Risk Measurement and Management Techniques - Essay Example

Bank risk management Introduction After the 2008 financial crisis, there was a change in the literature that surrounded the risk management of banks both internationally and each affected country. Though the literature on the crisis identifies different factors that led to the crisis, the key factor is found in the risk associated with all these factors. These factors range from diversification strategies, use of credit derivatives and develevarage activities taken at the start of the crisis. The 2008-2009 crisis also revealed that there exists gaps in the risk management practices of the individual institutions, the regulatory framework was not sufficient and banks had high leverage without accounting for the risk associated with such debts. It can be said that the crisis was caused by a fault in the risk management practices (Ellul and Yerramilli 2013) at the individual bank level that led to the systemic risk throughout the banking sector and the world at large. The financial crisis inquiry commission’s findings on the causes of the financial crisis concluded that corporate governance and risk management were the main causes of the financial meltdown (NC state university 2011). These measures include are the procedure that the financial institution would take in order to reduce their exposure to financial risks. It is on this premise that Ellul and Yerramilli investigate the impact of risk controls to the risk exposure of the bank holding companies. The hypothesis of the research in Ellul and Yerramilli (2013) is to investigate whether having strong independent risk management practices actually lowers the enterprise risk of the bank holding company. The risk can either be individual to the bank or be systemic, affecting the whole banking sector. Individual risks are manifested in the liquidity risk, credit risk, and operational risks. The senior supervisor’s group report (2009) confirms that risk control measure put in by management is more likely to be sustainable in the reduction of risk exposures. The report identified the factors that lead to liquidity problems of banks: reliance on excessive leverage, inadequate use of stress tests. Moreover senior supervisors group report (2009) outlines that the risk management measurement and management reporting was a key factor in determining how the institution was affected by the crisis. The argument is that having formal risk management practices increases the organizational outcomes of these institutions. Risk Measurement and Management Techniques The principal reason for investigation in this paper was to establish the extent to which risk management practices contribute to reduce the risk exposure of the institution. In particular, the focus is on organizational structure of the institution. The risk management index used to measure the risks of the institution is defined by the importance of the risk management in the organization. Risk management techniques are in more often cases identified by the presence of the chief risk officer, the remuneration packages of the CRO and how it compares to the chief executive. The dedication of the CRO to the function of the risk management and whether the CRO undertakes other management roles is also an indicator of risk management (Cassar and Gerakos 2016). Another valuable risk management technique is the inclusion of risk board committees in the banking holding companies. These techniques influenced the flow of information in the organization between management and its effectiveness was determined by the banking experience, frequency of meetings of the risk committee or whether the committee is independent or reports to the management. Organizational structure is likely to affect this risk management technique. The risk management techniques of CRO was measured using the variables: CRO present; CRO executive if the CRO was part of the management; CRO centrality which is the ratio Of the compensation of the CRO to the CEO; CRO top 5 indicating if the CRO was among the top 5 highly paid executives. The board committee risk management technique was measured using variables the board committee experience; active board risk committee indicating the frequency of their boards meetings; reports to board, a proxy for whether the CRO reports to the management or is independent. In orders to measure the risk management of the bank holding companies) and their impact, Ellul and Yerramilli (2013), defines risk to include both downside and aggregate risk. The aggregate risk is measured as the standard deviation of the weekly returns. Downside risk on the other hand is defined as the implied volatility estimated using put options on each firms stock. Econometric methodologies The econometric methodology outlines the approach that is applied in the analysis of economic data. Econometric analysis can take various approach such as the LSE approach, Vector auto regression, Cowles commission approach, calibration or experimental (hoover 2005). Each of this approach is based on different assumption that is taken in the analysis of the data. However, the fundamental econometric methodology does not change. LSE approach essentially analyses data by moving from the general to specific while VAR allows the econometric model to evaluate the impact of variables in the same model over a given time period. The Cowles commission approach applies the use of simultaneous equations to link theory to mathematics. In principle the methodology involves the identification of variables, choice of statistical methods, estimating the results using the relevant econometric tool or software and finally testing the relevance and the accuracy of the results. The hypothesis on which the study by Ellul and Yerramilli (2013) was based was to test if the bank holding institutions with strong independent risk management practices have a lowered enterprise wide risk. The null hypothesis being tested is internal risk controls do not have any meaningful effect on enterprise-wide risk (pg. 7). The hypothesis is based on hedging theories that show that institutions are more likely to be aggressive in their choice of risk management techniques if they are exposed to great risks of either financial distress. Based on this theory, Ellul and Yerramilli (2013) identify the endogenous choice hypothesis. The strength of the risk management practices was measured by the risk management index while risks was measured using the standard deviation of weekly returns and the volatility of the output options. The independent variables were: CRO present, CRO executive, CRO-Top 5, CRO centrality, Board Committee Experience, Active Board Risk Committee, Reports to Board. To test these hypotheses, Ellul and Yerramilli (2013) defined two linear equations: A multiple linear regression was applied in determining the relationships between the variables. . The analysis is carried out after controlling for the individual companies’ characteristic: size, profitability, asset and liability composition, corporate governance, executive compensation and other fixed effects. The regression results are tested on their significance at the 1%, 5% and 10% significant levels. The report further analyses the correlations between the various variables: between risk, RMI and BHC characteristics; between risk and components of the RMI. The data analysis also includes the median, mean, standard deviation, the 25th and 75th percentile and the maximum value for each variable. The analysis is carried out in two time horizon: before the financial crisis and after the 2008 crisis in order to capture the preparedness of BHC in handling risk. The final chapter of any econometric methodology is the result whether the null hypotheses hold true or not. The regression analysis show that risk management practice is effective in managing the risks that a BHC faces. Bank risk taking behaviors The business that banks usually engage in have seen them accused of engaging in risk taking behaviors, especially the so called ‘too-big-too-fail’ institutions. The risk taking behaviors of banks has been quoted to be one of the factors that led to the crisis in 2008; the housing bubble was as a result of excessive risk taking behaviors by banks (Baldwin 2012). (Small 2012) state that the risk taking by CEOs is affected by the compensation structure of the institution, especially during the pre-crisis period. Baldwin (2012), using a collection of different author’s views on risk taking identifies the factors: weak corporate governance; ineffective market discipline; banking resolution and its effectiveness. Archya et al (2009) explicitly state that regulations and market discipline are insufficient to mitigate the risk taking tendencies of financial institutions, especially, in the modern economy (Ellul and Yerramilli 2013). The corporate governance factor seem to hold much impact as the moral hazard nature not the banks increases with the size of the banks, the too-big-too-fail institutions, multiplicity of stakeholders and the compensation patterns (Baldwin 2012). The banking regulations, from capital requirements to deposit insurance, affect the risk taking incentives of managers but the impact is curtailed by the corporate governance of the bank and the ownership structure (Laeven and Levine 2008). Yeh (2017) in a study of Japanese regional banks found presence of foreign shareholders increased the risk taking activities of banks, increasing their default risk. Further, more diversified banks were vulnerable to default risk. Such decisions also impact on the individual risks of credit risks, liquidity risks as well interest rates risks. An increased exposure increases the systemic risks the bank has on the financial sector, as was the case in the 2008 financial crisis. Major findings and the related policy implications The regression analysis of the impact of risk management techniques on the level of risk exposure and vulnerability of BHC have very practical implications on the internal control decisions of banking institutions. A correlation analysis show that RMI and downside risk are negatively correlated, without controlling for BHC characteristics, implying that there is a chance that there is strong risk management practice could result in lower risks. However, the correlation between risk and size is negative. A relationship between the components of RMI, indicating CRO and committee management techniques, show a negative correlation. Empirical findings from the research show the causal relationship between RMI and BHC characteristics, and risk measures and RMI. The cross sectional regression analysis of BHC before the financial crisis show that the BHCs with strong risk managements were not at great risk to the crisis. This risk exposure during 2006 was measured against the mortgage backed securities, risky trading assets and off balance sheet trading activities. Further analysis of the BHCs before the crisis hit shows that the higher the RMI in this period, the lower the downside risk. Consequently, the analysis showed that for the BHCs that had in place a risk management practice in place before the crisis, was better paced at making decisions hence experience a low risk exposure to the crisis. Ellul and Yerramilli (2013) analysis on the relationship between RMI and Risk revealed for each particular year under study, the BHC that had in place an effective RMI in the previous year experiences a lower downward risk in the current year. The same results were found when risk was measured using aggregate risk. The study included a regression analysis on the relationship between the various BHC characteristics and RMI. An examination of how the RMI impact on risk varies with size show that BHCs with large sizes are more likely to benefit from risk management functions than small BHCs which supports the idea that the size of the bank is important in defining the systemic importance of that bank. Results show that BHCs with lower profits are more sensitive to internal control measures. The compensation of CEOs was found to have an impact on the risk taking behaviors of the CEOs only to the extent that their pay was sensitive to risky stock price and return. The findings of Ellul and Yerramilli (2013) change the landscape of the too-big-too-fail literature. The results show that the large BHCs are at more risk to fail if they do not have the effective risk control measure in place. The findings also support the conclusions of the senior supervisors group (2009) that the financial crisis was as a result of weak risk management measures. The main policy implications are how BHCs manage their risk even when there is no crisis: internal control measures are effective in reducing risk exposure as well as maintaining strong corporate governance. References Baldwin R March 2012 Excessive risk taking by banks [online] available from: voxeu.org/article/excessive-risk-taking-banks-ne-ereport [20/4/2017] Cassar G and Gerakos J September 2016 Does risk management work? Ellul A and Yerramilli V Stronger Risk Controls, Lower Risk: Evidence from U.S. Bank Holding Companies the Journal of Finance 5, pp. 1757-1803 Hoover K 2005 The Methodology of Econometrics Palgrave handbooks of econometrics, volume 1: theoretical econometrics Laeven L and Levine R June 2008 Bank Governance, Regulation and Risk Taking NBER WORKING PAPER SERIES WORKING PAPER 14113 NC state university January 3 2011 impact of risk management failures on the financial crisis [online] available from:https://erm.ncsu.edu/library/article/finanacial-crisis-failures [20/4/2017] Small C April 2012 Risk taking by banks HLS Forum on Corporate GOVERNANACE AND Financial regulation [online] available from: https://corpgov.law.havard.edu/2012/04/11/risk-taking-by-banks/ [20/4/2017] Yeh T M 2017 Governance, risk taking and default risk during the financial crisis: the evidence of Japanese regional banks Corporate Governance: the International journal of business in society [online] www.emeraldinsight.com/doi/abs/10.1108/CG-02-2016-0027 [20/4/2017] Read More