Risk management by financial institutions –

Time to hammer out the chinks

 Financial markets the world over have undergone far-reaching changes in

the last decade, spurred by deregulation and liberalization, as well as rapid
developments in communication and Internet technologies. Financial
institutions have generally not paid enough attention to the potential risks
and to evolve mechanisms and systems to control and manage them in line
with the global standards and procedures.

• As the Financial institutions no longer operate in a protected and regulated

environment, there is an imperative need for them to develop and improve
their capability to understand the changes in their economic environment and
other circumstances having a critical bearing on their business activities.

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Risk management is a comprehensive process adopted by an organization
that seeks to minimize the adverse effects it is exposed to due to various
factors -- economic, political or environmental, some of them inherent to the
business, others unforeseen and unexpected.

Present practices/situation Prevalent at financial institutions requires a hard

look and call for a greater understanding by bank managements and boards of
the risks involved in their operations
What is RISK ?
What is RISK ?
 It is the potential that events expected or unexpected, may have an adverse
effect on a financial institution’s capital or earnings.
 Risk is inherent in all business and financial activities.

 The greater the RISK associated with an activity the greater potential to
generate a high return.
 Financial institutions do take RISKS – The biggest RISK is Not Taking A
RISK.

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Definition of Risk Management

 Risk Management is the process of identifying, measuring, monitoring and

controlling risks

 These four points are essential to risk management

 This presentation will cover the main identified risks in Financial institutions
and determine how well risks are being managed.

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Identifying Risks

Where Risks should be Identified

 Institution-wide
 Business lines
 Products
 Transactions

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 Bank lending/Investment involves three parties :
o The suppliers of funds (The depositor)
o The users of funds (The borrowers)
o A financial intermediary (Bank)s

Supplier Bank Borrower

 Risk management is a decentralized process guided by centrally established
policies and rules .Senior staff committees define credit culture and established
overall policies and rules. Line management designs lending procedures and
controls risk.

 There are usually five major organization groups that participate in risk
management process. These groups are responsible for defining
implementation ,and/or reviewing risk management policies, rules and
procedures within the bank.
Taking risks can almost be said to be the business of bank management. A bank
that is run on the principle of avoiding all risks or as many of them as possible, will
be a stagnant institution ,and will not adequately serve the legitimate credit needs
of its society. On the other hand a bank that takes excessive risks or credit is
more likely, takes them without recognizing their extent or their existence will
surely run into difficulty.
 All business involves some type of risk and banking is no exception.

 Credit risk is major category of risk of the bank. It occurs whenever there is a
possibility that is the customer cannot meet contractual obligations to the bank
in term of :

-The delivery of documents or commodities where the bank bears the

whole risk OR
- The payment of principal, interest, fees or commissions.
The overall objective of Risk Management is to
increase enterprise value

INCREASE VALUE BY

Providing
Appropriate Increasing
Level Improving
Return on
and Consistency
Capital
Allocation of Earnings
of Capital

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The best way to reach this objective is to understand
the full risk environment within which you operate...
External Internal
Environment Environment

Economic Expansion/ Financial Risk

Conditions Diversification

Asset Risk
Culture
Social/Legal
Trends
Liability Risk
Distribution

Natural Catastrophes Risk Appetite

Business Risk
People
Competition

Event Risk
Processes
Political/
Regulatory Operational Risk
Climate Technology

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…and the complete set of strategies that are available to
you...

Financial Operational
Strategies Strategies

Hiring/Training
Financial Risk Capital
Structure
Incentive Programs
Asset Risk
Asset
Allocation Internal Controls
Liability Risk
Products
Pricing
Technology
Business Risk
Product Mix Customer Service
Event Risk
Market Strategy

Operational Risk Securitisation

Distribution

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…and to apply this knowledge
in a holistic risk management framework, to drive value
Increase Value

Return

Consisten
Capital

cy
Understand Internal
Holistically Optimise Financial
and Manage and Operational
External Environment Strategies
Financial and
Operational
Risks

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To accomplish all this in a consistent manner, it is necessary to
implement a continual management process

Develop
Best Implement
Strategie Strategies
s

Monitor
Performance and
Environment

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In summary, Enterprise Risk Management:

 Allows you to determine the necessary capital level, deploy unneeded capital
and improve return on capital

 Encourages proper allocation of capital to segments and supports

performance tracking

 Provides a method for ensuring that enterprise owners receive proper

compensation for risks assumed

Provides
ProvidesCompetitive
CompetitiveAdvantage
Advantage

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RISKS

MUST BE:
 KNOWN
 UNDERSTOOD
 QUANTIFIABLE
 CONTROLLABLE / ACCEPTABLE / BANKABLE

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RISKS FACED BY Financial institutions

 CREDIT RISK
 MARKET RISK
 INTEREST RISK
 LIQUIDITY RISK
 OPERATIONAL RISK
 COUNTRY RISK
 OWNERSIP / MANAGEMENT RISK

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THE RISK THAT THE OBLIGOR (BORROWER) WILL NOT BE ABLE TO
REPAY THE DEBT (LOAN) UNDER THE TERMS OF THE ORIGINAL
AGREEMENT (LOAN AGREEMENT).

• MOST CRITICAL RISK IN BANKING

• REQUIRES MOST SUBJECTIVE JUDGEMENT
• MUST BE MANAGED CAREFULLY

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CHANGES IN MARKET RATES AND PRICES WILL IMPAIR AN
OBLIGOR’S ABILITY TO PERFORM UNDER THE CONTRACT
NEGOTIATED BETWEEN THE PARTIES.

• NEEDS MONITORING OF CHANGES IN PRICES OF COMMODITIES,

REAL ESTATE, ETC.

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INTEREST RATE RISK IS THE EXPOSURE OF AN INSTITUTION'S
FINANCIAL CONDITION TO ADVERSE MOVEMENTS IN INTEREST RATES,
WHETHER DOMESTIC OR WORLD-WIDE.

• ANOTHER CRITICAL RISK

• RE-PRICING/ MISMATCHES NEED TO BE ADDRESSED.

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THE RISK THAT A BANK WILL BE UNABLE TO ACCOMMODATE
DECREASES IN LIABILITIES OR TO FUND INCREASES IN ASSETS. SUCH
RISKS ARISE WHEN THE REPRICING OR MATURITIES OF ASSETS DO
NOT MATCH THOSE OF LIABILITIES.

• CRITICAL RISK
• MATURITY MISMATCHES
• BASED ON MARKET CONDITIONS & PERCEPTIONS

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OPERATIONAL RISK

THIS RISK ARISES FROM THE LACK OF EFFECTIVE INTERNAL CONTROLS AND AUDITING
PROCEDURES. PARTICULARLY IMPORTANT IS THAT THE BANK SHOULD HAVE GOOD
INTERNAL CONTROLS

 Risk of a failure in the bank’s procedures whether from external

causes or as a result of error or fraud within the institution.

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RISK ASSOCIATED WITH THE ECONOMIC, SOCIAL AND POLITICAL
ENVIRONMENT OF THE BORROWER’S COUNTRY. COUNTRY RISK IS
MOST APPARENT WHEN LENDING TO FOREIGN GOVERNMENTS/ THEIR
AGENCIES AND OTHER CUSTOMERS.

• BANK’S HAVING GLOBAL PRESENCE

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THE RISK THAT OWNERS / SHAREHOLDERS, DIRECTORS OR SENIOR
MANAGEMENT MIGHT BE UNFIT FOR THEIR RESPECTIVE ROLES OR THEY
ARE ACTUALLY DISHONEST.

• ALSO A CRITICAL RISK

• ”THE BEST WAY TO ROB A BANK IS TO OWN IT”

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RISK MANAGEMENT
 Familiarisation of Management with Risks
 Implementation of Internal Controls
 Sound Internal Audit System
 Efficient MIS in Place
 Competent Group of Risk Managers
 Prompt Action & Monitoring

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Risk Quantification
 Risk quantification techniques becoming important to determine capital
requirements
 More reliance on Financial institutions’ own systems for identifying and
managing risk
 Not only quantitative; also processes and ‘culture’:

 scrutiny of model design

 data integrity
 risk management resources
 validation
 independent audit
 management understanding

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DEPOSITS IN A BANK REPRESENTS WHAT ?

 “financial institutions support a mountain of RISK on a slender capital base.

The bulk of their liabilities is redeemable at PAR and on DEMAND, with

depositors regarding their money as perfectly safe.”

 “Yet bank assets are subject to credit risk, market risk, and settlement risk.

With international lending, there is foreign exchange risk and transfer risk.
Also there is management risk and risk of fraud.”

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GENERAL

 Many of The Risks Overlap.

 Need To Be Evaluated In The Context Of Individual Institution With On-site

Presence.
 Evaluation of Risks Requires An Understanding of The Bank, its Customer

Mix, its Assets & Liabilities And The Economic And Competitive
Environment.

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INTERNAL CONTROLS
 RISK RATING SYSTEM FOR CREDITS
 CLOSE MONITORING OF OPERATIONS
 COMPETENT CREDIT MANAGERS
 DUAL CONTROLS
 SYSTEM TO STUDY THE INDUSTRIAL AND ECONOMIC DEVELOPMENT FOR ESTABLISHING TARGET AREAS
OF INVESTMENT

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Reliance on Internal Control ?

Once the management system is in place, supervisors can determine that the
systems are working properly by testing the systems. If the systems are
inadequate, the scope of the inspection can be expanded so that risks are
properly identified, quantified and corrective action initiated.

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Principles of Control

 Segregation of duties

• Dual control

• Rotation of assignments or duties

• Two weeks continuous vacation

• Adequate Compensation

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INTERNAL AUDIT SYSTEM

 IMPLEMENTATION OF INTERNAL CONTROLS

 PROVIDES SECONDARY RISK REVIEW

 INDEPENDENC.

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Objective of Internal Audit

 The overall objective of internal auditing is to assist all members of

management in the effective discharge of their responsibilities by furnishing

them with objective analysis, appraisals, recommendations and pertinent
comments concerning the activities reviewed. The internal auditor, therefore,
should be concerned with any phase of banking activity wherein he can be
any service to management

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Procedures for Internal Auditors Work
Organizational Structure of the Audit Department
Independence of the Audit Function
Auditors Qualifications
Audit Staff Qualifications
Content and Utilization of the Audit Frequency and Scope Schedule

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MIS
 AN ADEQUATE “MIS” HELPS IN TIMELY IDENTIFICATION OF RISKS

 REPORTS ON MATURITY OR INTEREST RATE MISMATCHES

 REPORTS ON PROBLEM CREDITS

 REPORTS ON CREDITS SHOWING DETERIORATING TREND IN RISK

RATING

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Thank you.
Questions

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