The Operational Risk Management Activities of HSBC Bank - Assignment Example

Introduction

As a large financial institute serving a wide range of customers from around the world, HSBC Bank considers a variety of operations within its business portfolio. Nonetheless, these operational considerations relate to the financial stability of the institute while at the same time ensuring the bank’s leverage regarding market or regulatory risks. To assess the level of risk the bank is exposed, the banks financial statement for the financial year 2014 is utilized to showcase the risks the organization faced during that financial year while at the same time assessing the applicability of the operational risk management activities

In order to assess the applicability of the operational risk management activities, the risks are identified forehand to ensure that the managerial approach to the risks is specific to certain risks. To test the validity of the managerial approach, the study considers the Financial Services Faculty publication of Basel III banking framework on capital and liquidity expectation. The application of the Basel III is described in the section on anticipated and preparedness of the banking institution to deal with market or operational challenges (Financial Services Faculty, 2015). However, the essentially useful approach of analyzing the operational risks is through the use of the Theory of Risk Capital which puts a value to risks and their associated impacts on the organizational performance and appeal to its stakeholders (Erel, Myers, & Read, 2015)

QUESTION 1: Discuss qualitative risk assessment models for operational risk advantages and disadvantages of qualitative techniques

Operational risk appetite statements are qualitative models seen as an integral part of how financial institutions are able to forecast and estimate the level of risks they are exposed to. As a result, the quantifying of the operational risks enables the organization to decide whether it is ready to incur risks and at the same time attaching an economic value to the risks. Thus, as a result, the importance of operational risk statements is related to the decision making processes of the organization such as capital allocation for the management and avoidance of the operating risks associated with the business portfolio. In addition, a well-articulated operational risk statement ensures communication to the stakeholders with an alignment of the management and board attitudes regarding the exposure to the risks and the associated returns from operations regarded as economically viable but also risky at the same time. Challenges associated with the allocation of operational risk appetites statements include the expression of operational risk considering a top-bottom perspective since a variety of facets and subtypes of operational risks are associated with the decentralization of the operational risk management. In addition, the link between operational risk and operational risk capital suffer the shortcomings of considering former operational risks which may affect the current estimate of operational risk due to changing managerial approaches which may incur or consider a larger operational risk capital which does not coincide with current risks. Finally, the integration of operational risk appetite with the decision-making needs of the company also troubles the management since it requires the establishment of a link between granular risks with high-level statements.

To a financial institution, the qualitative advantages of the operational risk appetite statements take into account the expected loss and unexpected loss measures, operational limits, and operational risk capital. Expected loss measures describe the operational appetite with regards to the amount of risks the organization is willing to consider in its operations. This measure can be allocated in terms of a percentage (%) of the revenue or a specified figure for offsetting the risk capital. Above a certain threshold, a company anticipates operational risks associated with losses and classifies these risk as unexpected losses. In terms of throughput measures, operational limits indicate the amount of activity the management can accept in its operations. Lastly, the operational risk capital is allocated with respect to the amount management is attributing to a business activity. For instance, the maximum percentage of the total regulatory capital allotted to the operational risks of the business at hand. In operational limits, the institution is able to note that it may not be able to accept a certain level of account openings per day.

Due to the fact that HSBC serves as a full-blown financial institution, its anticipation for risks such as impaired loans, legal proceedings following internal and external operations and reactions to the financial markets, it is not economically feasible for the bank to minimize its operational risks since the more returns expected from the operations of the bank require the institution to venture in more than one line of business. Hence, backing this claim with the theory of risk capital, it is observed that investments into one line of business must ensure sufficient balance of assets and liabilities (Cummins, Lin, & Phillips, 2006). In this regard, risk capital is an approach for protecting the risky business portfolios whose risks are associated with anticipated returns on assets and cost of liabilities. As a result, the risk capital offers the financial institution the upper hand in taking business risks whose cost of sustaining solvency are already anticipated and considered in the costs of sustaining the business’s credit quality (Panjer, 2002: (Rockafellar & Uryasev, 2002).

QUESTION 2: HSBC Appetite for Risks

HSBC Bank considered a high appetite for risks considering its allocation of risk capital with respect to core tier 1 and additional tier 1 capitals, the regulatory capital, and risk-weighted assets. In light of these capital allocation areas in the mitigation of operational risks, the institution considers common equity tier one capital of $133,200m, an additional tier 1 capital of $19,539m, tier 2 capital of $37,991, a total regulatory capital of $190,730, and risk weighted assets estimated at $1,219,765m (HSBC, 2014). HSBC Bank acknowledges in its financial statement of 2014 that it faces a variety of risks which vary in degrees of effect as well as relevance to the institution’s stakeholders. In order to identify the risks and their corresponding values and impacts on the institution, the expected risks of operations are observed in terms of their risk capital allocated to finance the anticipated outcome (Ahmed, Takeda, and Thomas, 1999). For instance, since in its operations, HSBC faces a variety of risks, the firm’s appetite for risks is considered in terms of occurrence and magnitude of losses, issues associated with operational risks management controls, issues related to risk culture, the rate of growth, change in capital, and factors associated with the external environment. In the classification of whether the firm’s appetite for operational risks is high or low, the above mentioned factors are considered with respect to their magnitude. Large operational losses are associated with a high appetite for risks which requires higher risk capital allocation to handle the associated impacts and prevent uncertainties such as defaults.

Based on the nature of operations and the magnitude of business portfolio, HSBC’s business model is faced with a high appetite for risks. Based in the 2014’s financial statements of the company, 2014’s credit risk relating to the operational risks returned a value of $60 billion as of June 30. Additionally, during a period of 6 months, the firm also identified that an increase by $11 billion registered the credit risk of the firm as $71 billion (HSBC, 2014). Based on the measures of operational risks, the growth in the firm’s credit risk shows a high level of increasing capital to indicate a high to too high operational risk and poor credit quality. In addition, following the economic capital approach, it is observed that the company anticipated a strong to impaired loans and advances to clients. Under the theory of risk capital, any activities that a firm engages in that raises the liabilities of the firm are associated with the operational risks of that company (Miller, 1992). Based on the uncollected loans and loan servicing which is rated strong and good for 2014, the firm identifies a low risk appetite for impaired loans which make $2,955 million as of June 30, 2014 and 2,115 million six months later showing an improvement in the offsetting of the associated liability to the bank. Under the theory of risk capital, the association of the banks impaired loans is minimal with respect to the company’s net assets of $2,753,593 million as of June 30, 2014 and $2,634,134. Nonetheless, since the risk capital approach derives meaning from the differences between assets and liabilities, the impaired loans and expected losses imposes minimal additional risk to the counterparties, customers, and creditors.

Credit quality is determined as the ratio of the firm’s default option to the default-free value of the firm’s liabilities (Saltelli, 2008). In light of this argument, the HSBC operational risks are considered a downside of the institution’s operations. Due to the scope of business operations, banks may require to limit their exposures to risks. However, since it is identified that risk capital is not constant and differs from one business model to another based on the scope of operations, it is observed that the high appetite for risk is an anticipated case for a large organization such as HSBC (Zanjani, 2010; Saunders & Allen, 2010). This anticipation is in light with the returns expected by the operational investments as well as the business portfolio of the institution at hand. In addition, the amount of expected risks is associated with the business profile of the institution (Stultz, 2009; (Scandizzo, 2005).

QUESTION 3: Theoretical Rationale for Holding Risk Capital

HSBC operational risks are related to the internal processes of the company which are measured with regard to economic capital modelling. The approach of the economic capital at HSBC aims at establishing the risks and the cost of offsetting them to ensure that the firm’s credit is not compromised. Unlike the application of Regulatory Capital, the Economic Capital approach is a considerable internal measure of risks which in return shows how much a company anticipates in terms of credit compromising internal activities. With reference to the rating of risks as either high or low, it is the duty of the economic capital approach to determining the solvency of a financial institute. Economic capital is also referred to as the risk capital which the company must allocate to ensure that the institution is not only sustaining its solvency at a specified confidence level and timeframe (Jorion, 2009). While the aspect of regulation relates to the factors leading to the measure of risk appetite, economic capital and regulatory capital go hand in hand as the latter offers a measure for capital required by the bank to sustain its solvency level based on regulation rules.

As identified through the theory of risk capital, banks and financial institutions have no means of controlling the external factors and in return do not have a way to deter future uncertainties. HSBC’s risk profile includes internal processes among the employee roles and responsibilities that amount to reputational risk requiring cash settlements for litigations against law suits. Nonetheless, using the economic capital strategy with the theory of risk capital, HSBC estimates that its operations have the capacity to deter the company the opportunity to be default-free taking into account the differences between assets and liabilities of the company (Hull, 2010). Nonetheless, the economic capital as it relates to the solvency of the firm is an approach by the HSBC to ensure that decisions made, especially in the determination of risk preparedness not only allocated efficient funds and liquid assets that can offset the likelihood of defaulting (Garleanu, and Pedersen, 2007).

With reference to the risk capital allocated for the case of HSBC, it is seen that among the anticipated risks as shown in question 2 above relate to the specific amount of capital allocated as surplus for dealing with the risks. As a result, the institution considers common equity tier one capital of $133,200m, an additional tier 1 capital of $19,539m, tier 2 capital of $37,991, a total regulatory capital of $190,730, and risk weighted assets estimated at $1,219,765m. With reference to the risk-weighted assets (RWAs), CRD IV is taken into account which shows that a requirement for increased capital was commissioned. Thus, the company considered a securitization positions that had previously been deducted by 50% from core tier 1 and the same percentage from the capital, in 2014 has been increased to 1250%. Additionally, there has been an increase in the capital charge covering market-to-market losses as associated with counterparty risks. Also there has been a deferred tax assets associated with significant investments which are risk weighted as of 2014 to 250% considering the allocated thresholds. The institution also has considered increased risk weights regarding exposures associated with financial institutions regarded as the asset value correlation.

Conclusion

Given the associated study of HSBC’s annual statements, the institution’s valuation approach of risks anticipates high operational risk appetite which allocate funds that can offset solvency issues. The risk capital required to sustain a reliable future of the business portfolios requires the use of rick capital theory which ascertains that financial institutions require a sustainable level of assets to ensure that the firm is solvent at any given time horizon and at an identified confidence level. As a result, HSBC’s operations management activities take into account reliable valuation approach, the economic capital method, to reflect the requirements of the theory of risk capital while at the same time observing regulatory capital obligations. In this regard, it has been established that the high appetite for risks has enabled the organization to allocate operational risk capital partitioned in terms of common equity tier 1 & additional tier 1 capitals, tier 2 capital, total regulatory capital, and risk-weighted assets as $133,200m & $19,539m, $37,991, $190,730, and $1,219,765m respectively.