Managing Risk in Financial Sector
Risk supervision is a hot topic in the financial sector especially in the light of the new losses of some multinational corporations e.g. Collapses of Britain's Barings Bank, WorldCom and also due to the incident of 9/11. Rapid changes in enterprise condition, restructuring of organizations to cope with ever expanding competition, development of new products, emerging markets and growth in cross border transactions along with complexity of transactions has exposed Financial Institutions to new risks dimensions. Thus the thought of risk has captured a growing point in contemporary financial society.
Managing Risk in Financial Sector
By facilitating transactions and production reputation and other financial products available, the financial sector is a crucial building block for underground as well as social sector development. In its broadest definition, it includes everything from banks, stock exchanges, and insurers, to reputation unions, microfinance institutions and moneylenders. As an sufficient service provider, the financial sector simultaneously fulfils an foremost function in the unabridged economy. Assorted types of Financial Institutions actively working in Financial Sectors contain Banks, Dfis, Micro Finance Banks, Leasing Companies, Modarabas, Assets supervision Company, Mutual Funds, etc.
Thus today's operating environment demands systematic and more integrated risk supervision approach.
Risk:
Risk by default has tow components; uncertainty and exposure. If both are not present, there is no risk. Definition of Risk as per Guidelines on Risk supervision issued by State Bank of Pakistan is, "Financial risk in a banking organization is possibility that the outcome of an performance or event could bring up adverse impacts. Such outcomes could either effect in a direct loss of earnings / capital or may effect in imposition of constraints on bank's ability to meet its enterprise objectives. Such constraints pose a risk as these could hinder a bank's ability to show the way its ongoing enterprise or to take advantage of opportunities to heighten its business."
Types of Risks:
Risks are regularly defined by the adverse impact on profitability of some sure sources of uncertainty. More or less all financial institutions have to carry on the following faces of risks:
1. Credit Risk
2. Market Risk
3. Liquidity Risk
4. Operational Risk
5. Country Risk
6. Legal Risks
7. Compliance Risk
8. Reputational Risk
Broadly speaking there are four risks as per Risk supervision Guidelines which surround Financial Sector i.e. reputation Risk, store Risk, Liquidity Risk and Operational Risk. These risk are elaborated here under:
i. Credit Risk
This is the risk incurred in case of a counter-party default. It arises from lending activities, investing activities and from buying and selling financial assets on behalf of others. This risk is connected with financing transactions i.e.:
a. Default in refund by the borrower and
b. Default in obliging the commitment by someone else Financial institution in case of syndicated arrangements.
It is the most essential risk in banking and one that must be managed carefully. It is also the risk that requires the most subjective judgment despite constant efforts to heighten and quantify the reputation decision process.
ii. Market Risk
Market risk is defined as the volatility of earnings or store value due to fluctuations in underlying store factors such as currency, interest rates, or reputation spreads. For commercial banks, the store risk of the garage liquidity venture briefcase arises from mismatches between the risk profile of the assets and their funding. This risk involves interest rate risk in all of its components: equity risk, transfer risk and commodity risk.
iii. Liquidity Risk
The liquidity risk is defined as the risk of not being able to meet its commitments or not being able to unwind or offset a position by an organization in a timely fashion because it cannot liquidate assets at inexpensive prices when required.
iv. Operational Risk
This risk results from inadequacies in the conception, organization, or implementation of procedures for recording any events about bank's operations in the accounting system/information systems.
Need for Risk supervision and Monitoring:
There are a amount of reasons as to why there is so much emphasis given to Risk supervision in Financial Sector now a day. Some of them are listed below: -
1. Present buildings of joint stock companies, wherein owners are not the mangers, hence risks increase; therefore permissible tools are required to perform the desired results by face the risks.
2. The financial sector has come out of easy deposit and lending function.
3. The world has come to be very complex so the financial transactions and instruments.
4. Increase in the amount of cross border transactions which caries its own risks.
5. Emerging markets
6. Terrorism Remittances
Risk monitoring in financial sector is very crucial and an sure part of risk management. Risk Monitoring is foremost in the financial sector due to the following reasons:
1. Deals in others' money
2. Direct stake of deposit holder.
3. Much riskier sector than trading and manufacturing.
4. Previous / new problems faced by banks i.e. Stuck briefcase that is reputation risk.
5. Bankruptcy of Barings Bank due to short selling / long position that is store risk.
6. Operational risk does not has immediate impact, but foremost for continuity and strengthen of organization.
7. Appetite of a financial institution to take risk is connected with the capital base of the build so it caries a huge risk of over exposure.
Components of Risk supervision Frame Work
Risk supervision Frame Work has five components. First of all risk is Identified, then it is Assessed to classify, seek explication and management, after assessing quick Response and implementation of explication and the last phase is Monitoring of the risk supervision strengthen and studying from this experience that such problem never occur again. Whole process is to be well Communicated while the whole process of risk supervision if it is to be managed efficiently.
The International organization for Standardization (Iso) has defined risk supervision as the identification, analysis, evaluation, rehabilitation (control), monitoring, spin and communication of risk. These activities can be applied in a systematic or ad hoc manner. The presumption is that systematic application of these activities will effect in improved decision-making and, most likely, improved outcomes.
Structure of Risk Management
Depending upon the buildings and operations of organization, financial risk supervision can be implemented in distinct ways. Risk supervision buildings defines the distinct layers of an organization at which risk is identified and managed. Although there are distinct layers or level at which risk is managed but there are three layers which are base to all. I.e.
Risk Management
For managing risk there are sure basic ideas which are to be followed by every organization:
1. Corporate level Policies
2. Risk supervision strategy
3. Well-defined policies and procedures by senior management
4. Dissemination, implementation and compliance of policies and procedures
5. Accountability of individuals heading Assorted functions/ enterprise lines
6. Independent Risk spin function
7. Contingency plans
8. Tools to monitor risks
Institutions can cut some risks naturally by researching them. A bank can cut its reputation risk by getting to know its borrowers. A brokerage firm can cut store risk by being knowledgeable about the markets it operates in.
Functionally, there are four aspects of financial risk management. Success depends upon
A. A sure corporate culture,
No one can carry on risk if they are not ready to take risk. While private initiative is critical, it is the corporate culture which facilitates the process. A sure risk culture is one which promotes private accountability and is supportive of risk taking.
B. Actively observed policies and procedures
Used correctly, procedures are distinguished tool of risk management. The purpose of policies and procedures is to empower people. They specify how people can perform what needs to be done. The success of policies and procedures depends critically upon a sure risk culture.
C. Effective use of technology
The original role technology plays in risk supervision is risk appraisal and communication. Technology is employed to quantify or otherwise summarize risks as they are being taken. It then communicates this facts to decision makers, as appropriate.
D. Independence or risk supervision professionals
To get the desired outcome from risk management, risk managers must be independent of risk taking functions within the organization. Enron's experience with risk supervision is instructive. The firm maintained a risk supervision function staffed with capable employees. Lines of reporting were reasonably independent in theory, but less so in practice.
Internal Controls
Para one on first page of the 'Guidelines on Internal Controls' issued by Sbp provides:
"Internal control refers to policies, plans and processes as affected by the Board of Directors and performed on continuous basis by the senior supervision and all levels of employees within the bank. These internal controls are used to furnish inexpensive assurance about the achievement of organizational objectives. The ideas of internal controls includes financial, operational and compliance controls."
The current lawful definition of internal control was advanced by the Committee of Sponsoring organization (Coso) of the Treadway Commission. In its influential report, Internal control - Integrated Framework, the Commission defines internal control as follows:
"Internal control is a process, effected by an entity's Board of Directors, supervision and other personnel, designed to furnish inexpensive assurance about the achievement of objectives in the following categories:
Effectiveness and efficiency of operations.
Reliability of financial reporting.
Compliance with applicable laws and regulations.
This definition reflects sure underlying concepts:
Internal control is a process. It is a means to an end, not an end in itself.
Internal control is effected by people. It is not course manuals and forms, but people at every level of an organization.
Internal control can be foreseen, to furnish only inexpensive assurance, not absolute assurance, to an entity's supervision and board.
Internal control should sustain and never impede supervision and staff from achieving their objectives. control must be taken seriously. A well-designed ideas of internal control is worse than worthless unless it is complied with, since the assemblance of control will be likely to carry a false sense of assurance. Controls are there to be kept, not avoided. For instance, exception reports should be followed up. Senior supervision should set a good example about control compliance. For instance, physical entrance restrictions to collect areas should be observed equally by senior supervision as by junior personnel.
Components of Internal Controls
Components of internal control also depend upon the buildings of the enterprise unit and nature of its operation. The Coso report describes the internal control process as consisting of five interrelated components that are derived from and integrated with the supervision process. The components are interrelated, which means that each component affects and is affected by the other four. These five components, which are the essential foundation for an sufficient internal control system, include:
I. Control Environment,
Control environment, an intangible factor and the first of the five components, is the foundation for all other components of internal control, providing discipline and buildings and encompassing both technical competence and ethical commitment.
Ii. Risk Assessments,
Organizations exist to perform some purpose or goal. Goals, because they tend to be broad, are regularly divided into exact targets known as objectives. A risk is anything that endangers the achievement of an objective. Risk assessments is done to decide the relative potential for loss in programs and functions and to build the most cost-effective and sufficient internal controls.
Iii. Control Activities,
Control activities mean the structure, policies, and procedures, which an organization establishes so that identified risks do not forestall the organization from reaching its objectives.
Policies, procedures, and other items like job descriptions, organizational charts and supervisory standards, do not, of course, exist only for internal control purposes. These activities are basic supervision practices.
Iv. Information and Communication, and
Organizations must be able to collect dependable facts to decide their risks and spin policies and other facts to those who need it. facts and communication, the fourth component of internal control, articulates this factor.
V. Monitoring
Life is change; internal controls are no exception. Satisfactory internal controls can come to be obsolete through changes in external circumstances. Therefore, after risks are identified, policies and procedures put into place, and facts on control activities communicated to staff, superiors must then implement the fifth component of internal control, monitoring.
Even the best internal control plan will be unsuccessful if it is not followed. Monitoring allows the supervision to recognize either controls are being followed before problems occur. In the same way, supervision must spin weaknesses identified by audits to decide either connected internal controls need revision.
Tools for Monitoring of Risk
Management facts System
M.I.S or supervision facts ideas is the variety and determination of data in order to sustain management's decision with respect to the achievement of objectives mentioned in the policies and procedures and the control of Assorted risks therein.
It is this area i.e. M.I.S, where I.T can play a vital and sufficient role as with the help of I.T large facts may be analyzed efficiently and with accuracy, so that sufficient decision may be taken by the supervision without the loss of any time.
Asset-Liability supervision Committee (Alco)
In most cases, day-to-day risk appraisal and supervision is assigned to a specialized committee, such as an Asset-Liability supervision Committee (Alco). Duties pertaining to key elements of the risk supervision process should be adequately separated to avoid potential conflicts of interest - in other words, a financial institution's risk monitoring and control functions should be sufficiently independent from its risk-taking functions. Larger or more complex institutions often have a designated, independent unit responsible for the build and supervision of balance sheet management, including interest rate risk. Given today's unabridged innovation in banking and the dynamics of markets, banks should recognize any risks potential in a new goods or service before it is introduced, and ensure that these risks are instantly carefully in the appraisal and supervision process.
Corporate Governance Principles
Corporate governance relates to the manner in which the enterprise of the organization is governed, including setting corporate objectives and a institution's risk profile, aligning corporate activities and behaviors with the hope that the supervision will control in a safe and sound manner, running day-to-day operations within an established risk profile, while protecting the interests of depositors and other stakeholders. It is defined by a set of relationships between the institution's management, its board, its shareholders, and other stakeholders.
The key elements of sound corporate governance in a bank include:
a) A well-articulated corporate strategy against which the unabridged success and the offering of individuals can be measured.
b) Setting and enforcing clear assignment of responsibilities, decision-making authority and accountabilities that are approved for the bank's risk profile.
c) A strong financial risk supervision function (independent of enterprise lines), adequate internal control systems (including internal and external audit functions), and functional process build with the essential checks and balances.
d) Corporate values, codes of show the way and other standards of approved behavior, and sufficient systems used to ensure compliance. This includes extra monitoring of a bank's risk exposures where conflicts of interest are foreseen, to appear (e.g., relationships with affiliated parties).
e) Financial and managerial incentives to act in an approved manner offered to the board, supervision and employees, including compensation, promotion and penalties. (i.e., compensation should be consistent with the bank's objectives, performance, and ethical values).
f) Transparency and approved facts flows internally and to the public.
Tools mentioned above can be utilized in identifying and managing distinct risks in the following manner:
I. Credit Risk
It is managed by setting prudent limits for exposures to private transaction, counterparties and portfolios. Credits limits are set by reference to reputation rating established by reputation Rating Agencies, methodologies established by Regulators and as per Board's direction.
o Monitoring of per party exposure
o Monitoring of group exposure
o Monitoring of bank's exposure in contingent liabilities
o Bank's exposure in clean facilities
o Analysis of bank's exposure goods wise
o Analysis of attentiveness of bank's exposure in Assorted segments of economy
o Product profitability reports
Ii. Market
Financial Institutions should also have an adequate ideas of internal controls to oversee the interest rate risk supervision process. A underlying component of such a ideas is a regular, independent spin and appraisal to ensure the system's effectiveness and, when appropriate, to recommend revisions or enhancements.
Interest rate risk should be monitored on a consolidated basis, including the exposure of subsidiaries. The institution's board of directors has ultimate accountability for the supervision of interest rate risk. The board approves the enterprise strategies that decide the degree of exposure to risk and provides advice on the level of interest rate risk that is approved to the institution, on the policies that limit risk exposure, and on the procedures, lines of authority, and accountability connected to risk management. The board also should systematically spin risk, in such a way as to fully understand the level of risk exposure and to correlate the performance of supervision in monitoring and controlling risks in compliance with board policies. Reports to senior supervision should furnish blend facts and a adequate level of supporting detail to facilitate a meaningful appraisal of the level of risk, the sensitivity of the bank to changing store conditions, and other relevant factors.
The Asset and Liability Committee (Alco) plays a key role in the oversight and coordinated supervision of store risk. Alcos meet monthly. venture mandates and risk limits are reviewed on a regular basis, regularly annually to ensure that they remain valid.
Risk supervision and Risk Budgets
A risk allocation establishes the tolerance of the board or its delegates to earnings or capital loss due to store risk over a given horizon, typically one year because of the accounting cycle. (Institutions that are not sensitive to each year earnings requirements may have a longer horizon, which would also allow for a greater degree of free time in briefcase management.). Once an each year risk allocation has been established, a ideas of risk limits needs to be put in place to guard against actual or potential losses exceeding the risk budget. There are two types of risk limits, and both are essential to constrain losses to within the prescribed level (the risk budget).
The first type is stop-loss limits, which control cumulative losses from the mark-to-market of existing positions relative to the benchmark. The second is position limits, which control potential losses that could arise from hereafter adverse changes in store prices. Stop-loss limits are set relative to the unabridged risk budget. The allocation of the risk allocation to distinct types of risk is as much an art as it is a science, and the methodology used will depend on the set-up of the private venture process. Some of the questions that affect the risk allocation contain the following:
* What are the essential store risks of the portfolio?
* What is the correlation among these risks?
* How many risk takers are there?
* How is the risk foreseen, to be used over the course of a year?
Compliance with stop-loss limits requires frequent, if not daily, performance measurement. performance is the total return of the briefcase less the total return of the benchmark. The estimation of performance is a essential statistic for monitoring the usage of the risk allocation and compliance with stop-loss limits. Position limits also are set relative to the unabridged risk budget, and are branch to the same considerations discussed above. The function of position limits, however, is to constrain potential losses from hereafter adverse changes in prices or yields.
Iii. Liquidity Risk
The Basel Committee has established sure quantitative standards for internal models when they are used in the capital adequacy context.
a. Allocation of capital into Assorted types of enterprise after taking into inventory the operational risks i.e. Disruption of enterprise activity, which has especially increased due to inordinate Edp usage
b. Allocation of the capital is also made among Assorted products i.e. Long term, short term, consumer, corporate etc. Considering the risks complex in each goods and its life cycle to avoid any liquidity crunch for which gap determination is made. This is the job of Alco
c. For instance Contingent liabilities not more than 10 times of capital,
d. Fund based not more than 6 times of capital
e. Capital store operations not more than 1 time of capital
f. However these limits cannot exceed the regulations.
g. Parameters of controls
o Regulatory Requirements
o Board's directions
o Prudent practices
For liquidity supervision organizations are compelled to hold reserves for unexpected liquidity demands. The Alco has accountability for setting and monitoring liquidity risk limits. These limits are set by Regulatory Bodies and under Board's directions retention in mind the store condition and past experience.
The Basel Accord comprises a definition of regulatory capital, measures of risk exposure, and rules specifying the level of capital to be maintained in relation to these risks. It introduced a de facto capital adequacy standard, based on the risk-weighted blend of a bank's assets and off-balance-sheet exposures that ensures that an adequate amount of capital and reserves is maintained to safeguard solvency. The 1988 Basel Accord primarily addressed banking in the sense of deposit taking and lending (commercial banking under Us law), so its focus was reputation risk.
In the early 1990s, the Basel Committee decided to update the 1988 accord to contain bank capital requirements for store risk. This would have implications for non-bank securities firms.
Thus, the method for determining capital adequacy can be descriptive as follows:
= Tier I + Tier 2 + Tier 3 *- 8% .
Risk-weighted Assets + (Market Risk Capital payment x 12.5)
Iv. Operational Risk
To carry on this risk documented policies and procedures are established. In addition, regular training is in case,granted to ensure that staffs are well aware of organization's objective, statutory requirements.
o Reporting of major/ unusual/ exceptional transactions with respect to ensuring the compliance of the ideas of Kyc and Anti-money laundering measure
o Analysis of ideas problems
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