Managing core risks in banks

CHAPTER 1: INTRODUCTION

RISK is a concept that denotes the precise probability of specific eventualities. It is simply the future uncertainty and not only the incidents of predictable outcomes but also the unpredictable favourable outcomes. All the firms or companies whether it is in real or providing service are facing some sort of RISK at present competitive business world to run its business. Banks are one of them in these regard and it is facing possibility of risk in terms of money and their achieved reputation. Bank is a financial institution that primarily deals with borrowing and lending money from the people by the people to the people. Besides this core activities now-a-days banks are also dealing with other roles related to economy. Modern banks are offering a wide range of financial services as a result the level and intensity of risk exposure have expanded today.

1.1 Significance:

All the policymakers and the managers are now believe that risk management is essential where it has been identified few core areas to be managed effectively and efficiently are as follows, credit risk, interest-rate risk, exchange-rate risk, environmental risk,, and money laundering risk, liquidity or funding risk, leverage or capital risk, strategic risk, which needed to be greater emphasis.

1.2 Problem Statements:

To do the whole research, at first, it is necessary to identify the problems regarding the selected topic. As the topic is related to risk in banks and its management it is the core need to know the problems that banks may face if the risks are not considered properly and those problems are as follows:

 Chances of variation in expected outcome.
 Possibility of suffering loss.
 Measure of probability and severity of adverse effects.

1.3 Research Objectives:

The core objectives of doing this research are as follows:

 To improve profit and profitability.
 To manage and reduce all the major risks in banking business.
 To ensure long-term solvency and viability of the bank.
 To develop a structured framework for risk management.
 To form some guidelines as a basis for customization of the risk management strategies of banks.

1.4 Rationale:

As a post graduate diploma student it is very essential to do some research to go depth of any topic. As banking sector is expanding its hand in different financial event everyday, as the demand for better services increases day by day it, they are coming with different ideas and product where the risk is also becoming higher. So it is necessary to know all the risks bank may face to run its business.

CHAPTER 2: LITERATURE REVIEW

The unanticipated part of the return, that portion resulting from surprises is the true risk of any investment. If we always receive what we expect, than the investment is perfectly predictable and, by definition, risk-free. In other words, the risk of owning an asset comes from surprises-unanticipated events. RISK is a concept that denotes the precise probability of specific eventualities. It is simply the future uncertainty and not only the incidents of predictable outcomes but also the unpredictable favourable outcomes. All the firms or companies whether it is in real or providing service are facing some sort of risk at present competitive business world to run its business. Banks are one of them in these regard and it is facing possibility of risk in terms of money and their achieved reputation. Bank is a financial institution that primarily deals with borrowing and lending money from the people by the people to the people. Besides this core activities now-a-days banks are also dealing with other roles related to economy. A wide range of financial services are offering by modern banks as a result the level and intensity of risk exposure have been expanded as well. So all the policymakers and the managers are now believe that risk management is essential, where they have been identified few core areas to be managed effectively and efficiently are as follows, credit risk, interest-rate risk, exchange-rate risk, environmental risk, money laundering risk, liquidity or funding risk, leverage or capital risk, strategic risk, which needed to discuss broadly.

Financial risk refers to the risk that a bank will not have ample cash flow to meet the financial obligations. Financial risks are taken in managing the balance sheet and off-balance activities. Financial risk covers, among others, credit risk which is thought the most dominant financial risk today. This is the risk of erosion of value due to simple default or non-payment by the borrowers. Credit risk is also known as counter-party risk since its come from the failure of counter party to meet its obligation as per contract or agreed terms and conditions. An interest-rate risk refers to the potential negative effect on the net cash flows and value of assets and liabilities resulting from interest-rate changes. In extreme conditions, interest rate fluctuations can create a liquidity crisis. The subject of interest rate risk also belongs to the Asset-Liability Management and is much broader than liquidity. The fluctuation in the prices of financial assets due to changes in interest rates can be large enough to make default risk which is the major threat to banks’ viability. Exchange-rate risk, or currency risk, is the risk of declines in cash flows and asset values of a bank due to change in exchange rate. The banks with overseas operations of those active in foreign exchange markets faces exchange rate risk. All the risk and how it can be reduced would be discussed thoroughly on the main body of the report.

All the risk that modern banks may face at the present competitive business world viewed by experts have briefly discussed as follows:

2.1 Credit Risk Management:

Saidur, (2008) defined that financial risk arises as a risk when a bank doesn’t have enough money to meet its financial obligations, are taken in managing the balance sheet and off-balance activities.

This risk includes, among others, credit risk which is the most dominant financial risk today that decomposition of value due to simple default or non-payment by the borrowers. Credit risk is also known as counter-party risk since its come from the failure of counter party to meet his/her obligation as per contract or agreed terms and conditions that also can be defined as the possible failure by the bank borrowers or counter-party within the agreed time period. According to BIS (2000), “Credit Risk is most simply defined as the potential that a bank borrower or counterparty will fail to meet its obligations in accordance with agreed terms.” To maximize the rate of return this risk should be managed properly. Banks need to manage credit risk in the entire range as well as the risk in individual credits or transactions. The effective management of credit risk is a critical component of a comprehensive approach to risk management and essential to the long-term success of any banking organization.

2.2 Interest-rate Risk Management:

According to Bank of Jamaica (2005), “Interest rate risk is the potential impact that faces by banks on its earnings and net asset values of changes in interest rates.” When bank’s principal amount and its cash flows differ in both on-and-off balance sheet items then interest-rate risk arises. Managing interest rate risk is a fundamental element in the safe and sound management of all banks. Although the facts of interest rate risk management differ among banks depend upon the nature and complexity of its asset and liability structure. A wide-ranging interest rate risk management programme requires getting interest-rate risk positions and risking profiles.

 To establish and implement sound and prudent interest rate risk policies;
 To develop and implement appropriate interest rate risk measurement techniques; and
 To develop and implement effective interest rate risk management and control procedures.

Managing interest rate requires a clear understanding of the sum at risk and the impact of changes in interest rates on this risk position. To make these determinations, adequate information should be available to consent appropriate action to be taken within acceptable, often very short, short periods. The longer it takes an institution to eliminate or reverse an unwanted exposure, the greater the possibility of loss. Interest-rate risk refers to the potential negative effect on the net cash flows and value of assets and liabilities resulting from interest-rate changes. In extreme conditions, interest rate fluctuations can create a liquidity crisis. The subject of interest rate risk also belongs to the Asset-Liability Management and is much broader than liquidity. The fluctuation in the prices of financial assets due to changes in interest rates can be large enough to make default risk which is the major threat to banks’ viability. (Saidur 2008)

2.3 Exchange-rate risk Management:

Saidur (2008) pointed out that exchange-rate risk or currency risk is the risk of declines in cash flows and asset values of a bank due to change in exchange rate. The banks with overseas operations of those active in foreign exchange markets faces exchange rate risk. The net long position and short position of foreign currency balances under trading book may be assessed to know the extent the risk as well as capital requirements for this purpose. However, the Value-at-Risk (VaR), one of the most sophisticated approaches that depend on inferential statistical parameters, may be used to determine the extent of risk in this area.

2.4 Environmental Risk Management:

Saidur (2008) suggested that Environmental Risk is the risk that the bank must guard against but over which it has at best limited control. The bank must take it that as a firm, like any other, it is open to risk resulting from changes in the external environment in which it operates. It includes: a) Defalcation risk—the risk of theft or fraud by bank officers or employees as well as by the customers must be carefully guarded against in order to avoid substantial losses. Code of conduct, moral value creation, punitive measures etc., may help reducing such risk.

2.5 Money Laundering Risk Management:

Saidur (2008) explained that the loss of reputation and expenses incurred as penalty for being negligent in prevention of money laundering. Sound Know Your Client (KYC) procedure, Cash transaction report (CTR), suspicious transaction report (STR), clear understanding of the business of the client, person’s identity will reduce the loss of reputation and expenses incurred as penalty from such types of risk. With money laundering on the rise around the world, regulatory response is also increasing. Recent enforcement actions have focused on an institution’s lack of consistent internal controls, governance and oversight. In response, financial institutions are in search of reasonable anti-money laundering measures they can take to ensure regulatory compliance, including implementing a monitoring system that:

 Migrates all risks identified in their risk assessment.
 Can be implemented in months rather than years.
 Has lower infrastructure and support costs.
 Is proven to pass regulatory muster.

2.6 Liquidity or Funding Risk Management:

Mathias and Kleopatra (2009) describes that Funding liquidity risk is the possibility that over a specific horizon, a bank will unable to meet the demand for money, as other risks, funding liquidity risk is forward looking and measured over a specific horizon. It is a zero-one concept, i.e. a bank can either settle obligations, or it cannot. Funding liquidity risk, on the other hand, can take on infinitely many values reflecting the magnitude of risk. Moreover, funding liquidity is a point-in-time concept, while funding liquidity is forward looking. As long as the bank is not in an absorbing state, both liquidity and illiquidity are possible. The likelihood of either depends on the time horizon considered and on the nature of the funding position of the bank. In this respect, concerns about the future ability to settle obligations or to raise cash at short notice, i.e. future funding liquidity, will impact on current funding liquidity risk.

2.7 Leverage or Capital Risk Management:

Leverage or capital risk is the potential inability of a bank to protect its depositors and creditors from declines in asset value and therefore, default. Banks need to maintain adequate capital because it is caution against unexpected losses; it ensures that a bank remains solvent and stays in business even under extreme conditions; it has directly linked with investment/credit operations and it aims at absorbing unexpected losses at certain confidence level. Banks are following the best international practice given by the Basel Committee on banking supervision for maintaining adequate capital to commensurate to exposure or risk on balance sheet from 1996. Saidur (2008).

2.8 Strategic Risk Management:

Saidur (2008), depicts that strategic risk is the risk of the bank choosing inappropriate geographic and product areas that will be profitable for the bank in a complex future environment. In other words, strategic risk may occur when a bank is not prepared or able to complete in a newly developing line of business.

2.9 Overview:

A widespread and classy management information system needs to be developed for analysing behavioural profile of depositors and borrowers. Also need to understand mature profile of assets and liabilities including duration gap analysis, calculation of potential loss from movements of rate of return, adoption of contingency plan for liquidity, analysing some crucial factors related to possibility of credit default, loss given default, exposure at default expected loss etc.

CHAPTER 3: METHODOLOGY
3.1 Research Types:

Quantitative and qualitative approaches are the beginning point to understand the collection of information for research. The observations and measurements that can be measured objectively and repeated by other researchers are known as the quantitative research. On the other hand the research which aims to increase our understanding of why is called qualitative research.

The research that we have done is a qualitative research because its increase our understanding of ‘why’? Suppose from this research we will be able to know that why banks should manage its core risk?

3.2 Methods of Data Collection:

To complete a research we have to collect a lot of data and information. This data and information can be two types: primary data or secondary data. By the term primary data generally we mean the immediate information while secondary data relates with the past period information. Primary data is more accommodating as it shows latest information and we can collect primary data directly from the work field and it take a lot of time. But secondary data can be collect effortlessly, rapidly and inexpensively. We made this research on the basis of secondary data. Mainly we collect the information from different journals, books and through some websites.

3.3 Research Framework:

Saidur’s definition was more reasonable so the definition was taken which is financial risk arises as a risk when a bank doesn’t have enough money to meet its financial obligations, are taken in managing the balance sheet and off-balance activities.

According to Bank of Jamaica “Interest rate risk is the potential impact that faces by banks on its earnings and net asset values of changes in interest rates.” When bank’s principal amount and its cash flows differ in both on-and-off balance sheet items then interest-rate risk arises.

Interest-rate risk refers to the potential negative effect on the net cash flows and value of assets and liabilities resulting from interest-rate changes. In extreme conditions, interest rate fluctuations can create a liquidity crisis. The subject of interest rate risk also belongs to the Asset-Liability Management and is much broader than liquidity. The fluctuation in the prices of financial assets due to changes in interest rates can be large enough to make default risk which is the major threat to banks’ viability, which was broadly discussed by Saidur.

He also pointed out that exchange-rate risk or currency risk is the risk of declines in cash flows and asset values of a bank due to change in exchange rate. The banks with overseas operations of those active in foreign exchange markets faces exchange rate risk. The net long position and short position of foreign currency balances under trading

Mathias and Kleopatra describes that Funding liquidity risk is the possibility that over a specific horizon, a bank will unable to meet the demand for money, as other risks, funding liquidity risk is forward looking and measured over a specific horizon. It is a zero-one concept, i.e. a bank can either settle obligations, or it cannot. Funding liquidity risk, on the other hand, can take on infinitely many values reflecting the magnitude of risk.

CHAPTER 4: RESULTS AND DISCUSSIONS

Banking has a diversified and complex financial activity which is no longer limited within the geographic boundary of a country. Since its activity involves high risk, the issue of effective internal control system, corporate governance, transparency, accountability has become significant issues to ensure smooth performance of the banking industry throughout the world. In many banks internal control is identified with internal audit; the scope of internal control is not limited to audit work. It is an integral part of the daily activity of a bank, which on its own merit identifies the risks associated with the process and adopts a measure to mitigate the same.
Internal Audit on the other hand is a part of Internal Control system which reinforces the control system through regular review. Internal Control refers to the mechanism in place on a permanent basis to control the activities in an organization, both at a central and at a departmental/divisional level. A key component of effective internal control is the operation of a solid accounting and information system.

The internal control environment is the framework under which internal controls are developed, implemented and monitored. It consists of the mechanisms and arrangements that ensure internal and external risks to which the company is exposed are identified; appropriate and effective internal controls are developed and implemented to soundly and prudently manage these risks; reliable and comprehensive systems are to be put in place to appropriately monitor the effectiveness of these controls. Each company needs to have in place an appropriate and effective internal control environment to ensure that the company is managed and controlled in a sound and prudent manner.

4.1 Credit risk:

This risk results from the possible inability of the borrower to repay the loan or its benefits or the inability of the company’s securities from the investor bank to pay the value of paper or revenues, and this danger is the quality of the portfolio of loans and investments in securities and the degree of risk in loan is often higher than securities. This risk can be controlled partly by examining the borrower’s financial appropriacy and his ability pay as an initial guarantee for payment of the loan, and to obtain assets or securities or goods as secondary guarantees for payment of the loan, as well as examining the financial situation of companies issuing the securities which the bank wishes to invest in.

However, we can not control another part of credit risk represented in non-payment due to general economic conditions or natural disasters.

4.2 Liquidity Risk:

This risk results from the inability of the bank to repay liabilities and obligations due on their maturity dates because the bank does not harmonize the maturities dates of assets and liabilities through investment in assets with maturities dates greater than those of liabilities, something which leads to the inability to meet the demands for the withdrawal of deposits when they are due. Liquidity risk can be divided into two types: Funding Liquidity Risk (it results from the inability of the bank in normal circumstances to obtain adequate liquidity to repay its obligations, or obtain new deposits or a new loan or its inability to liquidate its assets); Market Liquidity Risk (it results from sudden withdrawal of deposits resulting in the inability of the bank to pay without incurring unexpected loss).

4.3 Market or Price Risk:

This risk results from the decline in the value of some elements of logistical assets or liabilities, the Bank handles the assets and liabilities affected by the market price significantly, especially when interest rates differ between each of the assets and liabilities. General Market Risks (where all market tools move once as a result of taking economic decisions or general conditions and therefore this type of risk can not be controlled; Specific Market Risks (where a certain tool moves without the others for reasons related to the source of this tool, such as low profits or the returns of the portfolio or indicator of securities related to a certain industry that suffers from certain recession.. The bank’s management must predict and control such risks by diversifying investments.

4.4 Foreign Currency Risk:

The reason for this type of risk is the change in exchange rates of foreign currencies against the local currency, which affects revenues and costs associated with investments in foreign currency. The probability of this risk increases with the increase in the volume of investments in foreign currency or their concentration in one currency.

4.5 Interest rate risk:

A bank is exposed to interest rate risk when it experiences a situation of imbalance in terms of size or maturity dates between assets and liabilities sensitive to interest rates, leading to potential losses for the bank when interest rate increases or declines and this influences the net asset value in the budget, which some call risk gap.

4.6 Operational Risk:

It results from the inability of the information and control system in the bank to predict various other risks, and as a result their occurrence is ignored and the bank incurs losses. This shortcoming may be due to technical reasons related to the information system itself or to administrative and regulatory reasons.

4.7 Legal Risk:

This risk results from the decline of the market value of the assets of the bank compared with liabilities as a result of losses for any of the above reasons, and therefore the bank cannot pay dues to clients and resort to liquidation and the use of its capital to fill the gap between assets and liabilities. Thus, it can notice the multiplicity and diversity of the risks faced by commercial banks in their work due to the nature of the banking industry which is characterized by a range of factors that lead to increased risks. These factors include:

– Commercial banks’ dependency on others’ funds represented in deposits and loans so that the ratio of capital to net assets does not exceed 7% at most, which reduces the safety edge for small depositors and increases risks.

– The nature of the financial markets in which banks operate, as these markets are constantly changing, and the growing global inflation, which supports the state of instability of commercial banks.

– Increased competition faced by commercial banks on the part of other financial institutions to attract and grant funds such as insurance companies, pension funds and securities investment companies.

CHAPTER 5: CONCLUSIONS AND RECOMMENDATIONS
Banks can apply the follow strategies to manage the risk:

1. making intelligent investment/credit decisions so that the expected risk of investment /credit is both accurately graded and priced to compensate risk exposure;
2. diversifying across borrowers, activities and regions so that credit loses are not concentrated to a particular area, borrower or activity;
3. creating ‘investment caps’ to avoid over concentration on a particular sector;
4. imposing legal limit of investment/credit for each single client or group of companies
5. encouraging syndicated financing;
6. purchasing third party guarantees/credit insurance so that default risk entirely of partially can be shifted away from the banks; and
7. setting-up separate credit administration department to administer proper disbursement, documentation and custody thereof monitoring covenants and compliance.

In the economic reality from our days, banks face several challenges to sustain the economic development of every country. There are a lot of threats and risks which can interfere in the bank’s activity, with a great influence over the performance and profitability. Therefore, in this paper we analyzed some interesting and useful performance evaluation methods in commercial banks, concomitantly with a detailed analysis of the risks that a commercial bank faces in managing assets and liabilities.

Stable banking systems are able to maintain efficiency in unforeseen situations and to generate incentives and credible financial information for all participants. The importance of this approach is that a market economy can not function without profitable consolidated banks; together with the revival of economy and improving the business environment. The banking system has seen an accelerated development, both in terms of quantity, as particularly in terms of quality. In the context of the challenges associated with globalization, internationalization banking activity, as a consequence of reduce trade barriers between countries and the opening of financial markets to foreign investors, can not be achieved without an efficient banking system.

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