Intermediation Process and the Allocation of Resources
Info: 5463 words (22 pages) Dissertation
Published: 6th Dec 2019
The importance of the financial system in facilitating economic development cannot be overstated. Banks and other financial institutions have a key role in the efficient allocation of resources and as such, sound financial systems are systemically important to the economic viability of a country.
The Asian Financial crisis of 1997-98 brought home the significance of financial sector soundness by highlighting the consequences of underlying weaknesses in the financial sector and the negative impact that weak financial sectors could have on stakeholders, particularly the depositors. Sound financial system is therefore not only important for the welfare of the financial entities themselves, but it is also of vital importance to the growth of individual economies.
In allocating resources in an economy, financial institutions must assess competing demands for funds and prioritize the analysis of risk. Improper decisions about financing activities, that is, which activities to finance and which not to finance, (depending on which activities will bring the best risk-adjusted return), can have a crucial negative long-term impact on economic prospects. Sound investment decisions are vital ingredients in fostering economic growth and development. These decisions therefore should produce feasible outcomes not only for the financial intermediary but also for the economy. Investment should be for productive purposes and should be deployed for the common good.
Financial intermediaries should also have a harmonious relationship with the macro-economic space within which they operate. For example, in the nineteenth century, Britain was seen as the most successful economy and was the home to the world’s most successful financial centre at the time. This was not only due to the fact that London had developed expertise in assessing risk and in allocating financial resources efficiently, but also to the fact that the macro economic environment was conducive to the operation of financial intermediaries operating in the financial centre.
The assessment of risk also assists financial institutions to be individually more competitive with their peers. This results in a more efficient process of capital allocation in addition to engendering more prudent practices. Financial intermediaries that can assess risk and allocate resources efficiently will outperform those less skilled in this regard. Effective competition should reduce borrowing costs and help to diversify financial risk within the economy. However, to ensure that banks are performing as intended, an effective regulatory framework must exist. The importance of adequately capitalized financial institutions to underwrite appropriate risks in their portfolios cannot be over emphasised. If financial intermediaries undertake too little risk, then potentially efficient projects may be starved of capital and if they undertake too much risk, then less efficient projects may consume capital that could be used for more viable projects. The role of regulators in providing effective oversight for the sector and be able to respond appropriately to changes in the financial environment becomes even more important.
William J McDonough (1998) postulates that “a nation must be able to mobilize domestic savings and other sources of funds that are needed to finance investment and other productive expenditures. This requires the development of an effective banking system that transfers surplus funds of households and businesses to borrowers and investors”. He further argues that, “fair and impartial allocation of credit accommodates the economic development that results in improved national living standards”.
According to McDonough:
“financial intermediation is particularly important in the context of most emerging market countries given the relative scarcity of savings, a relatively under-banked population, and large-scale investment needs. The banking sector in emerging market countries also tends to be more concentrated and represents a larger share of the domestic financial system. Consequently, issues in the banking sector have an amplified effect on the economy and on the fiscal costs associated with bank rescues”.
Importantly, current developments in western economies are anchored in a robust financial sector development.. Consequently, the relationship between economic growth and financial sector health are now more closely linked than ever before.
Some of these linkages or interrelationships are further explored in this thesis from the perspective of risk relationships. The demands of the changing business environment emphasize the importance of effective risk management practices in banking institutions. Financial intermediaries continue to face tremendous unrelenting pressures regarding pricing decisions, increase in service expectations from customers, regulators and shareholders. There is also a demand for more sophisticated products and services, new regulatory requirements, improved capital standards, more capital injection and the introduction of new technologies and systems.
Technology is important in supporting new and flexible risk relationship structures in the areas of credit, market, liquidity and operational risk management. Advanced technologies are often used by intermediaries to identify, quantify and monitor risks. The employment of these technologies also comes with their own attendant risk exposures and as such significant investments and focus have been placed (particularly in recent times) on operational risk management issues from both regulatory and financial intermediary perspectives.
Risk management must be seen as an integrated process and as such managing existing relationships, developing new relationships and leveraging the value of all risks relationships are critical to the management of overall risk exposures. It is important therefore that the approach which institutions and regulators take in managing risk, be relational. Both the qualitative and quantitative aspects of risk management must find consensus within the same framework. No longer should institutions view risk as an isolated and individualized structure with separate and mutually exclusive elements but risk should be managed as a system, which is intricate, collaborative and bound by mutual responsibilities.
The identification, assessment, and promotion of sound risk-management practices have become central elements of good supervisory practice. Risk management has evolved as a discipline that is driven both by the private sector (made up of banking institutions and other market participants) and public sector (especially Regulatory Authorities and Banking Supervision). The relationship between the private sector’s interest in economic capital and the public sector’s interest in regulatory capital should be identified and managed in a framework that ensures optimization.
With regard to the management of risks and risk relationships, several key innovations have been made by the private sector over the years. These are evident in the way financial intermediaries have ordered their balance sheets to respond to various risk stimuli and impulses both internally and externally. Additionally, the private sector has been the driving force behind the development of sophisticated tools used to identify, measure and manage risk relationships. The public sector on the other hand, has been at the forefront in the development of best practice standards and principles used to guide financial intermediaries. For years, the public sector has been playing a pivotal role in preventing the total collapse of the entire financial systems in their capacity of lender of last resort. The regulatory and supervisory arms of the public sector have taken the lead in identifying emerging issues through their approach to supervision of financial intermediaries. Several regulatory bodies routinely performs on-site inspections and examinations as well as off-site monitoring and surveillance of banks and other financial institutions to assess risks and provide feedback to the financial intermediaries’ board and management. These reviews include the assessment of policies and procedures in place to guide risk management; the assessment of governance and internal controls and the assessment of capital adequacy, asset quality, earnings and liquidity and sensitivities to risks. Reviews could also include comparisons of peer institutions coupled with the establishment of guidelines that codify evolving practices.
Yellen (2005) argued that “although banks and bank supervisors have different motives, which certainly can lead to differing views about the appropriate levels of risks, they also have a common interest in having accurate measures of risk and in focusing on the processes and techniques for identifying and managing risks”.
According to Alan Greenspan (2004), “the growth in the size and complexity of the largest US and foreign banking organizations, in particular, has substantially affected financial markets and supervisory and regulatory practices”. He further states that “authorities are required to focus more than before on the internal processes and controls of these institutions and on their ability to manage risk”. According to Greenspan, “the regulatory authorities must provide the industry with proper incentives to invest in risk-management systems that are necessary to compete successfully in an increasingly competitive and efficient global market”.
The Basel Frameworks
Over the last two decades, the system of bank capital standards has been the Basel Capital Adequacy Standard, known as the Basel I framework, which was established internationally in 1988. The Basel I standard came out of the banking supervision sub-group of the Bank for International Settlement (BIS). The Banking subgroup is made up of supervisors from the G10 countries. This group has been charged with the responsibility for setting bank standards around the world, which it does predominantly through the development and implementation of the Basel Core Principles for Banking Supervision. The Basel I framework was particularly geared towards credit risks in banking institutions and resulted in higher capital levels, a more equitable international marketplace and the relating of regulatory capital requirements to risk appetite and risk profile.
The Basel framework is a dynamic one to which bank as supervisors continue to make important adjustments from time to time. For example, the 1988 Capital Accord was amended subsequently to incorporate a market risk component. Bernanke (2005) argues that “advances in risk management and the increasing complexity of financial activities have prompted international supervisors to review the appropriateness of the regulatory capital standards under Basel I, particularly for the largest and most complex banking organizations”.
Bernanke states further that “supervisors recognize that some of the largest and most complex banking organizations have already moved well beyond Basel I in the sophistication of their risk management and internal capital models”. The gap between the determinants of minimum regulatory capital (under Basel I) and the levels of risks that financial institutions were taking on began to widen, as risk relationships continue to become more complex and risk-management practices continue to evolve.
Several innovations have sought to collectively reinforce this gap and indeed the relationship (regulatory capital/risk appetite) between the public sector and the private sector has also being mutually reinforced. These innovations have predominantly being originated by bankers in the private sector and not by Supervisors. Bankers and Risk Managers had developed models that encompass their processes, procedures, and techniques, including statistical models for assessing risks in their portfolios. These innovations by the private sector were seen as state of the art risk management tools which the public sector could use and as such Regulators began to leverage the risk management techniques that banks were using to address shortfalls in Basel I. This phenomenon helped to push the Basel Committee back to the drawing board to create the new capital adequacy standards for internationally active banks, known as Basel II.
Bernanke (2006) argues that the new framework “links the risk taking of large banking organizations to their regulatory capital in a more meaningful way than does Basel I and encourages further progress in risk management. It does this by building on the risk-measurement and risk-management practices of the most sophisticated banking organizations and providing incentives for further improvements”. When this framework is applied consistently across internationally active banks, Supervisors can easily identify shortfalls in the relationship between banks capital and risk levels. Banking institutions with capital levels that are not commensurate with their risk profile and risk levels would be subjected to closer assessment and monitoring. Additionally, Basel II has provided the Supervisor with an added tool, under the supervisory review process (Pillar II) to assess risks in the banking system.
The new capital accord, Basel II, with its three pillars, will hopefully enhance and strengthen the process of risk management in banking institutions. Internationally active banks, and other banks and investment businesses in jurisdictions in which regulatory authorities deem it prudent to bring these institutions in scope, should expect significant revisions and modifications in their internal policies used to identify, measure, manage and report on risks. Not only should improvements be seen in risk management policies, but the process and general procedural framework would also see improvements. In this regards, banks and other financial institutions should envisage changes in their system used to capture and report on risks. Under Pillar I, changes are expected I the risk weights assigned to the credit portfolios, particularly, residential mortgages and as such banks could see some reduction in charges as weights for some categories are reduced. The reporting of market risks and operational risks should also improve as banks garner more granular data on its expected losses and risk exposures. In preparation for the supervisory review process (Pillar II) to be conducted by the regulatory authorities, banks should see significant improvements in their risk management practices as they subject their internal capital adequacy models to greater levels of scrutiny to ensure that the capital cover is adequate for all the material risks identified, their risk appetite, and risk exposures.
The use of stress testing on both the banks investment and credit portfolios under the pillar II process should also seek to strengthen the institutions approach to deal with adverse down turn and general deterioration in some macro economic variables in the economies in which the banks operate. This should push banks to increase capital levels to cushion expected losses.
Pillar III implementation under the new capital accord should also foster greater improvements in the risk management, policies, processes, and procedures of banking institutions as banks become more transparent in their efforts to disclose more information on the profile of risks, risk exposures and capital levels to their stakeholders.
The Sub-prime Mortgage Crisis
The conditions that gave rise to the current sub-prime mortgage crisis provides ample evidence to support the pressing need for both private and public sector, financial institutions and supervisors, to understand the nature and nexus of risk relationships and regulatory capital. The crisis also provide an opportunity for financial institutions and regulators to explore the risk relationships and risk dynamics existing within and outside of financial intermediaries, as well as the impact that failure to properly identify and assess risk exposures in financial institutions can have on the global financial system and economic growth and development in a particular country.
The ongoing economic problem resulting from the sub-prime mortgage crisis has manifested itself through liquidity issues in the global banking system. The credit crisis has its genesis in the bursting of the US housing bubble and the subsequent high default rates on “sub-prime” or other adjustable rate mortgages, made to borrowers with higher risk profile and lower income levels, instead of to borrowers who are considered “prime” borrowers with higher income and good credit history. Borrowers were encouraged to take up mortgages based on the attractive housing incentives that led them to believe that notwithstanding the long term trend of rising housing prices, they would be able to refinance these mortgages at more favourable terms in the future. During 2006 however, the prices of houses started to fall, albeit moderately and as such, the possibility of refinancing was becoming more remote. Consequently, the interest rates on the adjustable rate mortgages (ARM) that the sub-prime borrowers were able to obtain began to reset at the higher rate resulting in a significant increase in defaults and foreclosures. In 2007, foreclosure activities increased by approximately 80 percent over the 2006 figures as nearly 1.3 million United States housing properties were subjected to foreclosure activities.
Major banks and other financial institutions globally reported losses of approximately US $379 billion towards the end of the first half of 2008. The first set of financial institutions to be impacted was mortgage lenders that retained the risk of payment default (credit risk). Several third party investors were also affected, as mortgage lenders had passed on the credit default risks arising from the rights to the mortgage payments through mortgage backed securities (MBS) and collateralized debt obligations (CDO). Individuals, institutional investors and other corporate entities holding MBS or CDO were now faced with significant losses as the value of the underlying mortgage assets declined.
The sub-prime mortgage crisis also exposed financial institutions to liquidity risks as lenders were forced to reduce lending activities or grant loans at higher interest rates. The higher interest rate loans restricted the ability of corporations to obtain funds through the issuance of commercial paper, thereby posing liquidity challenges for several institutions. As a result, central banks, in their role of lenders of last resort, were forced to take action to provide funds to the banking sector so as to stimulate the commercial paper market and to encourage the resumption of lending to borrowers with good credit profile.
The rate at which economies grew was also impacted by the credit crisis as business investments and consumer spending were curtailed due to the general unavailability of loans or the high cost of loans in cases where it was available. The United States government responded by cutting the federal reserve interest rates as well as proposing its economic stimulus package which was passed by congress in February 2008. This was necessary to alter the risk exposure to the broader economy brought on by the credit crisis and the related downturn in the housing market.
Research Problem and Hypothesis
While the benefits of risk management and positive risk relationships have been increasingly recognized in financial sectors worldwide, this study postulates that (i) risk relationships have not been sufficiently explored in the region and current risk management practices in the Caribbean have not kept pace with international trends on financial risk management and (ii) levels of capital being held by financial intermediaries in the Caribbean could be deemed inadequate to mitigate risk exposures. It could also be argued that where there are high levels of risk exposures in financial intermediaries in the region, the impact of risk mitigating factors are low and risk management policies, processes and procedures are less than robust. Additionally, risk exposures and regulatory capital might vary according to core business activities, risk categories or geographic location.
In recognition of the existence of these relational gaps and the need to bridge them, this study will introduce principles, procedures, approaches, models and concepts in risk management, and concentrate on those risks inherent in the financial intermediaries’ balance sheet or risks associated with various elements of financial activities and environment. The writer will analyse the risk profile of financial intermediaries and their exposure to credit risks, funding/liquidity risks, interest rate risks and operational risk.
The study also seeks to develop benchmarks for measuring risks in the region as well as a risk management scoring model with particular emphasis on the risk profile of Caribbean financial intermediaries.
The first sub-problem is to ascertain the risk profile and relationship evident in financial intermediaries in Jamaica, Trinidad and Barbados, as well as those which may evolve consequent to the new Basel Capital Accord, Basel II, which is scheduled to be fully implemented by 2015 across all jurisdictions. The intention is to assess the risk profile and relationship in operation as a dynamic process and the likely impact of the capital accord on relevant financial entities.
The second sub-problem is, using both the relevant and existing literature concerning risks, risk relationships and risk management and observation of current techniques, to ascertain throughout the course of the study, types of risk relationships that exist in credit, liquidity, interest rate and operational risk management in financial intermediaries.
The third sub-problem is to provide the financial sector with a set of sound testable ideas that are systemically desirable and consistent with the future development of risk assessment. This will be done by reviewing the analyses outlined in the first two sub-problems, generating relevant model/framework of risk assessment, comparing the model/framework with real situation, identifying systemically desirable changes and documenting the results for the benefit of relevant stakeholders who are capable of applying change to the banking sector in general.
The first hypothesis is that risk exposures (credit, liquidity, interest rate and operational risks) in financial intermediaries in Jamaica are relatively high when compared with Trinidad and Tobago and Barbados and could exhibit parasitic tendencies. This could impair the financial intermediaries’ ability to identify, measure, mitigate and monitor risks due to the fact that the internal control framework could be seen as less than robust.
The second hypothesis is that there will be shortfalls in capital requirements specifically as a result of the introduction of the new Basel Capital Accord and more generally after taking account of specific risks not previously considered by financial intermediaries.
The third hypothesis is that the cycle of analysis, application and testing will result in the implementation of rigorously defined early warning system for modelling and scoring risks and that this system will be adaptable to change, both outside and within the environment, and extendable to additional use.
Justification for the Research
Sound risk management practices, which include appropriate tools and techniques and the employment of relevant steps to assess risk exposure are at the heart of effective financial intermediation. However, many institutions are exposed to high levels of risks in their operations and few have put in place the relevant infrastructure to appropriately capture their risk exposures. According to the Government of Jamaica, Ministry of Finance (1998): “the financial distress experienced in the mid nineties was in several ways due to the fact that many domestic financial institutions did not have the necessary risk and financial management capabilities to carefully assess the risk. As a result, they were left holding real estate and other long-term assets that could not be easily disposed of to meet their short-term obligations”.
The Ministry highlighted the fact that: “banks in Jamaica tended to invest in enterprises that were outside the scope of their core business which had the following implication:
- The banks entered sectors in which their management did not have the requisite skills or expertise.
- The banks, when lending to related parties or parties under common control either (i) made poor and biased credit decisions; or (ii) invested in companies on less than arm’s length terms resulting in poorly secured loans.
- The banks, in many instances had fund investments in non-core businesses with short-term borrowing instruments with guaranteed high interest rates. As a result, many non-core business had to contend with an unsustainable capital structure that relied heavily on high cost loans with relatively short maturities”.
Many studies have highlighted the risk management practices, including techniques and tools used to identify, measure, mitigate and monitor risks in industrial countries. However, few studies (note the researcher is not aware of any at the time of preparing this thesis) have sought to understand and explain the risk exposures, risk relationships and risk management practices in financial intermediaries in the Caribbean, particularly Trinidad and Tobago, Jamaica and Barbados.
The study utilizes a novel approach to analyse risk exposures and risk relationships, which has not been evidenced in the literature generally and definitely not seen in research on risk management in the Caribbean region. The risk profile of financial intermediaries are analysed using ratio analysis and statistical techniques including the standard deviation and arithmetic mean coupled with a five-point scale response to determine risk relationships based on a biological science description. This study will document over a ten-year period, sectoral differences in risk exposure reflected in the balance sheets and income statements of commercial banks, merchant banks, trust companies and building societies in three Caribbean countries.
The results of the research will provide a sound set of ideas for the management of risks in these institutions in emerging markets. It will also provide an enduring account of risk relationships and the implications of sound risk management practices in general.
Thesis Outline and Methodology
The study examines the risk management framework in emerging markets in the Caribbean region. The focus will be limited to three jurisdictions in the Caribbean region. These are Jamaica, Trinidad & Tobago and Barbados. This paper takes account of four types of deposit taking financial institutions – Commercial Banks, Trust & Merchant Banks, Finance Companies and Building Societies. There are 8 financial intermediaries across the three jurisdictions.
Elite interviews were also conducted with senior management in sixteen (16) financial institutions in Trinidad and Barbados. Interviews were held with select senior management executives in the financial institutions. Among the executives interviewed were CEOs, Senior Vice Presidents, Risk Managers, Credit Managers, Operations Managers and Treasury Managers. In Jamaica, detailed surveillance were done of all the in scope financial institutions ie, commercial banks, trust and merchant banks and building societies. Reviews of annual reports and websites of all the financial intermediaries captured in the scope of the thesis were also done. The purpose of the review of the elite interviews and qualitative reviews of the websites, annual reports and other published data was to obtain information on four risk categories, particularly on the policies, procedures and processes in place to manage risk.
Twenty risk proxies were used to calibrate risk exposure across four risk types in the financial intermediaries and the countries. These risk proxies were further reduced to eight based on their relative weights and significance as a risk-sensitive measure. Additionally, eight macro-economic variables were used to assess the economic environment within each country as well as to determine the extent to which these macro-economic variables were correlated with the risk proxies.
Using a Likert-type index, correlation analysis and the results of the observation and interviews, the study developed risk benchmarks and risk scores, which were later used to determine risk relationships within financial intermediaries as well as within each country. The aim was to identify the risk relationships and to provide the managers of financial institutions and policy makers with an early warning system to calibrate and mitigate risks.
The study analyzed the degree to which three major economies in the Caribbean region were exposed to credit, liquidity, interest rate and operational risks and the extent to which different countries are similar or different in light of these risk exposures.
The paper sought to determine the level of risk exposures across four different financial intermediary types in three Caribbean jurisdictions. It expounded on differences and similarities in the risk profile of financial intermediaries and sought to determine which intermediaries are likely to have higher risk profiles.
The paper also explored synergies and alliances between the four main categories of risk under study. These are credit, interest rate, liquidity and operational risk. It disaggregated proxies for risks based on risk types and highlighted risks drivers that are significant to different intermediary types or country.
Lastly, the paper explored relationship between the critical elements and proposed a model for the scoring of risks. The relational perspective to risk management envisaged risk within three basic constructs namely, Symbiotic, Parasitic and Saprophytic as well as the nexus between these constructs and the internal control framework as measured by financial intermediaries policies, procedures and processes used to manage risks.
The Saprophytic Construct
At this level, risk is calibrated as being relatively low. Risks outcome are systemically pleasing and financial intermediaries are making meaningful contribution to the common good. Risks and reward can thrive within a conducive macro environment and the profile of institutions’ balance sheet and income statement contributes positively to the risk calibration outcome. A low level of risk exposure is usually attributed to a very robust internal control framework and more effective risk mitigation strategies.
The Symbiotic Construct
Within the Symbiotic construct, risk relationships are generally balanced. Risk is calibrated as moderate and the regulatory interest and the economic interest are neutral. Risk management is generally integrated and there is usually a connection between the process of risk identification, measurement, mitigation and monitoring. The profile of intermediaries’ balance sheets and income statements are viewed as risk-neutral relative to risk outcome and the internal control framework and risk mitigation strategies used by financial intermediaries are generally adequate.
The Parasitic Construct
Within this construct risks are calibrated as high or very high. There is usually adverse macro-economic condition in existence and there is disconnect between the regulatory interest and the economic interest. There is a general state of disharmony in the qualitative and quantitative approaches and disunity in the way that risk is generally managed. The risk profile of institution’s balance sheets and income statements negatively impacts risk calibration outcomes. A hig
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