A Critical Review of the Current Risk Management Activities of Bank of America - Essay Example

? Provide a critical review of the current risk management activities of any one (large, international) financial of your choice ContentsContents 2 Introduction: Bank of America 3 Discussion 4 The appropriateness of their definition of risk appetite 4 Risk Appetite 6 Risk Appetite 7 The effectiveness of their Enterprise Risk Management Framework 11 Whether their corporate governance arrangements support their risk management activities 13 Conclusion 15 References 17 Introduction: Bank of America Bank of America is the second largest bank in United States and is rated among the top the four banks of US. The bank of America has its financial and banking services spread all over the world in 40 countries. Bank of America completed the acquisition of Merrill Lynch in 2008 to become one of the largest players providing wealth management services across the world. The services of Bank of America are accessed by majority of the US population and also holds considerable market share in the financial markets in different countries. Bank of America is also a popular name in the investment banking services provided to the customers in the finance industry. The growth of the financial services have been largely due to the effective strategies of the bank in investing its funds in the areas that have higher probability of generating returns at the cost of incurred risk. Bank of America provides a wide range of banking and non-banking financial services to its customers in several markets all over the world. The customers of the banks includes the corporate houses, individuals and even the government as they need financial management for managing their wealth as well as their investments. In the initial stages of the year 2012, Bank of America was able to expand their business in the US economy with the spurt in consumer expenditure and business investments. However, the investment banking and the wealth management operation of bank of America slowed down due to the end of tax incentives offered to the business as policies of the government. In such a scenario of slowdown in the business in vestments and the crunch of liquidity in the economy, the sustenance of the banking and financial services in almost the scale of growth as achieved earlier was subject to risk. Due to the global financial recession, the European markers of Bank of America slowed down in the face of decreasing demand followed by the decline of consumption expenditure and business investment. In order to manage the risks associated to the business of banking and financial services in the face of economic slowdown, Bank of America have taken active measures to restrict the losses due to funding and liquidity risk, credit risk, foreign exchange risk, interest rate risk, etc. The risk management practices have helped Bank of America to be resilient to the shock of economic recession in US and also provide best financial services solution to all of their customers. Discussion The appropriateness of their definition of risk appetite The risk appetite of Bank of America has been defined according to the prevailing economic conditions in the several markets in which the bank operates. The global financial turmoil and the varying performances of US, European and Asian markets have led the bank of America to define upper and lower limits of risk appetite. The range of risk appetite has enabled the organization to decide on the extent of risk to be undertaken in funding and liquidity arrangement, credit offered to their global customers and the uncertainties in the fluctuation of interest rate and foreign currencies (Handlechner, 2008, p.84). The definition of risk appetite of the organization also looks at the return on investments and the return on equity of the organizations. A review of the empirical literature shows that the risk-return trade off has been increasingly important for the organization in the financial markets. The higher risk level associated to the investment of funds of the financial services indicates higher fluctuation of returns on investment. Due to the increasing volatility of the market conditions and company specific risks, the returns are also subject to risk. The acceptance of higher level of risk of Bank of America has the underlying objective to attain high return on investments and thus maximize the wealth of the shareholders (Bank of America, 2013, p.5). The financial services units of Bank of America have, therefore, defined their risk appetite that is appropriate for the organization objectives and goals. The risk appetite is the amount of risk that Bank of America is ready to incur in the course of its business by being indifferent to the losses that could result from the risky ventures. However, risk appetite does not mean that the organization would invest blindly in avenues that offers higher rate of return. The various areas of business risk in which Bank of America has defined its risk appetite are the funding and liquidity risk of the company in the US and foreign markets, the credit risk, the interest rate risk, foreign exchange risk, etc (Khatta, 2008, p.28). The Bank of America has defined a lower and a higher limit of risk appetite in evaluation mortgage based securities that are accepted for the loans and leases provided to their customers. In case where the mortgage based security is less risky than the risk appetite of the bank, the funding arrangement to the customers are reviewed as this does not fall in line with the objectives of maximization of equity of shareholders. The funding arrangement is sanctioned by the management of Bank of America where the risk of funding lies with the capacity of defined limits of risk. In cases where the risk of funding is higher than the risk appetite, Bank of America has taken corrective action for balancing the risk with the rate of return of the funding arrangement. The bank implements its resolution and recovery services in cases where the risk exceeds the risk appetite of the bank. The same definition of risk appetite has been found to be appropriate in other areas of risk management practice of bank of America. Bank of America being a multinational financial services organization is subject to fluctuation of interest rates as set by the central banks. The fluctuation of interest rates in the economy leads to variation of interest earnings of the bank (Conrow, 2003, p.62). The bank generally offers credit where the interest rate fluctuation falls within the upper limit and below limit of interest rates fixed in their risk appetite capacities. The fluctuation of foreign currency also poses risk to the operations of the company. The financial services in the overseas markets achieve varying returns due to the variation of foreign currency. The bank undertakes investment banking, wealth management and commercial banking services where the calculated risk of foreign exchange fluctuations falls within the upper and lower limits of risk appetite. In order to adhere to the capacities defined for acceptance of risk for several business functions like credit, funding of loans, investment banking and wealth management services, Bank of America has set up a strong system of corporate governance for controlling the activities and the decision taken for sanctioning the investment of the organization in both domestic and foreign markets (Jolly, 2003, p.91). The organizational structure of Bank of America includes control functions like audit and compliance which ensures that the bank functions as per the policies of the organization and engages in investments where the risk matches the risk appetite of the organization. Risk Appetite It is the amount and type of risk which an organisation is willing to retain or pursue. Risk Appetite is a method which helps an organisation to approach the risks faced by an organisation. All organisation face a level of risk when in operation, and it needs to be reduced. Risk appetite can be defined as the variability in the results which senior executives of an organisation is prepared to accept in cognisance of the strategies which they have undertaken. The definition of risk appetite also includes the fundamental reviews and concerns of all the key stakeholders of the organisation along with the implications it will have on the corporate strategy (Chew, 2008, p. 31). Each company has its own risk appetite statement which addresses all the requirements of the company. Each of the individual elements of the risk appetite statement is allotted a tolerance level. The organisation should choose whether the risk is acceptable or it is undesirable. The risk appetite statement includes quantitative elements like debt rating, exposure concentration limits, minimum leverage ratios and cash flows at risk limits. It also includes other qualitative factors like minimum regulatory standards and operational risk tolerance levels. There are many levels to risk appetite of an organisation. The first level is Strategic. At the strategic level, risk appetite is mainly about risks which the organisation has a comparative advantage in managing it. Such level of risk appetite is also about deciding which types of risk the organisation needs to protect itself from. Another level of risk appetite is Tactical level. This represents the gap between strategic formulation and implementation. There are many organisation which struggles to implement the strategy which they have developed. The third level of risk appetite is Operational level. Companies face this risk while delivering the products and services. Hence they need to exercise appropriate control when doing their operation (Collier, 2012, p. 274). Figure 1: Risk Appetite Risk Appetite Credit risk is the risk of loss which the bank faces in the form of loss of their clients if they feel to meet the obligations due to deterioration in their risk rating. Losses may occur due to the reduction in their income and then re-negotiation is done by the bank to recover the cost whatever they can. There are many components within the definition of Credit risk. These include credit risk of counterparty, transfer risk, country risk, and possibility of the disbursements to honour the guarantees, joint obligations, securities, credit commitments and other operations which is of similar nature (Culp, 2002, p. 321). All the financial transaction of Bank of America Merrill Lynch which involves counterparty results in risk exposure for the institution, causing losses directly or indirectly. Hence the main goal of BofAML is establishing the procedures for the appropriate credit risk management and also maintaining the exposure levels which are compatible with their risk appetite. Hence the bank needs to assess the credit risk of each counterparty, its products etc. which are essential for continuation of their operations. The Credit Risk Policy of BofAML has to ensure that it has a robust risk management governance framework, systems, controls and practices which are in line with the Global Credit policy, the prudential principles, laws and rules. It has sufficiently robust credit risk policy which is adequate for the managers to manage the risk. Depending on this kind of framework, the Board of Directors and Credit Risk Department of BofAML takes actions in assessment, control and monitoring the credit risk. The Credit Risk Policy of the Bank assigns the Credit Risk Committee with a function which reviews and approves the policies, systems, processes, controls and local limits to provide a suitable framework for the management (Doherty, 2000, p. 152). Figure 2: Exposure Amount Subject to Mitigation by coverage percentage The Market Risk is the risk of losses due to fluctuations in the equity prices and other market related factors like interest rates, foreign exchange rates, assets prices etc. The component of Market risk structure consists of the clearly documented strategies and policies which establishes limits of maintaining the market risk exposure within levels acceptable to BofAML. The Market risk management of BofAML includes identification and measurement of existing and the potential market risks. It also includes mitigating and controlling of risks by using policies and procedures of the bank, monitoring the risk levels and adhering to the BofAML’s appetite for the risk and reporting the same to both the Board of Directors and also to the regulators (Fraser and Simkins, 2010, p. 211). BofAML uses Sensitivity Analysis for measuring the impact any changes in market specific factors have on their portfolio value. They have a Local Market Risk department which analyses and reports daily this measure to the relevant Business Units. Apart from sensitivity analysis the Local Market Risk department also uses VaR, stress testing to indicate the exposure levels. With the help of VaR, BofAML can measure the total potential losses it faces for the entire portfolio. BofMAL calculates the VaR on a daily basis with a confidence interval of 99% and having a horizon of 1 day. Figure 3: VaR Values The Operational Risk is the risk of losses which a company faces due to unsuitability or failure of the internal processes, systems and people or other external events. Such kind of risk can occur in any part of the BofAML and it need not be limited to only the operational areas. Its effects can extend beyond the financial losses. They have specific standard for maintaining the operational risk management which is in line with Basel II guideline. The Basel II requires that banks have appropriate operational risk management framework so that they can assess and measure the risk exposure and ensure that the bank has appropriate capital reserves for catering to the risk. The main elements of the operational risk management program are Risk control self-assessment, analysis of the operational loss, Scenario Analysis and KRIs. Liquidity risk is the risk faced by an institution when they are unable to meet their short term, midterm or long-term obligations because of insufficient resources. With an efficient management of liquidity risk the organisation can have the ability to meet the cash flow obligations under both normal times and uncertain times (Harrington and Niehaus, 2003, p. 176). The main objective of the liquidity risk management is developing a strategy so that BofAML is able to meet the occasional and contractual obligations the face during the market cycles. It is the responsibility of the Liquidity Risk Director for supervising the daily Liquidity Risk management, monitoring it and controlling it. He has to maintain proper communication channel with the Liquidity Risk department and Corporate Treasury department. It is the responsibility of the Liquidity Risk department for identifying the main factors of Liquidity Risk, and monitoring and measuring it. Once they have been able to identify the relevant factors, they should analyse the factors and do stress analysis on those factors to look at their performance. The Liquidity Risk Departments are responsible for all the liquidity factors are included in the system so that they can present a proper picture in front of the shareholders. The Bank of America does a Liquidity Gap analysis to anticipate the cash needs of the organisation which will impact the liquidity of the bank. Bank of America Merrill Lynch adopts this cash flow forecast so that they can get a future view of the flow of funds. This projected analysis helps BofAML to assess the cash generation capacity to meet the cash outflow from market volatilities and activities. Bank of America Merrill Lync projects their cash flow for a minimum period of three months. It is the duty of the Liquidity risk departments to daily monitor the whether there has been any violation in the present liquidity limit (Skipper and Kwon, 2007, p. 78). There is a need of reporting the monthly summary of approvals which are needed in case of any violation of liquidity limits by the bank. It also has to analyse the stress results. For Bank of America, Individual accountability is at the heart of their risk culture. In June 2006, BofAML has replaced the existing 1988 Basel Capital Accord and replaced it with new Basel Capital Accord commonly known as Basel II. Hence they have adopted such policy to promote safety and soundness within their bank by maintaining appropriate capital and thus enhancing the competitive equality and establishing a comprehensive approach while addressing the risks (Bessis, 2011, p. 351). Hence we can conclude that the risk appetite of Bank of America Merrill Lynch is high. The effectiveness of their Enterprise Risk Management Framework Enterprise risk management (ERM) includes methods and processes which are used by organisations to manage their risks and hence seize the opportunities to achieve the objectives of the company. Through this process, the company identifies a particular event which is relevant to the organisation’s objectives like the risks and opportunities associated with it. By identifying the risk and opportunities, business enterprises create value for the stakeholders like employees, owners, customers and regulators. Bank of America Merrill Lynch has a well-defined enterprise risk management system which mitigates and reduces the amount of risk faced by the bank. For Bank of America Merrill Lynch the market, credit and operational risk were the most important risk faced by them. These risk needs to be considered by the risk management committee of the bank as these were severely tested at the time of the financial crisis. Bank of America merged with Merrill Lynch to form the new Bank of America Merrill Lynch during the financial crisis. This suggests that they were under put under severe pressure at a result of the financial crisis. But Bank of America was able to avoid major credit default risk. The Loan products like lines of credit, credit cards and mortgages have high degree of risk and are turbulent in times of economic downturns. Bank of America was successfully able to avoid the difficult situations. They used to regularly employ a credit-risk management process which used to monitor and assess the credit portfolios (Nawalkha, Soto and Beliaeva, 2005, p. 321). The Corporate Investments Group (CIG) manages the Bank of America’s portfolio which is available for sale. They are responsible for calculating and modelling the probability of default on 9.5 million mortgages. The group also calculates the prepayment speeds, market value and sensitivity analysis in respect to changes in the interest rates. They have been able to provide the users with a robust platform to prioritize the jobs based on the computational requirements. With the help of CIG group Bank of America was able to counter most of the risk during financial crisis time. We can also see that the Bank of America Merrill Lync has a good operational risk framework through which they can quantity the operational risk losses. To further mitigate the operational risk of the organisation, they have improved the product approval process so that they can deliver loans at a much faster rate. Also they review their existing products and services continuously to keep it up to date with the changing economic scenarios. This overall discussion shows that Bank of America Merrill Lync has an effective risk management framework and constantly trying to improve the same. They can also face new risk due to change in economic scenarios and new products into the markets. Hence they are trying to incorporate changes in their risk management process. Whether their corporate governance arrangements support their risk management activities Bank of America has a Corporate Governance Committee which oversights the governance process of the company. It deals with the identification of the company’s material risks, and planning accordingly to mitigate that risk. It includes credit risk, operational risk, liquidity risk, interest rate risk, reputational risk, regulatory compliance risk and legal risk. IT also includes risk relating to the liquidity planning and capital management. The company maintains high ethical standards and effective practices to protect the reputation of the company. The bank develops and implements annual financial plan to oversight the strategic business plan of the bank. There is a separate committee for designing the compensation programs for employee along with looking at their benefits plans. The Board of Directors is responsible to monitoring, reviewing and approving the succession plan of the Chief Executive Officer along with other executives. The company has several committees looking at various governance issues of the bank. There is Enterprise Risk Committee which looks after the Risk aspects of the company. This committee identifies, manages and plans for the material risk of the company. Again there are other committees like Corporate Governance Committee, Executive Committee, Credit Committee, Audit Committee and Compensation and Benefits Committee. All these Committees look after the daily affair in their respective domains so that the Bank as a whole has Good corporate Governance (Deventer, Imai and Mesler, 2013, p. 24). Risk is inherent for every activity that the company undertakes. The company has described the risk management practices and policies in the report named Management’s Discussion and Analysis of the Financial Condition and the Results of Operations in their annual report. The company chooses the risks and evaluate their capacity for risk and as a result seek to protect their brand and reputation, value of their assets, their financial flexibility and strategic potential of the company. Hence to achieve the goal the company must build a comprehensive risk culture within the company though proper governance implementation. The Different Committees which handles risk of the bank are as follows. Audit Committee oversees the identification of the credit exposures for the entire enterprise. It deals with the compliance with regulatory and legal requirements along with the overall effectiveness of their internal control system. The Audit Committee takes into consideration the risk of the various committees and discusses the management policies and guidelines so as to govern the process of risk assessment. Credit Committee looks at the identification and management of the credit exposure of the whole enterprise in response to the market situation. Enterprise Risk Committee looks after the identification, management and planning of the risk for the entire enterprise. Such risk includes interest rate risk, market risk, reputational risk, liquidity risk and operational risk. This committee also looks after the capital management and liquidity planning. Compensation Benefits Committee looks after the compensation policies and practices such that it does not encourage excessive risk taking by their employees. Each of the above committees has to report regularly to the Board of Directors on these risk-related issues so that it collectively gives the Board an integrated view of the enterprise risk. The leadership structure of the board is consistent with the risk appetite of the company. Conclusion The Risk appetite of a business influences the business decisions of all the corporations. It changes the way a business is managed run. The company focuses more on the impact such risk can have on the solvency of a company. Bank of America faces many risks as per the market. The major risks faced by the company are credit risk, liquidity risk, market risk, operational risk. The Bank has different committees catering to these different kinds of risk. Hence the bank has been able to successfully mitigate the risk faced by it. At the time of financial crisis it was able to mitigate the risk and they have a high risk appetite. They have a good governance practice being implemented in their system which helps them to mitigate the risk. It ensures that the company has a comprehensive annual risk assessment process which they use to mitigate the risk faced by them. It has established limits for the legal, compliance and reputational risk which are analysed by the board of directors. They also have a supervisory guidance of Board of Directors which ensures that the risk faced by them is in accordance with their risk appetite. The bank engages in the activities of financial services in the domestic and the foreign markets by taking into account the risk of the investment and the expected return from such avenues. The risk appetite has been defined appropriately according to the economic conditions of the market. The risk appetite has been quantifies with the setting of upper and lower limits of the risk that is acceptable for the organization. The corporate governance structure and the legal and compliance teams ensure that the funding and investments by Bank of America contain the risk that falls within the range of risk appetite. A lower risk as well as higher risk of investment of funds is unsolicited for the sanctioning of the investment decisions. The lower risk would result in lost opportunity for maximization of return whereas uncalculated risk taking beyond the risk appetite could result in erosion of shareholders’ wealth. These are taken into consideration while undertaking risk management practices in bank of America. References Bessis, J. 2011. Risk Management in Banking. New Jersey: John Wiley & Sons. Chew, D.H. 2008. Corporate Risk Management. New York: Columbia University Press. Collier, P.M.M. 2012. Fundamentals of Risk Management for Accountants and Managers. 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