The Risk Measurement and Management Techniques Employed - Essay Example

BАNK RISK МАNАGЕМЕNТ СRIТIСАL RЕVIЕW Name Course Instructor’s name Institution Date Table of Contents 1.0.Introduction 3 2.0. Discussion of the risk measurement and management techniques employed 3 3.0. Description of the relevant econometric methodologies 5 4.0. Comprehensive and critical discussion 6 5.0. Critical analysis of the major findings and the related policy implications 7 6.0. Conclusion 9 References 10 BАNK RISK МАNАGЕМЕNТ СRIТIСАL RЕVIЕW 1.0. Introduction There is need for banks to operate in a common environment since in the banking industry faces a lot of threats which revolve around the future volatility that threatens the stability of the financial institutions. Risk in this case is considered as a vital element that poses a great threat to financial institutions such as banks. Economist have emphasized on the need for banks being involved in risk management. In this case, they have as well stressed on the need for risk management in the bank institution to range from the regulator, their staffs and the end users of their bank services who include both the brokers and clients. This paper therefore aims to provide a critique review of bank risk management through analyzing the article; Good for one, bad for all: Determinants of individual versus systemic risk. The purpose of this reviewed article is to analyze samples of major international banks that are strategically located in advanced economies and to evaluate the bank-specific factors impact on these banks solvency risks and their contribution to the systemic risk of these banks (Settlements2011, pp.721-730). The particular objective of this reviewed article revolves around the proposed five categories of indicators of systemic importance by Basel Committee on Banking Supervision. 2.0. Discussion of the risk measurement and management techniques employed The article starts off by outlining the traditional model of financial intermediation which relates to the concept of financial system. In this case the author argues that model revolves around short-term borrowing, long-term lending and holding of loans to maturity. Goodhart et al. (2004), states that this particular outline is attributed to making banks as well as other financial institution sensitive to the market conditions which are characterized by liquidity and credit risks (Pais and Stork, 2013, pp.429-451). On the other hand, the author also touches on the assumptions which are in line with the complete market paradigm assumptions. They emphasize that despite the strategies implemented by the bank managers in an effort to handle the heterogeneous sources which are uncertain it is not likely that this individual perspective could exacerbate systemic risk. In addition to this, the author goes ahead to give an example where he argues that one effective tool for alleviating the constraints of individual funding is pro-cyclical deleveraging of the trading books; however, this particular strategy might cause the financial contagion to propel. The author also uses the example where in situations that the shorter credits are suddenly curtailed the credit risk of these financial institutions and banks ends up being mitigated however in real sense the funding risks have been transferred to the borrowing parties (Sedunov 2016, pp.71-87). Moreover, he argues that systematic risks are also caused by the strategy of holding the market portfolio which is associated with the traditional risk management known as a strategy used to diversify form the idiosyncratic risk. He relates this scenario to the effects of the global financial crisis in Switzerland by claiming that this experience led to Basel Committee on Banking Supervision (BCBS) to introduce new regulation in an effort to promote stability in the country’s banking system. The author borrows from the concept of complete market paradigm assumptions by arguing that the regulatory framework of the Basel III intended to foster the resilience of the financial institutions that were individual through embracing a counterbalancing approach that was able to withhold the liquidity shock. However, the author stresses that Goodhart et al. (2004) emphasized that there was a tradeoff between financial stability and efficiency of these financial institutions. Conversely, the author also nullifies this argument by stating that these strategies in the long end tend to be micro-prudential (Blundell-Wignall and Roulet 2014, pp.7-28). Further, he stresses’ that the BCBS needs to adopt the other supplementary strategies such as identification of the needed capacity of traditional loss absorbency and the Global Systemically Important Banks (G-SIB’s). He also mentions his efforts in trying to bridge the gap between the micro-prudential and macro-prudential policies through the use of the systematic factors within the methodology for regulatory assessment contributed to the solvency risk (Pais and Stork, 2013, pp.429-451). In this case the author stresses that his main aim was to quantify the marginal responses that would be expected through using his chosen regulatory assessment methodology where he would assess the different measurement of changes in the systemic and individual risks under the BCBS systemic categories. 3.0. Description of the relevant econometric methodologies The econometric methodologies using in this article are those relating to model of control or policies purposes. In this case the main econometric methodology ranges from the policies of the Basel Committee on Banking Supervision (BCBS) (Sedunov 2016, pp.71-87). Through this methodology the author stresses that the findings were categorized into five systemic categories which include the funding risk which was measured through the short-term wholesale ratio of findings to assets, the cross-border interaction of business models which is depicted as the most relevant source of systemic risk, the measure of the financial institution in reference to the size attribute measured through their ratio to domestic GDP or their substitutability in regards to the payment system weight , the measurement of liquidity at a centralized level and the macro-prudential regulation pressure points through bridging the balance between the factors fostering individual resilience and the determinants of systematic risk (López-Espinosa et al., 2013 pp.287-299). Consequently, the author suggests that the results try to fall on the issue where the balance sheets of these banks and financial institutions appear to be funded by sources which are unstable which in the long end has proven to be a multifaceted source of risk. There is an emphasis that the risk of the individual institutions are worsened by this issue leading to further risks of financial spillovers and defaults. He claims that in the long end this fragility causes conflict between the liquidity management strategy and the risk management strategies (Settlements2011, pp.721-730). He relates this to the case in Switzerland where he asserts that this particular problem is what led to the formation of regulatory standards strategically created for the purpose of creating resilience of the country’s banking systems financial system. 4.0. Comprehensive and critical discussion One of the tools used by the author in this article is the international sample of 47 of the largest banks globally during the Q4 2001 and Q4 2010 period which also has an estimated 1313 observations. Another tool used by the author in this article is the data set that included different variables of specific banks in proxy to the identified CBSC indicators of systemic risk. In line with this data set tool that author emphasizes that he collected a number of variable data which entailed; accounting variables, ration of loan deposit, the rate of the loans growth, total asset ratio, short-term liabilities, bond and money markets, whole sale funding, total revenues, trading profits, as well as other money market instruments which were retrieved from these banks and financial institutions entities who entail both the shadow and parent entities (Acharya 2012, pp.224-255). Bloomberg and Dialogic databases were also other tools used by the author in this article. These particular tools were used for retrieval of the mentioned data variables. Additionally, the financial notes of various entities were also some of the tools used by the author in this article. These financial notes included reports and bank statements. One of the techniques used by the author in this article is the cross-sectional predictive regression technique which was used in measuring the individuals risk and systemic risk through the use of the mentioned variables. On the other hand, since systemic risk requires inference on suitable estimation technique basis the author used the CoVaR methodology which is recommended by Adrian and Brunnermeier, 2011. This particular methodology was chosen by the author due to its idealness in constructing feasible systemic risk proxy (Aldasoro, Delli Gatti and Faia, 2013, pp.54-55). The CoVaR is also ideal since it measures each bank and financial institution’s contribution to the downside risk on the other hand it is able to calculate the returns in the system portfolio as well as the individual bank’s returns. Moreover, this methodology is also ideal in computing the volatility of the stock market, it is also recommended for computing the liquidity spread (Acharya, n.d. pp.24-25). The author stresses that for the sake of accuracy he used the variables applicable to the US banking environment since majority of these variable differed depending on the banking environments of different countries. The used CoVaR approach emphasizes that he should use a single portfolio to represent the entire financial system since the returns of an individual portfolio and that of another portfolio differed. In addition to this, the CoVaR methodology used by the author requires the estimation of each individual bank VaR and the quantile regression methodology was preferred for the construction of the VaR in this paper (Berger and Roman, 2012, pp.11-14). 5.0. Critical analysis of the major findings and the related policy implications The result of this paper is that there are factors with opposing effects in the systemic risk and individual risk prediction. In this case it was noted that two min variables which were essential in fostering appear through the article results to reduce the individual’s solvency risk. In line with this it was noted that high activity in investment banking reciprocates to lower default probability. This particular result literally relates to the financial markets role in diversification of individual risks (Aldasoro, Delli Gatti and Faia, 2013, pp.54-55). On the other hand it was also noted that the decentralization of the liquidity management leads to improvement of the bank’s solvency. The isolation of the liquidity led to protection of the banks consolidated groups from default was also noted. Also it was noted that an increment in one figure in the standard deviation in regards to the business models’ proxy reciprocated to a decrease of the CDS basic points by 4.6 points (Blundell-Wignall and Roulet 2014, pp.7-28). However, for this particular case it was eminent that it is more common in the European Banks. On the other hand, centralization of liquidity led to a more positive hence, the probability of default was fostered by the centralization of the liquidity as observed. Overall through these results from different variables it was noted that the funding of these banks balance sheets through financial sources which are unstable leads to some multifaceted effects to these banks and financial institutions risk. Consequently, the pointed out fragilities evidently cause the individual bank’s default risk to worsen (Allen and Tang 2016, pp.1-14). In regards to the mentioned results and collapsing of many banks and financial institutions this led to the implementation of policies that were forced in an effort to revive them. For instance in Switzerland the author states that polices revolving around the recapitalization programs were put in place by the government in bid to prevent these banks and financial institutions from further collapsing. The government also implemented the CD’s spread policies which have relatively minimal impact on the issue at hand (López-Espinosa et al., 2013 pp.287-299). 6.0. Conclusion It is evident that the global financial crisis has led to a number of new regulation reforms in regards to systemic risk. It is also evident that this problem is caused by the balance sheets of these financial institutions and banks receiving funding from unstable financial sources. However, the author questions the policies implemented in an effort to prevent this problem from occurring again. In line with this the author emphasizes on bridging the gap between the macro-prudential and micro-prudential policies in order to come up with better and more effective policies. References Acharya, V. (n.d.). A Theory of Systemic Risk and Design of Prudential Bank Regulation. SSRN Electronic Journal. pp.24-25 Acharya, V. 2012. A theory of systemic risk and design of prudential bank regulation. Journal of Financial Stability, 5(3), pp.224-255. Aldasoro, I., Delli Gatti, D. and Faia, E. 2013. Bank Networks: Contagion, Systemic Risk and Prudential Policy. SSRN Electronic Journal. pp.54-55 Allen, L. and Tang, Y. 2016. What’s the contingency? A proposal for bank contingent capital triggered by systemic risk. Journal of Financial Stability, 26, pp.1-14. Berger, A. and Roman, R. 2012. Do Bank Bailouts Reduce or Increase Systemic Risk? The Effects of TARP on Financial System Stability. SSRN Electronic Journal. pp.11-14 Blundell-Wignall, A. and Roulet, C. 2014. Macro-prudential policy, bank systemic risk and capital controls. OECD Journal: Financial Market Trends, 2013(2), pp.7-28. López-Espinosa, G., Rubia, A., Valderrama, L. and Antón, M. 2013. Good for one, bad for all: Determinants of individual versus systemic risk. Journal of Financial Stability, 9(3), pp.287-299. Pais, A. and Stork, P. 2013. Bank Size and Systemic Risk. European Financial Management, 19(3), pp.429-451. Sedunov, J. 2016. What is the systemic risk exposure of financial institutions?. Journal of Financial Stability, 24, pp.71-87. Settlements, B. 2011. Marrying the Macro- and Micro-Prudential Dimensions of Financial Stability. SSRN Electronic Journal. pp.721-730 Read More