Chapter 1 Analyzing and managing Banking Risk 1.

2 Bank Exposure to Risk

Financial risks are also subject to complex interdependencies that may significantly increase a bank’s overall
risk profile. (Engaged in foreign currency business is exposed to currency risk but will also be exposed to
additional liquidity and interest rate risk if the bank carries open positions or mismatches in its forward
book. (eg. Balance Sheet structure, Income stmt structure (profitability), Capital adequacy, Credit, liquidity,
Market, Currency)

Operational risks are related to a bank’s overall organization and functioning of internal system compliance
with bank policies and procedures and measures against mismanagement and fraud. (Internal/External
Fraud, employment practices and workplace safety, client/products and business services, damage to
physical assets, business disruption and system failures (technological risk) and Execution, delivery and
process management)

Business risks are associated with a bank’s business environment including macroeconomic and policy
concerns, legal and regulatory. (Macro policy, financial infrastructure, legal infrastructure, legal liability,
regulatory compliance, reputational and fiduciary, country risk)

Event risks include all type of exogenous risks which could jeopardize a bank’s operations or undermine its
financial condition and capital adequacy. (Political, contagion, banking crisis and other exogenous)

1.4 Risk-Based Analysis of Banks

Bank Supervision is based on an ongoing analytical review of banks in maintain stability and confidence in
the financial system.

The analytical view of banks is similar to private sector analysis except the ultimate objective is some what
different.

Bank appraisal in a competitive and volatile market environment is a complex process.

In addition to effective management and supervision, other factors necessary to ensure the safety of banking
institutions, stability of financial systems and markets, include sound and sustainable macroeconomic
policies and well developed and consistent legal framework, adequate financial sector infrastructure,
effective market discipline and sufficient banking sector safety nets are also crucial.

Bank’s analyst must have extensive knowledge of the particular regulatory, market and economic
environment in which a bank operates, to attain meaningful assessment and interpretation of particular
findings, estimate of future potential, a diagnosis of key issues, and formulation of effective and practical
courses of action.

The practices of bank supervisors and the appraisal methods practiced by financial analysts continue to
evolve.

The evolution is necessary to meet the challenges of innovation and new developments to accommodate the
broader process of convergence of international supervisory standards and practices.

Traditional banking analysis has been based on a range of quantitative supervisory tools to assess bank’s
condition including ratios.
Ratios relate to liquidity, capital adequacy, quality loan, insider and connected lending, large exposures and
open foreign exchange positions.

Risk based bank analysis includes;

Important qualitative factors, financial ratios within a board framework of risk assessment, risk management,
changes or trend in risks and underscoring the relevant institutional aspects;

Institutional aspects include;

The quality and style of corporate governance, management, adequacy, completeness, consistency of a bank’s
policies and procedures, the effectiveness and completeness of internal controls, the timeliness and accuracy
of management information systems and support

Traditionally, Banks have seen the management of credit risk as their most important task but banking has
changed and the market environment has become more complex and volatile.

Awareness has developed of the critical need to manage exposure to other operational and financial risks.
Risk management normally involves several steps for each type of financial risk and for the overall risk
profile

Also important is the identification and measurement of specific risk exposure, including assessment of the
sensitivity of performance to expected and unexpected changes in underlying factors.

Where appropriate, a bank should be analyzed as both a single entity and on consolidated basis, taking into
account exposures of subsidiaries and other related enterprises.

A risk-based bank analysis should also indicate; a. whether an individual institution’s behavior is in line with
peer group trends and/or industry norms, b. particularly when it comes to significant issues such as
profitability, structure of the balance sheet, and capital adequacy.

Chapter 2 2.3 A framework for financial sector development

Bank appraisal in a competitive and volatile market environment is a complex process.

The assessment of a bank’s financial condition and viability normally centers on the analysis of particular
aspects, including; ownership structure, risk profile and management, financial statements, portfolio
structure and quality, policies, human resources, and information capacity.

In order to interpret particular findings, estimate future potential, diagnose key issues, and formulate
effective and practical courses of action.

An analyst must also have through; a) knowledge of the particular regulatory, b) market, and c) economic
environment in which a bank operates.

In order to his or her job well, an analyst must have a holistic view of the financial system. An environment
that includes a poor legal framework, difficulties with the enforcement of financial contracts, and/or unstable
macroeconomic conditions presents a higher level of credit risk and makes risk management more difficult.

Unstable domestic currency that lacks external convertibility presents a high level of risk.
A bank’s overall business strategy and its specific policies and practices must both accommodate the
economic and regulatory environment with which the bank operates and be attuned to market realities.

Unstable macroeconomic environment, with uneven economic performance and volatile exchange rates
and asset prices, is a principal cause of instability in the financial system.

The political environment is also important because it influences both the principles and the reality under
which the financial sector functions.

Legal and judicial environment directly impact many aspects of a bank’s operations, such as exercising of
contractual rights to obtain collateral or to liquidate nonpaying borrowers; while a transparent accountability
framework establishes the foundation for a well-functioning business environment for banks and other
institutions in the financial sector as well as for their clients.

The legal and regulatory framework for institutions, markets, contracting and conduct, and failure resolution
spells out the rules of the game for financial institutions and markets.

Key elements of the institutional legal framework of the banking system include the central bank law and
the banking law. The former defines the central bank’s level of autonomy, systemic and functional
responsibilities and regulatory prerogative and enforcement powers. The bank laws defines the type of
financial intermediation to be performed by banks, the scope of banking business in the particular country,
conditions of entry and exit from the banking system and capital and other minimum requirements that must
be met and maintained by banks. The banking law specifies the corporate organization and the relationship
between banks and the central bank.

Another important element of the legal and regulatory framework involves prudential regulations issued by
the regulatory authorities. The objectives underlying such regulations include maintenance of the safety
and stability of the banking system, depositor protection and the minimal engagement of public funds.
The most important prudential regulations include bank licensing, corporate governance, closure and
exit mechanisms, capital adequacy and financial risk management.

Financial sector infrastructure strongly impacts the quality of bank operations and risk management.
Payment system, accounting and auditing, properly registries and rating agencies are the key elements of
such infrastructure, may be organized and managed by the central bank, by members of the banking system,
or as arrangement between individual banks and the central bank.

Increased competition in banking and finance and the trend toward homogenization of banking business
have been major factors that influence changes in national banking systems. Competing the barriers, modern
banks have moved beyond traditional deposit and credit markets to establish a direct presence in partially all
aspects of the financial system. Banking skills is essential that banks have good personnel management and
that they are able to systematrically develop banking skills within their organization. A good bank should be
able to acquire the appropriate skis and to develop a suitable work culture. It should also have a process to
optimize the mix of staff skills and experience and to develop staff performance levels in concert with its
business and institutional goals.
Chapter 4

4.2 – Asset Structure: Growth and Changes

Assets:

The banking sector’s assets comprise items that are a reflection of individual bank’s balance sheet, although
the structure of balance sheets may vary significantly depending on business orientation, market
environment, customer mix, or economic environment.

Overall liquidity of assets:

Liquid assets are needed to accommodate expected and unexpected balance sheet fluctuations. In
environments where markets are not developed and the liquidity of different claims still depends on their
maturity rather than on the ability to sell them.

Banks tend to keep a relatively high level of liquid assets that bear little or no interest. Liquidity assets
typically account for at least 10 percent or in extreme situations as much as 20 percent of total assets.

Increasing market orientation, the growth of financial markets, and the greater diversity of financial
instruments worldwide entails greater short-term flexibility management, which in turn reduces the need to
hold large amounts of liquid assets. In banking environments with developed financial markets, liquid assets
typically account for only about 5 percent of total assets.

Cash and balances with the central bank represent the holding of highly liquid assets, such as bank notes, gold
coin and bullion, as well as deposits with the central bank.

Flat-rate reserve is requirements to control the amount of money that a bank is able to extend as credit. Hold
excessive reserve assets, no getting interest, is the cost to bank increases.

Stable liquidity investment and trading portfolios:

These assets represent the bank’s investment and proprietary trading books in securities, foreign currencies,
equalities and commodities. In many developing countries, banks have been or are obligated to purchase
government bonds or other designated claims usually to ensure that a minimum amount of high-quality
liquidity is available to meet deposit demands.

Loan and advances to customers are normally the most significant component of a bank’s assets. These
include; loan for general working capital (overdrafts), investment lending, asset-backed installment and
mortgage loans, financing of debtors (account receivable and credit card accounts), and tradable debt such as
acceptances and commercial paper.

Other investment could comprise a bank’s longer-term equity type investment, such as equalities and
recapitalization/non trading bonds held in the bank’s long-term investment portfolio, this includes equity
investments in subsidiaries, associates, and other listed and unlisted entities.

Fixed assets represent the bank’s infrastructure resource and typically include the bank’s premises, other
fixed property, computer equipment, vehicles, furniture, and fixtures.

Other assets often include intangible assets.

Chapter 7 7.2 – Credit Portfolio Management

Lending policy should contain: Outline of the scope, allocation of a bank’s credit facilities and the manner in
which a credit portfolio is managed; a) how loans are originated, b) appraised, c) supervised, d) collected.

A good lending policy: It is not overly restrictive, but allows for the presentation of loans to the board that
officers believe are worthy of consideration but which do not fall within the parameters of written guidelines.
Flexibility must exist to allow for fast reaction and early adaptation to changing conditions in bank’s earning
assets mix and market environment.

Sound lending policies:

Limit on total outstanding loans: A limit on the total loan portfolio is usually expressed relative to
deposits, capital, or total assets. In setting such a limit, factors such as credit demand, the volatility of
deposits, and credit risks should be considered.

Geographic limits are usually a dilemma: If a bank lacks understanding of its diverse markets does
not have quality management, geographic diversification may become a reason for bad loan problems. On the
other hand, the imposition of strict geographical limits can also create problems, particularly in the case of
regions with narrow economies. In that case, a bank’s business market should be clearly delineated and
commensurate with its market knowledge and managerial and staff experience. Bank officers should be fully
aware of specific geographical limitations for lending purposes.

Credit concentrations: A lending policy should stimulate portfolio diversification and strike a balance
between maximum yield and minimum risk. Concentration limits usually refer to the maximum permitted
exposure to a single client, connected group and/or sector of economic activity such as agriculture, steel or
textiles. This is especially important for small regionally originated or specialized banks. A lending policy
should also require that all concentrations be reviewed and reported on a frequent basis.

Distribution by category: Limitations bases on aggregate percentages of total loans in commercial,

real estate, consumer, or other credit categories are common.

Type of Loans

Maturities

Loan pricing

Lending authority

Appraisal process

Maximum ratio of loan amount to the market value of pledged securities

Financial statement disclosure

Impairment

Collections

Financial information