Risk Management Activities of Barclays Bank - Case Study Example

Provide a critical review of the current risk management activities of Barclays Bank using their annual report Table of Contents Chapter Introduction 4 Chapter 2: The Appropriateness of Barclays’ Definition of Risk Appetite 4 Chapter 3: Risk Appetite 6 Chapter 4: Effectiveness of Barclay’s Enterprise Risk Management (ERM) Framework 7 4.1 Effectiveness of ERM 8 4.2 Cost of ERM 10 4.3 Managing ERM 10 Chapter 5: Corporate Governance Arrangements Supporting Risk Management Activities 12 5.1 LIBOR Scandal 13 5.2 FOREX Fixing 15 5.3 Bank of Credit and Commerce International (BCCI) 16 5.4 Link in Three Lines of Defence Model 17 Chapter 6: Conclusion 19 References 21 Bibliography 25 Chapter 1: Introduction The banking industry has made considerable progress in addressing the weaknesses in risk management that were highlighted during the global financial crisis of 2008. The risk management framework and governance structures in particular has experienced significant changes post financial crisis. For instance, the Board of Directors are now playing a major role in developing organisational risk policies by devoting more time on risk issues. The powers and influence of Chief Risk Officer (CRO) and different risk teams operating under this position has been broadened and hence they are actively participating in diverse business areas including risk appetite development, strategy planning, product development and compensations (FRC, 2005, pp.3-15). Given these new reforms in the world of Banking and Financial services, one of the most renowned Banks, Barclays Group Plc, has been surrounded with various scandals starting from LIBOR manipulation during the period of crisis to more recent FOREX fixing and other issues. This case study aims to critically review the current risk management activities of Barclays Bank. Chapter 2: The Appropriateness of Barclays’ Definition of Risk Appetite The annual report of Barclays Plc reveals that the group’s risk management policies and practices are intended to identify and analyse risk so as to set suitable risk appetite. These policies aim to limit, monitor and control different types of risks based on reliable and updated data. The Board Risk Committee (BRC) has the authority to monitor Barclay Group’s risk profile against approved appetite. Such approval is decided by the Board which defines the level of risk that the Group may choose to take without requiring to pass any special resolution to pursue business objective. A careful analysis of Barclay’s risk appetite reveals that this has been an important area of focus for directors and senior management over the past few years. After the 2008 global financial crisis, the Board has taken many positive initiatives to advance industry assessment to modify traditional methodologies and approaches for determining risk appetite. From the annual report of Barclays it was found that the Group mainly focus on the following factors while considering risk appetite: Credit risk (downgrade in credit rating/sovereign credit quality/refinancing capability/debt servicing/counterparty risk) General economy (rising inflation/potential interest rate increase/extent of economic recession or recovery/austerity measures/etc) Business conditions (consumer loan affordability/corporate profitability) Market Risk (pension risk/traded or non-traded market risk) Funding Risk (capital risk/liquidity risk/structural risk) Operational Risk (legal, regulatory risk, and reputation risk) Foreign Exchange Risk (transactional currency exposure and translational foreign exchange exposure) (Source: E&Y, 2012) A research conducted by Ernest & Young on firms mostly affected from 2008 financial crisis reported that these banks and financial institutions, including Barclays, have increased their attention towards risk culture. However, there remain multiple views on definition, execution, and application of risk appetite the group faces challenges regarding how to embed risk appetite all over the business (Ernst &Young, 2012, pp.24-32). Chapter 3: Risk Appetite The current risk management activities of Barclays clearly states risk management objectives and strategies through core risk management processes. This process starts with identification of significant risks to business; the group then formulates appropriate risk strategies in-line with business plans and profile; the next step requires adoption of appropriate methodologies to ‘optimise’ risk-return decisions ensuring business growth suitably supported by efficient risk management infrastructure (Jenkins, 2011). Barclays has dedicated a separate team ‘Group Risk’ for strengthen, monitor, and oversee overall risk appetite that is required for appropriate risk management. This team is directly accountable to the Chief Risk Officer within each business. The CRO reports to the Group CRO who is further accountable to the Board of Directors and Chairman. The group’s purpose of risk management implies that current risk appetite is moderate (neither too high nor too low). These assumptions are incidental to group’s five core values namely Integrity, Respect, Excellence, Service, and Stewardship which reveals group’s corporate accountability and ethical values for different stakeholders. Chapter 4: Effectiveness of Barclay’s Enterprise Risk Management (ERM) Framework The ERM framework of Barclays is the responsibility of the Board of Directors that is defined in detail by the Group in the Barclays Plc Annual Report 2012 and the Pillar III Report. The principal framework risks clearly states ownership and accountability at all levels in organisational structure. This helps the Group to manage risk exposure by understanding agreed risk appetite for financial risk and risk tolerance for non-financial risks (IFC, 2013, pp.1-11). The framework follows five simple steps: 1. Identify 2. Assess 3. Control 4. Report 5. Manage and Challenges (Source: McKinsey & Company, 2013) Further, each type of key risk discussed in chapter 2 is under the responsibility of Group Key Risk Owner who basically proposes risk appetite statement in-line with Group’s Principal Risk Policies. 4.1 Effectiveness of ERM The four principal risks identified by Barclays are Market, Credit, Operational and Funding. The Group actively manages these risks across the entire enterprise which otherwise will have direct impact on Group’s income. The Group Key Risk Owners report their findings and assessments of business risk and effectiveness of control to oversight committees whose assessment forms the foundation of reports presented to Board Risk Committees (IFC, 2013, pp.1-11). The risk management committees are, Operational Risk Committee (manages all types of operational risk except Tax Risk) Treasury Committee (manages funding risk) Financial Risk Committee (manages market and credit risk) The ERM framework is effective primarily because of following important and practical factors that the Group considers while framing ERM: 1. After the global financial crisis of 2008 the group appreciates that optimal portfolio cannot be achieved without ‘internal pricing’ manipulation 2. Normal WACC methods are not applicable as deposits are widely available at risk-free rate 3. Focuses on improving Sharpe Ratio (based on shareholder rule) or minimise risk (based on debt-holder rule) 4. Economic capital is not equal to total capital (Basal Accord) 5. Debt-holder risk, which is basically stress on asset, is a constraint and hence Stress Test has to be employed 6. Shareholder risk, which is focused on volatility, needs to be allocated 7. Both debt-holders’ (asset stress) and shareholders’ (volatility) view must reflect all risk 4.2 Cost of ERM After carefully analysing the key risk issues of Barclays Group in relation to financial risk, including the Group’s entry into business segment through diversification of current products or geographic diversification, the Executive Management’s assessment of Group’s risk profile reveals that it has considered the following factors while determining the cost of ERM: a. The probability of risk being materialised into reality b. Adequacy and completeness of group’s internal controls to manage identified risks c. The committee after consulting other committees including Operational Risk, Reputational Risk Committee and Board of Conduct revised estimates cost of ERM framework d. The reports are required to be reviewed by external advisors but based on the Risk Appetite and Risk Profile of the Group, the Board concluded that cost of ERM may be anything between £150m to £500m (Barclays, 2013, pp.2-6). 4.3 Managing ERM The framework is planned and reviewed once every year with outlook focusing medium-term planning (MTP). The ERM is effective considering the fact that business outlook and economy is more predictable in short to medium-term whereas planning risk management with long-term outlook would make the framework risky by increasing uncertainty and making such ERM framework unreliable. The risk management strategies of Barclay’s reveal that it extensively uses quantitative methods to estimate risks. The ERM is based on various Risk Models including Exposure at Default (EAD), Probability of Default (PD), and Loss Given Default (LGD). These models are owned and developed by each business unit. The MTP process requires each business unit of Barclays Group to present action plans for business performance considering appropriate risks. Further, the GMRP (Group Model Risk Policy) is managed by independent Group Risk team and is annually reviewed by auditors. The management has made the process iterative (weekly activities by senior management) process that uses ‘bottom-up’ approach to establish unpredictability of key metrics. More specifically, if management projections necessitate high level risk, which is breach is breach of top-down financial objectives then management has the right to challenge specific areas that contribute high risk and rebalance risk profile. This is generally done by measuring risk appetite use against performance and this is reported to the Board and Executive Committee regularly all through the year. Chapter 5: Corporate Governance Arrangements Supporting Risk Management Activities Corporate governance refers to the structures and processes by which the affairs and business of corporate entities are directed or managed. The objective of corporate governance is to improve the shareholder value in the long-term by enhancing corporate accountability and performance primarily considering the interest of all stakeholders. From this definition of corporate governance it is clear that it ensures transparency and accountability in business by building credibility in corporate relationships. This is achieved by maintaining effective channels of flow of information and proper disclosures on which stakeholders rely for making important business decisions. The corporate governance report is available in a separate section of annual report of Barclays which is reported by the Chairman to shareholders. A careful analysis of Barclay’s CG report reveals that the primary agenda in 2012 was dominated by concerns over changes in regulatory environment. After the announcement of LIBOR scandal, the main objective of the Board was to determine the future of business direction by correcting its culture, values, and ethics in the light of external environment (Barclays, 2012, pg-317-320). 5.1 LIBOR Scandal The LIBOR scandal involved large banks including Barclays, UBS, and RBS who have reportedly manipulated key benchmark interest rates during the period of financial crisis. LIBOR is considered as benchmark rate that determines interest rate applicable in host of credit transactions such as home mortgage, commercial, and trade that follows variable interest rate. This event raised questions regarding corporate governance practices of the banking entities involved the scandal. This scandal is unarguably the outcome of systematic, organised, and planned malpractices involving multiple personalities associated directly with business. The research also surprisingly found that LIBOR debacle did not cause any direct damages/loss to banks that were involved in manipulation of benchmark rates. However, the scandal inflicted significant reputational damage into the banking and financial sector affecting their long-term relationship with stakeholders. Following the investigations, the one of the chief executives of Barclays stepped down while the bank was fined £290 million for involvement in LIBOR rate fixing scandal (Vasudev, 2013, pp.8-11). The Group responded positively from the LIBOR announcement and subsequent events by setting three specific committees who would report to the Chairman of Board: Business Practices review Committee The committee is responsible for independent review of business practices adopted by Barclays. This committee met twice during second half of 2012 top review the progress. LIBOR Employee Investigation Review Committee The function of this committee is to provide a broad level oversight and review of conduct of former and current employees in relation to LIBOR scandal. The committee ensures that all processes are properly employed, followed and outcomes remain correct. The committee conducted four board meetings during second half of 2012 to review the outcomes for dismissal of five employees and thirteen current employees who were then subject to disciplinary action. The CG report (2012) of Barclays Group Plc states that the management has decided to defer compensations worth £24.6 millions of these employees. The sum excludes voluntary surrender of illegal profits made by individuals resulting directly from LIBOR manipulation (Vasudev, 2013, pp.8-11). Regulatory Investigations Committee This committee was established during the fourth quarter of 2012 whose primary function is to oversee definite regulatory investigations by considering findings of these investigations and further directing, overseeing any remediation actions to determine whether any disciplinary actions is currently required for any Barclays’ employee. From the above discussions it is clear that Barclays has become more concerned about their corporate governance and is reorganising their business practices to incorporate risk management as inherent constituent of corporate governance practices. Such initiatives are expected to reduce the Group’s business and reputational risk in the market by monitoring business practices and controlling activities that are against the interest of stakeholders (Vasudev, 2013, pp.8-11). 5.2 FOREX Fixing Barclays’ currency traders have come under scrutiny for allegedly manoeuvring currency rates. The investigation is viewed as a global probe into workings of foreign exchange markets. Barclays said that multiple enforcement and regulatory authorities are currently investigating the matter in attempt to reveal whether there was any foul play in foreign exchange markets including effort to manipulate benchmark exchange rates. The LIBOR scandal discussed earlier which has affected the reputation of the Group and raised question on the corporate governance practices has made the operations of the bank more transparent. The bank also stated that it was reviewing its foreign exchange trading over many years and also cooperating with respective authorities (Bloomberg, 2014). Barclays has also reported suspension of six currency traders allegedly involved in foreign exchange fixing. This was part of the bank’s internal investigation into the alleged FOREX fixing. The increased accountability and ethical practices by the managers of the Group towards their stakeholders after the global financial crisis and scandal LIBOR prompted the investigation committee to even suspend its chief currency trader despite the fact that none of these individuals have formally been accused of committing any wrongdoing in the past. The investigation report tabled by the internal investigation committee reveals possibility of price fixing. The investigation apparently involved many market participants from different countries (Financial Times, 2013). Given that the investigations are at the initial stages, it is not possible for the bank to assess the actual impact of these investigations on its reputation and other legal risks. However, form the positive attitude of the Group for supporting and cooperating with regulatory bodies in the ongoing investigation, it may be said that the corporate governance arrangements support their risk management activities (Daily Mail, 2013). 5.3 Bank of Credit and Commerce International (BCCI) BCCI was a major international bank that was founded by a Pakistani financier whose head offices was in London and Karachi. The bank touched its peak within a decade and quickly spread across 78 countries. The bank had total assets over $20 billion making it as the seventh largest private bank in terms of assets. But, during the 80s BCCI came under the scrutiny of many intelligence agencies and financial regulators for possible involvement in money laundering activities and illegally gaining controlling stake in a major American bank. The transparency in business practices was minimum which raised issues related to accountability and corporate governance. In the year 1998, auditing firm Deloitte & Touché filed lawsuit against the auditors of BCCI (Ernest & Young and Price Waterhouse) that was ultimately settled for $175 million. The creditors of BCCI also filed $1 billion suit against Bank of England as it was the regulatory body which failed to control and oversee the activities of the bank. It took almost a decade for the case to go into trial in 2004 due to statutory immunity of the bank. Many believe that even after numerous trials and after a decade after liquidation the activities of BCCI are still not completely understood because of its complexity. The case is a genuine example of the failure of regulatory authorities to stop financial malpractices. The lessons learnt from this case illustrates the fact that not only the individuals banks should be responsible to the stakeholders but at the same time it is equally important for the regulators to be accountable to the society. 5.4 Link in Three Lines of Defence Model One of the aspects that uniquely distinguish banks from other businesses is their responsibility in transfer of risk and risk management. This is applicable for any bank as the business practices are related risk management and thus oversight is critical for banks. One of the standard approaches that are employed by the banks for design, implementation, and control of enterprise risk frameworks is the “Three Lines of Defence” model. The internal environment control of Barclays is implicitly based on this model which categorise main types of risks. In addition, the Group also provides reasonable general language of risk terminology, defines all processes for managing internal control environment, and assigns accountability for risks (Salz Review, 2013, p.150). (Source: SWEDBANK, 2011) First Line of Defence – Risk of Business Ownership An effective internal control environment is very essential for large and complex business models as it assures the Board and senior management that business practices are within approved risk limits and adhering to all regulations and laws. Barclays’ implements this level of defence with two components namely Principle Risks Policy (PRP) and Group Internal Control & Assurance Framework (GICAF). The front office of Barclays which mainly interact with customers and external stakeholders has some exceeding limits which conducting and executing transactions with clients. But, historically Barclays has been found to keep close supervision over its principal and proprietary trading. This is evident from recent FOREX fixing scandal when the bank suspended trading of six principal traders allegedly involved in the scam (Investment Week, 2013). The Second Line of Defence – Control Functions Barclays defines several second lines of defence functions to plan and operationalise internal control environment including Legal, Compliance, Human Resource, and Finance. Barclays states that its role of Risk is to appropriately deliver efficient risk control and management consistent with its long-term business strategies. The Group aims to implement this by providing appropriate and independent challenge at every level of business starting from a single transaction to comprehensive portfolio ensuring that there are no unexpected deviations. Most of these control functions directly report their respective business unit management head which clarifies their primary line of reporting. However, the bank also acknowledges that these enabled functions collaborate directly with business which might considerably challenge the business. The functions reporting lines have been changing recently and the Barclays are focusing more towards Group functions rather than individual units. The Third Line of Defence – Internal Audit This line of defence assures that the quality and effectiveness of internal control environments are maintained. The objective of Barclays Internal Audit is defined in detail in the Barclays’ Internal Audit Charter. In short, it may be said that the bank has been found to provide independent, values, reliable, timely and insightful assurance to the Executive Management and Board. This is apparent from its positive initiatives towards development of Corporate Governance and implementation of appropriate Risk Management practices after the financial crisis and other scandals surrounding it. The function of third line of defence has also increased its independence and since 2003 the CIA or Chief Internal Auditor of Barclays has regularly reported to the Chairman of Board, Group Chief Executive, and Group Audit Committee which shows the Banks’ accountability to internal and external stakeholders. Chapter 6: Conclusion In the 21st century where the financial markets have grown manifolds over the years and businesses are vastly expanding, the challenges embedding the risk culture of organisation has also increased. Inadequate internal control may lead to disastrous consequences including chances of filing insolvency by corporate entities as learnt from the global financial crisis (IARB, 2013). One of the areas of concerns for competitive today’s businesses environment is the alignment of risk- focus culture with sales-driven business unit mind set which appreciates the fact that risk management is not limited to senior management but it is everyone’s responsibility. Challenges such as proper training and motivating employees to balance risk appetite with business strategy is very important. Respective business units must not only focus in generating transactions and developing business but also be accountable to issues that increase different business risks as the market or volume change and risk gets transferred to upper chains of hierarchy. Employee morale, which is generally one-directional creating agency problem, should be properly trained and constantly motivated by senior management so that at no point of time the executives should from their expected course of action. This will ensure appropriate risk management and corporate governance practices at all level of organisation since every executive would be accountable to respective act. References Barclays Capital, 2011. Public Treasury 2011: Enterprise Risk Management an Integrated Approach to Financing and Risk Management Decisions for Public Sector Treasury. [Online]. 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