Risk Management In Commercial Banks

RISK MANAGEMENT IN COMMERCIAL BANKS

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By Malik Dilawar Vice President/Principal Senior Training Manager, North, UBL Training Centre, Islamabad, Pakistan. Phone: 0092-51-2820674(Off.), Fax: 0092-51-2821521 2

Risk management by commercial banks -- Time to hammer out the chinks 

Financial markets the world over have undergone far-reaching changes in the last decade, spurred by deregulation and liberalization, as well as rapid developments in communication and Internet technologies. Banks in Pakistan have, however, generally not paid enough attention to the potential risks and to evolve mechanisms and systems to control and manage them in line with the global standards and procedures. 3

Risk management by commercial banks -- Time to hammer out the chinks As the banks no longer operate in a protected and regulated environment, there is an imperative need for them to develop and improve their capability to understand the changes in their economic environment and other circumstances having a critical bearing on their business activities.

Risk management by commercial banks -- Time to hammer out the chinks Risk management is a comprehensive process adopted by an organization that seeks to minimize the adverse effects it is exposed to due to various factors -economic, political or environmental, some of them inherent to the business, others unforeseen and unexpected.

Risk management by commercial banks -- Time to hammer out the chinks Present practices/situation Prevalent at commercial banks requires a hard look and call for a greater understanding by bank managements and boards of the risks involved in their operations.

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What is RISK ? It is the potential that events expected or unexpected, may have an adverse effect on a financial institution’s capital or earnings.  Risk is inherent in all business and financial activities.  The greater the RISK associated with an activity the greater potential to generate a high return.  Banks do take RISKS – The biggest RISK is Not Taking A RISK. 

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Definition of Risk Management Risk Management is the process of identifying, measuring, monitoring and controlling risks  These four points are essential to risk management  This presentation will cover the main identified risks in banks and determine how well risks are being managed. 

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Identifying Risks  Where

Risks should be Identified

 Institution-wide  Business

lines

 Products  Transactions

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Serving the Needs of Depositor Borrowers and Banks 

Commercial Bank lending/Investment involves three parties :

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The suppliers of funds (The depositor) The users of funds (The borrowers) A financial intermediary (Bank) s

3. 4.

Supplier

Bank

Borrower

Challenge in Banking

“Banking is an art of striking a balance between Risk and Revenue.” [Swiss Banking Corporation’s Credit Manual] 11

TYPICAL BALANCE SHEET OF A BANK [Amounts in millions USD]

Assets:

Amounts

Percent

Cash

461

8.29

Balances with Other Banks

418

7.52

Money at Call & Short Notice

380

6.84

Investment [Net of Provisions]

962

17.31

2,785

50.11

98

1.76

Other Assets

354

6.37

Deferred Tax Asset

100

1.80

5,558

100.00

Loans and Advances [Net of Provisions] Operating Fixed Assets Capital w-i-p

TOTAL ASSETS

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TYPICAL BALANCE SHEET OF A BANK [Amounts in millions USD]

Assets as per previous slide

5,558

100.00

Deposits & Other Accounts Borrowings from other Banks, Agents

4,720 391

84.92 7.03

Bills Payable Other Liabilities TOTAL LIABILITIES NET ASSETS [ 1] Represented By: Share Capital Reserves

90 144 5,345 213

1.62 2.59 96.16 3.83

203 106

3.64 1.91

Other Tier 1 Capital

136

2.45

Accumulated Loss

284

5.11

Surplus on revaluation of Fixed Assets NET ASSETS [1]

52 213

0.94 3.83

Liabilities

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RISK MANAGEMENT ORAGNIZATION Risk

management is a decentralized process guided by centrally established policies and rules .Senior staff committees define credit culture and established overall policies and rules.Line management designs lending procedures and controls risk. There are usually five major organization groups that participate in risk management process.These groups are responsible for defining ,implementation ,and/or reviewing risk management policies,rules and procedures within the

bank.

Banking Risk Taking risks can almost be said to be the business of bank management.A bank that is run on the principle of avoiding all risks or as many of them as possible, will be a stagnant institution ,and will not adequately serve the legitimate credit needs of its society.On the other hand a bank that takes excessive risks or credit is more likely ,takes them without recognizing their extent or their existence will surely run into difficulty.

All

business involves some type of risk and banking is no exception. Credit risk is major category of risk of the bank.It occurs whenever there is a possibility that is the customer cannot meet contractual obligations to the bank in term of : The delivery of documents or commodities where the bank bears the whole risk OR The payment of principal ,interest ,fees or commissions.

The overall objective of Risk Management is to increase enterprise value

INCREASE VALUE BY Providing Appropriate Level and Allocation of Capital

Increasing Return on Capital

Improving Consistency of Earnings

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The best way to reach this objective is to understand the full risk environment within which you operate...

External Environment Economic Conditions

Internal Environment Expansion/ Diversification

Financial Risk Asset Risk

Culture Social/Legal Trends Distribution Natural Catastrophes

Competition

Risk Appetite

People

Processes Political/ Regulatory Climate

Liability Risk

Technology

Business Risk Event Risk

Operational Risk 18

…and the complete set of strategies that are available to you... Financial Strategies

Financial Risk

Capital Structure

Hiring/Training Incentive Programs

Asset Risk Liability Risk

Operational Strategies

Asset Allocation

Internal Controls Products

Pricing Technology

Business Risk Product Mix

Customer Service

Event Risk Market Strategy

Operational Risk

Securitisation Distribution

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…and to apply this knowledge in a holistic risk management framework, to drive value

Understand Internal and External Environment

Holistically Manage Financial and Operational Risks

Consisten cy

Return

Capital

Increase Value

Optimise Financial and Operational Strategies

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To accomplish all this in a consistent manner, it is necessary to implement a continual management process

Develop Best Strategie s

Implement Strategies

Monitor Performance and Environment

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In summary, Enterprise Risk Management:

Allows you to determine the necessary capital level, deploy unneeded capital and improve return on capital  Encourages proper allocation of capital to segments and supports performance tracking  Provides a method for ensuring that enterprise owners receive proper compensation for risks assumed 

Provides Competitive Advantage 22

RISKS MUST BE: - KNOWN - UNDERSTOOD - QUANTIFIABLE - CONTROLLABLE / ACCEPTABLE / BANKABLE

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RISKS FACED BY BANKS  CREDIT

RISK  MARKET RISK  INTEREST RISK  LIQUIDITY RISK  OPERATIONAL RISK  COUNTRY RISK  OWNERSIP / MANAGEMENT RISK 24

CREDIT RISK THE RISK THAT THE OBLIGOR (BORROWER) WILL NOT BE ABLE TO REPAY THE DEBT (LOAN) UNDER THE TERMS OF THE ORIGINAL AGREEMENT (LOAN AGREEMENT). • MOST CRITICAL RISK IN BANKING • REQUIRES MOST SUBJECTIVE JUDGEMENT • MUST BE MANAGED CAREFULLY 25

MARKET RISK CHANGES IN MARKET RATES AND PRICES WILL IMPAIR AN OBLIGOR’S ABILITY TO PERFORM UNDER THE CONTRACT NEGOTIATED BETWEEN THE PARTIES.

• NEEDS MONITORING OF CHANGES IN PRICES OF COMMODITIES, REAL ESTATE, ETC.

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INTEREST RATE RISK INTEREST RATE RISK IS THE EXPOSURE OF AN INSTITUTION'S FINANCIAL CONDITION TO ADVERSE MOVEMENTS

IN

INTEREST

RATES,

WHETHER

DOMESTIC OR WORLD-WIDE. • ANOTHER CRITICAL RISK • RE-PRICING/ MISMATCHES NEED TO BE ADDRESSED

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LIQUIDITY RISK THE RISK THAT A BANK WILL BE UNABLE TO ACCOMMODATE DECREASES IN LIABILITIES OR TO FUND INCREASES IN ASSETS. SUCH RISKS ARISE WHEN THE REPRICING OR MATURITIES OF ASSETS DO NOT MATCH THOSE OF LIABILITIES. • CRITICAL RISK • MATURITY MISMATCHES • BASED ON MARKET CONDITIONS & PERCEPTIONS 28

OPERATIONAL RISK THIS RISK ARISES FROM THE LACK OF EFFECTIVE INTERNAL CONTROLS AND AUDITING PROCEDURES. PARTICULARLY IMPORTANT IS THAT THE BANK SHOULD HAVE GOOD INTERNAL CONTROLS 

Risk of a failure in the bank’s procedures whether from external causes or as a result of error or fraud within the institution. 29

COUNTRY RISK RISK

ASSOCIATED

WITH

THE

ECONOMIC,

SOCIAL AND POLITICAL ENVIRONMENT OF THE BORROWER’S COUNTRY. COUNTRY RISK IS MOST APPARENT WHEN LENDING TO FOREIGN GOVERNMENTS/ THEIR AGENCIES AND OTHER CUSTOMERS. • BANK’S HAVING GLOBAL PRESENCE

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OWNERSHIP RISK THE RISK THAT OWNERS / SHAREHOLDERS, DIRECTORS OR SENIOR MANAGEMENT MIGHT BE UNFIT FOR THEIR RESPECTIVE ROLES OR THEY ARE ACTUALLY DISHONEST. • ALSO A CRITICAL RISK • ”THE BEST WAY TO ROB A BANK IS TO OWN IT”

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RISK MANAGEMENT  Familiarisation

of Management with

Risks  Implementation of Internal Controls  Sound Internal Audit System  Efficient MIS in Place  Competent Group of Risk Managers  Prompt Action & Monitoring 32

Risk Quantification Risk quantification techniques becoming important to determine capital requirements  More reliance on banks’ own systems for identifying and managing risk  Not only quantitative; also processes and ‘culture’: 

     

scrutiny of model design data integrity risk management resources validation independent audit management understanding 33

DEPOSITS IN A BANK REPRESENTS WHAT ? “Commercial Banks support a mountain of RISK on a slender capital base. The bulk of their liabilities is redeemable at PAR and on DEMAND, with depositors regarding their money as perfectly safe.”  “Yet bank assets are subject to credit risk, market risk, and settlement risk. With international lending, there is foreign exchange risk and transfer risk. Also there is management risk and risk of fraud.” 

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GENERAL 

Many of The Risks Overlap.



Need To Be Evaluated In The Context Of Individual Institution With On-site Presence.



Evaluation of Risks Requires An Understanding of The Bank, its Customer Mix, its Assets & Liabilities And The Economic And Competitive Environment.

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INTERNAL CONTROLS RISK RATING SYSTEM FOR CREDITS  CLOSE MONITORING OF OPERATIONS  COMPETENT CREDIT MANAGERS  DUAL CONTROLS  SYSTEM TO STUDY THE INDUSTRIAL AND ECONOMIC DEVELOPMENT FOR ESTABLISHING TARGET AREAS OF INVESTMENT 

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Reliance on Internal Control ? Once the management system is in place, supervisors can determine that the systems are working properly by testing the systems. If the systems are inadequate, the scope of the inspection can be expanded so that risks are properly identified, 37

Principles of Control •

Segregation of duties

•

Dual control

•

Rotation of assignments or duties

•

Two weeks continuous vacation

•

Adequate Compensation 38

INTERNAL AUDIT SYSTEM IMPLEMENTATION OF INTERNAL CONTROLS  PROVIDES SECONDARY RISK REVIEW  INDEPENDENC. 

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Objective of Internal Audit  The

overall objective of internal auditing is to assist all members of management in the effective discharge of their responsibilities by furnishing them with objective analysis, appraisals, recommendations and pertinent comments concerning the activities reviewed. The internal auditor, therefore, should be concerned with any phase of banking activity

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Inspection Procedures for Internal Auditors Work 

Organizational Structure of the Audit Department



Independence of the Audit Function



Auditors Qualifications



Audit Staff Qualifications



Content and Utilization of the Audit Frequency and Scope Schedule 41

MIS AN ADEQUATE “MIS” HELPS IN TIMELY IDENTIFICATION OF RISKS  REPORTS ON MATURITY OR INTEREST RATE MISMATCHES  REPORTS ON PROBLEM CREDITS  REPORTS ON CREDITS SHOWING DETERIORATING TREND IN RISK RATING 

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RISK MANAGERS QUALIFIED  OBJECTIVE  ENJOY ADEQUATE AUTHORITY  ABILITY TO CORRECTLY ANALYSE FOR CURRENT ACTION AND FUTURE PREDICTIONS  PROMPT IN ACTION 

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