Dissertation on Importance of the financial system
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The Intermediation Process and the Allocation of
Resources
The importance of the financial system in
facilitating economic development cannot be overstated. Banks and other
financial institutions have a key role in the efficient allocation of resources
and as such, sound financial systems are systemically important to the economic
viability of a country.
The Asian Financial crisis of 1997-98 brought
home the significance of financial sector soundness by highlighting the
consequences of underlying weaknesses in the financial sector and the negative
impact that weak financial sectors could have on stakeholders, particularly the
depositors. Sound financial system is therefore not only important for the
welfare of the financial entities themselves, but it is also of vital
importance to the growth of individual economies.
In allocating resources in an economy, financial
institutions must assess competing demands for funds and prioritize the
analysis of risk. Improper decisions about financing activities, that is, which
activities to finance and which not to finance, (depending on which activities
will bring the best risk-adjusted return), can have a crucial negative
long-term impact on economic prospects. Sound investment decisions are vital
ingredients in fostering economic growth and development. These decisions
therefore should produce feasible outcomes not only for the financial
intermediary but also for the economy. Investment should be for productive
purposes and should be deployed for the common good.
Financial intermediaries should also have a
harmonious relationship with the macro-economic space within which they
operate. For example, in the nineteenth century, Britain was seen as the most
successful economy and was the home to the world's most successful financial
centre at the time. This was not only due to the fact that London had developed
expertise in assessing risk and in allocating financial resources efficiently,
but also to the fact that the macro economic environment was conducive to the
operation of financial intermediaries operating in the financial centre.
The assessment of risk also assists financial
institutions to be individually more competitive with their peers. This results
in a more efficient process of capital allocation in addition to engendering
more prudent practices. Financial intermediaries that can assess risk and
allocate resources efficiently will outperform those less skilled in this
regard. Effective competition should reduce borrowing costs and help to
diversify financial risk within the economy. However, to ensure that banks are
performing as intended, an effective regulatory framework must exist. The
importance of adequately capitalized financial institutions to underwrite
appropriate risks in their portfolios cannot be over emphasised. If financial
intermediaries undertake too little risk, then potentially efficient projects
may be starved of capital and if they undertake too much risk, then less
efficient projects may consume capital that could be used for more viable
projects. The role of regulators in providing effective oversight for the
sector and be able to respond appropriately to changes in the financial environment
becomes even more important.
William J McDonough (1998) postulates that
"a nation must be able to mobilize domestic savings and other sources of
funds that are needed to finance investment and other productive
expenditures[1]. This requires the development of an effective banking system
that transfers surplus funds of households and businesses to borrowers and
investors". He further argues that, "fair and impartial allocation of
credit accommodates the economic development that results in improved national
living standards".
According to McDonough:
"financial intermediation is particularly
important in the context of most emerging market countries given the relative
scarcity of savings, a relatively under-banked population, and large-scale
investment needs. The banking sector in emerging market countries also tends to
be more concentrated and represents a larger share of the domestic financial
system. Consequently, issues in the banking sector have an amplified effect on
the economy and on the fiscal costs associated with bank rescues".
Importantly, current developments in western
economies are anchored in a robust financial sector development.. Consequently,
the relationship between economic growth and financial sector health are now
more closely linked than ever before.
Some of these linkages or interrelationships are
further explored in this thesis from the perspective of risk relationships. The
demands of the changing business environment emphasize the importance of
effective risk management practices in banking institutions. Financial
intermediaries continue to face tremendous unrelenting pressures regarding
pricing decisions, increase in service expectations from customers, regulators
and shareholders. There is also a demand for more sophisticated products and
services, new regulatory requirements, improved capital standards, more capital
injection and the introduction of new technologies and systems.
Technology is important in supporting new and
flexible risk relationship structures in the areas of credit, market, liquidity
and operational risk management. Advanced technologies are often used by
intermediaries to identify, quantify and monitor risks. The employment of these
technologies also comes with their own attendant risk exposures and as such significant
investments and focus have been placed (particularly in recent times) on
operational risk management issues from both regulatory and financial
intermediary perspectives.
Banking Supervision
The identification, assessment, and promotion of
sound risk-management practices have become central elements of good supervisory
practice. Risk management has evolved as a discipline that is driven both by
the private sector (made up of banking institutions and other market
participants) and public sector (especially Regulatory Authorities and Banking
Supervision). The relationship between the private sector's interest in
economic capital and the public sector's interest in regulatory capital should
be identified and managed in a framework that ensures optimization.
With regard to the management of risks and risk
relationships, several key innovations have been made by the private sector
over the years. These are evident in the way financial intermediaries have
ordered their balance sheets to respond to various risk stimuli and impulses
both internally and externally. Additionally, the private sector has been the
driving force behind the development of sophisticated tools used to identify,
measure and manage risk relationships. The public sector on the other hand, has
been at the forefront in the development of best practice standards and
principles used to guide financial intermediaries. For years, the public sector
has been playing a pivotal role in preventing the total collapse of the entire
financial systems in their capacity of lender of last resort. The regulatory and
supervisory arms of the public sector have taken the lead in identifying
emerging issues through their approach to supervision of financial
intermediaries. Several regulatory bodies routinely performs on-site
inspections and examinations as well as off-site monitoring and surveillance of
banks and other financial institutions to assess risks and provide feedback to
the financial intermediaries' board and management. These reviews include the
assessment of policies and procedures in place to guide risk management; the
assessment of governance and internal controls and the assessment of capital
adequacy, asset quality, earnings and liquidity and sensitivities to risks.
Reviews could also include comparisons of peer institutions coupled with the
establishment of guidelines that codify evolving practices.
Yellen (2005)[2] argued that "although
banks and bank supervisors have different motives, which certainly can lead to
differing views about the appropriate levels of risks, they also have a common
interest in having accurate measures of risk and in focusing on the processes
and techniques for identifying and managing risks".
The Basel Frameworks
Over the last two decades, the system of bank
capital standards has been the Basel Capital Adequacy Standard, known as the
Basel I framework, which was established internationally in 1988. The Basel I
standard came out of the banking supervision sub-group of the Bank for
International Settlement (BIS). The Banking subgroup is made up of supervisors
from the G10 countries. This group has been charged with the responsibility for
setting bank standards around the world, which it does predominantly through
the development and implementation of the Basel Core Principles for Banking
Supervision. The Basel I framework was particularly geared towards credit risks
in banking institutions and resulted in higher capital levels, a more equitable
international marketplace and the relating of regulatory capital requirements
to risk appetite and risk profile.
The Basel framework is a dynamic one to which
bank as supervisors continue to make important adjustments from time to time.
For example, the 1988 Capital Accord was amended subsequently to incorporate a
market risk component. Bernanke (2005)[5] argues that "advances in risk
management and the increasing complexity of financial activities have prompted
international supervisors to review the appropriateness of the regulatory
capital standards under Basel I, particularly for the largest and most complex
banking organizations".
Several innovations have sought to collectively
reinforce this gap and indeed the relationship (regulatory capital/risk appetite)
between the public sector and the private sector has also being mutually
reinforced. These innovations have predominantly being originated by bankers in
the private sector and not by Supervisors. Bankers and Risk Managers had
developed models that encompass their processes, procedures, and techniques,
including statistical models for assessing risks in their portfolios. These
innovations by the private sector were seen as state of the art risk management
tools which the public sector could use and as such Regulators began to
leverage the risk management techniques that banks were using to address
shortfalls in Basel I. This phenomenon helped to push the Basel Committee back
to the drawing board to create the new capital adequacy standards for internationally
active banks, known as Basel II.
Bernanke (2006)[6] argues that the new framework
"links the risk taking of large banking organizations to their regulatory
capital in a more meaningful way than does Basel I and encourages further
progress in risk management. It does this by building on the risk-measurement
and risk-management practices of the most sophisticated banking organizations
and providing incentives for further improvements". When this framework is
applied consistently across internationally active banks, Supervisors can
easily identify shortfalls in the relationship between banks capital and risk
levels. Banking institutions with capital levels that are not commensurate with
their risk profile and risk levels would be subjected to closer assessment and
monitoring. Additionally, Basel II has provided the Supervisor with an added
tool, under the supervisory review process (Pillar II) to assess risks in the
banking system.
Sub-problems
The first sub-problem is to ascertain the risk
profile and relationship evident in financial intermediaries in Jamaica,
Trinidad and Barbados, as well as those which may evolve consequent to the new
Basel Capital Accord, Basel II, which is scheduled to be fully implemented by
2015 across all jurisdictions. The intention is to assess the risk profile and
relationship in operation as a dynamic process and the likely impact of the
capital accord on relevant financial entities.
The second sub-problem is, using both the
relevant and existing literature concerning risks, risk relationships and risk
management and observation of current techniques, to ascertain throughout the
course of the study, types of risk relationships that exist in credit,
liquidity, interest rate and operational risk management in financial
intermediaries.
The third sub-problem is to provide the
financial sector with a set of sound testable ideas that are systemically
desirable and consistent with the future development of risk assessment. This
will be done by reviewing the analyses outlined in the first two sub-problems,
generating relevant model/framework of risk assessment, comparing the
model/framework with real situation, identifying systemically desirable changes
and documenting the results for the benefit of relevant stakeholders who are
capable of applying change to the banking sector in general.
Busn 2015 Company Accounting
Hypothesis
The first hypothesis is that risk exposures
(credit, liquidity, interest rate and operational risks) in financial
intermediaries in Jamaica are relatively high when compared with Trinidad and
Tobago and Barbados and could exhibit parasitic tendencies. This could impair
the financial intermediaries' ability to identify, measure, mitigate and
monitor risks due to the fact that the internal control framework could be seen
as less than robust.
The second hypothesis is that there will be
shortfalls in capital requirements specifically as a result of the introduction
of the new Basel Capital Accord and more generally after taking account of specific
risks not previously considered by financial intermediaries.
The third hypothesis is that the cycle of
analysis, application and testing will result in the implementation of
rigorously defined early warning system for modelling and scoring risks and
that this system will be adaptable to change, both outside and within the
environment, and extendable to additional use.
Justification for the Research
Sound risk management practices, which include
appropriate tools and techniques and the employment of relevant steps to assess
risk exposure are at the heart of effective financial intermediation. However,
many institutions are exposed to high levels of risks in their operations and
few have put in place the relevant infrastructure to appropriately capture
their risk exposures. According to the Government of Jamaica, Ministry of
Finance (1998)[7]: "the financial distress experienced in the mid nineties
was in several ways due to the fact that many domestic financial institutions
did not have the necessary risk and financial management capabilities to
carefully assess the risk. As a result, they were left holding real estate and
other long-term assets that could not be easily disposed of to meet their
short-term obligations".
The Ministry highlighted the fact that:
"banks in Jamaica tended to invest in enterprises that were outside the
scope of their core business which had the following implication:
- The banks entered sectors in which their management did
not have the requisite skills or expertise.
- The banks, when lending to related parties or parties
under common control either (i) made poor and biased credit decisions; or
(ii) invested in companies on less than arm's length terms resulting in
poorly secured loans.
- The banks, in many instances had fund investments in
non-core businesses with short-term borrowing instruments with guaranteed
high interest rates. As a result, many non-core business had to contend
with an unsustainable capital structure that relied heavily on high cost
loans with relatively short maturities"[8].
Many studies have highlighted the risk
management practices, including techniques and tools used to identify, measure,
mitigate and monitor risks in industrial countries. However, few studies (note
the researcher is not aware of any at the time of preparing this thesis) have
sought to understand and explain the risk exposures, risk relationships and
risk management practices in financial intermediaries in the Caribbean,
particularly Trinidad and Tobago, Jamaica and Barbados.
The study utilizes a novel approach to analyse
risk exposures and risk relationships, which has not been evidenced in the
literature generally and definitely not seen in research on risk management in
the Caribbean region. The risk profile of financial intermediaries are analysed
using ratio analysis and statistical techniques including the standard
deviation and arithmetic mean coupled with a five-point scale response to
determine risk relationships based on a biological science description. This
study will document over a ten-year period, sectoral differences in risk
exposure reflected in the balance sheets and income statements of commercial
banks, merchant banks, trust companies and building societies in three
Caribbean countries.
The results of the research will provide a sound
set of ideas for the management of risks in these institutions in emerging
markets. It will also provide an enduring account of risk relationships and the
implications of sound risk management practices in general.
At this level, risk is calibrated as being
relatively low. Risks outcome are systemically pleasing and financial
intermediaries are making meaningful contribution to the common good. Risks and
reward can thrive within a conducive macro environment and the profile of institutions'
balance sheet and income statement contributes positively to the risk
calibration outcome. A low level of risk exposure is usually attributed to a
very robust internal control framework and more effective risk mitigation
strategies.
The Symbiotic Construct
Within the Symbiotic construct, risk
relationships are generally balanced. Risk is calibrated as moderate and the
regulatory interest and the economic interest are neutral. Risk management is
generally integrated and there is usually a connection between the process of
risk identification, measurement, mitigation and monitoring. The profile of
intermediaries' balance sheets and income statements are viewed as risk-neutral
relative to risk outcome and the internal control framework and risk mitigation
strategies used by financial intermediaries are generally adequate.
The Parasitic Construct
Within this construct risks are calibrated as
high or very high. There is usually adverse macro-economic condition in
existence and there is disconnect between the regulatory interest and the
economic interest. There is a general state of disharmony in the qualitative
and quantitative approaches and disunity in the way that risk is generally
managed. The risk profile of institution's balance sheets and income statements
negatively impacts risk calibration outcomes. A high level of risk exposure is
usually attributed to less than robust internal control framework and less
effective risk mitigation strategies.
The paper examined the macroeconomic environment
and regulatory environment in the three major economies of the Caribbean -
Jamaica, Trinidad & Tobago and Barbados. It discussed the extent to which
these frameworks are similar or different and the correlation between select
macro economic variables and sector specific micro variables used as proxies
for risks.
Chapter 2 of the thesis reviewed existing
literature on the topic of risk, risk relationships and risk management and
best practices in these areas; Chapter 3 examines the dynamics of the three
emerging markets being analysed in this study, Jamaica, Trinidad & Tobago
and Barbados. Particular emphasis was placed on the macro-economic environment
and the regulatory framework within which the financial intermediaries operate.
The details of the methodologies and their effectiveness are discussed in
chapter 4 and chapter 5 analyses the data and related findings. In chapter 6,
conclusions are drawn about the research problem and hypotheses. Additionally,
implications for theory, policy and practice are discussed and the implication
for further research is also considered in this chapter.
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Delimitations of Scope and Key Assumptions
Use of Financial Ratios
The thesis utilizes extensively, ratio analysis
techniques to determine risk exposures and risk relationships. Financial ratios
were used to arrive at the risk indices that were later used to calibrate the
risk relationships in existence in financial intermediaries in the region.
The researcher is aware however, of the
limitations inherent in the use of financial ratio analysis techniques to
assess financial intermediaries, risk exposures and financial performance. Some
of the major concerns are outlined below:
Lack of Consistent Definition for Financial
Ratios
There is a general lack of definition of what is
considered a "correct" ratio to use in analysing balance sheet and
income statements of financial institutions. There are different ways and
different figures used to calculate financial ratios depending on the
objective. However, to a large extent, this could determine the outcome. For
example, the thesis utilises twenty different financial ratios to assess risks,
seven of which were used to assess liquidity risks in financial intermediaries.
As expected, all seven financial ratios gave a different result. However, eight
financial ratios covering the four risk categories under study were further
selected and justified for use in the scoring methodology.
Financial Ratios are subjected to Manipulation
The lack of clarity surrounding the used of
financial ratios, subjecs them to manipulation by business managers, students
and other practitioner. In manipulating financial ratios, one can include or
exclude particular line items from balance sheets or income statements to
produce "good" results. Depending on the desired outcome, analysts
can use different line items as the numerator or denominator for the ratios.
The Inflation Effect
The effect of inflation rates and depreciation
in foreign exchange rates could erode the value of longitudinal data for ratios
calculated over several years, as the value of currency in more recent period
could be different from that which obtained in earlier years. There is also the
challenge of comparing financial information expressed in historical cost
accounting formats with data prepared under new international financial
reporting standards. The underlined base figures could be distorted as a result
of information not being directly comparable with each other over time.
Financial Ratios are generally Backward Looking
Financial ratios tend to be backward looking in
nature as they are based on historic information. As a result financial ratios
do not have much predictive powers and must be combined with other techniques
such as stress testing and scenario analysis to provide more robust results.
The Use of the Primary Ratio as the Benchmark
for Regulatory Capital
The use of the Capital to Asset Ratio (otherwise
known as the primary ratio) as the benchmark for regulatory capital could be
argued as not being sufficiently robust. This benchmark has been in use by
regulators several years before the move towards a revised capital adequacy
frameworks for banks which is more risk sensitive. The use of the risk adjusted
assets ratio would have been more ideal, however due to the unavailability of
risk weighted assets breakout for sub-sectors under study, this was not
possible. Future work should employ a more risk sensitive framework for
assessing capital adequacy.
The Use of the Arithmetic Mean as the Benchmark
for Moderate Risk.
One of the key assumptions made in this thesis
is that the arithmetic mean of all outcome from the twenty financial ratios
used to calibrate risk exposures represents a moderate risk position for the
eight sub-sectors. The use of the mean could be viewed as not being
sufficiently independent as it is derived from the population of the financial
intermediaries in the region. The overall result provided by the risk indices
could be skewed positively or negatively by low or high risk exposures in one
sub-sector.
A more appropriate benchmark could be derived
from the mean of financial ratios computed from balance sheet and income
statement data sets of developed countries such as USA, UK and Canada. The mean
from financial ratios from these countries external to the Caribbean region
would provide a more independent benchmark and as such will the basis for
future work.
Unavailability of Granular Information
The general unavailability of granular data from
financial intermediaries in the region, (for example duration and maturity
structures for interest rates and liquidity risk assessment as well as
information on foreign exchange exposures and positions) prevented a more
detailed review on risk relationships. The absence of granular information on
risk sensitive assets and liabilities as well the unavailability of information
on off-balance sheet data, including contingent liabilities, also posed
challenges. More detailed information would augur well for the development of a
more robust regional risk index.
REVIEW OF EXISTING LITERATURE
Financial Institutions Risks and Risk Management
A substantive approach was taken to the review
of literature relating to risk relationships and regulatory capital. The
coverage of the subject ranged from a review of some generic risk types which
includes systematic risks, credit risks, counterparty risks, operational and
legal risks to more specific and current classification of risks including
interest rate, foreign exchange commodity pricing as elements of market risks
and liquidity risks. The literature review also takes account of the general
oversight framework for risk management as well as the principal functions of
risk management which seeks to insulate the firm from different types of risks
such as liquidity, market, operational or credit risks.
Several steps in the risk management process
were identified and explored in the literature review commencing with the
definition of risk objectives and identification of loss exposures through to
the measurement of potential losses and selection of risk procedures and tools
and culminating with the implementation of policies, procedures and processes
to manage and monitor risk exposures.
Sectoral similarities and differences in
financial intermediaries were also reviewed in the literature as it was felt
that different financial intermediaries could have different approaches to risk
management and regulatory capitals. For example, it was noted that specialised
and sophisticated approaches could be engaged for primary risks in a particular
sector however this was not evident in the management of the same type of risks
in another sector. This is because primary risks in one financial sector can be
seen as secondary risk in another sector. Commercial banks for example focus
primarily on credit and operational risks especially in cases where they have a
wide branch network and significant investment in Information Technology
whereas securities firms and merchant banks could focus more on market and
liquidity risks based on the nature of their activities.
The effectiveness of policies, processes and
procedures were also explored in the review and details of procedures or tools
that a financial intermediary uses to measure and manage firm-level exposures
were analysed. Some of the general tools in this regard include standards and
reports, positive limits and values; investment guidelines and strategies and
compensation and incentive contracts.
The importance of an enterprise-wide approach to
risk management was emphasised with focus on key business processes in the firm
and the required bottom-up approach that should be taken in risk management
vis-�-vis risk identification, measurement,
monitoring and reporting. The enterprise-wide approach includes the alignment
of risk management to the organizational strategy and business plan as well as
defining business activities in such a way as to facilitate risk
identification, measurement and monitoring.
The literature review also explored several
approaches to regulatory capital. The 1988 Basel Capital Accord which came into
being at a time when banks were still concentrating on traditional banking
functions and when credit risk was the single most important risk factor in
banking institutions. The lack of risk sensitivity in the 1988 Basel Accord
coupled with the absence of a market risk focus led the Committee of Bank
Supervisors to develop and adopt a revised capital adequacy standard, known as
the Basel II Capital Accord.
Other approaches to capital were also discussed
in the literature review. These include leverage ratios or primary ratio
(capital to asset), which utilizes a 6% international benchmark system however
this was seen as a crude benchmark to measure the adequacy of capital to cover
risks at the time. Interestingly, subsequent to the major financial crisis
which started in 2007, many jurisdictions have been discussing the possibility
of revisiting the primary ratios as a risk cover. The element of economic
capital and the link between regulatory capital and economic capital was also
discussed in the review of literature.
The use of economic capital can be proven to be
an effective tool in the risk management process in so far as it ensures that
financial organizations hold the required amount of capital to cover its
exposure to all material economic risks or potential unexpected losses. The use
of economic capital would not only assist in the proper assessment of capital
requirements by large intermediaries to cover risk exposure, but would also
seek to limit contagion risk in the financial system.
he review of related literature concludes with
detailed discussions on approaches to (i) credit risk management, including
structural and reduced form models and internal rating systems; (ii) liquidity
risk management, including lender of last resort theories, structural and
reduced form models of liquidity risks and value at risk (VAR) approaches.
(iii) market risk management, including interest rate risk management,
derivatives and foreign exchange risk management and (iv) operational risk
measurement and management issues with details on select operational risk
events in the Caribbean region (hurricane, financial sector consolidation,
money laundering and correspondent banking relationships).
Risk Management Framework
There is a wealth of literature concerning risk management
particularly within the context of industrial countries, due predominantly to
the speed at which the field has developed in recent years. The literature
generally addresses issues of risk oversight, functions and steps in the risk
management process. These emphases in the literature can be subsumed within an
effective framework for risk management which speaks to three pillars of the
risk management process for example, the policy imperative, the processes or
steps used in risk management and the tools/techniques used to identify
measure, monitor, mitigate and report risks in a financial intermediary.
Beder (1994)[12] defines risk management as
"the activities of the professional who price and transact the firm's
products and retain or hedge away resultant risk". In this regard, six (6)
features of an independent risk oversight framework were identified as follows:
1.
require board level
audit and oversight
2.
require specific written
policies
3.
institute proper
internal controls
4.
perform mark-to-market
at least once every day
5.
forecast cash and
funding requirements
6.
stress test financial
exposures
It is interesting to note that the first two
features are components of the risk management policy framework, the second
feature makes reference to the process framework or the steps used in the
management of risks in financial intermediaries and the final three features
relate to the tools/techniques used in the risk management process.
Patel (1990) in discussing risk management
identified four principal functions[13]of risk management. These are:
1.
Insulating the firm from
operational, legal, liquidity, credit, reputational and market risks in the
pursuit of profit maximization.
2.
The protection from
systematic risk to world markets and trade
3.
Protection of the firm's
clients from non-market risks (such as fraud) of dealing with the firm
4.
Ultimately providing a
framework for the operation of efficient markets.
Williams and Heins (1989) identified six steps
in the process of risk management as follows[14]:
1.
Define the objective the
firm wishes to achieve from the risk management process. These broad risk
management objectives should be established by the board of directors with
input from the risk manager.
2.
Identify the loss
exposure of the firm. Risk identification is perhaps the most difficult
function that the risk manager must perform.
3.
Measure the potential
losses during the budget period associated with these exposures. This
measurement includes a determination of;
the
probability or change that losses will occur;
the
impact these losses would have upon the financial affairs of the firm should
they occur and
the
ability to predict the losses that will actually occur
4.
Select the best
combination of tools to be used in attacking the problem. These tools include
primarily:
Avoiding
the exposure;
Reducing
the chance that losses will occur;
Transferring
the potential losses to some other party; and
Retaining
or bearing these losses internally.
5.
Implementing the
decision made.
6.
Monitoring - results
must be monitored to evaluate the wisdom of those decision and to determine
whether changing conditions suggest different solutions.
The discussion of risk oversight, functions and
steps highlighted above were quite general and generic. Specific references
were not made as to how these functions or steps might vary according to core
business activities of banking organizations. Neither was reference made
concerning whether the approaches to risk management oversight can be
interpreted differently based on activity type.
Similarities and Differences in Core Business
Activities
BIS (2001) assert that while there is
"convergence between various sectors" of financial organizations.
"There still remain significant differences in the core business
activities and the risk management tools that are applied to these
activities"[15]. The Forum states that "there are also significant
differences in the regulatory capital frameworks, in many cases reflecting
differences in the underlying businesses and in supervisory approaches, and
sectoral differences in core business activities and risk exposures were well
reflected in the balance sheets of firms within sectors".
It was found that "policies and procedures
exist to ensure that an independent assessment of risks occurs, and that
controls are in place to limit the level of risk that can be taken on by
individual business areas. The substantial efforts taken across all sectors to
develop quantitative measures of risk, including risks such as operational
risks (that are significantly difficult to measure) reflects the priority
placed on risk management in the sectors". The report alluded to the fact
that "continuing pressures to deliver strong and sustainable risk-adjusted
returns on capital motivate financial firms in all sectors to invest in improved
methodologies for quantifying risk".
"The emphasis on risk measurement can be
related to efforts to manage significant risks through hedging or holding
capital and or provisions". The Joint Forum admitted that "because
such measures and risk mitigation techniques are costly, a better understanding
of what risks should be hedged as well as how much capital and/or provisions
are truly needed to support their retained risk would tend to improve the
firms' risk-adjusted returns".
The Joint forum argues however that
"notwithstanding these broad similarities, there are significant
differences reflecting the different business activities and risk exposures in
each sector". In this regard, it was argued that "firms naturally
tend to invest more in developing risk management techniques for the risks that
are dominant in their business. Therefore, risk management will often be more
specialized and sophisticated for the primary risks in that sector than would
be the case for management of the same risk in another sector where it is a
more secondary risk".
"Securities firms focus mainly on the
market and liquidity risks associated with their activities. Hedging techniques
and capital play dominant roles in their strategies for the management of these
risks, and they frequently build on quantitative value-at-risk and stress
testing methodologies. The securities firm, it was argued, typically attempt to
reduce the amount of credit risk they take by requiring collateral and by
closely monitoring the size of exposures relative to collateral. The report
point out however that in recent years, credit risk has become a major concern
as the firms have become more involved in over-the-counter derivative
transactions".
In relation to banks, the Joint Forum states
that: "the taking on of credit exposure is a defining element of their
business and as such the risk management of lending activities is their major
challenge. It was further stated that banking risk management are currently
undergoing a significant transformation, entailing a greater emphasis on the
systematic assessment of the quality of all credits and the production of
detailed quantitative estimates of credit risk. These quantitative measures are
being used by banks to inform their internal estimates of the amount of provisions
and capital necessary to support these risks. Additionally, the increasing use
of quantitative credit risk measures is helping to spawn a large and growing
market to the trading and hedging of credit risk exposures".
Risk Management Procedures - Tools and
Techniques
Oldfield and Santomero (1997) argue that:
"if management is to manage risk, it must establish a set of procedures to
reach this goal[16]. The goal of the risk management plan is to measure and
manage the firm level exposure to various types of risks which management has
identified as central to their operations. They continue by adding that for
each risk category, the firm employs a four-step procedure to measure and
manage firm level exposure. These steps include:
- Standards and reports
- Position limits or rules
- Investment guidelines or strategies
- Incentive contracts and compensation
In general, these tools are established to
accurately define the risk, limit exposure to acceptable levels, and encourage
decision-makers to manage risk in a manner that is consistent with management's
goals and objectives. To see how each of these four steps of a risk management
system achieve these ends, Oldfield and Santomero (1997) elaborate on each part
of the process below.
Standards and Reports
The first step of these control techniques
involves two different conceptual activities, that is, standard setting and
financial reporting. They are listed together because they are the sine qua non
of any risk management system. Underwriting standards, risk categorizations,
and standards of review are all traditional tools of risk control. Consistent
evaluation and rating of exposure is essential for management to understand the
true embedded risks in the portfolio, and the extent to which these risks must
be mitigated or absorbed. The standardization of financial reporting is the
next ingredient. Obviously, outside audits, regulatory reports, and rating
agency evaluations are essential for investors to gauge asset quality and
firm-level risk. These reports have long been standardized, for better or
worse. However, the need here goes beyond public reports and audited statements
to the need for management information on asset quality and risk posture. Such
internal reports need similar standardization and much more frequent reporting
intervals, with daily or weekly reports substituting for the quarterly GAAP periodicity.
Position Limits and Rules
A second step for internal control of active
management is the establishment of position limits. These are imposed to cover
exposures to counterparties, credits, and overall position concentrations
relative to systematic risks. In general, each person who can commit capital
has a well-defined limit. This applies to traders, lenders, and portfolio
managers. Summary reports to management show counterparty, credit, and capital
exposure by business unit on a periodic basis. In large organizations with
thousands of positions maintained and transactions done daily, accurate and
timely reporting is quite difficult, but perhaps even more essential.
Investment Guidelines
Third, investment guidelines and strategies for
risk taking in the immediate future are outlined in terms of commitments to
particular areas of the market, the extent of asset-liability mismatching or
the need to hedge against systematic risk at a particular time. Guidelines
offer firm level advice on the appropriate level of active management - given
the state of the market and the willingness of senior management to absorb the
risks implied by the aggregate portfolio. Such guidelines lead to hedging and
asset-liability matching. In addition, securitization and syndication are
rapidly growing techniques of position management open to participants looking
to reduce their exposure to be in line with management's guidelines. These
transactions facilitate asset financing, reduce systematic risk, and allow
management to concentrate on customer needs that center more on origination and
servicing requirements than funding position.
Incentive Schemes
To the extent that management can enter into
incentive compatible contracts with line managers and make compensation related
to the risks borne by these individuals, the need for elaborate and costly
controls is lessened. However, such incentive contracts require accurate
position valuation and proper cost and capital accounting systems. It involves
substantial cost accounting analysis and risk weighting which may take years to
put in place. Notwithstanding the difficulty, well-designed compensation
contracts align the goals of managers with other stakeholders in a most
desirable way. In fact, most financial debacles can be traced to the absence of
incentive compatibility, as the case of deposit insurance illustrates".
Regulatory Capital
The current international standards for bank
capital requirements have its genesis in the Basel Accord of 1988[17]. This
accord establishes for the first time an international framework for measuring
regulatory capital and setting capital adequacy standards. The Capital Accord
was drafted at a time when banks were still concentrating on traditional
banking functions, and when credit risk was the single most important risk
factor as such, the Accord ignored market risk.
The difficulties the Basel Committee encountered
in producing a new set of comprehensive capital adequacy requirements have
prompted it to consider a revolutionary change in the way banks are supervised
and regulated. On April 12, 1995, the Committee issued for comment a new set of
capital requirements to be implemented by the end of 1997. It moves bank
regulation in a new direction by allowing banks to actively participate in the
design of the framework for establishing capital requirements by using their
own internal risk management models to estimate value-at-risk.[18]
Notwithstanding the advantages of the Basel
proposal, which includes eliminating the need for banks to maintain two parallel
systems (one for regulatory purposes and another for trading and portfolio
allocation), and providing banks with additional incentives to improve their
risk management systems the new approach also poses many challenges. For one
thing, there is little agreement in the banking industry about how to model and
measure risk.
Two banks holding the same portfolio could
likely come up with different estimates of value-at-risk, implying different
capital requirements for the same risks. Such an outcome violates a major
objective of international capital requirements: the achievement of a level
playing field.
Another problem with the new Basel approach is
the emphasis on quantitative measures, such as value-at-risk, which might lead
banks to over look major market elements that are not easily quantifiable. The
approach also ignores legal and operational risk - both important elements in
recent financial crises (such as the failure of U.K. based investment bank,
Barings). Hence in July 1994, in recognition of the importance of high quality
risk management systems by both banks and non-banks, the Basel Committee on
Banking Supervision and the Internal Organization of Securities Commissions
issued joint reports on risk management. These reports itemize many important
elements of sound risk management.
IMF (1995) highlighted the fact that regulation
and supervision of banking activities have been impacted by advances in
technology, the rapid growth of OTC (over the counter) derivative markets, the
shift in banking activity from lending to heavy involvement in these markets
and the globalization and liberalization of financial markets[19]. In
particular, the financial services industry has undergone a number of
fundamental structural changes. Market and operational risk have become more
important for banks. Linkages between financial markets and institutions have
strengthened, and banks now have the ability to restructure their portfolios
and risk exposures quickly, which ideally should be simple, extendable and
applicable. Capital standards therefore should be structured in a way that
encourages improvements in internal risk management. However, by the time the
Accord came into force, the minimum standards it defined were already
inadequate, partly because of changes in the nature of banking and in the
financial services industry as a whole.
IMF (1994) capital market study[20] argues that
the major challenge facing the industry at the time, was to find a single
measure of risk that captures comprehensively all the risks inherent in the
financial activities of a single financial institution. An important impediment
to greater transparency and disclosure is the absence of consensus about what
information to disclose, when to disclose it and to whom to disclose it to.
According to the article, recent initiatives have been undertaken by major
financial industry and regulatory bodies (the Institute of International
Finance, the Bank for International Settlements, and the U.S. Financial
Accounting Standards Board) to improve transparency and disclosure. But as the
IMF study notes, these initiatives leave unresolved many issues including: Risk
Aggregation, Non-quantifiable Risks and Trade-off between uniformity and
flexibility.
Basel (July 1988[21]) in its discussion on the
constituents of capital, states that "the key elements of capital on which
the main emphasis should be placed, are equity capital[22] and disclosed
reserves. The key element of capital is the only element common to all
countries' banking systems; it is wholly visible in the published accounts and
is the basis on which most market judgments of capital adequacy are made. It
also has a crucial bearing on profit margins and a bank's ability to
compete".
ISYS 111 Fundamentals of Information Systems
BIS (2001)[23] in discussing regulatory capital
in the Banking, Securities and Insurance sectors, indicated that "the
primary approaches in place in the three sectors reflected underlying
differences in the time horizons most appropriate to the risks in each sector,
as well as differences in supervisory objectives and emphasis".
Importantly, the issues relating to capital vis-a-vis provisions or reserves
across the three sectors were discussed.
According to BIS, "technical provisions for
insurance companies perform the role of providing an estimate of foreseeable
claims (policy benefits). Securities firms on the other hand, generally do not
maintain reserves because assets and contractual obligations can generally be
valued accurately on a mark-to-market basis, and there should be no expected
losses if market prices fully reflect current information. Capital therefore
serves as the primary cushion against losses in the securities sector. Banks on
the other hand hold both loan loss reserves to cover foreseeable losses and
capital to cover unanticipated credit losses".
The BIS Report (2001) suggests that when a
closer look at the underlying differences in starting points was taken, it was
found that the "specific capital regulation or solvency regime frameworks
are themselves quiet distinct. For banks, the dominant approach is based on the
Basel Accord". The paper discusses the two main approaches for securities
firms namely "(1) the Net Capital
1.
McDonough, William J
Remarks by William J McDonough for presentation in Mexico City on July 22, 1998 (10 January 2007)
2.
Yellen, Janet L ,
Presentation to the Western Independent Bankers Association Annual Conference,
Kauai, Hawaii March 2005 , (12 January 2007)
3.
Testimony of Chairman
Alan Greenspan, The state of the banking industry , Before the Committee on
Banking, Housing, and Urban Affairs, U.S. Senate , April 20, 2004
http://www.federalreserve.gov/boarddocs/testimony/2004/20040420/default.htm
4.
The Federal Reserve
Board: Testimony of Chairman Alan Greenspan, the state of the banking industry,
before the Committee on Banking, Housing, and Urban Affairs, U.S. Senate, April
20, 2004.
5.
Ben S Bernanke: Modern
risk management and banking supervision. - Remarks by Mr. S Bernanke, Chairman
of the Board of Governors of the US Federal Reserve System, at the Stonier
Graduate School of Banking, Washington, DC, 12 June 2006.
6.
Ben S Bernanke: Modern
risk management and banking supervision. - Remarks by Mr. S Bernanke, Chairman
of the Board of Governors of the US Federal Reserve System, at the Stonier
Graduate School of Banking, Washington, DC, 12 June 2006
7.
See Ministry of Finance
(1998) Financial Sector Crisis at http://www.mof.gov.jm/budget
memo/1998/appendix5.htm. for further information on Government intervention in
Jamaica's financial sector in December 1994 when the Ministry of Finance
assumes temporary management of the Blaise Financial Entities and the Century
Financial Institutions in July 1996.
8.
Ministry of
Finance(Jamaica) 1998 - Financial Crisis
9.
Oldfield, George S and
Santomero, Anthony M. (1997) Risk Management in Financial Institutions. Sloan
Management Review Fall
10.
Oldfield and Santomero
(1997) :The Place of Risk Management in Financial Institutions.
11.
Oldfield, George S and
Santomero, Anthony M. (1997) Risk Management in Financial Institutions. Sloan
Management Review Fall.
12.
Beder, Tanya (1994) Three
key challenges in independent risk oversight. Derivatives Use, Trading &
Regulation, Volume One, Number One, 1995, 9-13
13.
Patel, Alpesh (1999)
Training risk: The unrecognized operational risk management problem,
Derivatives Use, Trading & Regulation, Volume Five, Number One, 29-30
14.
Williams, C. Arthur and
Heins, M. Richard .JR (1989) Risk Management and Insurance 6th Edition, pp 8.
15.
Basel (2001) Joint Forum
Risk Management Practices and Regulatory Capital - Cross Sectoral Comparison -
Bank for International Settlement (BIS)
16.
Oldfield, George S and
Santomero, Anthony M, The Place of Risk Management in Financial Institutions
(Wharton Financial Institutions Center, 1997)
17.
The 1998 Basel Accord
was formulated by Basel Committee on banking Supervision which represents
supervisory authorities from 12 major countries and operates under the auspices
of the Bank for International settlement.
18.
Value-at-risk is the
Basel Committee's standard measure for risk exposure. It is an estimate of the
maximum loss in the value of a portfolio or financial position over a given
period, with a built-in probability that the actual loss will not exceed a
pre-specified maximum.
19.
IMF Survey (September
14, 1995) - Managing Risk in a new financial environment
20.
The IMF's annual review
of developments in capital markets and the implications of the December 1994
financial crisis in Mexico for other emerging markets; and the challenges for
international financial supervisors and regulators posed by the continuing
growth of international derivative markets and their impact on the activities
of he major money-centre banks (see the June 19 issue of the IMF Survey for an
overview)
21.
Basel Committee:
International convergence of capital measurement and capital standards (updated
to April 1998), p 3.
22.
ssued and fully paid
ordinary shares/common stock and non-cumulative perpetual preferred stock (but
excluding cumulative preferred stock).
23.
International
Association of Insurance Supervisors; The Joint Forum RISK MANAGEMENT PRACTICES
AND REGULATORY CAPITAL CROSS-SECTORAL COMPARISON; November 2001; THE JOINT
FORUM.
Some related topics:
ECON 1102 Macroeconomics 1
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