RISKLiquidity is
crucial to the ongoing viability of any banking organization. Banks? capital
positions can have an effect on their ability to obtain liquidity, especially
in a crisis. Each bank must have adequate systems for measuring, monitoring and
controlling liquidity risk. Banks should evaluate the adequacy of capital given
their own liquidity profile and the liquidity of the markets in which they operate. (Refer to ?Sound
Practices for Managing Liquidity in Banking Organizations?, February 2000).
(Basel Committee on
Banking Supervision)Liquidity risk
defined as bank transforms the term of their liabilities to have different
maturities on the asset side of the balance sheet At the same time, banks must
be able to meet their commitments (such as deposits) at the point at which they
come due. The contractual inflow and outflow of funds will not necessarily be
reflected in actual plans and may vary at different times. A bank may therefore
experience liquidity mismatches, making its liquidity policies and liquidity
risk management key factors in its business strategy.Liquidity risk
means that a bank has insufficient funds on hand to meet its obligations. Net
funding includes maturing assets, existing liabilities, and standby facilities
with other institutions. Liquidity risks are normally managed by a bank?s asset
and liability committee, and approach that requires understanding of the
interrelationship between liquidity risk management and interest rate
management, as well as of the impact that repricing and credit risk have on
liquidity or cash flow risk, and vice versa.Liquidity is
necessary for banks to compensate for expected and unexpected balance sheet
fluctuations and to provide funds for growth. It represents a bank?s ability to
efficiently accommodate decreases in deposits and/or to runoff of abilities, as
well as fund increases in a loan portfolio. A bank has adequate liquidity
potential when it can obtain sufficient funds (either by increasing liabilities
or converting assets) promptly and at a reasonable cost. The price of liquidity
is a function of market conditions and the degree to which risk, including
interest rate and credit risk, is reflected in the bank?s balance sheet.??? MARKET RISKThis
assessment is based largely on the bank?s own measure of value-at-risk.
Emphasis should also be on the institution performing stress testing in
evaluating the adequacy of capital to support the trading function. (Refer to
Part B of the ?Amendment to the Capital Accord to Incorporate Market Risks?,
January 1996). (Basel
Committee on Banking Supervision)In contrast to
traditional credit risk, the market risk that banks face does not necessarily
result from the nonperformance of the issuer or seller of instruments or asset.
Market or position risk is a risk that a bank may experience a loss in on ?and
off-balance-sheet positions arising from unfavorable movements in market
prices. It belongs to the category of speculative risk, wherein price movements
can result in a profit or loss. The risk arises not only because market change,
but because of the actions taken by traders, who can take on get rid of those
risks. The increasing exposure of banks to market risk is due to the trend of
business diversification from the traditional intermediary function toward
trading and investment in financial products that provide better potential for
capital gain, but which expose banks to significantly higher risks.? Market risk
results from changes in price of equity instruments, commodities, money, and
currencies. Its major components are therefore equity position risk, interest
rate risk, and currency risk. Each component of risk includes a general market
risk aspect and specific risk aspect, which originates in the specific
portfolio structure of bank. In addition to standard instruments, such as
options, equity derivatives, or currency and interest rate derivatives.? The price
volatility of most assets held in investment and trading portfolios is often
significant. Volatility prevails even in mature markets, though it is much
higher in new or illiquid markets. The presence of large institutional
investors, such as pension funds, insurance companies, or investment funds has
also had an impact on the structure of markets and on market risk.
Institutional investors adjust their large-scale investment and trading
portfolios through large-scale trades, and in markets with rising prices,
large-scale purchases tend to push prices up. Conversely, markets with
downwards trends become more skittish when large, institutional-size blocks are
sold. Ultimately, this leads to a widening of the amplitude of price variances
and therefore to increases market risk. By its very
nature, market risk requires constant management attention adequate analysis. Prudent
managers should aware of exactly how a bank?s market risk exposure relates to
its capital. In recognition of the increasing exposure of banks to market risk,
and to benefit from the discipline that capital requirements normally impose,
the Basel Committee amended the 1988 Capital Accord in January 1996 by adding
specific capital charges for market risk. The capital standards for market risk
were to have been implemented in G-10 countries by end-1997 at the latest. Part
of the 1996 amendment is a set of strict qualitative standards to risk
management process that apply to bank basing their capital requirements on the
results of internal models.Bank
organization of investment, trading, and risk management function follows a
fairly standard format. The necessary projections and quantitative and
qualitative analysis of the economy, including all economic sectors of interest
to a bank, and of securities and money markets are performed internally by
economists and financial analysts and externally by market and industry
experts. This information is communicated through briefing and reports to
traders/security analysts, who are responsible for government securities or a
group of securities in one or more economic sectors. If a bank has large
trading and/or investment portfolios, traders/analysts of groups of securities
may report to a portfolio manager who is responsible for certain types of
securities. The operational responsibility for a bank?s trading or investment
portfolio management is typically assigned to the investment committee or the
treasury team.???????????? INTEREST RATE
RISKThe measurement process should include
all material interest rate positions of the bank and consider all relevant
repricing and maturity data. Such information will generally include: current
balance and contractual rate of interest associated with the instruments and
portfolios, principal payments, interest reset dates, maturities, and the rate
index used forepricing and contractual interest rate ceilings or floors for adjustable-rate
items. The system should
also have well-documented assumptions and techniques.Regardless
of the type and level of complexity of the measurement system used, bank
management should ensure the adequacy and completeness of the system. Because
the quality and reliability of the measurement system is largely dependent on
the quality of the data and various assumptions used in the model, management
should give particular attention to these items. (Refer to ?Principles for
the Management and Supervision of Interest Rate Risk?, January 2001 for
consultation). (Basel
Committee on Banking Supervision)Central Bank and
the state-banking regulator have issued a policy on Interest Rate Risk (Policy
Statement). The Policy Statement provides guidance to bankers on sound interest
rate risk management practices. The procedure follows a multi-level framework
that incorporates the Policy Statement’s guidelines and efficiently allocates
examination resources. Examination scope will vary depending upon each bank’s
interest rate risk management and exposure. The procedures guide examiners
towards a qualitative interest rate risk assessment, rather than a uniform
supervisory measurement. Interest Rate
Risk ConceptsInterest rate
risk is the exposure of a bank’s current or future earnings and capital to
interest rate changes. Interest rate fluctuations affect earnings by changing
net interest income and other interest-sensitive income and expense levels.
Interest rate changes affect capital by altering banks’ economic value of
equity. Economic value of equity represents the net present value of all asset,
liability, and off-balance sheet cash flows. Interest rate movements change the
present values of those cash flows. Economic value of equity estimates the long-term,
expected change to earnings and capital that will result from an interest rate
movement. As financial intermediaries, banks cannot completely avoid interest
rate risk. However, excessive interest rate risk can threaten banks’ earnings,
capital, liquidity, and solvency. IRR has many components, including repricing
risk, basis risk, yield curve risk, option risk, and price risk. Repricing
Risk results from timing differences between coupon
changes or cash flows from assets, liabilities, and off-balance sheet
instruments. For example, long-term fixed rate securities funded by short-term
rate deposits may create repricing risk. If interest rates change, then
deposit-funding costs will change more quickly than the securities’ yield. Basis Risk results from weak correlation between coupon rate changes for
assets, liabilities, and off-balance sheet instruments. For example,
LIBOR-based deposit rates may change by 50 basis points, while Prime-based loan
rates may only change by 25 basis points during the same period. Yield Curve
Risk results from changing rate relationships
between different maturities of the same index. For example, a 30-year Treasury
bond’s yield may change by 200 basis points, but a three-year Treasury note’s
yield may change by only 50 basis points during the same time period. Option Risk results when a financial instrument’s cash flow timing or amount
can change as a result of market interest rate changes. This can adversely
affect earnings or economic value of equity by reducing asset yields,
increasing funding costs, or reducing the net present value of expected cash
flows. For example, assume that a bank purchased a callable bond, issued when
market interest rates were 10 percent, which pays a 10 percent coupon and
matures in 30 years. If market rates decline to eight percent, the bond’s
issuer will call the bond (new debt will be less costly). The issuer
effectively repurchases the bond from the bank. As a result, the bank will not
receive the cash flows that it originally expected (10 percent for 30 years).
Instead, the bank must invest that principal at the new, lower market rate. In addition,
many loan and deposit products contain option risk. For example, many borrowers
can prepay part or their entire loan principal at any time. Also, savings
account depositors may withdraw their funds at any time. Price Risk results from changes in the value of marked-to-market financial
instruments that occur when interest rates change. For example, trading
portfolios, held-for-sale loan portfolios, and mortgage servicing assets
contain price risk. When interest rates decrease, mortgage servicing asset
values generally decrease. Since those assets are marked-to-market, any value
loss must be reflected in current earnings. PROFITABILITYProfitability is
in indicator of a bank?s capacity to carry risk and / or to increase its
capital. Supervisors should welcome profitable banks as contributors to
stability of the banking system. Profitability ratios should be seen in
context, and the cost of free capital should be deducted prior to drawing
assumptions of profitability. Net interest income is not necessarily the
greatest source of banking income and often does not cover the cost of running
a bank. Management should understand on which assets they are spending their
energy, and how this relates to sources of income.A sound banking
system is built on profitable and adequately capitalized banks. Profitability
is a revealing indicator of a bank?s competitive position in banking markets and
of the quality of its management. It allows a bank to maintain a certain risk
profile and provides a cushion against short-term problems. Profitability, in
the form of retained earnings, is typically one of the key sources of capital
generation.The income
statement, a key source of information on a bank?s profitability, reveals the
sources of a bank?s earnings and their quantity and quality, as well as the
quality of the bank?s loan portfolio and the targets of its expenditures.
Income statement structure also indicates a bank?s business orientation.
Traditionally, the major source of bank income has been interest, but the
increasing orientation toward nontraditional business is also reflected in
income statements. For example, income from trading operations, investments,
and fee-based income accounts for an increasingly high percentage of earnings
in banks. This trend implies higher volatility of earnings and profitability.Changes in the structure and stability
of bank?s profits have sometime been motivated by statutory capital
requirements and monetary policy measures, such as obligatory reserves. In
order to maintain confidence in t he banking system, banks are subject to
minimum capital requirements. The restrictive nature of this statutory minimum
capital may cause banks to change their business mix in favor of activities and
assets that entail a lower capital requirement. However, although such assets
carry less risk, they may earn lower returns.Taxation is
another major factor that influences a bank?s profitability, as well as its
business and policy choices, because it affects the competitiveness of various
instruments and different segments of the financial markets.A thorough
understanding of profit sources and changes in the income profit structure of
both an individual bank and the banking system as a whole is important to all
key players in the risk management process. Supervisory authorities should, for
example, view bank profitability as an indicator of stability and as a factor
that contributes to depositor confidence. Maximum sustainable profitability
should therefore be encouraged, since healthy competition for profits is an
indicator of an efficient and dynamic financial system.Ratios must be
used with judgment and caution, since they alone do not provide complete
answers about the bottom line performance of the banks. In the short run, many
tricks can be used to make bank ratios look good in relation to industry
standards. An assessment of the operations and management should therefore be
performed to provide a check on profitability ratios.Asset /
liability management has become an almost universally accepted approach to risk
management. Since capital and profitability are intimately linked, the key
objective of asset / liability management is to ensure sustained profitability
so that a bank can maintain and augment its capital resources. An analysis of
the interest margin of a bank can highlight the effect of current interest rate
patterns, while a trend analysis over a longer period of time can show the
effect of monetary policy on the profitability of the banking system. It can
also illustrate the extent to which banks are exposed to changes in interest
rates.CAPITAL
ADEQUACYCapital is
required as a buffer against unforeseen losses. Capital cannot be a substitute
for good management. A strong core of permanent capital is needed, supplemented
by loans or other temporary forms of capital. The Basel Accord currently allows
for three tiers of capital, the first two measuring credit risk related to on
and off balance sheet activities and derivatives, and the third for overall
assessment of market risk.An 8 percent
capital adequacy requirement must be seen as a minimum. However, a 15 percent
risk weighted capital adequacy requirement is more appropriate in transitional
or volatile environments.The board of
directors of the banks? has a responsibility to project capital requirements to
determine if current growth and capital retention are sustainable.Almost every
aspect of banking is either directly or indirectly influenced by the
availability and/or the cost of capital. Capital is one of the key factors to