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RISK MANAGEMENT

IN COMMERCIAL
BANKS

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By
Malik Dilawar
Vice President/Principal
Senior Training Manager, North,
UBL Training Centre, Islamabad,
Pakistan.
Phone: 0092-51-2820674(Off.),
Fax: 0092-51-2821521
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Risk management by
commercial banks -- Time to
hammer out the chinks
 Financial markets the world over have
undergone far-reaching changes in the last
decade, spurred by deregulation and
liberalization, as well as rapid developments in
communication and Internet technologies.
Banks in Pakistan have, however, generally
not paid enough attention to the potential
risks and to evolve mechanisms and systems
to control and manage them in line with the
global standards and procedures.

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Risk management by
commercial banks -- Time to
hammer out the chinks
As the banks no longer operate in a
protected and regulated environment,
there is an imperative need for them to
develop and improve their capability to
understand the changes in their economic
environment and other circumstances
having a critical bearing on their business
activities.
Risk management by
commercial banks -- Time to
hammer out the chinks
Risk management is a comprehensive
process adopted by an organization that
seeks to minimize the adverse effects it is
exposed to due to various factors --
economic, political or environmental,
some of them inherent to the business,
others unforeseen and unexpected.
Risk management by
commercial banks -- Time to
hammer out the chinks
Present practices/situation
Prevalent at commercial banks
requires a hard look and call for a
greater understanding by bank
managements and boards of the
risks involved in their operations.

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What is RISK ?
 It is the potential that events expected or
unexpected, may have an adverse effect on a
financial institution’s capital or earnings.
 Risk is inherent in all business and financial
activities.
 The greater the RISK associated with an
activity the greater potential to generate a
high return.
 Banks do take RISKS – The biggest RISK is
Not Taking A RISK.

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Definition of Risk Management

 Risk Management is the process of


identifying, measuring, monitoring and
controlling risks
 These four points are essential to risk
management
 This presentation will cover the main
identified risks in banks and determine how
well risks are being managed.

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Identifying Risks

 Where Risks should be Identified


 Institution-wide

 Business lines
 Products

 Transactions

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Serving the Needs of Depositor
Borrowers and Banks
 Commercial Bank
lending/Investment involves three
parties :
2. The suppliers of funds (The depositor)
3. The users of funds (The borrowers)
4. A financial intermediary (Bank) s

Supplier Bank Borrower


Challenge in Banking

“Banking is an art of striking a

balance between Risk and

Revenue.”
[Swiss Banking Corporation’s Credit Manual]
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TYPICAL BALANCE SHEET OF A BANK
[Amounts in millions USD]

Assets: Amounts Percent

Cash 461 8.29


Balances with Other Banks 418 7.52
Money at Call & Short Notice 380 6.84
Investment [Net of Provisions] 962 17.31
Loans and Advances [Net of Provisions] 2,785 50.11

Operating Fixed Assets 98 1.76


Capital w-i-p
Other Assets 354 6.37
Deferred Tax Asset 100 1.80
TOTAL ASSETS 5,558 100.00

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TYPICAL BALANCE SHEET OF A BANK
[Amounts in millions USD]
Assets as per previous slide 5,558 100.00

Liabilities
Deposits & Other Accounts 4,720 84.92
Borrowings from other Banks, Agents 391 7.03
Bills Payable 90 1.62
Other Liabilities 144 2.59
TOTAL LIABILITIES 5,345 96.16
NET ASSETS [ 1] 213 3.83
Represented By:
Share Capital 203 3.64
Reserves 106 1.91
Other Tier 1 Capital 136 2.45
Accumulated Loss 284 5.11
Surplus on revaluation of Fixed Assets 52 0.94
NET ASSETS [1] 213 3.83
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RISK MANAGEMENT
ORAGNIZATION
Risk management is a decentralized process guided by
centrally established policies and rules .Senior staff
committees define credit culture and established overall
policies and rules.Line management designs lending
procedures and controls risk.
There are usually five major organization groups that
participate in risk management process.These groups are
responsible for defining ,implementation ,and/or reviewing
risk management policies,rules and procedures within the
bank.
Banking Risk
Taking risks can almost be said to be the
business of bank management.A bank that is
run on the principle of avoiding all risks or as
many of them as possible, will be a stagnant
institution ,and will not adequately serve the
legitimate credit needs of its society.On the
other hand a bank that takes excessive risks or
credit is more likely ,takes them without
recognizing their extent or their existence will
surely run into difficulty.
All business involves some type of risk and
banking is no exception.
Credit risk is major category of risk of the
bank.It occurs whenever there is a possibility
that is the customer cannot meet contractual
obligations to the bank in term of :
- The delivery of documents or commodities
where the bank bears the whole risk OR
- The payment of principal ,interest ,fees or
commissions.
The overall objective of Risk Management is to increase
enterprise value

INCREASE VALUE BY

Providing
Appropriate Increasing
Level Improving
Return on
and Consistency
Capital
Allocation of Earnings
of Capital

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The best way to reach this objective is to understand
the full risk environment within which you operate...

External Internal
Environment Environment

Economic Expansion/ Financial Risk


Conditions Diversification

Asset Risk
Culture
Social/Legal
Trends
Liability Risk
Distribution

Natural Catastrophes Risk Appetite

Business Risk
People
Competition

Event Risk
Processes
Political/
Regulatory Operational Risk
Climate Technology

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…and the complete set of strategies that are available to you...

Financial Operational
Strategies Strategies

Hiring/Training
Financial Risk Capital
Structure
Incentive Programs
Asset Risk
Asset
Allocation Internal Controls
Liability Risk
Products
Pricing
Technology
Business Risk
Product Mix Customer Service
Event Risk
Market Strategy

Operational Risk Securitisation


Distribution

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…and to apply this knowledge
in a holistic risk management framework, to drive value

Increase Value

Return

Consisten
Capital

cy
Understand Internal Holistically Optimise Financial
and Manage and Operational
External Environment Strategies
Financial and
Operational
Risks

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To accomplish all this in a consistent manner, it is necessary to implement a
continual management process

Develop
Best Implement
Strategie Strategies
s

Monitor
Performance and
Environment

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In summary, Enterprise Risk Management:

 Allows you to determine the necessary capital


level, deploy unneeded capital and improve
return on capital
 Encourages proper allocation of capital to
segments and supports performance tracking
 Provides a method for ensuring that
enterprise owners receive proper
compensation for risks assumed

Provides Competitive Advantage


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RISKS
MUST BE:
- KNOWN
- UNDERSTOOD
- QUANTIFIABLE
- CONTROLLABLE / ACCEPTABLE /
BANKABLE

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RISKS FACED BY BANKS
 CREDIT RISK
 MARKET RISK
 INTEREST RISK
 LIQUIDITY RISK
 OPERATIONAL RISK
 COUNTRY RISK
 OWNERSIP / MANAGEMENT RISK

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CREDIT RISK
THE RISK THAT THE OBLIGOR (BORROWER) WILL
NOT BE ABLE TO REPAY THE DEBT (LOAN) UNDER
THE TERMS OF THE ORIGINAL AGREEMENT (LOAN
AGREEMENT).

• MOST CRITICAL RISK IN BANKING


• REQUIRES MOST SUBJECTIVE JUDGEMENT
• MUST BE MANAGED CAREFULLY

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MARKET RISK
CHANGES IN MARKET RATES AND PRICES WILL
IMPAIR AN OBLIGOR’S ABILITY TO PERFORM
UNDER THE CONTRACT NEGOTIATED BETWEEN
THE PARTIES.

• NEEDS MONITORING OF CHANGES IN PRICES OF


COMMODITIES, REAL ESTATE, ETC.

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INTEREST RATE RISK
INTEREST RATE RISK IS THE EXPOSURE OF AN
INSTITUTION'S FINANCIAL CONDITION TO ADVERSE
MOVEMENTS IN INTEREST RATES, WHETHER
DOMESTIC OR WORLD-WIDE.

• ANOTHER CRITICAL RISK


• RE-PRICING/ MISMATCHES NEED TO BE ADDRESSED

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LIQUIDITY RISK
THE RISK THAT A BANK WILL BE UNABLE TO
ACCOMMODATE DECREASES IN LIABILITIES OR
TO FUND INCREASES IN ASSETS. SUCH RISKS
ARISE WHEN THE REPRICING OR MATURITIES OF
ASSETS DO NOT MATCH THOSE OF LIABILITIES.

• CRITICAL RISK
• MATURITY MISMATCHES
• BASED ON MARKET CONDITIONS & PERCEPTIONS
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OPERATIONAL RISK
THIS RISK ARISES FROM THE LACK OF
EFFECTIVE INTERNAL CONTROLS AND AUDITING
PROCEDURES. PARTICULARLY IMPORTANT IS
THAT THE BANK SHOULD HAVE GOOD INTERNAL
CONTROLS
 Risk of a failure in the bank’s procedures
whether from external causes or as a result
of error or fraud within the institution.

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COUNTRY RISK
RISK ASSOCIATED WITH THE ECONOMIC,
SOCIAL AND POLITICAL ENVIRONMENT OF THE
BORROWER’S COUNTRY. COUNTRY RISK IS
MOST APPARENT WHEN LENDING TO FOREIGN
GOVERNMENTS/ THEIR AGENCIES AND OTHER
CUSTOMERS.
• BANK’S HAVING GLOBAL PRESENCE

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OWNERSHIP RISK
THE RISK THAT OWNERS / SHAREHOLDERS,
DIRECTORS OR SENIOR MANAGEMENT MIGHT BE
UNFIT FOR THEIR RESPECTIVE ROLES OR THEY
ARE ACTUALLY DISHONEST.

• ALSO A CRITICAL RISK


• ”THE BEST WAY TO ROB A BANK IS TO OWN IT”

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RISK MANAGEMENT
 Familiarisation of Management with
Risks
 Implementation of Internal Controls
 Sound Internal Audit System
 Efficient MIS in Place
 Competent Group of Risk Managers
 Prompt Action & Monitoring

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Risk Quantification
 Risk quantification techniques becoming
important to determine capital requirements
 More reliance on banks’ own systems for
identifying and managing risk
 Not only quantitative; also processes and
‘culture’:
 scrutiny of model design
 data integrity
 risk management resources
 validation
 independent audit
 management understanding
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DEPOSITS IN A BANK
REPRESENTS WHAT ?
 “Commercial Banks support a mountain of RISK
on a slender capital base. The bulk of their
liabilities is redeemable at PAR and on
DEMAND, with depositors regarding their money
as perfectly safe.”
 “Yet bank assets are subject to credit risk,
market risk, and settlement risk. With
international lending, there is foreign exchange
risk and transfer risk. Also there is management
risk and risk of fraud.”

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GENERAL
 Many of The Risks Overlap.
 Need To Be Evaluated In The Context Of
Individual Institution With On-site Presence.
 Evaluation of Risks Requires An
Understanding of The Bank, its Customer
Mix, its Assets & Liabilities And The
Economic And Competitive Environment.

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INTERNAL CONTROLS
 RISK RATING SYSTEM FOR CREDITS
 CLOSE MONITORING OF OPERATIONS
 COMPETENT CREDIT MANAGERS
 DUAL CONTROLS
 SYSTEM TO STUDY THE INDUSTRIAL
AND ECONOMIC DEVELOPMENT FOR
ESTABLISHING TARGET AREAS OF
INVESTMENT

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Reliance on Internal Control ?
Once the management system is
in place, supervisors can
determine that the systems are
working properly by testing the
systems. If the systems are
inadequate, the scope of the
inspection can be expanded so
that risks are properly identified,
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Principles of Control
• Segregation of duties
• Dual control
• Rotation of assignments or duties
• Two weeks continuous vacation
• Adequate Compensation

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INTERNAL AUDIT SYSTEM
 IMPLEMENTATION OF INTERNAL
CONTROLS
 PROVIDES SECONDARY RISK REVIEW
 INDEPENDENC.

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Objective of Internal Audit
 The overall objective of internal
auditing is to assist all members of
management in the effective
discharge of their responsibilities by
furnishing them with objective
analysis, appraisals,
recommendations and pertinent
comments concerning the activities
reviewed. The internal auditor,
therefore, should be concerned with
any phase of banking activity 40
Inspection Procedures for
Internal Auditors Work
 Organizational Structure of the Audit
Department
 Independence of the Audit Function
 Auditors Qualifications
 Audit Staff Qualifications
 Content and Utilization of the Audit
Frequency and Scope Schedule

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MIS
 AN ADEQUATE “MIS” HELPS IN TIMELY
IDENTIFICATION OF RISKS
 REPORTS ON MATURITY OR INTEREST
RATE MISMATCHES
 REPORTS ON PROBLEM CREDITS
 REPORTS ON CREDITS SHOWING
DETERIORATING TREND IN RISK RATING

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RISK MANAGERS
 QUALIFIED
 OBJECTIVE
 ENJOY ADEQUATE AUTHORITY
 ABILITY TO CORRECTLY ANALYSE FOR
CURRENT ACTION AND FUTURE
PREDICTIONS
 PROMPT IN ACTION

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