Financial Risk Management in Mauritius Banking Sector

During the past 10 years, there have been great changes in the Mauritian banking sector and this is a continuing process that will not stop here. This is mostly because of fast innovations in the financial markets and the internationalization of the financial flows. Other factors like technological development and deregulation have both triggered competitive pressures and also provided new opportunities among banks. But these opportunities are also subject to complex risks that challenge traditional approaches to banking risk management. These factors have influenced the financial world on the international level and the Mauritian banking sector has not been left unaffected.

The growth of international financial markets banks have been exposed to a wider access to funds. As a result of which banks have been developing new products, services and techniques. The receipt of deposits and granting of loans, being the traditional banking practice, is today only one part of a bank’s activities.

These new instruments have also drawn interest to areas where financial risks were earlier thought to be relatively unimportant. Hence banks are now exposed to a greater variety of risks and their ability to measure, monitor and steer risks accordingly is becoming a decisive parameter for their survival.

The aim of this project is to provide an overview of the management process of financial risks in our Mauritian banking sector as risk is the fundamental element that influences the financial behavior.

Banking Risks

Banks are faced with a wide array of risks in their course of their operations, as illustrated in the figure below. In general, risks are categorised into three different parts: Financial Risks, Operational Risks and Business Risks.

Figure 1: Categories of Banking Risks

Banking Risks

Financial RisksOperational Risks Business Risks

• Interest Rate Risk 1) Business Strategy Risk1) Legal Risk.
• Foreign Exchange Risk 2) Internal System and Operational Risk 2) Policy Risk.
• Credit Risk 3) Technology Risk 3) Systemic
• Liquidity Risk 4) Management and Fraud (Country) Risk.

Source: Annual Report on Banking Supervision 2000 – BOM

Financial risk concerns the effective management and control of the finances of an organisation and the effects of external factors such as availability of credit, foreign exchange rates, interest rate movement and liquidity risk. For this project only the financial side of Risk Management is going to be considered. Focus will be on the four main types of risks which are:

• Interest rate Risk is the risk borne by an interest-bearing asset, for example in this case a loan, due to variation in interest rates.
• Foreign Exchange Risk is a form of risk that crop up due to the change in price of one currency against another.
• Credit Risk is the risk of loss due to a debtor’s non-payment of a loan.
• Liquidity risk is the risk to earnings arising from a bank’s inability to meet its obligations when they come due.

Operational risks are related to a banks overall organisation and functioning of internal systems, including computer-related and other technologies, conformity with bank policies and procedures and measures against mismanagement and fraud. Although these types of risks are important, emphasis will not be put on them in this project.

Business risks are associated with a bank’s business environment, including the macroeconomic and policy concerns, legal and regulatory factors and the overall financial sector infrastructure and payment system.

Outline of Chapters

Chapter 2:Literature Review

This chapter will focus on previous studies and surveys carried out with respect to financial risks encountered by banking institutions around the world. It will also focus on the different techniques used to manage these types of risks.

Chapter 3:Overview of the Mauritian Banking Sector

This chapter aims at giving an overview of the current Mauritian banking sector and also information pertaining to risk management.

Chapter 4:Research Methodology

In this chapter an outline of the methods used to collect data and carry out the research is given. The way in which the interview questions have been set and how the data has been analysed using different techniques.

Chapter 5: Presentation of findings and Analysis

This chapter which is the main one aims at presenting and explaining the answers received from the different interviews and data from the annual reports of banks, in a structured way.

Chapter 6: Recommendations and Conclusion

This last chapter consists of the suggestions regarding financial risk management for the Mauritian banking sector and also the answer to the main question.

2. LITERATURE REVIEW

2.1 Defining Financial Risks

Financial risks in the banking field are the probability that the result of an action or event could bring up unfavorable impacts. Such outcomes could either cause direct loss of earnings or capital or may result in limitations on bank’s capacity to meet its business objectives. Such constraints pose a risk as these could influence a bank’s capacity to perform its ongoing business or to take advantage of opportunities to advance its business

Risks are frequently defined by the negative impacts on profitability of numerous separate sources of uncertainty. While the types and degree of risks of an organization may be exposed to depend upon a number of factors such as its size, complexity business activities, volume etc, it is believed that generally the banks face Credit, Market, Liquidity, Operational, Legal and Systemic risks etc.

2.2 Definition of Financial Risks as Per Basel II

The role of risk management in banking has changed from the simple insurance of identified risks, to a discipline that concentrates on complex econometric and financial model of uncertainty. Financial risk management has been defined by the Basel Committee (2001) as a sequence of four processes: the identification of events into more or broad categories of market, credit, operational and ‘other’ risks and specific sub-categories; the assessment of risks using data and a risk model; the monitoring and reporting of the risk assessments on a timely basis; and the control of these risks by senior management.

The first Basel Accord (1988) analysed only credit risks in the banking book; the Basel Amendment (1996) extended this to market risks in the trading book; and now the new Basel 2 Accord that will be adopted by all G10 – and many other – countries in 2007 refines credit risk assessments to become more sensitive and extends the calculation of risk capital to include operational risks.

2.3 Distinction between Risk Management and Risk Measurement?

Risk measurement is a key part of the general risk management process, but it’s certainly just one of the parts. Other, similarly key parts include defining risks, setting policy risk limits and guidelines, and taking action when those limits are threatened of being breached. Risk management is as much about people, procedures, and communication, as it is about quantitative methods involved in risk measurement (Suren Markosov, 2001).

Risk measurement, however, is important to the success of the risk management process. Part of the risk measurement task is to guarantee that the risk measures being used are suitable to the nature of the risks, and since these risks can be quite various in nature, so can the necessary choices of risk measures.

2.4 Why do Banks manage Risks?

The analysis of risk management reported in Santomero (1995) gives us a lists of dozens contributions and at least four separate rationales considered 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.

Risk is a fundamental part of the banking business, it is not amazing that banks have been using risk management ever since there have been banks – the industry could never have survived without it. The only modification is the degree of sophistication now necessary to reflect the new complex and fast moving environment (Laurence H Meyer, 2000).

The Asian financial crisis of 1997 has shown us that ignoring necessary risk management can also add to economy-wide difficulties. The long period of extraordinary economic growth and prosperity in Asia had hidden weaknesses in risk management. Many Asian banks did not think about risk or conduct a cash flow analysis before giving way loans, but rather lent on the basis of their relationship with the borrower and the availability of guarantee – despite the fact that the security was often hard to seize in the event of default. The result was that loans – including loans by foreign banks – grew faster than the capacity of the borrowers to repay.

Risk management is clearly not free. In fact it’s expensive in both resources and in institutional disturbance. The cost of delaying or avoiding proper risk management can be extreme: failure of a bank and possibly failure of a banking system (Laurence H Meyer, 2000).

3.4 Determinants of Risks

When banks are exposed to risk, this implies that they are vulnerable to financial distress and failure. Determinants of risk are thus causes of problem bank failure. The common causes of bank failure are:

Management

Argenti (1984) attributed 17% of his A-scores to management style and composition. He attributed another 71% to accounting deficiencies, poor response to change, over-gearing, over trading and large projects; all of which hinge upon capabilities of management. Arguments that he put forward was that management is the primary and single most important cause of financial distress.

Asset quality

Loan and advances comprise a substantial portion (50%-80%) of commercial banks’ total assets and they account for more than 70% of their income. This highlights the bank’s role as financial intermediary. “Asset quality is the most important determinant of bank risk exposure”. This was pointed out by Hefferman (2000), Gonzalex-Hermossilo (1999), and Hardy (1998). The asset quality of a bank is affected by various factors such as, over concentration, insider lending and political loans.

Over-Expansion

Banks that grow quickly tend to have unjustified risks and often find that their administrative and management information system cannot keep up with the rate of expansion. Too much liquidity by way of rapid deposit growth could also be a problem in that management may undertake riskier credit proposals and this will adversely affect the asset quality.

Capitalization

Capital adequacy ratio is a function of adjusted risk assets. A bank can either maintain this ratio by increasing its capital or reducing of adjusted risk assets. The prime objective of this control is to protect depositors. However Blum (1998) found that with the incentives for asset substitution, capital adequacy requirements may actually increase risk. This was found in the case of J.P Morgan and Deutsche Bank. In Mauritius the BOM has adopted a capital adequacy ratio of 10% to match international standards.

Fraud

Fraud is one of the key determinants of risk. However it is closely related with the management competence that some fraudulent activities have passed off as incompetence. The BCI and Barings Bank are good examples.

2.5 HOW ARE RISKS MANAGED?

As pointed out by Anthony M. Santomero (1997) there need to be essential procedures that must be put in place to carry out satisfactory 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? The management of the bank relies on a series of steps to put into operation a risk management system. These can be seen as containing the following four parts:

2.5.1 Standards and reports,

2.5.2 Position limits or rules,

2.5.3 Investment guidelines or strategies,

2.5.4 Incentive contracts and compensation.

In general, these tools are used to measure 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 (Oldfield and Santomero, 1995). To see how each of these four parts of basic risk management techniques achieves these ends, we elaborate on each part of the process below.

2.5.1 Standards and Reports

The first of these risk management techniques involves two unlike conceptual activities, i.e., standard setting and financial reporting (Santomero and Babbel, 1996). They are listed jointly because they are the sine qua non of any risk system. Underwriting standards, risk categorizations, and standards of review are all traditional tools of risk management and control. Consistent evaluation and rating of exposures of various types are essential to understand the risks in the portfolio, and the degree to which these risks must be mitigated or absorbed (Hodgson, 1999).

The consistency of financial reporting is the next ingredient. Obviously outside audits, regulatory reports, and rating agency evaluations are necessary for investors to measure asset quality and firm level risk. These reports have long been standardized, for better or worse. However, the need here goes beyond public reports and audited statements to the need for management information on asset quality and risk posture. Such internal reports need similar standardization and much more frequent reporting intervals, with daily or weekly reports substituting for the quarterly GAAP periodicity.

2.5.2 Position Limits and Rules

The use of position limits, and minimum standards for participation can be categorized as a second method for internal control of active management. According to Santomero (1995) risk taking is restricted to only those assets or counterparties that pass some prespecified quality standard. Then, even for those investments that are eligible, limits are compulsory to cover exposures to counterparties, credits, and overall position concentrations relative to various types of risks. While such limits are costly to set up and control, their imposition restricts the risk that can be assumed by any one individual, and therefore by the organization as a whole.

In general, each person who can commit capital will have a well-defined limit. This applies to traders, lenders, and portfolio managers. Summary reports show limits as well as current exposure by business unit on a periodic basis. In big organizations with thousands of positions maintained, precise and well-timed reporting is difficult, but even more necessary (Lopez, 2003).

2.5.3 Investment Guidelines and Strategies

Investment guidelines and recommended positions for the instant future are the third technique commonly in use. Cummins et al (1998) provide that under this means of management control, strategies are shaped in terms of concentrations and commitments to particular areas of the market, the extent of desired asset-liability mismatching or exposure, and the need to hedge against systematic risk of a particular type.

The limits described above show the way to passive risk avoidance and diversification, because managers generally work within position limits and prescribed rules. Beyond this, guidelines offer firm level advice as to the appropriate level of active management, given the state of the market and the willingness of senior management to absorb the risks implied by the combined portfolio. Such guidelines lead to firm level hedging and asset-liability matching. In addition, securitization and even derivative activity are rapidly growing techniques of position management open to participants looking to reduce their exposure to be in line with management’s guidelines.

2.5.4 Incentive Schemes

Banks can enter incentive compatible contracts with line managers and make compensation linked to the risks assumed by these individuals, and then the need for complex and costly controls is decreased. However, such incentive contracts require precise position valuation and proper internal control systems.

Such tools which include position posting, risk analysis, the allocation of costs, and setting of required returns to various parts of the organization are not irrelevant. Despite the complexity, well designed systems align the goals of managers with other stakeholders in a most desirable way. In fact, most financial debacles can be traced to the absence of incentive compatibility, as the cases of the deposit insurance and so clearly illustrate. The association of managerial compensation to book earnings can bring about acquisition of investments with negative convexity, duration mismatch risk, liquidity risk and credit risk, whose book profits are higher than their expected return (Cummins et al., 1998).

• STRATEGIES USED BY BANKS TO MANAGE RISKS
• INTEREST RATE RISK

All banks face interest rate risk. This type of risks occurs when long term mortgages are funded by short term deposits. Interest rate risk is like the “blood pressure for banks and is vital for their survival.”(Ron Feldman and Jason Schmidt)

Furthermore, according to the Basel Committee (2001) “interest rate risk is the exposure of a bank’s financial condition to adverse movements in interest rates. Accepting this risk is a normal part of banking and can be an important source of profitability and shareholder value.”

According to the Bank of Jamaica each banking institution needs to establish explicit and prudent interest rate risk limits, and ensure that the level of interest rate risk exposure does not exceed these limits. Interest rate risk limits need to be set within an institution’s overall risk profile, which reflects factors such as its capital adequacy, liquidity, credit quality, investment risk and foreign exchange risk. Interest rate positions should be managed within an institution’s ability to offset such positions if necessary.

Gap analysis, duration analysis and stimulation models are interest rate risk measurement techniques used by the Bank of Jamaica (2005). Each technique provides a different perspective on interest rate risk, has distinct strengths and weaknesses, and is more effective when used in combination with another.

Gap Analysis

A simple gap analysis measures the difference between the amount of interest-earning assets and interest-bearing liabilities (both on- and off-balance sheet) that reprice in a particular time period.

Duration Analysis

Duration is the time-weighted average maturity of the present value of the cash flows from assets, liabilities and off-balance sheet items. It measures the relative sensitivity of the value of these instruments to changing interest rates (the average term to repricing), and therefore reflects how changes in interest rates will affect the institution’s economic value, that is, the present value of equity. In this context, the maturity of an investment is used to provide an indication of interest rate risk. The longer the term to maturity of an investment, the greater the chance of interest rates movements and, hence, unfavourable price changes.

Simulation Models

Simulation models are an important complement to gap and duration analysis. Simulation models analyse interest rate risk in a dynamic context. They evaluate interest rate risk arising from both current and future business and provide a way to evaluate the effects of strategies to increase earnings or reduce interest rate risk. Simulation models are also useful tools for strategic planning; they allow a banking institution to effectively integrate risk management and control into the planning process.

FOREIGN EXCHANGE RISK

It is the current risk to earnings and capital arising from negative movements in currency exchange rates. It refers to the impact of adverse movement in currency exchange rates on the value of open foreign currency position.

The use of hedging techniques by the Bank of Jamaica is one means of managing and controlling foreign exchange risk. Many different financial instruments can be used for hedging purposes, the most commonly used, being derivative instruments. Examples include forward foreign exchange contracts, foreign currency futures contracts, foreign currency options, and foreign currency swaps.

Generally, few banks will need to use the full range of hedging techniques or instruments. Each bank should consider which ones are necessary for the nature and extent of its foreign exchange activities, the skills and experience of trading staff and management, and the capacity of foreign exchange rate risk reporting and control systems.

CREDIT RISK

Credit risk is the oldest and important risk which banks exposure and important of credit risk and credit risk management are increasing with time because of some reasons like economic crises and stagnation, company bankruptcies, infraction of rules in company accounting and audits (Dr.Adem Anbar, 2006).

For the Norinchukin Bank in Japan (2006), transactions involving credit risk are one of the most important and strategic sources of earnings. In addition to assessments of the risks present in individual loans and other assets, the bank conducts comprehensive risk management from the perspective of its overall credit risk portfolio. In this way, the bank works to generate earnings proportionate with the level of credit risk it takes.

While frequently strengthening its credit analysis capabilities, the bank conducts expert checks on the standing of borrowers, taking due account of their characteristics as cooperatives, private corporations, public entities, or non-residents. To conduct credit analysis on private corporations and public corporations, the bank has established the Credit Risk Management Division, which is separate from the Corporate Business Management & Strategy Division, to prepare credit analyses by industry, drawing fully on the expertise the bank has historically acquired. To achieve greater accuracy in assessments, each senior credit analyst in charge of a certain industry assesses each client and business through comparisons with competitors in the same business, making use of industry research capabilities.

Credit risk is measured for loans, guarantees, foreign exchange and securities, such as corporate bonds, as well as for swaps and other off-balance transactions. Measurement of risk volumes are conducted according to types of transactions partners, including domestic and overseas corporations and financial institutions.

Based on estimates of the total credit extended, the bank uses information related to credit risk— such as rating transition ratios that measure the probability of rating changes and are computed based on background history and future business prospects, default ratios by rating, recovery ratios in the event of default and correlations among the creditworthiness of corporations and other entities to conduct tens of thousands of simulated scenarios, under various assumptions regarding defaults and rating changes for its customers and their products—to determine the distribution of potential losses.

For the estimated potential losses, the bank calculates two risk volumes: the “expected loss” that corresponds to the loss that can be expected on average over the next year and the “probable maximum loss,” which is defined as losses that can be expected under the worst case scenario. This enables the bank to check expected profitability against risk and determine the risk capital to be allocated for each business category.

LIQUIDITY RISK

Liquidity risk is the risk that could occur if an institution does not have enough funds accessible to meet all its cash outflow obligations as they become due. Liquidity risk management ensures that funds will be available at all times to honour the institution’s obligations (Bank of Mauritius).

A liquidity risk management involves not only analyzing banks on and off-balance sheet positions to forecast future cash flows but also how the funding condition would be met (Bank of Pakistan). The latter involves identifying the funding market the bank has access, understanding the nature of those markets, evaluating banks current and future use of the market and monitor signs of confidence erosion.

Banks use a variety of ratios to quantify liquidity. These ratios can also be used to create limits for liquidity management. However, such ratios would be meaningless unless used regularly and interpreted taking into account qualitative factors. Ratios should always be used in conjunction with more qualitative information about borrowing capacity, such as the likelihood of increased requests for early withdrawals, decreases in credit lines, decreases in transaction size, or shortening of term funds available to the bank. To the extent that any asset-liability management decisions are based on financial ratios, a bank’s asset-liability managers understand how a ratio is constructed, the range of alternative information that can be placed in the numerator or denominator, and the scope of conclusions that can be drawn from ratios. Because ratio components as calculated by banks are sometimes inconsistent, ratio-based comparisons of institutions or even comparisons of periods at a single institution can be misleading.

Cash Flow Ratios and Limits.

One of the most serious sources of liquidity risk comes from a bank’s failure to “roll over” a maturing liability. Cash flow ratios and limits attempt to measure and control the volume of liabilities maturing during a specified period of time.

Liability Concentration Ratios and Limits.

Liability concentration ratios and limits help to prevent a bank from relying on too few providers or funding sources. Limits are usually expressed as either a percentage of liquid assets or an absolute amount. Sometimes they are more indirectly expressed as a percentage of deposits, purchased funds, or total liabilities.

Other Balance Sheet Ratios.

Total loans/total deposits, total loans/total equity capital, borrowed funds/total assets etc are examples of common ratios used by financial institutions to monitor current and potential funding levels.

• EMPIRICAL EVIDENCE ON FINANCIAL RISK MANAGEMENT TECHNIQUES USED BY BANKS
• CREDIT RISK MANAGEMENT

Credit operations are traditionally the main source of income as well as risks for banks. I am going to elaborate on the result and analysis of market central bank meeting participants carried out by Ramon Moreno in 2005.

It was found that 40% of the respondents to his survey cited credit to household as an important source of credit risk. According to Moreno, a distinct increase in credit to the household sector has altered risk exposures and he also found that in some countries there is significant credit risks on the banking book associated with asset price fluctuation for example lending for residential real estate accounts for around 25% of total loans in Hong Kong and Korea, around 19% in Hungary, Poland and Israel, but lower in Colombia and Mexico.

Another study carried out by Santomero in 1997 found that banks usually use a credit rating procedure to evaluate investment opportunities in order for credit decisions to be made in a consistent manner and to limit credit risk exposure.

By using such a procedure banks were able to monitor the quality of its loan portfolio at any time. It was found that the credit quality report signals changes in expected loan losses, if the system is meaningful.

Also many banks are starting to develop concentration reports, indicating industry composition of the loan portfolio. Moody had developed a system of 34 industry groups that may be used to report concentrations. Reports such an industry grouping to illustrate the kind of concentration reports that are emerging as stand in the banking industry.

Moreover a credit risk survey study was done in the Turkish Banking by Dr Adem ANBAR, where he found that there is main quantitative credit risk measurer. There are expected loss (EL), unexpected loss (UL) and credit value at risk (CVAR). Although these credit risk measures are used for measuring credit risk of one asset, particularly they are used for measuring portfolio credit risk. Only 35% of the bank used these measures.

According to Dr Anbar, 30% of the banks said they measured credit risk using a portfolio credit risk model and software developed mostly by them.

Furthermore 95% of the bank used internal credit rating system and a credit scoring model in credit risk analysis. This technique was used to determine credit limits, to determine problematic credit and credit risk measurement.

According to the study there are 3 approaches in Basel II for credit measurement. These are Standardised Approach (SA), Foundation Internal Ratings Based Approach (FIRBA), and Advanced Internal Rating Based Approach (AIRBA). It was found that 60% of the banks used the first method and 20% the FIRBA and 20% the AIRBA.

Dr Anbar found that in general the tools which are used by Turkish banks are collateral, credit limits and diversification but they don’t use methods like loan selling, securitization, credit insurance for transferring credit risk. One reason for that was that these types of methods haven’t been developed in Turkish sector yet.

INTEREST RATE RISK MANAGEMENT

The tradition has been for the banking industry to diverge somewhat from other parts of the financial sectors in the treatment of interest rate risk.

According to Santomero (1997) institutions that do not have active trading businesses, value-at-risk has become the standard approach. Many firms use this model but in some cases it is still in an implementation process.

According to his analysis, commercial banks tend not to use market value reports and guidelines but rather, their approach relies on cash flow and bank values. This system has been traditionally been known as the GAP reporting system. This system has been supplemented with a duration analysis. (Hempel, Simonson and Coleman, 1994)

Most banks, however have attempted to move beyond this gap methodology, they have concluded that the gap and duration reports are static and do not fit well with the dynamic nature of the banking market.

Furthermore, according to the survey, many banks are using balance sheet simulation models to find the effect of interest rate variation on reported earnings overtime. This system requires relatively informed repricing schedules as well as estimates of prepayments and cash flows. The simulation system being completed, reports the resultant derivations in earnings associated with the rate scenarios considered. Officials then make use of cash, futures and swaps to reduce this risk.

2.7.3 LIQUIDITY RISK MANAGEMENT

The liquidity risk that does present a real challenge is the need for funding when and if a sudden crisis arises. Standard reports on liquid assets and open lines of credit, which are germane to the first type of liquidity need, are substantially less relevant to the second. Rather, what is required is an analysis of funding demands under a series of "worst case" scenarios. These include the liquidity needs associated with a bank-specific shock, such as a severe loss, and a crisis that is system-wide. In each case, the bank examines the extent to which it can be self-supporting in the event of a crisis, and tries to estimate the speed with which the shock will result in a funding crisis.

Institutions attempt to measure the speed with which assets can be liquidated to respond to the situation using a report that indicates the speed with which the bank can acquire needed liquidity in a crisis. Response strategies considered include the extent to which the bank can accomplish substantial balance sheet shrinkage and estimates are made of the sources of funds that will remain available to the institution in a time of crisis. Results of such simulated crises are usually expressed in days of exposure, or days to funding crisis.

Such studies are, by their nature, imprecise but essential to efficient operation in the event of a substantial change in the financial conditions of the firm. As a result, regulatory authorities have increasingly mandated that a liquidity risk plan be developed by members of the industry. Yet, there is a clear distinction among institutions, as to the value of this type of exercise. Some attempt to develop careful funding plans and estimate their vulnerability to the crisis with considerable precision.

2.8 FINANCIAL RISKS MANAGEMENT IN OTHER SECTORS

THE INSURANCE SECTOR

The financial risks that insurance companies face are different from other institution as the insurance field is concerned with risk element in all its form.

The insurance business represents the trading of risk profiles (Borwick, 2003). Insurance companies do use portfolio approach, i.e. they do not place “all their eggs in the same basket” (Hogarth, 2002). These firms are dependent on the insurance policies that they sell to clients for many various types for many various types of risks.

In the process of providing insurance and other financial services, they are faced with various kinds of actuarial and financial risks (Cummins et al, 1998).The risk that are found in an insurer's product sales, i.e. those already in the products sold to clients to protect against actuarial risk are not all accepted by the insurer itself as stated by Oldfield and Santomero (1995).

“In short, it should accept only those risks that are uniquely a part of the insurer's array of services”, as mentioned by Santomero and Babbel (1996).

The risks associated with the provision of insurance services differ by the types of services offered by the insurance companies. Actuarial risk is the most important risk that an insurance company faces. Actuarial risk is exclusive to the insurance industry.

Actuarial is the risk that emanates from the raising of funds through the issue of insurance policies. According to a study done by KPMG in 2002, it has been found that this risk which is the main risk faced by an insurer means that the insurer has either obtained too little premium for the risks it has agreed to underwrite and has not sufficient funds to invest and pay claims.

Insurers are typically quite skilled in managing actuarial risk according to Santomero and Babbel (1996). Different types of valuation models are adopted to clearly value insurance policies.

The insurer is also faced with systematic risk (Market risks) i.e. interest rate risk, basis risk and inflation risk (Santomero and Babbel, 1996). Insurers try to hedge against these risks to control the sensitivity of their financial performance. And of course like banking institutions, insurance companies are faced with credit risk and liquidity risk.

But the biggest difference is that insurance companies can use reinsurance to alleviate risks. Reinsurance can be defined as the transfer of risks from an insurer to a reinsurer (Hole and Shah, 2004). In general, every insurance company has a limit to the risk it is capable to assume in accordance of an individual policy. So, if the insurance company finds that it has entered into a policy with an expensive proposition for it, it will try to reduce the probability of any possible loss and thus giving up the contract by way of reinsuring a portion of risk with another insurer (Gupta and Gupta 1994).

INVESMENT COMPANIES

Generally, investors must take greater risks to achieve greater returns. Investments companies have almost the same types of financial risk (i.e.) liquidity risk, credit risk, foreign exchange risk and interest rate risk. There are two additional financial risks that an investment company will come across which are:

• Inflation risk is the danger that the dollars one invests will buy less in the future because prices of consumer goods rise. When the rate of inflation rises, investments have less purchasing power. This is especially true with investments that earn fixed rates of return. As long as they are held at constant rates, they are threatened by inflation. Inflation risk is tied to interest rate risk, because interest rates often rise to compensate for inflation.
• Reinvestment risk is the danger that reinvested money will fetch returns lower than those earned before reinvestment. Individuals with dividend-reinvestment plans are a group subject to this risk. Bondholders are another.

3. AN OVERVIEW OF THE BANKING SECTOR IN MAURITIUS

3.1 Introduction

As a result of the globalisation phenomenon the global banking sector is changing and Mauritius, though being a small economy has not been left untouched. Three key factors which are competition, innovation and efficient investment are making the banking sector dynamic and on its way to be successful.

3.2 Bank of Mauritius

The Bank of Mauritius (BOM) was created in September 1967 and is the central bank of the country. The BOM is based on the model of the Bank of England (which was created in 1694) as the country did not have a model of its own. The BOM was created to look after the technical aspects of the country's monetary affairs.

3.2.1 Objectives of the BOM

The BOM was created as the Central Bank of Mauritius under the Bank of Mauritius Act of 15 October 1966. The Bank of Mauritius Act 1966 clearly defined the purposes of the BOM which were to 'safeguard the internal and external value of the currency of Mauritius and its internal convertibility' and to direct its policy towards achieving monetary conditions conducive to strengthening the economic activity and prosperity of Mauritius ' which is still in force today. With the introduction of the Banking Act of Mauritius 2004, nothing much has change in the main objectives of the BOM.

The BOM has been set up as the authority which is responsible for the formulation and implementation of monetary policy reliable with stable price conditions.  It also has duty for preserving the stability and strengthening of the financial system of Mauritius. Its main objectives are:

• Formulation and implementation of monetary policy
• Provide an efficient payment, settlement and clearing system
• To Manage the foreign exchange reserves
• To regulator and be responsible for the supervision of banks

The primary objectives of the Banking Act are to keep a sound banking system in Mauritius and to defend the welfare of depositors. The following principles of prudential regulation and supervision of banks are included:-

• Licensing of Banks
• Capital Adequacy
• Liquidity Control
• Concentration of Risk
• Confidentiality of Information

The Bank of Mauritius is thus required to ensure:

• The promotion of sufficient and reasonable services to the public
• A high standard of conduct and management throughout the banking and credit system
• A sound financial structure, and
• The advancement policies which may be of national interest.

Since the establishment of the BOM, the Mauritian economy and the financial landscape of Mauritius have undergone considerable changes:

• Exchange control was completely abolished in July 1994
• The exchange rate of the Rupee is currently determined by market forces
• Interest rates are freely determined on the market
• Direct control which served its purpose in the old days is no longer an instrument of monetary control

In short the was a move from a system of direct monetary control to an indirect method of monetary control.

3.3 Commercial Banks

D.Begg et al (1984) defines commercial banks as financial intermediaries with a government license to make loans and issue deposits against which cheques can be written. The Bank Act 2004 stipulates that a “bank” means a company incorporated under the Companies Act 2001, or a branch of a company incorporated abroad which is licensed by the Central Bank to carry on banking business. It must be noted that following the enactment of the Banking Act 2004, the banks are now not classified under the Banking Act 2004. Banks are the main financial intermediaries in an economy; they are organisations which are the link between lenders and borrowers, which are better for both parties than if they dealt directly with each other and it is a business which deals with money.

With the enactment of the Banking Act 2004, the difference between Category 1 and Category 2 banks has been eliminated whereby a single license is issued for carrying out banking activities. Rules and regulations which were valid exclusively to past Category 1 banks have been extended to all banks.

New banking licenses were issued on 17 June 2005 to all banks operating in Mauritius. Prior to the coming into effect of the Banking Act 2004, eleven Category 1 banks and twelve Category 2 banks were licensed by the Bank of Mauritius.

At the end of June 2006 the Mauritian banking sector was composed of nineteen banks of which 4 were locally incorporated, 10 were foreign owned banks incorporated locally while 5 were branches of foreign banks. RMB (Mauritius) Ltd stopped all banking operations as from the beginning of June 06, thereby implying that there were 18 active banks at the end of the fiscal year.

During the year 2005-2006, there was the merger of Mascareignes International Bank with Banques des Mascareignes ltee. Furthermore a banking license was granted to HSBC Bank (Mauritius) Limited in the month of June 2006. And most recently Afrasia Bank began its operations in Mauritius.

3.3.1 Performance of Commercial Banks

There was a 17.9% increase of the total assets of banks between June 2005 and June 2006. It rose from Rs. 416,712m to Rs. 491,291m, that is, by Rs. 74,579m. Total deposits were on an increasing trend, it rose by 11.1%, from Rs.310,004m to Rs. 344,441m. Moreover loan and advances rose by 15.1% which was higher from the increase of 04-05 which was only 10.9%. (BOM Report)

The consolidated position of the profit & loss accounts of the 19 banks is based on combined audited data available due to different date closure of their accounts. During the year 05-06 with the exception of one bank, all banks had realised profits.

During the year, the banking sector maintained strong profitable position. The pre tax profits of banks rose by 24.4%. This rise in profits was mostly due to higher revenue from interest revenue and non-interest revenue as well as a lower charge for bad and doubtful debts.

3.5 BASEL II IN MAURITIUS

The Bank of Mauritius (BOM) agrees with the views of the World Bank and does not recommend acting quickly in the implementation of Basel II in Mauritius. However, the benefits of its implementation for the industry are too attractive to put off its application for too long. Over the past years, the Mauritian authority has made considerable progress in its compliance with the Core Principles.

The BOM has it a main concern to implement the more appropriate Core Principles, while taking on board the remaining few in a next round. The time has come to start preparing the industry for a material shift in the framework for capital regulation. Banks in Mauritius, especially those not forming part of large international banking groups, have relatively simple risk management systems and it is felt that unless they are encouraged to beef up their systems, processes, databases, capacities and logistics, there would be little incentive for them to do so. Eventually these banks may lag behind in implementing the new framework and thus let pass the associated opportunities.

It is proposed to use supervisory discretion, as recommended under the new framework, to adapt the Basel II model to the needs of the Mauritian jurisdiction, while keeping open the option for banks to proceed towards implementing the more sophisticated approaches, if they so desire.

The BOM has adopted a consultative and participative approach. The target for Basel II implementation in Mauritius has been cautiously set at year-end 2007. In this connection, a Committee for the Implementation of Basel II (the Committee), consisting of representatives of the Bank, banks and the Mauritius Bankers Association Ltd (MBA) and chaired by the First Deputy Governor, was set up in July 2005 by the Banking Committee. The Committee acts as a steering committee for the implementation of Basel II in Mauritius and assists in devising policy frameworks and proposes solutions to banks in response to the changing regulatory environment under Basel II. It serves as a forum to discuss, address and clarify issues and concerns, and guides banks in building their systems, processes, databases, capacities and logistics. The Committee has established various Working Groups, comprising representatives from the Bank and banks, to work on the different key issues relating to Basel II. There are eight Working Groups working on six different areas: Scope of Application, Credit Risk, Market Risk, Operational Risk, Eligible Capital and Market Discipline.

4. RESEARCH METHODOLOGY

4.1 Research Process

Research is a process that consists of several stages that we must follow in order to carry out and complete your research project and is a guide of how the gathering of data and its analysis took place.

This study comprises of six main steps:

• Formulating and Clarifying research objectives
• Reviewing the Literature
• Choosing a Strategy
• Collecting Data
• Analysing Data
• Presentation of Findings

4.2 Research Objectives

The main objectives of this study are:

• Identification of the financial risks faced by commercial banks
• Analysis of methods used to measure financial risks
• Effectiveness of the management process
• The importance of Basel II and its contribution to the financial risk management field

4.3 Data Collection

Primary data will consist of formal and informal interviews of officers and managers from the risk management department of banking institutions, which are going to be used for the gathering of information. Interviews are particularly useful as the interviewer can pursue in detail information about a topic. Interviews may be useful as follow-up to certain respondents to questionnaires, e.g., to further explore their answers. Formal interview, meaning the use of a questionnaire with predetermined questions and informal interview will compromise of broader questions hence leading to more interesting issues.

Even though primary data was useful, it was not enough, thus the use of secondary data like working papers, past dissertation, annual reports of banks, information gathered from the Registrar of Companies and textbooks.

4.4 Sampling Plan

The sample population is comprised of the selection from population interest. In this case the population will consists of risk officers, risk managers and compliance officers who are well versed in the management of financial risks. So the people chosen for the interviews were from the risk department of their respective banks. Out of the list of banks that operate in Mauritius only 8 of them accepted to answer my questions. They were the State Bank of Mauritius (SBM), the Mauritius Commercial Bank (MCB), the Mauritius Post Commercial Bank (MPCB), the Hong Kong Shanghai Bank Corporation (HSBC), the South East Asian Bank (SEAB), the Barclays Bank PLC, First City Bank and Standard Chartered Bank. The banks were then broken into different categories according to their activities.

The MCB and the SBM has dominated the Mauritian banking sector since a very long time whether it was in terms of market share or product development. These two banks account for more than 65% of the market share and choosing them in the sample in unquestionable.

4.5 Presentation of Findings and Analysis

After data collection, the data was verified for suitability to the topic. Tables and frequency tables were drawn and a small part of the analysis was based on ratio analysis. Microsoft Excel 2007 was used for the representation of the tables. The research findings are presented in the following chapter. The analysis is based on the Mauritian banking sector as a whole.

4.6 Organisation of Questionnaire

PART A:

Question 1 aims at classifying the banks in a specific category.

PART B:

Question 2 aims at finding out if there is a specific department in the bank that deals with risk management.

Question 3 is set to find out the structure of the risk management department.

Question 4 wants to know who are the people engaged in the management of financial risks.

Question 5 is set to determine if the personnel of that department has the necessary skills in dealing with financial risks.

Question 6 looks at the risks that are present in the everyday activities of the bank.

Question 7 aims at finding out which are the techniques listed that are used by managers to measure and manage financial risks.

Question 8 is set to find out the reasons for using such techniques.

Question 9 aims at determining the objectives of the management of the bank to manage financial risks.

Question 10 being a crucial one is set to know the methods that are used to measure the four types of financial risks.

Question 11 has been asked to know the reasons for using such methods.

Question 12 has been set up to determine if the management of risks has been efficient.

Question 13 aims at having proof of whatever answer has been obtained from question 12.

Question 14 seeks to know the effect of financial risk management on the performance of the bank.

Question 15 is to find out if the present management process needs any changes.

Question 16 aims at finding the reasons to why would the present management process require any changes.

PART C:

Question 17 and 18 are set out to find out if Basel II will be a success and why.

Question 19 and 20 aims' are to know if the methods that the bank uses are compliant to Basel II.

Question 21 wants to determine the interviewee views on the future prospects on the banking sector in Mauritius.

5. ANALYSIS

5.1 Questionnaire Analysis (PART A)

5.1.1 Question 1 aims to know the categories of banks which were interviewed for the purpose of the analysis.

Figure 2: Types of Banks

From the figure above we can see that out of the eight banks which were interviewed, 3 out of 8 were only commercial banks and 4 out of 8 were both commercial and offshore. It can be seen that out of the 8 banks, only 1 was an offshore bank.

5.1.2 Question 2 purpose was to find out if there is a specific department in the bank that deals with risk management.

Figure 3: Department for Risk Management 

From both diagram we can see that only one of the banks did not have a specific department and it was a commercial bank. All the other banks did have a department in their banking structure to deal with financial risk management.

5.1.3 Question 3 is set to find out the structure of the risk management department.

The structure was quite the same for the banks which did have a department dealing with financial risk management, where the main committee dealing with those issues was the ALCO Committee. The structures are explained in more detail in part 2 of the analysis in the section on Financial Risk Management.

5.1.4 Question 4 wants to know who are the people engaged in the management of financial risks.

Figure 4: People engaged in financial risk management

As we can see from Figure 4 above, Risk managers were the most exposed to financial risk management in banks. Only in one bank there was 1 risk officer which was responsible for financial risk management.

5.1.5 Question 5 is set to determine if the personnel of that department has the necessary skills in dealing with financial risks.

Figure 5: Level of Skill

Out of the 8 banks interviewed only one of the commercial banks stated that it does not have the necessary skills for the management of financial risks. All other banks did have the necessary trained and skilled personnel to deal with financial risk management.

5.1.6 Question 6 looks at the risks that are present in the everyday activities of the bank.

Figure 6: Financial risks in banks

All banks except one did encounter the 4 main types of financial risks. Only one bank was not involved in the management of Interest Rate risk and foreign exchange risk.

5.1.7 Question 7 aims at finding out which are the techniques listed that are used by managers manage financial risks.

Figure 7: Techniques used to manage financial risks 

We can see that none of the eight banks used incentive contracts to manage any of the risks. And only 7 out of 8 banks used guidelines to manage financial risks.

5.1.8 Question 8 is set to find out the reasons for using such techniques.

All the reasons set out were not enough clear for categorisation. 50 % of the interviewees did not answer the question.

5.1.9 Question 9 aims at determining the objectives of the management of the bank to manage financial risks.

Figure 8: Reasons for the management of financial risks. 

From the figure above we can see that all the eight banks manage financial risks in order to forecast risks and to be more profitable by devising strategies to manage them. 6 out of 8 answered that they did so because of the regulations imposed on them by the BOM. 5 out of 8 managed financial risks because of the introduction of new financial instruments. Finally only 2 banks out of 8 said they did so in order to minimise their reputational risks.

5.1.10 Question 10 being a crucial one is set to know the methods that are used to measure the four types of financial risks.

5.1.10.1 Credit Risk

Figure 9: Techniques to measure credit risk

All banks used the ratings system in order to calculate their exposure to credit risk. Only 5 of them used credit concentration and 2 out of 8 used ratios to measure credit risks.

5.1.10.2 Liquidity Risk Measurement

Figure 10: Techniques to measure Liquidity Risk

All banks used gap analysis in order to measure their liquidity risk. Out of the 8 only 4 supplemented the gap analysis by using liquidity ratios. And only one bank was able to go as far as using a more complicated technique like Liquidity-at-risk.

5.1.10.3 Foreign Exchange Risk Measurement

Figure 11: Techniques to measure Foreign Exchange Risk

Out of the 7 banks which said that they did have exposure to Foreign Exchange risk, 6 used Value-at-Risks to measure the foreign exchange risks and 2 of them used stress testing.

5.1.10.4 Interest Rate Risk Measurement

Figure 12: Techniques to measure Interest Rate Risk

According to Figure 12 all the banks used Gap analysis to measure Interest Rate risk. 5 out of 8 used Value-at-Risk and 2 even used Stress testing. Even if one bank answered that it did not have interest rate risk, it did measure it.

5.1.11 Question 12 has been set up to determine if the management of risks has been efficient.

Figure 13: Efficiency of banks in managing financial risks

Out of the 8 banks only 1 gave a negative answer.

5.1.12 Question 13 aims at having proof of whatever answer has been obtained from Question 12.

Here all the banks refused to give any more details or figures in order to prove the efficiency.

5.1.13 Question 15 and Question 16 are to find out if the present management process needs any changes.

Figure 14: Change in management process

4 out of the 8 banks said that they will need changes in their management process while the other 4 answered that their management process do not need any change.

5.1.15 Question 17 and 18 are set out to find out if Basel II will be a success and why.

Figure 15: Success of Basel II

All the interviewees without any exception believe that Basel II will be a success.

5.1.17 Question 19 and 20 aims' are to know if the methods that the bank uses are compliant to Basel II.

This was an open ended question like many others. The answers given were quite different from each other, this is why it was not possible to categorise them.

Presentation of findings (Part 2)

This second part of this chapter is aimed at explaining the answers obtained from the interviews and data that were extracted from the annual reports of our Mauritian banks. The analysis will be based on the Mauritian Banking Sector as a whole and not on individual banks. The Risk Management Process is divided into different parts. First there are the organizations objectives, that is, the reasons to manage risks. Then there is Risk Analysis which encompasses Risk identification and Risk Measurement. And finally the management of risks also deals with Risk Treatment and strategies to manage risks. All these different parts of the Risk management process will be presented and analysed in the following expose.

5.2 MAIN REASONS FOR THE MANAGEMENT OF FINANCIAL RISKS

The main reasons enumerated for Question 9 by the respondents were as follows:

• Regulations
• Reputational Risk
• Introduction of New Financial Instruments
• Profitability

5.2.1 Regulations

As far as the Mauritian banking sector is concerned, Basel II is a standard of practice and banks cannot choose but need to adopt, should their regulatory body wish to accept Basel II in the banking industry. In fact, the regulator, BOM requires all banks to adopt Basel II to set up a level playing field in the Banking industry management in bank gives highest priority to Basel II, as they are sure the system will be successful in their banks and they can afford to fully implement the framework as far as it is concerned.

5.2.2 Reputational Risk

It is the quantifiable risks as credit and market risks, which will retain the most attention amongst financial institutions but if financial risks, were to be ignored, then this would have a big impact on reputational risks though it is the current and prospective impact on earnings and capital arising from negative public opinion. The best way to manage reputational risk is in fact to proceed to the management of risk like financial risks that may impact on reputation or on the corporate image of the bank.

5.2.3 Introduction of New Financial Instruments

With the introduction of prudential capital requirements, which have in turn led to the introduction of new financial instruments like financial derivatives, such as futures and options have expose the banks to certain financial risks. Some of there instruments are very complicated, while others problem in terms of risk measurements, mgt and control thus the risk profile of banks in Mauritius have change to the use of more sophisticated measures. General concern exists especially with regard to off-balance sheet instruments, as they generally increase the volatility within the banking industry and this is due to financial innovation. This is the case of Foreign Exchange risk and Interest Rate Risk.

5.2.4 Profitability

Profits associated with off-balance sheet instruments and even the traditional banking practices are high in an expanding Mauritian Banking Sector. But due to the volatile financial markets, banks are exposed to new and higher degrees of risks. Thus the management of financial risks becomes very important to safeguard the profitability position of Mauritian banks. Most of the respondents answers for the Question Nine which dealt with the reasons for the banks to engage in the financial risk management included the profitability reason as profitability is typically one of the key indicator of a bank's competitive position in banking market and it also allow a bank to maintain a certain risk profile and protect itself against short term problems.

5.3 RISK IDENTIFICATION

All the respondents to the Question 6 of the questionnaire were unanimous. They were all faced with the four types of financial risks listed in question six, which were Interest Rate Risk, Foreign Exchange Risk, Liquidity Risk and Credit Risk. Risk identification is one of the important steps in the risk management process as it is closely linked with the organizations objectives. These are the four main types of financial risks that Mauritian banks faces. Risk identification has been approached in a methodical way to ensure that all important activities within the organization have been identified and also the risks associated to them.

The respondents also were able to clearly define and descried the four main types of financial risks faced by their respective banks. This was backed by the annual reports of the banks, in the management and discussion analysis section. Description of the main types of financial risks is important as banks have to find out the scope of the risks, loss potential of the banks due those risks and the risks treatment of such types of risks.

It is only after setting these parameters that the banks are able to proceed to the next step which is Risk Estimation, that is, Risk Measurement.

5.4 RISK MEASUREMENT

This section is aimed at giving an overview and explains the answers that the respondents gave to Question 10 and Question 11 which dealt with the techniques applied by banks in Mauritius to measure the four main types of risks which are namely:

• Credit Risk Measurement
• Liquidity Risk Measurement
• Foreign Exchange Risk Measurement
• Interest Rate Risk Measurement

5.4.1 Credit Risk Measurement

Credit is the most important risk that Mauritian banks are faced with as loans to customer forms part of their most important activities. The ability to measure credit risk has the potential to greatly improve the banks' risk management capabilities. With the forecasted credit loss distribution in hand, banks can decide how best to manage the credit risk in a portfolio, such as by setting aside the appropriate loan loss reserves or by selling loans to reduce risk.

The following methods are used by the Mauritian banks in order to measure the oldest risk that exists, i.e. Credit Risk:

5.4.1.1 Ratings system

Most of the banks have been able to implement a ratings system. SBM have even gone a step further by mapping its system to the moody's international ratings scales. Because of a limitation of historical data in Mauritius the Mauritius Credit Information Bureau (MCIB) has been created. The MCIB collects, stores and provides information to lending institution about customers' credit exposures. Details of credit facilities granted are also stored electronically in the information system of the MCIB. It is mandatory for all banks to make the necessary enquiry from the MCIB as from 1 December 2005 before allowing any credit facility to any customer. By law credit information will be kept strictly confidential.

The ratings tools allow the banks to quantify their expected losses and ensure that the risks taken are according to the risk profile of the company. In most of the banks it is the credit committee that takes decision about sanctioning loans but the MCB has been able to decentralize its credit sanctioning process to pass it to the branch levels.

There are other ratings system that banks use for internal ratings of customers and counterparties. As these were confidential information, the respondents refused to give further details or examples of how there ratings system works.

5.4.1.2 Credit concentration

Concentration limits usually refer to the maximum permitted exposure to a single client and sector of economic activity. These limits are used by the Mauritian banks in order to estimate their exposure to Credit risk. The figures in the table below have been calculated for the banking sector as a whole.

Percentage (%)

	Dec 04	Dec 03	Dec 02	Dec 01	Dec 00
Manufacturing	13.6	14.8	16.1	18.2	24.4
Agriculture	7.5	9.1	9.7	8.3	8.6
Traders	14.5	14.9	14.1	14.1	15.8
Personal and Professional	10.0	9.8	9.2	9.5	12.3
Construction	16.2	14.2	13.9	14.2	16.9
Tourism	15.4	15.9	15.0	14.1	8.3
Others	22.8	21.2	21.3	21.6	13.6

Source: Annual report on Banking Supervision 2005

In this table we see the proportion of credit which is allocated to each sector of the economy. Based on these figures the banks are able to calculate their exposure to the sectors and implement limits or loan diversification policies.

5.4.1.3 Ratios

Credit Risk can be evaluated from two perspectives: Customer Perspective and Credit Company Perspective. The first perspective includes the following measurements:

• Debt-Service Coverage Ratio (Net Operating Income divided by Total Debt Service)
• Loan-to-value (the Value of Loan divided by Appraised Value of Property)
• Debt-To-Income Ratio (Customer's debt payments divided by the customer's income)

The Credit Company Perspective is based on the following ratios:

• Capital Adequacy (the actual amount of capital (shareholders equity) divided by the calculated amount of Expected Loss)

5.4.2 Liquidity Risk Measurement

Almost every banking institution in Mauritius has its own methods to quantify liquidity risk that they are exposed to. A number of techniques exist, ranging from basic calculations to highly sophisticated modelling. It is important for banking institutions to adopt a technique that is most proper and to take into consideration the nature, scale and complexity of their activities. It has been found that some of the most common methods currently in use amongst the local banks are:

5.4.2.1 Gap analysis

This is the traditional method of managing liquidity risk and measures the difference or gap between the volume of interest earning assets and interest bearing liabilities repricing over various time periods. This is the first type of measurement that banks apply, and then complement it with the following types of measurement.

Liquidity ratios

They are the basic bank financial ratios, which measure a firm's ability to meet its short-term financial obligations on time. For example, liquid assets to total assets ratio, liquid assets total short-term liabilities ratio or the funding volatility ratio.

5.4.2.3 Liquidity-at-risk

The major banks are developing 'liquidity-at-risk' models, to complement the more familiar value-at-risk techniques. This method is used for determining the values of the cash flows associated with various on and off balance sheet assets and liabilities.

As expected, the gap analysis methodology is the most commonly used technique in the Mauritian banking sector today. Gap analysis is largely scenario driven and the current challenge for banks is to build in all realistic scenarios. Unfortunately, generating realistic scenarios is delayed as a result of constantly changing conditions. Consequently, banks need to pay attention and make certain that the scenarios are adapted accordingly with the current market conditions.

5.4.3 Foreign Exchange Risk Measurement

Most of the respondents to this question were not able to give a clear answer. Most of them talked about currency risk management and not about currency measurement. It has been found out that SBM uses Value at Risk in order to measure their exposure to currency risk. VaR is going to be explained in the following section as this method is used not only for currency risk but also for interest rate risk.

5.4.4 Interest Rate Risk Measurement

Interest rate risk can be measured by several methods. These methods differ by the period at which they are used and by detailed purpose. The basic concepts that the Mauritian banks uses are:

• Gap Analysis
• Value at risk (VaR)
• Stress Testing

5.4.4.1 Gap analysis

Gap analysis is the simplest and oldest methods that Mauritian banks choose to use. 90 % of the respondents affirmed that they use this method. When using this method assets and liabilities need to be sorted into buckets according to their maturity dates. In each of these buckets the difference between asset re-pricing volume and liabilities re-pricing volume is calculated and this difference is called the Interest Rate Gap. It indicates the volume of the asset or liabilities that might cause decrease in the interest income in case interest rates moves.

A positive GAP expresses a situation where assets re-pricing exceed liabilities re-pricing. The larger the GAP; the greater is the interest rate risk. Gap analysis is done separately for each currency the banks are holding in their portfolio. After of the analysis risk management can use Gap to set limits on interest rate GAP in each bucket.

But GAP analysis has been found to have some limitations. The first limitation is time buckets must be set so that they are able to capture majority of mismatches but on the other hand time buckets must be set relatively wide to enable measurement. Buckets setting are then compromise between precision and manageability. Another limitation is for GAP analysis the basic assumption is that all interest rates will move together in the same direction by the same amount. Finally the classification of some of the banks products properly is another problem.

5.4.4.2 Value-at-Risk (VaR)

This is the most recent method for measuring interest rate risk. Only a few banks are engage in the calculations of VaR in Mauritius. Only big banks like the SBM and MCB use such methods. The aim is to express total market risk as a single number i.e. to summarise the expected maximum loss over a target horizon within a given confidence interval. Value at Risk or expected loss is calculated from volatilities of returns on individual cash flows and correlation between market risk factors.

VaR model is usually used for a whole portfolio of assets. Its main advantage is that it calculates with correlation between individual risk factors, one of them being Interest Rate Risk and also for Currency Risk.

5.4.4.3 Stress Testing

So far only one big bank uses such a calculation for Interest Rate Risk. Stress (sometimes Called Scenario Analysis) testing is a complement to standard value at risk calculation. It cannot replace it but it can evaluate the worst-case effect of large movements in interest rates. It consists of subjectively specified scenarios of interest that are then applied to current portfolio and the change of value of this portfolio is then calculated. The aim of this method is to cover situations completely absent from the historical data. However, even if used only for this purpose, the model has several disadvantages. The main drawback is that the model ignores correlations. Users define the stress scenarios so that large movements of several risk factors were included in the scenario but with no knowledge about correlations of these factors.

5.5 RISK MANAGEMENT

This section analyses the answers to Questions 2-8 and Questions 12-16. These sections of the questionnaire dealt with issues like the structure of the Risk Management Department and people working in these departments, the effectiveness of the measures undertaken to limit Financial Risks and if the current management process require any changes.

5.5.1 Risk Management Structure

Among all the banks interviewed only one of the banks did not have a specific department in the bank that deals with risk management issues. The risk management process of Barclays bank plc and HSBC is likely to be different from our locally incorporated banks as policies, procedures and decision making are made by their head offices abroad. Out of the 7 banks, 6 of them did have a Risk Management Department.

Examples of our two biggest banks are given in the following graphs. The first one being that of SBM where the risk committee compromise of the directors and they are responsible for taking policy decision.

BOARD OF DIRECTORS

RISK COMMITEE

RISK MANAGEMENT FORUMS

RISK MANAGEMENT TEAMS

Source: Annual Report of SBM 2007

The risk committee has the responsibility of determining risk tolerance and appetite and reviewing significant risks and effectiveness of processes whereas the risk management forums which is responsible for the following departments (Portfolio Mgt Forum, Operational Risk Forum and Market Risk Forum) is responsible for Formulating and implementing the business strategies, risk policies and operational plans. And finally the risk management teams monitor prudential limits and group risk profile and ensure compliance with regulatory norms.

For the MCB the structure more less the same, it is as in the following diagram.

BOARD OF DIRECTORS

OPERATIONAL RISK

MARKET RISK

CREDIT RISK

GROUP RISK SBU

RISK MONITORING COMMITTEE

Source: Annual Report of the MCB 2007

The Risk Monitoring Committee (RMC) has principal responsibility for the monitoring of the risk portfolios at the Bank, set against the agreed risk appetites. As we can see the financial risks are managed by the Group Risk SBU.

For First City Bank there does not exist any risk structure or department where risks are managed by other departments.

It was found that this bank only lacked skilled personnel to deal with risk management issues.

5.5.2 Strategies used by banks to manage financial risks

We can see from all of the banks interviewed none used incentive contracts and compensation but reports limits and guidelines were used to manage financial risks. Thus explaining why one of the reasons mentioned by Santomero in his study of financial risks were not present in the lists of reasons given above for Financial risks management i.e. managerial self-interest.

Standards and reports are used to inform the management and board of the level of risks and exposures that the banks are faced with. Then according to the reports the risk committee can use position limits to manage such risks and set up parameters.

Guidelines are merely used to conform to international standards and the local regulatory body which is the BOM.

5.6 IMPLEMENTATION OF BASEL II IN MAURITIUS

This section of the analysis tries to explain the answers of Questions 17 - 20. All the interviewees without exception agreed that the introduction of Basel II in Mauritius in December 2008 will be a success. And the reasons to such an answer are as follows:

5.6.1 New Techniques to Manage Risks

The Basel II accord gives us more ways to measure risks. And most of the banks are already using them. Banks in emerging countries, including Mauritius is likely to use standardized approach. By using this system the benefits are that there will be a change in the risk weight of credit rating assessment bodies. And it will consequently increase risk sensitivity of minimum capital requirement and therefore raise the risk weights. The advanced approach also have some advantages like banks using them will enjoy competitive advantage and their risk weight will be more diversified making them better off. Out of the 7 banks interviewed only one of them does not use the techniques presented by Basel II. Techniques that banks are already using are internal rating for credit risk, capital adequacy, VaR, GAP Analysis, and Earnings at Risk.

5.6.2 Financial Stability

But the main advantage that the Basel II offers is that it provides a common platform for banks and regulators to communicate about risks management. This accord encourages banks to take risks. It will also improve the ability of banks to assess credit to the different sectors. This framework will definitely encourage the soundness and stability of banks according to the interviewees.

BIBLIOGRAPHY

Amine AWAD Strengthening Risk Management Practices within the Lebanese Banking Sector Board Member, Banking Control Commission Member of the Higher Banking Council

Anthony M. Santomero Commercial Bank Risk Management: an Analysis of the Process

Dale F. Gray, Robert C. Merton and Zvi Bodie A New Framework for Analyzing and Managing Macro-financial Risks of an Economy August 1, 2003

Dr. Adem ANBAR Credit Risk Management in the Turkish Banking Sector: A Survey Study

E Philip Davis A Reappraisal Of Market Liquidity Risk In The Light Of The Russia/Ltcm Global Securities-Market Crisis Bank of England London

George G. Kaufman Loyola Banking and Currency Crises and Systemic Risk: A Taxonomy and Review University Chicago and Federal Reserve Bank of Chicago

Ira G. Kawaller Kawaller & Company Controlling interest rate risk in an uncertain world

Mandira Sarma Yuko Nikaido Capital Adequacy Regime in India: An Overview July 2007

APPENDIX

Name of Bank:

Part A: General Information

• Type of Bank

Offshore Commercial Both

Part B: Risk Management Issues

• Is there a specific department or section in the bank that deals with risk issues?

Yes No

• If yes, can you give a brief description of the structure of the department?
• Who are the people which are concerned with the management of financial risks in the bank?
• Does your bank have the necessary skills, relating to the management of financial risks?

Yes No

• Are the following risks present in the everyday activities of the bank
• Credit Risk Yes No
• Liquidity Risk Yes No
• Interest Rate Risk Yes No
• Foreign Exchange Risk Yes No
• Does the management of the bank uses any of the following techniques to manage the different types of risk:

Standards and reports Yes No

Position limits or rules Yes No

Guidelines or strategies Yes No

Incentive contracts and compensation Yes No

• If yes, why?
• What are the main reasons your bank must engage in financial risk management.
• What are the methods that your bank uses to manage the four main financial risks mentioned below:
  • Credit Risk
  • Liquidity Risk
  • Interest Rate Risk
  • Foreign Exchange Risk
• Can you give me some reasons why your bank uses such methods?
• Has these methods used been efficient in the management of financial risks?

Yes No

• Can you give me figures showing that these methods were useful in decreasing risks?
• How the better management of financial risks affected the performance of the bank
• Does your management process require some changes

Yes No

• If yes why?

Part C: Basel II

• Do you think that the implementation of Basel II in Mauritius will be a success?

Yes No

• Why according to you?
• The Basel II presents some techniques in dealing with risks are your bank using any of them.

Yes No

• Can you name them?
• According to you what are the future prospects for the banking sector in Mauritius?