It is argued that each of the key players in the corporate governance process (such as shareholders, directors, executive managers and internal and external auditors) is responsible for some component of financial and operational risk management. This second edition - Analyzing and managing banking risk - has remained true to the objectives of the original publication. Jennifer Johnson-Calari of the World Bank Treasury provided technical assistance for the chapters related to treasury risk management and contributed chapter 10.
CHAPTER I
ANALYZENG AND MANAGENG BANKING IFIIIDTh'
CHIAPTER 2
A CONTEXT FOR THE RTSK-BASED REVIEW GIF BANKS
A Framework for Financial Sector Development
Central elements in the banking system's institutional legal framework include the Central Bank Act and the Banking Act. Another important element of the legal and regulatory framework involves supervisory regulations issued by the regulatory authorities. The specific organization of the payment system determines the mechanisms for payment transactions and the costs and risks borne by the banks.
A Holistic View of the Entire Financial System
Changes in market conditions have also changed regulators' attitudes toward the impact of portfolio structure regulations and other controls on the stability of the financial system. The different sectors of the financial system interact with the banking system, and vice versa. A reliable assessment of the financial condition of banks requires well-trained analysts and supervisors, as many bank assets are illiquid and do not have an objectively determined market value.
CHAPTER 3
- Management: Responsibility for Bank Operations and the Implementation of Risk Management Policies
With a market-oriented approach, the role of the regulator is focused on facilitating the improvement of risk management. In order to establish such a framework, the responsibilities of the various role players in the risk management process must be clearly delineated. External auditors, as an integral part of the risk management partnership, have a specific role to fulfill.
BALANCE SHEET STRUC7URWE AND MANAGEMENT
Asset Structure: Growth and Changes
The composition of a financial institution's balance sheet is usually a result of asset-liability and risk management decisions. For equity investments, the balance sheet should be reviewed on a consolidated basis to ensure a proper understanding of the effect of such investments on the structure of the bank's own balance sheet and to correctly assess the bank's asset quality. Financial innovation has also led to a number of new "off-balance sheet" financial instruments.
It is a challenge to manage the risks related to such off-balance sheet items. As part of managing the risk associated with off-balance sheet items, it is important that the extent of the obligation or right is quantified. Such an analysis indicates the general type of activities of a bank and requires an understanding of the structure of its balance sheet and the nature of its assets and liabilities.
Therefore, the structure of a balance sheet should be part of an assessment of the adequacy and effectiveness of policies and procedures for managing risk exposures. This chart can be used to determine the growth of off-balance sheet items and the proportion that such items constitute in total on- and off-balance sheet activities. The bank under review has been seen to increase its off-balance sheet activities, although the notional value of many off-balance sheet instruments may not be directly related to the amount of risk exposure.
Moreover, it is not known whether the return for the bank is equal to the additional risk taken and whether the bank has an adequate risk management system for off-balance sheet positions.
Managing Risk Effectively
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 extent. In developing economies – especially those in transition – unstable, volatile economic and shallow market environments significantly increase the scale and scope of banks' exposure to financial risk. Such conditions make risk management even more complex and the need for an effective risk management process even more urgent.
This will place the risk management function on an equal footing with other major functions and provide it with the. An established, explicit and clear risk management strategy and a related set of policies with corresponding operational targets. However, it should be noted that a variety of risk management strategies exist that have arisen from different approaches to the interpretation of interdependencies between risk factors.
Variations may also result from disagreements over the treatment of volatility in risk management. Relevant risk management issues and/or decision-making parameters at operational level should also be included for all relevant business and functional processes. 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.
The degree of sophistication and analytical capacity of such models used by a bank can early indicate a bank's seriousness in risk management.
CHAPTER 5
PROFITABILHT-Y
In the last two columns of this example, the various components of income and expenses (even gross interest income and gross interest expenses) are shown as a percentage of gross income per line 5. A breakdown of the interest expenses provides insight into the bank's financing sources and the associated financing costs. Net interest income is the core of a traditional bank's earnings, and the bank's goal would normally be to keep net interest income stable and growing.
This income is largely the result of the difference between the purchase and sale price of the underlying instruments, but also includes interest amounts. The information in a bank's income statement provides insight into the institution's business focus and the structure and stability of its profits. A similar type of chart and analysis can be used to assess whether or not the components of interest expense in total expenses have the same proportions as the associated liabilities.
The stability of the bank's income is likely to have weakened, as fee and trading income is generally considered less stable than net interest income (i.e. brokerage). Despite the much higher income level, the bank's bottom line does not seem to have improved. Operating expenses are one of the items on a bank's income statement that can be controlled.
A good performance measurement framework also allows analyzing the net contribution that a relationship with a major customer makes to the bank's bottom line.
CHAPTEIR 6
- Constituents of Regulatory Capital (Current Methodology) Tier 1 capital. The components of a bank's balance sheet that meet the
- Coverage of Risk Components by Constituents of Capital (Current Methodology)
A bank's ownership structure must ensure the integrity of the bank's capital and be able to provide more capital if and. The global financial system has experienced significant changes since the introduction of the Basel Accord. The overall capital requirement is then determined by calculating 8 percent of the total credit and assumed market risk weights.
The central focus of the Basel capital adequacy framework is credit risk, including the aspect of country risk. Options for calculating the capital requirement for credit risk include a standardized approach and two versions of the internal rating model (IRB). The advanced approach to the calculation of capital adequacy assumes the use of the same methodology as for foundations.
Calculation of the market risk capital requirement is also permitted by a standardized approach or an internal models approach. The second pillar of the Basel II proposals and a critical part of the capital adequacy framework is the supervisory review. A capital adequacy assessment begins with analysis of the components of a bank's capital, as illustrated in Figure 6.1.
The next step in the analysis is the assessment of the bank's on-balance sheet and off-balance sheet risk exposure.
Annex to Chapter 6
Tier I + Tier 2 + Tier 3
CHAPTER 7
- Review of Lending Function and Operations
- Credit Portfolio Quality Review
- Policies to Limit or Reduce Credit Risk
- Loan Loss Provisioning Policy
An overall credit risk management assessment includes an evaluation of a bank's credit risk management policies and practices. The maturity schedule should be determined in relation to the expected source of repayment, the purpose of the loan and the useful life of the collateral. Finally, a credit policy must be supplemented with other written guidelines for specific departments of the bank.
Since information is the basic element of the credit management process, its availability, quality and cost-effectiveness must be analyzed. 3 all loans to borrowers with total exposure greater than 5 percent of the bank's capital;. Other considerations include the quality of the security held and the ability of the borrower's business to generate the necessary cash.
An assessment should be made of the adequacy of credit risk analysis procedures and the supervision and administration of off-balance sheet credit instruments such as guarantees. In determining an adequate reserve, all important factors affecting the collection of the loan portfolio should be taken into account. With immediate write-off of non-performing assets, the reserve level will appear smaller relative to the outstanding loan portfolio.
Review of the bank's existing provisioning policy and methodology for its implementation.
CHIAPTER 8
- The Regulatory Environment
- Liquidity Risk Management Techniques
The price of liquidity is a function of market conditions and the market's perception of the inherent riskiness of the borrowing institution. It is in the nature of a bank to transform the maturity of its liabilities into different maturities on the asset side of the balance sheet. In the medium term, liquidity is also handled through the management of a bank's liability structure.
The difference between inflows and outflows in each period (ie, funds surplus or deficit) provides a starting point from which to measure a bank's future liquidity surplus or deficit at any given time. The liquidity strategy for each currency, or exactly how its foreign currency funding needs will be met, should be a central concern of the bank. Thus, the assessment of the structure and type of the deposit base and the assessment of the condition (ie, stability and quality) of the deposits is the starting point for the assessment of liquidity risk.
The marginal cost of liquidity (ie, the cost of additional funds purchased) is of great importance in the assessment of liquidity resources. For a bank that often operates in short-term money markets, the main determinant of its ability to borrow new funds is its market position. This analysis can be used to assess whether a bank's policy change is of a permanent or irregular nature, as well as to assess the regularity of funding problems (ie, the amount of funding that needs to be contractually renegotiated in a basic short term).
Overall, the increasing volatility in funding is a sign of the changes in the structure and sources of funding that the banking sector is undergoing.
