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CHAPTER ONE

1.0 INTRODUCTION Investment management is the professional management of various securities (shares, bonds and other securities) and assets (e.g., real estate) in order to meet specified investment goals for the benefit of the investors. Investors may be institutions (insurance companies, pension funds, corporations, charities, educational establishments etc.) or private investors (both directly via investment contracts and more commonly via collective investment schemes e.g. mutual funds or exchange-traded funds). The term investment portfolio management is often used to refer to the investment management of collective investments. Investment managers who specialize in advisory or discretionary management on behalf of (normally wealthy) private investors may often refer to their services as wealth management or portfolio management often within the context of so-called "private banking". The provision of 'investment management services' includes elements of financial statement analysis, asset selection, stock selection, plan implementation and ongoing monitoring of investments. Investment management is a large and important global industry in its own right responsible for caretaking of trillions of yuan, dollars, euro, pounds and yen. Coming under the remit of financial services many of the world's largest companies are at least in part investment managers and employ millions of staff and create billions in revenue.

1.1 BACKGROUND OF STUDY Investors, although often aided by sophisticated communication tools and guided by analysis of market conditions by computer programs, must still make the final determinations regarding his or her investments. A philosophy of investment portfolio management will help guide these decisions. Without one, an investor is at the mercy of an inviting target for unscrupulous 'advisors' and floundering from 'solution' to 'solution'. In the process, many assets are lost due to trading fees, transaction costs, and needless tax liability. Once the need for a philosophy of investment is clear, there must necessarily be assets to invest. Careful thought must be given to ascertain that investment moneys are not drawn from funds needed for everyday living or business. Investing involves considerable risk, and one must be prepared to be able to do without these resources should a worst case scenario develop. However, sources of extra funds may be more available than it seems. An evaluation of risk tolerance is another area which must be considered. The investor needs to determine where he or she is at regarding an investing time line. Developments in the global financial sector within the past decade have given stakeholders in the Ghanaian banking industry cause to not only consider the returns made in the sector but also critically examine frameworks used to manage investment portfolio and its risks in the sector and safeguard their interests. This is because the failures faced by the industry in recent times have been blamed largely on the weaknesses of the regulatory frameworks and the risk management practices of the financial institutions. The greatest impact of the crisis has been on the banking industry, where some banks which were hitherto performing well suddenly announced large losses with some of them going burst. Some reasons put forward for the failures in risk management in this regard include the limited role of risk management in assessing the risk associated with some investments made by the bank.

The general believe is that banks in Ghana have good risk management structures since there have not been any complaints or adverse findings against them by the regulators, that is, Bank of Ghana and Securities and Exchange Commission of Ghana (in the case of listed banks) concerning significant weaknesses in their risk management systems. The banks are believed to be generally compliant with major regulatory requirements which are basically in line with international standards set by the Basel Committee on Banking Supervision. These requirements include rigorous risk and capital management requirements designed to ensure that the banks hold capital reserves appropriate to the risk they expose themselves to through its lending and investment practices. However, in order to ascertain the resilience of the Ghanaian banking sector to withstand serious economic shocks, there would be the need for thorough assessments of the investment portfolio and components of the risk management frameworks and practices of the banks from time to time. This study was therefore a contribution to this exercise with a focus on Ecobank Ghana Limited (EGH). 1.2 JUSTIFICATION OF CHOICE OF INSTITUTION Ecobank Ghana limited was chosen for this study because of its reputation as being among the top four banks in Ghana. It is also listed on the Ghana Stock Exchange and therefore has its financial and other regulatory reports published, ensuring that the public has access to some basic information. Over the past decade EGH has won several banking awards in various categories including the coveted Bank of the Year Award for five consecutive years. According to the 2010 Banking Survey Report3 released by PricewaterhouseCoopers Ghana in collaboration with the Ghana Association of Bankers, EGH is ranked the fourth largest bank in terms of total assets contributing 10.1% to total assets of the banking industry. The bank was the third largest contributor to both industry deposits and gross loans and advances with 10.5% and 7.7% respectively. EGHs share of industry assets, deposits, and loans and advances, over the last three years, are indicated below.

Table 1.1: Summary of EGHs performance in Ghanaian banking industry 2009 2008 Category % Contribution 10.1 Ranking % Contribution 8.5 Ranking

2007 % Contribution 8.8 Ranking 4 4 3

4 4 Share of Industry Assets 10.5 3 8.7 4 8.9 Share of Industry Deposits 7.7 3 7.3 4 7.8 Share of Industry Gross Loans and Advances Source: 2010 Ghana Banking Survey Report issued by PricewaterhouseCoopers Ghana

As a further indication of public confidence in the banks performance, its shares have performed considerable well on the Ghana Stock Exchange since it got listed (Figure 1.1 gives an illustration of the banks performance on the Ghana Stock Exchange). Analysts also rate EGH quite favourably, with Bloomberg L. P. rating its short term local currency A1+ and Global Credit Rating Company (a reputable international rating agency) rating the banks long and short term credits (exposures) AA- and A1+ respectively. These give an indication of the soundness of its investment and credits. In the light of the above, I consider the bank to be an appropriate case for this study. Figure 1.1: Performance of Ecobank Ghana Limited on Ghana Stock Exchange

Source: Own construction with data compiled by Gold Coast Securities Limited

1.3 INTRODUCTION OF COMPANY Ecobank Ghana Limited (EGH) is one of the thirty one (31) subsidiaries of the Ecobank Group which is the leading Pan African banking group in Africa. It was incorporated under Ghanas Companies Code on January 9, 1989 as a private limited liability company to engage in the business of banking. EGH was initially licensed to operate as a merchant bank by the Bank of Ghana on November 10, 1989 but following the introduction of Universal Banking by the Bank of Ghana in 2003, it became the first bank to be granted the license to do general banking business. This action cleared the way for it to embark on its medium term strategic shift of moving from being a predominantly wholesale bank to one with a retail focus. In June 2006, EGH went public and was listed on the Ghana Stock Exchange. The bank operates four (4) subsidiaries: Ecobank Investment Managers Limited, Ecobank Leasing Company Limited, Ecobank Venture Capital Limited, and EB Accion Savings & Loans Company Limited. Together with its subsidiaries, EGH provides corporate banking, investment banking and retail banking products and services to wholesale and retail customers in Ghana. 1.4 STATEMENT OF THE PROBLEM There is the general belief that the banking sector in Ghana is relatively stable with individual banks having healthy investment Portfolio management and sound risk management frameworks. This belief stems from the fact that, with the exception of worsening asset quality which is blamed on internal macro economic factors; the industry has not experienced major losses in the face of the global financial crises. Also, the supervisory and regulatory bodies have not found any of the banks in Ghana culpable of flouting prudential arrangements aimed at protecting the interests of clients and shareholders as was experienced in Nigeria. There has, however, not been any major internal test to ascertain the resilience of the banking industry to withstand major shocks. So there is a vacuum between the general belief on the risk position of the Ghanaian banking industry and the investment management of the banks. To do this requires evaluation of the adequacy of the risk management framework employed by bank to handle the various risk they are exposed to in managing portfolio of investments.

1.5 OBJECTIVE OF THE STUDY The objectives of the study were two fold, which were to assess: I. the banks investment portfolio as at the end of the 2009 financial year. This involved an assessment of the income statement and balance sheet to identify inherent risks in their components and structure. It also involved using various tools (ratios, charts and tables) to ascertain the level of market (interest rate and, foreign currency) risks the bank investment is exposed to. II. the effectiveness of the banks risk management framework for managing investment portfolio, market and operational risks it is exposed to. This involved an assessment of: a. the strong governance structure in place, b. the adequate policies, procedures, tools and skills, c. the effective control measures, and d. the information management systems to support timely and accurate information delivery in place to manage risk associated with investment. 1.6 SIGNIFICANCE OF THE STUDY An assessment of EGHs investment management framework provided the state of the banks ability to handle the inherent risks in its operations. Also deviations from international best practices were also identified and alternatives recommended. The banks ability to deal with significant shocks and avoid losses during crisis periods was also tested. Since there is not much structural and operational difference amongst the banks in Ghana, it is hoped that this study will provide a guide to investment portfolio management and how the associated risk landscape looks like in Ghanas banking sector. In addition, it will provide a guide for further studies on investment management and risk management in the industry.

1.7 SCOPE AND LIMITATION OF THE STUDY In conducting investment and risk-based analysis of Ecobank Ghana Limited investment portfolio, information was mainly gathered from financial statements and other disclosures contained in the banks annual reports. In this regard, annual reports of the last three years (2009, 2008, and 2007) were considered to ensure consistency in the value used. This is because the bank shifted from the use of International Accounting Standards (IAS) to International Financial Reporting Standards (IFRS), in conformity with requirements by The Institute of Chartered Accountants (Ghana), Ghana Stock Exchange and the Securities and Exchange Commission for listed companies to prepare their financial statements for the year ended 31st December 2007 and beyond. The banks risk management policy manuals and other independent reports on its financial performance was used to gather relevant information concerning the banks current health (investment) and capacity to remain stable in the face of instability in the industry and the global economy as a whole. However, the bank considers most information, except those contained in the annual report and official releases, sensitive and for that matter detailed but relevant information was not available for use. Also, due to lack of adequate comparable data on other players in the Ghanaian banking industry, the study was unable to provide a complete picture of the performance EGHs investment in relation to peer group trends and industry norms in all cases. However, in cases where industry data was available comparative analysis was undertaken. 1.8 ORGANISATION OF THE STUDY

The study has been organised into five(5) chapters. Chapter One deals with the introduction of the study. It focuses on the background, introduction of company, objectives, significance, scope and limitation of the study. Chapter Two discusses the existing literature on the subject matter. This included theoretical and empirical literature. Chapter Three provides a framework (methodology) for assessing the bank investment portfolio. The assessment of the banks investment and risk profile is presented in Chapter Four, whiles Chapter Five includes research findings,conclusion and proposed recommendations, based on the assessment done.

C H A PT E R T W O R E VI E W O F S O M E S E L E CT E D R E L AT E D L I T E R A T UR E
2.0 INTRODUCTION This chapter reviews the literature on investment management in banking. It discusses issues on investment Portfolio and risk management from different perspectives and with the view of giving a theoretical foundation to the study. It starts with an exposition on investment management, followed by reviews of literature on the industry scope in investment management, approaches to investment decisions, qualities for successful investment management, rationales and categories of risk management activities as well as the kinds of risk faced by banks in managing investment portfolio, VaR as a risk management tool, Integrated Risk Management as the ultimate goal for risk management framework, Enterprise Risk Management and the place of Corporate Governance in bank risk management are also discussed in this chapter. 2.1INDUSTRY SCOPE The business of investment management has several facets, the employment of professional fund managers, preparation of reports for clients. The largest financial fund managers are firms that exhibit all the complexity their size demands. Apart from the people who bring in the money (marketers) and the people who direct investment (the fund managers), there are compliance staff (to ensure accord with legislative and financial controllers (to account for the institutions' own money and costs), computer experts, and "back office" employees (to track and record transactions and fund valuations for up to thousands of clients per institution). 2.2 PROCESS OF INVESTMENT MANAGEMENT Investment management also know as portfolio management is not a simple activity as it involves many complex steps which is broken down into following steps for a better understanding. Specification of investment objectives & constrains

research (of individual assets and asset classes), dealing, settlement, marketing, internal auditing, and the

regulatory constraints), internal auditors of various kinds (to examine internal systems and controls),

Investment needs to be guided by a set of objectives. The main objectives taken into consideration by investors are capital appreciation, current income and safety of principal. The relative importance of

each of these objectives needs to be determined. The main aspect that affects the objectives is risk. 8

Some investors are risk takers while others try to reduce risk to the minimum level possible. addressed.

Identification of constrains arising out of liquidity, time horizon, tax and special situations need to be

Choice of the asset mix

In investment management the most important decision is with respect to the asset mix decision. It is to do with the proportion of equity shares or shares of equity oriented mutual funds i.e. stocks and proportion of bonds in the portfolio. The combination on the number of stocks and bonds depends upon the risk tolerance of the investor. This step also involves which classes of asset investments will be places and also determines which securities should be purchased in a particular class. Formulation of portfolio strategy

After the stock bond combination is chosen, it is important to formulate a suitable portfolio aims to earn greater risk adjusted returns depending on the market timing, sector rotation, security selection or a mix of these. The second strategy is the passive strategy which involves holding a well diversified portfolio and also maintaining a pre-decided level risk.

strategy. There are two types of portfolio strategies. The first is an active portfolio strategy which

Selection of securities

Investors usually select stocks after a careful fundamental and technical analysis of the security they yield to maturity are factors that are considered.

are interested in purchasing. In case of bonds credit ratings, liquidity, tax shelter, term of maturity and

Portfolio Execution

This step involves implementing the formulated portfolio strategy by buying or selling certain securities in specified amounts. This step is the one which actually affects investment results.

Portfolio Revision

Fluctuation in the prices of stocks and bonds lead to changes in the value of the portfolio and this calls for a rebalancing of the portfolio from time to time. This principally involves shifting from bonds to stocks or vice-versa. Sector rotation and security changes may also be needed. Performance Evaluation

The assessment of the performance of the portfolio should be done from time to time. It helps the investor to realize if the portfolio return is in proportion with its risk exposure. Along with this it is also necessary 9

to have a benchmark for comparison with other portfolios that have a similar risk exposure. 2.2.1 KEY PROBLEMS OF RUNNING SUCH BUSINESSES Key problems include: revenue is directly linked to market valuations, so a major fall in asset prices can cause a precipitous decline in revenues relative to costs; above-average fund performance is difficult to sustain, and clients may not be patient during times of poor performance; successful fund managers are expensive and may be headhunted by competitors; above-average fund performance appears to be dependent on the unique skills of the fund manager; however, clients are loath to stake their investments on the ability of a few individuals- they would rather see firm-wide success, attributable to a single philosophy and internal discipline; analysts who generate above-average returns often become sufficiently wealthy that they avoid corporate employment in favor of managing their personal portfolios. 2.2.2 COMMON ERRORS IN INVESTMENT MANAGEMENT The errors made by an investor are given and are described below. Goals beyond rational expectations

The investor begins to assume that he is the owner of the company stock, lock and barrel and he also targets the expected rate of return beyond what the market is able to provide him steadily. The investor may also think that the market owes him profits because of the risks that he has exposed himself to in the market. Unjustified claims made by the company that is going for a new issue can lead to impractical goals being formed by the investor. Such out of reach goals are also formed because of excellent past performances by investment instrument or the portfolio manager.

An investment policy not clearly defined

This situation arises because investors do not have a clear cut idea about their risk disposition. It involves unclear view of risk and the investor is exposed to greed if the market is up and fear if it the market is down. The desire to reap profits when prices are high and the fear of running into losses when the prices are low are the major factors responsible for poor performance.

Stock Switching 10

It is a situation where the investor is selling one stock and at the same time buying another stock as he expects the value of the first stock to go down and expects the price of the second stock to go up. There are two important considerations to be taken into account when such a decision is taken. First, though it may be the correct time to sell the first stock it may not be the correct time to buy the second stock as it is very possible that the second stock is also falling in value. Second, it possibly sell the first stock as the stock might still have some appreciation in the market.

can be the right time to buy the second stock but it does not necessarily mean it is the right time to

Preference for a cheap stock

A low priced stock is a very appealing proposition for any investor as he is able to purchase more quantities of that stock. There are situations where even if the investment involved in buying stocks is the same, the investor would consider one alternative to be more difficult. For example, an investor shares of a Rs 100 stock. This happens for the simple reason that in the first case he is able to own more shares of a company than in the latter. The investor also commits the mistake of averaging a stock which can be dangerous. An investor might purchase more quantities of a stock when he realizes that the price of the stock is falling and averages his price down. However, he does not take price.

would find it more preferable to purchase 1000 shares of an Rs 10 stock rather than purchasing 100

into account that the price trend of the stock could reverse and can go above his average purchase

Over-diversification

It is a case where an investor has large number of names in his portfolio, maybe 30-40 different stocks. An investors portfolio in the case of over diversification is the same or is a tad above or stocks would become a very tough job. Decision making would become slow and ineffective. An investor should typically have 10-15 well researched stocks.

below the index depending on the names in the portfolio. Managing a portfolio with 30-40 different

Under-diversification

It is a situation where an investor has only 1-2 stocks in his portfolio. This happens because the investor is over confident of the performance of the stock or it is due to plain complacency. Cursory Decision Making

Investors often make decisions rapidly depending tips given by the media reports or by experts. They dont realize that if any of these sources had profitable stock tips or the guide to make big bucks they wouldnt be letting them out in public. This sort of error also happens when the investor is not 11

confident about his own assessment of the stock and tends to follow some other investors verdict.

2.3 APPROACHES TO INVESTMENT DECISION MAKING The stock market is thronged by investors pursuing diverse investment approaches which may be broadly divided into four categories as follows 1.Fundamental approach 2.Psychological approach 3.Academic approach 4.Eclectic approach Fundamental approach

The basic belief of the fundamental approach and commonly used by the majority of investment expert are as follows We know that security has an intrinsic value and this intrinsic value depends upon the basic economic (fundamental) factors and it can be determined by an insightful analysis of the fundamental factors concerning to the company, industry and economy. In some cases, at some given period of time the current market value of a security will differ from the intrinsic value of the security. Over the period of time the intrinsic value is more than its market value) and selling over-valued securities (securities whose intrinsic value is less than its market value) good amount of returns can be earned.

market price will fall in line with the intrinsic value. By buying under-valued securities (securities whose

Psychological approach

Psychological mood of an investor is believed to influence the stock price. Therefore it is rightly said that psychological approach is based on the belief that the stock market is not guided by reason but by emotions. Prices rises to great heights when greed and euphoria sweep the market and when the market is surrounded with fear and despair, prices falls drastically. J.M.Keynes in his book The general theory of employment, established as the outcome of the mass psychology of a large number of ignorant individuals is liable to change violently as the result of a sudden fluctuation of opinion due to factors which do not really make much difference to the prospective yield. Since psychic value seems to be more valued than the intrinsic value therefore it is suggested by the 12

interest and money described this phenomenon in eloquent terms. He said: A conventional valuation which is

psychological approach for a profitable outcome to analyze how investors tend to react as the market is swept by waves of optimism and pessimism. The castles-in-the-air theory by Burton G.Malkiel describes the psychological approach vividly. It is more of a technical analysis which involves study of internal market analyzing the market data one can recognize certain persistent and recurring patterns of price movement. Variety of tools are used in technical analysis such as moving average analysis, point and figure chart, bar chart, breadth of market analysis etc.

data and it also concerns in building some trading rules as it beneficial and aimed at profit making. By

Academic Approach

Over the last four- five decades, various aspects of capital structure are studied by the academic community There appears to be substantial support for the following belief despite numerous unsolved issues and controversies arising from the studies which are pointing out in different directions. Stock price reflect the of information. This means that Current market price = Intrinsic value

particularly in the advanced countries by taking help of comparatively sophisticated methods of examination.

intrinsic value fairly well as they are practically efficient in responding promptly and reasonably to the flow

We can say that stock price behaviour is like a random walk in the park that means past price behaviour cannot be used to determine or predict future price behaviour as the successive price changes are independent. The expected return from the security is linearly associated to its systematic risk (market risk or non-diversifiable risk) because in a capital market there is a positive relationship between risk and return.

Eclectic approach

It is the combination of all the three approaches discussed above, the basic belief of eclectic approach are as follows. Total dependency on fundamental analysis is not appreciated as there are some uncertainties associated with it but fundamental analysis is helpful in forming a basic standard and benchmark. Fundamental analysis should be viewed with caution because of excessive refinement and complexity 13

associated with it. Technical analysis is usefully in gauging the current mood of investors and comparative strength of supply and demand forces. Total dependency on technical indicators can result in to a situation which is very dangerous and one might not be able to control it, as the mood of the investors is very unpredictable. Complicated fundamental system habitually represents figments of imagination to a certain extent than tool of proven usefulness therefore it should ordinarily be regarded as the suspect. The market is neither as speculative as the psychological approach indicates nor as well planned as academic approach recommends. Eclectic approach does have some inefficiency and it is not perfect but it does react rationally and quite efficiently to the flow of information. There are some instances that the securities are mispriced but still there appears to be quite strong association between risk and return. The operational implications of the eclectic approach are as follows Certain value Anchors are established by conducting fundamental analysis. The state of market psychology is assessed by technical analysis. Which securities are worth buying, worth selling or worth disposing is determined by the combine result of fundamental and technical analysis

2.3.1 QUALITIES FOR SUCCESSFUL INVESTMENT MANAGEMENT Investment is like a game and just like any other game it requires certain qualities and virtues to do well in the long run. These qualities are discussed below, however, it must be noted that cultivating these qualities on improves ones performance but doesnt guarantee success.

Contrary Thinking Investors are like a flock of birds, all moving in the same direction. There are two factors that attribute to this quality of investors. The first is the natural instinct in human beings to be part of the group and the second is the low confidence of investors in the own judgment. Scanty investment results are produced as a result of the behavior of following the crowd. A share gets overpriced the moment everyone is attracted to buying that share. This also makes the share bullish for a 14

longer period than it is actually supposed to be. However, in due course of time the market corrects itself and falls suddenly causing widespread losses. Developing the habit of contrary thinking is crucial while investing as it saves one from going into losses. It is difficult to develop such thinking because of the human desire to fall in line with others. However, developing the habit of contrary thinking does not mean that as an investor one must always go against the current market sentiment. Contrary thinking can be developed by avoiding stocks that have a high price earnings ratio. It also includes regulating the buying and selling of stocks by specifying the target prices at which the investor will buy and sell. Understanding failure An entry into the stock market comes with making losses at the beginning which is inevitable. This is mainly because of a few wrong decisions that an investor takes due to lack of knowledge or experience. However, to be successful in investment management it is necessary for the investor to be mentally prepared to bear such losses. The investor must learn and understand from his mistakes and take the right decision in the future to make up for the loss at a later stage. One must always keep the long-term profit in mind and move ahead. Investigate, then invest A thorough market research is required on a daily basis to avoid any unsound decisions made by the investor. A lot of developments happen even in after hours of trading and therefore it becomes necessary to learn about them before taking any investment decision. Flexibility and openness Changes in the world of investment are the most assured things to take place. Investor expectations are influenced by factors like emergence of new industries, introduction of new technologies, changes in macroeconomic conditions etc. Most adjust to the certainty in a very poor manner. Further, investors increase the problem by being over protective of their previous judgment mainly due to psychological reasons. This leads to a failure to absorb and interpret new formations with an open mind and thereby cripples the investors capacity to make good judgments about the future. An open mind on the other hand is not blocked by biases and prejudices making the investor more flexible in terms of assimilating the changes. This enables the investor to make better decisions and reap more profits.

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2.4 ASSET ALLOCATION

The different asset class definitions are widely debated, but four common divisions are stocks, bonds, realestate and commodities. The exercise of allocating funds among these assets (and among individual securities within each asset class) is what investment management firms are paid for. Asset classes exhibit different market dynamics, and different interaction effects; thus, the allocation of money among asset classes will have a significant effect on the performance of the fund. Some research suggests that allocation among asset classes has more predictive power than the choice of individual holdings in determining portfolio return. Arguably, the skill of a successful investment manager resides in constructing the asset group of competing funds, bond and stock indices).

allocation, and separately the individual holdings, so as to outperform certain benchmarks (e.g., the peer

2.4.1 LONG-TERM RETURNS It is important to look at the evidence on the long-term returns to different assets, and to holding period returns (the returns that accrue on average over different lengths of investment). For example, over very long holding periods (e.g. 10+ years) in most countries, equities have generated higher returns than bonds, and riskier (more volatile) than bonds which are themselves more risky than cash. 2.4.2 DIVERSIFICATION

bonds have generated higher returns than cash. According to financial theory, this is because equities are

Against the background of the asset allocation, fund managers consider the degree of diversification that makes sense for a given client (given its risk preferences) and construct a list of planned holdings accordingly. The list will indicate what percentage of the fund should be invested in each particular stock or bond. The theory of portfolio diversification was originated by Markowitz (and many others) and effective issues internal to the portfolio (individual holdings volatility), and cross-correlations between the returns. 2.4.3 INVESTMENT STYLES There are a range of different styles of fund management that the institution can implement. For example, growth, value, growth at a reasonable price (GARP), market neutral, small capitalisation, indexed, etc. Each

diversification requires management of the correlation between the asset returns and the liability returns,

of these approaches has its distinctive features, adherents and, in any particular financial environment,

distinctive risk characteristics. For example, there is evidence that growth styles (buying rapidly growing 16

earnings) are especially effective when the companies able to generate such growth are scarce; conversely, when such growth is plentiful, then there is evidence that value styles tend to outperform the indices particularly successfully.

2.5 PERFORMANCE MEASUREMENT Fund performance is often thought to be the acid test of fund management, and in the institutional context, accurate measurement is a necessity. For that purpose, institutions measure the performance of each fund also measured by external firms that specialize in performance measurement. The leading performance

(and usually for internal purposes components of each fund) under their management, and performance is

measurement firms (e.g. Frank Russell in the USA or BI-SAM [1] in Europe) compile aggregate industry periods. In a typical case (let us say an equity fund), then the calculation would be made (as far as the client is concerned) every quarter and would show a percentage change compared with the prior quarter (e.g., +4.6% institution (for purposes of monitoring internal controls), with performance data for peer group funds, and with relevant indices (where available) or tailor-made performance benchmarks where appropriate. The specialist performance measurement firms calculate quartile and decile data and close attention would be paid to the (percentile) ranking of any fund. Generally speaking, it is probably appropriate for an investment firm to persuade its clients to assess performance over longer periods (e.g., 3 to 5 years) to smooth out very short term fluctuations in performance and the influence of the business cycle. This can be difficult however and, industry wide, there is a serious preoccupation with short-term numbers and the effect on the relationship with clients (and resultant business risks for the institutions).

data, e.g., showing how funds in general performed against given indices and peer groups over various time

total return in US dollars). This figure would be compared with other similar funds managed within the

An enduring problem is whether to measure before-tax or after-tax performance. After-tax measurement

represents the benefit to the investor, but investors' tax positions may vary. Before-tax measurement can be

misleading, especially in regimens that tax realised capital gains (and not unrealised). It is thus possible that solution is to report the after-tax position of some standard taxpayer.

successful active managers (measured before tax) may produce miserable after-tax results. One possible

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2.5.1 RISK-ADJUSTED PERFORMANCE MEASUREMENT Performance measurement should not be reduced to the evaluation of fund returns alone, but must also integrate other fund elements that would be of interest to investors, such as the measure of risk taken. Several other aspects are also part of performance measurement: evaluating if managers have succeeded in reaching their objective, i.e. if their return was sufficiently high to reward the risks taken; how they compare to their peers; and finally whether the portfolio management results were due to luck or the managers skill. The need to answer all these questions has led to the development of more sophisticated performance measures, many of which originate in modern portfolio theory. Modern portfolio theory established the quantitative link that

exists between portfolio risk and return. The Capital Asset Pricing Model (CAPM) developed by Sharpe

(1964) highlighted the notion of rewarding risk and produced the first performance indicators, be they riskSharpe ratio is the simplest and best known performance measure. It measures the return of a portfolio in excess of the risk-free rate, compared to the total risk of the portfolio. This measure is said to be absolute, as it does not refer to any benchmark, avoiding drawbacks related to a poor choice of benchmark. Meanwhile, it

adjusted ratios (Sharpe ratio, information ratio) or differential returns compared to benchmarks (alphas). The

does not allow the separation of the performance of the market in which the portfolio is invested from that of replaced by a benchmark portfolio. This measure is relative, as it evaluates portfolio performance in reference to a benchmark, making the result strongly dependent on this benchmark choice. Portfolio alpha is obtained by measuring the difference between the return of the portfolio and that of a benchmark portfolio. This measure appears to be the only reliable performance measure to evaluate active portfolio exposure to different risks, and obtained through passive management, from abnormal performance good fortune. The first component is related to allocation and style investment choices, which may not be under the sole control of the manager, and depends on the economic context, while the second component is an evaluation of the success of the managers decisions. Only the latter, measured by alpha, allows the evaluation of the managers true performance (but then, only if you assume that any outperformance is due to skill and not luck). Portfolio return may be evaluated using factor models. The first model, proposed by Jensen (1968), relies on the CAPM and explains portfolio returns with the market index as the only factor. It quickly becomes clear, however, that one factor is not enough to explain the returns very well and that other factors have to be of portfolio risks and a more accurate evaluation of a portfolio's performance. For example, Fama and French 18

the manager. The information ratio is a more general form of the Sharpe ratio in which the risk-free asset is

management. In fact, we have to distinguish between normal returns, provided by the fair reward for

(or outperformance) due to the managers skill (or luck), whether through market timing, stock picking, or

considered. Multi-factor models were developed as an alternative to the CAPM, allowing a better description

(1993) have highlighted two important factors that characterize a company's risk in addition to market risk. These factors are the book-to-market ratio and the company's size as measured by its market capitalization.

Fama and French therefore proposed three-factor model to describe portfolio normal returns (Fama-French persistence of returns to be taken into account. Also of interest for performance measurement is Sharpes (1992) style analysis model, in which factors are style indices. This model allows a custom benchmark for allocation, and leads to an accurate evaluation of portfolio alpha 2.6 RISK MANAGEMENT IN BANKING Risk management is described as the performance of activities designed to minimise the negative impact (cost) of uncertainty (risk) regarding possible losses (Schmidt and Roth, 1990). Redja (1998) also defines risk management as a systematic process for the identification and evaluation of pure loss exposure faced by an organisation or an individual, and for the selection and implementation of the most appropriate techniques for treating such exposure. The process involves: identification, measurement, and management of the risk. Bessis (2010) also adds that in addition to it being a process, risk management also involves a set of tool and models for measuring and controlling risk.

three-factor model). Carhart (1997) proposed to add momentum as a fourth factor to allow the short-term

each portfolio to be developed, using the linear combination of style indices that best replicate portfolio style

The objectives of risk management include to: minimise foreign exchange losses, reduce the volatility of cash flows, protect earnings fluctuations, increase profitability, and ensure survival of the firm (Fatemi and Glaum, 2000). To ensure that banks operate in a sound risk management environment, where there is reduced impact of uncertainty and potential losses, managers need reliable risk measures to direct capital to activities with the best risk/reward ratios. They need estimates of the size of potential losses to stay within limits set through careful internal considerations and by regulators. They also need mechanisms to monitor positions and create incentives for prudent risk taking by divisions and individuals.

According to Pyle (1997), risk management is the process by which managers satisfy these needs by indentifying key risks, obtaining consistent, understandable, operational risk measures, choosing which risks to reduce, which to increase and by what means, and establishing procedures to monitor resulting risk positions. Bessis (2010) indicates that the goal of risk management is to measure risks in order to monitor and control them, and also enable it to serve other important functions in a bank in addition to its direct financial function. These include assisting in the implementation of the banks ultimate strategy by providing it with a better view of the future and therefore defining appropriate business policy and assisting in developing competitive advantages through the calculation of appropriate pricing 19

and the formulation of other differentiation strategies based on customers risk profiles. According to Santomero (1995), the management of the banking firm relies on a sequence of steps to implement a risk management system. These normally contain four parts which are standards and reports, position limits or rules, investment guidelines or strategies, incentive contracts and compensation. These tools are generally established to measure exposure, define procedures to manage these exposures, limit individual positions to acceptable levels, and encourage decision makers to manage risk in a manner that is consistent with the firm's goals and objectives.

2.6.1 RATIONALES FOR RISK MANAGEMENT IN BANKING The main aim of management of banks is to maximise expected profits taking into account its variability/volatility (risk). This calls for an active management of the volatility (risk) in order to get the desired results. Risk management is therefore an attempt to reduce the volatility of profit which has the potential of lowering the value of shareholders wealth. Various authors including Stulz (1984), Smith et al (1990) and Froot et al (1993) have offered reasons why managers should concern themselves with the active management of risks in their organisations. According to Oldfield and Santomero (1995), recent review of the literature presents four main rationales for risk management. These include managers self interest of protecting their position and wealth in the firm. It is argued that due to their limited ability to diversify their investments in their own firms, they are risk averse and prefer stability of the firms earnings to volatility because, all things being equal, such stability improves their own utility. Beyond managerial motives, the desire to ensure the shouldering of lower tax burden is another rationale for managers to seek for reduced volatility of profits through risk management.

With progressive tax schedules, the expected tax burden are reduced when income smoothens therefore activities which reduce the volatility of reported taxable income are pursued as they help enhance shareholders value.

Perhaps the most compelling rationale for managers to engage in risk management with the aim of reducing the variability of profits is the cost of possible financial distress. Significant loss of earnings can lead to stakeholders losing confidence in the firms operations, loss of strategic position in the 20

industry, withdrawal of license or charter and even bankruptcy. The costs associated with these will cause managers to avoid them by embarking on activities that will help avoid low realisations. Finally, risk management is pursued because firms want to avoid low profits which force them to seek external investment opportunities. When this happens, it results in suboptimal investments and hence lower expected shareholders value since the cost of such external finance is higher than the internal funds due to capital market imperfections. This undesirable outcome encourages managers to actively embark upon volatility reducing strategies, which have the effect of reducing the variability of earnings. It is believed that any of the above mentioned rationales is sufficient to motivate management to concern itself with risk and embark upon a careful assessment of both the level of risk associated with any financial product and potential risk mitigation techniques. 2.6.2 CATEGORIES OF RISK MANAGEMENT As Merton (1989) noted, a key feature of the franchise of financial institutions (including banks) is the bundling and unbundling of risks. However, not all risks inherent in their business should be borne directly by them; some can be traded or transferred whiles others can be eliminated altogether. It is therefore useful to defragment the risks inherent in their activities and assets into three distinctive subgroups in accordance with their nature so that the appropriate strategies can be adapted to mitigate them. Oldfield and Santomero (1995) argue therefore that risk facing financial institutions can be segmented into three separable categories from a management perspective. These are risks that can be eliminated or avoided by simple business practices, risks that can be transferred to other participants, and risk that must be actively managed at the firm level.Avoiding risk altogether by business practices has the goal of ridding the bank of risks that are not essential to the services provided or absorbing on the optimal quantity of a particular kind of risk. This is done by engaging in actions such as underwriting standards, diversification, hedging, reinsurance and due diligence investigation to reduce the chances of idiosyncratic losses by eliminating risks that are superfluous to the banks business purpose. After this is done, what will be left is some portion of systematic and operational risks which should be minimised to the greatest extent possible and their level and costs communicated to stakeholders. This is because an attempt to aggressively avoid these risks will constrain risks alright but will also reduce the profitability of the business activity. Some risks can also be transferred by the bank, when there is no value-added or competitive advantage associated with absorbing and/or managing them, to other parties who are in better positions to manage and benefit from them. There is yet another class of risks which should be adsorbed and aggressively managed at the 21

originating bank level because good reasons exist for using further resources to manage them. Some activities whose inherent risks have to be managed by the bank include those where the nature of the embedded risk may be complex and difficult to reveal to non-firm interests. For instance, banks holding complex illiquid and proprietary assets may find communicating the nature of such assets more difficult or expensive than hedging the underlying risk6. Moreover, revealing information about customers or clients may give competitors an undue advantage. Internal management of some risks may also be necessary because it is central to the banks business purpose because they are the raison dtre of the firm. This includes propriety positions that are accepted because of their risks and expected return. In all these circumstances when risk is absorbed, risk management activity requires the monitoring of business activity risk and returns and it is considered as part of doing business. In effect, banks should accept only those risks that are uniquely a part of the banks array of unique value-added services (Allen & Santomero, 1996, Oldfield & Santomero, 1995).

2.7

KEY BANK RISKS

The risks associated with the provision of banking services differ by the type of service rendered. Different authors have grouped these risks in various ways to develop the frameworks for their analyses but the common ones which are considered in this study are credit risk, market risks (which includes liquidity risk, interest rate risk and foreign exchange risk), operational risks which sometimes include legal risk, and more recently, strategic risk.

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2.7.1MARKET RISKS Market risk is generally considered as the risk that the value of a portfolio, either an investment portfolio or a trading portfolio, will decrease due to the change in value of the market risk factors. Pyle (1997) defines market risk as the change in net asset value due to changes in underlying economic factors such as interest rates, exchange rates, and equity and commodity prices. There are three common market risk factors to banks and these are liquidity, interest rates and foreign exchange rates. 2.7.1.1 LIQUIDITY RISK

Greuning and Bratanovic (2009), indicate that a bank faces liquidity risk when it does not have the ability to efficiently accommodate the redemption of deposits and other liabilities and to cover funding increases in the loan and investment portfolio. These authors go further to posit that a bank has adequate liquidity potential when it can obtain needed funds (by increasing liabilities, securitising, or selling assets) promptly and at a reasonable cost. The Basel Committee on Bank Supervision, in its June 2008 consultative paper, defined liquidity as the ability of a bank to fund increases in assets and meet obligations as they become due, without incurring unacceptable losses. Bessis (2010) however considers liquidity risk from three distinct situations. The first angle is where the bank has difficulties in raising funds at a reasonable cost due to conditions relating to transaction volumes, level of interest rates and their fluctuations and the difficulties in finding a counterparty. The second angle looks at liquidity as a safety cushion which helps to gain time under difficult situations. In this case, liquidity risk is defined as a situation whereshort-term asset values are not sufficient to match short term liabilities or unexpected outflows. The final angle from where liquidity risk is considered as the extreme situation. Such a situation can arise from instances of large losses which creates liquidity issues and

doubts on the future of the bank. Such doubts can result in massive withdrawal of funds or closing of credit lines by other institutions which try to protect themselves against a possible default. Both can generate a brutal liquidity crisis which possibly ends in bankruptcy. Liquidity is necessary for banks to compensate for expected and unexpected balance sheet fluctuations and to provide funds for growth (Greuning and Bratanovic, 2009). Santomero (1995) however, posits that while some would include the need to plan for growth and unexpected expansion of credit, the risk here should be seen more correctly as the potential for funding crisis. Such a situation would inevitably be associated with an unexpected event, such as a large charge off, loss of confidence, or a crisis of national proportion such as a currency crisis. Effective liquidity risk management therefore helps ensure a bank's ability to meet cash flow obligations, which are uncertain as they are affected by external events and other agents' behaviour. The Basel Committee on Bank Supervision consultative paper (June 2008) asserts that the fundamental role of banks in the maturity transformation of short-term deposits into long-term loans makes banks inherently vulnerable to liquidity risk, both of an institution-specific nature and that which affects markets as a whole. A liquidity shortfall at a single bank can have system-wide repercussions and hence liquidity risk management is of paramount importance to both the regulators and the industry players. The price of liquidity is however a function of market conditions and the markets perception of the inherent riskness of the borrowing institution (Greuning and Bratanovic, 2009). So if there is a national crisis such as acute currency shortage or decline, or perception of the banks credit standings deteriorates, or fundraising by the bank becomes suddenly important and recurrent or has unexpected fluctuation, funding becomes more costly. Financial market developments in the past decade have increased the complexity of liquidity risk and its management.

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2.7.1.2

INTEREST RATE RISK

In general, interest rate risk is the potential for changes in interest rates to reduce a banks earnings or value. Most of the loans and receivables of the balance sheet of banks and term or saving deposits, generate revenues and costs that are driven by interest rates and since interest rates are unstable, so are such earnings. Though interest rate risk is obvious for borrowers and lenders with variable rates, those engaged in fixed rate transactions are not exempt from interest rate risks because of the opportunity cost that arises from market movements (Bessis, 2010). According to Greuning and Bratanovic (2009), the combination of a volatile interest rate environment, deregulation, and a growing array of on and off-balance-sheet products have made the management of interest rate risk a growing challenge. At the same time, informed use of interest rate derivatives such as financial futures and interest rate swaps can help banks manage and reduce the interest rate exposure that is inherent in their business. Bank regulators and supervisors therefore place great emphasis on the evaluation of bank interest rate risk management, particularly since the Basel Committee recommends the implementation of market risk based capital charges.

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Greuning and Bratanovic (2009) posits that banks encounter interest rate risk from four main sources namely repricing risk, yield curve risk, basis risk, and optionality. The primary and most often discussed source of interest rate risk stems from timing differences in the maturity of fixed rates and the repricing of the floating rates of bank assets, liabilities, and off-balance sheet positions. The basic tool used for measuring repricing risk is duration, which assumes a parallel shift in the yield curve. Also, repricing mismatches expose a bank to risk deriving from changes in the slope and shape of the yield curve (nonparallel shifts). Yield curve risk materialises when yield curve shifts adversely affect a banks income or underlying economic value. Another important source of interest rate risk is basis risk, which arises from imperfect correlation in the adjustment of the rates earned and paid on different instruments with otherwise similar repricing characteristics. When interest rates change, these differences can give rise to unexpected changes in the cash flows and earnings spread among assets, liabilities, and off-balance-sheet instruments of similar maturities or repricing frequencies (Wright and Houpt, 1996). An increasingly important source of interest rate risk stems from the options embedded in many bank asset, liability, and off-balance-sheet portfolios. If not adequately managed, options can pose significant risk to a banking institution because the options held by customers, both explicit and embedded, are generally exercised at the advantage of the holder and to the disadvantage of the bank. Moreover, an increasing array of options can involve significant leverage, which can magnify the influences (both negative and positive) of option positions on the financial condition of a bank. Broadly speaking, interest rate risk management comprises various policies, actions and techniques that a bank uses to reduce the risk of diminution of its net equity as a result of adverse changes in interest rates from any of the sources mentioned above. Risk factors related to interest rate risk are estimated in each currency in which a bank has interest-rate-sensitive on and off-balance sheet positions. Since interest rate risk can have adverse effects on both a banks earning and its economic value, an approach which focuses on the impact of interest rate changes on a banks net interest income is combined with another which takes a more comprehensive view of the potential long-term effects of such interest rates changes on its economic value is used to assess the interest risk exposure.

2.7.1.3

FOREIGN EXCHANGE RISK

Bessis (2010) defines foreign exchange risk as incurring losses due to changes in exchange rates. Such loss of earnings may occur due to a mismatch between the value of assets and that of capital and liabilities denominated in foreign currencies or a mismatch between foreign receivables and foreign payables that are expressed in domestic currency. According to Greuning and Bratanovic (2009), foreign exchange risk is speculative and can therefore result in a gain or a loss, depending on the direction of exchange rate shifts and whether a bank is net long or net short (surplus or deficit)in the foreign currency. In principle, the fluctuations in the value of domestic currency that create currency risk result from long-term macroeconomic factors such as changes in foreign and domestic interest rates and the volume and direction of a countrys 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 foreign exchange changes. All these factors can affect the supply and demand for a currency and therefore the day-to-day movements of the exchange rate in currency markets. Foreign exchange risk is generally considered to comprise of transaction risk, economic risk and revaluation risk. Transaction risk is the price-based impact of exchange rate changes on foreign receivables and foreign payables, that is, the difference in price at which they are collected or paid and the price at which they are recognised in local currency in the financial statements of a bank or corporate entity. Alternatively known as business risk, economic risk relates to the impact of exchange rate changes on a countrys long-term or a companys competitive position. With increasing globalisation, capital moves quickly to take advantage of changes in exchange rates and therefore devaluations of foreign currencies can lead to increased competition in both overseas and domestic markets. This phenomenon makes this component of foreign exchange risk very critical for its management. The third component, revaluation or translation risk arises when a banks foreign currency positions are revalued in domestic currency, and when a parent institution conducts financial reporting or periodic consolidation of financial statements. Banks conducting foreign exchange operations are also exposed to foreign exchange risk in forms of credit risks such as the default of the counterparty to a foreign exchange contract and time-zone-related settlement risk.

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2.7.2 OPERATIONAL RISK The Basel Accord (2007) defines operational risk as the risk of direct or indirect loss resulting from inadequate or failed internal processes, people and systems or from external events. Malfunctions of the information systems, reporting systems, internal monitoring rules and internal procedures designed to take timely corrective actions, or the compliance with the internal risk policy rules result in operational risks (Bessis, 2010). Operational risks, therefore, appear at different levels, such as human errors, processes, and technical and information technology. Because operational risk is an event risk, in the absence of an efficient tracking and reporting of risks, some important risks will be ignored, there will be no trigger for corrective action and this can result in disastrous consequences. Developments in modern banking environment, such as increased reliance on sophisticated technology, expanding retail operations, growing e-commerce, outsourcing of functions and activities, and greater use of structured finance (derivative) techniques that claim to reduce credit and market risk have contributed to higher levels of operational risk in banks (Greuning and Bratanovic, 2009).

The recognition of the above-mentioned contributory factor in operational risk has led to an increased attention on the development of sound operational risk management systems by banks with the initiative being taken by the Basel Committee on Banking Supervision. The Committee addressed operational risk in its Core Principles for Effective Banking Supervision (1997) by requiring supervisors to ensure that banks have risk management policies and processes to identify, assess, monitor, and control or mitigate operational risk. In its 2003 document, Sound Practices for the Management and Supervision of Operational Risk, the Committee further provided guidance to banks for managing operational risk, in anticipation of the implementation of the Basel II Accord, which requires a capital allocation for operational risks. Despite all these efforts by the regulators at addressing operational risk, practical challenges exist when it comes to its management. In the first place, it is difficult to establish universally applicable causes or risk factors which can be used to develop standard tools and systems of its management since the events are largely internal to individual banks. Moreover, the magnitude of potential losses from specific risk factors is often not easy to project. Lastly, it is difficult designing an effective mechanism for systematic reporting of trends in a banks operational risks because very large operational losses are rare or isolated.

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2.7.3 STRATEGIC RISK While financial risk and credit risk in banking have been rigorously explored, the risk management implications of many corporate strategies and the external market and industry uncertainties have received relatively little attention (Miller, 1992). Slywotzky and Drzik (2005), define strategic risk as the array of external events and trends that can devastate a companys growth trajectory and shareholder value. Whiles these two authors consider strategic risk as a sole consequence of external occurrences, other authors look at strategic risk as the current and prospective impact on earnings and/or capital arising from internal business activities such as adverse business decisions, improper implementation of decisions, or lack of responsiveness to industry changes. They therefore consider strategic risk as a function of the compatibility of an organisations strategic goals, the business strategies developed to achieve those goals, the resources deployed against these goals, and the quality of implementation. Emblemsvg and Kjlstad (2002), also define strategic risk as risk which arises as a firm pursues its business objectives either by exploiting opportunities and/or reducing threats. Which ever way this is considered, strategic risk encompasses a variety of uncertainties which are not financial in nature, but rather credit or operational related caused by macro-economic factors, industry trends or lapses in a firms strategic choices which affects the firms earnings and shareholders value adversely. Strategic risks often constitute some of a firms biggest exposures and therefore can be a more serious cause of value destruction. Unfortunately, as strategic risks are often highly unpredictable and of different forms, managers have also not yet been able to systematically develop tools and techniques to address them (Slywotzky and Drzik, 2005). This is because the more formalised risk management approaches often remain focused on identifiable exposures and thus less suitable to deal with many of the unexpected economic and strategic events that characterise contemporary business environment in which strategic risks are embedded. Slywotzky and Drzik (2005) attempted to identify significant events which contribute to strategic risk and categorised them into seven main classes. These include industry margin squeeze, threat of technology shift which has the possibility of driving some products and services out of the market, brand erosion, emergence of one-of-a-kind competitor to seize the lion share of value in the market, customer priority shift, new project failure and market stagnation. The idea was to provide a framework for assessing a companys strategic risks and develop counter measures to address them. The authors intimate that the key to surviving strategic risks is; knowing how to assess and respond to them and therefore devoting resources to it. They also advice management to adjust their capital allocation decisions by applying a higher cost of capital to riskier projects and to build greater flexibility into their 29

capital structure when faced with riskier competitive environments. How these risks can be managed is determined by the organisational characteristics the strengths and weaknesses. They include communication channels, operating systems, delivery networks, and managerial capacities and capabilities. The organisations internal characteristics must be evaluated against the impact of economic, technological, competitive, regulatory, and other environmental changes. An effective strategic risk management approach should embrace both the upside and downside of risk. It should seek to counter all losses, both from accidents and from unfortunate business judgments, and seize opportunities for gains through organisational innovation and growth. Seizing upside risk involves searching for opportunities and developing plans to act on these opportunities when the future presents them. Countering downside risk on the other hand is done by reducing the possibility of occurring (probability) and scope (magnitude) of losses; and financing recovery from these losses (Herman and Head, 2002). Beasley and Frigo (2007) posit that the first step in strategic risk management is finding a way to systematically evaluate a companys strategic business risk. Thus, strategic risk management begins by identifying and evaluating how a wide range of possible events and scenarios will impact a businesss strategy execution, including the ultimate impact on the valuation of the company.

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2.8 VAR: A TOOL FOR MEASURING MARKET RISKS Jorion (2007) defines VaR intuitively as a summary of the worst loss over a target horizon that would be exceeded with a given level of confidence. It estimates the maximum potential loss that may be incurred on a position at a given horizon and level of confidence. Greuning and Bratanovic (2009) refer to it as a modelling technique that typically measures a banks aggregate market risk exposure and, given a probability level, estimates the amount a bank would lose if it were to hold specific assets for a certain period of time. It is a forward-looking method that expresses financial market risk in a form that anybody can understand, namely currency. It measures the predicted worst loss (maximum movement of the yield cure), over a target horizon (for example, 10 days, which provides the benefit of early detection), within a given confidence level (99 percent is the level chosen by the Basel Committee). VaR-based models cover a number of market risks, the bank is able to fine-tune its portfolio structure, drawing on a range of options for portfolio diversification to reduce the risk to which it is exposed and the associated capital requirements. The well-known proprietary models that use VaR approaches are JP Morgans Risk metrics, Bankers trust Risk Adjusted Return on Capital, and Chases Value at risk. Inputs to a VaR-based model include data on the banks positions and on prices, volatility, and risk factors.

VaR-based models combine the potential change in the value of each position that would result from specific movements in underlying risk factors with the probability of such movements occurring. The changes in value are aggregated at the level of trading book segments and across all trading activities and markets. The VaR amount may be calculated using one of a number of methodologies which are the historical simulation approach, the delta-normal or variance/covariance methodology and the Monte Carlo simulation method. According to the Basel Committee on Banking Supervision, the disclosure requirements for each portfolio9 should include VaR calculations, broken down by type of risk or asset class and in the aggregate, estimated for one-day and two-week holding periods, and reported in terms of high, medium, and low values over the reporting interval and at period end. Also there should be information about risk and return in the aggregate, including a comparison of risk estimates with actual outcomes. Further, there should be qualitative discussions to assist with a comparison of the P/L to VaR, including a description of differences between the basis of the P/L and the basis of the VaR estimates, and quantitative measure of firm-wide exposure to 31

market risk, broken down by type of risk, that in the banks judgment best expresses exposure to risk, reported in terms of high, medium, and low values over the reporting period and at period end. VaR numbers should be aggregated on a simple-sum basis across risk factor categories, taking into consideration cross correlations within each category. The Basel Committee market risk capital standard also requires that the VaR be computed daily and the market risk related capital requirements met on a daily basis. The capital requirement is expressed as the higher of the previous days VaR and the average of the daily VaR measures for each of the last 60 business days. This is then multiplied by an additional factor designated by national supervisory authorities and related to the quality of a banks risk management system. VaR faces some limitations based on the fact that it assumes that historical experiences may be repeated in future. It should therefore be used as one tool in an integrated set of tools and not as the only measure of a portfolios exposure.

2.9 THE PLACE OF CORPORATE GOVERNANCE IN THE MANAGEMENT OF BANK RISKS The importance of corporate governance has captured the attention of both national authorities as well as institutions engaged in international trade, and financial flows. Corporate governance is also essential to protecting the stability of international markets such as the Organisation for Economic Co-operation and Development (OECD), the Bank for International Settlements (BIS), the International Monetary Fund (IMF), and the World Bank. Several factors can be attributed to this increased attention. These include the growth of institutional investors such as pension funds, insurance companies, mutual funds, and highly leveraged institutions and their role in the financial sector. In addition, the widely articulated concerns and criticism that the contemporary monitoring and control of publicly held corporations are seriously defective, leading to suboptimal economic and social development, is also a factor to consider. Further, the shift away from a traditional view of corporate governance as centred on

shareholder value in favour of a corporate governance structure extended to a wide circle of

stakeholders and the impact of increased globalisation of financial markets, a global trend toward deregulation of financial sectors, and liberalisation of institutional investors activities, all account for the growing importance of corporate governance (Greuning and Bratanovic, 2009). 32

According to Greuning and Bratanovic (2009), corporate governance relates to the manner in which the business of the bank is governed. It is defined by a set of relationships between the banks management, board, shareholders, and other stakeholders. This includes setting corporate objectives and a banks risk profile, aligning corporate activities and behaviours with the expectation that management will operate the bank in a safe and sound manner, running day-to-day operations within an established risk profile and in compliance with applicable laws and regulations, while protecting the interests of depositors and other stakeholders. An effective governance practice in the banking system helps maintain public trust and confidence in the banking system. It is also said to create an enabling environment that rewards banking efficiency, mitigates financial risks, and increases systemic stability. Cost of capital tends to be lower when corporate governance is perceived to be good as it conveys a sense of lower risk that translates into shareholders readiness to accept lower returns. Good corporate governance has been proven to improve operational performance and reduce the risks of contagion from financial distress. Besides mitigating the internal risk of distress by positively affecting investors perception of risk and their readiness to extend funding, good governance increases the firms robustness and resilience to external shocks.

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C H A PT E R T H RE E M E T H O DO L O G Y
3.0 INTRODUCTION This chapter lays down the methodology for the analysis. It presents a detailed and systematic process of how the significant investment portfolio and its risk by Ecobank Ghana Limited (EGH) are identified, measured and managed. The main discussions of this chapter includes data sourcing, benchmarking, analytical tools to be used, analytical techniques used for interpreting the data as well as an outline of the analytical components of the investment and risks the bank is exposed to. 3.1 DATA SOURCE The study relied mainly on secondary data. This was obtained from the annual reports and other reports issued by the bank and other organisations. Some of these external secondary data comes from the regulators, industry watchers and other financial analysts. The banks policy documentations and guidelines concerning the management of investment portfolio and its various risks are also a major source of information for determining whether the banks structures and risk management tools are adequate in handling inherent risk in their investment portfolio. 3.2 BENCHMARKS The major benchmarks used for this assessment are the various documents released by the Risk Management Group of the Basel Committee on Banking Supervision regarding principles which ensure sound management of investment by banks. This helped in

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evaluating the adequacy of the EGHs investment management framework as the essential components of the recommended guidelines were mirrored to those in the banks policies in respect of its structures, processes, procedures and tools put in place to manage investment and its risks. To assist in assessing the performance of EGH vis--vis that of the Ghanaian banking industry, the Financial stability reports issued by the Bank of Ghana on periodic bases were relied upon for industry data. Also, the 2010 Ghana Banking Survey report issued by Pricewaterhouse Coopers Ghana in collaboration with Ghana Association of Bankers provided some peer ratios and industry averages and served as useful benchmarks for assessing the risk profile of EGH.

3.3 ANALYSTICAL TOOLS The analysis in this report relied heavily on excel models. These consisted of a series of spreadsheet-based data input tables that allowed data to be collected and manipulated in a systematic manner. The spreadsheet allowed for the generation of relevant tables, ratios and graphs which assisted in the interpretation and analysis of the data collected to help measure the banks investment performance as well as judge the effectiveness of its risk management process. 3.3.1 RATIOS A ratio refers to the mathematical expression of one quantity relative to another. There are many relationships between financial accounts and between expected relationships from one. point to another. In addition to giving an indication of current situations, ratios also aids in making forward-looking projections. The ratios covered the areas of investment management in

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varying degrees of detail using the balance sheet, income statement and cash flow schedules. Some of the areas of investment where ratios helped in expressing useful relationships include profitability, liquidity, and leverage and capital adequacy. Ratios, however, do not provide a complete picture of a banks investment performance and should be considered in conjunction with other qualitative information and contextually. Some of the ratios used in assessing bank investment can be found in table 3.1

Table 3.1: Ratios in assessing bank investments and its risk Category Solvency Ratios Capital Adequacy: Total Qualifying Capital / Total Risk Weighted
Assets Return on Assets: Profit After Tax / Average total Assets

Profitability Efficiency

Return on Equity: Profit After Tax / Average total Shareholders' Funds Net Interest Income / Average total Assets Net Interest Income / Gross Loans and Advances Operating Expenses / Average total Assets Operating Expenses / Gross Operating Income

Credit Risk

Customer Loans / Gross Loans and Advances Bank Loans / Gross Loans and Advances

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50 Largest Exposures / Gross Loans and Advances Collateral / Non-performing Loans (Coverage ratio) Non-performing Loans / Gross Loans and Advances Impairment Charge / Gross Loans and Advances Allowances for Impairment / Gross Loans and Advances Liquidity Risk Customer Loans / Customer Deposits Interbank Loans / Interbank Deposits Readily Marketable Assets / Total Assets Liquid Assets / Volatile Liabilities (Volatility Coverage) Volatile Liabilities / Total liabilities Liquid Assets /Total deposits (Bank Run) GAP / Total Assets GAP / Total Equity Interest Rate Sensitive Assets / Interest Rate Sensitive Liabilities Interest Rate Sensitive Assets / Total Assets Interest Rate Sensitive Liabilities / Total Liabilities Net Open Currency Position / Qualifying Capital

Interest Rate Risk

Currency Risk Source: Own construction

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3.3.2 GRAPHS AND CHARTS Graphs and charts provided visual representations of some of the analytical results. They provided a quick snap short of the current situation of the bank by presenting the structures in the assets, liabilities and incomes. They also facilitated comparison of performance over time and show trend lines and changes in significant aspects of the banks operations and performance. A high-level overview of the trends in the banks investments and risks was presented through graphs and charts as they were used to illustrate levels of profitability, capital adequacy, composition of portfolios, major types of credit risk exposures and exposures to interest rate, liquidity and currency risks.

3.4 ANALYTICAL TECHNIQUES These refer to the ways in which the data is interpreted. Some of the common analytical techniques used in this report include ratio analysis, common-size analysis, and trend analysis.

3.4.1 RATIO ANALYSIS Ratio analysis involves attempts to put ratios into perspective and make them more meaningful. When seen in isolation ratios mean little so there is the need to interpret the meaning in the context of other information. In some cases, the ratios in this report were compared with those of the industry averages as put forward by the Bank of Ghana in the periodic Financial investment and Stability Reports by PricewaterhouseCoopers Ghana in their 2010 banking Survey Report. The ratios for the previous two years were considered in addition to those of the current year in order to have a better view of the current years investment performance and also provide a basis for making projections into the future. The banking industry in Ghana is generally considered stable and gathering from the banks managing directors statement in the 2009 annual report, the bank is not expected to make any acquisition or divestiture which will significantly affect its business operations. Therefore, any forward looking analyses based on the ratios calculated from the past years values could be assumed to be appropriate. In evaluating the performance of EGH using ratios, the banks goals concerning the various investments and the risks it faces, the banking industry norms and the general economic conditions were taken into consideration.

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3.4.2 COMMON-SIZE ANALYSIS This analysis involved converting all financial statement items to a percentage of a given financial statement item, such as total assets or total revenue. It revealed the composition of the various financial statement items and presents the structure of the financial statements. The compositions of financial statements are normally a result of investment and risk management decisions and are normally in response to the banks business orientation, market environment, desired customer mix or the general economic conditions. Therefore, in assessing the banks investment portfolio and risk profile, common-size analysis was useful in analyzing the relative share of the various asset and liabilities as well as the major sources of income and changes in the proportionate share over time. Rapid increases in some items, for instance, could imply increase in risk associated with investment and therefore would raise questions as to whether the banks risk management systems were adequate to accommodate the increase in risk associated with investment management. In addition, a structural change in the balance sheet revealed through common-size analysis could disclose a shift to another area of risk associated with investment. A review of the proportion of income earned in relation to the amount of energy invested through the deployment of assets allowed for challenging assessment of risk versus reward.

3.4.3 TREND ANALYSIS Trend analysis technique was used to show whether there was an improvement or otherwise in an amount or a ratio. It was used to provide useful information regarding the historical performance and growth in investment of the bank. The growth of the bank was assessed through the expansion of its balance sheet and increase in its earning base. More importantly, trend analysis revealed the growth in the individual balance sheet and income statement items which gave an indication as to whether the growth was sustainable or was as a result of extraordinary items. Also, whether the growth was healthy for the bank in terms of risk absorption associated with investment, could be identified from the rate of growth and commensurate growth in stable sources funding. The analysis in this report incorporated both currency and percentage changes for the last three years to ensure that significant currency changes are not hidden by small percentage changes. Because the economic environment in Ghana could be said to be generally stable, past trends could serve as good predictors of future behavior and thereby being of great assistance as a planning tool.

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3.5 ANALYTICAL COMPONENTS The analysis of the EGHs investment portfolio management and risk profile was based the six main types of financial risks it is exposed to, which are: Balance sheet structure, Income statement structure, Credit, Liquidity, Interest rate and Currency risks. These risks are inter related as one can give rise to another or a transaction aimed at reducing one of the risks can end up shifting the risk to another area of investment. In this regard, the analysis took cognizance of this interrelationship and adopted a holistic approach. Figure 3.1 provides a conceptual representation of the financial risk types, components and inter-relationships.

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Figure 3.1: Diagrammatic r

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CH APTE R FO UR AS S ES SME NT O F B ANK I NVES T ME NT PO RTFO LIO AND RIS K PROFIL E


4.0 INTRODUCTION This chapter assesses the investment portfolio and the risk exposures of Ecobank Ghana Limited. It considers the various risks inherent in the assets and liabilities (investments) of the bank and the adequacy of the amount of capital and reserves available to safeguard against solvency. The chapter also considers the banks level of profitability and whether it provided adequate cushion for short-term and long term problems. Further, the level of credit and market risks associated with investment the bank is exposed to is assessed. 4.1 BALANCE SHEET 4.1.1 ASSETS It is important to evaluate the composition and structure of a banks assets risk to ascertain any inherent risks in them. Table D1 in the appendix depicts an expansion in Ecobank Ghanas balance sheet by 50.94% over the year to GHS 1,388,193. This was an improvement of the previous years growth of about 38%. This expansion was mainly due to the increase in the amount of government securities held as well as the operating accounts balances and placement with other banks. Meanwhile, the growth in the expansion of the Ghana banking industrys balance sheet was relatively slower as the 31.3% growth it experienced in 2009 fell behind the 37.2% growth it recorded in 2008. Analysts believe that this was largely underpinned by a reduction in the growth rates of total loans and fixed assets. As at December 2009, Held-to maturity investments constituted the largest portion of the banks assets with about 51%. This was in contrast with the case in 2007 and 2008 where the bank adopted more aggressive strategies and grew its loans and receivables to total assets ratios to 43.2 % and 43.7% of respectively making it the biggest contributor to the banks asset size. The general industry trend also reflected a similar situation where banks investments in bills and securities in 2009 grew by 93% compared to the 13% growth in 2008, bringing their stake in total assets to 21% from 15% in 2008 (see table D3 in appendix for assets and liabilities structure of banking sector of Ghana).

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Consequently, the proportion of the industrys net loans and advances in total assets also declined from 52% in 2008 to 44% in 2009. The shift in the allocation of resources from credit purposes to investments was because the slowdown of the countrys macro economic condition resulted in deterioration of the banks loan books. Meanwhile, returns on short term instruments became attractive and for that matter captured the bigger chunk of the banks funds. This shift in growth and composition in assets resulted in the reduction in risk inherent in the banks assets. A decrease in the proportion of loans and receivable reduces the level of credit risks in the banks assets. Held-to-maturity investments are safer than loans and receivables since the probability of default and variations in interest rates are lower. Therefore shifting concentration from loans and receivables to customers, to investments in more government securities and loans and advances to banks result in lower credit and market risks whiles maintaining adequate liquidity cover for the bank. It appears therefore that the bank was more cautious in its growth approach in 2009 and this is reflected in the asset-liability and risk management decisions.

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Figure 4.1: Changes in the composition of assets over the past three years.

Source: Own cons truction with data from comparative balance sheet in appendix B1

4.1.2. LIABILITIES Total deposits of the bank accelerated in its growth by about 45% in 2009 compared to the 40% growth recorded in 2008. This was in contrast with the industry trend which saw an aggregate slowdown in the growth of total deposits. The total deposits of the industry grew by some 29.1% which fell short of the growth of 41.4% recorded in year 2008. It, however, maintained its position as the main source of funding constituting 73% and 63% of both EGHs and the industrys funding base respectively. Deposits from banks and other credit institutions saw the highest growth rate of about 532% by year end 2009 even though it contributed only about 6.5% to total liabilities and equity. Such funds are regarded as volatile and prone to funding risks and therefore an increase in its volume and value over the past year signified an increase in inherent funding risk but their relatively low proportion in the banks funding base kept the risk under control. The banks largest contribution to funding still came from deposits to customers with 66.4% even though the percentage contribution fell below the 74% recorded in the previous year. As reported in the 2009 annual report, the banks twenty 48

largest depositors constitute 20% of the total deposits at the year end. This is lower than the 29% figure that the twenty largest depositors contributed the previous year indicating that the bank is taking steps to reduce the reliance on large corporate deposits which are less stable and expensive to effectively manage their concentration risk. The reduction in the reliance on large corporate depositors and shifting to more retail and standard deposits reduces uncertainty and liquidity risk associated with the deposits as well as cost of deposits which involves active management and attracts higher rates of interest. Figure 4.2: Changes in the composition of liabilities over the past two years.

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Source: Own cons truction with data from comparative common-size analysis of balance sheet in appendix D1

A trend analysis of the balance sheet items (contained in appendix D1) confirmed a 3 3.5% increase in the borrowings of the bank in year 2009. The banking industry in Ghana also registered a general growth of 37.6% in total borrowings at the end of year 2009 compared with 29.5% growth in 2008. The ratio of borrowings to total liabilities for EGH lagged behind that of the industry with EGH recording 6% whiles the industry increasing in its proportion to 13.3% from 12.7% (appendix D5). This general industry trend of a decline in the dominance of total deposits coupled with the share of borrowings gradually gaining prominence increases the likelihood of an increase in cost of intermediation. With respect to EGH, the foreign currency denomination of such borrowing exposes the bank to foreign currency risk even though it provides an indication of international confidence in the bank. It appears from the liquidity gap analysis as presented in the 2009 Annual Report of the bank that the bank is funding quite a substantial amount of its long term loans with short term deposits which creates maturity mismatch and liquidity concerns. There is also indication of currency mismatch due to the fact that deposits and borrowing in the various currencies traded in by the bank are not adequate to fund the lending in those currencies. The value of interest rate sensitive financial assets which matures within one to five years falls short significantly of the value of interest rate sensitive 50

financial liabilities giving rise to significant interest rate risk. 4.1.3 EQUITY AND CAPITAL ADEQUACY

Shareholders funds increased tremendously at a rate of 142% in 2009 compared to the 31% growth recorded in the previous year. This increased its share in the banks funding base in the year under review to 14.8% from about 9% in the previous year (refer to appendix D1). The bank took steps to boost its capital significantly through a rights issue in October 2009 in its attempt to meet the new capital requirements of GHS60 million set by the Central Bank of Ghanas for commercial banks operating in the country14. Consequently, the bank has been able to maintain a good balance between regulatory capital requirements and its total assets and risk-weighted assets. EGHs regulatory capital adequacy ratio (CAR) increased by about 37% to 22.6% in year 2009. This was significantly higher than the industry average capital adequacy ratio of 18.2%. A 34% growth in the banks core capital adequacy ratio (tier 1) in year 2009 contributed hugely to its growth in regulatory CAR (Table 4.1). Table 4.1: Capital adequacy and off-balance sheet measures EGH Industry 2007 2008 2009 2007 2008 2009 % % % % % % Growth EGH Industry 2008 2009 2009

Capital adequacy & Offbalance sheet Items Core capital Adequacy (tier I 13.10 12.57 16.82 15.70 12.80 17.00 -4.10% 33.83% 32.81% CAR)

Capital adequacy ratio (CAR) 18.06 16.48 22.62 13.60 13.80 18.20 -8.75% 37.26% 31.88% Off-balance sheet items as a 9.76 14.49 16.79 18.67 16.37 10.53 48.44% 15.92% -35.69% % of Risk-weighted assets/Total total assets 71.96 71.93 81.34 73.20 78.10 69.80 -0.04% 13.08% -10.63% assets Source: 2008 & 2009 annual reports of EGH & February 2010 Financial Stability Report of Bank of Ghana

Table 4.1 also indicates that the ratios of off-balance sheet items and risk-weighted assets to 51

total assets of the bank increased marginally whiles those of the industry declined. This means that the bank needed more capital than its peers to cover for contingent liabilities and increasing levels of risk-weighted assets on its books. Though the increase in the level of contingent liabilities presented the bank with additional financial risk, the corresponding trade fees appeared to provide adequate compensation for it. Greater attention should however be given to these items and adequate risk management system should be put in place for such exposures to ensure they do not get out of hand. 4.2 INCOME STATEMENT RISKS The income statement provides information on a banks profitability, reveals the sources of the banks earnings and their quality and quantity. Ecobank Ghana Limited is still enjoying high levels of profitability in 2009, recording a growth of about 44% from the previous years profit. Even though there was a slowdown in the growth of its after tax profit in 2009, EGH still towered above it peers about 6 times in its earning growth as average industry growth rate for the same period was about 7%. The consistency in the banks profitability growth enabled it to maintain a stable risk profile as well as providing a cushion against short term problems. Profit margin (post tax) increased marginally from 31% in 2008 to about 34% in 2009%. This performance was still about 4.5 times above the industry average of 7.5% which experienced a significant fall from the previous years figure of 28.5% as a result of the general decline in loan asset quality of banks in Ghana. Return on Assets (ROA) remained stable over the past three years while Return on Equity (ROE) saw a decline in the year under review from about 40% in 2008 to 26% in 2009 (figure 4.5). The marked decline in ROE was primarily as a result of the sharp increase in the banks equity through a rights issue undertaken at the later part of the year. It is instructive to know that in the case of both after tax ROA and ROE, EGH surpassed the performance of its peers with the average industry figures about 1.7% and 13.8% respectively in 2009 (refer to table D8 in appendix). About 51% of the banks total income was obtained from interest on loans and advances in 2009. This performance fell below the average industry contribution of 58.7% but was an improvement of the 2008 figure of 43%. Getting its main source of income from returns on loans and advances ensured the stability of the banks earnings. Fees and commission 52

incomes as well as trading income saw marginal increases in their contributions to total earnings from about 18% to 26% (see appendix D2). This was good for the bank given that there is no provision on non-funded income as opposed to interest on loans and advances which can be provided for if those assets are impaired in future. Stiff competition in the Ghanaian banking industry coupled with the drop in interest rates due to the reduction of the prime rate by the Central Bank of Ghana, put pressure on interest income. This situation compelled the bank to look at increasing its non traditional businesses like international trade finance and trading operations as viable options to maintain its profitability. Emphasis on feegenerating income reduces the banks exposure to lending risk which is inherent in increasing interest margins in a stable market environment as that of Ghana. There are however higher levels of volatility surrounding these sources of earnings because they depend on general economic conditions and trading performances. In addition to them being less stable, these non-traditional sources of earnings are subject to market risk which can be substantial if not closely monitored. It appeared the bank had made some strides in its cost reduction effort as there was a slow down in the growth in operating expenses resulting in operating expenses as a percentage of gross operating income declining marginally to 49% in the year under review from 53% the previous year. Though a further improvement would be preferred, this performance was quite commendable as it fell below the 55% industry average. EGH has been efficient in the use of its funds as it recorded an impressive increase in its return on loans and advances from 11% in the previous year to 17% in 2009 which was also above the industry average of 14%. The bank however lagged behind the industry performance in the utilization of its capacity in generating interest income with the ratio of interest income to total assets of 5.9% compared to 6.9% for industry. It is also worth noting that whiles the bank is increasing its loan portfolio, the level of non performing loans is also increasing (appendix D9). This indicates an increase in credit risk and the bank has responded by beefing up its remedial and collections unit to intensify the recovery of doubtful debts.

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Figure 4.3: Profitability & efficiency indicators

Source: Own cons truction with data from appendix D7

Ecobank Ghanas total cost of doing business increased due to significant increases in operating expenses and taxation. The increase in operating expenses over the past year, though at a reducing rate, was mainly due to increases in staff cost as a result of the banks branch expansion drive. The enactment of the National Stabilisation Levy Act, 2009, brought about the charging of an additional 5% levy on profit before tax and caused an increase in taxation and levy significantly (about 82% of previous year). Since this class of cost cannot be controlled by the bank, it will have to factor it into its expected expenditure and consequently profit target. Operating income adequately covered operating expenses and with the exception of year 2008, interest income has been enough to meet operating expenses since 2007. This also confirmed the stability of the banks profitability and shields the bank from funding (liquidity) risk.

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Figure 4.4: Sources of Income versus Operating Costs

Source: Own cons truction with data from comparative income statement in appendix B2 4.3 CREDIT RISK ASSOCIATED WITH INVESTMENT The credit risk associated with Ecobank Ghanas operations is inherent in its credit exposures. The risk areas have to do with concentrations and large exposures, diversification, lending to related parties and over exposure to an economic sector. Another area also has to do with making adequate allowances to absorb anticipated loss. In the worse case scenario, total credit risk exposure to the bank as at December 2009 amounted to GHS1.57 billion without taking into account any of the collateral held or other credit enhancements attached. There has been a consistent increase in the amount of maximum credit risk exposure at a rate of about 50% in the last three years due to the growth in the banks operations and expansion in its financial assets. This situation places greater responsibility on the banks board and management to strengthen the banks systems and processes as well as personnel to manage the risk well. 4.3.1 SIZE About 57% of the total maximum exposure is derived from loans and advances to banks and customers. The total loan portfolio of the bank increased by about 42% in year 2009 to amount to GHS918 million. Whiles there was acceleration in this loan growth from 37% in the previous year, there was slowdown in the growth rate in the industry loan portfolio as it 55

recorded a growth of 15.9% in 2009 compared the 43.9% recorded in the previous year. Loans and advances to customers constituted 51.8% of the total loan portfolio after experiencing a growth of 15% from year 2008. Compared to the ratio of customer loans to bank loans (64%: 36%) in the previous year, the proportion of Ecobank Ghanas lending to customers in the current year under review was not impressive (refer to chart D11 in appendix). This situation was as a result of lower demand of credit by the local industries than anticipated due to the fact that most of them had not recovered from the global economic meltdown experienced in the years 2007 and 2008. The banks in Ghana were therefore forced to do business amongst themselves and generate some returns on their idle funds leading to higher levels of loans and advances to banks as well as deposits from banks. Additionally, the slow down in credit also occurred as a result of the consolidation strategy adopted by the Ecobank Group to focus on recoveries of bad debts to clean their books rather than growing their assets.

4.3.2 CONCENTRATION The 50 largest exposures by customers constitute 55% of the gross loans and advances to customers in 2009 which was a marginal improvement of 2008s situation of 56%. This means that the bank was still relying on a few large corporate clients to build its loan portfolio thus any distress to these large clients posed a threat to its total loan size, loan quality and profitability. This situation did not also appear healthy in terms of credit risk as it exposed the bank to risk associated with sectoral over exposure. This is even more worrying when the banks fifty largest exposures are almost the size of the banks qualifying capital, which is the internal buffer of the bank to cater for losses in its operations.

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Figure 4.5: 50 largest exposures

The high concentration of the 50 largest exposures in the total loan portfolio supports a condition where, the bank is seen as supporting more corporate banking business than retail business. It is worth noting that, whiles loans to wholesale borrowers grew by about 48% from last years figure, loans to retail customers decreased significantly by 28% leading to wholesale loans to retail loan ratio of 73:27. This situation does not support the banks strategic transformation intent and drive towards positioning it as a predominantly retail bank as opposed to its previous classification as a wholesale bank after the acquisition of its universal license in 2003.

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Table 4.2: Customer loans distribution by borrower group Composition Loans to Customers per GH'000 GH'000 GH'000 2007 2008 2009 borrower Wholesale 197,628 232,683 344,888 67.41% 56.35% 72.59% group Retail 95,526 180,224 130,224 32.59% 43.65% 27.41% Gross Loans 293,154 412,907 475,112 100.00% 100.00% 100.00% and Source: Own construction with data from 2008 & 2009 Annual reports of EGH advances 2007 2008 2009 Growth

2008 17.74% 88.66%

2009 48.22% -27.74%

With regards to economic sector concentrations, the services sector seems to get the greatest portion of the banks credit facilities as 36% of total credit went to that sector. This is followed by the manufacturing sector which benefited from 19% of total credits. There was however an inverse growth trend amongst the two sectors where the service sectors portion of total loans increased by about 14% and the manufacturing sectors portion saw a decline of also about 14%. The rather increasing proportion of total loans being benefited by the service sector was due to boost in that sector of Ghanas economy coupled with dwindling of the manufacturing sector resulting from the increase of cheap imports and high operating cost. Commerce, which is the third highest beneficiary of EGHs total loans and advances, benefits the most from the industrys total credit facilities taking up 31.6%. It is then followed by the services and the manufacturing sectors in that order with 21% and 11.6% respectively (see figure 4.8). Incidentally, the manufacturing, finance and commerce, construction as well as transport, storage and communication sectors saw declines in the proportion of credit they benefited with agriculture, forestry and fishing as well as electricity, gas and water sectors picking up gradually in response to current policy initiatives by the government of Ghana to promote agriculture and also position the economy to take advantage of the oil find in Ghana.

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Figure 4.6: Sectoral allocation of loans

Source: Own construction with data from appendix D12 The shrinking of the proportion of credit benefits in greater parts of the Ghanaian economy in favour of just a few created an unhealthy concentration of lending. It made the bank vulnerable to weakness that could have arisen in the services sector resulting in significant risks to the bank such as simultaneous failures amongst several clients in the services sector for similar reasons which may lead losses to the bank. 4.3.3 LOAN QUALITY The bank also recorded some success in its efforts to improve the quality of its loan portfolio and reduce the incidence of losses. In the first place, the growth in the level of non-performing loans in the year under review has reduced to 8.5% from 11% in year 2008. The resultant nonperforming loan ratio saw a marginal decline to 3.4 1% in year 2009 from 3.62% in the previous year indicating a tightening of EGHs lending processes coupled with intensified monitoring and debt recovery drives. This is in contrast with the current aggregate industry trend which saw an acceleration of the growth in non-performing loans from a rate of 72% in 2008 to about 126% in 2009. Industry non-performing loans ratio in the current year under review consequently shot up to almost 15% from 7.7% in the previous year. Also, the allowances for loan impairment and impairment charges increased consistently over the past three years. 59

EGHs rate of impairment allowance to gross loans and advances increased from about 1.5% in 2008 to 4% in 2009 whiles the average rate for the industry jumped from 5% to 9.4%. Impairment charges made by EGH in respect of loans and advances, has also increased consistently from 0.2% to 2% of gross loans and advances from 2007 to 2009.

Figure 4.7: Loan Quality

Source: Own construction with data from appendix D9 and D10 The situation buttressed the banks desire to enhance its capacity to absorb losses by making available adequate reserves for them in response to loan growth, prior loss experiences, changes in business conditions and general economic conditions. This was made possible with an improvement in the banks management information systems which enabled it to properly classify its loans. With a coverage ratio (collateral as a % of non-performing loans) of 173% (see table 4.3), the bank made adequate collateral cover for its non-performing loans to further reduce the incidence of loan losses.

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Table 4.3: Loan loss coverage 2007 GH'00 0 14,658 13,436 % 2008 GH'00 0 15,812 14,948 % 2009 GH'00 0 28,136 16,224 % 173.42

Collateral Non-performing loans

Collateral as % to Non-performing loans (Coverage ratio) 109.09 105.78 Source: Own construction with data from 2008 and 2009 annual report of EGH 4.4 LIQUIDITY RISK

An evaluation of the liquidity risk of Ecobank Ghana limited involves an assessment of the banks ability to efficiently accommodate the redemption of deposits and other liabilities and to cover funding increases in the loan and investment portfolio. In addition to having enough funding to serve as cushion for expected and unexpected fluctuations in the balance sheet, the bank is said to have adequate liquidity if it is able to acquire needed funds promptly and at a reasonable cost. Having adequate liquidity serves as a defence mechanism that protects the banks capital from loses on unscheduled asset sales which may become neccesary with deposit runoffs. The assessment of the banks liquidity risk includes the review of the maturity profile of assets and liability (Liquidity Mismatches), the composition of the funding structure, cashflow analysis and liquidity ratio. 4.4.1 LIQUIDITY MISMATCHES

A review of the maturity ladder (see table 4.4) indicates that the bank has maintained its positive liquidity profile in year 2009 with a total liquidity position of GHS 139,248. However the huge negative mismatch in the very short term (one to three months) indicated that the bank had problems funding all its contractual obligations during the period at a reasonable cost. This situation was as a result of the bank not having adequate liquid assets maturing during the period to meet deposits which are due for redemption in the same period. The bank also had funding difficulties for its medium term liabilities, that is, those falling due between one and five years.

A greater portion of its long-term borrowings fell due during this period and there were not commensurate assets to meet such obligations, creating a negative net liquidity position. The 61

large liquidity surplus in the previous maturity bracket helps smoothen the shortfall and improves the net cummulative situation. Table 4.4: Maturity Ladder
Maturity Profile of Assets and Liabilities

Assets

1 - 3 months 4 - 12 months 1 - 5 years Over 5 years Total Liabilities 1 - 3 months 4 - 12 months 1 - 5 years

2007 GH'0 00 434,727 93,998 135,811 7,615 672,151 333,721 224,344 58,351 0 616,416 101,006 -130,346 77,460 7,615 55,735

2008 GH' 000 581,591 206,183 119,938 14,282 921,994 575,402 172,715 38,095 48,745 834,957

2009 GH' 000 767,720 335,501 73,807 162,201 1,339,2 29 866,044 167,686 116,207 50,044 1,199,9 81Cumulative -98,324 69,491 27,091 139,248

Over 5 years Total

Liquidity Mismatches 1 - 3 months 4 - 12 months 1 - 5 years Over 5 years Total

6,189 33,468 81,843 -34,463 87,037

-98,324 167,815 -42,400 112,157 139,248

Source: Own construction with data from 2008 and 2009 Annual reports of EGH

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4.4.2 STRUCTURE OF FUNDING Ecobank Ghanas direct portfolio is funded by a mix of sources as presented in Figure 4.1 3. Its main funding source continued to be from customer deposits which constituted about 67% of the total funding base. Figure 4.8: Funding sources

Source: Own construction with data from appendix D17 T 63

he significant contribution of customer deposits to the banks funding base implied that the soundness of the banks liquidity management hinged on the stability and quality of its customer deposit base. A review of the product types employed by the bank to mobilise funds indcate that the greatest contribution to the banks funding base was from current accounts. It formed the bulk of the banks core deposits and ensured greater stability and cheaper source of funds for the bank. It however appeared that the majority of current accounts funds came from large depositors and therefore reduced the level of stability since these depositors could come for bulk funds without notice and may cause liquidity problems. Since all the banks are after the same funds from these large depositors, the interest cost of these funds may be higher than the interest on current account funds. The deposits of these corporates are also dependent on the prospects of their business which fluctuates with response to both internal and macroeconomic developments making it volatile in nature. Liquid assets as a percentage of total assets of 61% indicated a positive sign from a liquidity standpoint as it enabled the bank to easily liquidate some of its assets to meet unexpected demands for funds. The banks liquidity situation was more sound in this regard vis--vis industry performance of 47% in 2009.With about 86% of Ecobank Ghanas liability structure consisting of volatile funding, its short term investment were adequately catered for. Liquid assets (short-term) were about 79 % of the banks volatile liabilities in 2009, indicating an adequate cover for short-term investments. As represented by the volatility liability dependency ratios, the bank relied heavily on volatile funds to support it long-term assets. The high positive ratios (163% for 2009, 299% for 2008 and 221% for 2007) showed that the bank was highly exposed to liquidity risk in times of financial stress or adverse changes in market conditions which impacts on the banks ability to retain these volatile finds.

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4.5. INTEREST RATE RISK An interest repricing schedule is used to generate simple indicators of the interest rate risk sensitivity of both earnings and economic value to changing interest rates. It involves evaluating earnings exposure of Ecobank Ghana to interest rate movements by subtracting interest rate sensitive liabilities in different time bands from the corresponding interest rate sensitive assets to produce a repricing "gap" for that time band. It is the responsibility of the bank in this regard to strive to achieve a balance between reducing risk to earnings from adverse movements in interest rates, and enhancing net interest income through correct anticipation of the direction and extent on interest rate changes. An analysis of Ecobank Ghanas interest repricing schedule (appendix D20) indicated that there was a positive or asset sensitive gap of GHS 515,317 in the year 2009, notwithstanding the negative interest repricing mismatches for the 1-5 years maturity bucket. This represented a 17% increase in the situation in the previous year positive repricing gap. It meant that generally the banks interest income declined as a result of the decline in the average market interest rates. This is because more assets were invested at lower market rates than liabilities during the period.

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Figure 4.9: Interest rates repricing gap

Source: Own construction with data from appendix D19 It would therefore have been a prudent strategy for the bank to have a negative interest repricing mismatch which would have result in interest income of the bank increasing because declining average market interest rates meant more liabilities would have been taken on at lower market rates. In general, it appeared the banks assets and shareholders equity are significantly exposed to risk associated with movements in interest rate. The Gap to total asset ratio of 3 8.5% for 2009 was still on the high side even though it experienced a decline from about 49% from the previous year considering that general prudent limits are between - 15% to 15%. GAP to equity ratio was also about 251% in 2009 from a high of 518% in the previous year. There was a significant decline in the ratio of interest rate sensitive assets to interest rate sensitive liabilities from about 360% in 2008 to 217% in 2009 in response to the falling market rates. The bank however could not react adequately to reverse the mismatch situation to avoid losses in interest income basically because of the unpredictable nature of the macroeconomic conditions in the country and the global financial situation.

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4.7. CURRENCY RISK ON INVESTMENT Because Ecobank Ghana maintains correspondent banking relationships with foreign banks, lend and borrow in foreign currency and supports customer transactions denominated in foreign currencies, it is prone to currency risks. A review of the currency mismatch schedule in appendix D22 indicated that the bank had positive net open currency positions for all its currencies in year 2009. Also with the exception of USD liabilities whose percentage contribution is more than USD assets, the contribution of the other currencies in the assets of the bank adequately covered the contribution of the currencies to the liabilities. The currency structure of the banks loans and deposits were also encouraging as its funding capacity provided by the deposit base in the various currencies exceeded its loan portfolio in the various currencies significantly. In both the cases of loans and deposits, the bank kept a little above 50% of its exposure in Ghana cedis with the greater portion of the remainder taken by USD denominated exposures. Basel Accord requires that certain capital charges be made for market risks including currency risks. Currency exposure as a percentage of qualifying capital indicated that the bank had adequate capital base to cover current currency risk exposures (refer figure 4.19). Figure 4.10: Currency Structure of Loan Portfolio and Customers Deposits

Basel Accord requires that certain capital charges be made for market risks including currency risks. Currency exposure as a percentage of qualifying capital indicated that the bank had adequate capital base to cover current currency risk exposures (refer figure 4.19). 67

Figure 4.11: Currency Risk : Currency Exposure as % of Qualifying Capital

Source: Own construction with data from appendix D21

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CHAPTER FIVE RESEARCH FINDINGS ,CONCLUSIONS AND RECOMMENDATION

5.0 INTRODUCTION The investment management framework of Ecobank Ghana Limited comprises a comprehensive set of policies, standards, procedures and processes designed to identify, measure, monitor and report significant risk exposures in a consistent and effective manner across the banks investment portfolio. This chapter assesses these tools employed by the bank in managing the investment portfolio, market (interest rate, currency) and operational risks it faces. 5.1 RISK IDENTIFICATION ON INVESTMENT Ecobank Ghana believes in having effective systems in place to enable it acquire adequate information on their investment portfolio. This enables the bank to properly identify risks associated with individual investment and investment portfolio. The banks risk analysts work in partnership with the investment function in the various business units (Financial Institutions, and Investment Banking) to identify risks associated with the individual transactions from the onset. After an in-depth review of the investments and the actual transactions being proposed to identify the inherent risks, risk ratings developed internally by the bank are assigned to the type of investment. A rating of 1 identifies an investment of the highest quality, comparable to AAA on the scale of Standard and Poors. A risk rating of 10 is assigned to investment of lowest quality or highest risk, identical to D on the scale of Standard and Poors. The ratings, which are based on the identified inherent risks, inform the risk analysts decision as to whether the investment should be accommodated having in mind the limits set in the banks investment policy manual and other industry and regulatory standards.

The review of the proposed investment includes a thorough examination of the Ghana stock 69

exchange, business activities of the bank, analysis of its financials and sometimes solicitation of opinion of other banks, business partners, customers or external rating agencies all in a bid to have a good assessment of the possible inherent investment. 5.1.2 MEASUREMENT OF INVESTMENT PORTFOLIO Ecobank Ghana limiteds investment management framework includes a methodology to measure the average amount of expected loss inherent in its investment portfolio over a period of time. This enables the bank to decide on how best to manage the investment in its activities and portfolio, such as by setting aside the appropriate investment income loss reserves to reduce risk associated with the investment. In arriving at the return on investment measure at a particular point in time, the bank determines the level of the statistical expected economic loss in the event of loss, that is, the banks exposure at negative return on investment. This figure measures the net present value on cost of investing that the bank would face from the time of initial investment until the end of the recovery process.

5.2 MARKET RISK The board of Ecobank Ghana Limited articulates statements of market risk direction associate with it investment portfolio and appetite through the banks market risk management policy which is developed and approved by the board. The market risk management policy contains the framework for managing market risk in a consistent manner across the bank in order to stabilise earnings and capital of investments under a broad range of market conditions. The Risk Committee of the board, the Chief Executive of the bank and the Country Risk Manager coordinate, facilitate and oversee the effectiveness and integrity of the banks market risk management framework. The supervision and management of market risk in the bank is however vested on the Asset and Liability Committee (ALCO) who meet monthly and anytime market conditions warrant it. The committee is responsible for recommending specific strategies to address market risks in the light of macroeconomic and industry changes as well as the banks risk tolerance level on investments. The committee reviews the banks investment portfolio and the structure and pricing of the banks assets and liabilities. It also articulates the banks interest rate view and decides on 70

the required maturity profile and mix of incremental assets and liabilities on investments. In addition to ensuring a good governance structure to manage market risk associated with investment, another essential requirement for a strong market risk management framework is that it creates a good atmosphere for management of investment portfolio. In this regard, the banks framework prescribes limits within which market risks should be absorbed on investments and prescribes procedures to handle exceptional activities. There are also limits on lowest tolerable loss level (stop loss exposure), presence of new markets and trading in new financial instruments. The bank is also able to build adequate personnel and system capacity to accommodate additional risk that may come with investing into new financial instruments and entering new markets. Generally, Ecobank Ghana Limited applies the Value at Risk methodology (VAR) to its investment portfolios to estimate the market risk of positions held and the maximum losses expected based on a number of assumptions for various changes in market conditions. This methodology provides a statistical estimate of potential loss on the current investment portfolio from adverse market movements.

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5.3 CONCLUSION The impressive financial performance of the Ghanaian banking industry coupled with the absence of any major complaints or adverse finding against banks investments in Ghana gives the impression that the banks are generally stable. The implications of this belief are that the banks have relatively good risk profiles as well as sound frameworks for managing investments inherent in their business activities. The extent to which this can be verified relies on thorough assessments of the nature and quantum of risks confronting the various banks in the country on managing investment portfolio. I have no knowledge of any previous work on Ghana banks in this area of study and therefore this study provides an initial contribution to this exercise with a focus on Ecobank Ghana Limited. It provides an empirical indication of the types and levels of risks the bank is exposed to on investments and its capacity to effectively manage investment portfolio as at the end of the financial year . The evidence from the study suggests that the investment portfolio of Ecobank Ghana Limited is good based on the following observations: i. Though there was a significant expansion of the size of the banks balance sheet, the resulting structural changes lead to a healthy asset mix balancing liquidity with profitability. The consecutive approach taken by the bank in 2009 saw its investments in government securities constituting the largest portion of its asset mix so as to avoid increasing lending risk. The growth in assets was also backed by stable funding sources from customer demand deposits and adequate capital base which saw a huge increase through additional capitalization by shareholders. ii. The profitability level of the bank was also high which provided a cushion for short term liquidity problems and a stable source of capital generation on investment. This was fueled by significant growth in the banks main revenue streams; net interest income and fee-based incomes. The banks demonstration of high levels of efficiency in the use of its potential (assets) and in its operations, indicated in the stable Return on Assets and relatively high Net Income . iii. By keeping more short term interest sensitive assets compared to short term interest sensitive liabilities in the face of falling interest rate levels on investments, the bank iincurred loss of interest income. The level of the banks exposure to interest rate risk on investment was further revealed by the high GAP to total assets ratio which even fell 72

outside the general prudential limits. The bank however appears to have adequate equity to cushion it against any threats from adverse interest rate movements. iv. Finally expanded investment exposure with significant concentration levels to few large stocks and bonds in the exchange sector of the economy creates some worry for the banks investments on stocks and bonds. However, the investment quality improved as the level of non-performing shares and bonds in the investment portfolio declined with tightened investment processes and increased monitoring and recovery activities. The banks capacity to absorb losses on investment was also improved with adequate cover.

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5.4 RECOMMENDATIONS Despite a fairly good investment management framework in place to adequately manage the various types of investments of EGH , I would like to make a couple of recommendations which I believe would help strengthen its investment management system and make investments more profitable. These are primarily related to interest rate measurement on investments and risk integration and aggregation.

Currently, EGH applies the Maturity Gap Analysis method where assets and liabilities are categorised by their repricing dates to identify mismatches within specific time periods, for estimating interest rate risk on investment portfolio. An alternative which will help address the shortfalls in this accounting approach of evaluating interest rate risk on investments will be one which focuses on estimating the interest rate sensitivity of the economic value of a bank's on- and off-balance-sheet positions. Economic Value Analysis (EVA) can serve as a good indicator of quality of net interest margins over a long term and help identify risk exposures on investments such as changes in market conditions not evident in the analysis of short term. This can help the bank to avoid strategies that maximize current earnings at the cost of exposing future investments to great risk. Two such approaches which have been recommended in recent times are the simulation technique and duration analysis. Simulation involves the use of sophisticated computer models to generate the effects of a wide array of interest rate scenarios on a bank's financial condition. The measures it generates can address both the accounting and economic perspectives of EGHs interest rate risk exposure on investments. However, simulations are highly data intensive, and the results rely heavily on assumptions as with many computer modeling techniques. Moreover, these assumptions on target variables such as net interest income it is difficult to objectively isolate the influence of changing interest rates on the measures. In the light of these, duration analysis is highly recommended to EGH to maintain a balance between simplicity and results. Duration is the measure of the sensitivity of the present value (economic value) of the assets and liabilities of investments to changing interest rates. Duration analysis therefore helps in estimating the durations of assets, liabilities, and off-balance-sheet positions. Through this, EGH can estimate the net duration of its portfolio and the interest sensitivity of the present value of its net worth. In this sense, duration analysis offers a more comprehensive approach to measuring interest rate risk on investments by incorporating the entire spectrum of a bank's repricing mismatches. It expands the basic maturity gap approach to assess the effects of changes in rates on the 74

present value of all future earnings on investment, not just on next year's book earnings on investment. 5.4.1 ADOPTING AN INTEGRATED APPROACH TO RISK MANAGEMENT Currently, the structure of EGHs investment portfolio management framework allows for specific risk-related decisions to the multiple levels of the banks investments. Also different approaches are used in managing the different investment types at investment unit in the bank. This result in fragmented investment portfolio management practices and a disjointed approach for dealing with the risks associated with investment of the bank. There is therefore the need for the bank to develop an integrated system which ensures a systematic and comprehensive approach to managing investment portfolio of the bank. The above approach will enable EGH to know the risk assocated with investment portfolio of its investment unit in addition to getting the bank-wide total exposure. EGH can now set aside an amount of money (economic capital) with the help of statistical tool such as VAR (for market risk). The economic capital will be the amount the bank believes will be necessary to absorb potential losses from each risk type associated with the various investments. Aggregation of risks and estimation of economic capital can assist EGH in its investment management efforts in many ways. It can assist the bank in good investment management, in that, the amount of economic capital allocated to investment unit constraints the risks it takes. Also it can help in performance measurement as it is use in well-known measures like riskadjusted return on capital (RAROC) and return on risk-adjusted capital (RORAC) which can be used to evaluate performance of investments across the various business lines in the bank. EGH can also vary the amount of economic capital allocated to an ivestment unit from time to time to promote or discourage certain activities sometimes in response to business cycles shifts. For instance it can allocate more economic capital to units with low RAROC so that those units may reduce their activities when macro economic conditions are too volatile and thereby save the bank from probable huge losses.

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APPENDIX A: Glossary of key financial terms and ratios Capital adequacy ratio is the ratio of adjusted equity base to risk adjusted asset base as required by the Bank of Ghana (BoG), i.e. Total regulatory capital / Total risk weighted assets. Core capital adequacy ratio (Basel I capital adequacy): Total tier 1 capital / Total risk weighted assets. Cash assets include cash on hand, balances with the central bank, money at call or short notice, and cheques in course of collection and clearing. Core Customer Deposits includes current accounts, cash collateral account, individual consumer savings, and money market accounts. Cost income ratio = Non-interest operating expenses / Operating income. Interest Rates Sensitive Assets refers to assets principally of loans with maturity within a year. Interest Rates Sensitive Liabilities refers to liabilities principally of deposits with maturity within a year. Liquid assets include cash assets and assets that are relatively easier to convert to cash, e.g., investments in government securities, quoted and unquoted debt and equity investments, equity investments in subsidiaries. Loan loss provisions = (General & specific provisions for bad debts for + Interest in suspense) / Gross loans and advances. Long term Assets includes securities which mature beyond one year, other real estate owned and net loans Net interest income = Total interest income - Total interest expense Net interest margin = Net interest income / Average assets Non-performing loans refers to loans and advances with payments of interest and principal past due by 90 days or more, or at least 90 days of interest payments have been capitalized, refinanced or delayed by agreement, or payments are less than 90 days overdue, but there are other good reasons to doubt that payments will be made in full. Profit after tax margin = Profit after tax / Total income Profit before tax margin = Profit after extraordinary items but before tax / Total income Qualifying capital includes share capital, regulatory risk reserves, statutory reserves, retained earnings, non controlling interest, subordinated debt and other reserves. Return on assets = Profit after tax / Average total assets Return on equity = Profit after tax / Average total shareholders' funds Risk-weighted assets refer to banks assets adjusted for risk. Shareholders' funds comprise paid-up stated capital, income surplus, statutory reserves, and capital surplus or revaluation reserves. Short term Investments includes government securities + loans to bank with maturity less than 1 year + trading assets + investments securities. Volatile Liabilities refers to short term borrowed funds and short term non-core deposits normally from institutional investors. Volatile Liability Dependency ratio = (Volatile liability - Short Term Investments) / (Long Term Assets)* 100 76

APPENDIX B: Comparative Financial Statements of EGH for 2007 - 2009 ECOBANK GHANA LIMITED B1. BALANCE SHEET 2007 2008 2009 ASSETS GH'000 GH'000 GH'000 Cash and Cash Balances with central bank 48,273 69,797 104,162 8,234 5,092 2,540 Financial assets held for trading - Equity instruments Available-for-sale financial assets - Equity 5,804 35,182 24,363 instrumentsreceivables Loans and 288,694 401,531 456,159 Held-to-maturity investments Debt instruments 86,468 89,679 268,534 177,580 232,609 442,806 Loans and advances Derivative financial instruments 3 0 0 Tangible assets - Property, Plant and Equipment 16,932 24,381 44,015 0 2,190 3,630 Intangible assets - License for corporate software 970 918 1,319 Tax assets - Deferred tax assets Other assets 35,791 58,316 40,665 TOTAL ASSETS 668,749 919,695 1,388,193 LIABILITIES GH'000 GH'000 GH'000 Deposits from banks and other credit institutions 59,801 14,261 90,127 Borrowings 55,661 61,782 82,499 Deposits from customers 437,951 682,705 922,077 Tax liabilities 4,724 4,341 3,374 Other liabilities 45,946 71,868 84,703 TOTAL LIABILITIES 604,083 834,957 1,182,780 EQUITY GH GH GH Stated capital 16,400 16,400 100,000 Income Surplus Account 23,496 41,619 59,041 Revaluation Reserves 1,602 1,595 15,491 Statutory Reserve Fund 18,747 22,965 29,654 Regulatory Credit Risk Reserve 4,421 2,781 2,716 Capital and Equity attributable to parent equity's Equity holders 64,666 85,360 206,902 Non-controlling interest 0 -622 -1,489 TOTAL EQUITY 64,666 84,738 205,413 TOTAL LIABILITIES AND EQUITY 668,749 919,695 1,388,193 Contingency liabilities and commitment 65,268.00 133,237.00 233,129.00

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B2. INCOME STATEMENT 2007 GH'000 Interest Income Available-for-sale financial assets - Equity instruments Loans and receivables Held-to-maturity investments - Placements & ST funds (Interest Expense) Demand deposits Time deposits Borrowed funds Savings Fees and Commission Income Trade finance fees Credit related fees and commission Cash Management Other fees and commissions (Fees and Commission Expenses) Realised gains on financial assets & liabilities not measured at fair value through profit or loss, net - finance lease on financial assets and liabilities held for Gains trading, - net trading income net Gains on financial assets and liabilities designated at fairthrough profit or loss, net - Dividend income value Other operating income Profit on sale of equipment other income Total Income Operating Expenses Impairment charge on loans and advances Profit before income tax Income tax expenses National stabilisation levy Profit for the year Attributable to: Equity holders of the parent entity Non controlling interest 13,393 27,915 10,471 -1,348 -12,083 -2,627 0 5,027 3,089 1,073 7,824 -501 2,878 6,907 328 8 1,559 63,913 -33,143 -591 30,179 -7,830 0 22,349 22349 0 22,349

2008 GH'000 16,203 44,860 11,691 -2,399 -13,304 -6,678 -4,224 4,879 3,746 9,186 3,067 -1,107 4,310 35,309 613 13 1,024 107,189 -57,505 -5,793 43,891 -10,312 0 33,579 34,085 -506 33,579

2009 GH'000 42,452 76,545 12,382 -8,667 -11,808 -19,313 -9,134 17,626 6,231 16,419 3,928 -2,052 5,066 28,148 448 148 1,469 159,888 -77,681 -9,518 72,689 -17,195 -1,641 53,853 54,720 -867 53,853

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B3. CASHFLOW STATEMENT 2007 GH'000 Cash flows from operating activities Interest paid -16,059 Interest received 50,542 Net fees and commissions receipts 16,512 Other income received 1,568 Dividend received 328 Net trading income 9,533 Lease income 2,878 Payments too employees and suppliers -28,471 Tax paid -6,438 Cash flow from operating activities before changes inassets and liabilities operating 30,393 Changes in operating assets and liabilities Loans and advances -126,513 other assets 37,015 Investment securities 0 Customer deposits 102,314 Other liabilities 42,537 Mandatory reserve requirement 0 Net Cash generated from operating activities 49,548 Cash flow from investing activities Purchase of property and equipment -8,887 Purchase of software 0 Proceeds from sale of sale equipment 310 Purchase of Government securities 2,382 Net cash used in investing activities -6,195 Cash flow from financing activities Dividend paid -10,859 Proceeds from right issue Repayment of borrowed funds Proceeds from borrowed funds 6,122 Net cash generated/(used in) from financing -4,737 activities Net increase in cash and cash equivalents 69,009 Cash and cash equivalents at beginning of year 97,132 Cash and cash equivalents at the end of year 166,141 Source: 2008 and 2009 Annual Reports of Ecobank Ghana limited

2008 GH'000 -26,606 72,205 19,254 1,037 614 29,993 4,310 -53,389 -11,903 35,515 -118,631 -22,470 -29,378 244,754 57,328 -5,041 126,562 -13,147 -2,351 19 3,211 12,268 -13,384 0 0 6,122 -7,262 144,236 166,144 310,377

2009 GH'000 -42,681 125,710 42,152 1,617 448 23,354 4,662 -69,730 -19,360 66,172 -54,628 17,651 -10,819 239,372 -14,604 -24,329 152,643 -11,418 -2,870 161 -59,180 73,307 26,574 79,500 -9,578 21,135 64,483 209,991 310,377 520,368

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APPENDIX C: Bloomberg L. P ratings and Stock Trends C1: Ratings for short-term and Long-term credits.

Source: Bloomberg L. P

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Source: Bloomberg L. P

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C1: Table annual share price performance of EGH on the Ghana Stock Exchange Share Price Performance of EGH Trading Date Stock Price 11-Jul-06 1290.0 03-Jan-07 1352.0 11-Jul-07 1456.2 04-Jan-08 2050.0 11-Jul-08 4100.0 02-Jan-09 4500.0 10-Jul-09 2060.0 05-Jan-10 2800.0 09-Jul-10 3300.0 Source: Own construction with data compiled by Gold Coast Securities Limited

APPENDIX D: Tables and Charts for Investment and Risk Profile Assessment D1: Common Size and Trend analysis of Balance Sheet of EGH BALANCE SHEET Composition 2007 2008 2009 ASSETS % % % Cash and Cash Balances with central bank 7.22 7.59 7.50 Financial assets held for trading- Equity 1.23 0.55 0.18 instruments Available-for-sale financial assets - Equity 0.87 3.83 1.76 instruments Held-to-maturity investments 39.48 35.04 51.24 Loans and receivables 43.17 43.66 32.86 Tangible assets - Property, Plant and 2.53 2.65 3.17 Equipment Other assets 5.50 6.68 3.29 Total Asset 100 100 100 LIABILITIES & EQUITY Deposits from banks and other credit 8.94 1.55 6.49 institutions Borrowings 8.32 6.72 5.94 Deposits from customers 65.49 74.23 66.42 Tax & other liabilities 7.58 8.29 6.34 Equity 9.67 9.21 14.80 Total 100 100 100 Source: Own cons truction with data from comparative balance sheet

Growth 2008 2009 % % 44.59 49.24 -38.16 -50.12 506.17 -30.75 22.06 120.72 39.09 13.60 43.99 80.53 67.08 -25.74 37.52 50.94 -76.15 11.00 55.89 50.40 31.04 37.52 531.98 33.53 35.06 15.57 142.41 50.94

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D2: Common Size and Trend analysis of Income statement of EGH Composition INCOME STATEMENT 2007 2008 2009 Net Interest Income 55.89% 43.05% 5 1.57% Fees and Commission Income 25.84% 18.44% 26.36% Realised gains on finance lease 4.50% 4.02% 3.17% Net trading income 10.81% 32.94% 17.60% Dividend income 0.5 1% 0.57% 0.28% Other operating income 2.45% 0.97% 1.01% Total Income 100.00% 100.00% 100.00% Operating Expenses 79.74% 77.59% 72.67% Impairment charge on loans and 1.42% 7.82% 8.90% advances Profit before tax Taxation and levy 18.84% 13.91% 17.62% Profit for the year Profit attributed to Non controlling 0.00% 0.68% 0.81% interest Total Cost 100.00% 100.00% 100.00% Source: Own cons truction with data from comparative income statemen

Growth 2008 2009 29.19% 78.68% 19.74% 113.20% 49.76% 17.54% 411.21% -20.28% 86.89% -26.92% -12.93% 25.15% 67.81% 48.73% 73.5 1% 35.09% 880.20% 64.30% 45.44% 65.61% 31.70% 82.66% 50.25% 60.38% 0.00% 71.34% 78.32% 44.24%

D3:Table of cash flow summary 2007 2008 2009 Growth 2009 Cash Flows GH'000 GH'000 GH'000 2008 Net cash operating from/(used in) activities 49,548 126,562 152,643 155.43% 20.61% Net cash used in investing activities -6,195 -12,268 73,307 -98.03% 697.55% Net cash (used in)/generated from financing -4,737 -7,262 64,483 -53.30% 987.95% activities Net increase in cash and cash equivalents 69,009 144,236 209,991 109.01% 45.59% Source: Own cons truction with data fromcash flow statement

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D4: Balance Sheet and growth trend of Deposit Money Banks in Ghana Key Developments Deposit Money Banks' Balance Sheet 2008 2009 ASSETS GH'000 GH'000 Foreign Assets 978,800 1,526,200 Domestic Assets 9,713,400 12,512,400 Investments 1,547,900 2,989,300 Bills 993,000 1,798,300 Securities 529,700 1,131,700 Net Advances 5,593,900 6,917,600 of which foreign currency 1,510,400 1,655,200 Gross Advances 5,966,800 6,917,600 Other Assets 506,600 763,600 Fixed Assets 344,600 424,200 Total Asset 10,692,200 14,038,600 LIABILITIES & EQUITY GH'000 GH'000 Total Deposits 6,949,000 8,968,600 of which foreign currency 1,804,700 2,749,200 Total Borrowings 1,360,000 1,871,700 Foreign liabilities 905,900 1,103,400 Short-term borrowings 341,900 518,400 Long-term borrowings 372,200 349,700 Deposits of non-residents 191,800 235,200 Domestic liabilities 8,590,500 11,144,300 Short-term borrowings 547,600 877,800 Long-term borrowings 98,300 125,800 Deposits of Deposits 6,757,200 8,733,500 Other Liabilities 1,262,800 1,375,700 Paid-up capital 445,800 1,103,700 Shareholders' Funds 1,112,800 1,762,800 Source: February 2010 Financial Stability Report Growth 2008 % 54.9 35.6 12.8 111.3 -40.0 42.7 52.1 43.9 14.5 42.6 37.2 % 41.4 77.6 29.5 35.8 2.0 59.9 93.6 36.5 55.3 -24.3 40.3 32.2 60.0 38.1 2009 % 55.9 28.8 93.1 81.1 113.6 23.7 9.6 15.9 50.7 23.1 31.3 % 29.1 52.3 37.6 21.8 51.6 -6.0 22.6 29.7 60.3 28.0 29.2 8.9 147.6 58.4

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D5: Table of interest rate risk measures Interest Rate Repricing/Maturity dates Assets 1 - 3 months 4 - 12 months 1 - 5 years Non-Interest bearing Total Liabilities 1 - 3 months 4 - 12 months 1 - 5 years Non-Interest bearing Total Interest Repricing Mismatches 1 - 3 months 4 - 12 months 1 - 5 years Non-Interest bearing Total Interest rate sensitive assets Interest rate sensitive liabilities Gap Interest rate sensitive assets/Interest rate sensitive liabilities sensitive assets / Total assets Interest rate Interest rate sensitive liabilities / Total Liabilities Gap / Total assets Gap / Total equity 2007 GH'000 427,954 83,505 13,063 126,222 650,744 302,601 203,112 20,102 73,543 599,358 125,353 -119,607 -7,039 52,679 51,386 511,459 505,713 5,746 101.14% 78.60% 84.38% 0.88% 8.89% 2008 GH'000 436,778 171,056 112,054 173,236 893,124 122,410 46,118 83,056 576,418 828,002 314,368 124,938 28,998 -403,182 65,122 607,834 168,528 439,306 3 60.67% 68.06% 20.35% 49.19% 518.43% 2009 GH'000 639,985 315,927 73,807 309,510 1,339,229 301,155 139,440 163,446 575,365 1,179,406 338,830 176,487 -89,639 -265,855 159,823 955,912 440,595 515,317 216.96% 71.38% 37.36% 38.48% 250.87%

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Stability Report of Bank of Ghana D7: Asset invested compared with income sources

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D9:Table of growth in capital adequacy and off-balance sheet item Composition of components in Total Assets 2000 2001 2002 2003 2004 2005 2006 2007 2008 ASSETS % % % % % % % % % Cash and due from banks 25.5 25.2 28.9 29.5 27.0 20.7 23.5 23.3 25.2 Investments 24.2 28.0 31.7 27.7 27.7 26.9 23.3 17.6 14.5 Net advances 39.6 37.7 30.4 305.2 35.6 43.0 45.0 50.3 52.3 Other assets 8.0 5.7 5.7 4.8 6.3 6.5 5.2 5.7 4.7 Fixed assets 2.7 3.4 3.3 2.7 2.7 3.0 3.1 3.1 3.2 LIABILITIES & EQUITY Total deposits 61.4 58.3 60.0 62.7 64.2 64.8 65.2 63.0 65.0 Total borrowings 12.7 8.4 7.5 8.0 7.4 9.0 11.3 13.5 12.7 Other liabilities 13.6 19.5 19.0 16.7 15.5 13.4 10.7 12.2 11.8 Shareholders' funds 11.9 13.1 12.6 12.5 12.6 12.8 11.7 10.3 10.4 Source: February 2010 bulletin of the Financial Stability Report by Bank of Ghana 2009 % 26.3 21.3 43.8 5.4 3.0 63.9 13.3 9.8 12.6

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APPENDIX E:International Recommended Principles for ensuring Sound investment Management E1. __ Corporate Governance for Banking Organizations (Enhancing Corporate Governance for Banking Organizations) Principle 1: Board members should be qualified for their positions, have a clear understanding of their role in corporate governance, and be able to exercise sound judgment about the affairs of the bank. Principle 2: The board of directors should approve and oversee the banks strategic objectives and corporate values that are communicated throughout the banking organization. Principle 3: The board of directors should set and enforce clear lines of responsibility and accountability throughout the organization. Principle 4: The board should ensure that there is appropriate oversight by senior management consistent with board policy. Principle 5: The board and senior management should effectively utilize the work conducted by the internal audit function, external auditors, and internal control functions. Principle 6: The board should ensure that compensation policies and practices are consistent with the banks corporate culture, long-term objectives and strategy, and control environment. Principle 7: The bank should be governed in a transparent manner. Principle 8: The board and senior management should understand the banks operational structure, including where the bank operates in jurisdictions, or through structures, that impede transparency (that is, know-your-structure). Source: Basel Committee on Banking Supervision (February, 2006)

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Trends in risk integration and

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