Bank risk management and risk aggregation
Mantrac, the official distributor of caterpillar equipment in the country, has been operating for the past 78 years in Ghana. Maxwell Akalaare Adombila of the GRAPHIC BUSINESS (GB) caught up with the Managing Director, Mr Emad Adeeb (EA), and first asked him how Mantrac Ghana is faring currently?
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Bank risk management is a major concern and forms an integral part of day-to-day banking operations, especially after the financial crisis and credit crunch in the late 2000s. The role of risk management in the banking industry cannot be underestimated.
Generally, risk management refers to the mechanism of assessing and measuring the potential or actual dangers that an industry is likely to face. Stated differently, itis the process of monitoring and addressing the potential for loss. Managing banks and financial institutions has never been an easy approach.
However, the uncertainty of the economic environment, especially the banking industry, has increased in recent years. This has necessitated the adoption of right measures and strategies to mitigate risks exposures. Bank risk management has been an area of concern to the financial industry, especially supervisory authorities. This can be attributed to the fragile nature of the industry.
The banking industry is prone to many forms of crises and failures. This makes it necessary for regulators and authorities in the industry to put in place risk measures that would deal with any form of risk the industry is confronted with; and to mitigate current and future risks that could lead to failures or crises.
This is a major challenge to authorities; it behoves regulators to develop prudent regulations that would stabilise the financial sector. Figure 1 below presents a summary of some identified forms of risk in the banking industry.
Figure 1: Types of Banking Risk
Figure 1 above depicts various forms of risk a bank could face in its day-to-day operations. It shows some pertinent factors that affect risk management in the banking sector. These bank risk factors are broadly categorised into economic environment, market opportunities, and business model. The following section presents brief explanations on some of the major forms of risk inherent in the banking sector.
FORMS OF RISK
Market Risk is a major type of risk that arises due to market factors, especially macroeconomic factors, such as the movement of interest rates, volatility of exchanges rates, changes in prices of commodities, bonds and equities. Adaption of pragmatic measures could effectively mitigate the adverse effect of market risk on the performance of institutions in the financial industry.
Credit Risk refers to the likelihood that counter party may not pay amounts (debts) owed to the other party when they fall due; it is the risk that a borrower will not repay a loan according to the terms of the loan, either defaulting entirely or making late payments of interest or principal.
Stated differently, it is the risk characterised by an uncertainty in counterparty’s ability to meet his or her obligations in accordance with agreed upon terms.
This is so severe with the financial industry because it could arise from both internal and external factors. Usually, competition in the industry leads to many adverse and moral hazards, resulting in loan default.
Operational Risk relates to loss attributable to action on or by people or processes; infrastructure or processes; infrastructure or technology or similar, which have an operational impact, including fraudulent activities.
It refers to risk of loss resulting from inadequate or failed internal processes, people and systems, or from external events. Operational risk includes internal and external fraud; employment practices and workplace safety; clients, products and business practice; damage to physical assets, business disruption and system failures execution; delivery and process management.
Prudent internal control measure could mitigate operational risk.
Liquidity Risk is the risk that amounts due for payment cannot be paid due to lack of funds. This creates the problem of overall poor performance, since inadequate cash flow or liquidity could limit the frequent transactional activities of the firm.
Legal or Regulatory Risk is the risk of non-compliance with legal or regulatory requirements. The emergence of such risk could lead to huge amount of cost and decrease in revenue or close down of the institution.
Reputation Risk is the risk that the reputation of a financial would be seriously affected. It refers to the potential that negative publicity, whether true or not, would result in loss of customers, severing of corporate affiliations, decrease in revenues; and increase in costs.
In addition to the foregoing, there are other types of risks that could equally affect banks’ performance. The easiest way of measuring risks faced by banks is to start from the common forms such as market, credit, and liquidity risks, to the more complex ones such as reputation risk and others.
That is, from quantitative to qualitative measurements and assessments. Bank risk management seeks to measure or have an economic capital that would allow banks to stay solvent. This is often made possible through risk aggregation.
Risk aggregation and bank risk management
As noted earlier, banks are saddled with many forms of risk. As a result, there is the need for banks to aggregate these risks in order to obtain with relative ease or estimate the needed economic capital required to stabilise the banks in case of failure.
Risks aggregation refers to efforts by the banks to develop quantitative risk measures that incorporate multiple types or sources of risk. The most common approach is to estimate the amount of “economic capital” that a bank or the financial institution believes is necessary to absorb potential losses associated with each of the included risks.
This is typically accomplished through statistical techniques or methods designed to assess the likelihood of potential adverse outcomes, although the use of specific stress scenarios is also relatively common.
Risk management for banks involves risk measurement and risk control at the individual risk level, including market risk for trading books, credit risk for trading and banking books, operational risks and aggregate risk management.
In many banks, aggregate risk is defined using a rollup or risk aggregation model; capital, as well as capital allocation, is based on the aggregate risk model. The aggregate risk is the basis for defining a bank’s economic capital, and is used in value-based management such as risk-adjusted performance management.
According to Basel Committee on Banking Supervision (2008), some firms (Banks) remain doubtful of the value of these methods and techniques, particularly efforts to reduce all risks into a single number. Others believe there is the need for a common metric that allows risk-return comparisons to be made systematically across business activities whose mix of risks may be quite different.
Basel committee (2008) described risk aggregation as one of the more challenging aspects of banks’ economic capital models. Realising that there has been some evolution in banks’ practices in risk aggregation, the Basel Committee noted that, the approaches to risk aggregation are generally less sophisticated than sub-risk measurement methodology.
One of the main concerns in risk aggregation and calculation of economic capital is their calibration and validation, requiring a substantial amount of historical time-series data.
However, most banks do not have the necessary data available and may have to depend heavily on expert-judgment in calibration. In brief, one can say the core aim of aggregating risk is to help, and simplify the work of bank risk management with the aim of arriving at or estimating a reliable economic capital.
The most concern of regulators is how to persuade banks to meet the dire requirements for preventing systemic risk exposures. Thus, the ultimate expression of the risk aggregation trend is the emergence of economic capital methodologies that seek to aggregate multiple types of risks into a single metric.
The economic capital methods seek to assess the amount of capital needed to support a given set of risks. They are often based on statistical methods, for example, the amount of capital needed to absorb losses up to a specified probability say, 99%.
But in many cases, they also incorporate stress-test or scenario-based methods to measure the amount of economic capital that a firm would need to cover up potential losses that would be associated with a given set of risk exposures.
Among the industry players that are at the forefront of exploring economic capital approaches, there is wide variation in the manner in which aggregated risk measures, such as economic capital, are used in risk management decision-making.
For credit risk, banks have increasingly applied Value-at-Risk (VaR)-based methods to estimate the required economic capital, although there is substantial diversity across banks in their approaches. The economic capital is of major concern because it helps the banks in conducting the day-to-day business activities of the bank and capital planning.
The economic capital should be transparent and taken seriously if it would be the core capital for making business decision and risk management.
The subsequent edition would explain briefly, some of the common methodologies employed by the banks to aggregate risk.