Literature Review of Risks in Banking

Introduction

Commercial banks play an important role in economic development of a country. The stability, integrity and efficiency of the banking system are therefore, critical to the performance of an entire economy. Historically, banks have played an important role in the financial markets. This is mainly because; they perform a critical role in facilitating payments and play a significant role in channeling credits to households and businesses.

Innovations in the financial markets and free movement of capital flows have changed the face of banking sector almost beyond recognition. Today, banks have diversified into non- traditional markets and no longer perform only the simple intermediation function of deposit taking and lending. Apart from traditional banking, they also offer specialized services such as fund administration, custodial services, trusteeship, structured lending, structured trade finance; international portfolio management, investment banking, private client activities, treasury and specialized finance.

Following the fact that they have ventured into sophisticated services, the overall profitability of banks has increased. Nonetheless, it is noteworthy that this has rendered the market very volatile. According to Julian S. Alworth and Sudipo Bhattacharya (1995) “the wave of financial innovation and changing character of banking activity, which has swept through financial markets since 1980s, raised several doubts about the adequacy of financial institutions’ risk management procedures and contributed to several changes in the existing regulatory framework. The new instruments have also drawn attention to areas where financial risks were previously thought to be relatively unimportant.” Hence, banks are now exposed to a greater variety of risks and their ability to measure, monitor, and steer risks comprehensively is becoming a decisive parameter for their survival. In order to survive the ever changing environment, it is critical for banks’ managers to develop risk management capabilities.

In recent years, risk management at banks has come under increasing scrutiny. Banks and bank consultants have attempted to sell sophisticated credit risk management systems that can account for borrower risk (e.g. rating), and, perhaps more important, the risk-reducing benefits of diversification across borrowers in a large portfolio. Regulators have even begun to consider using banks’ internal credit models to devise capital adequacy standards.

THEORETICAL REVIEW

2.2 Risks in banks

Risk is defined as “the potential that events, expected or unanticipated, may have an adverse impact on the organization’s capital or earnings.” Broadly speaking, risk arises as consequence of activities or as consequence of non-activities and is considered to be an inherent factor in the financial system. Those interacting in the financial market usually face different types of risks.

2.2.1 Taxonomy of risks

Several classifications have been proposed in the context of risks faced by financial markets and institutions; the major risks are as follows:

Operational risk
Liquidity risk or funding risk
Market risk
Interest rate risk
Foreign Exchange risk
Credit risk

Operational risk

Operational risk is the risk of direct or indirect loss resulting from inadequate or failed internal processes, people, and systems or from external events (Basel Committee on Bank Supervision, 2001). In other words, operational risks arise from a breakdown in the bank’s system of internal controls, and corporate governance. In fact, banks is exposed to various types of operational risk, including the Bank is exposed to various types of operational risk. This includes the potential losses arising from internal activities or external events caused by breakdowns in information, communication, physical safeguards, business continuity, supervision, transaction processing, settlement systems and procedures and the execution of legal fiduciary and agency responsibilities.

Liquidity or funding risk

Liquidity risk is the risk of loss arising from an inability to quickly realize asset value or obtain funding. In banking jargon, it is the risk that there arises a massive withdrawal by depositors and the consequent obligation for the banks to make payments. This may oblige the banks to liquidate assets in very short period of time and at low prices.

At the micro- economic level, liquidity management is not fundamentally different for banks than for other industrial and commercial firms. However, at the macro- economic level, the situation is different because the liquidity problems of a single bank can affect other banks.

Liquidity risks are normally managed by a bank’s Asset Liability Management Committee (ALCO).

Market risk

Market risk is defined as the possibility that a bank makes a loss caused by changes in the market variables. It is, in fact, the impact that movements in the market will have on the value of on/off balance sheet positions of an institution. In other words, it is the risks to the bank’s earnings and capital following changes in the market level of interest rates or prices of securities, foreign exchange and equities, as well as the volatilities of those prices.

Interest rate risk

In the context of banking, interest rate risk is the risk incurred by a bank when the maturities of its assets and liabilities are mismatched and there are changes in market interest rates. This risk arises mainly because the liabilities (deposits) of banks are on average of a much shorter maturity than their assets (loans). Interest rate risks can be classified into 4 groups, namely: repricing risk, yield curve risk, basis risk and optionality risk.

Foreign Exchange risk

Foreign Exchange risk, currency price risk, or currency exposure is defined as the increase or decrease in net income and economic value as a result of fluctuations in currency exchange rates.

Banks and other institutions can experience currency risk in one of the three ways: translation risk; translation risk and economic risk.

As regards the management of foreign exchange risk, the basic tools used are spot and forward contracts.

Credit risk

Credit risk is the rise or fall in the net asset value which arises when parties to an agreement are not able to fulfill their contractual obligation. In other words, it is the risk that the promised cash flows from the loans and securities held by banks may not be paid in full. Credit risk can be subdivided into three risks: default risk, exposure risk and recovery risk. Following the fact that the major risk banks encounter is credit risk, sound credit risk management should be undertaken.

The management of credit risk in banking industry follows the process of risk identification, measurement, assessment, monitoring and control. It involves identification of potential risk factors, estimate their consequences, monitor activities exposed to the identified risk factors and put in place control measures to prevent or reduce the undesirable effects. This process is applied within the strategic and operational framework of the bank.

The largest source of credit risk in banking institutions arise from loans. Moreover, other sources of credit risk includes acceptances, inter bank transactions, trade financing, foreign exchange transactions, financial futures, swaps, bonds, equities, options, and in the extension of commitments and guarantees, and the settlement of transactions.

Following recent crises and financial disasters, regulators have increased the examination and enforcement standards as far as credit risk is concerned. In banking sector, Basel II has established a direct linkage between minimum regulatory capital and underlying credit risk, market risk and corporate risk exposure of banks. Basel II follows Basel I (enacted in 2001) and is an international business standard that requires financial institutions to maintain enough cash reserves to cover risks incurred by operations.

The theoretical banking literature is, however, divided on the effects of capital requirements on bank behavior and consequently, on the risks faced by the institutions. Some academic works point toward that capital requirement clearly contributes to various possible measures of bank stability. On the contrary, other works conclude that capital requirements make banks riskier institutions than they would be in the absence of such requirements.

Over the years, banks have been developing models to improve their calculation of credit risk. In fact, it varies on a bank to bank case. It should be noted that regardless of the size, it must take into account three main factors: the probability of default, the exposure of credit and the estimated rate of recovery. Apart from calculating credit risk, banks can also instigate credit risk limits and stipulate a maximum amount that an individual or party can loan.

Profitability

Generally speaking, profit refers to the surplus money available in an institution after all expenses have been met. In the same line, banks earn profit by deducting its expenses from its receipts. The main portion of banks’ profit arises from the fees that they charge for the services provided and interest that they earn on their assets. On the other hand, the major expense is the interest paid on its liabilities.

Return on Equity in banks

The measurement of bank’s performance has been developed over time. Traditionally, many banks have been using a pure accounting driven approach, the Return on Assets. This approach however disregards the underlying risks involved following the transactions and the growth of off balance sheet activities. With time, banks notice that equity has become the scarce resources. As a result, banks started to focus on return on equity to measure the profitability of their institutions. The efficiency of the banks can be evaluated by applying ROE, since it shows that banks reinvest its earnings to generate future profits. The growth of ROE is also dependant on the capitalization of the banks and operating profit margin. If a bank is highly capitalized through the risk weighted capital adequacy ratio or tier 1 capital adequacy ratio, the expansion of ROE will be retarded.

Empirical review

Risk can be basically defined as the degree of uncertainty of net future returns. Those interacting in the financial markets will usually face different types of risks since uncertainty come in several ways. This is the reason why uncertainty is used as a source to classify risk.

David H.Phyle (1997) defined risk as a fall in a firm’s value because of the changes in the dynamic business environment. In my study, I will be focusing mainly on credit risk.

The Monetary Authority of Singapore (2006) has defined credit risk as the “risk arising from the uncertainty of an obligor’s ability to meet its contractual obligations.”

Regarding the importance of this kind of financial risk, Kaminski and Reinhart, as cited by Jackson and Perrraudin (1999) think of it to be the largest element of risk in the books of most banks and if not managed in a proper way, can weaken individual banks or even cause many episodes of financial instability by impacting on the whole banking system. In the same line, according to M.J Mc Donough (1999) “credit risk remains the predominant risk for most banks”.

Since this risk carries the potential of wiping out enough of a bank’s capital to force it into bankruptcy, managing this kind of risk has always been one of the predominant challenges in running a bank (Broll, Pausch and Welzel, 2002).

Different authors have expressed different criteria regarding the classification of credit risk. It was argued by Hennie (2003) that the main types of credit risk are consumer risk, corporate risk and sovereign or country risk. Culp and Neves (1998), on the other hand, consider realized default risk and resale risk to be the two main types of credit risk. Horcher (2005) defines six types of credit risk, namely, default risk, counterparty settlement risk, legal risk, country or sovereign risk and concentration risk.

According to Horcher (2005), traditional credit risk relates to the default on a payment, especially lending or sales.

Suresh N, Anil Kumar S, and Gowda D.M (2009) conducted a study to establish a framework for measuring and managing credit risk for fifteen private banks in India. The main aim of the research was to evaluate the Non Performing Assets (NPAs) as a percentage of total assets of private banks. It was concluded that the NPAs level of private banks had a decreasing trend and by comparing the critical values, it was found that homogeneity does not exists among banks with their credit exposures.

A. Sinan Cebenoyan and Philip E. Strahan (2001) tested how active management of bank credit risk exposure through the loan sales market affects capital structure, lending, profits, and risk.

They estimated a series of cross-sectional, reduced form regressions that relate measures of capital structure, investments in risky loans, profits and risk to control variables (designed to capture the extent of a bank’s access to an internal capital market) to measures of the bank’s use of the loan sales market to foster risk management. They concluded that banks that engage banks that engage in both buying and selling of loans are better able to take advantage of positive net-present- value investment opportunities, as they are able to increase their C&I and commercial real estate loans and are better able to manage with less liquidity and less capital. In fact, they argued that increasingly sophisticated practices in banking are expected to improve the availability of banking credit but not reduce bank risk. Similarly as Froot and Stein (1998), they found that that credit risk management through active loan purchase and sales activity affects banks’ investments in risky loans. In addition, they also tested whether loan sales activity reduces risk and leads to an increase in return on equity (ROE) and risk adjusted returns on equity (RAROC). They found that the buy-and-sell banks do display significantly lower risk (i.e. lower variability of loan losses and profits) and higher profit than banks doing similar activities but not using loan sales to manage their credit risk.

Xiuzhu Zhao (2007) studied the credit risk management in the major British banks. He found that the UK banks are generally maintaining same level of credit exposure from 2004 to 2006. In fact, following the analysis, he argued that the major British banks with larger size have managed credit risk in a more comprehensive manner when compared to the smaller banks. He further argued that the larger banks follow the Basel guidelines better and have adopted different means for assessing, granting and mitigating credit risk.

Athanasoglou, et al.(2006) study the profitability behavior of the south eastern European banking industry over the period 1998–02. The empirical results suggest that the enhancement of bank profitability in those countries requires new standards in risk management and operating efficiency, which, according to the evidence presented in the paper, crucially affect profits. A key result is that the effect of market concentration is positive, while the picture regarding macroeconomic variables is mixed.

Demirguc-Kunt and Huizinga (1999) examined how capital requirement alter the incentives that banks face. An increase in capital requirement necessitates banks to substitute equity for deposit financing, reduce shareholder’s surplus. The decline in surpluses intensifies the probability of loss, driving a rise in the cost of intermediation to sustain profitability. In support of this hypothesis, authors have provided empirical evidence showing a significant effect on interest margins pursuant to higher capital holdings and the share of total assets held by banks. The evidence also supports higher net interest margins and more profitability for well-capitalized banks. This is in harmony with the fact that banks with high capital ratio have low interest expenses due to less probable bankruptcy costs.

Samy and Magda (2009) focus on the impact of capital regulation on the performance of the banking industry in Egypt. The study provides a comprehensives framework to explicitly measure the effects of capital adequacy on two specific indicators of bank performance: cost of intermediation and profitability.

Goddard, Molyeux and Wilson (2004) analyzed the determinants of profitability of European banks. The authors found a considerable endurance of abnormal profits from year to year and a positive relationship between the capital-to-asset ratio and profitability.

Ara Hosna, Bakaeva Manzura and Sun Juanjuan (2009) studied the relationship between risk management and profitability of Sweden’s commercial banks. The proxy used to determine profitability is Return on Equity and that for credit risk management are Non Performing Loan Ratio and Capital Adequacy Ratio. They argued that indeed there is an effect of credit risk management on profitability on reasonable level with 25.1% possibility of Non Performing Loan Ratio and Capital Adequacy Ratio in predicting the variance in Return on Equity.