See discussions, stats, and author profiles for this publication at: https://www.researchgate.

net/publication/345239531

Risk Management in Banking Sector

Chapter · October 2020

CITATIONS READS

2 9,477

1 author:

Veclal Gündüz
Bahçeşehir Cyprus University
18 PUBLICATIONS   10 CITATIONS   

SEE PROFILE

All content following this page was uploaded by Veclal Gündüz on 28 May 2021.

The user has requested enhancement of the downloaded file.

 __________________________________________ Management & Strategy

CHAPTER 7

RISK MANAGEMENT IN BANKING SECTOR

Assoc. Prof. Dr. Veclal GÜNDÜZ

Bahçeşehir Cyprus University
Banking and Finance
ORCID: 0000-0002-6002-582X
veclal.gunduz@baucyprus.edu.tr

INTRODUCTION
The healthy growth of a country’s economy depends on the healthy growth
of that country’s banking sector. One of the most important factors for a healthy
banking sector is effective surveillance and supervision. The main purpose of
surveillance and supervision is to ensure that banks retain sufficient capital
against the risks they bear and to ensure that they operate in an environment
where reliable conditions are created. Effective surveillance and supervision in
banking plays a critical role in ensuring stability in the financial system of every
country. It provides the benefits in free market conditions and in the implemen-
tation of effective macroeconomic policies.
Risk Management is an important aspect of the Bank’s policies. Risk is the
possibility of a decrease in economic benefit in the event of a monetary loss or
an expense or loss related to a transaction or activity of a bank.
In order to monitor and control the risks the banks are exposed to establish
and operate an adequate and effective internal audit, internal control and risk
management system that is compatible with their activities and structure in
accordance with changing conditions, covering all branches and departments,
and reporting to the board of directors within the framework of the principles
set for them.
121
Management & Strategy __________________________________________

To create a risk management culture and control perspective in line with le-
gal requirements in the Bank and its subsidiaries subject to consolidation, and
to ensure that the risks incurred within the scope of established procedures and
principles; to define, measure, analyze, systematically and effectively monitor,
audit and report functions and regularly review them to create a risk management
cycle.

1. RISK TYPES
Risk is another factor that must be taken into consideration while calculating
the performance of a bank. The main question is how to calculate the amount
of the risk and which factors will involve into the model (Gunduz and Gonenc,
2019). Memmel et al. (2014) divided the risks into two main sections, systematic
(common) and idiosyncratic (purely borrower-specific) factors. The key risks in
banking can be summarized as:

Figure 1: Typology of bank risks

Source: compiled by the author

Some of the risks definitions in a bank are given more detailed below.
Specific risk:
The probability of loss that may arise from the positions related to financial
instruments within the trading accounts of the Bank due to problems that may

122
 __________________________________________ Management & Strategy

arise from the management and financial structures of the institutions that issue
or guarantee the financial instruments that make up these positions.
Credit risk:
The probability of loss that the bank may be exposed to due to the bank
customer failing to fulfill its obligations partially or completely on time by not
complying with the credit contract requirements.
The concentration of the credit portfolio can change the ability of hedging
the credit risk according to the companies. The deterioration of the financial
statement of the big companies will increase the amount of NPL’s of the bank
(Gunduz, 2018).
Country Risk:
In international credit transactions, the possibility of failure to fulfill the ob-
ligation partially or completely on time due to the economic, social and political
structure of the country in which the person or organization operates.
Transfer Risk:
The possibility of non-repayment of the foreign currency debt with the same
type or another convertible currency due to the economic situation and legisla-
tion of the country where the person or institution is located.
General market risk:
The probability of loss in the value of positions related to financial instru-
ments included in the trading accounts of the Bank due to interest rate risk and
stock position risk.
Market risk:
The risk that market conditions will change, affecting the liquidity of the
bank and the value of its trading and accrual portfolios and its investments, re-
sulting in a loss for the bank.
Liquidity risk:
As a result of the imbalance in the cash flow of the bank, the risk of failing to
fulfill its payment obligations on time because it does not have sufficient cash or
cash inflows to meet its cash outflows fully and on time.
Certainly, the painful experiences and lessons throughout the financial crisis
have highlighted the dimensions and severity of consequences from liquidity
123
Management & Strategy __________________________________________

problems. (Pricewaterhousecoopers, 2009, Balance sheet management bench-

mark survey)
Liquidity Risk Regarding the Market:
The possibility of loss that may arise if the bank fails to enter the market
properly, cannot close its positions at an appropriate price, sufficient amounts
and quickly due to the shallow market structure in some products and the barriers
and divisions in the markets.
Liquidity Risk Regarding Funding:
Potential failure to fulfill the funding obligation at reasonable cost due to
irregularities in cash inflows and outflows and maturity-related cash flow mis-
matches.
Commodity risk:
The probability of loss that the Bank may suffer due to movements in com-
modity prices depending on the position of the commodity and commodity-based
derivative financial instruments.
Swap risk:
In transactions that involve the delivery of a security, foreign currency or
commodity at the price stipulated in the contract and require the fulfillment of
the obligations of both parties on the maturity date, the transaction is subject
to the transaction, the probability of loss that the bank will suffer due to price
changes in the security, currency or commodity.
Stock position risk:
The probability of loss due to movements in stock prices depending on the
stock position in the trading accounts of the Bank.
Currency risk:
The probability of loss that banks may suffer as a result of changes in ex-
change rates due to all their foreign currency assets and liabilities.
Interest Rate Risk:
The probability of loss that the bank may be exposed to depending on the
position of the bank due to movements in interest rates.
The acceptance and management of financial risk is inherent to the business

124
 __________________________________________ Management & Strategy

of banking and banks’ roles as financial intermediaries. To meet the demands of

their customers and communities and to execute business strategies, banks make
loans, purchase securities, and take deposits with different maturities and interest
rates. These activities may leave a bank’s earnings and capital exposed to move-
ments in interest rates. This exposure is interest rate risk (OCC Bulletin, 2020).
Operational risk:
The possibility of damages that may arise from overlooked errors and irregu-
larities as a result of disruptions in internal controls, failure to act in accordance
with time and conditions by the bank management and personnel, errors in the
bank management, errors and failures in information technology systems and
disasters such as earthquakes, fires and floods or terrorist attacks.
Insufficient Information Risk Regarding Legislation:
The likelihood of lower than expected rights and higher than expected as a
result of transactions made by the Bank based on insufficient or incorrect legal
information and documents.
Reputation Risk:
The loss that may arise due to the loss of trust in the bank or damage to its
reputation as a result of failure in its operations or failure to comply with current
legal regulations.
Risk of Non-Compliance:
Loss that may occur as a result of failure to comply with the provisions of the
legislation and legal obligations expresses.
Senver (2020) emphasized the complex of banking risks because of;
Deregulation of financial services,

More supervision and audit,

Globalisation of financial services,

Growing sophistication of financial products, services and technologies,

Highly automated technologies,

Growth of internet banking and mobile banking,

Large scale acquisition and mergers and consolidations in banking,


125
Management & Strategy __________________________________________

Banks acting as large volume service providers,


Banks operating 24 hours/365 days,

Growing use of outsourcing by banks,

Growing use of outsourcing by banks,

Growing derivative products and markets,

Volatile economies and country risks.


2. RISK MANAGEMENT STRATEGY

Bank’s general risk strategy, within the scope of materiality criteria. Risk;
● capital allocation,
● portfolio / investment preference,
● performance evaluation and
● in new product / activity decisions
It is among the priority issues that should be evaluated.

Risk management activities in a bank consist of;

Figure 2: Process of risk management

Source: compiled by the author

126
 __________________________________________ Management & Strategy

2.1. General Risk Management Policy

The basics of the bank’s risk management policy are:
1- To carry out daily activities within the scope of functional separation of du-
ties (deciding to perform a transaction that causes risk, accounting of the transac-
tion and assigning the functions of control of the transaction to the responsibility
of different personnel)
2- To adopt portfolio approach in Risk Management; systematically analyze
and compare observed information and events within correlation and probabil-
ities,
3- To establish a strong control and risk management culture within the bank,
execution of trading transactions units responsible for recording the resulting
transactions units. The third dimension is the control function. It is the effective
monitoring and management of all risks that the bank may be exposed to by
evaluating the risks.
4- “Being aware” of the risks undertake during the activities, taking “mea-
sures” to prevent the realization of risks, allocating “provisions” if necessary,
“hedging” the risk within the framework of the Bank’s policies if market condi-
tions are appropriate, and “making a profit” during all these activities.
5- Avoiding concentration through portfolio diversification.
6- It will not affect the service quality negatively but maximize process reli-
ability
to support daily activities with checkpoints to keep them at controlled level.

2.2. Basel Accord

The “Basel Accord” on capital adequacy measurement of 1988 is con-
sidered as the major success of the Basel Committee and has received an
unexpected degree of acceptance. Its main goal was to strengthen the consis-
tency and stability of the international banking system and to calculate the
minimum capital levels for banks operating in the international arena (Basel,
1988).
Basel Committee on Banking Supervision, Bank for International Settlements
(2017) reported briefly the changes in 2017 for Basel III.

127
Management & Strategy __________________________________________

Figure 3: Main features of Basel III

Source: https://www.bis.org/bcbs/publ/d424_inbrief.pdf

The main purpose of the Basel III is to improve the quality of risk manage-
ment in the banking business, which in turn should enhance financial system
stability as a whole (Chornous & Ursulenko, 2013).

DISCUSSION
Risks on a Bank’s Balance Sheet
A bank’s balance sheet lists the bank’s assets, liabilities and shareholder eq-
uity. Each of those items is subject to risk, especially during a so-called liquidity
crisis – roughly speaking, a situation in which banks lack the cash to meet their
short-term obligations (Orduna & Schwaab, 2019).
We can analyze the risks on a balance sheet of a bank with details on Table 1.

128
 __________________________________________ Management & Strategy

Table 1. Risks on Balance Sheet Items of a Bank

ASSETS
Local Currency Period Risk Type Total Risk
Liquid Assets - Liquidity Risk Liquidity Risk
Short term Income Risk
Loans
Long term Price Risk
Credit Risk
Securities Short term Income Risk
Long term Price Risk

FX
Short term Income Risk
Loans FX Rate Risk
Long term Price Risk
Securities Short term Income Risk Credit Risk
Long term Price Risk

LIABILITIES & EQUITY

Local Currency Period Risk Type Total Risk
Demand deposit Liquidity Risk
Deposits Short term Income Risk
Long term Price Risk Liquidity Risk
Short term Income Risk
Other Liabilities
Long term Price Risk

FX
Demand deposit Liquidity Risk
Deposits Short term Income Risk FX Rate Risk
Long term Price Risk
Short term Income Risk Liquidity Risk
Other Liabilities
Long term Price Risk

Capital adequacy risk, Credit Risk,

Equity -
Liquidity Risk, Interest Risk, FX Rate Risk

Off-balance sheet Credit Risk,

Items -
Liquidity Risk, Interest Risk, FX Rate Risk

Source: compiled by the author

129
Management & Strategy __________________________________________

HOW TO CALCULATE THE RISKS

There are some methods used to evaluate the risk of a bank like GAP Anal-
ysis, Value at Risk (VaR), Risk Adjusted Rate of Return on Capital (RAROC),
credit metrics, interest rate risk measuring, revaluation, maturity model and du-
ration model.
GAP Analysis is an interest rate risk management tool based on the balance
sheet which focuses on the potential variability of net-interest income over spe-
cific time intervals (Kanchu & Kumar, 2013).
The Value at Risk (VaR) indicates how much a firm can lose or make with a
certain probability in a given time horizon.
Risk Adjusted Rate of Return on Capital (RAROC) analysis shows how much
economic capital different products and businesses need and determines the total
return on capital of a firm.
Duration is value and time weighted measure of maturity of all cash flows and
represents the average time needed to recover the invested funds.
The modern technology combines the latest advances of artificial intelli-
gence, numerical mathematics, statistics, heuristic approaches. It allows offering
new promising approaches to risks estimations (Chornous & Ursulenko, 2013).
The banks can select the best calculation method according to the data and its
portfolio diversification. The main difficulties for using the new approaches are
the lack of historical data, credit policy and the credit portfolio in details.

Comparison of Balance Sheet Items for Risks

The timing for both sides of the balance sheet is important for the liquidity
risk; if the duration of total assets is greater than the total liabilities and equity
side, there will be a liquidity risk for the bank. If we formulize it;
Total Assets > Total Liabilities & Equity Liquidity Risk ↑
Total Assets < Total Liabilities & Equity Liquidity Risk —
Total Assets = Total Liabilities & Equity Liquidity Risk —

If the timing for both sides of the balance sheet is different, in other words

130
 __________________________________________ Management & Strategy

shorter or longer, there will be interest rate risks. There is a negative gapping for
a bank if the total assets duration is greater than the total liabilities and equity
side. The opposite situation will cause a positive gapping. Interest risk is the
most important financial risk for banks.
For FX rate risk the bank has to pay attention for its FX position. If the FX
assets are more than the FX liabilities, the long position will appear, and the
profit of the bank will increase parallel to the FX rate increase. The vice versa
will cause the bank fall in short position, which can cause a loss with the increase
of FX rate.

Risk Calculations with Ratios

The ratios can be used to calculate the risks in a bank. The leverage ratio
measures the risk of non-capital funding of overall balance sheets. This ratio is
based on the definition in Basel II for total regulatory capital.

The formula is;

Leverage ratio = Total assets/(Total shareholders’ equity + subordinated debt)

The capital ratio is related with the risk of bank assets. The Tier 1 capital ratio
as a percentage (%) is;

Tier 1 capital ratio = 100 x Adjusted net Tier 1 capital/Total risk-weighted

assets

Both the leverage ratio and the capital ratio focus on whether the bank has
sufficient capital to support its assets. Funding liquidity and asset liquidity are
also important determinants of the ongoing viability of a bank (Chen et al., 2012)

The third ratio is an asset-liquidity ratio;

Asset-liquidity ratio (%) = 100 x (Cash and cash equivalents + public securi-
ties + secured short-term loans)/Total assets.

The higher the asset-liquidity ratio, the more an institution is able to with-
stand adverse shocks that increase the need to liquidate assets.

The last ratio is funding ratio as the proportion of a bank’s total assets that are
131
Management & Strategy __________________________________________

funded by wholesale funding. It is;

Funding ratio (%) = 100 x (Non-personal deposits + repos)/Total assets.

Capital Adequacy as an Example From Turkey Banks

One of the most complex problems in the banking sector is determining the
optimal level of capital. Although a bank operating with excessive capital does
not pose a problem for the supervision authority it poses a serious problem for
the investors (Yaylalı & Şafaklı, 2015).
The capital adequacy ratio calculation is done by the Banks Association of
Turkey for 2019 year-end. It is prepared in the “Financial Position” section of the
Communique-Financial statements and related explanation and footnotes of the
banks that is disclosed to the public.
Total risk weighted items are:
Amount subject to credit risk + Amount Subject to Market Risk + Amount
subject to operational risk
The ratio is calculated as follows;
Capital Adequacy Ratio = (Shareholders’ Equity / (Total Risk Weighted
Items)*100)

132
 __________________________________________ Management & Strategy

Table 2: Capital Adequacy Ratios of Turkey Banks Between 2015-2019

Capital Adequacy Ratios, %

  2019 2018 2017 2016 2015
Banking System in Turkey 18,4 17,4 16,8 15,5 15,6
Deposit Banks 18,0 16,9 16,4 15,1 15,0
State-owned Banks 16,1 15,1 15,0 14,0 14,6
Türkiye Cumhuriyeti Ziraat Bankası A.Ş. 17,0 14,8 15,2 14,5 15,1
Türkiye Halk Bankası A.Ş. 14,3 13,8 14,2 13,1 13,8
Türkiye Vakıflar Bankası T.A.O. 16,6 17,0 15,5 14,2 14,5
           
Privately-owned Banks 18,5 16,9 16,1 14,5 14,6
Adabank A.Ş. 197,5 204,8 207,8 206,8 211,3
Akbank T.A.Ş. 21,0 18,2 17,0 14,3 14,6
Anadolubank A.Ş. 16,9 18,6 14,2 13,8 14,5
Fibabanka A.Ş. 19,5 19,5 16,1 13,5 13,6
Şekerbank T.A.Ş. 13,4 15,1 15,4 13,1 13,7
Turkish Bank A.Ş. 20,2 18,7 14,8 16,7 19,9
Türk Ekonomi Bankası A.Ş. 16,9 16,9 16,1 14,4 13,9
Türkiye İş Bankası A.Ş. 17,9 16,5 16,7 15,2 15,6
Yapı ve Kredi Bankası A.Ş. 17,8 16,1 14,5 14,2 13,8
Banks Under Depo. Insurance Fund 81,2 104,6 70,7 64,3 61,0
Birleşik Fon Bankası A.Ş. 81,2 104,6 70,7 64,3 61,0
Foreign Banks 19,5 19,0 18,5 16,9 15,7
Foreign Bank Founded in Turkey 19,3 18,9 18,3 16,7 15,4
Alternatifbank A.Ş. 17,8 17,2 18,1 18,3 15,5
Arap Türk Bankası A.Ş. 21,5 18,0 18,2 18,8 18,6
Bank of China Turkey A.Ş. 63,3 190,7 - - -
Burgan Bank A.Ş. 21,3 20,7 19,6 17,7 16,0
Citibank A.Ş. 28,5 22,7 19,2 18,2 17,6
Denizbank A.Ş. 17,7 19,5 19,5 17,5 16,1
Deutsche Bank A.Ş. 38,4 31,5 21,5 21,6 20,7
HSBC Bank A.Ş. 20,4 20,0 17,6 20,4 15,7
ICBC Turkey Bank A.Ş. 18,6 30,8 14,4 19,8 12,8
ING Bank A.Ş. 26,8 21,7 19,9 17,7 15,8
MUFG Bank Turkey A.Ş. 19,8 14,0 14,0 12,9 14,1
Odea Bank A.Ş. 21,7 21,4 20,3 15,0 12,2
QNB Finansbank A.Ş. 15,7 15,4 15,0 14,5 15,4
Rabobank A.Ş. 70,9 51,0 56,1 69,8 227,9

133
Management & Strategy __________________________________________

Turkland Bank A.Ş. 15,5 13,1 14,1 16,0 15,6

Türkiye Garanti Bankası A.Ş. 19,6 18,3 18,7 16,2 15,0
Foreign Banks Having Branches
in Turkey 32,2 41,4 33,9 31,0 38,5
Bank Mellat 90,9 105,5 62,8 80,2 95,6
Habib Bank Limited 42,8 37,4 40,2 46,0 52,2
Intesa Sanpaolo S.p.A. 22,1 28,6 23,8 15,1 20,5
JPMorgan Chase Bank N.A. 118,8 129,3 107,1 112,5 120,4
Société Générale (SA) 40,2 38,9 32,5 21,2 23,3
           
Development and Investment Banks 25,4 24,2 23,6 23,5 28,3
State-owned Banks 28,8 28,1 27,3 27,3 34,9
İller Bankası A.Ş. 46,0 46,1 47,8 49,6 57,2
Türk Eximbank 19,1 18,7 13,6 13,4 18,9
Türkiye Kalkınma Bankası A.Ş. 22,3 14,2 16,7 13,4 17,8
           
Privately-owned Banks 18,0 16,2 16,2 15,3 16,3
Aktif Yatırım Bankası A.Ş. 14,8 12,9 13,4 12,7 13,6
Diler Yatırım Bankası A.Ş. 52,9 53,4 52,8 51,9 51,2
GSD Yatırım Bankası A.Ş. 15,4 16,9 15,1 15,3 16,5
İstanbul Takas ve Saklama Bankası A.Ş. 23,5 19,5 15,2 22,8 26,3
Nurol Yatırım Bankası A.Ş. 15,5 15,2 18,0 17,3 21,7
Türkiye Sınai Kalkınma Bankası A.Ş. 17,8 16,2 17,0 14,3 14,9
           
Foreign Banks 44,7 45,9 38,3 30,3 31,0
BankPozitif Kredi ve Kalkınma Bankası
A.Ş. 33,9 32,1 26,2 17,9 17,1
Merrill Lynch Yatırım Bank A.Ş. 92,2 91,9 102,2 80,0 63,6
Pasha Yatırım Bankası A.Ş. 32,0 37,8 31,4 53,8 91,7
Standard Chartered Yatırım Bankası Türk
A.Ş. 105,3 104,4 104,1 108,2 129,6

Source: https://www.tbb.org.tr/en/banks-and-banking-sector-information/statisti-
cal-reports/20

134
 __________________________________________ Management & Strategy

PEFERENCES
Basel Committee on Banking Supervision, BIS (2017), Finalising Basel III in brief,
https://www.bis.org/bcbs/publ/d424_inbrief.pdf

Chen D. X., Damar H. E., Soubra H. and Terajima Y. (2012), An Analysis of Indicators of Bal-
ance-Sheet Risks at Canadian Financial Institutions, Bank of Canada Review, https://
www.bankofcanada.ca/wp-content/uploads/2012/08/review-summer12-chen.pdf

Chornous G. & Ursulenko G., (2013), Risk Management In Banks: New Approaches To
Risk Assessment And Information Support, ISSN 1392-1258. Ekonomika Vol. 92(1),
https://pdfs.semanticscholar.org/9c43/12f792b9ccf5da86e49f7b4bf2ee846a0c39.pdf

https://www.bis.org/press/p200327.htm

https://www.bseducation.net/bs-courses/

https://www.tbb.org.tr/en/banks-and-banking-sector-information/statistical-reports/20

Gunduz V., Gonenc H. (2019), Credit Portfolio Diversification and Bank Performances
During the Recent Crisis Period, 4th International Conference on Banking and
Finance Perspectives

Gündüz V. (2018) Due Diligence for Bank M&A’s: Case from Turkey, Emerging Trends
in Banking and Finance, Springer

Kanchu T., Kumar M.M., Risk Management In Banking Sector -An Empirical Study
(2013) International Journal of Marketing, Financial Services & Management
Research ISSN 2277- 3622 Vol.2, No. 2

Office of the Comptroller of the Currency (US Treasury, 2020), https://www.occ.gov/

topics/supervision-and-examination/capital-markets/balance-sheet-management/
interest-rate-risk/index-interest-rate-risk.html

Orduna D. C., Schwaab  B. (2019), Unconventional monetary policy operations: The

upside for central bank balance sheet risks,  https://voxeu.org/article/upside-un-
conventional-monetary-policy-central-bank-balance-sheet-risks

Pricewaterhousecoopers, (2009) Balance sheet management benchmark survey, https://

www.pwc.com/gx/en/banking-capital-markets/assets/balance-sheet-manage-
ment-benchmark-survey.pdf

Yaylalı P., Şafaklı O. V. (2015) Risk Management in the Banking Sector: Case of TRNC,
International Journal of Academic Research in Economics and Management Sci-
ences, Vol. 4, No. 2, ISSN: 2226-3624

Zupanovic I. (2014) Sustainable Risk Management in the Banking Sector, Journal of

Central Banking Theory and Practice, Vol.3 No.1, pp. 81-100
135

View publication stats