Analysis of Risk Management in Banking Activity

The Case of Mauritian Banks

Financial deregulation, globalization and liberalization have heightened considerable banking risks. Moreover, banks necessitate effective risk management strategies to promote banking welfare, protect outside agencies transacting with banks and to ensure stable banking operations. Risk managers need to focus on the diversity of risks and secure the interests of the overall banking sector. Risk Management is nowadays segregated where there is “inconsistency in reporting, insufficient evaluation and low quality of management” and becomes ineffective due to lack of pertinent information and improper analysis of the risk factors (Prabir Sen, 2009).

Nonetheless, banks are unable to keep equilibrium in the situations of risks with huge losses and slight possibility of occurrence and risks of minimal losses with propensity of occurrence.  According to Talmimi and Hussein, Mazroezi and Mohammed (2007), risk management enables profits maximization and entails restrictions in risky activities. Risks can be averted by ordinary banking procedures, can be shifted to other institutions and can be managed “actively in banks” (Oldfield and Santemero, 1997).

1.1 Objectives of the Study

The core objectives of the study are:

• To probe into the methodologies and aspects of the risk identification, assessment, monitoring, management and mitigation in Mauritian banks.
• To ascertain the effects of risk management on Mauritian banks.
• To determine to which extent risk management strategies like Basel II, derivatives, stress testing and Asset and Liability Management are applicable in Mauritian banks.
• To analyze the factors which improve Risk Management Practices in Mauritian banks and the perspectives about Banking Risk Management.
• To explore the reasons for managing risks in Mauritian banks.

1.2 Statement of the Problem

There is an increasing awareness that the gradual intensification of banking risks impacts adversely on banking transactions which raises the concerns for risk management. The basis concern of this study is whether the Mauritian banks are using diverse risk management tactics and whether they are able to cope with the present and prospective challenges of risks and risk management requirements.

1.3 Significance and Contribution of the Study

Bank managers can be conversant with divergent risk management techniques, their implications, effects and their relevance in banks through the practical aspects of risk management application. Bank managers can analyze the mechanisms resulting in the increasing level of risk exposures. Business administrators and management practitioners can use this study as guide to design efficient measures to mitigate risks in the process of developing marketing tactics.

1.4 Structure of the Project

• Chapter 2 elaborates on the literature review related to the risk management.
• Chapter 3 uncovers the general overview of Mauritian Banking Sector.
• Chapter 4 focuses on the detailed research methodology that has been used.
• Chapter 5 discusses the analysis and interpretation of the Mauritian banking risk management information.
• Chapter 6 probes on the recommendations to improve Risk Management practices in Mauritian banks.
• Chapter 7 concludes the whole findings of the project.

PART 1- THEORETICAL ASPECTS

2.1 Introduction

The advent of technology, globalization and the competition has encouraged banks in risk taking activities exposing banks to risks. Regulatory and supervisory institutions have emphasized the need for banks to enhance their risk management practices. Risks arise from the probabilities of the occurrence of losses and usually emerge from the internal and external banking transactions.

2.2 Banking Failures determinants

The past decades have encountered numerous bank turbulences where high costs have been incurred on both local and overseas level (Gaytán and Johnson 2002, p.1), hindering the credit facilities, minimizing investment and consumption and generating bankruptcy cases (Demirguc-Kunt and Detragiache, 1998a, p.81). According to them, the expensive monetary policy was used to force the sound banks to sustain the failures of insolvent banks which dissuade risk management.

Fluctuations in interest rates post abolition of Brettons Woods System, higher banking competition, the non existence of “intermediation margins”, unskillful lending and investment tactics (Hellwig 1995, p.724-726 ) , the diminishing role of the “oligopoly rents” as stated by Gehrig (1995 cited Hellwig 1995, p.726 ), the lower level of capital reserves in banks, companies’ high reliance on banks for external finance mentioned by Rajan and Zingales (1998 cited Randall S. Kroszner 2007),systemic shocks caused by credit risks, the inability to diversify loans, “trade deterioration and decrease in asset prices caused bank failures” argued by Gorton (1988 cited Demirguc-Kunt and Detragiache1998b, p.85). Moreover, regime changes like “financial repression, liberalization and severe macroeconomic conditions” encourage the entry of “inexperienced players” and preference for the acquisition of useless loans stated by Honohan (1997 cited Gaytan and Johnson 2002, p.4) have generated banking turbulences.  Non-performing loans increase where the asset returns are less than the returns to be paid on liabilities. Banks borrow in international currency and lend in local currency where the latter depreciates if the foreign exchange currency risk is shifted to local borrowers if they loaned in foreign currency. Banks buy insurance protection which encourages risk taking activities in the absence of prudential supervision and regulation. Bank managers engage in fraudulent actions by taking a portion of money for their personal use (Demirguc-Kunt and Detragiache 1998c, p.85-87). Diamond and Dybrig (1983 cited Demirguc and Detragiache 1988d, p.86) argued that bank’s portfolio assets can worsen and depositors believe that other depositors are removing their money. Obstfeld and Rogoff (1995 cited Demirguc and Detragiache 1988e, p.87) mentioned that an anticipated devaluation could occasion bank runs in local banks and these deposits are shifted overseas and render the domestic banks without liquidity.

2.3 Banking risks

alsamakis et al (1996 cited Young 2001, p.57) argued that risks can be classified as pure risks and speculative risks. Pure risks which embody market risks, credit risks, interest rate risks, liquidity risks, country risk and settlement risk are associated with the probability of occurrence of loss or no loss and can be curtailed by risk management strategies. However, speculative risks comprising of operational risks, technology risk, reputational risk, compliance risk, legal risk and insurance risks involve an opportunity for gain or loss which can be hedged.

2.3.1 Credit Risks

These major risks occur in banks when the borrower defaults on his obligation to reimburse the principal amount and the interest charged of the loan. Credit risks consist of three types of risks like (Arunkumar and Kotreshwar 2005, p.9):

Transaction risk emerges from the fluctuations in the credit type and capital depending on how ‘the bank underwrites individual loan transactions’.

Intrinsic Risk is risk prevailing in some institutions and on granting credit to some firms.

Concentration risk is the average of transaction and intrinsic risk within the portfolio and encourages granting of loans to one borrower or one firm.

2.3.2 Interest rate risks

Koch (1995 cited Beets and Styger 2001, p.9) defined interest rate risk as the future changes “in a bank’s net interest income and market value of equity due to changes in the market interest rates”. Kropas (1998 cited Martirosianien) enumerated three types of interest rate risks like:

Reappraisal risk stems from the diverse periods of assets and liabilities

Profitableness curve risk entailselements affecting the ‘reappraisal risk’.

Basic point risk concernsflawed association between the ‘receivable and payable interest rate’.

Option risk is where the benefits of options can adversely affect the bank’s equity.

2.3.3 Liquidity risks

Liquidity risks occur when the banks are unable to meet the demands of the depositors because of lack of funds and the illiquid assets resulting eventually in bank insolvency. Credit, strategic, interest rate and reputation risks build up liquidity risks (Gaulia and Maserinskieno 2006, p.49). 2 types of liquidity risks are (ADB Report 2008, p.9):

Funding liquidity risk is the potentiality to obtain money via the sale of bank property and by borrowing.

Trading Liquidity risk arises from making a constant entry in market activities and dealings.

2.3.4 Market risks

These risks arise when the value of the financial products changes negatively and consist of “currency risk, interest rate risk, equity or debt security price risk” (Gaulia and Maserinskieno 2006, p.49).

2.3.5 Operational Risks

Basel Committee (2004) which imposes a capital charge defined operational risks as “the risk of direct or indirect losses resulting from inadequate or failed internal processes, people, and systems, or from external events”. “This definition includes legal risk, but excludes strategic and reputational risk”.

2.3.6 Reputational Risks

These risks emerge when the number of clients decreases as they hold negative perspectives about the quality of services offered by the banks.

2.3.7 Strategic risks

Strategic risks arise when bad decisions and projects are undertaken to develop a special system in banks due to the lack of resources, technological tools and the expert staff.

2.3.8 Foreign Exchange Risks

These risks come when the prices of the currency fluctuate when engaging in foreign activities. There are 3 types of foreign exchange currency risks. (Deloitte Treasury and Capital Markets 2006)

Transaction risk entails the future of original cash flows like imports and exports.

Translation risk is concerned with the disparities between foreign exchange encountered when again transforming “a foreign exchange value into the functional currency of the company concerned”. Translation risks are usually converted into transaction risks “on a late basis as earnings are repatriated or assets and liabilities are realized”.

Economic risk arises when indirectly exposed to buying and selling of goods from someone who buys goods overseas.

2.3.9 Systemic risks

The bank cannot collect money from an organization it is dealing owing to the political, economic and social conditions prevailing in the country where the organization is situated. “Country risk includes political, economic risk and transfer risk” (National Bank of Serbia).

2.3.10 Legal Risks

Legal Risks are losses incurred when the bank is sanctioned by a court for the non-compliance with the lawful rules and regulations and on not fulfilling its obligations towards the other parties (National Bank of Serbia).

2.3.11 Financial Fraud

There is mismanagement of money and fraudulent actions from the members of the banks who embezzle some deposited money and when there is lack of security controls.

2.4 Bank risk management methods

Greenspan (2004 cited in Lam 2007, p.3) said that

It would be a mistake to conclude…..that the only way to succeed in banking is through ever-greater size and diversity. Indeed, better risk management may be the only truly necessary element of success in banking.

2.4.1 Risk Management in Banking Sector

Flaker (2006, p.4-8) proposes three methods:

2.4.1.1 Risk Identification

The board must set the risk profile of the bank and identify the risk-return tradeoff. The bank should understand and identify types of risks exposures, their sources and their effects on the overall banking stability.

2.4.1.2 Risk management and reduction

Risk management and minimization embody the following:

(1) Allow loans after considering their financial status of the borrowers.

(2) Comparison of the expected risks with the actual ones to diminish the “loan losses” in a bigger portfolio.

(3) Loan losses will decrease due to diverse borrowers in the lending transactions.

(4) Actual risks can be compensated through the opposite movement of other risks in particular financial activities.

(5) Insurance negotiations can be used to protect against diverse risks.

2.4.1.3 Risk Management System

This flexible system encompasses the combined structure of identification, evaluation and risk mitigation techniques. The Board must set up a strong risk culture and an effective governance structure where the risk management system aligns with the existing structure of the bank. Risk management procedures are possible when retaining higher level of capital to cushion the risks.

Furthermore, the risk management functions comprises of:

(1) Delegation of responsibilities to each banking segment

(2) Auditing system to deal with the “internal control” processes and proper execution of “risk controls” (Nikolis, 2009).

(3) Ongoing reviews, reporting, updating and the control of risk management system must be executed to ensure that they tailor with the banking aims

(4) Training courses gaining know-how about the design of the risk management system and “risk models” must be offered to avert banking failures.

(5) Establish rules and regulations and take necessary actions to those who contravene with them regarding risk management practices.

(6) Participation of the banks, regulatory and supervisory bodies where information is disseminated externally and internally in the banks (Kroszner, 2007).

2.4.2 Asset and Liability Management

Asset and Liability Management entails the design of “organizational and governance models” which define the risk approaches subject to the banking operations (ADB 2008, p.10).

2.4.2.1 ALM operations are as follows (ADB 2008, p.10-12):

1. ALM ensures a “risk and return management process” where the combination of expertise and risk appetite is needed.
2. ALM unit manages bank risks either through a passive or aggressive approach thus increasing its value.
3. ALM unit investigates upon the “static and dynamic mismatch; sensitivity of net interest income; and, market value under multiple scenarios -including under high stress.”
4. The net interest income evaluates the sophisticated bank’s operating results. It does not project the effects of risk compared to the economic value which can identify banking risks but is inaccessible to most banks.

5. Funds Transfer Pricing eradicates the interest rate risks by securing a spread in loan and deposits by allocating a “transfer rate” that mirror the repricing and cash flows of the balance sheet. Liquidity risks can be managed like diversification of financing sources, correlate the liquidity risks with other risks and use stress testing analysis.

2.4.3 Stress testing Practices

Stress testing is another risk management strategy where “Stress testing is a generic term used to describe various techniques and procedures employed by financial institutions to estimate their potential vulnerability to exceptional but plausible event” (Kalfaoglou 2007, p.1). It uses statistical data analysis to risk management techniques, interpret and control the unfavorable outcomes.

JP Morgan Chase has integrated stress testing equipment to manage and analyze the sources of possible banking risks, implement tests on the value of its portfolio, analyze its risk profile and contemplate the effects while applying diverse scenarios. An effective risk management scheme, stress testing project and bank staff expertise are requisite to tackle the statistical and economical fundamentals of stress testing with a data measurement tool. Board of directors should monitor the inputs of stress testing system (Seminar on Stress Testing Best Practices & Risk Management Implications for Egyptian Banks 2007, p.2-3). Furthermore, the 2 types of stress testing strategies in banks like:

(1) Simple Sensitivity Test deals with the rapid fluctuations of the portfolio value due to a “risk factor” on a short term basis.

(2) Scenario analysis is used by large complex banks and is associated with a realistic and econometrics approach towards shifts in portfolio value due to changes in many risk factors.

2.4.4 Basel II

Basel II published in June 2004, promotes banking supervision and emphasizes the specified capital requirements to cushion against potential losses. Basel II uses qualitative and quantitative requirements to monitor risk management strategies, to ensure compliance with regulations and reinforce corporate governance structure. The risk based supervision has enabled the supervisors to concentrate on the origins of banking risks.

2.4.4.1 Pillars of Basel II

Pillar 1 entails capital needed for credit risk, market risk and operational risk. Moreover, banks under this regime must have a capital adequacy of 8 %.

The methods for the computation of the capital charge to measure operational and credit risks (Ma, 2003)are:

Basic Indicator Approach– The size and capital requirements of the operational risk are estimated as “a fixed proportion of the bank’s net interest income and non-interest income, measured as the average over the last three years”.

The Standardized Approach –The activities of the banks are allocated risk ratios weights related proportionally to the quantity distributed to every category. The aggregate capital requirements are the addition of all the requirements for the categories.

Advanced Measurement Approach– Computation of credit and market risks and the capital requirements are founded on the “bank’s internal system for the measurement and management of operational risk” for large banks

An Internal Rating Based System – The BIS stated that capital requirements must be founded on a “qualitative and quantitative” analysis of credit risk and must be used for diverse bank units. Founded IRB approach indicates that large banks should calculate probability default related to a borrower’s grade to demonstrate the capital requirement level. However, under advanced IRB approach, these banks with an “internal capital allocation” can furnish the loss given default and exposure at defaults which are processed.

Pillar 2– A supervisor must ensure that the bank has the adequate capital requirements to deal with risks. Banks estimate the internal capital adequacy by adopting quantitative and qualitative techniques. On-site investigation and ongoing reviews probe in capital adequacy.

Pillar 3- Market discipline framework provides with detailed information about the bank’s risk profile to evaluate and report capital adequacy where risk exposures can be analyzed through quantitative and qualitative approach regularly. The “risk based capital ratios” and qualitative information about the internal procedures are needed for capital adequacy purposes.

2.4.5 Derivatives

olatility of financial market, “the liberalization and deregulation in the 1980’s and 1970’s” has founded derivative markets (Hehn no date a, p.100). Derivatives are financial tools (like futures, commodities futures, options, swaps, forwards) whose returns, values and performance are derived from the returns, values and performance of the underlying assets. Hedging is covering against potential risk through an opposite position in the derivative markets. Bank International Settlements (2004 cited Bernadette A. Minton et al 2008, p.2) noticed that the quantity for derivatives has leveled from $698 billion in 2001 to $ 57,894 billion in 2007.

Proper derivatives trading can insure against market risks and interest rate risks without retaining additional capital requirements in the balance sheet (Kaudman no date a, p.85). The determinants of derivatives use are banking size, balance sheet constituents, aggregate risk exposures, profitability, performance and risk taking incentives. Jason and Taylor (1994 cited in Hundman b, p.86) argued that speculation used with derivatives to make profitable returns can engenders more interest rate risks.

Moreover, Tsetsekos and Varangis (1997 cited Roopnarine and Watson 2005a, p.9) argued that financial derivatives promote “increase in resource allocation” and increase the productivity of investments projects. Jorion (1995 cited Roopnarine and Watson 2005b, p.9) argued that in price discovery, market participants are offered information on balance prices that mirror the present demand on the supplies which enable effective decision making and reveal the position of the “cash prices”. Besides, liquid funds are increased and transaction costs are reduced and the futures market reflects the large transactions at prevailing prices (Roopnarine and Watson 2005c, p.10). 

However, derivatives have generated enormous failures in “Barings Collapse, Merill Lynch and Procter Gambler” (Hehn b, p.101). Bank staff must be trained and educated about derivatives use. Derivatives trading can be constrained with the liquidity problems and legal uncertainties that emerged from the market price movement which is argued by Bhaumik (1998 cited Roopnarine and Watson 2005d, p.11). Pricing of assets becomes difficult if there is insufficient information about the derivatives use. Principal agent problem is aggravated (Roopnarine and Watson 2005e, p.12). The derivatives market must be regulated properly to avert fraudulent actions and insolvency. Partnoy and Skeel (2006 cited Minton et al. 2008a, p.2) claimed that derivatives intensify systemic risks as banks do not control the lending activities. Hunter and Marshall (1999 cited Roopnarine and Watson 2005f, p.28) argued that derivative markets attract investors whose private information are assimilated in the observable prices and diminish the bid ask spread. The underlying cash prices reduce the transaction costs and the demand for money thereby affecting the operations of the monetary policy.

Bedendo and Bruno (2009a, p.2-4) argued that credit transfer tools like securitization, credit derivatives and loan sales reduce “regulatory capital requirements”, motivate lending and enhance the banking liquidity positions. Moreover, they remedy the issues of information asymmetries as stated by Greenbaum and Thakor (1987 cited in Bedendo and Bruno 2009b, p.2). Duffee and Zhou (2001 cited Minton et al. 2008b, p.11) mentioned that credit derivatives are used if the loan sales or securitization techniques become expensive due to moral hazard problem and can shift default risk where “information advantage” is insignificant and retain some portion of risks where “information advantage” is huge. Banks use credit transfer tools as they have little access to “inter-bank funding”, huge funding expenses, low capital and want “loan transfer” (Bedendo and Bruno 2009c, p.8-9). CRT tools encourage banks to use “originate-to-distribute models” via aggressive lending occasions (Bedendo and Bruno 2009d, p.10). Pricing of CRT tools is preferred by large banks having higher skills. Some loans sales have loan characteristics like small size, asymmetric issues and standardization convenient for securitization (Bedendo and Bruno 2009e, p.11).

PART 2- EMPIRICAL REVIEW

There is a growing literature that examines the relationship of banking risks with other many economic and financial variables. Moreover, this section describes the diversity of banking literature where different types of risk management strategies were tested and criticized. Even the links between different types of risks were experimented using banking information and models derived from other authors’ empirical work.

Peek and Rosengren (1996) found that the large users of derivatives for speculation purposes are the “troubled” organizations using derivative information of 25 active banks in the United States from 1990 to 1994 in the US dummy regression model.  Banks are unable to track the risky aspects of these derivatives and guide their risk profile because of insufficient derivative information which could jeopardize the overall banking system. The “onsite targeted examinations” can enable banks to “window dress” their derivatives. Regulatory rules and formal transactions must be imposed on the banks taking unfavorable speculation and to constrain the “moral hazard problem” related to the derivative transactions. The use of speculative derivatives constitutes a stringent criminal penalty for breaching the established rules and regulations.

Cebenoyan and Strahan (2001) used data of the sale and purchase of bank loans and “those loans sold or purchased without recourse” from all domestic commercial banks in the US from 1987 to 1993 in a regression model. They found that banks that engage in loan sales market to manage credit risks retained minimum level of capital which can be modified. Moreover, these banks retained more risky loans since they managed credit risks and were exposed to an unsafe position despite they endured lower level of risks compared to the other banks who manage risks without the loan sales market. Banks that employed the risk management techniques are more inclined to engage in risk taking activities. In fact, banks that manage credit risks lend to more risky loans depicting that complex risk management practices enhanced the bank credit position rather than minimizing the risks.

Gatev et al (2006) investigated upon the presence of liquidity risk from both sides of bank balance sheets using some aspects of the Kashyap, Rajan and Stein (2002) model (“that liquidity risks originating from the two fundamental businesses of banking promotes a diversification benefit”) to analyze the link between deposit taking and commitment lending for large, publicly traded banks using regression analysis. “Pooling deposits and commitment lending” insure against banking liquidity risks and deposits activities insure against liquidity risk from idle loan activities. “Bank stock-return volatility” increases with idle loan transactions which is insignificant for banks with huge amount of depository dealings. The “deposit-lending risk management” becomes more reinforced when there is low level of liquidity and when troubled market participants deposit money in banks.

Shao and Yeager (2007) used information of large publicly traded U.S BHCs from 1997 to 2005 using regression models to find the link between credit derivatives and their risk, return and lending issues. Banks buy credit derivatives to hedge against risks, to increase their equity and to compensate for the risky loan losses. However, they sell credit derivatives exposing themselves to risks to gain a premium charge. Moreover, the credit derivatives users enjoyed minimal returns and increase risks which are compensated. Their findings implied that on a general basis, the impact of credit derivatives on risk relies on the risk management strategies.

Holod and Kitsul (2008) used panel data of stock returns from 53 U.S BHCs from 1986 to 2007. They found that after 1996, poor capitalized banks engaged in active trading transactions are more exposed to systemic risks compared to well capitalized banks. Banks cannot always have enough capital to cushion the market risks and must sell their illiquid assets or invest in the financial markets to compensate for the lack of capital to adhere to the “market-based capital requirements”. Capital requirements in Basel II do not help to reduce banking risks totally but contribute towards increasing systematic risks.

Topi (2008) used a model of “Allen and Gale (2004) where banks offer deposit contracts to ex ante identical, risk averse depositors who face heterogenous liquidity shocks” for Bank of Finland which shows that the liquidity can impact on the bank’s motivations to minimize the default losses. The bank runs encourage the banks to avert the credit losses after the sub-prime mortgage crisis. However, the bank runs without a signal of the credit risks will reduce the banks willingness to curb the incidence of credit losses. The central bank can mitigate the propensity of liquidity stress for solvent banks rather than insolvent banks. In addition, this research provides an area for further research where the “policy interventions and financial market innovations” can be integrated in the model to identify the impact on bank’s motivations.

Achou and Tenguh (2008) used regression model for Qatar Central Bank by executing a time-series analysis of financial data from 2001-2005 to examine the correlation between profitability and loan losses. They showed that effective credit risk management improves the financial result of the bank with the aim to secure the banking property and to work in the welfare of the market participants. Besides, their study revealed that credit risk management infrastructures are used to minimize the credit losses. Banks with efficient credit risk management system have insignificant “loan default ratios”, good revenues, minimal non-performing loans and are able to tackle credit losses.

Minton et al. (2008) investigated the use of credit derivatives using U.S BHCs (assets overtakes $ 1 billion) and “non-missing data on credit derivatives use from 1999 to 2005”. Few companies use credit derivatives for dealer activities rather than for hedging against default losses. Credit derivatives use is constrained because the liquidity of credit derivatives market is favorable for “investment grade” companies since they can use derivatives to insure against the default losses. Therefore, the illiquidity of credit derivatives market affects the “non-investment grade” companies as they need confidential information for loans where higher cost of hedging will dissuade banks to hedge. Nevertheless, the bank borrowers get loans at a cheap price and banks are more on a competitive stance with the capital markets to provide loan facilities if the credit derivatives can help bank to retain capital. Credit derivatives can only promote the financial health of banks if they generate lesser banking risks. The sub-prime crisis prior to 2007 has shown that the dealer activities via the credit derivatives contain many risks and in 2008 generated systemic risks. This study provides an avenue to assess the risks posed by credit derivatives when engaging in dealer’s transactions dealers.

Bedendo and Bruno (2009) differentiated between the application of loan sales, securitization and credit derivatives for a sample of US large domestic commercial banks (total assets greater than one billion USD) for June 2002-2008  They found that the most CRT users employ conservative tools and large international banking corporations utilize credit derivatives. They detected that highly capitalized banks with “less risky portfolios” purchase credit derivative protection to hedge against capital inadequacy.  Moreover, banks with “riskier loan portfoli