Risk Management in the Banking Industry - Essay Example

Risk Management in Banking and Insurance - Identify and discuss the principal reasons for introduction of the New Basel Capital Accord (Basel II) andcritically appraise its contribution to more effective management of risks in the banking sector. Introduction Risk management in banking industry as based on New Basel Capital Accord (Basel II) is intended to minimize risk associated with operational and financial procedures of banks. Basel II encompasses a set of practical recommendations issued in connection with banking regulations and laws by the Basel Committee on Banking Supervision. Its three Pillars consist of a structured approach to risk reduction. Its primary purpose is to provide the essential protection against all probable risks that arise from banking activities so that the international financial system might be immune to the kind of failures that banks are often faced with nowadays (Hussein and Al-Tamimi, 2008, Vol. 16 (2), pp.173-187)). Thus its basic function is to set up some international standard so that all banking activities could be subject to a rigorous framework of overall supervision and regulation. Basel II regulates banks in a manner that the latter’s freedom of action in such activities as lending and credit creation is limited through stringent requirements in managing risk and capital. Thus it’s obvious that these regulations are primarily and immediately aimed at the very constitution of the capital structure of banks and above all its nature. While banks’ lending and investment portfolios would be influenced by these regulations the most remarkable feature of them is the ability to control risk and its spread into diverse areas of the bank’s financial operations. Finally macroeconomic stability and smooth structural change are sought to be ensured by Basel II, though this outcome has not been realized yet. Body of explanation The Basel Committee on Banking Supervision was set up in 1974 as an international body to supervise, recommend and advise in matters related to banking supervision and financial risk management. The committee consists of members from the USA, the UK, Canada, Japan, Switzerland, Germany, Italy, Spain, France, Belgium, Sweden, Luxembourg and the Netherlands. The following are the principal reasons for the establishment of Basel II. The first and foremost reason or requirement under Basel II for the introduction of new regulations could be found in the systematic development of rules and regulations. Basel II consists of the Capital Adequacy Accord and the Capital Requirements Directive. These two documents in turn encompass a series of rules and regulations on matters related to banks’ financial and investment activities. Though such activities are regulated by national laws and authorities as well the overall supervisory role of the Committee cannot be underestimated. Its influence in spheres of banking, risk management and risk insurance go a long way to reinforce the correlations among a number of causal factors (Pitschke and Bone-Winkel, 2006, Vol. 24(1), pp.7-26). The first Pillar of Basel II is basically intended to ensure banks’ conformity with some rules and regulations to enable the management of a bank or a building society to face unplanned for and unanticipated contingencies in their day-to-day operations, i.e. operational risk, credit risk and market risk. For instance operational risk can be assessed by using basic indicator approach which requires banks to hold an amount of capital that is equal to a fixed percentage of positive gross annual earnings over the last three years. Though a number of such methods are available under the Accord no particular bank is under obligation to adopt a particular one. Similarly banks are not under obligation to accept credit ratings given by outside agencies. Secondly, Basel II has a set of rules on capital requirements that demand both compliance with and conformity to in accordance with international banking practices along with risk management techniques. These rules seek with concerted aim and objective to establish a certain international standard for effective risk management and insurance provision against would-be failures (Milne, 2001, Vol. 9(4), pp.312-326). In the first place there was no established standard on banking before this. Their professed objectives include such general rules as the minimum amount of financial capital and reserve ratios to meet contingency demands by customers. Apparently such requirements are intended to reduce the leveraging or debt raising capacity of banks. Organizations have a tendency to benefit from tax cuts through higher levels of leverage. Thus their equity capital as against debt capital tends to be marginal. This entails a higher level of risk. Thirdly the second Pillar of the Accord enunciates a regulatory mechanism for the first Pillar. While it enables regulators to deal with risk related matters at banks with a greater degree of sophistication than what was afforded under Basel I, there is also provision under it to deal with all other types of risk such as strategic risk, residual risk, systemic risk, pension risk, concentration risk and so on. Financial solvency of big banks in the world matters to such an extent that the Accord places emphasis on the banks’ ability to meet contingency demands by customers at all times (Zsidisin, Panelli and Upton, 2000, Vol.5(4), pp.187-198). As a corollary what’s expected of the bank’s management is prudential oversight and management of sound financial ratios. It’s the degree of liability on the part of the bank in times of impending insolvency that is taken into consideration by the Committee. Fourthly the primacy and immediacy of a new capital requirements framework in place of the older one was recognized as expediency by the Committee. The logicality behind this move is to be found in the pressing need for a comprehensive and risk-sensitive framework that would meet demand for day-to-day operational exigencies. The compulsion for a thorough risk management mechanism is quite understandable given the spate of bank failures and degree of their exposure to risk at a given time (Krause, 2006, Vol. 32(9), pp.774-785). A risk management mechanism based on sound principles of strategic management would be desirable against the backdrop of ever increasing industry disintegration caused by a gradual drop in customer confidence. These rules and regulations on risk management are intended to ensure immunity to the bank against failure. Yet there are no adequate mechanistic provisions to preempt such collapses suddenly though. Fifthly according to the second pillar of Basel II there is a supervisory review process which requires banks to have their own supervisory staff to put in place standards to supervise banks’ capital requirements. While the risk profile is evaluated by this staff the reason for the establishment of standards is obvious. Capital requirements of the average bank are not determined by external criteria. They are determined by internal processes. The very foundation of sound banking depends on the ability of the bank to manage its capital stock with foresight. The requirement might have been designed with a view to reduce risk associated with poor capital management and improper predictions about future requirements to meet sudden demands for finance by customers. Banking, insurance and asset management within the internal banking environment have to be coordinated in keeping with this requirement and it’s a management imperative to have the staff well trained (Allen, 2001, Vol.9(4), pp.305-311). Next, Basel II not only investigates the financial viability of the bank but also the soundness of management principles. Management structures and choices play a big role in determining the management’s ability or inability to overcome such unanticipated for disasters. Thus risk management practices and subsequent insurance against failure originate in the very organizational environment where the management practices are based on sound principles including strategic responses to unfolding market situations. Contingency planning with sound internal value chain management would help the bank to face such consequences with a degree of confidence. There is also the requirement for the adoption of Internal Ratings Based approach (IRB) which envisages the preparation of banks’ own credit risk ratings so that excessive dependency on outside ratings would not bring about a disastrous turn of events within the organization (Gup, 2004, p.50). Such ratings would enable the management to avoid future failures to a certain extent. But nevertheless Basel II does not anticipate failures in the light of management shortcomings. What it tells is that sound management is a prerequisite to better manage risk involved in financial operations of the bank. Even if these sentiments are not taken seriously, there is still the possibility of developing a cohesive set of alternative management principles that would adequately address the need for a basic turn around in the approach to tackling such unforeseen developments as customer panic. When customers panic due to the unfolding scenarios, it’s the responsibility of the management to respond to such situations with some sense and sensibility (Jones and Ashenden, 2005, p.23). Here too the decision making process comes in to play a significant role. Finally Basel II has as its third pillar the requirement for the improvement of market-centric behavioural discipline of the bank. This is directly connected with final reason, i.e. systematic management of the information flow and thereby public relations. Asymmetry in information distribution could have a debilitating impact on risk related information as well. Risk related information has to be distributed as a two-way flow from and into the organization. The Committee anticipates better management of this flow with sound internal communication systems. The assumption that better information management would enhance risk management perspectives is not to be denied here. It’s altogether one of the most basic and formidable requirements under Basel II. The final version of Basel II Accord has as its objectives the separation of operational risk from credit risk and preparing metrics on both. There is also an attempt to reduce the requirement for regulatory arbitrage by closely matching the economic capital concept with regulatory capital concept. Banking industry is not the same as any other but many industries like insurance and investment banking share many common features on information related problems (Akkizidis and Bouchereao, 2006, p.56). This last pillar necessarily reinforces what was discussed above under the first two pillars. While capital structure of banks and associated risk parameters might not give a clearer picture of the bank’s performance, there is the basic requirement for the proper management of capital reinforced by regulatory obligations to meet internationally enforced standards of performance and compliance. Conclusion In conclusion Basel II agreement’s innovative features need to be recapitulated in succinct form in order to drive the point home that despite a number of good reasons for the establishment of Basel II Accord on good international banking practices, strategic bottlenecks in the banking industry have forced managers to abandon prudential financial management principles in preference for risk-prone investment strategies that basically have a negative impact on operations and credit management. What’s so obvious is the fact that all three pillars of Basel II reiterate the need for better and well informed regulatory mechanisms to control risk associat4ed with banks’ financial management and credit operations (Perraudin, Editor, 2004, p.289). How best such mechanisms would work themselves out to produce positive outcomes is not known. This is one of the big shortcomings of Basel II. In the absence of external arrangements to ensure proper implementation of procedures and processes recommended by Basel II, it’s not known as to how far the recommendations would be accepted and implemented to the letter by banks. Finally, the overall principled effort of Basel II Accord has been to establish an internationally accepted system of banking regulations that address both risk and insurance aspects of banking industry at large. While the effort itself is laudable enough the outcomes so far have not been so desirable because despite general adherence to them by banks, the global banking and insurance industry has been experiencing a roller-coaster ride as of lately. This latest development has refocused the attention of the global financial community on the feasibility of Basel II as a practical document to bring about financial stability through good banking practices. These are the primary reasons for the establishment of the Basel II Accord. Number of words: 1954 REFERENCES 1. Akkizidis, I.S. and Bouchereaw, V. 2006, Guide to Operational Risk and Basel II, Auerbach Publications, Florida. 2. Allen, T. 2001, Revisions to international bank solvency standards: A UK supervisory perspective, Journal of Financial Regulation and Compliance, Vol.9, Issue 4, pp.305-311. 3. Gup, B.E. 2004, The Basel Capital accord, South-Western Education Pub, California. 4. Hussein, A. and Al-Tamimi, H. 2008, Implementing Basel II: an investigation of the UAE banks Basel II preparations, Journal of financial regulation and Compliance, Vol.16, Issue 2, pp.173-187. 5. Jones, A and Ashenden, D, 2005, Risk management for Computer Security: Protecting Your Network and Information Assets, Butterworth-Heinemann, Massachusetts. 6. Krause, A. 2006, Risk, capital requirements, and the asset structure of companies, Managerial Finance, Vol.32, Issue 9, pp.774-785. 7. 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