Risk Management in International Banking, Insurance and Finance - Case Study Example

Management of Market Risk at Barclays Bank

Introduction

The following analysis focuses on Barclays Bank Group and its market risk management framework. The assessment highlights how Barclays handles market risk using various risk modelling models. The bank has a governance structure for managing and measuring market risks, which occur across the group. The analysis will focus on three key elements only. First, the paper will look at the appropriateness of the evaluation techniques. Second, the assignment will determine whether risk appetite is too high or too low for market risks. Finally, the evaluation will determine whether Barclays is holding sufficient capital resources to cushion it against market risk exposures.

The Appropriateness of the Evaluation Techniques at Barclays

Guided by the Annual Pillar 3 report of 2015, the Group uses quantitative risks models to the manage market risks. The report identifies three major risks pension, insurance, traded, and non-traded market risks. Companes utilize Value at Risk (VaR) model but reinforces it using scenario analysis and stress testing for each marketing risk. The bank understands the diversity of market risks, which compels it to have a comprehensive management structure for the market risks (Barclays PLC, 2015). The varied nature of risks under traded, non-traded, pension and insurance risk categories demands the use of different models to maintain capital or earnings by reducing the volatility of trading book positions.

However, various risks models have deficiencies, which put companies at the risk of incurring losses. Jorion (2009) found that the 2007-2008 financial crisis was a true test for risk management models used by various institutions within the Eurozone. While the study emphasized the essence of risk management, it acknowledged the misleading nature of the returns-based VaR because it does not provide a proper framework for understanding risk diverse portfolio. Jorion (2009) recommended utilization of position-based risk measures to accommodate new instruments and managers. The approach of the analysis was relevant considering 2007-2008 financial crisis presented a significant risk management tests for financial institutions.

Correspondingly, Stulz (2009) attributes mismanagement of risks to the utilization of ineffective models but admits that financial institutions can make losses, which corresponded with Jorion (2009) findings. Using past data in scenario analysis and stress would produce significant errors. Banks require modelling risks position in various portfolios to contain the errors of historical data. Furthermore, financial innovation demands reinvention of risk management to confront changing nature of risks. Additionally, Stulz (2009) argues that VaR may not help banks to keep with the rapid changes in market conditions because it has a narrow focus. Hence, VaR risk modelling may limit protection from losses, which leads to loss of capital. A case study of UBS helps to identify the incapability in VaR in assisting banks to capture catastrophic losses. Stulz (2009) ignores the fact that banks have learned from the financial crisis to change portfolio model to accommodate changing risks and market conditions. Risk managers flop in risk management for failing to confront risks real time and identifying conceivable as well as known risks.

On the other hand, stress testing helps in the identification of susceptibility to risks (Borio, Drehmann, and Tsatsaronis, 2014). Investing in the current technology would provide the cushion so that firms can sustain a disciplined thinking to achieve financial stability. Scenario analysis and stress testing require customization to provide clarity of disclosures and prevent asset substitution (Schuermann, 2014). Stress testing has become a standard tool in the regulatory platform due to the recent financial crisis. A risk modelling approach should vary with crisis and normal times.

Barclays PLC has a sound risk modelling framework for market risks. Using VaR and complementing it with stress testing and scenario analysis eliminates the forecasting and focusing on risks in real time as identified by Jorion (2009). The design and execution of market risks management at Barclays has a wide scope, which implies that using a single method would result in errors and unrealistic results. VaR, in particular, does not guarantee the Group sufficient protection from losses because it could lead to insufficient capital to financial risk taking agendas. However, the 2015 Pillar 3 report shows a firm that has changed its portfolio over the years to prevent activities such as hedging, which exposure firms to solvency due to low liquidity levels. Jorion (2009) argues that firms cannot survive during the financial crisis by using VaR alone to limit losses on a daily basis.

Determining Whether Barclay’s Appetites for Market Risk Are Too High or Too Low

According to Ashby and Diacon (2012), an appropriate risk level entails balancing risk and return. The profit and value of a company should reflect the capacity to respond to risks involving the environment, capabilities, as well as stakeholders. Generating the long-term profits and value for the investors requires firms to mitigate implement clear risk appetite management and control. Risk taking process calls for an articulation of right strategy to maximize the level of outcome and value as a going concern (Ashby and Diacon, 2012). The current regulatory environments require banks to consider managing emerging market risks. The board determines the extent boundaries of the risk taking activity.

Barclays takes a market-conscious approach to defining its risk appetite framework. Utilization of risk modelling methods comes in handy for a financial institution seeking to reduce indebtedness and weaknesses in the capital market (Barclays PLC, 2015). The Group uses a scenario-based approach because it considers the macro environment as the highest source of risk factors such as foreign exchange, market spread, inflation, and traded credit. The essence of using scenarios is to reduce the effect of the events that may expose Barclays to risk. Currently, the uncertainty of political and economic environment in Africa and Europe requires banks to remain vigilant to protect itself from downturns (Jin and Nadal, De Simone, 2014). The constitution of Medium Term Plan encompassed in Pillar 3 report indicates that Barclays was ready to focus on risk factors such as litigations and interests rates, for example, the mortgage regulations in the UK housing market could have led to a rise in interest rates. Increasing rates could reduce expected returns.

Approving stress-testing themes in 2015 indicates that Barclays was ready to sustain its stakeholders’ maximum value. Stakeholders’ value is an essential factor in the determination of an appropriate risk appetite level. The Board focused on structural reforms to complement the stress-based themes to protect its capital base. A market oversight role in the Barclays bank report provided a foundation for testing the risks factors that could damage the control of the bank in US, UK, and South Africa. Modelling the risks through stress testing and scenario-based analysis was a strategy intended to determine the risk appetite on a quantified basis.

The risk management process is a part of the strategic vision for Barclays. The Board Risk Committee declared its commitment in supervising the level of risk appetite to sustain volatility in the external markets. The financial crisis of 2007-08 brought significant macroeconomic deterioration of the market conditions (Bremus and Fratzscher, 2015). According to Lundqvist (2014), only firms with strategic objectives for reducing risk can survive the disrupted market conditions. The effort to control market risks through robust measurement, reporting and oversight called aligns with the Non-Core strategy of asset reductions. According to Barclays PLC (2015), the risk management process forms a foundation for managing the Group’s wider strategy.

The balance sheet of the Group shows a company that utilizes quantitative and qualitative approaches to mitigate market risks. According to Ashby and Diacon (2012), articulating risk appetite for regulatory compliance is not enough because firms must indicate to investors, the extent of its commitment to mitigating risks. The Pillar 3 report shows Barclays’ effort in rebalancing risks profile. The Group managed to reduce the measures of market risks from €52.1billion in 2014 to €37.6billion in 2015. The reduction averaged 28% due to the commitment to an investment bank and Non-Core strategies.

Evidently, the risk appetite towards market risks is too high. The commitment to maximizing stakeholders’ value, aligning the risk management process with core strategies, using scenario based and stress testing approaches indicates the Group’s intention to reduce risks. Barclays cannot utilize a conservative approach guided by the scope of its market in US, UK and South Africa (Barclays PLC, 2015). Furthermore, the post-financial crisis period demands robust risk appetite framework.

Determining Whether Barclays Group Is Holding Sufficient Capital to Protect Itself against Market Risk Exposures

Banks must maintain risk capital to maintain credits and liability obligations in accordance with the theory of capital by Erel, Myers, and Read (2015). Maintaining relevant capital maintains the credit quality of financial institutions. The theory of capital acknowledges that efficient capital allocations help in the prevention of risk shifting, which powers investment and contracting decisions among firms. The essence of trading off costs and benefits related to risk capital is to prevent a negative effect on the optimal portfolio of a bank (DeAngelo and Stulz, 2015). Therefore, the theory maintains the balance between risks and returns, which maintains an appropriate level of risk appetite.

Kashyap, Rajan, and Stein (2008) argue that failure to maintain sufficient risk capital is principle reason U.S banks and investments lost $250 billion due to the residential mortgages securities. Related occurrences in banks destabilize the inter-banks market and the larger economy. The U.S investment banks did not anticipate the risks of mortgaged-backed securities, which compelled them to consider selling their assets due to loss of fundamental value (Kashyap, Rajan, and Stein, 2008). Shim (2013) argues that maintaining a risk capital is critical for a bank that aims to sustain itself despite the prevailing interest rates and spreads among other risk factors that spill over to borrowers as well as the entire economy.

Barclays maintains a sufficient risk capital to respond to the prevailing market risk. Equities and interests led to asset reductions in non-core business. The CET1 ratio in 2015 averaged 11.4% from 10.3% in 2014. The increase in the ratio indicates that the Group was seeking a regulatory capital adequacy to prevent exposure to market risks (Barclays PLC, 2015). On the other hand, total capital ratio averaged 14.7%, which indicates a low-risk exposure amount. The overall reduction occurred due to the absorption adjusting items in paid and foreseen debts. A risk-based capital and surplus should absorb market risks for a firm.

Both CET1 and total capital ratio increased significantly. The CET1 ratio saw an increased from 10.3% in 2014 to 11.4% while the total capital ratio increased from 15.4% to 17.3%. However, the risk-weighted assets (RWA) decreased by €43.5billion, which averaged 28% in 2015 (Barclays PLC, 2015). The company sustained a strong capital to prevent exposure to market risks, for example, the increased rates in the UK housing markets. The market risks level decreased in 2015 due to equities, asset reductions, and interests. The management VaR reduced by 23% In addition, the political and economic uncertainties in Europe and U.S indicate the need to meet regulatory requirements for capital resources.

Currently, the Group has made progress in maintaining a strong risk capital due to a strong risk culture within the business. The Board and the Executive Committee aims at meeting the fully loaded CRD IV CET ratio 1 alongside reviewing the RWA, capital and leverage ratios in accordance with the prevailing. The bank hopes to attain Counter-Cyclical Capital Buffer (CCCB) to contain exposures in the UK by 2017 (Barclays GB, 2016). Evidently, the progress in maintaining relevant risk capital shows that Barclays does not have enough confidence in the level of capital despite making notable progress in 2015 than 2014.

The move to reinforce capital is a response to the increasing competition from Standard Chartered. Wallace (2015) argued that the Bank would to €5billion raise to reinforce its capital resources. Raising capital levels would sustain shareholders value. The review by Wallace (2015) on The Telegraph indicated that rallying its non-core and investment bank trading positions would take 2-3 years. However, the recent slump in profits and shares by 8% implies that Barclays may not sustain its risk framework in the long term (Tutt and Ellyatt, 2016). The board has attributed the reduction due to the restructuring of the core business in the U.K. In addition, the conduct and litigation issues may disturb the non-core business if the Group does not maintain a sound capital position.

Conclusion

Evidently, Barclays Bank has clear risk modelling framework, which utilizes appropriate techniques such as VaR, scenario analysis and stress testing. Using a multidimensional modelling approach prevents drawbacks associated with VaR where stress testing and scenario testing complements the framework. The three approaches are appropriate for Barclays due to the wide scope and varied nature of risks, which include traded, non-traded, pension and insurance. The Group has overcome the market risks associated with equities and interests through the modelling approaches. On the other hand, the Group has a too high risk, which indicates it does not take a conservative approach towards mitigating market risks. A clear board risk committee and market conscious approach utilize VaR and Stress testing models to confront the uncertainty of the political and business environment. The management framework for market risks aligns with the core objective of the firm and aims to achieve stakeholder’s value maximization in the US, UK, and South Africa. Additionally, Barclays understands that poor risk capital could increase exposure to market risks. The Group has made progress by reducing market risks and maintaining a sufficient capital position in 2014-2015. The Pillar 3 report indicates that the bank aims to carry out the program to maintain competition and facilitate restructuring.

Reference List

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Tutt, P. and Ellyatt, H., 2016. Barclays shares down 8% as profits slump. [online] CNBC. Available at: <http://www.cnbc.com/2016/03/01/barclays-2015-pre-tax-profits-up-3-to-96b.html>.

Wallace, T., 2015. Barclays 'may have to raise £5bn to keep up with rivals'. [online] Telegraph.co.uk. Available at: <http://www.telegraph.co.uk/finance/newsbysector/banksandfinance/11765673/Barclays-may-have-to-raise-5bn-to-keep-up-with-rivals.html>.