Khaled Mahmud Raihan concluding his three-part article on risk management in banks

Among the various types of risks of a bank, interest rate risk has a potential impact on its earnings and net asset values due to changes in market interest rates. Interest rate risk arises when a bank's principal and interest cash flows (including final maturities), both on-and off-balance sheets, have mismatched re-pricing dates. The amount at risk is a function of the magnitude and direction of interest rate changes and the size and maturity structure of the mismatch position. The immediate impact of a variation in interest rates is on the bank's net interest income, while a long-term impact is on the bank's net worth since the economic value of bank's assets, liabilities and off-balance sheet exposures are affected. Thus, interest rate risk should be managed from a holistic approach with proper monitoring and attention.

Interest rate risk: Managing interest rate risk requires a clear understanding of the amount of risk and the impact of changes in interest rates on this risk position. To make these determinations, sufficient information must be readily available to permit appropriate action to be taken within acceptable time frame. In order to ensure efficient management, use of appropriate measurement techniques is vital which include gap analysis, duration analysis, simulation analysis etc. However, each bank needs to develop and implement effective and comprehensive procedures and information systems to manage and control interest rate risk in accordance with its interest rate risk policies.

Foreign exchange risk: Foreign exchange risk is the current or prospective risk to earnings and capital arising from adverse movements in currency exchange rates emanating from trading in foreign currencies through spot, forward and option transactions as a market maker or position taker, holding foreign currency positions in the banking book (e.g. in the form of loans, bonds, deposits or cross-border investments) and engaging in derivative transactions that are denominated in foreign currency for trading or hedging purposes.

Managing foreign exchange risk involves prudent management of foreign currency positions in order to control the impact of changes in exchange rates on the financial position of the bank. A comprehensive foreign exchange risk management programme requires establishing and implementing sound and prudent foreign exchange risk management policies and developing and implementing appropriate and effective foreign exchange risk management and control procedures. A bank should establish a written policy on foreign exchange risk that includes foreign exchange risk principles and objectives, foreign exchange risk limits and delegation of authority. Foreign exchange management and control procedure need to include measurement of foreign exchange risk, control of foreign exchange activities, independent inspection and audit etc.

Equity risk: Equity price risk is the risk of losses caused by changes in equity prices. These losses could arise because of changes in the value of listed shares held directly by the bank; changes in the value of listed shares held by a bank's subsidiary; changes in the value of listed shares used as collateral for loans from a bank or a bank subsidiary, whether or not the loan was made for the purpose of buying the shares; and changes in the value of unlisted shares. Equity price risk associated with equities could be systematic or unsystematic. The former refers to sensitivity of portfolio's value to changes in overall level of equity prices, while the later is associated with price volatility that is determined by firm specific characteristics. Banks need to have security/equity analysts and portfolio management experts to take judicious decision.

Sound portfolio management involves prudent management of risk/reward relationship and controlling and minimising portfolio risks across a variety of dimensions such as quality, portfolio concentration/diversification, maturity, volatility, marketability, type of security, and the need to maintain adequate liquidity. For a comprehensive securities management programme, banks need to have well documented securities portfolio management policies, portfolio management process, portfolio monitoring and controlling procedure, portfolio management control and independent inspection on internal and regulatory compliance. Again there should be portfolio concentration limit along with transaction approval authorities to keep the risk in a tolerable level. Globally different tools are used in measuring equity price risk such as VaR (Value at Risk), variance-covariance method, historical simulation method etc. These methods are used to predict maximum loss over a target horizon within a given confidence level.

Management of liquidity risk: Liquidity risk is the potential for loss to a bank arising from either its inability to meet its obligations as they fall due or to fund increases in assets as they fall due without incurring unacceptable cost or losses. Liquidity risk arises when the cushion provided by the liquid assets are not sufficient enough to meet maturing obligations. Banks with large off-balance sheet exposures or those rely heavily on large corporate deposits have relatively high level of liquidity risk. Further, banks experiencing a rapid growth in assets should have major concerns for liquidity. Basel Committee on Banking Supervision (BCBR) also gives due consideration to liquidity in Basel-III capital adequacy framework. Considering its importance, BB also started monitoring liquidity profile of the banks at regular interval.

Liquidity risk management involves not only analysing banks on and off-balance sheet positions to forecast future cash flows but also how the funding requirement would be met. The later involves identifying the funding market the bank has access, understanding the nature of those markets, evaluating banks current and future use of the market and monitor signs of confidence erosion. While devising liquidity management strategy, banks should consider specific policies on composition of assets and liabilities, diversification and stability of liabilities, managing liquidity in different currencies etc. In order to measure liquidity position and predict liquidity needs banks can use different tools like maturity ladder, liquidity ratios and limits and contingency funding plan etc.

Management of operational risks: Operational risk is defined as the risk of unexpected losses due to physical catastrophe, technical failure and human error in the operation of a bank. These include fraud, failure of management, internal process errors and unforeseeable external events. Operational risk can be subdivided into two components: Operational strategic risk and operational failure risk. Operational strategic risk arises from environmental factors such as a new competitor that changes the business paradigm, a major political and regulatory regime change, and other factors that are generally outside the control of the bank. On the other hand, operational failure risk arises from the potential for failure in the course of operating the business emanating from people, process and technology.

Operational strategic risks can be managed through proper strategic planning on market scenario while operational failure risk can be managed through internal control and internal audit, code of conduct, delegation of authority, segregation of duties, compliance, succession planning, mandatory leave, staff compensation, recruitment and training, complaint handling, record keeping etc. Adoption of operational risk management tools ultimately helps the bank to minimise internal and external fraud, damage to physical assets, business disruption and system failure and can take the advantage of changing business environment.

Capital management: Capital management plays the most crucial role under Basel-II capital adequacy framework. Capital management refers to implementing measures to maintain 'adequate capital.' It helps to ensure that bank has sufficient capital to cover minimum risks under Pillar-I as well as capital required under supervisory review process (Pillar-II) through internal capital adequacy assessment process (ICAAP). In order to ensure sound capital management, bank should set an appropriate level of capital target for short-term, medium-term and long-term and develop a capital plan to achieve the business target considering Bangladesh Bank's regulatory capital requirement, coverage of unexpected losses up to certain probability of occurrence (economic capital), expected asset growth and profitability, dividend policy and stress test scenarios. For the same, banks need to have the policy of capital rationing in each business segment considering their risk weights. While public sector entities (PSE), banks, non-banking financial institutions (NBFI) and corporate exposures carry variable risk weight, others carry fixed risk weight. Capital rationing should be started with a sound capital allocation process. Capital requirements against operational and market risks are usually centrally controlled while capital allocation against credit risk is to be based on business line wise, sector-wise and more importantly branch wise.

It is evident that there is a clear demarcation between a bank which has a sound risk management system and a bank which does not have the same. However, successful implementation of sound risk management mechanism only can be ensured through an active oversight of board of directors and senior management, adequate policies, procedures and limits, adequate risk management, monitoring and information system, comprehensive internal control and above all sound trained human resource base to take the lead. Only then risk management can be turned into a 'profit centre' from a so-called 'cost centre'!

The author is the Chief Rating Officer of Credit Rating Information and Services Ltd. raihan175@gmail.com

News: The Daily Financial Express/Bangladesh/20-Sep-12