A CONTEXT FOR THE RTSK-BASED REVIEW GIF BANKS
2.3 A Framework for Financial Sector Development
Bank appraisal in a competitive and volatile market environment is a com- plex process. The assessment of a bank's financial condition and viability normally centers around the analysis of particular aspects, including own- ership structure, risk profile and management, financial statements, port-
A CONTEXT FOR THE RISK-BASED REVIEW OF BANKS 19
folio structure and quality, policies and practices, human resources, and information capacity. In order to interpret particular findings, estimate future potential, diagnose key issues, and formulate effective and practi- cal courses of action, an analyst must also have thorough knowledge of the particular regulatory, market, and economic environment in which a bank operates. In sum, in order to do his or her job well, an analyst must have a holistic view of the financial system.
An environment that includes a poor legal framework, difficulties with the enforcement of financial contracts, and/or unstable macroeco- nomic conditions presents a higher level of credit risk and makes risk management more difficult. For example, an unstable domestic currency that lacks external convertibility presents a high level of risk. A bank's overall business strategy and its specific policies and practices must both accommodate the economic and regulatory environment within which the bank operates and be attuned to market realities.
Figure 2.1 illustrates the building blocks that are required for sustain- able financial sector development. In Figure 2.2, the same theme is pre- sented in matrix format in order to provide an overview of the financial system as a whole, and a context for assessing financial risk and risk man- agement.
An unstable macroeconomic environment, with uneven economic performance and volatile exchange rates and asset prices, is a principal cause of instability in the financial system. Such an environment makes the realistic valuation of a bank's assets and the accurate evaluation of financial risks very difficult. The political environment is also important because it influences both the principles and the reality under which the financial sector functions. For example, under centrally planned financial systems, markets were greatly limited and banks, as well as their clients, did not have autonomy. Legal and judicial envinronments directly impact many aspects of a bank's operations, such as the exercising of contractual rights to obtain collateral or to liquidate nonpaying borrowers; while a transparent accountability framework establishes the foundation for a well-functioning business environment for banks and other institutions in the financial sector, as well as for their clients.
The legal and regulatory framework for institutions, markets, contracting and conduct, and failure resolution spells out the rules of
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Political -Insurance actia nd Central bank Derities
environment -Pension fundsAcutn(n etrlbn omdte Taning institutes
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disclosure management firms registries Contractusl Savings -supplier's credit
Contracting and conduct I- nsnarantees
-Contract enforcement Share registries i
-Property rights Capital markets/exchange
-Lending/collateral -Secuaities trading and fund
-Financial instruments Research and rating management
-Market conduct agences -Exchanges
-Wholesale and retail - u
investment services -Equitnes
-Accounting and auditing Fixed-income
-Regulations Government
-Municipal
-Private sector companies
Failure-resolution laws -Commodities
-Insolvency -Deposit insurance -Restructuring agencies
A CONTEXT FOR THE RISK-BASED REVIEW OF BANKS 21
the game for financial institutions and markets. Before appraising a bank, an analyst should understand the philosophical basis for pertinent laws and regulations and ascertain if the legal and regulatory framework is complete and consistent. The analyst should be thoroughly familiar with the framework not only because bank operations must comply with it, but also because it provides a context for a bank's business, including the objectives and scope of allowed activities. In addition, knowledge of laws and regulations can prompt measures and actions that can be taken in cri- sis situations.
Key elements of the institutional legal framework of the banking sys- tem include the central bank law and the banking law. The former defines the central bank's level of autonomy, systemic and functional responsibil- ities (which often include prudential supervision), and regulatory prerog- atives and enforcement powers. The banking law defines the type of finan- cial intermediation to be performed by banks (e.g., universal banking), the scope of banking business in the particular country, conditions of entry and exit from the banking system, and capital and other minimum require- ments that must be met and maintained by banks. In addition, the banking law specifies the corporate organization and the relationship between banks and the central bank.
Another important element of the legal and regulatory framework involves prudential regulations issued by the regulatory authorities. The objectives underlying such regulations include maintenance of the safety and stability of the banking system, depositor protection, and the minimal engagement of public funds. The most important prudential regulations include bank licensing, corporate govemance, closure and exit mechanisms, capital adequacy, and financial risk management. Financial risk manage- ment regulations (as elaborated in Chapters 4 through 13) aim to limit the degree of a bank's risk exposure, such as through foreign exchange and liq- uidity. Such measures serve to ensure that a bank has sufficient capital to support its exposure to risk (also known as "capital adequacy require- ments") and that it has adequate procedures or systems to assess and hedge and provide against risks, such as asset classification and provisioning pro- cedures, and value-at-risk models for market price fluctuations.
A legal framework also encompasses other sections of the financial sector through laws pertaining to insurance companies, pension funds,
capital market authorities, and the wholesale and retail investment ser- vices industry. A body of laws also exists to regulate contracting and mar- ket conduct and behavior, in order to protect consumers.
Other relevant laws relate to failure resolution - for example, to insol- vency, deposit insurance, and restructuring agencies - and to the technical capacity of the judiciary. The mechanisms for failure resolution and the banking sector safety net are intended to enhance the stability of and confi- dence in the banking system; however, if they are poorly designed, they can undermine market discipline. Elements of the banking safety net include the
"lender-of-last-resort" function and deposit-insurance facilities. The specif- ic form of a banking safety net has significant implications for risk man- agement. For example, the existence of lender-of-last-resort facilities - the main purpose of which is to provide temporary liquidity support to illiquid but solvent institutions - may weaken risk management incentives for banks, which tend to maintain less liquidity and lend more when these facil- ities are in place. Likewise, the existence of deposit insurance, especially where the cost is underwritten by the state, may engender situations of moral hazard, such as the automatic bailout of banks, regardless of the qual- ity of corporate governance or the status of financial risk management.
Financial sector infrastructure strongly impacts the quality of bank operations and risk management. Apart from the supervisory authorities (which will be discussed in Chapter 3), the payment system, a key ele- ment of such infrastructure, may be organized and managed by the central bank, by members of the banking system, or as an arrangement between individual banks and the central bank. The specific organization of the payment system determines the mechanisms for payment transactions and the cost and risks borne by the banks. An inefficient payment system can result in significant cost and settlement risk to the banks.
Infrastructure also encompasses various professions that are central to the financial sector, such as accounting and auditing, the actuarial pro- fession, and investment advising. An adherence to international standards of accounting and auditing, coupled with a well-trained cadre of profes- sionals in these fields, can make a significant difference to the fairness and transparency of financial statements. Fair, transparent statements greatly contribute to the facilitation of risk management, bank supervision, and consumer protection.
A CONTEXT FOR THE RISK-BASED REVIEW OF BANKS 23
Property registries are also a part of risk management infrastructure.
Such registers define fixed and movable assets and marketable securities, and effectively protect property rights. They also facilitate the registration and collection of collateral, and subsequent credit risk management. Risk reference registers serve the same purpose through the collection and maintenance of information on the credit history of individuals and firms, as well as its ready distribution to interested parties.
In addition, rating agencies help with risk management by systemat- ically researching banks, companies, and markets and making findings available to both financial professionals and the general public. In many countries, financial infrastructure may also include research institutes, financial advisory services, and similar establishments.
The next block of Figure 2.1 illustrates the institutionalization of the l;7n!anlU system. This includes forms and rules under which a particular financial institution can be incorporated, and, on a broader scale, identi- fies its potential competitors. Increased competition in banking and finance and the trend toward homogenization of banking business have been major factors that influence changes in national banking systems.
The concept of universal banking and the reality of financial markets have, however, increasingly blurred the lines between various institutions.
In the context of risk management, the structure and concentration of own- ership are of key importance. A banking system dominated by state-owned banks or financial institutions is prone to moral hazard situations, such as implicit guarantees, and tends to have competitive distortions in its mar- kets. A high concentration of ownership or assets also increases risk by subjecting the system to political pressures, since some banks are consid- ered by government entities to be "too big to fail" and may therefore be artificially supported. In exceptional cases where systernic risk is at stake, a supervisory authority may choose to support the too-big-to-fail approach. In addition, the absence of foreign ownership typically indicates closed and inefficient financial markets.
The financiaR mairkets and instruments block of Figure 2.1 depicts the markets operating in the financial system, their modi operandi, and the terms of their operations. As mentioned previously, modem banks have moved beyond traditional deposit and credit markets to establish a direct presence in practically all aspects of the financial system. Originally
established as specialized institutions, banks have sought new customers in wider geographical areas and have come to offer increasingly similar types of accounts, credit, and financial services.
In addition to more intense competition among the different types of bank, the number and diversity of nonbank financial intermediaries have also increased. As a result, effective substitutes for banking products now exist and a broader range of services is available. The threat that non- banking institutions will expand into banking services has likely been another stimulus to banks to adopt market-oriented behavior. Secondary markets have also grown in importance, which has reduced market seg- mentation and created more uniform cost structures for different financial institutions.
Each type of market deals with specific financial products. Innovation has brought about a greater variety of financial instruments, the respective markets of which are continuously increasing. In financial risk manage- ment terms, the understanding of the risk involved in key products offered by a bank and of the implications of specific markets, for example, in terms of liquidity or price stability, is key to being able to adequately
appraise a bank.
As the last block of Figure 2.1 shows, the availability and quality of banking skills is a central concem in the risk-based appraisal of banks. It is essential that banks have good personnel management and that they are able to systematically develop banking skills within their organization. A good bank should be able to acquire the appropriate skills and to develop a suitable work culture. It should also have a process to optimize the mix of staff skills and experience and to develop staff performance levels in concert with its business and institutional goals.