Bassabikova Margarita, Smoleyeva
Ludmila (
“Risk
Management in the 2nd tier banks of
Abstract.
The research is devoted to the consideration of
risk management techniques employs in the 2nd tier banks in
Introduction
For the recent years,
The past decade has seen dramatic losses in the banking industry. Firms
that had been performing well suddenly announced large losses due to credit
exposures that turned sour, interest rate positions taken, or derivative
exposures that may or may not have been assumed to hedge balance sheet risk. In
response to this, commercial banks have almost universally embarked upon an
upgrading of their risk management and control systems.
Regardless of the
sophistication of the measures, banks often distinguish between expected and
unexpected losses. Expected losses are
those that the bank knows with reasonable certainty will occur (e.g., the expected default rate of
corporate loan portfolio or credit card portfolio) and are typically reserved
for in some manner. Unexpected losses
are those associated with unforeseen events (e.g. losses experienced
by banks in the aftermath of nuclear tests, losses due to a sudden down turn in
economy or falling interest rates, etc.) (Alexander,
2002).
The risk is the integral characteristic of bank activity. It plays a
defining role in formation of financial bank activity results, serves as an
important characteristic of bank assets and liabilities quality, and, thus,
should be used in the comparative analysis of their financial condition and its
position in the bank services market. Bank risk is the uncertainty in the
relation of future cash flows, possibility of losses or limited gains in
comparison with expected and the probability of unexpected expenses occurrence
while realization of banking operations, presented in cash equivalents (Saunders,
1996).
Risk Management is a
discipline at the core of every financial institution and encompasses all the
activities that affect its risk profile. It involves identification,
measurement, monitoring and controlling risks. The acceptance and management of
financial risk is inherent to the business of banking and banks’ roles as
financial intermediaries. Risk management as commonly perceived does not mean
minimizing risk; rather the goal of risk management is to optimize risk-reward
tradeoff (Ibid.). Notwithstanding the fact that banks are in the business of
taking risk, it should be recognized that an institution need not engage in
business in a manner that unnecessarily imposes risk upon it: nor it should
absorb risk that can be transferred to other participants. Rather it should
accept those risks that are uniquely part of the array of bank’s services.
Originally, banks only accepted deposits, they have quickly ripened, becoming
intermediaries in means transfer, and have taken up other risks, for example
credit. The credit became a basis of banking activity and the one that the bank
was judged about the quality and work by. The special attention is devoted to
managerial credit risk process, because the success of bank’s performance
depends on its quality. The principal cause of banks’ bankruptcies all over the
world was a poor quality of assets.
The development of banking system should focus on such an issue, as the
presence of variety of risks. The money market concerns with the circulation
sphere, and modern Kazakhstani commercial banks are the most active and mobile
part there. Commercial banks are professional participants in the financial market
and in various sectors. Banks aspire to keep the reached level of
profitability, therefore first of all they are anxious about the problems a
rational combination of profitability, liquidity and minimization of risks.
Commercial banks form not only the market of credits, a securities market and
the currency market of the country, but also take part in creation and
functioning of commodity, share and currency stock exchanges. They are owners
of the available information about a financial position of the enterprises and
the organizations, a conjuncture of the share, credit and currency markets of
As the activity experience of the largest, dynamic and profitable credit
institutes of
·
flexible market strategy;
·
high reliability;
·
constant improvement of service
quality (Lavrushin, 1995:37).
The expansion of clientele, increase of competitiveness and growth of
financial results are substantially promoted to grant more preferential
conditions for clients of settlement-cash service, opening of some new
branches, commercial banks’ organizational structure optimization, new bank
products introduction, active work with commercial banks’ actions on a
secondary securities market, carrying out of successful operations with the
state securities and in the market of short-term credits.
The credit stimulates the development of productive forces, accelerates
formation of the capital sources for reproduction expansion. It is impossible
to provide the fast and civilized establishment of facilities, enterprises,
introduction of other kinds of enterprise activity on interstate and external
economic space without credit support. On the other hand, crediting is
connected with the certain risk, especially under conditions of developing
market economy. In literature reviews two types of risk is considered: 1) unary
risk (where any activity is considered separately); 2) portfolio risk (where
the activity is a part of a portfolio) (Alexander,
2002:19). Another point that only portfolio risks exist aspires banks to
diversify their assets; therefore it is impossible to consider each activity
separately.
It is known, that the key elements of efficient control are: well
developed credit policy and procedures; good portfolio management; an effective
credit control; and, that is the most important - well trained personnel. Banks
and similar financial institutions need to meet forthcoming regulatory
requirements for risk measurement and capital. However, it is a serious mistake
to think that meeting regulatory requirements is the one or the most important
reason for establishing a sound, scientific risk management system. Managers
need reliable risk measures to assign direct capital to activities with the best
risk/reward ratios. They need estimates of the size of potential losses to stay
within limits imposed by required level of liquidity, by creditors, customers,
and regulators. They need mechanisms to monitor positions and to create
incentives for prudent risk-taking by divisions and individuals.
The main objectives of the research are:
·
to find out what types of risks are
considered by the Kazakhstani banks;
·
risks, which are the most typical for
our banks;
·
what is undertaken by the management
to mitigate or eliminate these risks.
In
addition, the emphasis is made on risk management techniques, applied by the
banks.
The backbone of the work is a survey of banks of
Risk classification
The leading principle in commercial banks’ activity is the aspiration of
greater profit reception. Thus, the size of
possible profit is directly proportional to risk (Gitman, 2003). Risks in
banking sphere are an opportunity of bank’s losses due to occurrence of certain
adverse events. Similar risks can be as bank’s ones, connected with the credit
organization functioning, and as external. Acceptance of risks is a basis of
banking sphere. Banks are successful when risks, accepted by them, are
reasonable, controllable, are within the limits of their financial
opportunities as well as competence.
There are three leading criteria, which banks consider in the process of
their activity: liquidity, profitability and safety (Lavrishin, 1995). In
practice, banks are based on the identical importance of these three criteria
or assume maximization of profit at maintenance of liquidity and the safety
account as a basis. The maintenance, classification, and methods of the
analysis are constantly exposed to changes in connection with constant change
of market structure, an aggravation of competition, fluctuation of interests,
caused by the external factors, amplifying clients’ requirements, etc. During
their operations, banks face various types of risks, which differ by a place and
time of occurrence; external and internal factors that influence their
magnitude; way of risk analysis and methods of their description. Besides, all
kinds of risks are interconnected and influence a bank’s activity. Change of
one type of risk causes change of almost all others. That complicates analysis
of method choice at a concrete risk level.
In the research it was suggested that the risk level increases, if:
·
problems arise suddenly and contrary
to expectations;
·
the new tasks mismatching the last
bank’s experience;
·
management is not able to take
necessary and urgent measures that can lead to financial damage (deterioration
of necessary reception opportunities and\or additional profit);
·
existing rules of bank’s activity or the
legislation imperfection hind to some optimum measures acceptance for a
concrete situation.
Consequences of incorrect risks estimations or absence of an
opportunity, along with effective methods, may be the most unpleasant down to
full bankruptcy of a bank. Therefore, analysing risks of the Kazakhstani banks
at the present stage, it is important to consider:
·
destabilization of real estate
market;
·
increase in mortgage and consumer
credits;
·
absence or imperfection of some basic
acts, discrepancy between legal base and really existing situation;
·
inflation, etc.
Bank risks cover all banks’ activities: external as well as internal. Usually,
external risks consist of:
•
Country risk;
•
Legal risk;
•
Social risk;
•
Risk of competition;
•
Branch risk ( Saunders, 1996:62).
Internal risks result from a bank’s activity and depend on operations,
performed by it, and are connected with:
•
bank’s assets (credit & currency market, settlement, leasing, factoring,
cash, etc.);
•
bank’s liabilities (risks on depositary operations);
•
bank’s quality management of its assets and liabilities (interest rate risk,
risk of unbalanced liquidity);
•
a process of financial service realization (operational risks, technological
risks, personnel risks) (Ibid.)
As bank’s activity inherently assumes a “game” on interest rate changes,
exchange rate, etc., none of the mentioned above risks can be eliminated
completely. Therefore, the primary goal of the bank is an achievement of an
optimum combination of risk and return.
The risks associated with the bank's principal activities, i.e., those
involving its own balance sheet and its basic business of lending and
borrowing, are not all borne by the bank itself. In many instances the
institution will eliminate or mitigate the financial risk associated with a
transaction by proper business practices. In others, it will shift the risk to
other parties through a combination of pricing and a product design.
The banking industry recognizes that an institution does not need to be
engaged neither in business with that unnecessarily imposes risk, nor should it
absorb risk that can be efficiently transferred to other participants. Rather
it should only manage risks at the firm’s level that are more efficiently
managed there than by the market itself, or by their owners in their own
portfolios. In short, banks should accept only those risks that are uniquely a
part of the bank's array of service. It is argued that risks facing all
financial institutions can be segmented into three separable types, from a
management perspective. They are risk that can be:
·
eliminated or avoided by simple
business practices,
·
transferred to other participants,
and,
·
actively managed at the firm level (Mishkin,
2004:16).
The risk avoidance practice is the standardization of process, contracts
and procedures to prevent inefficient or incorrect financial decisions. Another
practice is the construction of portfolios that benefit from diversification
across borrowers and that reduce the effects of any loss experience. Finally,
the implementation of incentive-compatible contracts with the institution’s
management requires that employees be held accountable.
It seems
appropriate for discussion of risk management procedures to begin with
considerations of why the firms manage risk. According to economic theory,
managers of value maximizing firms ought to maximize expected profit without
regard to the variability around its expected value (Hoffman, 2002). In fact,
at least four distinct rationales are offered for active risk management. These
include: managerial self-interest, the non-linearity of the tax structure, the
costs of financial distress and the existence of capital market imperfections (Salkind,
2000:26).
Risk measurement
involves the quantification of certain risk exposures for the purpose of comparison to a company-defined risk tolerance. The
risks, which a firm is subject to, can change because of change in the composition of a company's assets or
liabilities, or as a result of
external factors affecting the cash-flows. These external factors include:
interest rates, exchange rates, prices for
inputs, or other economic variables. The risk management process of a firm will always be targeted at decision
variables (e.g., hedge ratios) that affect at least one dimension of the firm's financial condition: value,
cash-flows, or earnings. The
risk management process is a dynamic one. A properly functioning risk
management process includes risk
audit, exposure oversight, and “fine tuning” of the process itself. This
includes external audits of risk management policies and procedures, and
internal reviews of quantitative
exposure measurement models.
In light of
the above, what are the necessary procedures that must be in place to carry out
adequate risk management? In essence, what techniques are employed to both
limit and manage the different types of risk, and how are they implemented in
each area of risk control?
After
reviewing the procedures employed by leading firms, an approach emerges from an
examination of large-scale risk management systems. The management of the
banking firm relies on a sequence of steps to implement a risk management
system. They consist of the following four parts:
(i)
standards and reports,
(ii) position limits or rules,
(iii) investment guidelines or strategies,
(iv) incentive contracts and compensation (Santomero,
1995:69).
In general,
these tools are established to measure risk 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.
Risk
can be managed, i.e. some measures might be undertaken to decrease a degree of
risk, allowing, to some extent, to predict the risky event occurrence.
Efficiency of the risk management organization in many respects depends on a
risk classification. It is necessary to understand a distribution of risk to
specific groups as classification of risk to the certain attributes for objects
achievement.
Due to tome and resources constraints, current research is devoted to
consideration only financial types of risk. In the bank risks system financial
risks occupy a special place. They lead to unforeseen changes in volumes,
profitability, structure of assets and liabilities, changing one into another.
They directly influence the end results of bank activity: parameters of
profitability and liquidity and, finally, the capital size and solvency. The
scope of financial risk includes: credit risk, liquidity risk, market risk,
interest rate risk, currency risk, inflation risks, insolvency risks,
functional risks, strategic risks, technological risks, risk of inefficiency,
inclination risk.
Risk
Measurement Techniques
The banking
industry has a long viewed problem of risk management as a need to control five
of the above mentioned risks, which make up most, if not all, of their risk
exposure. While banks recognize counterparty and legal risks, they view risks
as less central to their concerns. Some banking firms would also list
regulatory and reputation risk in their set of concerns. Nonetheless, all would
recognize the first five as key, and all would devote most of their risk
management resources to constraining these key areas of exposure.
Where
counterparty risk is significant, it is evaluated using standard credit risk
procedures, and often within the credit department itself. Likewise, most
bankers would view legal risks as arising from their credit decisions or, more
likely, a proper process not employed in financial contracting. Accordingly,
the study of a bank’s risk management processes is essentially an investigation
of how they manage these five risks. Thus, various analytical techniques are trying to quantify these risks
as possible. To illustrate how this is achieved, this review of
firm-level risk management begins with a discussion of risk management
controls.
Most widely used techniques covers the Value at
Risk (VAR) method (Jorion, 2003:73), risk budgeting and hedge
ratio approach (Hofman,
2002), effective duration and effective convexity measure (Fabozzi & James, 2000), scoring method for clients’ identification (Churchill et al., 1977), credit risk structure (Caouette at al., 1998). The measurement methodology of the
operational risk framework provides a way of calculating the measures of risk for the
factors defined through the business unit analysis. The operational risk measurement
methodology is called Delta-EVT™ (Kaufman, 2002:136). It involves the use of two
analytical techniques:
·
the
delta method and Extreme Value Theory (EVT)
·
the calculation of a
threshold.
The measures of the Delta-EVT are
loss measures from the two loss-generating sources -value adding processes and
rare events, and include the following:
·
Excess Value at Risk
(EVAR)
·
Earnings at Risk (EAR) (Vinichenko,
1998:240).
Probably, the
most popular approach in performance measurement was developed by “Bankers Trust” (now “Deutsche Bank”) in
the 1980s (Ibid.). It is known as a Risk Adjusted Return on Capital (RAROC). It gives an economic basis to measure all the
relevant risks consistently and gives managers tools to make the efficient
decisions regarding risk/return tradeoff in different assets. As economic
capital protects financial institutions against unexpected losses, it is vital
to allocate capital for various risks that these institutions face. RAROC
analysis shows how much economic capital different products and businesses need
and determines the total return on capital of a firm. Though, RAROC can be used
to estimate the capital requirements for market, credit and operational risks,
it is used as an integrated risk management tool.
RAROC = Risk-adjusted
Return / Risk Capital,
where
risk-adjusted return equals total revenues less expenses and expected losses
(EL), and risk capital is that reserved to cover the unexpected loss given the
confidence level. While the expected loss is factored in the return (as loan
loss provision), the unexpected loss is equivalent to the capital required to
absorb the loss [Crouhy et al, 2001).
Besides, the securitization is used, where the bank pools a group of
income-earning assets (like mortgages) and sells securities against these in
the open market, thereby transforming illiquid assets into tradable
asset-backed securities (Caouttee at al., 1998). However, a special attention
is paid to the variety of hedging instruments. There are two methods
of hedging: structural and derivatives (Asaf, 1972). Structural hedging
represents the decrease or elimination of interest rate risk with the help of
equivalence of percentage asset profit and expenses on an interest paid. The
emergence of substantial markets in forwards/futures, options, swaps, and other
Derivative Financial Instruments (DFIs) have altered the conduct of financial
management and investment activities substantially. Credit Default Swaps (CDSs)
have emerged as one of the primary building blocks of the bond and loan
sectors, serving as a vital tool for banks to manage credit risk or accept
exposure to lucrative opportunities.
Methodology and data collection
The current research was represented both
in two types of data: primary and secondary. The literature review was
presented in secondary type of the research as the authors use expressions and
definitions of other people and the analytical part represents primary data as
the authors collecting data via questionnaires and interviews. Moreover, the
positivistic approach might be considered as the approach of the work, as it
uses a survey as the main methodology. The research questions generated by the
current work and stated above allow to define the current research as an
exploratory study, because there is not a great deal of information about bank
risk management techniques in
The first part of the survey has descriptive nature,
because the researcher tries to identify types of risks and existing practices
in bank risks management. A sample of risks is supposed to be generalised on
the whole number of banks operating in
Despite all efforts to come across a similar research conducted
previously, it was not possible to find any published surveys on the specific
management methods on bank risk mitigation in
The questionnaire was compiled in English and then translated into
Russian. Respondents had an option to fill out questionnaires in either
language. Seventeen respondents chose to complete the questionnaire in Russian
while only two stick to the English version.
Individual results in the questionnaires were kept confidential, and the
data was only used in the aggregate form. However, 3 out of 19 respondents
omitted some of the questions. Therefore, the number of responses to
straightforward questions varied from 16 to 19. For the tabulation of the survey
results, percentages were calculated based on the number of responses to each
question.
To obtain the relevant information for the research a 3-page
questionnaire was designed with the total of 20 questions. Responses to the
questions are carefully analyzed in the following paragraphs of this chapter.
The questionnaire had 5 sections: background
information, overall bank risks, market risk, credit risk, operational risk.
Most of the questionnaires (13,68%) were completed by credit risk
analysts. The others were completed by credit risk managers (3,16%), financial
analysts (2,11%), and a financial manager (1,5%). Moreover, more than half of
the respondents (13 or 68%) held a bachelor degree. Five of the respondents
(27%) indicated that they held a master’s degree. No respondents reported that
they held less than a bachelor degree. Most
respondents (16 or 84%) indicated their field of study was finance. Two
respondents (11%) stated that management was their major and the only one (5%)
has economics as the field of study. The majority of the respondents (12 or 63%)
had less than five years' experience, while 6 respondents (32%) had more than 5
years experience in their work. This information suggests that the respondents,
who completed the questionnaire, were, in general, well placed to contribute
knowledgeably to this research as they are closely connected with the sphere of
risk management.
Analysis of results.
The second section of the questionnaire was specifically designed to
determine types of risks faced by banks, extent of exposure to these risks and
instruments used to manage this exposure. There were a total of 7 questions in
this section and the primary focus was on specific techniques used for the
mitigation or limitation of risks. The attention was paid to the type of risk
analysis presentation, its regularity and models applied. First of all,
respondents were supposed to range types of risks and extent of the exposure.
The main focus here was on tree types of risks: credit, market and operational.
Other types of risks were chosen for comparative purposes and obtaining the
whole picture of risk exposure in the industry. Exposure of banks to 8 main types
of risk is shown in Figure 1.
As it was expected, financial risks were the risks of the greatest
concern to most banks in Kazakhstan that include market, credit, interest rate
and currency risks. They also may contain risks of financial controls failing,
treasury risks, lack of counter-party or credit assessment, sophisticated
financial fraud, and the effect of changes in macroeconomic factors.
Interest rate risk arises when interest rates start to change. These
changes affect loan and investment structure of an organization’s assets. It is
especially true for banks that acquire money through deposits and issuing bonds
and invest them at a higher rate. If loans and investments are not balanced,
the change in interest rates might cause big losses for an organization.
However, more than half of the answers (12,63%) assume that interest
rate risk has moderate exposure to their financial institution. Six (32%) out
19 respondents claimed that they were highly exposed to interest rate risk,
while only one responded indicated low exposure.
Figure 1. Exposure to
different types of risks
Source: compiled by
the authors
As it was examined above, credit risk can be considered as the largest
risk inherent in bank activity and arises when the borrower does not pay the
principal amount and interests on it in conformity with the terms and
conditions of a credit management. As the study has proven, all respondents
face credit risk, where the majority of banks – 13 (68%) have moderate
exposure, 2 (11%) – high exposure and 4 (21%) – a quite low.
Another main risk that Kazakhstani banks face is a currency risk. This
risk arises from the change in price of one currency against another. Whenever
investors or companies have assets or business operations across national
borders, they face currency risk.
According to the perceptions of the respondents, currency risk exposure
was ranked quite low relative to other types of risk exposure. The results show
that 17 out of 19 respondents admitted that their company was exposed to
currency risk to some extent. Out of those 17, 3 identified it as moderate
exposure and 14 – as low exposure. Only 2 respondents alleged they were not
exposed to the currency risk. The strange outcome is probably connected with
misunderstanding of currency risk management tools as well as the absence of
such tools at all. Though, the concrete currency risk management analysis
determined a high rate of the risk.
High rate of a currency risk exposure is dangerous if not managed
properly. Recent decades have seen a number of regional and world currency
crises. Asian Crisis in 1998 lead to a depression of the financial system of
the whole region, which adversely affected the world economy. Such crises will
continue to appear with effects on the world financial system because of the
rapid globalization processes. Even without crises, there is a high volatility
of world currencies reveals a high level of currency exposure of companies,
especially in the financial industry.
As it was previously discussed, market risk encompasses liquidity risk and price risk, both
of which arise in the normal course of business of a global financial
intermediary. Liquidity risk is the risk that some entity, in some location and in some currency, may be
unable to meet a financial commitment to a customer, creditor, or investor when due. Price risk is the risk to
earnings that arises from changes
in interest rates, foreign exchange rates, equity and commodity prices, and in
their implied volatilities. Price risk arises in non-trading as well as trading
portfolios.
Not surprisingly, that many financial
institutions identified market risk influence as moderate, because prices
volatility and inflation rate instability may cause rise of other types of
risks, connected with market risk (liquidity risk and other two, which were
mentioned above). Only 5 (26%) respondents regarded market risk as one with
moderate exposure and 2 (11%) – as low one. However, 12 (63%) indicated that
they do not know about the extent of market risk.
Closely connected with the market risk, liquidity risk arises from
situations in which a party interested in trading an asset cannot do it because
nobody in the market wants to trade that asset. Liquidity risk becomes
particularly important to parties, who are about to hold or currently hold an
asset, since it affects their ability to trade. If one party cannot find
another party interested in trading the asset, this can potentially be only a
problem of the market participants with finding each other. This is why
liquidity risk is usually found higher in the emerging or low-volume markets.
Kazakhstani financial market can be considered as a low-volume or even
emerging market and, though, liquidity risk is fairly low. According to the
survey results, 4 respondents (21%) noted a low exposure to liquidity risk, 5
respondents (26%) marked no exposure. Unfortunately, most do not know what the
extent of liquidity risk is and some (3, 16%) left this field unmarked. This
makes it possible to conclude that many banks do not have operations in the
open market or, probably, people are not able just to identify what the
liquidity risk is.
Compared to previously analyzed types of risks, country risk was not
regarded as relatively important for Kazakhstani banks. Country risk measures
the stability of the country in terms of legislation base and political strain
and the stability of the counterparts as well. This risk arises from the
possibility of the government to change laws or regulations that might
adversely affect a company’s position.
Until recently, Kazakhstani banks increased volumes of crediting mainly
in the home market, however, last two years their strategy is more often aimed at
the expansion of operations in
Operational risks include risks of human error or omission, design
mistakes, unsafe behaviour, employee practices risks, and sabotage. Although operational risk applies to any
organization in business, it is of particular relevance to financial
organizations, which are responsible for establishing safeguards to protect
against systemic failure of the financial system and
the economy. It is relatively difficult to identify or assess levels of
operational risk and its many sources. Historically, organizations have
accepted operational risk as an unavoidable cost of doing business.
Probably, that is why all 16 respondents agreed that their organizations
face at least some level of exposure to operational risk, where 10 (53%) face a
high exposure and 6 (32%) - moderate. It is very important for financial
organizations to identify this type of risk and minimize it through the
implementation of strict risk management standards, internal regulations and
controls.
As it was expected, 15 (79%) banks out of 19 has no exposure to
strategic risk, while 4 (21%) just do not know the rate of its influence.
Strategic risks include risks of plans failing, poor corporate strategies, weak
marketing strategies, poor acquisition strategies, and changes in consumer behaviour. It is possible to say that corporate
strategy and planning are highly regulated by Kazakhstani banks.
The results of the questionnaire show that our banks do use different
types of risk analysis to mitigate or avoid its influence. All respondents
indicate that their banks provide risk analysis both quantitatively by using
Rates of Return calculation, risk management ratios and standard deviations and
qualitatively, using ranking systems and normal distribution diagrams. This
makes it possible to conclude that banks pay a special attention to the risky
situations that might occur. 17 (89%) banks provide simulation (stress testing)
analysis, 5 (or 26%) of which develop it quarterly and 12 (or 64%) -
semi-annually. All respondents stated that they usually model basic risks and
some (2, 11%) model political risks as well. It is not surprising, that all
Kazakhstani banks subscribe to existing agencies for interest rate forecasts
and apply a quantitative model for their simulations. Thus, 4 banks develop its
own in-house models, when 15 (79%) out of 19 use both possibilities – in-house
and acquire from outside sources.
The most interesting part was to determine what indices banks use for
overall risk measurement. The answers provided following results: almost all
banks (17,89%) employ the Value at Risk (VaR) as overall risk measure The RAROC
is used by 15 (79%) organizations, Sharpe ratio is applied by 4 (21%) and only
one bank uses Beta coefficient (systematic risk measure). As can be seen from
the results, most of banks use two and sometimes even three indices for risk
estimation. The special emphasis was made on coefficient of determination (R2),
while using Beta (b),
but this question was missed by all respondents. This might mean that banks use
Beta as provided by other resources, such as the level of Treasury securities.
The only bank, which uses Beta, applies special procedures to lower it, when
the value of Beta is higher than interval from 1.51 to 2. As it can be seen
from the analysis, Beta coefficient is not used well, probably, because banking
personnel do not see the need to use a complex approach in risk management as
well as the trust to Treasury bills and their level. The level of Beta 1.5 is
generally acceptable, thus, if it appears higher, banks will have to apply some
techniques to mitigate its influence. Figure 2 summarizes information about
those indices used by Kazakhstani banks in its risk management.
Figure 2. Indices for overall
risk management
Source: compiled by the authors
As it was discussed in previous part, banks pay a close attention to the
interest rates forecasts and have a quite perceptible influence of its
fluctuations, therefore, all interrogated banks have a special method for the
interest rate risk estimation. As the answers showed, some financial
institutions have more than one technique for risk determination. The results
of findings are presented in Figure 3.
Figure 3. Interest rate risk measure
Source: compiled by the
authors
Duration is a value
and time weighted measure of maturity of all cash flows and represents the
average time needed to recover the invested funds. It is used by 8 (42%)
Kazakhstani banks. Gap analysis, which focuses on the potential variability of
net-interest income over specific time intervals, is provided by 6
(32%) banks out of 19. The most popular measure of interest rate risk is the
VaR method, which indicates how much a firm can loose or make with a certain
probability in a given time horizon, is applied by the majority – 12 (63%)
banks. Among those that use different approaches 3 (18%) make analysis daily, 7
(37%) – monthly and 9 (47%) quarterly. This indicates that time interval before
the next estimation is small enough, that gives the opportunity to control
interest rate risk. The movement in
market prices is calculated by banks by reference to the market data from the
last two years.
Aggregation of the VAR from different types of risk is based upon the
assumption of independence between risk types. The model assumes that changes
in risk factors follow a normal distribution. This may not be the case in reality and may lead to an underestimation of the probability
of the extreme market
movements. The model uses a ten-day holding period and assumes that all
positions can be liquidated or
hedged in ten days. This may not fully reflect the market risk arising from times of severe liquidity, when a ten-day
holding period may be insufficient to fully liquidate or hedge all positions. Among the
respondents, the VAR model uses a
99 percent confidence level, and does not taking account any losses that might
occur beyond this level of confidence.
Figure 4 shows how much of the assets of
financial companies are invested into foreign currencies. 5 out of 19
respondents (26%) had 26-50% of assets invested in foreign currencies, 7 (37%)
invested 1-25% of their assets in foreign currencies, and another 37% do not
know this information. It is not surprising that given this statistics the
financial companies were quite exposed to the currency risk. As
it was derived from the interviews, the quite stable rate of tenge and most
deposits and credits are held in the national currency, therefore, the currency
risk is manageable and moderate.
Figure 4.
Proportion of assets invested in foreign currency
Source: compiled by the authors
It was found out, that the majority of banks – 12 (63%) use hedging instruments
to mitigate currency risk versus 7 (37%) out of 19, that do not use these
instruments at all. Those, who mentioned the
positive answer on hedging instruments use, had to provide the analysis of what
types of derivatives are used by their banks. The reasons for not managing the currency
risk exposure were market underdevelopment and legal limitations preventing
from using instruments for mitigating the currency risk. Many respondents
claimed that their organization did not use instruments involving the currency
risk.
Currency forwards, futures, options and swaps are excellent instruments
for mitigating currency risk. The research showed, however, that they were not
commonly used by our financial organizations. As can be seen from Figure 5, out
of 19 respondents, 4 used forwards, 3 – futures, financial options were used by
5 banks and 4 used swaps.
It is very interesting that nobody among respondents indicated full
hedge of the currency risk. Most banks use hedging instruments partially (10
out of 12) and the rest (2) do not know to what extent the instruments are
used. Figure 6 shows the result of hedging volume.
Figure 5. Hedging of currency
risk exposure
Source: compiled by the authors
This data says that Kazakhstani banks try to mitigate currency risk with
the help of swaps, options, futures and forwards, however the sphere of usage
is quite small or it is difficult to evaluate how it is used.
According to the answers of bank employees, credit risk management
process relies on corporate-wide standards to ensure consistency and integrity,
with business-specific policies and practices to ensure applicability and
ownership. It arises principally from lending, trade finance, treasury, and
leasing activities (Markova,
1995).
Figure 6. Level of currency
risk exposure management by banks
Source: compiled by the author
For corporate clients and investment
banking activities across the organizations, the credit
process is grounded in a series of fundamental policies, including:
·
ultimate business accountability for
managing credit risk;
·
independent risk management
responsibility for establishing limits and risk management practices;
·
single centre of control for each
credit relationship that coordinates credit activities;
·
portfolio limits, including obligor
limits by risk rating and by maturity, to ensure diversification;
·
a minimum of two authorized
credit-officer signature requirements on extensions of credit – one from a
sponsoring credit officer in the business and one from a credit officer in
independent credit risk management;
·
uniform risk measurement standards,
including risk ratings, which must be assigned to every obligor;
·
consistent standards for credit
origination, measurement, and documentation, as well as problem recognition,
classification, and remedial action.
As it was expected, client scoring method is widely used among
Kazakhstani banks. More than two third of respondents 15 (79%) out of 19
positively answered the question about adoption of the method when analyzing
and ranging clients. Unfortunately, only 10 banks are informed about the
numerical scale range of their clients. 7 (37%) adopted 8 scale range system,
while 3 out of 19 use 10 range system. The rest did not answer the question and
supposed that client scoring method is used, however every client does not
usually have its own number. All the respondents review the numerical scale of
their clients every month when preparing monthly reports to the National Bank.
It is also surprising that more than half of banks (11, 58%) do not have
Required Rate of Return (RRR) for clients, and only 8 (42%) do really have. The
RRR is set depending on clients’ range, sum of the loan and purposes for money
needed. Therefore, the standard procedures used by many banks in Kazakhstan to
mitigate credit risks are the volume of primary payment, income verification,
the difference between market and mortgage cost of property.
Another interesting fact about banking activities, connected with
overall macroeconomic risk, is borrowing abroad. A lot is being discussed now
by the government and the National Bank about the limitation and special
restrictions on borrowing abroad as it promotes the increase of the country’s
external debt. In more details, this information and banks’ policies will be
examined later in section 3.2. According to the questionnaire, all banks, 19
out of 19, do borrow abroad. This situation has some advantages as well as
disadvantages and is closely connected with currency and country risks.
The results showed that operational risk takes the integral part of
every-day bank activity and, nowadays, more and more attention is paid to
operational risk management. 18 banks out of 19 provide framework to identify,
control, monitor, measure, and report operational risks in a consistent manner
across the company. The core operational risk principles, which are applied
without exception to all bank businesses, are:
·
senior managers are accountable for
managing operational risk;
·
all respondents have a special system
of checks and balances in place for operational risk management, including an
independent oversight function, reporting to the director of credit and risk
department, and an independent audit and risk review function;
·
every department must have approved
specific policies and procedures for managing operational risk including risk
identification, mitigation, monitoring, measurement, and reporting, as well as
processes for ensuring compliance with corporate policies and applicable laws
and regulations. (King, 2001).
It is not surprising that all banks have a special backup system for
prevention of information loss and in the case of incorrect utilization by
people. As there is a law about obligatory annual external audit, all banks are
audited annually. However, there is a small difference concerning internal
audit. Special attention is paid to the management of a loan’s problem. Regular
audits of bank’ credit processes are undertaken by internal audit function.
Such audits include consideration of the completeness and adequacy of credit
manuals and lending guidelines, together with in-depth analysis of a representative sample of accounts in the portfolio to
assess the quality of the loan book and other exposures. Individual accounts
are reviewed to ensure that the facility grade is appropriate, that the
credit procedures have been properly followed, and that where an account is
non-performing, provisions are adequate. Internal audit discuses any facility
grading it considers should be revised at the end of the audit and its
subsequent recommendations for the revised grades must then be assigned to the
facility. 13 (68%) respondents conduct internal audit annually and only 6 (32%)
– semi-annually.
Another interesting fact of borrowings abroad was commented by
interviewees. As the growth of involved deposits lags behind the growth of
crediting, large banks actively attract means in the international financial
markets and the debt instruments markets for credit operations financing.
Despite all benefits of foreign resources attraction (low interests, long time
to maturity), it creates a danger of resource base concentration and
refinancing risks occurrence. Moreover, there is a threat of assets
deterioration as a result of probable tenge rate downturn as the majority of
given credits are nominated in the foreign currency and are counterbalanced by
conterminous currency resources. Eight people out of 13 interviewed noted that
banks borrow much, but place abroad much money as well. This does not mean that
all money, which come to
While the interviews were being conducted, the question of latest
Kazakhstani market liberalization for foreign banks has been raised. It is
possible to assume that foreign banks have some advantages over the national
banks, especially because of high ratings and cheaper funding over Kazakhstani
banks. However, the local banks are able to compete by the better market
knowledge and clients’ needs understanding. Anyway, risks are possible, but the
local banks are able to compete and to get some foreign experience from the
foreign banks.
All the information provided by respondents with the help of interviews
assisted the researcher in understanding the phenomena of borrowings and credit
risk management situation. It will make possible to give some general
recommendations and to make a relevant conclusion of the research.
Recommendations and conclusions
Analysis of
the information provided by questionnaires and interviews allow suggesting that
during the years of independence Kazakhstani banking industry has undergone
some development. There are several types of risks that cannot be eliminated
completely; therefore they have to be managed correctly. Survey indicates that
overall risk management processes in Kazakhstani financial institutions are
employed. The results indicate that while banks have established a relatively
good risk management environment, the measuring, mitigating and monitoring
processes and internal controls needs to be continuously upgraded.
First
of all, the main attention should be paid on internal risk control. Some
improvements have to be taken by a bank’s board of directors concerning
internal audit, because appearing problems must be determined by a bank itself
as soon as possible. In house regulations on internal audit and risk management
should be designed so that departments are administratively independent of each
other and accountable to the bank's board of directors and senior management
individually within the scope of the internal control function. Each bank should
improve their organizational structure and cooperation procedures for their
internal audit system and risk control and management system provided.
Secondly, as
the results of the questionnaire show, a lot is being done to determine the
level of risks and there are some general risk mitigation measures. Besides, it
is possible to advise to use risk management techniques in complex, because
only this approach allows measuring risks with certain precision. It sounds
optimistic that Kazakhstani banks use internationally admitted methods for risk
identification, while some missing elements throughout our banks were found.
Number of banks applies different techniques complexly, but others use only one
of them. In the international practice, banks give their clients a numerical
scale range to easily identify the clients’ risk category. Surprisingly, banks
of
Thirdly, the most pessimistic result was derived from the fact that
Kazakhstani banks partially use some methods of risk mitigation. This includes lack
of instruments (like short-term financial assets and derivatives) and money
markets. Financial companies do use over-the-counter derivatives
like forwards, options and swaps, yet the use of derivatives by financial
companies is very low. Low usage of derivatives can be explained by the fact
that Kazakhstani financial organizations do not have access to liquid derivatives
markets. In order to make the derivatives market successful, a proper legal
base should be in place. For that purpose, a working group consisting from
representatives of governmental bodies and private financial companies should
be assembled. This group would have to develop a project of a law on
derivatives market. Innovations would have to include a creation of or rather
delegation of supervising power to the AFC. This calls for more research in these
areas to develop risk management instruments and procedures that are compatible
with regulation standards.
A main focus was made on the operational risk management. First of all,
requirements needed for operating risk management should be applied by the
board and top management, and then transmitted to every department. Management
need to evaluate the adequacy of countermeasures, both in terms of their
effectiveness in reducing the probability of a given operational risk, and of
their effectiveness in reducing the impact should it occur. Where necessary,
steps should be taken to design and implement cost-effective solutions to
reduce the operational risk to an acceptable level. It is essential that
ownership for these actions be assigned to ensure that they are initiated. Risk
management and internal control procedures should be established by the
business units, though guidance from the risk function may be required, to
address operational risks. While the extent and nature of the controls adopted
by each institution will be different, very often such measures encompass areas
such as Code of Conduct, Delegation of authority, Segregation of duties, audit
coverage, compliance, succession planning, mandatory leave, staff compensation,
recruitment and training, dealing with customers, complaint handling, record
keeping, physical controls, etc. Operational risk metrics or “Key Risk
Indicators” (KRIs) should be established for operational risks to ensure the
escalation of significant risk issues to appropriate management levels. KRIs
are most easily established during the risk assessment phase. Regular reviews
should be carried out by internal audit, or other qualified parties, to analyze
the control environment and test the effectiveness of implemented controls,
thereby ensuring business operations are conducted in a controlled manner.
Finally, banks should have in place contingency and business continuity
plans to ensure their ability to operate as going concerns and minimize losses
in the event of severe business disruption.
Bibliography
1.
Alexander C., (2002), ‘Rules and models’, Risk Magazine Operational Risk
Supplement, January, pp.18-20.
2.
Asaf S., (1997), ‘Maximizing corporate shareholder value
using risk profile dynamics’, Templeton
College, University of Oxford.
3.
Bodie Z., Merton R., (2000), “Finance”, Prentice Hall.
4.
Caouette J., Altman E., Narayan P., (1998), Managing Credit Risk: The Next
Great Financial Challenge, Wiley and Sons.
5.
Churchill G., Nevin J., Watson R., (1977), The role of credit scoring in
the loan decision, Credit World, March, pp. 47-98.
6.
Crouhy M., Dan G., Robert M., (2001), Risk Management, McGraw Hill.
7.
Fabozzi F., James L., (2000), Value Based Metrics: Foundations and
practice, Whiley & Sons.
8.
Gitman L. J., (2003), Principles of Managerial Finance, Prentice Hall.
9.
Gribanova S., (2007), ‘Risk elimination’, Kazakhstan Expert, #
10.
Hoffman D.,(2002), Managing Operational Risk: 20 firm-wide best practice
strategies, Whiley & Sons.
11.
Jensen M., Meckling W., (1976),
‘Theory of the Firm: Managerial Behavior Agency Costs and Ownership Structure’,
Journal of Financial Economics 3, p.305-60.
12.
Jorion P., (2003), Financial Risk Manager Handbook, 2nd Ed., Wiley &
Sons.
13.
Kaufman G., (2002), Too big to fail in banking: what remains? The Quarterly
Review of Economics and Finance 42, pp. 423-436.
14.
King J., (2001), Operational Risk:
Measurement and modeling, Whiley & Sons.
15.
Lavrushin O., (1995), Banking industry,
16.
Markova O., (1995), Commercial banks and their operations,
17.
Mellcher R., Norton E., (2000), “Finance”, Thomson Learning.
18.
Mishkin F., (2004), The Economics of Money, Banking and Financial Markets,
Addison-Wesley.
19.
Salkind N. (2000), Exploring research, 4th Ed., Prentice Hall.
20.
Santomero A., (1995), “Financial Risk Management: The Whys and Hows,”
Journal of Financial Markets, Institutions and Investments, pp.25-35.
21.
Saunders A., (1996), Financial Institutions Management: A Modern
Perspective, Irwin Publishers,
22.
URL: www.caucaz.com (05.08.07)
23.
URL: www.wikipedia.com (05.08.07)
24.