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According to studies, banks are facing a global crisis that is believed to be the worst financial conflagration today (Gregoriou 2009). Ensuring a safe system of finance will benefit not only the owners of the banks but the customers, managers as well as this will enable the hedge funds, pension funds, private equity firms, insurance companies and individual investors to run their businesses. It is of paramount importance to take into consideration how substantially vital banks are treated. It is apparent that the financial clutter was as a result of a number of causes. Therefore, there is a great need not to undermine the role executed by several big banks in the universe, which operate with insufficient liquidity, insignificant capital as well as poor practices for managing risks. It is believed that banks were in a position to address the losses facing them as a result of their poor decision making on investment in collateralised debt duty tranches as well as sufficient liquidity to address their unyielding commitments to their operations, everything would be fruitful and promising for them other than the severe losses and cleanup, which is to be funded over a long period of time (Gregoriou 2009).
This paper aims at analyzing the risk management as well as the measurement issues experienced by the banks as they move to the Basel III Era in relation to Interest Rate Risk, Liquidity Risk and Operational Risk.
Interest Rate Risk
The term is defined as the risk to capita,l which is as a result of the movement of interest rates. Interest risk rates arise from the difference between rate changes timing and the cash flow changes commonly referred to as the repricing (Crouhy et al. 2006). In addition, it arises from the rate changing relationships amidst the yield curves, which impact the activities of the bank. This is also referred to as the basis risk. Moreover, it arises from the changing rate relationships over the continuum of maturities referred to as the yield curve risk. It also arises from the interest rate related options which are entrenched in the products of the bank. It is also referred to as option risk. Evidently, the assessment of interest rate risk ought to take into consideration the effects of sophisticated products or strategies of illiquid hedging as well as the possible effects on the income fee that is subtle to the changes in the interest rates (Crouhy et al. 2006).
Apparently, interest rates movement impacts the reported earnings as well as the book capital of a bank by altering the following:
- Net interest income
- Trading accounts of market value as well as any other instruments which the market value accounts for.
- Interest subtle expenses as well as income, for instance, the mortgage servicing fees.
Control over the bank’s interest rate effectively necessitates a risk management process, which is comprehensive, and one that ascertains that the risk is timely identified, measured and monitored as well as controlled (Bessis 2010). However, the convention of the procedure varies with the size as well as the sophistication of the bank. In most instances, the banks usually choose to introduce and communicate the practices and principles of risk management in writing. In order to ensure an effective risk management communication throughout the bank, the OCC recommends that the principles be communicated in writing. Nevertheless, if a bank has sound principles through which it ensures an effective risk management procedure, then there is no need to present the guidelines in writing (Bessis 2010). In case the bank’s sound principles are not effective, and when the risk interest rate management of a bank is sophisticated and its management by informal policies is difficult, then it is of paramount importance to introduce some written policies to formally communicate risk controls and guidelines (Saunders and Cornett 2010).
Irrespective of the method used, the procedure of an interest rate risk management of the bank ought to establish:
Obligation as well as authority to determine the probable interest rate risks as the result of existing and new products or activities; introducing and upholding a measurement system for interest risk rate; articulating and implementing strategies as well as approving policy exclusions (Crouhy et al. 2006).A measurement system for interest risk rate; it is recommended that a bank establishes a measurement system that is in a position to determine as well as quantify the critical source of the risks in time (Resti and Sironi 2007).
A monitoring and reporting risks exposure system; the bank’s senior management ought to receive reports regarding interest rate risk of the bank at least four times in an year. The risks are aimed at allowing the management of the bank to assess the degree of the interest rate risk that is being taken in conformity with the risk limits in place as well whether the strategies of the management are suitable in light of the expressed risk forbearance by the board (Resti and Sironi 2007).
Limits and controls to the risks depending on the nature and quantity of the interest rate risk that could be withstood (Crouhy et al. 2006). When identifying limits of risk exposure the senior management of the bank ought to take into consideration the nature of activities and strategies of the bank in its previous performance of the Interest Rate Risk Comptroller's Handbook, the degree of income and capital available to address the probable losses (Resti and Sironi 2007).
Internal process for control; in the internal control process, it is necessary to have the oversight of the senior management. Moreover, in order to identify strong lines of responsibility, authority as well as risk restrictions, the management ought to ensure that sufficient resources are availed to enhance risk audit, monitoring and control functions (Resti and Sironi 2007). Besides, those in charge of monitoring and controlling the functions of risks need to be different from those who create risk exposure. According to studies, the individuals could also be part of basic operations, compliance, risk management or audit and treasury unit (Resti and Sironi 2007).
Studies reveal that an appropriate risk management and control system requires a timely and accurate measurement of the interest risk rate (Saunders and Cornett 2010). As evidenced by the Basel III Era, a risk measurement system of a bank ought to be in a position to determine quantifying the critical sources of the interest risk rate exposure of the bank. In addition, the system should also ensure that the management of the bank identifies the risks as a result of the customary activities of the bank as well as new businesses (Saunders and Cornett 2010). The kind of measurement system required is determined by the mix and nature of the interest rates of business lines of the bank and characteristics of the interest rate of its activities. The risk measurement systems are different across the banks (Bessis 2010). All risk measurement systems have their own disadvantages, which are different depending on the level to which they endorse different aspects of the exposure of the interest rate. In order to manage interest rate exposure, the banks should use different kinds of the risk measurement systems. There are three most commonly used models of measuring risk (Saunders and Cornett 2010). They include; net income stimulation models, repricing maturity gap reports, and the economic valuation.
Irrespective of the sophistication of the management system being used by the bank, the management system ought to ensure that the system is sufficient for the task (Bessis 2010). It is required that all banks collect as well as input position data and postulate about the interest rate environments as well as customer behaviour for the future. In addition, they should quantify and compute risk exposure (Bessis 2010).
Liquidity Risk Management and Measurement
The financial crises can be viewed to be a major influence that made liquidity risk to take a center stage (Barua 2010). Regulators have taken a stringent approach to address liquidity risk. Certainly, liquidity risk obtained limited interest both in Basel I and II, with the whole Basel framework merely focusing at the asset part only of the balance sheet (Bank for International Settlements 2010). Liquidity risk is recognised by regulators as a significant risk that encompasses funding liquidity and market liquidity risks. Funding liquidity risk is delineated as the incapability of obtaining funds in order to meet the requirements of the cash flow, whilst market liquidity risk crops up when a company is incapable of concluding a huge transaction in a specific instrument.
Liquidity risk instigates from the disparity between cash outflows and inflows timings (Barua 2010). This implies that it is basically intrinsic to the financial systems. Actually, in the contemporary economic system, the banking system has a major responsibility of facilitating the reallocation of monetary resources from sectors that have surplus monetary resources to be invested (liquid sectors).
After the financial crises, the banking institutions experienced major difficulties that occurred as a result of the fall in the fundamental standards of management of liquidity risks. This resulted to the publication of Sound Principles in 2008, which was the basis of liquidity framework for the management of liquidity risks (Barua 2010). The Sound Principles offer comprehensive guidance regarding the management and regulation of liquidity risks and besides, it should assist in the better management of risks. However, this necessitates complete implementation both by the supervisors and the banking institutions.
In order to complement the principles, two standards have been developed by the committee with an aim of further strengthening the liquidity framework (Onorato 2009). These standards have detached, nevertheless, complimentary aims to be employed by supervisors in the supervision of liquidity risks. The initial aim is to enhance the short term flexibility of the banking institutions liquidity risks by making certain that they have enough high-class liquid assets so that they would be able to endure a major stress situation that may last for at least thirty days (Bank for International Settlements 2010). After this, suitable remedial measures can be put into effect by the supervisors or the management. In order to attain this aim, a Liquidity Coverage Ratio was developed by the committee.
Stock of high-quality liquid assets
Total net cash outflows over the next 30 calendar days
Source: (Bank for International Settlements 2010)
The other aim is enhancing pliability over a long period of time through the creation of added incentives for banking institutions to be able to fund their doings with steady sources of funds on a continuing basis (Barua 2010). To facilitate the amplification of flexibility of the banking institutions to prospective liquid shocks, supervisors all over the globe should consistently implement the standards. The Net Stable Funding Ratio (NSFR) necessitates banking institutions to have sufficient funding that can last for a minimum of one year in order to compensate for monetary requirements forecasted to take place beyond that duration (Barua 2010).
Available Amount of Stable Funding >= 100%
Required Amount of Stable Funding
The standards are the main element of the supervisory of liquidity risk procedure. Nevertheless, the standards should be enhanced by comprehensive supervisory evaluations of other features of the institutions management framework for the liquidity risks that corresponds to the Sound Principles (Barua 2010). Furthermore, it is essential for the supervisors to make certain that banks implement further strict parameters or standards to mirror their profile of liquidity risks as well as the supervisor’s evaluations of their adherence to the Sound Principles.
There are various metrics employed that focuses on the management of liquidity risks. Such encompass the contractual maturity divergence, market linked management instruments, concentration of funding, liquid coverage ratio by considerable currency, and availability of unencumbered assets (Bank for International Settlements 2010).
The profile of contractual maturity divergence aims at categorizing the breach between contractual outflow and inflow of liquidity (Barua 2010). The gaps show the amount of liquidity a banking institution requires rising if outflows took place before the end of the specified period. This metric offers insight into the degree to which the banking institution depends on the maturity alteration under its recent contracts. A banking institution should make sure that it reports its security flows and contractual cash in the pertinent time period. In every jurisdiction, the supervisors should determine the exact template, encompassing necessitated time bands when information should be reported, which also allows for the understanding of the cash flows of banks. This data is essential as the management is able to take adequate measures regarding the monitoring of liquidity risks (Barua 2010).
The concentration of funding metric aims at categorizing various wholesale sources of funding important to a bank as their withdrawal may result in problems linked with liquidity. This tool encourages banking institutions to diversify their sources of funding as suggested in the Sound Principles by the committee (Bank for International Settlements 2010). The comparison of liabilities and assets amounts by currency offers the managers a basis for debate with the banking institutions regarding the management of currencies divergences via forwards and swaps (Barua 2010). This aims at offering a baseline for more debates instead of offering a perception of likely risks.
The availability of unencumbered metric offers supervisors the information regarding the main features and quantity encompassing location and currency denomination, of the accessible unencumbered assets of the bank (Onorato 2009). Certainly, these assets may be used as collateral in order to raise more funding and besides are entitled at the central bank and as a result, they can act as added sources of liquidity for a banking institution. The monitoring of liquidity currency ratio may also assist the supervisors and the banks to track probable currencies divergence problems which may arise. In addition, high frequency information linked with the financial market may be employed as an untimely warning sign in the management of probable liquidity risks at the banks (Onorato 2009).
Operational risk is a term used to refer to the risk of loss as a result of insufficient or failed procedures, individuals as well as systems. In addition, the term is used to refer to the risk of loss as a result of external events (Allen et al. 2007). The definition of operational risks comprises of the legal risk. This is the risk that arises from the risk of loss as a result of not conforming to the laws and contractual obligations, and practical ethical standards. In addition, it comprises of exposure to proceedings from all components of the activities of an institution.
With the wheels of Basel III being in motion and the bigger banking institutions in the world having been identified, of concern to many people is the operational risk management. It is apparent that the global financial services have continued to experience the crisis. The banks have continued to face shut down bailouts, fraud, bankruptcies, layoffs, greed, rogue trading, greed and poor internal controls.
The persistence and scale of the credit crisis revealed that extreme unfettered and leverage financial innovation in combination with imprudent credit origination, insufficient assessment methods could catalyse disruptions of the market with severe impacts for the financial stability and economic growth (Allen et al. 2007). A close scrutiny of the financial crisis as well as financial organizations universally makes it clear that the failures were a result of poor management of operational risks. It is apparent that rising sophistication of the financial products and banking, critical developments in technology, increased susceptibility of financial institutions as well as quick expansion of the operations of the bank led to the crisis in the global banks. As evidenced by studies, the causes have a close resemblance to the operational risk events. Moreover, it is believed that the operational risk management failure by the by the financial institutions catalyses credit and liquidity crisis.
According to the scholars, the management and measurement of the operational risk management is still evolving (Allen et al. 2007). Managing operational risks is widely acknowledged by most universal banking institutions. Critical areas that need to be taken into consideration comprise of operational risk definition, its measurement mode as well as theory culture formalization. According to the Basel III framework, an efficient operational risk management process timely enhances and improves the organization’s internal control (Resti and Sironi 2007). According to the scholars, internal audits ought to take into consideration the entire procedure of executing the processes of managing operation risks in the institutions. Furthermore, it is argued by some scholars that the huge sophistication of the banking activity as well as rising dependence on new technology innovations and expert skills have resulted in operational risk being the worst risk facing banking institutions globally (Allen et al. 2007).
Evidently, the operational risk is not a new risk. In addition, it has come to the attention of most bankers that most of the losses described earlier as market or credit risk were a result of poor internal and operational procedures. The scholars emphasise the publicised loss events linked to the lack of operational risk management. They assert that management of operational risk enhances a more appropriate behaviour within firms’ (Resti and Sironi 2007).
According to Basel III, market value reduction due to the announcements of loss of the operational events was of a higher magnitude than the losses that cause them. It is apparent that the sustainability and growth of most banking institutions in the middle of a high competition are highly dependent on the management as well as control of the operational costs. In order to be able to solve the rising operational crisis in the banking institutions, it is of paramount importance to endorse cross department approach to business continuity strategies and risk management. In the past, a number of approaches were suggested to address and manage the operational risks (Allen et al. 2007).
According to studies, there are two distinct sides of the operational risk. They include the operational risk management as well as operational risk measurement. Evidently, some tension exists between the two terminologies. Due to this, there is a frequent overlap between the two words. Basel III necessitates that the capital is held for the operational risk (Gregoriou 2009). In addition, it believes that it also offers probable calculation methods for the same capital. The requirement for capital is the center for measurement of operation risk activities. Due to this, it needs quantitative approaches. The banking institutions should exhibit that they are in a position to manage their operational risks effectively by using the qualitative approaches. An effective operational risk management procedure uses both the quantitative and the qualitative approaches to ensure that the operational risks are appropriately managed.
It is recommended that as the banks move to the Basel III Era, they ought to establish a framework for operational risk management as well as assess the sufficiency of the capital provided for the same framework (Gregoriou 2009). The framework is supposed to cover the appetite as well as tolerance of the bank for the operational risk indicated by the policies of managing the risks including manner and extent in which the operational risk is moved outside the bank. Besides, it is necessitated that the framework should also have policies outlining the approach of the bank to identify, assess, monitor as well as control the risk (Gregoriou 2009).
Measurement of the operational risk mainly emphasises the calculation of operational risks’ capital (Crouhy et al. 2006). Basel II offers three probable methods to calculate operational risk capital. According to some institutions, operational risk capital is calculated without taking into consideration the regulatory requirement as they wish to embrace the operational risk capital within their strategic planning as well as capital allocation for business and strategic reasons (Resti and Sironi 2007).
Operational Risk Case Study: Reflective Statement on the Problems, the Lessons Learned and Future Direction Needed To Avoid the Problems
The National Australian Bank made announcements in 2004 linked to the losses that were experienced in the transactions of foreign exchange options. The effect of false transactions was one of the causes identified to have caused these losses, which ranged between 175 million dollars and 360 million dollars. Mainly, the cause of these losses was a result of amplification in currency options risk taken together with unfavourable movements in currency. Besides, the currency options were overstated and this together with the deteriorating of the United States dollars resulted in the increase of losses. This scandal was perpetrated by various traders in the currency options including one from London and four in Melbourne. These traders knew about the considerable losses, which were incurred and covered in 2002, 2003 and 2004. The traders undertook the practice of smoothing profits and covering losses for a period of more than two years. The losses were covered up by the traders through entering fake transactions within the trading systems. Moreover, the traders made use of numerous techniques to exploit these gaps including entering false transactions, recording valid transactions incorrectly, and making use of wrong revaluation rates (National Australian Bank 2004).
There are various lessons that can be learnt in this case study. The PricewaterhouseCoopers made various observations linked to these problems and categorized a number of important weaknesses in most areas encompassing people integrity, governance and culture, and risk and control framework (National Australian Bank 2004). It is apparent that traders misstated losses and profits for numerous years through the employment of smoothing practice. The practice advanced to suppression of considerable losses through the dispensation of fake transactions to cover up the factual place of currency options. The behaviour of traders was not honest and besides, they covered up losses by assuming that they would in future gain sufficient profits that can be used to overturn the past covered losses.
PricewaterhouseCoopers made a summary of the main risks that were more salient in shaping the operation of the bank. It identified the lack of adequate supervision of the currency trading options as one of the key areas that needed to be addressed. The daily supervision of the traders was not enough and it was identified that apart from the review of the profits of the bank there was minimal supervision by the management on other aspects that were crucial in the general running and operation of the bank. Based on the fact that there was a reported moderately stable return, there was a general assumption that the strategies were being followed effectively. Clear summary on the operation indicated the contrary, for instance, several limit breaches were ignored without a thorough investigation (National Australian Bank 2004). Also, even though staff appraisals of the traders gave unpleasant observation of there being some aspects of unwarranted risk taking, there was no effective action taken to arrest the problem. It was also brought to the surface that contracts were made without the prior permission from the product usage authorities.
The National Australian Bank made a day to day report on the risks giving out details of various risk positions including naming the limits, which had been breached. All the same as a result of dependability issues on the VAR calculations, their limit breaches regarding the currency options were not included on the front page of the report from the year of 2002, up to when the losses were discovered in the year of 2004. Breaches relating to other limits were made on a day to day basis in the last quarter of the year of 2003. From 2000 to the end of 2003, the VAR calculations made by the National Australian Bank were not effective enough to reflect the true values of the currency options and were therefore concluded to be undependable (National Australian Bank 2004). As a result, the National Australian Bank used another system for the evaluation of the currency option and product control, though it needed to upgrade the system to deal conclusively with the different options on the currency options market. The system went into operation in the few last months of the year 2003 (National Australian Bank 2004). During the operation of the system, the VAR calculations produced were more than the limit agreed upon on the option market and for this reason traders termed the VAR calculations as still undependable.
The traders also carried out big and strange transaction activities, which encompassd multifaceted structured transactions. The operations identified these transactions and submitted to the control function. Besides, it is apparent that there was no financial control or if it was present, their operations were not efficient. The back office processes had considerable omissions and gaps. The back office (operations) had the responsibility of processing the entire bank transactions encompassing confirmation, verification, reconciliations, settlement, amongst other processing (National Australian Bank 2004). The operations processes for currency options were improperly designed, which offered the traders a chance of entering fake transactions, and this was not detected by the operations. This problem was facilitated by the failure of the organization to check all internal transactions that were surrendered.
Future Direction Needed To Avoid the Problems
In order to avoid these predicaments, it is essential to implement significant measures and precautions. One of the key measures is ensuring adequate supervision of the currency trading options. This is based on the fact that daily supervision of the traders was not enough, and it was identified that apart from the review of the profits of the bank, minimal supervision by the management was needed on other aspects that were crucial in the general running and operation of the bank. The second measure is to ensure that contract is made with the prior permission from the product usage authorities. Making certain that there is a proper and dependable VAR calculation is another measure. Another measure is to ensure that there is an effective financial control and checking of all internal transactions taking place in the back office by the operations.