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Risk Management for Banking Sector
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WEL COME ALL OF
YOU
IN
Briefing session on
RISK MANAGEMENT IN COMMERCIAL
BANKS
ByByMalik DilawarMalik DilawarVice President/PrincipalVice President/PrincipalSenior Training Manager, North,Senior Training Manager, North,UBL Training Centre, Islamabad, UBL Training Centre, Islamabad, Pakistan.Pakistan.Phone: 0092-51-2820674(Off.), Phone: 0092-51-2820674(Off.), Fax: 0092-51-2821521Fax: 0092-51-2821521
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.
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.
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.
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.
Identifying Risks
Where Risks should be IdentifiedInstitution-wideBusiness linesProductsTransactions
Serving the Needs of Depositor
Borrowers and Banks Commercial Bank
lending/Investment involves three parties :
1. The suppliers of funds (The depositor)
2. The users of funds (The borrowers)
3. A financial intermediary (Bank) s
SupplierSupplier BankBank BorrowerBorrower
Challenge in Banking
“Banking is an art of striking a
balance between Risk and
Revenue.”
[Swiss Banking Corporation’s Credit Manual]
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
Loans and Advances [Net of Provisions] 2,785 50.11
Operating Fixed Assets 98 1.76
Capital w-i-p
Other Assets 354 6.37
Deferred Tax Asset 100 1.80
TOTAL ASSETS 5,558 100.00
TYPICAL BALANCE SHEET OF A BANK [Amounts in millions USD]
Assets as per previous slide 5,558 100.00
LiabilitiesDeposits & Other Accounts 4,720 84.92
Borrowings from other Banks, Agents 391 7.03
Bills Payable 90 1.62
Other Liabilities 144 2.59
TOTAL LIABILITIES 5,345 96.16
NET ASSETS [ 1] 213 3.83
Represented By:
Share Capital 203 3.64
Reserves 106 1.91
Other Tier 1 Capital 136 2.45
Accumulated Loss 284 5.11
Surplus on revaluation of Fixed Assets 52 0.94
NET ASSETS [1] 213 3.83
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
Providing Appropriate
Level and
Allocation of Capital
Increasing Return on
Capital
Increasing Return on
Capital
Improving Consistency of Earnings
Improving Consistency of Earnings
The best way to reach this objective is to understand the full risk environment within which you operate...
ExternalEnvironment
Economic Conditions
Competition
Natural Catastrophes
Social/Legal Trends
Political/Regulatory Climate
Technology
Expansion/Diversification
People
Culture
Distribution
Processes
Risk Appetite
InternalEnvironment
Financial RiskFinancial Risk
Asset RiskAsset Risk
Operational RiskOperational Risk
Liability RiskLiability Risk
Business RiskBusiness Risk
Event RiskEvent Risk
…and the complete set of strategies that are available to you...
Financial Strategies
Pricing
Securitisation
Capital Structure
Product Mix
Asset Allocation
Operational Strategies
Incentive Programs
Technology
Internal Controls
Distribution
Products
Customer Service
Market Strategy
Hiring/Training
Asset RiskAsset Risk
Liability RiskLiability Risk
Business RiskBusiness Risk
Event RiskEvent Risk
Financial RiskFinancial Risk
Operational RiskOperational Risk
…and to apply this knowledge in a holistic risk management framework, to drive value
HolisticallyManage
Financial and Operational
Risks
HolisticallyManage
Financial and Operational
Risks
Optimise Financial and Operational
Strategies
Understand Internal and
External EnvironmentC
ap
ital
Retu
rn
Con
sis
ten
cy
Increase Value
To accomplish all this in a consistent manner, it is necessary to implement a continual management process
Develop Best
Strategies
Develop Best
Strategies
Implement StrategiesImplement Strategies
MonitorPerformance and
Environment
MonitorPerformance and
Environment
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 AdvantageProvides Competitive Advantage
RISKS
MUST BE:
- KNOWN
- UNDERSTOOD
- QUANTIFIABLE
- CONTROLLABLE / ACCEPTABLE / BANKABLE
RISKS FACED BY BANKSCREDIT RISKMARKET RISK INTEREST RISKLIQUIDITY RISKOPERATIONAL RISKCOUNTRY RISKOWNERSIP / MANAGEMENT RISK
CREDIT RISKTHE 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
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.
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
LIQUIDITY RISKTHE 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
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.
COUNTRY RISKRISK 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
OWNERSHIP RISKTHE 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”
RISK MANAGEMENTFamiliarisation of Management with
Risks Implementation of Internal ControlsSound Internal Audit SystemEfficient MIS in PlaceCompetent Group of Risk ManagersPrompt Action & Monitoring
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
04/08/23
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.”
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.
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
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, quantified and corrective action initiated.
Principles of Control
Segregation of duties
Dual control
Rotation of assignments or duties
Two weeks continuous vacation
Adequate Compensation
INTERNAL AUDIT SYSTEM
IMPLEMENTATION OF INTERNAL CONTROLS
PROVIDES SECONDARY RISK REVIEW INDEPENDENC.
Objective of Internal AuditThe 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 wherein he can be any service to management
Inspection Procedures for Internal Auditors Work
Organizational Structure of the Audit Department
Independence of the Audit FunctionAuditors Qualifications Audit Staff QualificationsContent and Utilization of the Audit
Frequency and Scope Schedule
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
RISK MANAGERS
QUALIFIED OBJECTIVE ENJOY ADEQUATE AUTHORITY ABILITY TO CORRECTLY ANALYSE FOR
CURRENT ACTION AND FUTURE PREDICTIONS
PROMPT IN ACTION