Risk Management Practices in Conventional Banks - Essay Example

RISK MANAGEMENT PRACTICES IN CONVENTIONAL BANKS Name: Tutor: Subject: Date: Introduction Risks refer to all the things which act as barriers or obstacles to various systems and prevent them from realizing their goals and objectives. The cause of the risks can be environmental factors which can be both external and internal. The risks occur differently depending on the circumstance. In the business world, risks are common and sometimes they are regarded to be natural phenomena. It is therefore vital for the institutions to addresses them early. Early detection and identification of the risks is important because it will assist in avoiding poor end results which they may cause if not identified. Financial institutions especially banks are facing several banks. These risks include: liquidity, market risks and credit risks among many other risks. Risk management is a mitigation strategy which is used to prevent risks in an institution. This discussion describes various risks which affect conventional banks and how the management of those banks implements mitigation strategies. Liquidity Liquidity risk refers to excessive loss of value, extreme cost of transaction and too much time exertion by the bank while allocating the risk to a third party. Liquidity risk mainly occurs due to disparity between assets and liabilities. The outcomes of such mismatch can be either excess cash needs which requires investment or shortfall of cash which calls for funding. The risk also raises the cost of transaction. To prevent liquidity risk from occurring, banks holds a particular amount of liquid assets such as holding account and cash with central bank. Liquidity is also caused by external factors which include: low economic growth, sudden and unplanned withdrawal of government support and sensitive financial market. In most bank institutions, most of the long-term products sold by the banks are illiquid in nature while the short-term products are liquid. There is also a variance between a bank’s depositors, regulators and borrowers which contributes significantly to liquid crisis. The rates of deposit and loans must be high for banks to remain competitive in the market (Akhtar, et al 2011) Ratios are used to measure liquidity crisis in the banks. One of the ratios used is the ratio between liquid assets and liquid liabilities. The ratio is high for the banks with fixed deposit and with minimum government intervention. The other type of ratio which can be used is the ratio between demand deposit and private sector loan. In this ratio, it is assumed that, deposit will create more liquid crisis while the loan is illiquid. The other common ratio is the non-performing ratio (NPR). Due to high disparity in duration of liability assets, the ratio will pressurize the treasury sector (Akhtar et al, 2011). High loan-deposit ratio reserves liquidity. Liquid risk management in the banking sector is required to use financial slack so that it will provide liquidity. The banks can also practice cash transactions, deposits in other commercial banks and certification by the central bank are the practices which helps the banks curb issues related to liquidity crisis. The other strategy they can employ is to expand the financial resources and borrow short-term loans from the central banks (Akhtar et al, 2011). To manage the problem of fluctuating liquid demand, the bank should adapt protective measures. The measures can include establishment of contingency fund plan which will help in addressing emergency of liquidity. Some of the insurance companies help in resolving the issue of liquidity. Credit risks Credit risks describe chances of loss occurrence because of a barrower’s failure to pay his/her debt. There are several causes of credit risks. One of the causes is global financial crisis. This emanated from US sub-prime mortgage crisis. It later spread to other banks across the world. It is also associated with poor management which includes: lack of accountability between the management and stakeholders, heavy reliance on debt, human weaknesses such as greed and attitude and management’s poor knowledge on risks of the sector (Chang C. et al 2011). Management of credit risks requires full understanding of risks in the banks. The management team of the bank should analyze risks at different levels. That is; individual, customer and assortment levels. The assessment of the risks assists the bank to get information from different units within the institution. Credit risk management also involves implementation of integrated quantitative credit risk solution. This solution helps in reducing losses caused by loans. This also creates refined measures for credit risks and reduces monitoring in the institution. There are a number of factors which challenges success of credit risk management. Inability to access the right data due to inefficient data management is one of the contributing factors. Lack of risk management tools is another factor which hinders the success of credit risk management. Most of the banks are lacking group wide risk modelling framework and therefore they cannot develop complex measures which are important in managing risks. The reporting is tiresome making the personnel responsible for the analysis to be overburdened. Market risks Market risks refer to the losses associated to balance sheet fluctuation due to unfavourable market price changes, interest rates, foreign exchange rate and credit distribution. The risks originate from all positions of a bank’s trading book and also foreign exchange and commodity risks presented in the balance sheet. Most of the banks today are engaged with illiquid materials leading to liquidity and credit risks and these are not suitable for the market. To address the issue of market risks in Europe for example, they have introduced material changes in the market risk framework. The European Banking Authority produced some guidelines which are meant for promoting the convergence of the introduced capital requirements such as increment risk charge (IRC) and stressed value at risk (VaR). However, this model and other risk management models have faced criticisms because they were not able to solve European bank crisis of 2007-8 ( Chang C. et al 2011). Management of market risks relies on management of other risks such as liquidity risks, interest rate risks and currency risk management. The other forms of market risk management include data management which is the responsibility of the risk group under operation unit. The data available should be decentralized. The other mitigation strategy for controlling market risks is by developing pricing models and valuations. The conventional banks which develop these are more effective and reflective. It enables calculations to be easy because of the IT use. Market risks should be report early enough so that they can be handled and stopped from causing more damages (Aniunas et al, 2015). Operating risks Operational risk can be defined as losses which occur due to failed or insufficient personnel, systems and internal or external processes. The external factors are mainly natural disasters which damage physical assets of the firm or even disrupt electricity supply. Internal factors are caused by the employee and product risks. To measure such risks, banks need to install databases for monitoring and indicating the risks. The risks should be categorized into “high frequency, low impact” (HFLI) or “low frequency, high impacts” (LFHI). HFLI are mainly caused by small errors in the bank such as typing mistake while LFHI are losses due to terrorist attack or fraud. The firm can take several steps to mitigate operation risks. For natural disasters, the bank needs to insure its assets and establishing backups in order to address the issue of electricity and telecommunication. Internal auditing in the bank helps in preventing the occurrence of internal risks such as fraud and product flaws. Good management information systems such as contingency systems are important in mitigating operational risks. The bank should involve all the members in management of the operation risks (Saunders A. et al 2006) . In the banking sector, compliance risks are becoming complicated and they raise the potential for failed process leading to consumer’s confusion and breakdown in control of compliance. This is because compliance expectations are growing to an extent where banking regulation rules are in adequate to control them. The consequences of operational risks and compliance risks in banks are increased litigation, staffing requirements and penalties. To manage these risks, banks need to simplify products and channels, standardize compliance testing, mange changes, leverage analytics and to employ compliance and operational risk management measures. Interest rate risk Interest rate risk is increasing in the banks as a recent research shows. It refers to the probability of changes in the interest rate to decrease bank’s earnings and reduces its net worth. The main cause of interest rate risk is inconsistence in the bank’s assets maturity such as loans. The liabilities on the other hand such as deposits are more consistent and this difference creates the risk. For example, if a bank is selling mortgage loans which are fixed for 5 years and fund itself with certificates of deposits which matures after one year, then any increase in the interest rate will cause the cash flows from the bank to increase (Turner P, 2014). To regulate interest rate risks, banks perform “gap analysis” which involves grouping of assets and liabilities by their maturity period. This “gap” is expressed in terms of dollar value of assets less liabilities. If the gap is negative, then the bank has large amount of liabilities and this equates high interest rate. The banks can also use advance computer models which enables them to determine interest rate risk on time. They can also take a step of seeking advice from experts on how to manage the risk. In addition, they can engage in financial contracts and this will assist them in transferring some of the interest rate risks to those who can manage them better (Turner P, 2014). Foreign Exchange risk This kind of risks occurs when banks holds assets and liabilities in foreign currencies which affect the earnings of the bank because of the changing interest rate. It is not possible to predict exchange rates because of its fluctuating nature. This behaviour exposes the earnings and the capital of the bank to risks. There are two types of risks associated with foreign exchange. One is translational and the other is transactional risk. Translational risk is associated with account risk which occurs due to translation of assets held in foreign currencies. Transactional risk on the other hand occurs when the foreign exchange rates are unfavourable during foreign currencies transactions (Chance D and Brooks R, 2015). According to Saunders et. al (2006), mitigating foreign exchange risk in commercial banks requires hedging. Hedging is the process in which banks eliminates or reduces risks exposure. The process involves several ways. One of them is matching of foreign assets and liabilities to ensure continuous profitability. Hedging also involves use of derivatives such foreign currency swap, foreign currency futures etc. The process also includes diversification of asset-liability portfolio. By diversification, banks hold their assets and liabilities in different foreign currencies which lower the cost of capital as well as minimizing the risk of foreign exchange. Central banks also play major roles in managing risks of foreign exchange. They give commercial banks directions on how to handle risks and the commercial banks should follow them. Conclusion In conclusion, risk management is important for banks and it is carried out to prevent risks from affecting their daily transactions and other aspects of a bank. These risks include liquidity, market risk, interest rate risks, foreign exchange risk and credit risk. The risk management practices include monitoring, identification, evaluation and controlling the risks on real-time. The banks need to come up with a long term plans which will prevent the risks from occurring. They should involve different stakeholders such as central banks and forming alliances with other commercial banks. Investing on liquid assets helps the banks from experiencing liquidity risks. They should also ensure that there is balance between the liabilities and the assets (Akhtar et al 2011). Thorough research on markets should be carried out to establish favourable conditions and also seeking for advice from experts who can explain the best mitigation practices. REFERENCES Akhtar, M. F., Ali, K., & Sadaqat, S. (2011). Liquidity risk management: a comparative study between conventional and Islamic banks of Pakistan.Interdisciplinary Journal of Research in Business, 1(1), 35-44. Aniūnas, P., Nedzveckas, J., & Krušinskas, R. (2015). Variance–covariance risk value model for currency market. Engineering Economics, 61(1). Chance, D., & Brooks, R. (2015). Introduction to derivatives and risk management. Cengage Learning. Chang, C. L., Jiménez-Martín, J. Á., McAleer, M., & Perez Amaral, T. (2011). Risk management of risk under the Basel Accord: Forecasting value-at-risk of VIX futures. Available at SSRN 1765202. Hassan Al-Tamimi, H. A., & Mohammed Al-Mazrooei, F. (2007). Banks' risk management: a comparison study of UAE national and foreign banks. The Journal of Risk Finance, 8(4), 394-409. Saunders, A., Cornett, M. M., & McGraw, P. A. (2006). Financial institutions management: A risk management approach (Vol. 8). McGraw-Hill/Irwin. Turner, P. (2014). The global long-term interest rate, financial risks and policy choices in EMEs. Read More