Risk Management Case Study Essay Research Paper

Risk Management Case Study Essay, Research Paper

THE PROBLEM AND THE PLANIncidentals of Authorization and

SubmittalThis study of

risk management recommendations of Turk Eximbank is submitted to Mr. H. Ahmet KILIÇOGLU, General

Manager of Turk Eximbank, on Aprıl 30, 2001.As authorized on February 20, 2001,

the investigation was conducted under the direction of Barış Samana and GÜrkan Kocgar. Objective of Risk Management

RecommendationsThe objective of the study was to define

why risk management was needed in Turk Eximbank and how to adjust the risk

management system at the bank. The plan for achieving this objective involved

first determining the techniques used for risk measurements. This information

will then be used for Turk Eximbank?s risk evaluation process.Use of?

Techniques for Risk MeasurementThe methodology used in this investigation was an obsevational study of

defining the risk measurement techniques and then applying them to Turk

Eximbak?s risk evaluation process, if necessary.Investigations have been made at the Bilkent University Library and

Internet, also we have interwieved with the risk analysts of Turk Eximbank. INTRODUCTIONIn recent years, a number of programs

aimed at enhancing the effectiveness of supervisory process for banks. Although

effective risk management has always been central to safe and sound banking

activities, it has become even more important as new technologies, product

innovation, and the size and speed of financial transactions have changed the

nature of banking markets. In response to these changing market realities,

certain supervisory risk management processes have been refined, while others -

in particular, those that have proven most successful in supervising banks

under a variety of economic circumstances and industry conditions – have been retained.

The objective of a risk-focused examination is to effectively evaluate the

safety and soundness of the bank, including the assessment of its risk

management systems, financial condition, and compliance with applicable laws

and regulations, while focusing resources on the bank?s highest risks. The

exercise of examiner judgment to determine the scope of the examination during

the planning process is crucial to the implementation of the risk-focused

supervision framework, which provides obvious benefits such as higher quality

examinations, increased efficiency, and reduced on-site examiner time.UNDERSTANDING THE BANKThe risk-focused supervision process for

banks involves a continuous assessment of the bank. The understanding of the

bank developed through this assessment enables examiners to tailor the

examination of the bank to its risk profile. Understanding the bank begins with

a review of available information on the bank. In addition to examination

reports and correspondence files, each bank maintains various surveillance

reports that identify outliers when a bank is compared to its peer group. The

review of this information assists examiners in identifying both the strengths

and vulnerabilities of the bank and provides a foundation from which to

determine the examination activities to be conducted. Contact with the organization is

encouraged to improve the understanding of the institution and the market in

which it operates. A pre-examination interview or visit should be conducted as

a part of each examination. Such a meeting gives examiners the opportunity to

learn about any changes to bank management, bank policies, strategic direction,

management information systems, and other activities. Particular emphasis

should be placed on learning about new products or markets into which the bank

has entered. The interview or visit also provides examiner’s with management?s

view of local economic conditions, an understanding of the bank?s regulatory

compliance practices, its management information systems, and its

internal/external audit function. In addition, banks should contact the

state-banking regulator to determine whether they have any special areas of

concern that should be focused on during the examination. RELIANCE ON INTERNAL RISK

ASSESSMENTSInternal audit, loan review, and

compliance functions are integral to a bank’s own assessment of its risk

profile. If applicable, it may be beneficial to discuss with the bank’s

external auditor the results of the most recent audit it has completed for the

bank. Such a discussion gives the examiner the opportunity to review the

external auditor?s frequency, scope and reliance on internal audit findings.

Examiners should consider the adequacy of these functions in determining the

risk profile of the bank and the opportunities to reduce regulatory burden by

testing rather than duplicating the work of these audit functions. Transaction

testing remains a reliable and essential examination technique for use in the

assessment of an institution?s condition. The amount of transaction testing

necessary to evaluate particular activities generally depends on the quality of

the bank’s process to identify, measure, monitor, and control the activity’s

risk. Once the integrity of the management system is verified through testing,

conclusions on the extent of risks within the activity can be based on internal

management assessments of the risks rather than on the results of more

extensive transaction testing by examiners. If, however, initial inquiries into

the risk management system, or efforts to verify the integrity of the system,

raise material doubts as to the system’s effectiveness, then no significant

reliance should be placed on the system and a more extensive series of tests

should be undertaken to ensure that the bank’s exposure to risk from a

particular activity can be accurately evaluated. SCOPE

MEMORANDUMThe scope memorandum is an integral

product in the risk-focused methodology as the memorandum identifies the

central objectives of the on-site examination. The scope memorandum also

ensures that the examination strategy is communicated to appropriate

examination staff. A sample scope memorandum is presented in Appendix – A. This

document is of key importance, as the scope will likely vary from examination to

examination. Examination procedures should be tailored to the characteristics

of each bank, keeping in mind its size, complexity, and risk profile.

Procedures should be completed to the degree necessary to determine whether the

bank?s management understands and adequately controls the levels and types of

risk that are assumed. In addition, the memorandum should address the banking

environment, economic conditions, and any changes that bank management fore

sees that could affect the bank?s condition. A preliminary estimate of staffing

required to perform the examination should also be prepared as part of the

scope memorandum.The key factors that should be addressed

in the scope memorandum include:Preliminary Risk AssessmentThe risks associated with the bank’s

activities should be summarized and based on a review of all available sources

of information on the bank, including but not limited to, prior examination

reports, surveillance reports, correspondence files, and audit reports. The

scope memorandum should include a preliminary assessment of the bank’s

condition and major risk areas that will be evaluated through the examination

process. Summary of the Pre-Examination MeetingThe results of the pre-examination

meeting should be summarized with particular emphasis on the meeting results

that affect examination coverage. Summary of Audit and Internal Control EnvironmentA summary of the scope and adequacy of

the audit environment should be prepared which may result in a modification of

examination procedures initially expected to be performed. Activities that

receive sufficient coverage by the bank’s audit system can be tested through

the examination process. Sufficient audit coverage could result in the

elimination of certain procedures if the audit and internal control areas are

deemed satisfactory.Summary of Examination ProceduresExamination modules have been developed

related to the significant areas reviewed during an examination. The modules

are categorized as being primary or supplemental. The primary modules must be

included in each examination. However, procedures within the primary modules

can be eliminated or enhanced based on the risk assessment or the adequacy of

the audit and internal control environment. The scope memorandum should specifically

detail the areas within each module to be emphasized during the examination

process. In addition, the use of any supplemental modules should be discussed.Summary of Loan ReviewBased on the preliminary risk assessment,

the anticipated loan coverage should be detailed in the scope memorandum. In

addition to stating the percent of commercial and commercial real estate loans

to be reviewed, the scope memorandum should also identify which speciality loan

references to the general loan module are to be completed. The memorandum

should specify activities within the general loan module to be reviewed, as

well as the depth of any speciality reviews.Job StaffingThe staffing for the examination should

be detailed. Particular emphasis should be placed on ensuring appropriate

personnel are assigned to the high risk areas identified in the bank?s risk

assessment.USE OF THE

EXAMINATION MODULESThe state-banking regulator has jointly

developed bank examination modules. This automated format was designed to

define common objectives for the review of important activities within the bank

and to assist in the documentation of examination work. It is expected that

full-scope examinations will include examiners? evaluation of six critical

areas that are necessary to determine the bank?s CAMELS rating. To evaluate

these areas, examiners must perform procedures tailored to fit the risk profile

of the bank. The seven primary examination modules are: Capital Adequacy Earnings Analysis Loan Portfolio Management Liquidity Analysis Management and Internal Control Evaluation Securities Analysis Other Assets and Liabilities There are six supplemental modules that

are available for use if any of these activities present significant risk to

the bank. The supplemental modules are: Electronic Funds Transfer Risk Assessment International Banking Credit Card Merchant Processing Mortgage Banking Electronic Banking Related Organizations In addition, there are ten Loan

References (for specialized lending areas) included in the general Loan

Portfolio Management module. The loan reference modules are: Construction and Land Development Commercial and Industrial Real Estate Residential Real Estate Lending Commercial and Industrial Loans Agricultural Lending Direct Lease Financing Floor Plan Loans Troubled Debt Restructuring Consumer and Check Credit Credit Card Activities The modules establish a three-tiered

approach for the review of a bank?s activities.The first tier is the core

analysis, the second tier is the expanded review, and the final tier is the

impact analysis. The core analysis includes a number of decision factors, which

should be considered collectively, as well as individually when evaluating the

potential risk to the bank. To assist the examiner in determining whether risks

are adequately managed, the core analysis section contains a list of procedures

that may be considered for implementation. Once the relevant procedures are

performed, the examiner should document conclusions in the core analysis

decision factors. Where significant deficiencies or weaknesses are noted in the

core analysis review, the examiner is required to complete the expanded

analysis for those decision factors that present the greatest degree of risk to

the bank. On the other hand, if the risks are properly managed, the examiner

can conclude the review and carry any comments to the report of examination.The expanded analysis provides guidance

to the examiner in determining if weaknesses are material to the bank?s

condition and if they are adequately managed. If the risks are material or

inadequately managed, the examiner is directed to perform an impact analysis to

assess the financial impact to the bank and assess whether any enforcement

action is necessary. The use of modules should be tailored to

the characteristics of each bank based on its size, complexity, and risk

profile. As a result, the extent to which each module should be completed will

vary from bank to bank. One of the features included in the automated format

for the modules allows examiners to select the appropriate procedures in the

modules that address t he area(s) of concern while eliminating unnecessary

procedures. The degree of expected completion of the modules should be

documented in the scope memorandum. The individual procedures presented for

each level are meant only to serve as a guide for answering the decision

factors. Each procedure does not require an individual response and each

procedure may not be applicable at every community bank. Examiners should continue

to exercise discretion in deciding to exclude any items as unnecessary in the

evaluation of the decision factors. Moreover, the listed procedures do not

represent every possible factor to be considered during an examination.

Examiners should reference supervisory and administrative letters for

additional guidance. CREDIT RISKBanks should have methodologies that

enable them to assess the credit risk involved in exposures to individual

borrowers or counter parties as well as at the portfolio level. For more

sophisticated banks, the credit review assessment of capital adequacy, at a minimum, should cover four areas:

risk rating systems, portfolio analysis/aggregation, securitisation / complex

credit derivatives, and large exposures and risk concentrations.Internal

risk ratings are an important tool in monitoring credit risk. Internal risk

ratings should be adequate to support the identification and measurement of

risk from all credit exposures, and should be integrated into an institution?s

overall analysis of credit risk and capital adequacy. The ratings system should

provide detailed ratings for all assets, not only for criticized or problem

assets. Loan loss reserves should be included in the credit risk assessment for

capital adequacy.The analysis

of credit risk should adequately identify any weaknesses at the portfolio

level, including any concentrations of risk. It should also adequately take

into consideration the risks involved in managing credit concentrations and

other portfolio issues through such mechanisms as securitisation programs and

complex credit derivatives. Further, the analysis of counter party credit risk

should include consideration of public evaluation of the supervisor?s

compliance with the Core Principles of Effective Banking Supervision. (Refer to

?Principles for the Management of Credit Risk?, September 2000). (Basel Committee on Banking

Supervision)Credit risk

defined as the chance that a debtor will not be able to pay interest or repay

the principal according to the terms specified in a credit agreement is an

inherent part of banking. Credit risk means that payments may be delayed or

ultimately not paid at all, which can in turn cause cash flow problems and

affect a bank?s liquidity. Despite innovation in the financial services sector,

credit risk is the still the major single cause of bank failures. The reason is

that more than 80 percent of a bank?s balance sheet generally relates to this

aspect of risk management. The three main types of credit risk are as fallows: Personal or consumer risk Corporate or company risk Sovereign or country risk Because of the

potentially terrible effects of credit risk, it is important to perform a

comprehensive evaluation of a bank?s capacity to assess, administer, supervise,

control, enforce and recover loans, advances, guarantees, and other credit

instruments. An overall credit risk management will include an evaluation of

the credit risk management policies and practices of a bank. This evaluation

should also determine the adequacy of financial information received from a

borrower, which has been used by banks as the basis for the extension of credit

and the periodic assessment of inherently changing risk.The review of a

credit risk management function is discussed under the following themes: Credit portfolio management Lending function and operations Credit portfolio management Nonperforming loan portfolio Credit risk management policies Policies to limit or reduce credit

risk Asset classification Loan loss provisioning policy ???? LIQUIDITY

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


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

be considered when the safety and soundness of a bank is assessed. An adequate

capital base serves as a safety net for a variety of risks to which an

institution is exposed in the course of its business. Capital absorbs possible

losses, and thus provides a basis for maintaining confidence in a bank. Capital

is also the ultimate determinant of a bank?s lending capacity. A bank?s balance

sheet cannot be expanded beyond the level determined by its capital adequacy

ratio. Consequently, the availability of capital determines the maximum level

of assets.The key purposes

of capital are to provide stability and to absorb any losses, thereby providing

a measure of protection to depositors and other creditors in the event of

liquidation. As such, the capital of a bank should have three important

characteristics: It must be permanent It must not impose mandatory fixed

charges against earnings and It must allow for legal

subordination to the rights of depositors and other creditors. Capital

Adequacy requirements:The minimum

risk-based standard for capital adequacy was set by the Basel Accord at 8

percent of risk-weighted assets, of which the core capital element should be at

least 4 percent. If a bank is also exposed to market risk, the adjustment for

the market risk is added by multiplying the measure of market risk by 12.5 and

adding the resulting figure to the sum of risk-weighted assets compiled for the

credit risk purposes. The capital ratio is then calculated in relation to the

sum of the two, using as numerator only eligible capital. Tier 3 capital is

eligible only if it is used to support the market risk.The quality of a

bank’s assets must also be mentioned in the capital adequacy context. A bank’s

capital ratios can be rendered meaningless or highly misleading if asset

quality is not taken into account. BALANCE SHEET

STRUCTUREThe composition

of a bank’s balance sheet assets and liabilities is one of the key factors that

determine the risk level faced. Growth in the balance sheet and resulting

changes in the relative proportion of assets or liabilities impact the risk

management process. Monitoring key balance sheet components may alert the

analyst to negative trends in relationship between asset growth and capital

retention capability. Balance sheet structure lies at the heart of the asset /

liability management process. Asset / liability management, comprises strategic

planning and implementation and control process that affect the volume, mix,

maturity, interest rate sensivity, quality and liquidity of a bank’s assets and

liabilities. CURRENCY RISK?????? Currency risk

results from changes in exchanges rates between a bank?s domestic currency and

other currencies. It is a risk of volatility due to a mismatch, and may cause a

bank to experience losses as a result of adverse exchange rate movements during

a period in which it has an open on-or off-balance-sheet position, either spot

or forward, in an individual foreign currency. In recent years, a market

environment with freely floating exchange rates has practically become the

global norm. This has opened the doors for speculative trading opportunities

and increased currency risk. The relaxation of exchange controls and the

liberalization of cross-border capital movements have fueled a tremendous in

international financial markets. The volume and growth of global foreign

exchange trading has far exceeded the growth of international trade and capital

flows, and has contributed to greater exchange rate volatility and therefore

currency risk.?Currency risk arises from a mismatch between

the value of assets and that of capital and liabilities denominated in foreign

currency (or vice versa) or because of a mismatch between foreign receivables

and foreign payables that are expressed in domestic currency. Such mismatches

may exist between both principal and interest due. Currency risk is of a

speculative nature and can thereby result in a gain or a loss, depending on the

direction of exchange rate shift and whether a bank is net long or net short in

the foreign currency. For instance, in the case of a net long position in

foreign currency, domestic currency depreciation will result in a net gain for

a bank, while appreciation will produce a loss. Under a net short position,

exchange rates movements will have the opposite effect.In principle,

the fluctuations in the value of domestic currency that create currency risk

result from changes in foreign and domestic interest rates that are, in turn,

brought about by differences in inflation. Fluctuations such as these are

normally motivated by macroeconomic factors and are manifested over relatively

long periods of time, although currency market sentiment can often accelerate

recognition of the trend. Other macroeconomic aspects that affect the domestic

currency value are the volume and direction of a country?s trade and capital

flows. Short-term factors, such as expected or unexpected political events,

changed expectations on the part of market participants, or speculation-based

currency trading, may also give rise to currency changes. All these factors can

affect supply and demand for a currency and therefore the day-to-day movements of

the exchange rate in currency markets. In practical terms, currency risk

comprises the following:Transaction

risk, or the price based impact of exchange rate

changes on foreign receivables and payables.Economic or

business risk related to the impact of exchange

rate changes on a country?s long term or company?s competitive position. Such

as, a depreciation of the local currency may cause a decline in imports and

growth of exports.Revaluation

risk or translation risk arises when a bank?s

foreign currency positions are revalued in domestic currency, or when a parent

institution conduct financial reporting or periodic consolidation of financial

statements. ?RISK


Risk) The general

approaches to VaR computation have fallen into three classes called parametric,

historical simulation, and Monte Carlo. Parametric VaR is most closely tied to

MPT, as the VaR is expressed as a multiple of the standard deviation of the

portfolio’s return. Historical simulation expresses the distribution of

portfolio returns as a bar chart or histogram of hypothetical returns. Each

hypothetical return is calculated as that which would be earned on today’s

portfolio if a day in the history of market rates and prices were to repeat

itself. The VaR then is read from this histogram. Monte Carlo also expresses

returns as a histogram of hypothetical returns. In this case the hypothetical

returns are obtained by choosing at random from a given distribution of price

and rate changes estimated with historical data. Each of these approaches have

strengths and weaknesses. The parametric

approach has as its principal virtue speed in computation. The quality of the

VaR estimate degrades with portfolios of nonlinear instruments. Departures from

normality in the portfolio return distribution also represent a problem for the

parametric approach. Historical simulation (my personal favorite) is free from

distributional assumptions, but requires the portfolio be revalued once for

every day in the historical sample period. Because the histogram from which the

VaR is estimated is calculated using actual historical market price changes,

the range of portfolio value changes possible is limited. Monte Carlo VaR is

not limited by price changes observed in the sample period, because

revaluations are based on sampling from an estimated distribution of price

changes. Monte Carlo usually involves many more repricings of the portfolio

than historical simulation and is therefore the most expensive and time


BANKSShort Term

Export Credits, one of the most important facilities of Turk Eximbank, are

extended both directly by The Bank and indirectly using selected Turkish banks

as intermediaries. For indirect lending, Turk Eximbank determines short term

TL, FX and letter of guarantee limits for intermediary banks through a risk

evaluation process of each bank. These banks are responsible for the default

risk of the borrowers. Therefore, selected commercial banks must be financially

sound and deemed to be active in the foreign trade business according to Turk

Eximbank standards. The evaluation

process named as risk evaluation study is explained in the following part of

this guide.This study

covers analyzing the financial structures of banks divided into 6 categories; Large-scale private banks Middle / Small- scale private

banks Foreign banks Investment banks Development banks State-owned banks This

categorization is done regarding ownership structure, scale, activities, and

its growth in the sector.This risk

evaluation study is reviewed quarterly in a year. Besides this, extra reports

are prepared according to the requests from the banks, executive committee and

the important changes about the banks. The quarter analysis includes; Basic Information Guideline (It

should be updated when necessary) Financial Sheet Sum Table (covering the sector

data) Tiering (Risk Group Determination) Executive Summary 1.BASIC


requests the banks ready to work with itself to submit ?the basic information

guideline? which covers following information; General information about the bank Ownership structure Board of directors Directors / top executives The list of group companies, if

the bank belongs to a group The list of subsidiaries, joint

ventures and/or equity participation of the bank This information

guideline is updated with every changes. (Enclosure 1.) 2. FINANCIAL

SHEETBanks are

sending their balance sheets and income statements in every 3 months, in the

same format as they prepare for Turkish Central Bank and Undersecretariat of

Treasury. These data submitted with diskettes and written form are transferred

to the standard format of Turk Eximbank in use of risk evaluation study. The

financial sheet covers percentage changes in financial data of the bank and the

financial ratios, which are calculated automatically according to a computer

program developed by Turk Eximbank, about capital adequacy, asset quality, liquidity

and profitability in addition to summarized balance sheet and income statement.3. SUM TABLE This is the

table that gathers the processed financial data of all banks, which are subject

of the risk evaluation study. These data are automatically taken from financial

sheets of each bank. The table covers financial ratio values of each bank based

on divided group and average, minimum and maximum values of each group, also

the sector, in addition some basic financial highlights as total loans, total export

credits, total deposits, paid-up capital etc. and their percentage changes for

each bank. The table is used as a reference guide while conducting regular risk

evaluation study.4. TIERING


earlier, the banks? risk profile is depicted quarterly through a detailed risk

evaluation study of each bank. For each bank category 8 different financial

ratio standards are determined compared with group and sector averages, minimum

and maximum values placed on the sum table.The financial

ratios are divided into 4 categories; Capital Adequacy Asset Quality Liquidity Profitability The standards of

8 ratios could be different for each bank category. For example, the ratio of

share holders? equity / risk bearing asset was applied as minimum 10% for

State-Owned Banks, while it was applied as minimum 15% for Large-Scale Private

Banks in September 2000 period.Banks are rated

and ranged into one of four categories regarding to the criteria they are

violating.There are 4

financial analysis groups indicating the risk levels of the banks. 4th

financial analysis risk group covers banks with maximum risk, whereas 1st

risk group covers banks with minimum risk. The total number of violated

criteria of each bank is important, since; If a bank violates maximum 2

criteria, it is placed in the 1st financial analysis risk

group, If a bank violates maximum 3

criteria, it is placed in the 2nd financial analysis risk

group, If a bank violates maximum 4

criteria, it is placed in the 3rd financial analysis risk

group, If a bank violates more than 4

criteria, it is placed in the 4th financial analysis risk

group. After

determining the financial analysis risk groups of each bank, the violation

criteria?s table is prepared showing violated criteria as minuses.The second step

of the study is that the banks are scrutinized according to the proportion of

export credits financed through the bank?s own sources and average rate of

using Turk Eximbank?s credit line as compared to the sector averages. In other

words, effective use of Turk Eximbank limits by the bank is very important. The

banks? risk groups are altered depending on these two rates and a new risk

group is created called limit allocation group. (For example, the being above

the average rate of export credits is considered a positive factor and upgrades

that specific bank?s ranking)The third step

of the study is that the banks are ranked for final risk group taking into

considerations the following additional criteria; Ownership structure Management quality Whether top management is

frequently changed or not Customer / market segmentation Human resource quality Reputation of the bank in the

market place Interest rate policies FX short position and exchange

rate exposure Importance of export credit

financing among its financing activities, Giving emphasis to technology

investments. Notified credit

line allocations do not create a binding obligation on Turk Eximbank. The bank

can easily slow down or cease credit payments and partially or fully cancel

credit limits, if necessary. When the financial strength of an intermediary

bank becomes questionable, Turk Eximbank may require the bank to establish

collateral with Turk Eximbank in the form of cash deposits and/or Treasury

Bills and Government Bonds.5. EXECUTIVE


summary reports is prepared by analysts in every three months for each bank and

covers a summation about changes in the bank?s performance, it?s risk group,

and current position in the sector for the specified quarter.In addition to

that, extra reports are prepared in the case of demands of the banks regarding

increase in their limits, extra-ordinary changes of status or ownership

structure etc. and presented to the top management of Turk Eximbank.Also, analysts of

Risk Assessment Division regularly visit the intermediary commercial banks?

CEO?s to get information on their future strategies and plans, new activities,

loan and interest rate policies, customer portfolio and target customer

segment, etc. After visiting, analysts prepare a meeting report and present to

the top management of the Bank. TURK EXIMBANK?S RISK MANAGEMENT


DOSSIERSAll of the

information about the banks is collected in credit limit dossier separately and

they include the information; Basic information guideline Financial sheet Executive summaries Corresponds with the bank Meeting reports and Press releases about the bank 2) GENERAL


studies done with the banking sector, corresponds and documents are collected

in these documents. They include; Risk group determination studies Limit allocation studies Management decisions Reports and other studies DISCLOSURES


determination studies of the banks? are made with the financial sheets and sum

tables that are prepared quarterly in a year. By using these, banks? capital

adequacy, asset quality, liquidity and profitability ratios are calculated. As

regards with the told banks? groups ratios and banking sector averages are

found in order to determine the risk groups. Bank groups are

state-owned banks, large-scale private banks, middle and small-scale private

banks, foreign banks, investment banks and development banks. Ratios are

determined according to the bank groups? specialties.These ratios are

used for all kinds of bank groups: Net asset / Risky assets Balance sheet excluded risks / Net

assets Follow up debt receivables / Total

credits Risky assets / Total assets Net profit / Net assets Net asset /

Risky assets ratios: In order to meet the banks?

risky asset, indicates the competence of the net assets.Balance sheet

excluded risks / Net assets ratios: They are

important for the control of non-cash credits and minimum ratios are valid in

order to rival known level of assets.Follow up

debt receivables / Total credits ratios: One of the

important problems of the banks? is the credits that cannot be collected back

and when they rise by the ratios they can be risky for the financial situations

of the banks. Follow up debt receivables / Total credit ratios are important

indicators of the banks? assert qualities and if it is high, it is a negative

development for the bank. Maximum boarders are put, as it is wanted to be low

as it can be.Net profit /

Net assets ratios: Indicates net asset

profitability.Bank groups

main peculiarities and ratios that differ according to the groups are:State-owned

banks: in addition to the ratios that are used for

all kinds of banks; Cash values / Current liabilities and Cash values /

Deposit ratios are being used. These ratios indicate the banks? sufficiency

to reinsure the deposits and short-term liabilities.Large-scale

private banks: Again for this group Current

liabilities / Cash values ratios are important liquidity indicators. An

upper limit is determined for the Current deposits not to exceed the Total

deposit ratio. Another ratio that is used for all kinds of bank groups

except the state-owned banks is Net interest incomes ratio. This ratio

indicates the banks income assets profitability.Middle /

Small- scale private banks: Cash values / Total asset ratio that is used except for the large scale private banks and

state-owned banks is also an indicator of how liquid are the banks? assets.Foreign

banks: As if their credit policies are the same

with the small-scale private banks, the same ratios are also used for them.Development

banks: They are founded in order to finance the

state investments and they don?t have profit goals, Eximbank doesn?t work with


banks: As if they don?t have a main goal of export

financing, Eximbank doesn?t work with them. RECOMMENDATIONS FOR RISK MANAGEMENTBanking

supervision, which is based on an ongoing analytical review of banks, continues

to be one of the key factors in maintaining stability and confidence in the

financial system. The methodology used in an analytical review of banks that

are in the process of off-site surveillance and on-site supervision is similar

to that of private sector analysts (for example, external auditors or a bank?s

risk managers), except that the ultimate objective of the analysis is somewhat

different. To attain a

meaningful assessment and interpretation of particular findings, estimates of

future potential, a diagnosis of key issues, and formulation of effective and

practical courses of action, a bank analyst must have extensive knowledge of

the particular regulatory, market, and economic environment in which a bank

operates. In short, to be able to do this job well, an analyst must have a

holistic perspective on the financial system even when considering a specific

bank.The practices of

bank supervisors and the appraisal methods practiced by financial analysts

continue to evolve. This evolution is necessary in part to meet the challenges

of innovation and new developments, and in part to accommodate the broader

process of convergence of international supervisory standards and practices,

which are themselves continually discussed by the Basel Committee on Banking

Supervision.? Traditional

banking analysis has been based on a range of quantitative supervisory tools to

assess a bank?s condition. Ratios normally relate to liquidity, the adequacy of

capital, loan portfolio quality, insider and connected lending, large exposures

and open foreign exchange positions. While these measurements are extremely

useful, they are not in themselves an adequate indication of the risk profile

of a bank, the stability of its financial condition or its prospects.The central

technique for analyzing financial risk is the detailed review of a bank. Risk

based bank analysis includes important qualitative factors and places financial

ratios within a broad framework of risk assessment and risk management and

changes or trends in such risks, as well as underscoring the relevant

institutional aspects. Such aspects include the quality and style of corporate

governance and management; the adequacy, completeness and consistency of a

bank?s policies and procedures; the effectiveness and completeness of internal

controls; and the timeliness and accuracy of management information systems and

information support.


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