Risk Management in Banking - Essay Example

ANDREW BANK RISK MANAGEMENT CASE STUDY 29TH FEBRUARY Assessment Task Risk Management Models Introduction Financial institutions face many risks which affect their operations, and that need to be analyzed critically using the most appropriate risk management models. Risk management involves recognition of risks, critical examination of their various impacts, and selecting the best method of avoiding or reducing their effects. This thesis is divided into three sections, which critically analyze risk management models and the risks facing Andrew Bank Ltd. The first part covers the problems associated with using risk management models, the second part explains the ways which can be adopted to improve the use of the models, and the last part outlines three risks that are likely to face Andrew Bank Ltd. Problems in using Models The new deposit account offered by Andrew Bank Ltd. may have a number of unforeseen risks, since the response of the target customers is unknown. Therefore, the management of the bank must adopt a risk management model that is effective enough to identify the future risks, the bank will be exposed to after introducing the Abide a Wee While Deposit Account. In order to measure risk, the key factors or risk factors that are likely to cause unpredictability in the returns from the new account should be considered (Crouhy, Galai and Mark, 2006). There are a number of problems associated with models of risk management, and which will help analyze the risks likely to face Andrew Bank after introducing the new bank offering. Some of the problems are discussed in details below. Risk management models are expensive in terms of, production and implementation: Creating a risk management model consumes a lot of time, since all the risk factors must be adequately analyzed, and all necessary information considered. The risk analysis manager must make sure that all the risk factors are identified, and that the relevant data concerning the factors is collected, so as to make more accurate predictions about the future. The risk factors that need to be considered include; lending rates, economic conditions, government policies and political environment among other factors. Models may be even more expensive, in situations where they prove to be ineffective, for example, where the model employed improperly manages an expected risk. The cost of preparing a model may even go higher, since its preparation require experienced personnel who must be compensated for their services. The models may not be reliable: Due to the unpredictable nature of the future, models can not be a hundred percent accurate. Therefore, a rigid model may lead to poor planning and poor decision making. For example, a company may predict an economic growth rate 5 percent in the next year and decide to borrow a long term loan so as to buy machinery. In a situation where the company’s predictions are less than 5 percent, its repairmen of the loan may be difficult. In Andrew Bank Ltd’s case, a model may proof to be unreliable where it predicts that the economy will grow and so it decides to offer low interest rates in its new Abide a Wee While Deposit account. Where inflation occurs, which is in opposition of the bank’s predictions, the bank will be in big problems. Insufficiency of data used in decision making concerning risks: Past and present data is vital in prediction of future events and activities. Relevant data should be collected necessary for decision making concerning an identified risk. Where data is inadequate, the plans or decision made may not be accurate or reliable. For example, a bank lacking adequate information may increase its lending rates in cases where there is an expected increase in money supply by the region’s central bank. The banks’ customers will look for loans from other banks, and therefore, ignore the bank resulting in low profits of such a bank. This shows that data and information relevant to a particular risk factor is necessary, in order to make accurate decisions. Risk appetite and risk measurement: Measurement of risk very important and a model should have the capacity to quantify the risk so as to verify a company’s ability to risk. The most challenging part of risk measurement is the methods employed in quantifying. Though different methods may be used, they do not give similar answers. A corporation should choose a risk measurement method that suits its needs and is flexible enough to meet the industry dynamics. Where the risk measurement method is appropriately chosen, a company can properly decide on its risk appetite and so it can not surfer beyond its capacity in the occurrence of the risk. For example if the risk manager of Andrew Bank Ltd utilized the most appropriate method of risk measurement available, the bank can effectively make decisions on minimum requirements to take a loan in its new Abide a Wee While Deposit Account. The bank can also make decisions on lending rates and implementation of other strategic plans. The model should also show the expected payoffs compensate for the risk taken which triggers risk appetite. Poor communication in the organization may be a challenge in the management of risks, especially in a situation where a bank such as Andrew Bank Ltd is introducing a new product: When dealing with risks associated with the decision of introducing the Abide a Wee While Deposit account, staff may lark information about the laid down strategies and so the risk are more likely to affect the bank. A risk management model is likely to be ineffective, as it larks support from staff. The staff may also lark the skills to execute proposed plans of dealing with risks associated with the introduction of the account. Training of staff may also be an additional cost which will result in more challenges in the implementation of the risk management model. Improving the Use of the Model A risk management model should be cost effective. Production of the model should not be too expensive in a way that a corporation may not afford. A model used by Andrew Bank Ltd should be cost effective so that it does not affect its cost structure and profitability ratios. The model should be tailor made so as to be suitable for the bank’s needs. A tailor made risk management model ensures that, the cost of its preparation is kept at its minimum, and that it is also well suited for its specific purpose. A tailor made model will also ensure that, all the risk factors are considered and the most appropriate decision made. The flexibility of the risk management model should be improved. The risk manager should identify the various risks Andrew Bank Ltd is exposing itself to by introducing the new Abide a Wee While Deposit account. The various risks associated with the decision will require new or improved risk management models. Therefore, a risk management model should have the capacity to be changed so as to fit with the business environment changes. Other unidentified risks may arise and in such a situation risk management model should be created without delay so as to deal with the risk, thus the need for a flexible risk management model. To improve on the reliability of the model, the bank should have the ability to identify all the risk factors involved in a given decision, and ensure that all the essential data is collected and the unnecessary data and information left out. A reliable risk management model should predict the future activities and situations likely to have an effect on a business negatively with highest possible certainty. The risk manager should exhaustively scrutinize all the risk factor the business is exposed to due to the decisions made by management, political leaders and the central bank of a given region. The accuracy of forecasts made by a model largely depends on past and present data and information. The essential data collected should be stored so that the forecasts made are more accurate with less allowance of unforeseen events and activities. Andrew Bank Ltd should have a well defined risk appetite. This means that, the management of the bank should clearly specify what value of money it is willing to risk when introducing the Abide a Wee While Deposit Account. This will be one of the precautions the bank will have put in place, so as to manage its risk exposure and make sure that the bank does not risk more than what it can loose. To arrive at the amount the bank is willing to risk, the risk must be measured using the most appropriate method to establish the worst outcome incase the risk occurred and its impact on the operations of the bank. If the impact is going to affect the bank to a large extent, then the bank should trim down its risk exposure by reducing its risk appetite. In case the risk is not going to affect the bank to a large extent, it can raise its risk exposure which might also increase its profitability if the predicted risk does not occur. Some of the methods that can be used to examine risks and their impact on the business are using probability ratios. This method is simple to use and understand. The bank’s plans and goals should be effectively communicated to the staff involved in their achievement. This will ensure that the employees are not only dedicated in achievement of the goals, but they will have the knowledge that their effort should be inline with the goals of the bank. In case of managing the risks related with the introduction of Abide a Wee While Deposit account, effective communication will ensure that all the employees understand the part they have to play in avoiding or reducing the effects of the risks. Assessment Task 2: Three Main Risks facing Andrew Bank Ltd Like all other commercial banks, Andrew bank faces many forms of risks which are generated by the frequent business environment changes. Risks that the bank may face can be dealt with in different ways. Some risks can be done away with or evaded by simple business practices such as forecasting and looking at past data and information. Risk avoidance involves actions which reduce the chances of losses caused by unwise decision making through the elimination of risks that are superfluous to the bank’s business goals. Other risks can be moved to other participants in the business like for example, customers and the government. Other risks which cannot be avoided or transferred must be actively managed at the bank’s level. These are the risks that are under the control of the management although they may be influenced by uncontrollable risk factors such as inflation, government policy and political instability. Interest Rate Risk This risk arises in a situation where the value of an investment is expected to change due to a change in the interest rate. In such a situation, a bank may experience losses which are cause by the rising interest rates which force the bank to compensate relatively more on its deposits than what it receives on its loans interests. The Andrew Bank Ltd’s new Abide a Wee account may result into such a risk, as it is a deposit account. The bank may receive low interest from its loans due to government regulations and competition from other financial institutions. The risk manager of Andrew Bank Ltd must in this case, analyze all the causes of the interest rate risk before making a decision on how to deal with such a risk. This risk should be ranked first among the three risks, because of the bank’s decision of introducing a new deposit account which exposes the bank to more interest rates risk. This risk should be considered top most since its effect are more expected and controllable by the management of the bank. Liquidity Risk One of the risks that Andrew Bank Ltd may face is the risk of liquidity. Liquidity risk may arise where a large number of customers who have deposited their money in the bank decide to withdraw in surplus of the available funds (Joseph, 2006). The funds may be in shortage due for the reason that, the bank is as well in the business of lending money. This situation may arise where the terms and conditions of the new Abide a Wee While Deposit account have turned out to be unattractive, that is the interests earned from the deposits are too low compared to other deposit accounts in other banks and therefore, most of the customers are requesting for withdrawal. An example of a liquidity risk is the bank’s running during the great depression of the 1933 in United States of America, where customers withdrew their money for fear of the banking industry’s collapse. The effects of the risk of liquidity may even be more detrimental to the Andrew Bank Ltd where the economy is experiencing inflation. In such instances, people tend to spend more on the necessities which are more expensive at such times. The customers of the bank will tend to ask for more loans, in order to meet their necessities. On the other hand, those who have deposited in the Abide a Wee While Deposit account will tend to withdraw, a situation likely to result into liquidity risk. The risk manager of Andrew bank should be in a position to analyze the lending rates of the bank so as to avoid these risks. This risk should be considered after interest rate risk, since the deposit account may offer unattractive rates to its customers, who may choose to withdraw their deposits, a situation which may result into the risk of liquidity. Credit Risk Another risk that Andrew Bank Ltd may face is the credit risk. This risk arises where loan borrowers are unable or unwilling to finance their loans. An international example of credit risk can be shown by the Asian crisis of September 2001, which was caused by changes in government policy that lead to increase in bank rates, rendering the loan borrowers unable to service their loans. Inflation may result in credit risk to financial institutions since lending rates rise insignificantly which greatly affects the borrowers’ power of financing their loans. The operations of the bank may be greatly affected since it may lose some of its funds to the defaulters, especially where the number is too high. Other uncontrollable risk factors may result to credit risk to a financial institution. The external forces that affect all businesses and households within the society or economic system include bankruptcies, stock market declines, and unemployment, among other factors. These factors contribute to the decrease in earnings of individual households making it impossible to repay the finances used to invest in their economic activities. Similarly, political risk factors such as military coups, new elected government policies, wars, terrorism, international isolation, and many other factors may impact the quality of a credit asset which leads to losses and later credit risks. Although caused by uncontrollable risk factors, the management of a financial institution such as Andrew Bank Ltd may make some strategic decisions in order to counteract the effects of credit risks. The bank may carefully choose what countries to operate in, by analyzing the political stability of the region and its potential to grow. The bank may also diversify their risks by extending credit to a range of customers. References Crouhy, M., Galai, D. and Mark, R. 2006. The Essentials of Risk Management. New York: McGraw Hill. Joseph, C. 2006. Credit Analysis: A Tryst with Strategic Prudence. New York: McGraw Hill. Read More