RISK MANAGEMENT IN BANKS: A DESCRIPTIVE STUDY
Habib-ur-Rahman, Professor, Sarhad University of
Science & IT, Peshawar. Email:
hod.ba@suit.edu.pk
Abstract. Banking,
though integral part of an economy, is the most volatile business because of
the commodity it deals in changes value with variation in its circulation.
Money value in the market, at times, is determined by its quantity, but the
number of transactions carried out with money is of equal importance. Rarely,
it happens that the quantity alone affects its purchasing power. The value of
money is thus a function of both the supply and demand which together
determines the trend of prices in the market. The supply of money results from the
credit decision of banking industry as a whole which generally takes into
account the market scenario depicting future economic activities and safety of
banks funds. No doubt the scope of market mostly depends upon the availability
of finances yet the market stability ultimately helps in credit expansion by
promoting optimism and growth opportunities in the economy. This paper will
discuss the various elements of risks which render the money market more
volatile and will suggest preventive measure to minimize the chances of Loss so
that the flow of credit may continue unhindered.
Key words: Bank,
finance, economy, risks, business, safety, assets, risk mitigation
Introduction
Risk is a concept widely used in matters associated with the assets and
liability management. The term denotes a phenomenon where in danger of loss in
the value of assets is apprehended or there is an apprehension that a
substantial addition to the liability may arise due to the happening of a
presumed event. It is potential danger of loss associated with the happening of
particular event. It is a contingent loss which may or may not arise.
According to Khan Risk is a probable loss in income or assets. He
further elaborated his views and said that it is unexpected loss which comes in
the definition of Risk and the expected loss is not included. Nevertheless it
needs to be guarded against. The term is normally used for the losses which
arise during the course of business due to imprudent management. To mitigate
the repercussion or eliminate the chances of occurrences, the shrewd managers
use various instruments and technique to minimize the quantum of loss although
danger cannot be eliminated altogether. The practices and use of such
techniques which minimize the chances of loss in the value of an asset or
additional impact of liability is in fact the management of risk. In banking
both the assets and liabilities aspects are equally important to be taken care
of. The banking business largely depends upon the volume of deposits secured
and any such event which may result in the loss of deposits, may it be with
drawl by the customers due to declining trust or quality of service may attract
initiate attention of the managers. Under such circumstances the managers are
always anxious not only to retain the exiting portfolio but also make all out
efforts to increase the deposits. This is because the ever increasing deposits
give strength to the management to increase and enlarge its investing and
leading post folio and there by generate maximum revenue to add to its
profitability. Profit is no doubt the major goal of bank yet it can be
increased only by disbursing quality finances and keenly caring of its
investment portfolio. The curiosity of manager in selecting customers with
integrity and worth is an artful job and demands extra skills to predict and
identify the risks associated with a particular post folio and prevent the
occurrence of the contingent event which may possibly cause a loss to the
institution.
Calvin (1994) emphasized upon the effectiveness and
efficiency of the organizational unit. He was of the view that an efficient
organization achieves its purpose with minimum waste of resources. He further
said that effectiveness and efficiency are co-related and are both necessary
for long term success.
The risk management, therefore, warrants in time identification of
various types of the risk involved in the transaction of the business and also
take preventive measures to mitigate the loss.
Methodology
It will be a descriptive study. In order to ensure safe disbursement and timely
repayment of bank’s finances an extensive study of the various elements causing
the loss in the value of bank’s finances either due to classification or
through delayed payment will be found. Besides advances portfolio bank’s money
is lost due robbery, fraud, forgery, and embezzlement. The study will mainly
focus on cause of the losses to banks and will eventually find the alternatives
to prevent the occurrence of events which lead to losses. These causes will be
analyzed for suggesting preventive measures. Secondary data available in the
market will be utilized and also a case study of a local bank be made for
academic purpose.
Risks in Banking Business
Banks as custodian of public money on one hand play a significant role
in determining the direction of the national economy and on the other hand are
charged with the responsibility of safeguarding the interest of the
stakeholders.
As fund supplier, they move the economy towards growth and
satiability. However, the organizational
goal of bank can be achieved only when money lent is recovered in time and
without incurring additional expenses. Such institution is in fact an ideal for
the stake holders which ensures growth and promotes the interests of all the stakeholders. Therefore, operational mechanism is so
designed and procedure so carefully implemented that least chances of loss are
left uncovered. So every risk is
properly analyzed and preventive suggestions are made to avoid occurrence of
any event which may cause any loss to the institution.
Since banking business mainly revolves around money, therefore, its
sensitivity and intricacies requires extra vigilances to ensure the smooth flow
of credit besides optimal utilization of other resources. For academic purpose
there are numerous risks which needs attention but the risk involved in credit
both pre and after disbursement has since attained paramount importance. The
identification of risks helps in managing them through affective measures. But
in some cases where the happening of events becomes beyond the jurisdiction of
management, then alternative arrangements are made with the help of insurance
companies. The most commonly known risks encountered by banker among others are
as follows.
(1) Poor Information Risk. The
pre sanction/ disbursement risks take their origin from the selection of
borrower. It is commonly observed that the infected port folio of the bank
comprises on loan accounts owned by sponsors of high worth with regular income
flow. The default has never been due to non availability of funds with the
borrowers, rather it is always due to the weak will to pay back the banks dues.
Although will to pay is a psychological phenomenon, yet the past track record
and market reputation of the prospective borrowers helps in determining the
integrity and credit worthiness. In fact an intensive and extensive inquiry on
the borrowers before initiating a loan proposal saves the money from loss.
State Bank while introducing the KYC mechanism has provided guide lines in
obtaining information on the genuineness or other wise of the borrowing
applicant at the very initial stage. Although in some cases social pressure
forced the defaulters to arrange repayment of the classified advances yet the
common proverb“Nip the Evil in the Bud” will save the bank from cumbersome
recovery process or expensive litigation. It is, therefore, imperative that in
the matter of lending decisions the inherent risk in the loan proposals may be identified and preventive measure be taken
prior too taking a final decision of loan disbursement.
(2) The income generating capacity of
the business entity for which the loan is being asked for needs to be
considered to because the incapability of the business renders the borrower incapable to
liquidate the liability within a specified time period which
phenomena will ultimately put the credit
at risk. It is because of these reasons that poor income generating capacity
leaves nothing to pay back the original loan amount what to talk about the
interest and mark up and eventually adds to the liabilities of the defaulting
borrower. In case of newly established business concerns the financing manager
has to take into consideration the market and the business trend of the
products being produced because in case of non disposal the stock will continue
accumulating and will ultimately put the bank money at risk. The elasticity of
demand for such products sends a signal of warning to the lending agency due to
the availability of substitutes or increase in supply in the market may place
the borrowing entity as a weaker competitor. Also an infant business entity
takes time to establish its integrity and worth in the market.
Political Risk
Political instability in the country results in frequent change of
charge which eventually affects the policies relating to trade and industry.
Policy variations directly affect the growth process, ultimate impact of which
falls on the creditors. The business activities suffer due to uncertainty. This
leads to a declining trend in over all businesses and cause a fall in the
income generating capacity of the borrowing entities. With little amount of
liquid assets the repaying capacity of the debtors falls adding to the
frequency of default. In many cases sabotage activities resulted in destruction
of valuable assets and industries in the region lost its core capital
paralyzing the industrial growth process.
A failure of one unit generally sends shock throughout the economy and
banking, the more volatile industry, suffers comparatively more than any other
sector/industry.
The nationalization policy of late Zulfiqar Ali Bhutto in Pakistan in
early 70’s set a severe setback to industrial growth in the private sector
because no entrepreneur was ready to undertake risk loss of factory unit which
might be the result of subsequent taking over by the state. Hesitation of by
the industrialist on the one hand and poor management of taken over industries
on the other hand retarded the growth process.
As a result of declining trend in the production the money borrowed from
banks went in default. On the other hand since establishment of new units
carried the danger of nationalization the demand for credit fell and surplus
funds with banks could not be properly deployed and caused a fast decline in
the revenue of the banks. A change in policy relating to Industrial estates in
Hattar and Gadoon was major cause of closure of most of the units which created
a serious problem for banks in recovering their finance.
Country Risk
Cross the border internal disturbances due to political unrest
invariably affect the trade and business activities in the neighboring
countries which directly change the business scenario. This change, besides
other, reduces the income generating capacity within a country and thus poses a
risk to the assets of bank troubled relations with such countries carry a great
risk of loss of business. Barring imports or restricting exports by these
countries retard international trade process occasionally resulting in closure
of the units running on the imports of raw materials from neighboring states
with strained diplomatic relations.
Trade restriction between
countries equally adversely affect the export business which in turn disturbs
the balance sheets of the exporting industries and finally result in decreasing
and many a times no repaying capacity.
The rift eventually leads to pressure on the units carrying their business on
bank credit because of income loss causing liquidity problems. Such a situation
generally affects the entire banking sector because of its more sensitivity.
Loss of trade between Pakistan and India since 1965 war deprived both
countries benefitting from the results of the innovative efforts and loss of
revenue.
Location Risk
Business or industry location plays an important role in the standing
of the business entity. Unauthorized establishments or remote areas without
infrastructure facilities have led to the collapse of the business. The non availability of social security,
continued disruption in the power
supply, non availability of skilled labor, difficult accessibility of raw material and market cause
a deadlock in the business and loss of revenue. As an example of
business established in the residential areas of University Town and Hayatabad,
Peshawar which have been sealed under the order of Peshawar High Court. The
restricted supply of Mulla Gori Marble was one of the major causes of failure
of big marble industrial units in K.P.K. The failure of K.P.K flour mills was
absolutely due to non availability of wheat from Punjab. The closure of such
units affected the operation of credit giving institutions and banks which had
to restructure or reschedule their dues against such units.
Environmental Risk
Depending on the nature of business, environment impacts the success or
otherwise of the business. Extreme hot weather conditions have caused failure
of poultry business. At times the existence of industries is found injurious to
the public health due to environmental pollution. Under such circumstances the
regulatory authorities at any time resort to cleansing operation consequences
of which directly hit the repaying capacity of the business entity. Plant
diseases in the locality cause a severe failure of crops and under such
circumstances not only the Agriculture sector loses its capacity but all the
Agro- based industries in the area face a worst situation while liquidating
their liabilities. Hilly tracks adjacent to volcanoes have always been in a
risk trap. An abnormal snow fall in the
high altitude areas cause failure of crops and delayed transportation. Credit
dealing with such industries carried greater risk of physical destruction of
the industrial units and other structures built with help of bank’s finances
due to natural hazards.
Socio-cultural Risk
Socio cultural values play an effective role in the promotion of
business. No doubt strong publicity has
induced a major part of the consumer community to adapt to the changing market
supply which includes fashion and style yet in some societies, religious and
social values still hold strong grip. Industrial units if propagated against
producing Haram/Non permissible consumer goods will fail to dispose off their
stock and thus unable to off load their loan amount. Conservative communities
specifically adhere to their customs and traditions which usually affect
aggregate effective demand. An abrupt decline which sometimes occurs due to
prejudice and boycott curtails sale and reduces the revenue generating
capacity. The lenders in such a situation cannot recover the loan amount due to
liquidity problems with borrowers.
A very important aspect of these phenomena is common hesitation of the
majority of the population transacting with because of its non permissibility
under the law of Islamic Jurisprudence which is in fact part of the socio
cultural values of the Muslim Ummah.
Natural Disasters Risk
Areas normally relying on weather and mercy of Nature are more expose
to events like famine and flood. Nature is beyond the jurisdiction of human being.
An earth quake, epidemic, famine, or any catastrophic mishap turns good
businesses into collapsing entities. Such businesses shocked by nature
phenomenon lose their worth due to financial hardship and face difficulty in
discharging their liabilities in time. The situation is worst from the repaying
point of view of the borrowers when the business has been established or
running with the help of borrowed money
because it directly hits the lending institutions like banks.
Organizational Risk
Organizational hierarchy is responsible for putting right policies in
place at right times and also keep close watch over business trends so that
immediate measures are suggested to cope with changing situations. The Board of
Directors are required to keep themselves abreast with the business environment
so that each lucrative opportunity is in time tapped. While lending or
financing a project the creditor has to keep into account the quality of
management of the organization being financed. At times the collateral had
priority \and it was presumed that security protects the lender/financier from
any inability of the borrower. , but the concept has now gone a radical change.
The bankers does not stand to earn for one time rather banking business is a
continuous process which succeeds with a success of entire commerce and
industrial sector. The academic back ground, experience and managerial skill of
the sponsors/ stake holders help the middle management in properly handling
every critical situation. Policy formulation and implementation both are
equally important in the matter of organizational success. Intelligent and bold
decisions are necessary and pre-requisites for availing the market opportunity.
The poor organizational hierarchy with incompetence carries a great risks of
loss and so a loss to the financing institution. Weak administrative control
leaves loopholes for mismanagement. A lack of strict vigilance and close
supervision has always resulted in misuse of power and authority.
Habib (2014) taking the failure story of Baring Brothers and Company of
England observed that it originated from the unbridled powers vested in its
young executive Nick Leeson posted as General Manager in Singapore who used to
deal in Futures and Options. Although in the year 1994 Nick Leeson could book
unexpected false profit of GBP 28.5 (M), yet none of the senior executives in
the company ever took notice of the fictitious account No. 88888 operated by
Nick Leeson to hide losses which ultimately cause collapse of the Baring Bank.
The management’s professional competence and acumen could detect the abnormal
transactions and also the hazards involved in the dealing of swap, futures and
options.
Maciariello (1984) while discussing environmental scanning observed
that “Top management is generally responsible for activities leading to the
formulation of goals and objectives, strategies, policies for the acquisition
of resources and allocation of resources for the company’s “portfolio” of
businesses”.
Lehman brothers of USA unscrupulously continued disbursing mortgage
financing without taking care of the repaying capacity of the borrowers and
also the market if the housing industry. The borrowers could not meet their
commitments and the bank failed to overcome the liquidity problem. The Central
Bank did not support the Lehman Brothers Bank which fell in need. The failure
of this bank sent shock through out the financial system. Because one of the
reasons of financial crisis not only the American Economy suffered but it caused
a global depression.
Credit Risks
According to Patial –Abera (2014) Credit Risk is the probability that
some of bank’s assets specially its loans will decline in value and possibly
become worthless.
However the concept covers a variety of variables which affect the
value of assets or for that the quantum of liabilities. The safe lending decisions are accordingly affected by
more than one factor to minimize the risks involved in credit approval
/disbursement. The following risks endanger the profitability of the bank.
(a) Equity Risk
It is common experience that flourishing business attracts new
clientele. Growth of business is the urge of every entrepreneur but in case the
banks continue lending imprudently without taking in to account the statutory
restrictions there is every possibility of violating the law of the land which
may attract severe penalties from the regulatory authorities putting the bank
in hard water. The lending/financing by
banks must be in proportion to the net equity as per laid down rules of
business. This issue has clearly been resolved by the State Bank of Pakistan
promulgating Prudential Regulations wherein exposure limits have been defined
both for the banks as financier and the client as borrower. The Debt equity
ratio both for Bank and client prescribed in the Regulation must be observed if
a bank desires to be on safe side. It,
therefore, necessitates an increase in the paid up capital before increasing
the total lending. Disproportionate lending puts the bank’s corporate image at
stake because of contingent run on bank. Alternately the outstanding finances
are to be reduced to bring them to reasonable level. The quantum of core
capital and also the available reserves play a significant role in the
determination of lending capacity of a Bank. The Assets /Liabilities Committees
normally known ALCO formed in banks are primarily charged with the
responsibility of ensuring maintenance of statutory ratios between the assets
and liabilities of the lending bank of which most important is adequacy of core
capital. Any deficiency in the equity
poses the institution to very unhealthy situation and if not checked in time
attracts regulatory action which may result in ban on lending/ financing. Such
a phenomenon directly impacts the market reputation of the bank besides
financial penalty.
(b) Market Risk
No doubts banks deal in money yet the funds collected from various
depositors are in turn financed to the business and industrial community. The
borrowers of the bank money in their way invest in different business ventures
to produce and distribute goods and services in the market. The success of the
borrowers is, in fact, the building of revenues generating capacity. This
characteristic can be attained only when the borrowers are able to dispose of
their product in the market. In other words the market demand for goods and
services of the borrowers determines the demand for funds and repaying capacity
of the borrowers. Future demand for a
particular product determines the eligibility of the borrower for finance. Ever
changing fashion trend and technological innovation invariably affect the
existing tempo trade and status of machinery. A change in demand for and supply
of a particular product changes the revenue generating capacity of the borrower
and so a change in the repaying capacity. Introduction of substitutes is one of
the main reasons of which exposes bank’s finance to a greater risk of default.
Borrowing entities dealing in stock, securities and goods with more fluctuating
market trends carry heavy default risk. Illegal import of substitutes often
carry dumping phenomena with it directly adversely affects the local demand
resulting in reduced sales and poor debt servicing. The 80’s decade and even
afterwards the electronic and synthetics textile industries in Pakistan
suffered huge losses due to a flood of Russian and Japanese products which
wiped off very established industries due to cut throat competition. Prudent
banker takes notice of future business trends and changes financing policies
accordingly.
(c) Business Risk
The business trends of the borrowing entity directly affect the
collection rate of the financing institution. The borrowers depending on single
supplier or a particular market may face difficulty the moment the supplier
fails / refuses to supply or the market being depended upon by the borrower
fails to absorb the quantity or refuse to accept the goods being produced by
the borrowing entity. Under such circumstances the revenue generating capacity
of the borrower declines and so the repaying capacity of borrowing client falls
creating a severe problem for the lending bank to recover. Borrower’s market
share and marketing strategy is of much significance because only those
entities succeed in the market which can face the competition and this is
possible only when the firm or company foresees market trends and shape its
policies accordingly.
Armour (2014) was of the view that the risk of potential competitors
and managing for it in advance adds to the strength of the firm to sustain any
pressure from the cut throat competition.
(d) Collateral Risk
Customarily banker mitigates risk of borrower’s default by making an
effort to reduce the losses occurring due to poor or non debt servicing by the
borrowers and gets its debt assets secured
through obtaining either actual or constructive possession of various
tangible marketable assets/commodities in addition to the personal surety. At times Central Bank had prescribed marginal
requirements against various items under selective credit control system which
aimed at exercising extra caution while extending finance facility. This very
requirement emphasized the sufficiency of the quantity which can cover the
finance amount in spite of price variation. Still inherent danger of decrease
in the value of such securities due to deterioration in the quality of the security or declining
trend of market prices puts the bank’s assets at stake. Securities pledged with
bank are often meant to avail the price margin. A sudden fall in the prices of
stock pledged/hypothecated renders the borrower unable to meet his/her
commitment. The securities rarely saleable lose their market when put to
auction. Immoveable property in the hard areas
or for that matter borrowers
with strong political influence are
difficult to be persuaded to repay in case of default and so is difficult to
recover outstanding amount out of the securities placed with bank.
(e) Documentation Risk
Every security offered against a finance facility is valid only if it
is genuinely placed with bank for the purpose of ensuring timely repayment of
the finance amount. In case of default the banker resorts to securities for
appropriation of the sale price towards the adjustment of the bad debt. The
banker derives this right of appropriation from the document evidencing the
authority reposed in banker by the borrower in the form of letter of pledge/
mortgage/lien/ earmarking.
However the right still seeks its justification when the borrower is
either him/herself is the owner or holds valid authority of by the owner to so
offer the security.
A title subsequently found fake or defective cannot pass on a good
title to the transferee. Thus the document is void and invalid. Documents later
on found fake signed under impersonation, beyond jurisdiction, unauthorized or
with defective title does not entitle the bank to recover the amount. Similarly
expired documents deprive the banker from right of foreclosure and hence the
risk of loss of the asset.
It, therefore, necessitate that proper standard be set for various
measures and steps to check and scrutinize the transactional instruments for
ensuring the criteria compliance.
Anthony M. Santomero (1997) while discussing the implication of various
risks in Commercial Banks found that “The first of these risk management
techniques involves two different conceptual activities, i.e.,
i.
Standard setting and Financial reporting. They are listed together
because they are the sine qua non of any risk system. Underwriting standards,
risk categorizations, and standards of review are all traditional tools of
risk management and control.
ii.
Consistent evaluation and rating of exposures of various types are
essential to understand the risks in the portfolio, and the extent to which
these risks must be mitigated or absorbed.”
(f) Moral hazards
(i) Human Resources Risk: Banks while dealing in money are confronting a number
of problems due to undesirable human behavior. During the course of business
bank loses its assets due to frauds, forgeries and embezzlement. Also money is
lost due to default by the borrowers only because of sheer negligence,
inefficiency and connivance of the officials at the helm of affairs. The men
assigned with the responsibility of safeguarding the interest of the bank
indulge in professional malpractices and the public money is placed into the
wrong hands. Criminal involvement of bank employees is a serious problem
confronted by banking institutions. Lack
of skill and professionalism makes the bank employees fall prey to the
fraudulent elements of the society. Professional development, strict vigilance
through both regular and surprise audit/inspection and effective
punishment/reward system mitigates this particular risk which entails
defamation of the institution besides financial loss.
(ii) Personal Risk: Moral
hazards is serious risk. Repaying capacity of the borrower is closely
associated with his/her will to repay.
This is a psychological phenomena and is subject to many factors other than the
financial worth and income of the borrower. Capacity to pay can be measured by
working the value of the assets and also the sources of revenue but the Will to
Repay cannot be determined in terms of money. It is commonly observed that big
business men of political and social
influence with sufficient resources evade debt servicing till last moment to get remission and waiver
of .The existing resources have been found diverted to other venues and
loan/finance amount is left to pile up.
A detail enquiry in to the personal character, social status and
integrity of the borrower in the market and goodwill of the business entity
helps in making credit decisions.
Technological Risk
The ever expanding scope of modern technology has no doubt facilitated
accounting procedure and client service but in the absence of skilled work
force it carries more risk of wrong payments and fraudulent withdrawal. T o ensure safe operation, training needs
assessment, proper training and development of the employees will improve upon
the efficiency of human resources. However, strict vigilance can only minimize
the risk of loss due to moral hazards.
Basel committee on Banking Supervision provides guidelines for secure
operation at all level worldwide. In its report of June 2014 the committee
observed that a Transparent operating procedure reduces the risk because least
interference of political elements and legal and accounting frame work. Her
supervisory role of the middle management attains more significance.
Timely detection of irregularities prevents any
fraudulent act provided the early identification is ensured through regular
Monitoring and proper reporting of financial transaction. This requires on-site
examination, close liaison with audit and inspection team members and
management of the bank. With the deployment and use of Information technology i.e.,
introduction of E-banking the need of developing skill of the employees is
urgently felt.
The role of Policy makers of which the Board of
Directors attains the most significance influence is more decisive. The Basel Committee
Report disclosed that “it is incumbent upon the Boards of Directors and banks'
senior management to take steps to ensure that their institutions have reviewed
and modified where necessary their existing risk management policies and
processes to cover their current or planned e-banking activities”.
Financial Risks
Return (Interest) Rate risk: In fact the
banking industry is run on the basis o f surplus funds collected from public as
well as private sector. A continuous flow of these funds is linked with
incentives to the fund holders so that they may continue saving a part of their
income for further injection in the economy. This incentive is generated by the
banks by investing the deposits and earning thereon by way of interest which is
sometime called Mark-up.
This rate of return or for that matter Interest is more vulnerable to
market changes and is, therefore, volatile. A small downward movement disturbs
the whole financial statement of a bank. It thus carries heavy weight on the over all
financial performance.
Lending rate once agreed continues till the expiry of the validity of
the facility but the Market rate varies with a change in the monetary policy
besides the changes in the market trends. A sudden upward change in the interest rate payable
to depositor adversely affects the earning of the bank because net interest
income falls on account of increased or interest expense. The bank must,
therefore, be capable enough to absorb such a shock without much disturbing the
balance sheet. The significance of bank rate in cannot be overemphasized in
evaluating the impact of interest rate. To counter such an eventuality the bank
evaluates the vulnerability of the income portfolio and adjusts to the
fluctuation in the interest rate
As a primary measure, a duration gap,
which the time period of market value of the asset to a percentage changes in
the market interest rate, is found. By working out the average duration gap
which arrives at by finding out the difference between the average time period of
bank’s assets and average time period of bank’s liabilities. The bank can
manage the risk of interest rate fluctuation by narrowing the duration gap. The
risk can be minimized if not eliminated altogether.
The Gap arises because assets and
liabilities are held against different amounts of loans with different maturity
dates or renewal with different rates and dates which allows exposures to
unanticipated changes in the interest rate prevalent in the market.
Interest
Rate risk: from its economic value perspective emerges
out of the difference between cash inflow on assets and cash out flow on
liabilities plus net cash flow on off balance sheet items. This perspective
tells about long term interest rate gap.
Anthony (1997) in his essay on Commercial Bank Risk Management: an
Analysis of the Process disclosed that some of the risks can be transferred and
thus the risk of the transferring bank can be mitigated. Explaining his point
of view he says that
“There are also some
risks that can be eliminated, or at least substantially reduced through the
technique of risk transfer. Interest rate risk can be transferred by interest
rate products such as Swaps or other Derivatives. Borrowing terms can be
altered to effect a change in their duration. Finally, the bank can buy or sell
financial claims to diversify or concentrate the risks that result from
servicing its client base.
However, there are two
classes of assets or activities where the risk inherent in the activity must
and should be absorbed at the bank level. In these cases, good reasons exist
for using firm resources to manage bank level risk. The first of these includes
financial assets or activities where the nature of the embedded risk may be
complex and difficult to communicate to third parties. This is the case when
the bank holds complex and proprietary assets that have thin, if not
non-existent, secondary markets. The second case included proprietary positions
that are accepted because of their risks, and their expected return. Here, risk
positions that are central to the bank's business purposes are absorbed because
they are the raison d'etre of the firm. In all such circumstances, risk is
absorbed and needs to be monitored and managed efficiently by the institution.
Only then will the firm systematically achieve its financial performance goal.”
Risk
Identification-Warning Signals
A shrewd banker keeps himself posted with
the business trend and the business status of the borrower and notes the
negative changes for in time remedial rather preventive measures.
Foresightedness of the bank manager helps him to make timely decision for
safeguarding the interest of the institution by withdrawing the financing
facility not only from the particular customer but also review his decisions
about the prospective clients engaged in the affected industry. Although the
monitoring the finance commences after the disbursement of the finance/loan
amount yet a minor mistake during the processing of finance proposal or even at
the time of disbursement may
unexpectedly result in an irretrievable loss. Strict vigilance and close
monitoring can, however, check the situation from further deterioration.
Therefore, as prudent banker the manager must focus on the following aspect
which guide in diagnosing the health of the borrowing unit.
1. Examining the comments in the
periodical inspection and audit reports on borrower’s account and collateral.
The report will guide in continuing the business dealing with borrower.
2. Obtaining information on the
business trends and status of the borrower from the external sources using the
business contacts which will help in verifying the market reputation.
3. Surprise re-evaluation of the
stock and other securities held by the bank will disclose the factual position
of the business.
4. Weak turn over in the inventory
and stock of the borrower tells that the borrower has lost the market and is
unable dispose off the existing stock.
5. Increasing receivable and also
payable account of the borrower with average period of signals warning that the
borrowers can not liquidate the liabilities due poor cash flow. Also it
indicates that with minimum sales the borrower is constrained to sell out on
longer credit which unhealthy symptom.
6. The perusal of balance sheet will
reveal the current assets and liabilities ratios and hence the liquidity
position of the borrower.
Yield
Curve Risk arises as result of
earning of an asset which is depicted in the form of movement in the yield
curve. It tells impact on the values of various investments and their affect on
income.
Embedded
Option Risk: Since the borrower has
the option to repay the amount before the expiry date and similarly the
depositor can withdraw the amount from the account or encash the fixed deposit
at any moment before the maturity date, the eventuality affects the income
portfolio unexpectedly.
For
management of risk there are certain
measuring tools which help in suggesting the management techniques.
1. Maturity
Gap Analysis. It helps in finding the sensitivity of the interest rate in
relation to the gap between assets and liabilities.
2. Duration
Gap Analysis. This measure the sensitivity of the interest rate to capital
3. Value
at Risk. The analysts attribute this approach to bifurcation of banking
business into segments and so classify the transaction on the basis of the
nature of various transactions. These transactions are classified into Trading
Books and Banking Books. Trading Book assets are consisting on the primary
assets held for generating revenue and making profit by investing for short term whereas the Banking Book comprise on assets and liabilities contracted
for long term relationship and meeting statutory requirements.
The Trading Book assets focus on the price variation whereas the
Banking Book assets and liabilities take care of the economic value of the
entries. This method assess the market risk with the help of statistical
techniques and measures the expected loss over a given time period (interval)
under usual market scenario. Based on a
confidence level Value at Risk Method
is distribution of future probability and not the actual results which will be
known only when the event takes place.
4. The Risk Management Process. To devise an effective risk management program the
banker has to take certain measures before advancing money to an individual, a
group or a company. These measures in fact help the banker to minimize the
chances of possible loss. The initial measures may start from the establishment
of relationship with the customer and it commences from the opening of account.
The Application of Prudential Regulation and introduction of KYC (Know Your
Customer) concept has minimized the chances of fake opening accounts which has
been one of the means of fraudulent operation and unauthorized withdrawal of
money. Thorough investigation about the antecedents of the prospective customer
and thereby guarding against the impersonation has proved instrumental in
minimizing the risk.
a) Identify the
probable or potential loss. Banker often does this by taking into account the
average loss occurred during the previous years.
b) Based on the
past experiences he makes an evaluation of the losses which may occur during
the process of recovery.. The bankers under the directives of State Bank of
Pakistan ahs since started implementing Prudential Regulation and provisions
are made on the basis of the default period.
c) Rejda (1995)
while discussing the risk management process suggested that selecting
appropriate technique or a combination of techniques for treating loss
exposures will avoid the losses.
5. Credit Risk Management Tools. Risks associated with the approval and disbursement of
credit can be minimized using the following tools.
a) Proposal Appraisal: Every credit application must be scrutinized
in terms of its economic and financial viability, future prospects of the
business entity. Availability of inputs and marketability of the product are
core issues and need to be taken into account before taking a credit decision.
Complete resumes of the applicants/ sponsors indicating experience, standing, and
net worth, market reputation, sources of income and financial contribution or
self investment. And complying with KYC requirements minimizes the mishap of
impersonation and fake account.
b) Approval: Each facility
differs from other in terms of purpose, quantum, and collaterals. Depending on
the nature of facility the finance sanctioning authority be defined with
delegated powers. The level of authority will decide on the credit approval
from case to case basis leaving least opportunity to be exploited. Amour (2014) in believed that effective corporate governance
with a broadened vision is prerequisite for risk avoidance. He wrote; “Bank
regulators are turning their focus from balance sheets to board rooms as they
try to forestall the chance of another financial crisis by forcing banks to
better understand and manage their own risks.” Forming of Credit Approval Committees to scrutinize the case and accord
approval has always been help in minimizing the chances of wrong approval. The
central Bank in Pakistan has been issuing instruction in line with envisaged
prudential Regulations which must adhered to while according sanction to
finance/loan applications.
c) Credit Exposure: Besides
collaterals, bank must observe per party limit which describes the eligibility of
single party for availing a finance facility. Where individual borrower is
eligible on the basis of investment in business coupled with collaterals, the
firms and corporate sector entities are financed on the basis of net equity and
minus charge on assets. State Bank of Pakistan i.e., Central Bank of the
country has since fixed limits under Prudential Regulation No.1 which provides
proper guidance on per party exposure limit to banks in allowing finance to
various entities. Under the Prudential Regulation each party is allowed finance
only within the overall exposure limits violation of which renders the bank
liable for penalties.
d) Disbursement procedure. No
disbursement be allowed until all the documentation formalities as envisaged in
the sanction advice are completed.
Verification of documents before and after sanction is equally important lest
fake title without physical securities is accepted which places the bank in
trouble at the time of realization of securities. Continuous verification and evaluation of
securities needs to made part of the responsibility of the disbursing office.
Regular effective monitoring and control system helps in identifying the trend
in business and so the repayment capacity of the borrower. Keeping close
vigilance over the status of a finance /loan the bank must follow the aging
guidelines provided in the form of prudential regulations for in time
classification and initiating efforts for immediate recovery.
e) Per party exposure. Capital
adequacy ratio requirements both in
respect of lending bank and the
prospective borrower helps in
determining the eligibility of the borrower and also power of
banker which limits must be
observed. The existing Prudential Regulation No.1 part-B which has puts limit
on exposure to a single person guides in making credit decisions and links the
bank’s lending power with capital adequacy . The regulations restrict the power
of a banker to the prescribed limit of the bank’s own net equity.
f) Pricing of Loan/ Finance. At
times there was a concept that greater the risk of loss the higher will be the
rate of interest /return. This very concept loses weight when we discuss Risk
Management because raising the rate of interest means overburdening the
borrower and further increasing the rate and chances of risk. Instead, borrower
be selected on the basis of merit which means better and brisk business trend
and worth of the borrower.
g) Diversification of portfolio.
A wise man does not put all the eggs in one basket. The assets allocation be
made on the liquidity preferences. Concentration of exposures will eventually
lead to greater risk ratio. Diversification of portfolio has always been a wise
decision from the banker’s point of view. A scrupulous banker, therefore, never
puts all the eggs in one basket. Also see that lending continues so long as the
business of the borrower shows signs of prosperity and growth. The moment
banker feels that the borrower’s business
shows a declining trend the banker initiates efforts to recover the
amount. Wise banker lends the umbrella when it is shining and immediately
withdraws when it rains.
h) Control Mechanism. A dog’s
watch on the operations in account of the borrower as well as the turnover in
the business of the borrowing entity guides in noticing danger signals. A
downward trend points to cautious treatment lest the default may ultimately
lead to a big disaster. The Lehman Brother and Company of United States of
America collapsed due to imprudent
Mortgage Financing and became one of the causes of Global Financial Crisis.
Therefore, strong and effective audit and inspection and its timely
implementation for removal of anomalies detected on regular basis as well as on
surprise check basis will mitigate the risk of loss. There must be Credit Review System which may periodically
review individual cases in terms of Prudential Regulations No 11 and ensure
that proper in time classified, provisioning is made and preventive measures
are taken before a party violates any of the Regulations.
i)
Insurance Coverage. Till the end of 20th century banks had
mostly been relying on the Insurance Cover to mitigate their risk. Although in
some cases the insurance companies have been helpful in reducing the quantum of
losses caused to a banking unit but the risk still remains associated with the
business because of unpredictable future events. Although the prudent bankers
always make all out efforts to forecast the contingent liabilities, yet 100%
provision and providing cushion has not been advisable in the business of
banking. Again lengthy and complicated claim realization procedure also cost
which expenses are born by the bank exclusively. Then depreciation, depletion
and conveyance losses also reduce the claimed amount in spite of premium paid.
Therefore, insurance policy is one of the risk mitigates and cannot relied upon
exclusively.
Suggestions
Management Control System
For effective preventive measure the designing /development and
implementation of Strong Management Control system is a pre requisite. All efforts for minimizing the risk
will go in vain if the Control system is weak and ineffective. Any loophole in
this system itself invites misappropriation, misuse, unauthorized disbursement
and non recovery due to either connivance or ignorance. An effective system
ensures risk free operation for the achievement of this objective emphasize
upon preventive measures instead of detective. The Management Control System is responsible for plugging
these loopholes by identifying the discrepancies ,irregularities and
malpractice, guiding the organization to improve the performance through strict
vigilance, close cooperation among the various tiers of the organization
and developing the Human Resources to
shoulder their responsibilities with all honesty, efficiency and diligence.
Conventionally banks rely on periodical audit of accounts and inspection. This
exercise is beneficial only to the extent of identification and detection of
the irregularities and discrepancies.
However, the basic issue of risk
remains intact because its elimination or for that matter mitigation preventive measures are required to be
suggested and implemented which audit and inspection fails to ensure. The
observations in audit reports are, no doubt, dealt with through compliance but
the process of compliance remains restricted to the extent of removal of the
discrepancies detected. Independent Management Control System will cater to the
overall efficiency needs of the organization. The System will not only be confined to the monitoring and supervision but give equal importance to
the skill development and behavioral improvement of the Human Resources which,
in fact, plays decisive role in
risk minimizing process of the organization.
Good Governance
Systems do not automatically operate. System is developed to guide and
control the human activities for achieving the organizational goals. The
development of system and its operation will be useful when it has been built
with all expertise .The activity of system building, therefore, needs an honest
team to design and build. Again the operation requires sincere organizational
support for its real success. The management and control system lose its
efficacy if the governing body has ulterior motives and least care for the
proper application of the regulations which have been approved for the conduct
of business smooth and safe. Connivance on the misconduct, least interest in
the application of rules of business, absence of control and check, non
existence of coordination and cooperation among the various tiers of management
encourage the vested interest to exploit and ultimately turn the organization a
total failure. It the top hierarchy which is responsible for the ensuring the
organizational activities to be carried out in accordance with the
predetermined objectives by fair distribution of operational results. No doubt
effective Control System is a key to success in the process of Risk Mitigating
yet the success of Control System lies in its strict implementation by the top
hierarchy. Hence the need of Corporate Good Governance cannot be over
emphasized.
References
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