BALANCE SHEET STRUC7URWE AND MANAGEMENT
4.5 Managing Risk Effectively
The goal of financial management is to maximize the value of a bank, as defined by its profitability and risk level. Financial management com- prises risk management, a treasury function, financial planning and budgeting, accounting and information systems, and internal controls. In practical terms, the key aspect of financial management is risk manage- ment, which covers strategic and capital planning, asset-liability man- agement, and the management of a bank's business and financial risks.
The central components of risk management are the identification, quan- tification, and monitoring of the risk profile, of both banking and finan- cial risks.
The risks associated with banking include product, market, and cus- tomer (loan portfolio) risk. Banks have little or no control over external risks, which are affected by changes in the economic and business envi- ronment, actions of competitors, regulators and tax authorities, and demo- graphic shifts. As already discussed, these risks have increased signifi- cantly in the last two decades, in particular because of the impact of
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increasing competition and volatility in the economic environment and in financial markets. Volatile prices have also contributed to the introduction of new financial instruments and services and to the determination of their success in the market place, since financial innovation has rarely been the norm during periods of stable prices.
The main types of financial risk include capital adequacy and liquid- ity, credit, interest rate, currency, and market risks (the assessment of which is the theme of this publication). The operational objective of risk management is to identify, quantify, and properly balance the elements of financial risk, many of which are interdependent to some degree. The ongoing operations of a bank affect financial risk factors and therefore require continuous attention.
Effective risk management, especially for larger banks and/or banks operating in deregulated and competitive markets, requires a formal process. In developing economies - especially those in transition - unsta- ble, volatile economic and shallow market environments significantly increase the range and the magnitude of bank exposure to financial risk.
Such conditions render risk management even more complex and make the need for an effective risk management process even more acute. The key components of effective risk management, which should be present in a bank and be assessed by the analyst, should normally include the following:
a An established line function at the highest level of the bank's management hierarchy that is specifically responsible for risk management, and possibly also for coordination of the opera- tional implementation of ALCO (asset and liability committee) policies and decisions. This would place the risk management function on par with other major functions and provide it with the
necessary visibility and leverage within the bank.
[ An established, explicit, and clear risk management strategy and a related set of policies with corresponding operational targets. It should, however, be noted that a variety of risk management strategies exist that have originated from different approaches to interpreting interdependencies between risk factors. Variations may also be due to differences in opinion concerning the treat- ment of volatility in risk management.
* Introduction of an appropriate degree of formalization and coordi- nation of strategic decision-making in relation to the risk manage- ment process. Relevant risk management concems and/or parame- ters for decisionmaking on the operational level should also be incorporated for all relevant business and functional processes.
Parameters for the main financial risk factors (normally established according to the risk management policies of a bank and expressed as ratios or limits) can serve as indicators to business units of what constitutes an acceptable risk. For example, a debt-to-equity ratio for a bank's borrowers is a risk parameter that expresses a level of credit risk. Maximum exposure to a single client is a risk parame- ter that indicates credit risk in a limited form.
* The bank's business and portfolio decisions should be based on rigorous quantitative and qualitative analyses within applicable risk parameters. This process, including an analysis of a consoli- dated risk profile, is necessary due to the complex interdepen- dencies of and the need to balance various financial risk factors.
Because the risk implications of a bank's financial position and changes to that position are not always obvious, details may be of critical importance.
* Systematic gathering of complete, timely, and consistent data rel- evant for risk management, and provision of adequate data storage and manipulation capacity. Data should cover all functional and business processes, as well as other areas such as macroeconomic and market trends that may be relevant to risk management.
* Development of quantitative modeling tools to enable the simu- lation and/or analysis of the effects of changes in economic, busi- ness, and market environments on a bank's risk profile and the related impact on its liquidity, profitability, and net worth.
Computer models used by banks range from simple PC-based tools to elaborate mainframe modeling systems. Such models can be built in-house or be acquired from other financial institutions with a similar profile, specialized consulting firms, or software vendors. The degree of sophistication and analytical capacity of such models used by a bank may indicate early on the seriousness of a bank toward risk management.
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The new Basel Capital Accord will significantly increase the impor- tance of quantitative modeling tools and of bank's capacity to use them, as they provide a basis for implementation of the Internal Rating Based (IRB) approach to measurement of bank's capital adequacy. It is hoped that the IRB approach would bring additional risk sensitivity, in that a cap- ital requirement based on internal ratings would be more sensitive to the drivers of credit, market, and operational risk and economic loss in a bank's portfolios, and higher incentive compatibility, in that the bank would thus be encouraged to continuously improve its internal risk man- agement practices.