Thursday, March 7, 2013

FIs and their Risk Resilience Capacity Building

The share market debacle in the first quarter of 2011 has indicated that banks should have the sufficient resilience capacity against market risks. In addition to that, the recent unpleasant "Hall Mark" scandal has reminded the banking industry of a better resilience capacity against operational risks. Consequently a question has arisen about whether the banking sector has enough preparation to protect their assets from further sequential or other unexpected losses. The speed at which the risk events unfold and the extent of their impacts on the businesses across different risk categories appear to be escalating. When the Barings Bank declared bankruptcy in 1995, the world was stunned. As Britain's oldest merchant bank, Barings, had weathered disasters like the Great Depression and Two World Wars - only to be later brought down by a single man in a small office in Singapore. Nick Leeson, a derivatives trader employed by the bank, took unauthorised speculative positions primarily in futures linked to the Nikkei 225 and Japanese Government Bonds (JGB). For the time being, a big zero was added to his name. For best results, the risk management framework should be integrated across the entire value chain. This is not only complex and costly, it also requires management approval. What banks need is a single platform that centralises, streamlines and automates compliance and information technology (IT) risk management.

The role of the risk control framework is to evaluate the risk inherent in the business activities of an institution and to ensure that these risks don't endanger the institution even in extreme circumstances. However, financial institutions (FIs) have struggled as the current financial crisis has unfolded and many have not been able to withstand the shocks that the financial system has experienced. But exactly why did these failures occur? Well, the diagnosis is clear: industry reports highlight that the risk control framework in many institutions was not robust enough, due primarily to weak governance and lack of understanding of the risks inherent in the business strategies adopted. The reports conclude that risk management reforms are necessary to create stronger institutions and a resilient financial system. The growth of informal settlements, fuelled by urbanisation and migration, has led to the growth of unstable living environments in many countries. Often located in ravines, on steep slopes, along flood plains, or adjacent to noxious or dangerous industrial or transport facilities, the disaster risks for already vulnerable and marginalised communities are exacerbated by their location. Another example: while development choices made to promote water-intensive cash-crops in semi-arid regions may boost local economies for the short term, such practices depend so heavily on canal irrigation that can have serious consequences in the case of even a slight variation in rainfalls. Poor development planning has contributed therefore to increased exposure to drought risks in many arid and semi-arid regions of the world.

Recognising the relationship between development and risk and investing in disaster risk reduction can lead to better development practices which are also cost-effective. Here that risk can be modelled and analysed-and there is enough accumulated experience - in both developing and developed countries-to manage it if the appropriate strategies and measures are put in place.

Bank and non-bank financial institutions are the most important financial intermediaries in every economy. Not only this, banks have an important role to play in blood circulation of the economy and the ultimate result of growth. Therefore, close regulated operation and their safety from potential threat are very much essential for economic growth and activities. An adequate risk resilience fund that is capital is required to protect depositors' interest and to ensure the survival of banking business. However, the banking sector or the financial sector as a whole is passing an invisible liquidity crisis which is ultimately slowing down investment. In Bangladesh, banks are fairly allowed to invest in the capital market. Therefore, it is required to analyse the real development of the risk resilience capacity of the banking industry after the BASEL-2 implementation. Risk management is becoming a crucial part of the business strategy. Without it, thousands of people are adversely affected - shareholders, bankers, employees, customers and even the government who spends millions of dollars trying to bail a bank out. Developing a risk management framework can be extremely challenging. Banks need to analyse risk reports, assess and test controls and choose the appropriate risk mitigating strategy. Adequate capital then has to be allocated. The whole process can be costly in terms of money, time, effort, technology and personnel required.

In terms of raising quality, consistency and transparency, it is important that banks' risk exposures are backed by a high quality capital base. The crisis has demonstrated that credit losses and write-downs come out of retained earnings, which is part of banks' tangible common equity base. It has also revealed the inconsistency in definition of capital across jurisdictions and the lack of disclosure that would have enabled the market to fully assess and compare the quality of capital between institutions. The BASEL-II framework increased the risk sensitivity and coverage of the regulatory capital requirement. Indeed, one of the most pro-cyclical dynamics has been the failure of risk management and capital frameworks to capture key exposures. However, it is not possible to achieve greater risk sensitivity across institutions at a given point of time without introducing a certain degree of cyclicality in minimum capital requirements over time.

Financial recession in 2008 which had hit the world drastically changed the scenario of global business and economy. The crisis transmitted into the financial system rapidly as their currency, dollar, is systematically a vital currency. These experiences are now influencing policymakers to implement BASEL-I and BASEL-II and so on, in achieving good economic outcomes. Almost all stability reports after the financial crisis suggested structural changes in the financial sector, especially their risk management capacity. High debt burdens and weakened balance sheets are still extending the crisis, especially in advanced economies. In a business environment characterised by natural disasters, vandalism, terrorist attacks, epidemics and technological failures, it is imperative to implement an effective business continuity plan. Banks should develop a recovery strategy that targets technical systems, management and employees. So it is clear that risks are faced enormously in different financial institutions. But by following the BASEL II requirements, they can work towards building a safer financial system and improving customer and investor confidence.

Risk resilience capacity is defined as improvement of a risk absorbance fund and a fall in lending default rate. Not only the capital enhancement but also the decreasing nonperforming load will be treated as improvement of the risk resilience capacity. However, the risk-assessed adequacy measurement always carries some uncertainties. In general, risk can be defined as the, "Probability or threat of a damage, injury, liability, loss or other negative occurrence, caused by external or internal vulnerabilities, and which may be neutralised through pre-mediated action." In the financial sector, risk is defined concerning some special market factors and other externalities which can affect an individual or organisation's decision. In finance, risk is defined as "Probability that an actual return on an investment will be lower than expected." Every business encounters risks, some of which are unpredictable and uncontrollable. Risk management is a central part of any organisation's strategic management. Risk management involves identifying, analysing and taking steps to reduce or eliminate the exposures to loss faced by an organisation or individual. The practice of risk management utilises many tools and techniques, including insurance, to manage a wide variety of risks.

A bank's attitude to risk is not passive and defensive, a bank actively and willingly takes on risk, because it seeks a return and this does not come without risks. Indeed, risk management can be seen as the core competence of an insurance company or a bank. By using its expertise, market position and capital structure, a financial institution can manage risks by repackaging them and transferring them to markets in customised ways.

Mostly the US dollar is used in the global financial system. The dollar monopoly is also prevailing in the international transactions across the globe as most of the transactions are pegged with the dollar during quoting or exchange rate determination. That's why, the US dollar gains extra demand from outside. Since implementing the BASEL II framework in 2009, the banking sector's risk resilience capacity has moderately improved. In fact, real improvement of risk management also depends on reducing probability of default, especially lending default rate. The overall improvement can be determined by analysing the trend of banks' lending default rate,.

The BASEL framework is working effectively in the banking sector in Bangladesh and it helped improve the risk resilience capacity. This improvement may not be sufficient to face the potential unexpected events but it has a significant role in reducing banks' lending default rate. However, the recent banking scandals signal the necessity of further qualitative improvement of the risk management culture in the banking sector. Any dual control or government intervention in banks' corporate governance is no longer wise, when it comes to the total banking system. In the lead-up to the crisis, too often amid the clamour for ever higher returns, the voice of reason was not heard and risks were ignored. The crisis has exposed this and has revealed significant shortcomings in the risk control frameworks of financial institutions. In particular, the failure to properly assess the risks inherent in business models, in portfolios, and in off-balance sheet activities has become evident. Consequently, rebalancing of risk and return is required to ensure resilient institutions and a resilient financial system. To achieve this, strengthening of the risk control framework is needed so that our financial institutions are ready to face the challenges that lie ahead. Such a framework needs to put risk management at the heart of the strategy and decision making processes of each institution. The framework should be supported by the twin pillars of risk analysis, that is a suite of statistical risk models to provide a measure of the different risks faced by the institution and a comprehensive stress testing programme which consists of a more judgmental and coherent risk analysis based on scenarios that the institutions may be facing in the future.

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