BUSINESS WORLD What Are Risks to Banking Institutions Posted by on May 2, 2008, 13:51

Commercial banks are in the risk business. In the process of providing financial services, they assume various kinds of financial risks. Over the last decade our understanding of the place of commercial banks within the financial sector has improved substantially. Over this time, much has been written on the role of commercial banks in the financial sector, both in the academic literature and in the financial press. In performing these roles they generally act as a principal in the transaction, As such, they use their own balance sheet to facilitate the transaction and to absorb the risks associated with it. To be sure, there are activities performed by the Sierra Leone Commercial Bank, which do not have direct balance sheet implications. These services include agency and advisory activities such as (i) trust and investment management, (ii) private and public placements through "best efforts" or facilitating contracts, (iii) standard underwriting through Section 20 Subsidiaries of the holding company, or (iv) the packaging, securitizing, distributing and servicing of loans in the areas of consumer and real estate debt primarily. These items are absent from the traditional financial statement because the latter rely on generally accepted accounting procedures rather than a true economic balance sheet. Nonetheless, the overwhelming majority of the risks facing the banking firm is in on-balance-sheet businesses. It is in this area that the discussion of risk management and the necessary procedures for risk management and control has centered. Accordingly, it is here that our review of risk management procedures will concentrate.

B. What Kinds Of Risks Are Being Absorbed?

The risks contained in the bank's principal activities, i.e., those involving its own balance sheet and its basic business of lending and borrowing, are not all borne by the bank itself. In many instances the institution will eliminate or mitigate the financial risk associated with a transaction by proper business practices; in others, it will shift the risk to other parties through a combination of pricing and product design. The banking system recognizes that an institution need not engage in business in a manner that unnecessarily imposes risk upon it; nor should it absorb risk that can be efficiently transferred to other participants. Rather, it should only manage risks at the firm level that are more efficiently managed there than by the market itself or by their owners in their own portfolios. The fact is that risks facing all financial institutions can be segmented into three separable types, from a management perspective. These are:

(i) risks that can be eliminated or avoided by simple business practices,

(ii) risks that can be transferred to other participants, and,

(iii) risks that must be actively managed at the firm level.

In the first of these cases, the practice of risk avoidance involves actions to reduce the chances of idiosyncratic losses from standard banking activity by eliminating risks that are superfluous to the institution's business purpose. Common risk avoidance practices here include at least three types of actions. The standardization of process, contracts and procedures to prevent inefficient or incorrect financial decisions is the first of these. The construction of portfolios that benefit from diversification across borrowers and that reduce the effects of any one-loss experience is another. Finally, the implementation of incentive-compatible contracts with the institution's management to require that employees be held accountable is the third. In each case the goal is to rid the firm of risks that are not essential to the financial service provided, or to absorb only an optimal quantity of a particular kind of risk. There are also some risks that can be eliminated, or at least substantially reduced through the technique of risk transfer. Markets exist for many of the risks borne by the banking firm. Interest rate risk can be transferred by interest rate products such as swaps or other derivatives. Borrowing terms can be altered to effect a change in their duration. Finally, the bank can buy or sell financial claims to diversify or concentrate the risks that result in from servicing its client base. To the extent that the financial risks of the assets created by the firm are understood by the market, these assets can be sold at their fair value. Unless the institution has a comparative advantage in managing the attendant risk and/or a desire for the embedded risk they contain, there is no reason for the bank to absorb such risks, rather than transfer them. However, there are two classes of assets or activities where the risk inherent in the activity must and should be absorbed at the bank level. In these cases, good reasons exist for using firm resources to manage bank level risk. The first of these includes financial assets or activities where the nature of the embedded risk may be complex and difficult to communicate to third parties. This is the case when the bank holds complex and proprietary assets that have thin, if not non-existent, secondary markets. Communication in such cases may be more difficult or expensive than hedging the underlying risk.4 Moreover, revealing information about the customer may give competitors an undue advantage. The second case included proprietary positions that are accepted because of their risks, and their expected return. Here, risk positions that are central to the bank's business purpose are absorbed because they are the raison d'etre of the firm. Credit risk inherent in

the lending activity is a clear case in point, as is market risk for the trading desk of banks active in certain markets. In all such circumstances, risk is absorbed and needs to be monitored and managed efficiently by the institution. Only then will the firm systematically achieve its financial performance goal.

How Are These Risks Managed?

In light of the above, what are the necessary procedures that must be in place to carry out adequate risk management? In essence, what techniques are employed to both limit and manage the different types of risk, and how are they implemented in each area of risk control? It is to these questions that we now turn. After reviewing the procedures employed by leading firms, an approach emerges from an examination of large-scale risk management systems. The management of the banking firm relies on a sequence of steps to implement a risk management system. These can be seen as containing the following four parts:

 (i) Standards and reports,

(ii) Position limits or rules,

(iii) Investment guidelines or strategies,

(iv) Incentive contracts and compensation.

In general, these tools are established to measure exposure, define procedures to manage these exposures, limit individual positions to acceptable levels, and encourage decision makers to manage risk in a manner that is consistent with the firm's goals and objectives. To see how each of these four parts of basic risk management techniques achieves these ends, we elaborate on each part of the process below. In Section IV we illustrate how these techniques are applied to manage each of the specific risks facing the banking community.

(i) Standards and Reports

The first of these risk management techniques involves two different conceptual activities, i.e., standard setting and financial reporting. They are listed together because they are the sine qua non of any risk system. Underwriting standards, risk categorizations, and standards of review are all traditional tools of risk management and control. Consistent evaluation and rating of exposures of various types are essential to understand the risks in the portfolio, and the extent to which these risks must be mitigated or absorbed. The standardization of financial reporting is the next ingredient. Obviously outside audits, regulatory reports, and rating agency evaluations are essential for investors to gauge asset quality and firm level risk.

These reports have long been standardized, for better or worse. However, the need here goes beyond public reports and audited statements to the need for management information on asset quality and risk posture. Such internal reports need similar standardization and much more frequent reporting intervals, with daily or weekly reports substituting for the quarterly GAAP periodicity.

(ii) Position Limits and Rules

A second technique for internal control of active management is the use of position limits, and/or minimum standards for participation. In terms of the latter, the domain of risk taking is restricted to only those assets or counterparties that pass some pre-specified quality standard. Then, even for those investments that are eligible, limits are imposed to cover exposures to counterparties, credits, and overall position concentrations relative to various types of risks. While such limits are costly to establish and administer, their imposition restricts the risk that can be assumed by any one individual, and therefore by the organization as a whole. In general, each person who can commit capital will have a well-defined limit. This applies to traders, lenders, and portfolio managers. Summary reports show limits as well as current exposure by business unit on a periodic basis. In large organizations with thousands of positions maintained, accurate and timely reporting is difficult, but even more essential.

(iii) Investment Guidelines and Strategies

Investment guidelines and recommended positions for the immediate future are the third technique commonly in use. Here, strategies are outlined in terms of concentrations and commitments to particular areas of the market, the extent of desired asset-liability mismatching or exposure, and the need to hedge against systematic risk of a particular type. The limits described above lead to passive risk avoidance and/or diversification, because managers generally operate within position limits and prescribed rules. Beyond this, guidelines offer firm level advice as to the appropriate level of active management, given the state of the market and the willingness of senior management to absorb the risks implied by the aggregate portfolio. Such guidelines lead to firm level hedging and asset-liability matching. In addition, securitization and even derivative activity are rapidly growing techniques of position management open to participants looking to reduce their exposure to be in line with management's guidelines.

(iv) Incentive Schemes

To the extent that management can enter incentive compatible contracts with line managers and make compensation related to the risks borne by these individuals, then the need for elaborate and costly controls is lessened. However, such incentive contracts require accurate position valuation and proper internal control systems.5 Such tools which include position posting, risk analysis, the allocation of costs, and setting risk sharing incentive contracts for assuring incentive compatibility between principals and agents.