Strategies for Risk Management

Risk

A strong and efficient banking system is the catalyst for sustainable economic growth. Banks offer services to people wishing to save and plays a vital role in lending money to business to invest and expand, therefore banks are essential in enabling economic growth. Risks in the financial sector is an inherent part of the industry. The way banks monitor these risks depends on the internal controls and their procedures to limit the effects of the risks. However, not all risks are negative; sometimes there is an upside to risk, such as, the event of a project being under budget, hence they have saved money. Risk and the uncertainties around it are an integral part of banking, which by nature demands taking risks.

Each transaction that the bank performs will alter the risk profile of the bank, therefore calculations need to be carried out to understand the impact of the risk and procedures that must be implemented in the scenario of that risk occurring. Risk falls into three main categories; Credit, Market and Operational Risk.

Credit Risk

Credit risk refers to the probability of loss due to a counterparty’s failure to make payments on any type of debt. Credit risk management is the practice of mitigating losses by understanding the adequacy of a bank’s capital and loan loss reserves at any given time – a process that has long been a challenge for financial institutions. (UK Essays).

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The global financial crisis put credit risk management in the spotlight, regulators demanded more transparency in what they knew of their customers and client’s assets and the risks associated with them. Competition in the financial industry stems from survival of the fittest, therefore it is necessary to identify, measure and monitor risks. A better credit risk management structure provides the opportunity to improve overall performance of the bank and the entire sector.

In 1988 Basel I Accord was a regulatory framework that was implemented to help provide a set of minimum requirements that financial institutions had to meet, with the aim of minimising risk. Recently, Basel II Accord has been implemented to enhance further risk management and financial stability. The three pillars of Basel II are:

• Mandating that capital allocations by institutional managers are more risk sensitive.
• Separating credit risks from operational risks and quantifying both.
• Reducing the scope or possibility of regulatory arbitrage by attempting to align the real or economic risk precisely with regulatory assessment.

Pillar one addresses risk directly and says that the minimum capital requirement is 8%. This requirement is in place to safe guard against adverse events. Pillar two is the regulatory response to pillar one, it provides a framework for dealing with systemic risk, liquidity risk and more. Pillar three promotes the sharing of market information. This allows other bodies such as investors and rating agencies to assess the bank. The market discipline supplements regulation, leading to sound corporate governance. The main goal of Basel I remains key in these requirements: maintain enough capital in the banking system to safe guard against the volatility of the financial sector.

Market Risk

Market Risk refers to the risk that an investment may face due to fluctuations in the market, for example, the share price will change, foreign exchange rates modulate, or interest rates go up or down. Market risk cannot be prevented but they can use models to identify risk events, calculate a probability of that event happening and quantify the potential loss. Banks should have a market risk management team, so they can understand their market risk profile, the volatilities of the market, short term profit and loss and long-term economic risk. Understanding all these factors will allow financial intermediaries to get maximum efficiency out of its capital.

Market risk management teams implement frameworks to systematically identify, assess and monitor risk events by various models and portfolio analysis. Two of these measures are value at risk and stress testing. VaR is a statistical measure of riskiness in a portfolio, providing a quantitative analysis on the potential loss due to movements in the market. VaR is an essential part of assessing market risk because it allows a comparison across different business and provides correlations among different asset classes in a portfolio. (Alessandro Aimone) A business may also use VaR to compare their market risk over time and against their daily results. Stress Testing is a quantitative tool used to assess market risk; it evaluates the possible effects of extreme market events and movements. Both of VaR and stress testing allows a business to predict future risk they may encounter, providing them with time to mitigate the risk occurring. (Dr. Paul Achleitner)

Operational Risk

Operating risk is defined as ‘the risk of direct or indirect loss resulting from inadequate or failed internal processes, people and systems or from external events.’ This can be viewed as the most important as it can be the most detrimental to the business. A lack of operational risk management can lead to damaged reputation. An effective operational risk management structure will allow financial intermediaries to develop measures to examine the adequacy of internal risk processes and improve the viability of the methods used to calculate operational risk. (Alan Greenspan)

Availing of an operational risk management structure will help detect events quickly and adjust deficiencies in policies and procedures to reduce the severity of the risk. Banks should implement an adequate and regular monitoring process. The outcome of these monitored activities should be added to management and board reports. The report should have all adequate information on the potential risks posed in the company. These risks should then be passed on to the areas of the bank where these risks may occur, providing the probability of the risk and the loss incurred. It is then the banks job to put up safe guards to mitigate the effect of the event. There are three ways in which the bank can do this: avoid the risk, reduce the risk or transfer the risk. Avoiding the risk is a good strategy when the impact could be large on the project. Reducing the risk means limiting the impact of the risk so if it occurs, the problem it creates is smaller and easier to fix. Transference means to transfer the risk to a third party, so it is their responsibility to manage the risk. (Sonia Pearson)

Banco De Cali

Operational risk is the failure of internal processes. Catedral, a business in the oil and gas sector is one of Banco De Cali’s biggest clients. They have been providing loans to Catedral for the past ten years despite Catedrals poor cash flow problems. Frequent defaults affect the credit worthiness of the business and threatens closing the business down due to insolvency. This is an example of poor operational risk management in Banco De Cali as they have failed to comply with regulations and regulatory administrative actions and policies. Banco De Cali should have been analysing the performance of the businesses they lend to and checking their credit ratings. The withdrawal of Fitch’s credit rating on Catedral should have been noticed by Banco De Cali’s internal risk management team and issued a warning that loans will not be distributed to them until their cash flow problems are sorted.

In Section 14.1 of the procedures of Banco De Cali it states that “prior to entering a Client relationship, documentation must be considered to evaluate the validity of the client’s business activities. Where appropriate, exceptions to this standard may be permissible with the written approval of the Senior Relationship Manager.” Banco De Cali’s failure to comply with regulatory organization standards has resulted in material financial loss of $350 Million. This is an example of compliance risk within Banco De Cali because their client, Catedral, was not supplying adequate information to the ratings firm, therefore they are a company at the risk of default. From 2015 to 2018 Catedral dropped from BBB to B-. Banco De Cali should have been aware of this and not provided any short-term loans with high interest rates to Catedral.

Under section 2 of Credit Facilities and Covenant breaches it clearly states that “relationships with clients who have breached terms of a loan covenant (including deteriorating financial ratios & external credit rating downgrades) will be evaluated and where appropriate escalated to management.” The operational risk management team has been negligent here as there were clear signs of poor cash flow in Catedral yet they still provided short term loans to them. Banco De Cali were given a mandate to grow the oil and gas sector, however, they did not follow appropriate procedures; there short-term vision blinded them from the long-term objective of the company, leading to a loss of money.

Through the advancements of technology over the past number of years there are an increasing number of operational risks that risk managers need to look out for. It is beginning to be increasingly difficult for operational risk managers to control operational risks, especially when there are events like IT disruption, such as a disabling cyber-attack, or a data compromise. In 2018 these threats are the top threats to financial services firms. In relation to the case of Banco de Cali, there are many ways of preventing operational risks from happening in the future.

In order to prevent similar events from occurring within Banco de Cali and other subsidiaries of Town Bank, a successful operational risk management team needs to establish a risk culture which needs to be communicated throughout the whole organisation with each manager and employee being fully accountable for the identification and control of risk as part of their job description.  A strong foundation is required to ensure consistency in measurement and management. The creation of benchmarks is necessary for future actions and encourage the right behavior among employees. Therefore, due to a wide variety of sources in which operational risks can arise, risk management must be aligned within all parts of the business in order to be effective.

Operational risk managers realize there are several key areas within a bank that need attention in preventing operational risks from occurring. One area is people; employees and the customers. People within the business can be at fault for fraudulent activities, whether intentional or unintentional. This may involve a lack of knowledge and training on behalf of an employee and breaches of business rules and principles. Also, employees may be under an ‘incentive plan’ in which they have been set aggressive sales targets. This can cause inappropriate risk taking and spells serious consequences for those acting in an unethical way. Effective operational risk management is needed to ensure that employees have the correct training to anticipate for something to go wrong and to work with the correct ethical attitude. Ways to ensure you have trustworthy staff are pre-employment checks on all new staff, rotation between staff for duties which involves dealing with cash and inventories and maintain good employment conditions. Although it is very useful to do a check on your employees, the practice of ‘Know Your Customer’ (KYC) is very important for any business to avoid any fraudulent behavior. KYC involves verifying the identity of a business’s client to assess potential risks of illegal intentions for the business relationship. For Banco de Cali and other subsidiaries of Town Bank to prevent further disasters, clients must provide appropriate documentation which evaluates the validity of the client’s business activities, nature and compliance with Town Bank’s Anti-Money Laundering (AML) standards. The Town Bank’s Chief Risk Officer must approve any exceptions to this standard. ‘Fraud prevention can be promoted through an anti-fraud culture that creates and supports employee awareness.’ (Collier, 2009) An anti-fraud culture can bring long-term benefits, as high ethical standards attract customers, new employees and investors since they are aware, they are dealing with a trust-worthy organization.

Similar events to the case of Banco de Cali can be prevented so it doesn’t happen in the future. Banco de Cali, where there was an extension of approximately $550 million of short-term credit to Catedral in which Petromex was attributable to $200 million of accounts receivable to us, however, the remaining amount receivable were fraudulent documents. This may be known as credit risk, where ‘… a borrower will fail to repay the principal borrowed.’ (Collier, 2009) In order to mitigate credit risk, there are a range of techniques that ensures a firm’s credit exposure stays within available parameters, including netting, collateral and diversification. In order to prevent such a credit risk from happening in the future, the credit manual must be consulted before any extension of credit to a client in order to ensure compliance with the credit policies of the Town Bank. All subsidiaries of Town Bank are required to follow the best practices and credit procedures to the extent permissible within local regulation. Therefore, any relationships with clients who have breached terms of a loan covenant will be re-evaluated and escalated to the Senior Credit Officer for remedial management.

Maintaining a good relationship between banks and clients is very important for the future of any bank and business, however it is essential to review all relationships between banks and clients. To start a relationship with a bank and to ensure a relationship with a client is safe for the bank, all documentation must be provided to the bank, and this then requires a review process to guarantee accuracy and validity. As with the case of Banco de Cali and Catedral, it is more important to a bank to continue the review process with ongoing relationships between bank and client. The ongoing review process between bank and client involves inspection of documentation with the relationship manager, along with review of documentation with an independent party within the business in order to assure factual accuracy. The independent party whose job it is to review this documentation must be independent from the relationship manager and ‘bear no direct reporting line to avoid potential conflict of interests.’ This inspection can prevent catastrophic outcomes for both bank and client, for example with the relationship between Banco de Cali and Catedral there were continuous signs of Catedral becoming a liable client, with the reduction of their credit rating from S&P showing that in 2015 Catedral they had an adequate capacity to meet its financial commitments, to 2017 where they became more vulnerable, with economic conditions having a massive impact on whether they can meet its financial commitments.

In conclusion, we have analyzed what went wrong in Banco de Cali and their weaknesses within the internal control environment. In doing so we have explained the three main risks; credit risk, market risk and operational risk. We have also provided ways in which Banco de Cali and other subsidiaries of Town Bank can prevent similar events in the future.

Bibliography

• UKEssays. November 2013. Credit Risk Dissertation. [online]. Available from: https://www.ukessays.com/dissertation/examples/education/credit-risk.php?vref=1 [Accessed 6 December 2018].
• Alessandro Aimone (Dec 2018) Value at Risk, Available at: https://www.risk.net/(Accessed: November 2018).
• Dr. Paul Achleitner (November 2018) Trading Market Risk, Available at: https://annualreport.deutsche-bank.com 
• Alan Greenspan (December 2018) Operational Risk Management (ORM) Framework in Banks and Financial Institutions, Available at: https://www.metricstream.com/
• SONIA PEARSON (October 2018) What is Operational Risk Management – Definition and Core Concepts, Available at: https://tallyfy.com/operational-risk-management/(Accessed: November 2018).
• Collier, P. (2009). Fundamentals of Risk Management for Accountants and Managers. 1st ed. Elsevier