Risk Management Issue - Essay Example

The cost of capital has an essential role to play in most aspects of banking, as does the availability of capital. This importance can be seen in almost every function of a bank. Most of the roles that capital plays are seen to be interrelated. A chain of functions is observed: starting from building up an admirable public image, leading to attracting adequate deposits and finally being able to lend money and earn interest off of it. The cost of capital helps attract and retain customers, which in turn determines the available funds in a bank due to the amount of money being deposited to the bank. As far as earning interest is concerned, the cost of capital is the key determinant in offering an appropriate cost of borrowing on loans.

The availability of capital is also an influential factor in the functioning of this business, as the bank will need to maintain a capital buffer especially to uphold its public image and confidence (Greuning and Bratanovic, pp. 122-142, 1999). It is, therefore, an essential issue to consider capital sufficiency in a bank when managing risk.
The importance of the availability of capital in managing banking risk has been recognized by the banking industry, as the Basel Committee on Bank Supervision (BCBS) moved to impose a set of regulations in 1988, pertaining to capital adequacy in financial institutions. The Basel Accord directs banks to keep a certain amount of capital as a buffer, as compensation for capital adequacy risk. Capital adequacy risk is the chance that an unexpected loss will severely damage the bank. In case this happens, the institution must have sufficient funds for two functions: to settle any financial obligations and to neutralize the effect of this loss. It is, therefore, essential that a bank maintains a mandatory level of capital (Catarineu-Rabell et al, 2005, pp. 537-557).

To further analyze this issue of capital adequacy, we need to assess the assets of the bank in light of the Basel Accord. The Basel Accord classifies an institution’s assets according to risk levels. It examines the capital of the bank according to its risk profile; a step that provides a clearer picture of the risk the bank faces, especially the credit risk. Apart from these, the Accord also assesses off-balance sheets items (Dempster, pp. 29-31, 2002). Every item is assigned a risk weight. This practice assists one in being able to correctly assess the nature of risk the bank faces and therefore helps analyze the capital adequacy of a bank (Greuning and Bratanovic, pp. 122-142, 1999). This method is an important guiding factor pertaining to the decision-making involved in managing the capital adequacy of a bank. It assigns risk categories to the capital, from amongst zero, twenty, fifty and a hundred percent.

The capital in a bank comprises several different components. According to the book ‘Analyzing Bank Risk’ by Greuning and Bratanovic, there are three characteristics a balance sheet item must have in order to be classified as capital. It must be permanent, it must “not impose mandatory fixed charges against earnings, and it must allow for legal subordination to the rights of depositors and other creditors. The Basel Accord, thus, classifies equity shares, nonredeemable, noncumulative preference shares and retained earnings as tier 1 capital. It is the ‘core capital’ of the bank. Due to the characteristics of this capital, it is the most preferred capital for a buffer” (Greuning and Bratanovic, pp. 108, 1999).

The 1988 Basel Accord was seen, however, to have a few shortcomings which are to be addressed in a new Accord which is to be fully implemented in 2015 (Ghosh and Nachane, 2003, pp. 777-778+780-784). Basel 1 was said to be pro-cyclic, and often seen as a negative influence rather than the positive protective measure that it was initially meant to be. This new accord is said to be focused on minimum capital requirements as well as other areas such as market regulation and supervisory assessment. This shows that even though capital adequacy may have many important implementations to banking today, its relevance cannot deem other areas irrelevant to risk management in the industry. There is still, no doubt, a large role that capital adequacy plays in risk management.

Conclusively, the paper has analyzed some of the noteworthy aspects of risk management by discussing one of the risk management issues in a particular organization. In specific, the paper discussed that risk management is not a narrow field, and thus, confronts a broad number of issues that affect its processes adversely. In addition, the paper has identified different studies related to the topic, and it is expected that future researches in this regard will allow a more comprehensive and updated understanding of this issue. It is anticipated that the paper will be beneficial for students and professionals in better understanding of the topic.