As we all know the banking industry have faced the greatest losses in the past decade. Big companies and small as well was highly influenced by this dilemma that led some of them to bankruptcy and announcing big losses. Due to this shocking experience, commercial banks have boarded upon an upgrading of their risk management and control systems. We all wonder about How commercial banks manage their risks?, And what are the risks do they face?, here in this papers we will answer these questions and focus more in commercial bank risk management. We will begin define the commercial bank, and their role, then we start focus on the types of risks engaged, the risk in providing banking services, bank risk management system, non-performing assets and what is their problem, risk aggregation, and comparison between UAE and foreign banks.
Commercial banks and their role
Commercial banks: are financial institutions and the middle, and they are accepting deposits from clients as well as they lend money and providing transactions, saving accounts and money market accounts.
The role of the commercial banks
-processing of payments by way of telegraphic transfer, EFTPOS, internet banking, or other means
-they issue bank drafts and bank cheques.
-accepting money on term deposit.
-lending money by overdraft, installment loan, or other means.
- Cash management and treasury.
Types of Risks engaged
Risk business that is what commercial banks are involved in. In fact, Commercial banks believe in wide different kinds of financial risks, in the phase of processing and providing financial services. The understanding of the commercial bank's places, have been improved significantly over the last decade, and that was the reason behind all risks that have been written in the financial sector of the commercial banks, in two ways, the financial press and the academic literature. Since these financial institutions have the skill and capability in providing funding capacity, market knowledge, and transaction efficiency, that helps the market participants to seek all what they need of services from these financial institutions. And these rules have been managed in order to be performed and gives these financial institution the ability to act as a principle in the transactions, and they use their balance sheet to assist the transaction and attract the risks that comes from it. In the other hand there are some of the activities that are performed without having direct balance sheet implications, and it's including the advisory and agency activities.
Financial institution's risks can be divided into three types, first one is the risk that any simple business practices can avoided it, and they make a lot of actions that can reduce the risk and the chance of losses from any standard banking activity. And it should contain at least three different types of actions, and the aim of these actions is to try as hard as they can to get the firm scarlet from any risks that are not necessary to the financial services. Second one is the type of risks that we can easily reduce it, by transferring it into other participants. That helped in doing changes in the duration of the borrowed items. The third type of risks is the one that they use the firm's resources which help in managing the firm level. In this case the firm can easily achieve and seek for the financial performance goals, but all that matters that the institutions should keep in managing and observing the risks efficiently.
Managing the risks is an essential part of the institution's actions, although the management of the banking firms should relies on a series number of steps that must be apply a risk management system. These steps are divided into four main parts:
Standards and reports: which include two main activities one is the financial reporting and the other is the standard setting.
Position limits and rules: where they use minimum standards and position limits for any participants. Assets and counterparties, is the only who restrict the risk taking and they pass some pre specified quality standard.
Investment guidelines and strategies: here the strategies are pointed in terms of concentrations to some particular places of the market, and they need to hedge against any systematic risk of a particular type when there is any mismatching in the extent of desired asset-liability.
Incentive schemes: management here can enter into line managers and make some reward because of the incentive compatible contracts that they enter it, and it's related to the risks that actually stands by these individuals, after that they need for some elaboration and costly controls is tapering.
Risk in providing banking services
In order to talk about the risk that the banks might take by providing their services there are so many types of them and it depend on the service they will give.
There are six types of risks the banks could face which they are the market risk, credit risk, Counterparty risk, liquidity risk, operational risk, and legal risks.
But we are going to brief on the three types of them.
The first type is the systematic risk: The systematic risk has an issue that it can't be diversified but it can be hidden, and this kind of risk is undiversified risk.
The systematic risk can come in many different forms, for the banking sectors there are two factors to be concern about the first one is the variation in the general level of interest rate and the second one is the change of currencies value.
Since that the banks relies on this systematic factors they are trying to limit the risk that this factors could give them which could impact on their performance and tries to hide against them. The international banks with a high currency position they can monitor the foreign exchange risk.
The second type is the liquidity risk: the best description of this risk as the funding crises, which includes the need for planning a growth and the unexpected increase of credit which the risk is obviously seen here as a likely of supporting crises. And such a situation could have an unexpected event might occur like a huge claim could happen, the price of currency might fall down, or the less of confidence.
The third type is the operational risk: It is Associated with everyday operation problems. It also arises in record keeping, developing system failures and observance with different regulations. As such, individual operating problems are small probability events for well-run organizations but they expose a firm to outcomes that may be cost a lot.
Bank Risk Management Systems
The thing that we all need to understand is that we are also influenced by this risk. The risk exposure reaches us through dealing with credit, interest rate, foreign exchange and liquidity risk. While they distinguish counterparty and legal risks, they view them as less related to their interest. Where counterparty risk is weighty, it is estimated by using standard credit risk procedures, and often within the credit department itself. Similarly, most bankers would view legal threats as ascending from their credit choices or, proper a process not engaged in financial contracting.
So the study of bank risk management is a look for a solution of how they can manage these risks to achieve this or making it happened each of these risks should be outlined and pointed to control it in each area. And it starts with discussing the risk. The more difficult and complicated issues like legal, regulatory or reputational risk will be left to the end.
The Problem of Non-Performing Assets
Globalization guided by the government in the early 90s exploded many face up to the financial sector, which directed banks among many others to combine theirs standards to meet global and international standards set by global players. They needed to have a deeper look into their balance sheet and examine them seriously. Banks depend critically on the profits they get from loans and advances. Advances represent more than 60% of the total assets of the bank. It means it is the base of the structure of the bank. Improvement in assets quality is essential to intensification working of banks and improving their financial capability.NPAs are an expected load on the banking industry. Successful management of NPAs requires suitable internal checks and balances system in banks. This part is designed to give an outline of trends in NPAs, and highlight the importance of NPAs management. NPA is an advance where payment of interest or repayment of instalment of principal or both remains unpaid for a period of 90 days or more.
Trends in NPA levels:
The study was based on information collected from banks about RBI reports, data and discussion with bank officials. For assessing comparative position on CARR, NPAs and their recoveries in all scheduled banks viz., Public sector Banks, Private sector banks were perused to identify the level of NPAs. The Table below lists the level of non-performing assets as percentage of advances of public sector banks and private sector banks. An analysis of NPAs of different banks groups indicates, the public sector banks hold larger share of NPAs during the year 1993-94 and gradually decreased to 9.36 per cent in the year 2003. On the contrary, the private sector banks show fluctuating trend with starting at 6.23 per cent in the year 1994-95 rising up to 10.44 per cent in year 1998 and decreased to 8.08 per cent in the year 2002-03.
Year / Banks
Public Sector Banks
Private Sector Banks
Gross NPAs Net NPAs
Gross NPAs Net NPAs
1993-94
24.80 14.5
6.23 3.36
1994-95
19.50 10.7
6.47 4.10
1995-96
18.00 8.9
7.45 4.34
1996-97
17.84 9.18
8.49 5.37
1997-98
16.02 8.15
8.67 5.26
1998-99
15.89 8.13
10.44 6.92
1999-00
13.98 7.42
8.17 5.14
2000-01
12.37 6.74
8.37 5.44
2001-02
11.09 5.82
9.64 5.73
2002-03
9.36 4.54
8.08 4.95
International comparison of NPA levels
To find out more about the financial sector problems comparisons should be made especially with countries with a developed economy. Also there is a need to solve the problems related to the loans. The NPAs level in Japan, for example is at 3.3 per cent of total loans, it is 3.1 per cent in Hong Kong, 7.6 per cent in Thailand, 11.2 per cent in Indonesia, and 8.2 per cent in Malaysia during 94-95.
According to Ernst & Young, the accounting norms in growing economic countries are less stringent than those of the developed economies. Banks that have the tendency to extend past due loans, make the problem bigger. Forcing low will help banks to focus on good business by eliminating the business of bad loans.
Reasons for NPAs:
Internal Factors
External Factors
1. Conversion of funds for
- attractive up new plans and projects
- expansion / diversification / upgrading
1. Changes in government policies in excise, import duties, pollution control orders etc.
2. Cost, time overruns through the project stage of implementation
2. Accident and natural calamities etc.
3. lack of co-ordination among lenders
3. Exchange rate fluctuation
inefficiency in management
4. Price growth
Business collapse
5. Recession
looseness in Credit Management and observing
6. Input / power shortage
Credit Risk Management
So, by now we should be settled that risk is not only a loss from unexpected causes but also from expected ones, and that such losses could damage the bank's earnings on the short term and may reach the capital on the long run if no action was made from the beginning. Moreover, commercial bank risks are very inter-reliant on each other which mean that one event can affect more than one risk and the effect can cause all risks to be triggered.
Credit risk is considered the major risk for banks; it is the uncertainty that comes with the providing of a loan; which means that there is a risk that a borrower won't repay the loan lent. In commercial Banks's case, they cannot stop giving loans, for it is their industry, they are depository institutions that rely on deposits to provide loans. It is basically their business. So they have to deal with such risk, it is part of their day to day job. Banks normally manage such risk with two ways; one is the historical data and the second one is actually immeasurable, yet it happens. In other words, banks use a probability system to measure the risks that happen once and a while, yet other risks are associated with the borrower's character, capability and will to continue the repayment of a loan.
Credit risk modules
Transaction risk: it is the risk the concentrates on the instability and quality of credit before giving a loan. It is responsible for, selection, underwriting, and operations.
Intrinsic risk: this risk deals with certain lines of businesses and loans in certain industries. Since loans are not only given to individuals, businesses also are major borrowers from commercial banks. Commercial real estate is the riskiest borrower. In this type of risk, banks address three weaknesses:
Historic elements; which looks after the historic events and the stability of each business.
Predictive elements; which looks for the special characters in each business that could collapse this business.
Lending elements: it concentrates on the terms that the bank offers and the weaknesses in it.
Concentration Risk: the combination between the previous two risks can cause chaos between loans in different business lines. That is why the diversification of portfolio becomes very important not only in investments but also in lending, for that protects the bank from having a downturn.
Strategic Credit Risk Management
The past years showed a significant pressure on banks that is due to the fact that there was no effective strategic risk management system. That is why senior management decided to be responsible for risk selection which is basically the area in risk strategy that make sure that the priorities of the bank are maintained. It is divided to four steps:
Establishing the priorities of the corporate
Choosing what credit culture the corporate belongs to
Determining the strategy for credit risk
Implementing the controlling tools for the risk.
Credit risk management is one of the bad headaches to all businesses, and it's a migraine for commercial banks being a financial institution that deals with all types of risk. That is why it is important to know how to control such risk and make sure that the analysis of each case is smartly examined.
Interest Rate Management Procedures
This procedure goes under the major of concern and monitoring the ongoing risk, and it's in the second area. The banking industry actually tries to move away from some parts of the financial segment while they are doing some treatments of the interest rate risk. Commercial banks, they try to make an obvious difference and features between what they are trading and between their balance sheet interest rate exposures. However, in investment banks they use the interest rate risk as a typical part of their market risk; in addition they monitor and measure any exposure, as a result of their development of elaborating the trading risk management.
Foreign Exchange Risk Management Procedures
In foreign exchange risk management procedures, there is a different in current practices, and they explain it by the different licenses that coexist in the banking industry. Most of the banking institutions view and analyze the activities in the foreign exchange market afar of their license, whereas other banks are active participants. No principal risk, no expectations of trading volume and no forward open position will be taken in any former. In this area, the most active banks have a multiple trading locations and large trading account.
Liquidity Risk Procedures
There are two different nations of liquidity risk procedures that are developed in the banking sector and each one has its own strength and authority. The easiest one is the one they need for continued funding. It is easy to analyze the standard cash management in the counterpart; so far the results are not worth much. In addition, in today's capital market banks, they have sufficient resources for growth, plus the resources that are used for the additional liabilities for any unpredictably high asset growth. The risk management agenda try to analyze the liquidity risk, as a need for the resources that they use it to make possible and facilitate the growth or honour outstanding of the credit line.
Other Risks
Further than the main four financial risks, credit interest rate, liquidity risk, and foreign exchange, banks actually have congregation of other concerns as the one that was indicated above. Some have a normal outgrowth of their business and banks, just like the system failure or operating risk. Yet, there are other risks, that somehow are more shapeless, but no less important.
Risk aggregation
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.
The risk decision is not the same as the risk analysis , if the aggregate risk being controlled , when banking firms needs to use such a methodology they need to have a broad idea about it , not only about the banking system. And both of these methodologies impose that they should reduce all of the risks that might accrue, and the trading risk is comparable to the credit risk.
A Comparison between UAE national and foreign banks
It must be known by now that risk management is one of the basic elements in the banking sector, for banking is certainly the business of risk. During our research, we have found that there are a huge number of researches on credit risk management but less of them are on commercial bank related. This project is an attempt to summarize our finding of these papers and summarizing them. Recent studies such as the linbo fan (2004) inspected the risk in USA banks and he discovered that Profit sensitivity is related to credit risk but nor liquidity and loan products. On the other hand, niinimaki (2004) figured that the risk tends to increase as competition increases. Going towards the Arabic point of view, Al Tamimi ( 2002) found that commercial banks in UAE use systematic techniques in allocating these risks and that the major risk faced by these banks was credit risk.
According to the study that consisted 13 national and foreign banks, the study showed that the banks are reliable in most steps of finding and measuring the risks, however, risk assessment shows to be the least reliable step of the overall steps, which are: understanding the risk management and the concept of risk, risk identification, risk assessment and analysis, monitoring and management practices, while it is the most important one. The study first decided to look for the types of risks in UAE banks; it found out that the banks face all kinds of risks but in different rates. For example, the banks face foreign exchange risk in the maximum, followed by credit risk, operating risk and liquidity risk. Yet that couldn't just be logical, for the liquidity risk for example, could seem so right, for it is widely known nationally that banks are not exposed to huge liquidity risks, for it had a liquidity ratio of 0.76 in 2004 which means that the banks are doing great in this matter. According to the credit risk analysis, it has been spoken earlier about the importance of such risk and its danger; moreover, we've said that this risk is the banks worst fear. The story is also implemented on UAE banks. According to the study, many people through that providing collateral against some loans are important while they made sure that the banks don't give collaterals to all loans. On the other hand, the banks do require collaterals even from small borrowers.
The study found out the following:
criteria
National vs. foreign
Reason
Understanding the risk and risk management
There is a difference
Staff of foreign banks has better understanding.
Practice and risk identification
There is no significant difference
-
Practice of risk assessment and analysis
There is a difference
Because foreign banks have more qualified staff
Risk monitoring & controlling
There is a difference
Same reasons as criteria 1 and 3
Context of risk management practices
There is no significant difference
Because both banks work in the same environment and subject to same rules and regulations.
Practice of credit risk analysis
There is no significant difference
Same environment, rules and regulations.
Risk identification & risk assessment are the most important and influencing variables in bank risks
