Risk Management in Banking - Assignment Example

"past (banking) crises would cause less damage today if they were to secure because of the greater dispersion of credit risk, the improvements in risk management and the size of the capital cushions maintained by banks" In analyzing this statement make by the president of the Federal Reserve Bank of New York, it is imperative to understand with clarity the key concepts as used in his comments. The subject matter of this comment is banking crises. The role of banks in the growth of an economy cannot be overemphasised; this is because banks represent the main channel by which funds can flow from lenders to borrowers. In addition to this, it plays the role of a custodian for valuables such as gems, will; money e.t.c. investments can also be facilitated and banks where they act as agents to customers. If for one reason or the other, a bank is unable to meet this statutory obligation, the resultant is a banking crises, the banks are then said to have failed. Another terminology that requires definition is credit risk. This can alternatively be referred to as Expected Loss and is a product of Probability of default, Exposure of default and loss given default. These three factors which are considered in credit risk all have standard measurement yardsticks against which they are calculated. Probability of default (PD) is measured using statistical data (past default rates, external and internal ratings together with credit scoring. Exposure at default (EAD) takes into consideration remaining outstanding debt alongside other forms of credit like guarantees, commitments e.t.c. Loss given default in its own case is measured considering the amount and values of the security on ground. Other kinds of risks that have contributed in one way or the other to past banking crises are as follows - Liquidity risk - A situation in which a bank is unable to meet its obligations as a result of lack of liquid assets. Interest Rate Risk - An unfavourable change in interest rates pertaining assets and liabilities resulting in losses. Market Risk - An unfavourable change in the market values of assets or portfolios ultimately resulting in losses. Operational Risk - A situation where losses result because of people, process or system failure. These, together with credit risk are the main types of risk involved in banking. Legal Risk, Reputation risk, settlement risk, sovereign / country risk, Rogue trader risk and sovereignty risk are further risks that have been experienced in the banking sector in the past. In the 1970's Western European and American banks were involved in credit risk and its attendant problems when they loaned out deposits of oil- rich OPEC countries to oil-poor undeveloped countries. The expected profits form these loans never materialised because the borrowing nations defaulted in payment. To further complicate the issue some banks within the period made out loans to just one nation that amount to a substantial past of their assets. In the events of a default in payment by this nation, the bank in question is sure to incur such a loss capable of precipitating financial crises. In modern day banking, banks try to minimise losses by greatly dispersing their credit risk. It could be by arranging it in such a way that the risks are not concentrated in country or by spreading risk over different sectors of an economy. This is an improvement of what obtained in the past. Risks, nowadays, are spread to withstand world shaking defaults. Risk Management is the process of reducing the threat of loss due to uncontrollable events. There has been a continued improvement in Risk management over the years with four major approaches being adopted. The first approach is Risk Avoidance, and this approach may be adopted when the risk involved in a particular venture far outweighs whatever gains that might result. Depending on the risk management team, credit facility may be denied the seeker on account of the risk level. The second approach is to minimise losses through sound management principles and techniques, properly and accurately analysing risk helps the bank in risk management. As was earlier considered, credit risk otherwise known as Expected Loss can be calculated using the following formula. Expected loss (EL) = probability of Default(PD) * Exposure at default(EAD) *loss given default(LGD) Simply put EL = PD X EAD X LGD These factors (defined previously) are good risk management tools. Furthermore losses can be absorbed in such a way that its effect is not visibly notice in banking operations. Lastly insurance can be purchased to pay for loses where they cannot be avoided Financial and economic viability assessment is another risk management tool that considers the ability of a business to generate surplus (profit). It is less likely for a more-viable business (Financially and economically) to default on repayment of loans than would a less-viable one. Other improved risk management practice are recognition of more productive sectors and channeling of funds in the same direction, credit ceiling, interest rate ceiling etc.. Reduction in overall risk is the major function of the risk managers with these improved risk management tools he is able to identify, with much more precision and accuracy, sources of potential danger before mishaps occur, unlike in the past. Another fact that enhances the view form of the president of the Federal Reserves Bank of New York is the massive recapitalization that has swept through the banking sector. Banks have through strategic investment and planning, continued to improve on their capital base. As it stands today it would take a phenomenon of cataclysmic proportion to precipitate major banking crises. The sheer size of bank capitals today cushions the effect of any anticipated crises, acting as a shock absorber and gently spreading the effects in almost ignoble proportions with very little effects. Also today credit is not simply allocated to the highest bidder. A diligent process is undertaken to ascertain borrowers that are the most likely to repay. Unlike in the past where under funded banks allocate credit facility to excessively risky projects. The bank for international standards (BIS) is also in place today to ensure that banks do not take on inappropriate levels of risk. On a regular basis, risk managers assess the risk level of a banks portfolio in order to encourage prudence in credit risks. Substantial collateral would be required today from a borrower to reduce the risk of his defaulting in payment. In seeking collateral /security from a borrower, there ha been a decline in the use of real estate as collateral based on declines in asset prices of the past. Experiences in the banking sector of Turkey and Mexico in past years provide lessons today for banks on how not to dispense credit. In 1975 Turkish banks made out loans public enterprises and public administration to the tune of 47 percent of bank assets. In the case of Mexico, 75 percent of its loans meant for industries were allocated to four state-owned enterprises. These public enterprises turned out unprofitable. Banks will therefore rather direct credit facilities to the private sector. The three objectives of banks today are solvency, liquidity and of course profitability which despite their conflicting nature are still being pursued simultaneously. Today banks in allocating credit will rather prefer firms with track record and not by political or other unprofessional considerations. The probability of default is higher with indiscriminate credit allocations. A case study of Indonesia and Korea in the 1980's lends credence to this view. Indonesian banks failed to consider potentially credit-worthy medium-size firms that lacked the political influence of large enterprises and it affected the repayment rates of loans which was as low as 53 percent in a particular World Bank supported program. And on the other hand Korea was more prudent in its credit allocation and the result was a repayment rate in the excess of 98 percent. Improved risk management techniques available at the moment in banking include mechanisms for monitoring the performance of a borrower. The implication of this is that it enables the financial institutions to take early steps if loan repayment is in arrears. Effective appraisals and monitoring coupled with continual and pragmatic review will result in very low loan losses. Furthermore, the role of insurance cannot be downplayed as a risk management tool in today's banking world. Banks are able to distinguish between an insurable risk and an uninsurable one. This helps them reduce the uninsurable risks by constant loss-prevention efforts. Since some risks are easier to foresee than others, banks are then able to make good credit allocation decisions. All of these analyses seem to be saying in conclusion that while there may yet be the possibility crises in the banking sector, its overall effect would be less damaging than was witnessed in the past. REFFERENCES 1. S. A Hefferman (2005): Modern Banking, 2nd edition. Wiley (Chapter 3) 2Greenbaum, S.I and Thakor, A.V (1995), Contemporary Financial Intermediation Mason, Ohio, South-Western / Thomson Learning (chapter 4) 3. Bessis, J. (1998), Risk Management in Banking, Chichester; New York; Wiley 4. Jackson, P., Nickell, P. and Perraudin W. (1999), Credit Risk Modeling; Bank of England Financial Stability Review June. 5. Danielson, J (2002), the Emperor Has No Clothes; Limits to Risk Modelling, journal of Banking &Finance, 26, 1273-96 6. Allen F. and Santomero, A.M (1997), The Theory of Financial intermediation; Wharton Financial Institutions 7. Kimball, R.C (2000), Failures in Risk Management; New England Economic Review (January - February) 8. F. T Reports; Risk management 2005 9. Insurance; Risk management 2003 10. Economic Surveys; Risk, vol 370 issue 8359, 24 January 2004. Read More