SUMMARY ON CHAPTER 2:

MANAGEMENENT OF RISKS IN BANKING

Outline:
A. Definition D. Approaches
B. Process types
definition E. Conclusion.
stages
C. Categories
sources
The possibility that the outcome of an action/event could
bring about adverse impacts on the institutions’ capital
and/or earnings.
This may be
i. direct loss of capital/earnings
ii. Indirect loss via imposition of constraints on the
banks ability to meet its business objective
Risk is indispensable in the banking business, hence risk
management system is an integral part of the banks’
business.
T. Koch & S MacDonald in their book titled “ Banking
Management” state that the banks objective is to maximize
shareholder wealth. And that the only way to do this is
through:
1.Lowering operational costs

2.Take an increased risk

It is thus evident that profitability varies with the riskiness

of the banks portfolio and operations.
DEFINITION:
The process of identifying, monitoring, and managing
potential risks in order to minimize the negative impact
they may have on an organization.

 The overall capacity adequacy is assessed in relation to

the banks’ risk profile.
 The process should match the size & complexity of the
bank.
i) Risk identification
Almost every product/service offered by the bank has a
unique risk profile composed of multiple risks at both
the portfolio and transactional level. These need to be
identified on a continuous basis.
E.g. credit risk, interest rate risk, liquidity risk,
operational risk
ii) Risk measurement
The significance of the risk needs to measured
accurately and timely in terms of the size, duration and
probability of adverse occurrence
iii. Risk controlling
Attempts to eliminate/minimize the risks’ adverse
consequences by:
1. Pre-emptive - Placing limits on certain
activities/risks through policies, standards &
procedures that define responsibilities &
authority
2. Mitigate – the overall approach to reduce the risk
impact in severity and /or probability of
occurrence
3. Offsetting - by balancing out the negative effect
so that the result is still positive. This is done by
balancing the expected rewards against risks and
expenses
4. Risk monitoring –develop a monitoring system
that identifies changes in the risk profiles of
significant products, services and activities.
These depend on the size, complexity of business activity
& volume.
Current & prospective impact on capital/earnings may arise
from various sources
SOURCES:
1)strategic risk - (organization planning)
adverse business decisions, improper
implementation of decisions or lack of responsiveness to
industrial changes.
These may impact on the achievement if the banks’
vision & strategic objectives
2) Credit risk – (loan)
Obligator unable to meet the terms of any contract with
the bank.
This is associated with the quality of the individuals
assets.
Risk inherent as it is extremely difficult to asses
individual asset quality due to the limited public
information available
Sources of credit risks:
 loans (largest source)

 Banking books

 Trading books

 On & off balance sheet

3) Liquidity risk – (cash)
banks’ inability to meet its obligations as they fall due,

The consequences of liquidity stress are:

•Financial distress

•Insolvency

•Confidence crisis
4) Market risk – (external)
value of on & off balance sheet positions are adversely
affected by movements in the market rates or prices
resulting in loss of earning & capital.
This may be through:
 interest rate

 currency risk

 Credit spreads

 Equity prices

 Commodity prices
Exposure to market risk may be through:
a) Portfolio securities/equities

b) Interest rate of mismatched loans & deposits

c) Off balance sheet activities

Sources of market risks:

a) Interest rate risk – caused from adverse movements in
the interest rating
b) Price risk – may experience loss due to unfavorable
movement in market prices
c) Currency risk – arising from revaluating foreign
exchange positions on both on & off balance sheet items
5) ICT risk – (technological)
Inherent risks in ICT systems need to be identified,
measured, monitored & controlled

Purpose:
a) for data integrity, availability, confidence &
consistency.
b) Provide early warning mechanisms
5) Operational risk – (processes)
loss resulting from inadequacy/failure of internal
processes, people, systems or external events.
7) Reputational risk – (image)
the potential that negative publicity ( true/false)
regarding the banks business practices will cause a
decline in customer base, costly litigation and/or
reduction in revenue.
This is essentially caused by failure to manage all other
types of risks.
8) Compliance risk – (regulations)
Risks arising form:
a) violation or non compliance of laws, regulations,
agreements, prescribed practices & ethical standards.
b) Incorrect interpretation of laws & regulations

Banks are constantly exposed to this as they deal with

many stakeholders. E.g. regulators, customers, counter
parties, tax authorities, local authorities
The consequences of non compliance include:
regulatory - fines, penalties, damages, violation of
contracts,
Image – harm to reputation

Business - reduced franchise value, limited business

opportunities, reduced expansion potential, inability to
enforce contracts.
9) Country risk –(geo-political)
risk that political, socio &/or economic events &
conditions in a foreign country will adversely affect the
banks’ financial condition
E.g.
 Strategic – nationalization ( transfer of assets from
private to national)
 operational –currency controls, devaluation, regulatory
changes, instability
 Credit risk – rate of defaulters, government cancelation
of external indebtness
 Market – expropriation of assists, sudden change on
exchange control policies, currency depreciation
10) Transfer risk – (forex)
risk that a borrower may not be able to secure foreign
exchange to service his external obligations.
This may be caused by a country suffering from
econ/political/social problems to the point of draining
its foreign currency obligations.
11) Currency risk – (forex)
risk that a borrowers currency holding & cash flow
becomes inadequate to service its’ foreign currency
obligations.
This may be caused by devaluation of the local
currency
 TYPES:
1) Strategic risk mgt
This is the process of identifying, assessing, measuring,
controlling and managing the risk in an institutions
business strategy.
Strategic planning process
2) Credit risk mgt
This is establishing and using current & potential
credit exposure to be reduce in part/whole by the
collateral.
The most common way to mitigate:
 collateral guarantees

 netting off loans against deposits

In Kenya the Credit Reference Bureau is used as a
source for rating the credit worthiness of individuals.
There are currently 3 companies that carry out this
rating.
E.g. Metropol Corporation set up in 1996 as a business
information & credit management company.
Its’ sources of data are: banks, micro finance
institutions, saccos, utility companies, mobile
companies, Helb, etc
3) Liquidity risk mgt
This involves establishing how the funding requirement
could be met by identifying funding markets .
i. Definition:
the analysis of both on & off balance sheet
positions to forecast cash flows
ii. Process
By identifying, monitoring & controlling liquid risk
iii. Mitigations
a) minimum liquid ratio
This is the minimum holding liquid asset as set by the
regulator
b) loan to deposit ratio
The extent to which a bank is funding its liquid assets by
stable liabilities
c) Liquidity coverage ratio
promotes resilience to potential liquidity
disruptions over a 30 day period so as to handle
acute short term stress
d) net stable funding ration
aims to limit the over reliance on short term
wholesale funding during robust market liquidity.
e) GAP analysis
cash flow projections by estimating net deficit
and surplus over time
f) Value at risk
calculates the maximum loss expected on an
investment over a given period of time, in a
specific degree of confidence.
g) back testing
testing a mathematical model by entering
known/estimate inputs into the model to see how
well the input matches the known results
h) stress test
an analysis/stimulation designed to determine the
ability of a financial institution/instrument to deal
with an economic crisis
i) market to market
This involves the accounting for the fair value of
an asset/liability based on a current market price.
4) Asset liability mgt
the mechanism to address risk faced by a bank due to
mismatch between assets & liabilities.
The focus here is on:
5) Innovation and risk mgt
These 2 management approaches are complimentary
Balancing innovation & risk
 Flexibility – building a portfolio of early
innovation investments that acts as option, then
present a risk scenario. This entails designing
risks tools that measure both positive & negative
uncertainties
 Speed – successful innovations require speed.
Risk management allows for risk taking speedy
reaction within limits
 Control – increasing risk tolerance & fostering a
culture that embraces the logic of intelligent
mistakes, the back bone of innovation. By
creating an environment for experiments where
risks are controlled managed and measured
6)Organization structure and risk mgt
The board should ensure the organization structure
facilitates effective decision making & good
governance. This is achieved by clearly defining
and enforcing lines of responsibility &
accountability
Capital adequacy
Here the Risk is managed by measuring the banks’ capital.
Capital adequacy ratio is expressed as a % of the banks’
risk weighted credit exposure
CAR tier 1 capital tier 2 capital
risked weighted assets
This is used to
 protect the depositors

 promote bank stability

 promote bank efficiency

Types of capital ratio:
a) Tier 1 capital
 This is the core capital

 Definition: grading of a banks’ capital adequacy

 A rank is then given to the bank as being one of

the following: well capitalized, under capitalized,
significantly capitalized or critically capitalized
E.g in Kenya banks Tier 1 banks are required to have
a minimum of Ksh 1billion core capital
Measure of a banks financial strength based on:
 Sum of equity capital

 Disclosed reserves

 Retained earnings

 50%unaudited after tax profit

 Investment in equity instruments of other banks

 Tangible assets less computer software and good

will
b) Tier 2 capital
 This is the supplementary capital
 This is less reliable than Tier 1

 Should always be less than Tier 1

This includes:
 revaluation reserves

 undisclosed reserves

 hybrid instruments

 subordinate tem debt

In Kenya, Banks are required by the Central bank of Kenya
to maintain minimum capital requirements:
Core capital to total risk weighted assets (tier1) = 10.5%

Core capital to total deposits = 10.5%

Total capital to risk weighted assets (tier2) = 14.5%

Banks operate in a RISK PRONE industry.
 This is because for them to trade, the calculations are
based on assumptions that can shift at anytime.
 Hence managers need reliable risk measures to direct
capital to activities with the best risk/reward ratio
 The greater the risk, the higher the returns

 Yet the risks taken need to be prudent, calculated and

containable
 The Central Bank of Kenya requires every bank to have
a Risk Department