Done by: Mariam Zahid Ghulam Esraa Al Awadhi Lulwa Al Naoimi Najlaa Al Khalifa

Table of Contents

Title Abstract Risk Management Intro Venture Capital Bank Managing Risk at VCBank VCBank and Industry Ratios Analysis Conclusion References Capital Adequacy Ratio Return on Equity Return on Investments

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Abstract

Risk management is an important part of any company, but especially when it comes to financial intermediaries. But why is it so important? In order for any firm to gain high returns, they must face high risk in other words, no pain, no gain. Because of this, banks must establish and execute an effective risk management plan to ensure optimal performance.

This report is divided into 2 main parts: a personal interview with a risk executive at a bank and analyzing that banks risk management performance on the basis of various financial ratios. The theoretical information was gathered through various secondary resources including business websites and risk management books, while the financial information on the banks was obtained through BankScope. The aim is to understand how efficient any risk team is in implementing their risk management plan to be easily portrayed in their financial results.

Risk Management

Risk management is a practice of identifying, assessing and prioritizing varieties of risks associated. The first step is to define the risk, and then the risk manager will set up a plan in order to diminish or eliminate the potential results of the negative event. There are varieties of risks that may be associated, and the chosen strategy depends on the nature of the business. The risk management is a vital component in the business planning. The role of the business management is set to dispose of risk that may pose a threat to the business. Applying it on a broader view, RM plays an essential role in the financial system as a whole, the results obtained from this activity has a great impact on society. An example of an inadequate risk management is the recession that occurred in the 2008, which was a result of loose credit risk management of financial institutions. In order to assure a sound system, and avoid another chaotic event, there are several risk management standards to be applied, such as the International Organization for Standardization (ISO).

Venture Capital Bank

Venture Capital Bank is the oldest Islamic investment bank in the GCC, Middle East and North Africa that specializes in venture capital investments opportunities and offers risk adjusted returns on investments. In October 2005, VCBank was established in the kingdom of Bahrain, with the license of Islamic investment banking from the Central Bank of Bahrain. VCBanks offers exclusive services and distinctive opportunities to its clients across the GCC and MENA Markets. The bank is segregated into 4 areas, which are venture capital and business development, private equity, financial advisory and real estate. Venture Capital Bank has been distinctively set in order to support the fundamentally strong, high potential and undervalued small to medium enterprises(SMEs) substantially, who lack the necessities for growth and expansion, and in order to lead this emerging venture capital industry. The bank ensures that all their performance, activities, rules and principles are all Shariah compliance, and use the Shariah as a guide for their behavior and profession. Venture Capitals vision is to continue growing, and to be the leading regional Islamic venture capital based investment bank, helping to drive business growth, and supporting the social and economic development of the MENA region. Venture Capital has been the chosen bank to conduct our assignment on, and have interviewed the Risk Management Executive, to address certain information we seek.

Head of Risk Management

Tat Thong Tan (FRM, CFP) is an executive director at Venture Capital Bank. Malaysian by nationality, Mr.Tan grew up in Singapore and England. He came to the region in 2007, after spending 17 years in Malaysia, Singapore and Hong Kong. What had interested him to join the bank was the fact that it was a venture capital, which in this region, is still in its infancy. His job as a risk manager is attempting to manage the banks risk.

Managing Risk at VCBank

The bank became operational in late 2005 with the aim of being a top Islamic investment bank focusing on venture capital/private equity. It was established with a paid up capital of 66 million dinars which increased to 150 million over a year. In terms of their risk profile, they have implemented the originate to distribute model where an asset is sourced for which they must find investors. They are also performing asset management business that functions on a much smaller scale.

Venture Capitals risk management process is set up of three broad functions: 1. Identify 2. Quantify (measure) 3. Mitigate

The identifying part of risk management starts out with a clear understanding of the various risks the banks will be faced with. The financial statements of the bank are studied for any of the banks risks. It is then the managers job to get involved with his employees, review the banks policy and the entire set up. The various risks faced by the bank derive the acronym CMOLOGIC which stands for credit, market, operational, liquidity, others, governance, interest rate, and capital risk. There are 2 types of liquidity risks: the banks cash position and fluctuations in asset prices. As an Islamic bank, they face risks when they are unable to find investors for their assets these assets for which they themselves are sponsors and they inject their cash. Despite of the different kinds of risks, Venture Capitals main concerns are credit and liquidity risk. In order to manage credit risks, VC has assigned certain limits such as concentration risk (need to know geographic and sectorial spread of assets), single exposure limits (where the carried value exceeds 10%), 6

connected counter parties (whether investments have been extended to a subsidiary/shareholder), and interbank limits. The bank carries out scenario analyses and sensitivity analyses to test how they would react to various situations. Quantifying risk involves applying numeric figures to each of the banks risks. VC bank has implemented different methods to measuring each type of risk. For credit risk, they are following one of Basel IIs prescriptions of 3 approaches: the standardized rating approach. In the case of market risk they use value at risk (VAR) and the risk matrix system, among others. Self assessment and loss registering are applied to measuring operational risks (basic indicator approach). Liquidity risks are managed by the banks own cash injections and, at the same time, they provide a certain level of capital for their other types of risks. VC also carries out risk governance where the board of directors delegates the risk committee overseeing the risk management framework. The risk manager, Mr.Tan, reports to (and gets instructions from) the risk committee functionally and, on an administrative basis, reports to the CEO. As a part of mitigating risks, the manager keeps an eye on controls via limits and then makes reports. Being a venture capitalist, they are not using any tools (web-based or software) in their risk management process. This is because of the fact that typically systems are associated with market risks and to give an overview or macro view of their banks risk position. The risk manager strongly believes that Venture Capital has incorporated Basel II fully, though they are facing challenges (ICAAP Internal Capital Adequacy Assessment Plan). In order to calculate their Capital Adequacy Ratio, they are using the following formula:

Single exposure limit those investments whose value exceeds 10% of capital, hence if capital is 100 and investments is $20 then the investment is a large exposure of 20%. The risk weighted assets is divided into credit, operational, and market risks. If the bank faces any risk problems, their risk option is to share not transfer risk.

Regardless of the application of Basel II, it is found to be ineffective for an investment bank even though it is a good framework to monitor risks. The central bank requires banks to keep their capital at 12%, but the company has kept this value in the region of high 30s - indicating they are a fairly well capitalized bank. The risk manager finds this level of ratio as ideal and even wishes to strengthen it further. Both Basel II and Basel III frameworks are efficient when applied to commercial banks, irrespective of whether they are conventional or Islamic, but need to be reassessed in terms of investment banks.

According to the risk executive, risk management is both an art and a science. The science involves implementing the correct systems, while art requires creative thinking. Essential for risk management: know the types of risk, know the process, and risk management is a science and an art.

VCBank and Industry Ratios

To obtain a macro view of the banks performance, several financial figures were gathered and compared to that of the industry. Venture Capital is a relatively small bank, in comparison to many banks in the sector, including those which were chosen to conduct the analysis. The banks chosen along with VCBank were Arcapita, another Islamic bank that also deals in venture capital along with many other activities, and Investcorp Bank BSC, a conventional investment bank. The following table gives a brief description on the position of the three banks:

Venture Capital Bank

Total Assets* Net Income* 199 mil USD -59 mil USD

Arcapita
3718 mil USD 50 mil USD

Investcorp
2859 mil USD 140 mil USD

Country Ranking World Ranking

*latest figures available

28 10007

9 2323

10 2644

As can be seen, VCBank possesses a weak position in the industry, both country- and worldwide. Even with its narrow performance (dealing mostly with SMEs), the bank has been incurring a loss in the past year. Despite its size, the bank should be able to perform on positive results, if not at the same level. This analysis studies how VCBank is able to control the risks it is subject to and stop it from affecting its performance.

Capital Adequacy Ratio (CAR)

Total Capital Ratio Total Capital Ratio Total Capital Ratio

VC Arcapita Investcorp

n.a. 15.80 25.70

45.44 12.70 22.90

50.74 17.10 20.04

46.52 18.59 18.37

Banks throughout Bahrain are required to keep a minimum capital adequacy ratio of 12% as per enforced by the Central Bank of Bahrain. A CAR ratio at 12% is essential while one that is only slightly higher is considered favorable by most banks. Comparing the three banks, Arcapita is the only bank that has maintained its ratio at and around the required percentage (fluctuating without a clear pattern). Investcorp, on the other hand, has had its CAR ratio increase over the years and is currently at 25.70 projecting the banks sound position. Venture Capital is the only bank to go beyond the necessary percentage, with a CAR ratio of over 50% in 2009. It is approximately double that of Investcorp and almost tripling over Arcapita. Though maintaining a CAR above the requirement is acceptable, and, at times, preferable, this level may be a side effect to VCBank. This means that a large amount of the money belonging to the bank is tied up in provisions/risk management and therefore, less than half that amount is made available for investment and continuation of other business activities.

Risk Weighted Assets

2011 2010 2009 2008

Venture Capital Bank

n.a. -7.82 1.70 10.16

Arcapita
0.79 -7.87 -1.25 6.10

Investcorp
3.51 2.44 -17.67 2.24

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Return on Equity (ROE)

Peer group:

Comparison: Return on Average Equity (ROAE) 2011/2010/2009 - 3 banks

All investors would like to gain the highest possible return without dealing with any of the risks involved. A high equity ratio is good for the economy as it protects banks against future crises. Overall, the higher a banks ROE in comparison to the rest of the industry, the better. While, banks like Arcapita and Investcorp are striving to increase their return on equity, VCBanks ROE ratio faces a drop. Although, this ratio has its drawbacks. It encourages banks to select risky, high leverage investments in order to increase its performance. It may also be argued that in the finance industry, there is generally no reason why banks ROE stays high for an extended time period because of high competition. Hence, high returns as compared to industry norms may be a sign of future problems. It could possibly mean the business is unaware of its risk, taking too much risk, or barely meeting regulations. Despite this, rare a case exists where high-return banks have failed.

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Return on Investments (ROI)

Comparison: Return on Average Assets (ROAA) 2011/2010/2009 - 3 banks Peer group:

Return on investments seeks to measure the profitability on an investment and can be modified to accommodate the type of investments made (in this case, assets). It must be remembered that banks are constantly highly leveraged when calculating this ratio and therefore, a percentage as small as 1 indicates large profits. By a look at the chart, it seems that there is some correlation between a banks ROE and ROI as one ratio increased or decreased, so did the other. As a result, when the return on equity for VCBank dropped in 2010-2011, return on the assets of the bank plummeted to an even greater degree. This value is again inconsistent with those that are a norm in the industry at the current period. The issue with this ratio is that it can be manipulated in favor of the banks purposes.

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Analysis

Just by looking at the financial performance of Venture Capital Bank, Mr.Tan may be right about the fact that the Basel Accord is ineffective when dealing with investment banks. But in comparison to two highly ranked banks that function within the same industry, it shows that investment activities have little to do with Basel, regardless of whether it is a conventional or an Islamic bank. VCBank is spending too much capital to protect against risks, when they are barely taking any risks in the first place. Based on the CAR ratio results, the bank is either too wary of the risks of activities or it is heavily investing in risky businesses. The latter may be true as the bank deals largely with SMEs, but then the remaining two ratios, ROE and ROI, should be showing positive results much higher than those of its rivals. In relation to the argument against high ROE, where the bank is unaware of its risk, taking too much risk, or barely meeting regulations, it is understandable as to why a bank may wish to simply maintain its current positive ratio. Though, despite the fact that VCBank has exceeded financial regulations and working hard to mitigate risks, the bank has been showing increasingly dropping return on equity. This is another factor that indicates the company is actually not taking enough risks. Finally, ROI has been falling in the same manner as ROE, which is a vivid statement of the banks negative income and poor performance. Experts say that a minimum of 10% is required for future growth, so the bank is clearly making the wrong investments that are bringing losses.

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Conclusion

The bank is following a highly conservative approach and there is definitely poor management performance. They may not be up to proper risk management standards as Mr.Tan states it to be. Strong adherence to the financial regulations is useless if the bank is not willing to take the necessary risks to become successful. VCBank must reestablish their risk management plan in such a way that will allow them to take the risks that will grant them a profitable position. It is logical as to why the bank would want to maintain a high CAR ratio, especially when Islamic banks are not allowed to take excessive risks, but it also unacceptable, in finance and in Islam, for the money to remain idle or be invested without a gaining purpose. If other banks can perform profitably while following CBB standards, then there is no reason for Basel to not be effective when applied to investment banks.

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References:

http://www.vc-bank.com/vision.html http://www.investopedia.com/terms/r/riskmanagement.asp#ixzz1wqdE6D7y http://www.whatisriskmanagement.net/

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