Risk Management: Challenges for Banks and Regulators - Example

Running Head: RISK MANAGEMENT Risk Management: Challenges for Banks and Regulators Name Institution Date Risk Management: Challenges for Banks and Regulators Introduction A risk is an uncertainty that will have an impact on the operations of an institution if it is allowed to happen. During the operations of the banking institutions, the banks are faced with so many risks that may have negative impacts on their business operations, and some may have positive impacts. To avoid the negative impacts of the risks from putting down their businesses, banks have to employ strict and effective risk management measures. The process of risk management in the banks involves identification of the risks, measurement of the potential impact of the risk and assessment of the risk. The aim of this is to minimize the negative impacts the risks can cause to the bank, and which might consequently affect the bank’s financial performance and the capital of the bank (Dunnan, 1998). It is therefore essential for the banking institutions to form a special unit within them that will be dealing with the issues of risk management. They are also to formulate procedures to be followed in the process of identifying risks, measurement and assessment as well as for the entire process of risk management. Risks are however an innate thing in the business of banking and therefore risk management should be effected in order to achieve financial soundness. For example, the Bank of India has incorporated an approach for risk management and in tune with this, it has formulated policy documents that consider the business requirements and also the best internationally defined practices for risk management as defined by the national supervisor (Scott, 2008). Banking risks Various risks that the bank faces during its operations include liquidity risk, credit risk, market risk, exposure risks, investment risks, strategic risks and reputational risks. The most common risks that are faced are liquidity risks, interest rate risks and operational risks. Liquidity risk is the risk that results from negative impacts on the financial results and the capital of the bank that occurs when a bank is unable to meet all its obligations. Interest risks are the risk of negative effects on the financial results and capital of the bank as a result of changes in the interest rates. Operational risk is the risk of negative impacts on the financial results and the capital of the bank as a result of omissions in the operations of the employees, lack of enough internal procedures and processes, inadequate management of information systems and unpredictable external events. Banks also face risks as a result of their country of origin and the risks faced by that country. A country may be facing political, economic, social and transfer risks which the banks will also experience (Greuning, & Bratanovic, 2009). With the rising competition and technological advancement in the banking industry, the banks have expanded their services in a wide range so that retail and wholesale customers can accesses them through the electronic distribution channels known as the e-banking. The development of the e-banking however carries a lot of risks with it as well as several benefits. Such risks have to be recognised, immediately addressed and managed by the banks in the most discreet manner due to the significant characteristics and challenges faced by the electronic banking (Kondabagil, 2007). Such characterist that poses the banking system with risks is the extraordinary speed changes that are associated with the technology and customer service innovations. Theses coupled with the interest risk, the operational risks and the liquidity risks influences the overall risk profile of the banking industry. The risks management procedures and units in the e-banking should therefore be tailored towards addressing the challenges as well as the risks associated. The management and the board of directors of the banks should therefore ensure that their institutions have updated their already existing risk management procedures and processes to incorporate the changing demands brought by the e-banking. Principles of risk management There are several principles that need to be followed for effective management of risks. The management and board of directors in the banking institutions need to be aware of these and put them into practise to ensure effectiveness in risk management. Understanding of the methods of identifying and dealing with the risks in an organization can help in avoiding the difficulties which may arise later and also makes the management and the institution members to be prepared for such incidences. The first principle to be understood is the organizational context (Cade, 1997). The managers of any banking institution should first and foremost consider the context of their organization so that they can know the best risk identification and treatment procedure to apply. This also entails a clear understanding the political, social economic, technological and legal environment in the organization. Another principle to be observed is stakeholder involvement. Stakeholders are the key players in any business organization. The management should therefore understand the role played by the stakeholders since it is very crucial to manage the stake holders properly for the success of any organization. The stakeholders should be informed of the risks that can arise in any organization. The management should also be aware of how the occurrence of risks can impact the stakeholders. In a banking institution, the stake holders have the largest role to play. They face the most impact of the risks. Organizational objectives are another principle that should be considered in risk management. This is because risks that usually happen are in relation to the activities that take place in an organization, and the objectives that the organization aims to achieve. It is very essential that the person who is designing the risk management procedures be aware of the business objectives so that the procedures can be directed towards the achievement of those objectives. In a banking institution, most of the objectives are monetary, money making, and safe keeping of the client’s money. The risks that occur in the banking institution affects the financial results and the procedures should therefore be based on the financial results (Angelopoulos, & Mourdoukoutas, 2001). Another principle that the management can apply in management of risks is the M-o-R (management of risks) approach. The policies, processes, and strategies in this form of approach provide the general guidelines and models within a specific organization. These guidelines and models are founded on the experience and research carried out by professional risk managers from a variety of organizations and from different management backgrounds. Observing the best practices ensures that individuals who are involved in managing those risks which are associated with the activities of a business learns from the lessons and mistakes done by others. The other principle is reporting. This entails accurate and clear date presentation and the transfer of data to the right person among the staff, the management team and the stake holders. This is very essential in risk management (Leaven, 2000). The principle of roles and responsibilities is also very important in risk management. A significant practice in risk management is clearly outlining the roles and responsibilities of the management team. The functions and duties of each individual must be observed with transparency both within and without the organization. Transparency is also very important in the banking sector. Any institution that deals with financial matters needs a lot of transparency due to the possibility of fraud which is big risk to the banking institutions. Another principle to be observed is the support structure. This is the provision of standardized guidelines, information and funding within the organization especially to the individuals who are charged with the duty of managing risks that arise in specific areas. This involves a federal risk management group, a standardized risk management approach and guidelines for best practices in reporting and assessing risks. In a banking institution, since risks are part of their daily activities, a support structure is very essential to prevent the risks form paralysing the banks operations once they occur (Greuning, & Bratanovic, 2003).. The principle of early warning signs should also be observed. This will help to deal with the risks early before they cause an impact to the bank’s operations. Early warning signs alert the management of an impending risk occurrence and are therefore able to get prepared to deal with it. This will help avoid the impacts that the risk would have made, and to safeguard the institution form the losses that could have occurred if the risk could have happened. Risk management also requires a supportive culture that will ensure that those involved in risk management have the confidence to raise, discuss and manage the risk. Such a culture involves rewards for effective risk management skills. Any banks that adopt risk management policies need to keep re-evaluating and continuously improving the policies. This will keep the policies up to date and will be able to deal with any newly arising form of risk. Challenges faced by the banks and regulators The ever changing economic environment has made an important impact on the banks, in their efforts to ensure effective management of the spread of interest rates on loans, competition for deposits and the overall changes in the market and economic fluctuations. The recent market economy has been very challenging for banks who want to effectively set their growth approaches. Another challenge that is being faced by the banks and financial institutions is the management of the bank’s portfolio. The primary asset for the banks is the loans and when their quality is suspected, the groundwork of the bank is shaken. Diminishing asset in the banks has however become a great challenge for most banks. Due to the difficult economic times, the banks are struggling to cut their financial costs by eliminating some of the expenses they are faced with. The banks also face challenges of aging management teams who have the knowledge and experience in risk management. Pressures from the shareholders also contribute to the challenges that the banks experience (Freixas, & Rochet, 1997). Assimilation of the risk management skills among their systems is also another challenging task for the banks. This is because technology is a major factor in the development of risk management skills which is also costly and demanding to effect it into the bank’s systems. Risk management has however become a very expensive issue due to its demands. Risk management in the banking institutions is facing a lot of threats from the cyber hackers. With the increase in threats, the banking institution is facing security risks which are highly complex, frequent and with malicious intentions (Cade, 1999). The banks regulators are also facing great challenges in their duties since the economic hardness has led to merging of the supervisory regions coupled with decrease in the staff level, in order to cut the costs. The regulators who have remained working are faced with a burden of excessive workload and one regulator attending to many banks. As a result of this, the banks are receiving limited attention on assessment done by the regulators, limited time that the regulators spends with each banking institution and consequently more problems getting into the banking institutions. Competition has therefore become more intense in the financial industry posing a challenge to the banks. Liquidity risk Liquidity is the means by which a bank funds increases in its assets to enable it meet its responsibilities as they appear without incurring any losses. The function that the bank plays in mature conversion of short term deposits into long term loans increases its vulnerability to liquidity risks of which is both institution specific and the others which affect the market as a whole. Almost all the financial transactions in a bank places it a risk of liquidity. The bank therefore needs to strategise effective risk management skills that will ensure its ability to meet its cash flow responsibilities which are in most cases uncertain due to their influence by the external agents and the behaviour of other agents. Liquidity risk management is of principal importance since any shortfall in liquidity in any institution can have impacts which are felt in the whole system. The developments that have been taking place in the financial market in the past decade have raised the complexity of liquidity risks and the process required in its management (Leaven, 2001). There are two types of liquidity: market liquidity and funding liquidity. A security is said to have good market liquidity if it is easy to trade. This implies that the security has low bid spread, a small price effect and easy resilience. A bank or an investor is said to have good funding liquidity if it has adequate funds from its capital or from borrowings. However, funding liquidity risks have liabilities that cannot be met when they occur, and can only be met at a higher price. Liquidity however differs according to time and the markets. The current economic environment has led to many banking institutions to experience extreme market liquidity. Dealers are closing their bids especially in the markets which deal with asset-backed securities and changeable bonds. The businesses are also experiencing funding liquidity because most of the banks are running short of capital so they will have to reduce the businesses that require large amount of capital to start. They will also have to reduce the amount of capital that they lend to the borrowers. The two forms of liquidity are related and can support each other in liquidity spirals where improper funding can lead to limited trading, decreasing the market liquidity, raising the margins and tightening the risk management and consequently worsening funding (Banks, 2005). Causes of liquidity risk Liquidity risk is brought by situations whereby an individual or an organization has interests in trading with a certain asset but it is not possible since there is nobody in the market who is also interested in trading with that asset. Liquidity risk becomes a problem to parties who are planning to hold an asset, or who already have the asset since their trading ability gets affected. Liquidity risk manifests itself in different ways from price drop to zero prices. Drop of an asset’s price to zero is termed as worthless in the market. However, if the party holding the asset cannot find another one who is interested in the asset, this can be possibly a problem with the market participants not finding each other. This is the reason as to why liquidity risk is most common in the newly emerging markets or in markets with low volumes Bank for International Settlements, 2000). Liquidity risk is also caused by uncertain liquidity. A banking institution may lose its liquidity if its credit rating drops, if it is faced with sudden cash outflows, or any other reason that may make the counterparts to start avoiding trading with the bank. The bank can also face liquidity risk if the marketers which it used to depend upon are also facing loss of liquidity. Liquidity risks are also likely to compound other risks. If a business organization has a position in an illiquid asset, its restricted capacity to liquidate that position at an immediate notice will compound will compound its market risk. For example if a financial institution is experiencing frustrating cash flows, from two distinct parties at a given time, and then the party that owes it a payment defaults, the financial institution will have to find other sources of money to meet the payment. If the institution is not able to find another source, it will also have to default the payment. In such a situation, the liquidity risk is compounding credit risk. The major cause of liquidity risk is most likely to come from the management of the bank. The management may fail to manage unexpected conditions that face the bank such as costumer’s negligence, economic crisis, financial crisis and regulatory failures. Liquidity risk management Banks need to create a well established liquidity risk management system to help them form the negative impacts of liquidity risks. Economic and financial cooperation between countries has led to more developed information systems and wide financial access that have enabled the banks and other financial institutions to deal with risk issues. Research has shown that in the current global financial situations, most banks failure happened due to lack of liquidity management system. However, it is hard for banks to deal with liquidity risk as individual since in case of liquidity shortfall in an individual bank will have severe repercussions that may have double impacts. Therefore, it is very necessary for a bank in the process of analysing the liquidity requires that the bank do a continuous measurement of the liquidity position and also to continuously examine how their requirements for funds are likely to come up in different situations. This would save the economy from the bank breakdown that would affect the entire financial system. Liquidity risk management is therefore the risk of the bank being unable to raise funds without getting extraordinary high costs (Neu, & Matz, 2007). The effectiveness of a risk management system is determined by the strength of the pressures from the liquidity, how the bank has arranged its liquidity management policy, the bank’s financial condition at the moment and the ability of the bank to find liquid resources from within and without the bank. The main objective of a bank being to add value on its equity by maximizing low risk returns to the shareholders and to achieve this, the function of risk management is very essential. Considering the severe impact of liquidity risks, risk management should be taken seriously by the banks. However, banks operate in the business of risk taking but should not engage in operations that impose unnecessary risks upon them. The bank should only take those risks which are a unique part of their wide range of its services. Risk management in the banks does not mean minimizing the risks. Its goal is to maximize the risk-reward trade-off. Financial ratios are tools that can be used by the bank to measure the position of its risk management policies. Financial ratios can be used to identify incoming liquidity problems. An example of such financial ratios is the ratio of liquid assets to liquid liabilities. This ratio may be high in economies where the government fails to mediate to meet funding irregularities, where financial institutions are risk-averse or where there are fixed interest rates (Mark, Crouhy& Galai, 2006). The type and level of uncertainty that leads to liquidity risk depends on the size of the business, the business volume and the complexity of its activities. Through bank operations, the modern way of managing risks is by applying the liquid management process. This process involves setting up the risk management policies, starting an asset liability committee which is supported by an appropriate information system for monitoring and reporting incidences of liquidity risks. The information system should be regularly checked by internal control (Basel Committee on Banking Supervision, & Bank for Int. Settlements, 2008) Liquidity Risk Management Policy The first step in the process of liquidity risk management is for the bank setting up risk management policies and strategies to guide the whole process of risk management. With use of these policies and strategies it is easy to formulate a risk management process. Risk management policies however vary according to the banking institution. In formulating these policies, various element need to be considered. These include: the policies should cover the general liquidity strategy in the long term and not in the short term. Should also cover specific goals and objectives of the bank that relates to the liquidity risk management and risk authorization order in the institution. Another consideration is that the policies should determine the duties of the individuals who are involved in the liquidity risk management role including asset liability management, setting up the prices, marketing process, managing information and formulating and issuing reports. It should also decide the structure to be used in monitoring, reporting and reviewing of the liquidity risk management process. The risk management framework that is formed should be confirmed to ensure that it is capable of confronting uneven liquidity scenarios (Jorion, 2009). After the policies and strategies are formulated, they should be communicated to every party in the institution, implemented, continuously monitored and reviewed to ensure that they are valid. After the policies have been effected, an effective information system should be put in place for monitoring and reporting the progress of the risk management process. This will enable the bank to identify and take note of early warning signs of incoming liquidity risk issues. The information system should be able to look over both internal and external indicators of the bank that depict a potential liquidity risk. External factors that could result in liquidity risk problems arises from economic features such as downward trend in economic cycles and cases of highly sensitive financial markets having a great influence on the economy. Internal factors include limited and unstructured banking tools that could result in liquidity mismatch, unsafe investment decision and reckless banking operations that result in decreased depositor’s trust on the bank. The information system will therefore enable the managers to monitor all information concerning the indicators. An internal control system is also very important in a bank’s liquidity risk management process. This will help ensure effective implementation of the set policies and also ensure that the procedures are being followed. Internal control unit is involved in regular review of the processes to ensure that the risk management team is in compliance with the conditions set by the board of directors. An important part of the internal control is the independent review that they carry out and evaluation of the effectiveness of the process. If the results of the review reveal any irregularity, they should also ensure that the process is revised and the necessary adjustments made (David, 2008). Ways of mitigating the liquidity risk There are three defined approaches that a bank can use to quantitatively control its liquidity risks. These include the stock approach, the cash flow matching approach and the mixed approach. While using the stock approach, the bank can keep a record of its liquid instruments that can be easily drawn upon when required. The number, quality and form stock for those assets are standardized to deal with the crisis event, but the stock of those assets can also deal with normal cash flow. In the cash flow matching approach, the banks try to equate cash out flows with cash inflows. This method may be used using pure contractual cash flows or adjusted cash flows. The adjusted cash flow influences the contractual cash flow so as to cover the possible behaviour of the counterparts and the non contractual cash flow required to main the business franchise. Changes may be done based on the expected usual conditions or stress conditions. The mixed approach puts together the principles of cash flow matching approach and the stock approach. Adjusted cash flow are perceived to be under the cash flow matching approach apart from the assumption that the stocks of liquid assets are not kept until they matures but they are used to produce cash inflows through their sale or other lending operations. The use of cash flow model is however, destined for stress environments. However, banks require liquidity to carry on with their regular and irregular operations. Liquidity risks can also be reduced by use of liquid assets which means investing more on liquid loan, or having more cash at hand. The other procedure that can be adopted is by dispelling withdrawal risk which means broadening its sources of funds by creating several and distinct depositors. The other way that liquidity risk can be curbed with is by use of lender of last resort. This depends on the central bank’s conditions for regular liquidity needs. With the irregular predictable liquidity, banks can try to foresee the future basing their judgement on previous experiences. However, it is sometimes hard to foresee since one cannot tell when the economy will be hit by abrupt shocks (Doherty, 2000). However, making use of a meaningful liquidity mechanism requires a well coordinated organization. This mechanism could be put in place if at all the bank has put in place a standard regulation on the required capital to all its auxiliaries. In managing regular liquidity, the bank requires that its subordinate banks will have shorter or equal asset maturity to the maturities of the total borrowings of the main company. But in normal operations, the bank’s holding company gets is basic sources of funding from dividends got from its auxiliary banks. Conclusion The banking industry is a very sensitive sector that deals with highly risky operations. The risks are very high in the daily operations and these when not properly dealt with can have negative impacts on the bank’s operations and may consequently paralyse most of the bank’s activities. With the liquidity risks, there is a need of an immediate action since this can very easily lead to closure of the banking institutions. A proper and effective liquidation risk management process with all the required procedures, policies and strategies should be put in place to ensure that the liquidations risks, which must occur in every banking institution, do not bring down the activities of the banks. The risk management process should also be properly followed and operated by knowledgeable staff that will ensure effectiveness of the process. Strict monitoring of compliance by the management is also necessary for best results of the process. The process of liquidity risk management however faces many challenges due to its many requirements. The first challenge that faces liquidity risk management is incorporating it in all levels of management in the bank. This plan should be a long term one and not short term. The process is therefore demanding in terms of resources and time to ensure that it is implemented at all levels. Another challenge is for the process to work in all banking institutions, there must be a set of clear guidance and high requirements (Frenkel, 2005). The backs can easily achieve this but it often lacks in the regulators who make the process to be hard to implement. The other challenge is the large amount of resources that are required in implementing the process and in complying with the regulations. This process requires an information system which requires commitment for funds to set it up. Staff are also required to operate the information system and for the review of the process that also requires funds to hire. Liquidity risk management also requires stress testing approach to be used when complications arises during the day to day activities of the process. Integration of the stress testing approach is also a challenge to the financial institution. Lastly, projection of contractual cash flow is also a challenge especially with those institutions that are involved in millions of transactions. References Angelopoulos, P., & Mourdoukoutas, P., (2001). Banking risk management in a globalizing economy. New York: Greenwood publishing group. Banks, E., (2005). Liquidity risk: managing asset and funding risks. New York: Palgrave Macmillan. Bank for International Settlements. Monetary and Economic Dept. (2000). Managing foreign debt and liquidity risks. California: University of California press. Basel Committee on Banking Supervision, & Bank for International Settlements, (2008). Liquidity risk: management and supervisory challenges. London: Publisher Basel Committee on Banking Supervision. 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