee recommends zero percent rates on the central government currencies, ten percent on the public-sector business entities. In addition, there is also a provision of about 20% with more than one year claim on all the banks The Basel pillars provide the bank supervisors with a clear insight on how to manage the market risks. Pillar entails minimum capital requirements for the banks, credit and operational risks (Basel Committee on Banking Supervision 2006, p.14). On the other hand, Pillar 2 covers the Supervisory Review Process that sets capital requirements of international banks. Finally, the third pillar, pillar 3 entails market discipline for the banks (Basel Committee on Banking Supervision 2006, p.204). Pillar has been instrumental for explaining the fundamentals of market risks mitigation. There are many market risks that bank supervisors that include general risks, single currency risks, directional risks and basis risk (Chen & Ming 2013, p.1). However, the most suitable model in managing risk is the Value-at-Risk model that also requires banks to update their bank status within the period of three months. For banks to reach the danced stage, they must consider the Loss given default (LGD) each of its sovereign, corporate and sovereign bank exposure (Kosmidis & Terzidis 2011, p.181). However, the banks, the banks can identify their LGD using to approaches, the foundation and advanced approach. In this context, the advanced approach helps small banking organisations to reach higher standards. In this context, it allows supervisors and banks to use their won LGD estimates for sovereign, bank and corporate exposures (Kosmidis, K & Terzidis 2011, p.183). The supervisors and the bankers must measure LGD exposure on their own using this approach (Kosmidis & Terzidis, 2011, p.185). The advanced approach recognition The advanced approach using advanced approach enables banks to manage and mitigate the credit derivatives and guarantees approach through adjustment of the LGD estimates (Kosmidis & Terzidis 2011, p. 187). The adjustments must be consistent for any credit or guarantee derivative type. In doing this, the banks be careful not to include double default effects in their adjustments. The supervisors make sure that the risk weight that they adjust is not less than that of comparable direct exposure to their protection provider (Chen & Ming 2013, p.1). In calculating VaR, bankers assume no trading and normal marketing that makes the losses observable (Burchi 2013, p.289). In some cases, it becomes impossible to identity these losses due to unavailable market prices or when the loss-bearing institutions decide to break up. The VaR model always marks boundaries that exist between normal business days and extreme financial events. However, banks sometimes loose more than the VaR. Although VaR represents losses in the business entities, the accountants and financial experts always express it as appositive number (Chang et al 2011, p. 1060). The supervisor must understand that negative VaR implies that the portfolio is highly likely to make profits. On the other hand, some financial events or situations refer to VaR as profit-loss and sometimes the represents the maximum loss in a financial period. Bank supervisors also help in the governance of the banks. In some context, VaR may also refer to governance and it applies in trusts, pension plans and endowments (Burchi, A 2013, p.291). Instead of the probable estimates, VaR defines the maximum acceptable loss. This estimate adds to the accountability of bank members because the management directs them to operate within constrains. This in turn makes it possible for the managers to also avoid financial risks within the a clear risk parameter. If supervisors use VaR in the governance approach, they will be able to monitor all the procures of risk management The basel II improved the the VaR model thus it has become more popular among bankers (Burchi, 2013, p. 298). This model is beneficial to banks that wish to reach the advanced stage because it allows firms to clearly define their strategy that helps bankers in managing their risks. When an organisation publishes its number with specific numerical properties, it leads to high standards in performance. It is also vital for the organisations to include good back-up plans for this model. The positions that bankers report, price or model incorrectly do stand out when they use VaR (KRAUSE 2003, p.23). The other inaccurate data feeds, late or extremely down also reflect in this system. In addition, any figure that is affects profits as well the bank’s loss automatically shows up in the excess VaR or inflated VaR (Burchi 2013, p.301). The bank management must understand that computing VaR leads to these losses and banks that never compute VaR do escape this loss problem (KRAUSE 2003, p. 25). The use of VaR also enables companies to separate their risks. In addition, specific data and short-term data also are also applicable for use in this model. Estimates using VaR becomes meaningful in this context since enough data exists for such use Conclusion In summary, managing the financial risks is the basis for success for small banks that want reach the advanced stage. The Basel II Committee set out procedures that supervisors might follow when changing banks from using standardized approaches to advanced approaches that large banks adopt. Banks that use computerized systems have to deal with the problems value at risks (VaR) that portrays the potential risk factors under defined parameters that banks should avoid. The Basel Committee also sets out rules that regulate both supervisors both in the host country and the origin country of the international banks. International banks advanced banks refer to the Basel II recommendations and provisions when managing their internal capital requirements. Adherence to procedures of the Basel II enables banks to manage their market risks effectively. Bibliography Basel Committee on Banking Supervision, June 2006, International Convergence of Capital Measurement and Capital Standards: A Revised Framework - Comprehensive Version. Chen, Ming, J, April 17, 2013. 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