Risks Faced by Financial Institutions - Essay Example

Risks Faced by financial s The understanding of Risks faced by Financial s is essential for the effective management of any economy. These risks that face the modern financial institutions and form the absolute nightmares of financial regulators can be fatal to the health and wealth of any institution. (Black, 1972). The globalization of financial markets as well as the constant development of innovation in the field of financial instruments has changed both the operational and structural qualities of financial institutions. Although global efforts to counter Risks encountered by Financial institutions are underway the nature and characteristics of these risks keep changing.For example the Basel Committee (under the Bank of International Settlements ) which was formed in response to the crises caused by the insolvency of Bankaus Herstatt and the problems caused by Nixon's announcement of the closure of the Golden Window ,has worked since 1974 to prevent such risks from injuring the health and wealth of such financial institutions. (Aharony, 1986) Its 1988 Basel Accord deals with credit risk and has extensively guided international banks in their risk management.Similarly the Basel II(International Convergence of Capital Measurement and Capital Standards) deals with the problem of operational ,legal and strategic as well as those arising out of the loss of goodwill. ( Hsaio 2008) , This paper therefore discusses the risks faced by modern financial institutions,international efforts to resolve such risks as well as the techniques used by banks to calculate interest risks. Introduction The past two decades have indeed seen an increased banking response to the systemic risks in the financial system which emerged in response to the 1930's banking crises of the 1930s.Banks and other financial institutions perform the functions of financial intermediaries that distinguish them from other businesses. They intermediate liquidity between economic subjects and in this process face a number of risk atypical of non-financial firms. (Aharony, 1986)This financial risk measurement and management becomes very important for banks than for other companies. The modern financial institutions are very complex as they increasingly offer fee-based financial services and relatively new financial instruments and this has led to the creation of a number of new risks.Essentially the riskier the bank's business, the more capital it should hold to be able to cover future fiscal losses. Although various banks face different risks (with regards to their category) some risks are common to most banks like Credit risk , Liquidity risk , Solvency risk , Operational risk , Market risk and Interest rate risk. (Aharony, 1986) In the above paragraph a number of risks have been identified and while many of them have been overcome by regulation many still sting the face of financial prudence as unresolved dilemmas. (Aharony, 1986) These are risks like operational risks (which have been defined by the Basel Committee(Basel II) as arising from 'inadequate or failed processes, people and systems or from external events'. ( Hsaio 2008) , Operational Risks cover a wide category of risks which pertain to human error or technical deficiencies.(Black,1972) and are related to all other types of risk such as capital needs, inflation, concentration of revenues (by customers, products, geographies, etc.) new competitive conditions and environmental remediation obligations(reinforced by the new concept of Corporate Social Responsibility).(Black,1972). Operational risk is the newest area of focus in the the arena of the financial institutions but there are theoretical and practical difficulties involved in it's assessment as well as statistical irregularities in the data available. ( Hsaio 2008) , However more serious risks pertain to losses which arise due to the failure of the obligator to perform(Credit Risk) and such losses are reported to be responsible for more that 50% of yearly bank losses.(Black,1972).Today the current lending practices pertaining to credit risk management methodology have made considerable progress. Modern financial institutions are careful to estimate the risk in relation to the magnitude of the asset and are careful to assess the levels of risk apparent from the credit quality of the company and the risk caused by the particular product. ( Hsaio 2008) . Another type of risk is the market risk which related to the unpredictability surrounding future earnings, because of the volatile changes in the value of financial instruments (which again accounts for 25% of yearly bank losses) ( Staikouras 2000).Reporting risk is different from market risk and credit risk as its primary focus is on derivatives and other financial instruments and is related to the problem of Accounting Risks which are caused by the likelihood of wrongly perceiving or estimating the amounts of risk arising out of their accounting assumptions and methodologies( Staikouras 2000).However the tendency of financial institutions to suffer from Accounting risk, can be remedied by care in the preparation of financial statements.(like appropriate disclosures related to estimates contained in the financial statements) .(Black,1972,Chen 1983) Modern Market Risks are no longer defined by outright exposure and are currently calculated by a popular method of the Value at Risk (VaR)This method estimates the maximum amount of loss possible in a portfolio subject to certain periodic intervals and has its advantage of being comparative in nature, i.e it will allow the financial institutions in question to allocate capital more efficiently.(Chance 1979).These methods employ the risk level models of capital , which are used to estimate the profitability of capital, like the risk-adjusted capital (RORAC) or risk-adjusted return on capital (RAROC) and such models today play a pivotal rile in the management of risks inherent in the management of financial institutions. Interest rate risk This type of risk is related to the relative value of an interest-bearing asset diminishing due to a rise in the interest rate. (Bower 1984).High interest rates cause the prices of fixed rate bonds to fall and pivotal to the measurement of Interest Rate Risk is measurement of the duration of the interest-bearing asset. (Scholes. 1972.Officer. 1985)Here we are concerned with differing interest rate/yields basis which can erratically change the profits and liabilities.Also present is the Yield curve risk which is presented by the differentials between the short and long term interest rates and their utility for making a profit by short term selling and long term gains. (Scholes. 1972.Officer. 1985) Then we are concerned with the option risks which are difficult control and even more difficult to measure.Repricing risks are also an incident of the banks margins fluctuating and causing interest rate irregularities. (Bower 1984)A popular way of hedging or protecting against interest rate risk with the use of fixed income instruments or interest rate swaps. Related to Interest rate Risk are the interest parity conditions which prevent the risk of arbitrage in an economy. (Scholes. 1972.Officer. 1985). According to this formula the returns from borrowing (in Currency A), exchange of that currency for Currency B if added to the investment required for this exchange and investing in interest-bearing instruments of Currency B, while at the same time purchasing futures contracts to convert that currency back when the investment period ends should be the equivalent of purchasing and holding similar interest-bearing instruments of the first currency. (Scholes. 1972.Officer. 1985) .The imbalance is actually favorable for foreign investors because when these returns are different there is a chance that investors can commit "arbitrage or make risk-free returns". (Scholes. 1972.Officer. 1985) Interest rate risk analysis is often calculated by the "Heath-Jarrow-Morton framework" which is allows to establish consistent yield curve movements to avoid the risk of arbitrage. 1 It can be calculated by a variety of ways to give an estimate as to how changing interest rates are impacting upon a bank's portfolio. (Bower 1984)These include the "market value of portfolio equity" method which uses market value of the assets,analysis of the shifts within the Yield curve ,the Value at Risk method, and measuring irregularities within the interest sensitivity gap of assets and liabilities. Basically it should be noted that Interest rate risk affects bank portfolios by Influencing the interest income that is large source of bank's profit.(Earning Risk) Influencing the present value of bank's asset and liabilities.(i.e. the amount of future cash flows-Economic Value Risk) There are three main models for measuring interest rate risk and differ by by the period at which they were used .They are -The GAP analysis, - Duration, - Value at Risk (VaR). The oldest of these methods remains the GAP analysis and it measures the influence of interest rate risk on portfolio of instruments .It can be calculated by sorting assets and liabilities by using their r re-pricing dates into several time buckets.2 A positive Gap figure indicates that volume of assets re-pricing exceeds volume of liabilities re-pricing, negative GAP express the situation where volume of liabilities re-pricing exceeds volume of assets re-pricing. Thus the Positive GAP is an indicator of an asset -sensitive situation where it is anticipated that the majority of assets will re-price before liabilities when interest rates change. The disadvantages of using the GAP analysis are as follows, The need for time buckets to be balanced is a tussle between precision and manageability.This is so because too narrow or too wide buckets can affect the accurate capturing of mismatches or measurement. (Brickley, 1986.) It is based on the assumption that all interest rates will move together in the same direction by the same amount and thus this is only compatible with the n assumption that only parallel yield curve movements appear.It does not say much for the yield curve risk or basis risk. (Brickley, 1986.) It may fail to properly position some of bank's products into given time buckets as the correct selection of right time buckets requires setting many assumptions which have to be based on the given internal bank's research data. (Brickley, 1986.) Duration analysis This analysis is an essential calculation for interest rate elasticity; as it gives information about how the present value of a financial instrument or portfolio changes if interest rates change for a given percentage.It measures the impact on shareholders' equity if a risk-free rate for all maturities rises or falls. The longer the duration therefore the higher the interest rate risk. (Scholes. 1972.Officer. 1985) Advantages and disadvantages of duration analysis are as follows. It's main shortcoming is its simplicity as it shows a single value and this can lead to over or underestimation of mismatches . Like the GAP analysis it does not address the yield curve risk or basis risk. Requires the preparation of large portfolios which can be highly exhaustive in terms of the volume of data input. There is also a hybrid version of the above two analyses known as the Duration GAP analysis which will combine the GAP and duration analysis. Here all the items of bank portfolio which are easily influenced by the interest rate can be placed in time bands depending on the maturity date. (Cates, D.C. 1978.) Value at Risk models It is one of the most modern methods of measuring interest rate risk and is an integral part of the modern market risk measurement framework and it aims at expressing the total market risk as a single number, i.e. to summarize the expected maximum loss over a target horizon within a given confidence interval. (Cates, D.C. 1978.)This framework was the brainchild of the investment bank J. P. Morgan and today banks use "pure" VaR models to calculate interest rate risk . The Value at risk can have several forms and these differ by means of calculating volatilities of market risk factors and include the stages of Value estimate for individual instruments, Risk factor identification, and Risk estimate. (Cates, D.C. 1978.) Basel revisited Basel I and Basel II have played a seminal role in the creation of international banking standards for regulators in order to insulate them from the types of financial risk and capital management requirements to regulate banks against credit and operational risks which they are exposed to through their lending and investment practices. As one commentator has put it , "Basel II has been designed to ensure the capital adequacy of internationally active banks. A framework has been designed to measure capital adequacy and the minimum standard to be adopted by national regulatory authorities. The two objectives are soundness and stability of international banking system, and consistency among international active banks." ( Hsaio 2008) The banks are required to do this by not only ensuring that their capital allocation is more risk sensitive, but also paying sufficient attention to operational and credit risk and all these measures are aimed primarily to counter regulatory arbitrage. In Particular the Basel II employs the concept of three pillars which include the minimum capital requirements, supervisory review and market discipline for a more stabilised and healthy economic system. ( Hsaio 2008) However these international efforts to curb the damage from the risks facing financial institutions have their own shortcomings as they are not well suited to the global diversity of cultures and banking models and therefore their implementation is unlikely to be smooth. ( Hsaio 2008) Basel II's implementation is already underway in the European Union through the EU Capital Requirements Directives and many of its signatories have demonstrated the intention to implement these measures with in the next few years. ( Hsaio 2008) Conclusion This paper has discussed the various financial risks faced by financial institutions particularly in the area of interest rate risk exposure and the models to manage it. The crux of financial regulation pertaining to these risks centers onto the changes in economic regimes with a subsequent effect, positive or negative, on financial intermediaries' equity returns. The role of the modern regulation and international initiatives pertaining to supervisory banking practices like the Basel I and Basel II have also been reviewed. It can be concluded that while substantial efforts to curb and counter these risks are underway by practical calculation and financial prudence, International regulatory efforts are not far behind in playing their role towards making financial institutions more secure. References Aharony, J., A. Saunders, and I. Swary. 1986. "The Effects of a Shift in Monetary Policy Regime on the Profitability and Risk of Commercial Banks." Journal of Monetary Economics 17: 363- 77. Bae, S.C. 1990. "Interest Rate Changes and Common Stock Returns of Financial Institutions: Revisited." Journal of Financial Research 13: 71- 79. Black F., M.C. Jensen and M. Scholes. 1972. "The Capital Asset Pricing Model: Some Empirical Tests." Pp. 79- 121 in Studies in the Theory of Capital Markets, eds. M.C. Jensen. New York Booth, J.R. and D.T. Officer. 1985. "Expectations, Interest Rates and Commercial Bank Stocks." Journal of Financial Research 8: 51- 58. Bower, D.H., S. Bower and D.E. Logue. 1984. 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