BOQ Financial Risks and Risk Management - Example

Running Head: BOQ FINANCIAL RISKS AND RISK MANAGEMENT NAME: COURSE: TUTOR: DATE: Introduction Defining Financial Risk Financial risk in a banking organization is possibility that the outcome of an action or event could bring up adverse impacts. Such outcomes could either result in a direct loss of earnings / capital or may result in imposition of constraints on bank’s ability to meet its business objectives. Such constraints pose a risk as these could hinder the bank’s ability to conduct its ongoing business or to take benefit of opportunities to enhance its business. Risks are usually defined by the adverse impact on profitability of several distinct sources of uncertainty. While the types and degree of risks an organization may be exposed to depend upon a number of factors such as its size, complexity business activities, volume etc, it is believed that generally the bank face Credit, Market, Liquidity, Operational, Compliance / legal / regulatory and reputation risks. Among these risks, Bank of Queensland limited (BOQ) is faced with two major financial risks that is the credit and liquidity risks. The bank is therefore faced with the task identifying the appropriate risk management strategies. Credit risk Managing credit risk Credit risk occurs from the probable that an obligor is either reluctant to carry out on a responsibility or its capacity to execute such commitment is impaired resulting in financial loss to the bank. In the bank’s portfolio, sufferers branch from absolute failure to pay due to lack of ability or refusal of clientele or opposite party to meet up obligations in relation to lending, trading, payment and other economic transactions. Components of credit risk management Typically, Credit risk administration outline in this financial organization may be broadly categorized into following main components. a) Senior Management and board Oversight b) Managerial structure c) Systems and procedures for recognition, reception, capacity, control and monitoring risks. Board and Senior Management’s Oversight It is on the whole accountability of bank’s board to support bank’s credit risk policy and important policies involving credit risk and its administration which should be based on the bank’s overall commerce strategy. To maintain its present, the general strategy has to be evaluated by the board, if possible annually. The responsibilities of the Board with regard to credit risk management shall, interalia, include: a) Delineate bank’s overall risk tolerance in relation to credit risk. For the purpose of these guidelines the term Obligor means any party that has a direct or indirect obligation under a contract. b) Ensure that bank’s overall credit risk exposure is maintained at prudent levels and consistent with the available capital c) Ensure that top management as well as individuals responsible for credit risk management possess sound expertise and knowledge to accomplish the risk management function d) Ensure that the bank implements sound fundamental principles that facilitate the identification, measurement, monitoring and control of credit risk. e) Ensure that appropriate plans and procedures for credit risk management are in place. The very first purpose of bank’s credit strategy is to determine the risk appetite of the bank. Once it is determined the bank could develop a plan to optimize return while keeping credit risk within predetermined limits. The bank’s credit risk strategy thus should spell out a) The institution’s plan to grant credit based on various client segments and products, economic sectors, geographical location, currency and maturity b) Target market within each lending segment, preferred level of diversification/concentration. c) Pricing strategy. It is essential that the bank gives due consideration to their target market while devising credit risk strategy. The credit procedures should aim to obtain an in depth understanding of the bank’s clients, their credentials & their businesses in order to fully know their customers. Systems and Procedures Credit Origination. The bank ought to function within a resonance and distinct criteria for innovative credits as well as the spreading out of accessible credits. Credits should be unlimited within the target markets and lending policy of the organization. Prior to allowing a credit capacity, the bank ought to make an appraisal of risk profile of the client/operation. This may include; Credit assessment of the borrower’s industry, and macro economic factors, the purpose of credit and source of repayment, the track record / repayment history of borrower, assess/evaluate the repayment capacity of the borrower, the proposed terms and conditions and covenants, adequacy and enforceability of collaterals and approval from appropriate authority Limit setting A significant component of credit risk administration is to ascertain disclosure limits for particular obligors and grouping of associated obligors. The institution is expected to develop its own limit arrangement whereas remaining inside the disclosure limits put by State Bank of Australia. The magnitude of the limits ought to be based on the credit potency of the obligor, actual prerequisite of credit, financial conditions and the institution’s risk lenience. Suitable confines should be set for relevant products and actions. Credit Administration. Ongoing administration of the credit portfolio is an essential part of the credit process. Credit administration function is basically a back office activity that support and control extension and maintenance of credit. A typical credit administration unit performs following functions: Documentation, Credit Disbursement, Credit monitoring, Loan Repayment, Maintenance of Credit Files and Collateral and Security Documents. What Exposures are rated? Ideally all the credit exposures of the bank should be assigned a risk rating. However given the element of cost, it might not be feasible for the bank to follow. The bank may decide on its own which exposure needs to be rated. The decision to rate a particular loan could be based on factors such as exposure amount, business line or both. Generally corporate and commercial exposures are subject to internal ratings and the bank use scoring models for consumer / retail loans. Credit Risk Monitoring & Control Credit risk monitoring refers to incessant monitoring of individual credits inclusive of Off-Balance sheet exposures to obligors as well as overall credit portfolio of the bank. The bank need to enunciate a system that enables them to monitor quality of the credit portfolio on day-to-day basis and take remedial measures as and when any deterioration occurs. Such a system would enable a bank to ascertain whether loans are being serviced as per facility terms, the adequacy of provisions, the overall risk profile is within limits established by management and compliance of regulatory limits. Establishing an efficient and effective credit monitoring system would help senior management to monitor the overall quality of the total credit portfolio and its trends. Consequently the management could fine tune or reassess its credit strategy /policy accordingly before encountering any major setback. The bank credit policy should explicitly provide procedural guideline relating to credit risk monitoring. Liquidity risk Managing Liquidity Risk Liquidity risk is the potential for loss to an institution arising from either its inability to meet its obligations or to fund increases in assets as they fall due without incurring unacceptable cost or losses. Liquidity risk is considered a major risk for bank. It arises when the cushion provided by the liquid assets are not sufficient enough to meet its obligation. In such a situation, the bank often meets their liquidity requirements from market. The bank with large off-balance sheet exposures which rely heavily on large corporate deposit, have relatively high level of liquidity risk. Further the bank experiencing a rapid growth in assets should have major concern for liquidity. Liquidity risk may not be seen in isolation, because financial risk are not mutually exclusive and liquidity risk often triggered by consequence of these other financial risks such as credit risk, market risk etc. For instance, a bank increasing its credit risk through asset concentration etc may be increasing its liquidity risk as well. Similarly a large loan default or changes in interest rate can adversely impact the bank’s liquidity position. Further if management misjudges the impact on liquidity of entering into a new business or product line, the bank’s strategic risk would increase. Board and Senior Management Oversight The prerequisites of an effective liquidity risk management include an informed board, capable management, and staff having relevant expertise and efficient systems and procedures. It is primarily the duty of board of directors to understand the liquidity risk profile of the bank and the tools used to manage liquidity risk. The board has to ensure that the bank has necessary liquidity risk management framework and bank is capable of confronting uneven liquidity scenarios. Liquidity Risk Strategy: The liquidity risk strategy defined by board should enunciate specific policies on particular aspects of liquidity risk management, such as: Composition of Assets and Liabilities, diversification and Stability of Liabilities and access to Inter-bank Market. Liquidity Risk Management Process Besides the organizational structure discussed earlier, an effective liquidity risk management include systems to identify, measure, monitor and control its liquidity exposures. Management should be able to accurately identify and quantify the primary sources of the bank’s liquidity risk in a timely manner. To properly identify the sources, management should understand both existing as well as future risk that the institution can be exposed to. Management should always be alert for new sources of liquidity risk at both the transaction and portfolio levels. Key elements of an effective risk management process include an efficient MIS, systems to measure, monitor and control existing as well as future liquidity risks and reporting them to senior management. Management Information System. An effective management information system (MIS) is essential for sound liquidity management decisions. Information should be readily available for day-to-day liquidity management and risk control, as well as during times of stress. Data should be appropriately consolidated, comprehensive yet succinct, focused, and available in a timely manner. Ideally, the regular reports a bank generates will enable it to monitor liquidity during a crisis; managers would simply have to prepare the reports more frequently. Managers should keep crisis monitoring in mind when developing liquidity MIS. There is usually a trade -off between accuracy and timeliness. Liquidity problems can arise very quickly, and effective liquidity management may require daily internal reporting. Since bank liquidity is primarily affected by large, aggregate principal cash flows, detailed information on every transaction may not improve analysis. Liquidity Risk Measurement and Monitoring An effective measurement and monitoring system is essential for adequate management of liquidity risk. Consequently the bank should institute systems that enable them to capture liquidity risk ahead of time, so that appropriate remedial measures could be prompted to avoid any significant losses. It needs not mention that the bank varies in relation to its liquidity risk (depending upon its size and complexity of business) and requires liquidity risk measurement techniques accordingly. For instance the bank having large networks may have access to low cost stable deposit. However, abundant liquidity does not obviate the need for a mechanism to measure and monitor liquidity profile of the bank. An effective liquidity risk measurement and monitoring system not only helps in managing liquidity in times of crisis but also optimize return through efficient utilization of available funds. Discussed below are some (but not all) commonly used liquidity measurement and monitoring techniques that may be adopted by the bank. Reference: Beechey, V. &Perkins, Risk Management Guidelines Minneapolis: University of Minnesota Press. (2007). Tybout, A. & Calder, J. B. Financial Risks River Street Hoboken, NJ: John Wiley and Sons (2010). Coughlan, A.T. BOQ Risk management guideline, Upper Saddle River, NJ: Prentice Hall (2001). Icun Y. & Getty, M. BCI: Fundamentals of Financial Risk management, New York: Elex Media http://www.asx.com.au/asx/research/company http/www.boq.com/ Read More