Risk Management in Financial Institutions

“Risk management is important in financial institution than in other parts of the nation. Although its complex. The banking sectors and other similar financial institutions is facing risk in situation of uncertainty. How the Turnbull report describe, author was the project director in which, formed a new basic approach to risk. It provides guide in which the multiple Turnbull ideas have become the foundation of risk management and suggests how they can be develop”. (Anthony Carey; 2001)

“The Risk management of financial institutions focused on managing return and hazard in modern financial institutions. The inner theme of risk management is that the risk faced by the managers in financial institutions and the methods and markets through in which these risk are managed are becoming gradually more similar whether and financial institutions is acting as noncommercial bank and commercial banks, investment bank, saving bank or loan providing and insurance companies. even though the rational nature of each sectors such as quality securitization, international banking off balance sheet banking”.(Saunders, Cornett et al. 2006)

“Risk management framework is important for financial institutions like banks. Insurance companies, investment fund and loan companies. In conjunction with the underlying frameworks, basic risk management process that is generally accepted is the practice of identifying, analyzing, measuring, and defining the desired risk level through risk control and risk transfer. BCBS (2001) defines financial risk management as a sequence of four processes: (1) the identification of events into one or more broad categories of market, credit, operational and other risks into specific sub-categories; (2) the assessment of risks using data and risk model; (3) the monitoring and reporting of the risk assessments on a timely basis; and (4) the control of these risks by senior management. BCBS (2006), on risk management processes, require supervisors to be satisfied that the banks and their banking groups have in place a inclusive risk management process. This would include the Board and senior management to identify, assess, examine and manage or mitigate all material risks and to assess their general capital adequacy in relation to their risk profile. In addition, as suggested by Al-Tamimi (2002), in managing risk, commercial banks can follow comprehensive risk management process which includes eight steps: exposure identification; data gathering and risk quantification; management objectives; product and control guidelines; risk management evaluation; strategy development; implementation; and performance evaluation (e.g. Baldoni, 1998; Harrington and Niehaus, 1999).

A comprehensive explanation of risk management in Islamic banking are made by Akkizidis and Khandelwal (2008) covering the aspect of risk management issues in Islamic financial contracts, Basel II and Islamic Financial Services Board (IFSB) for Islamic financial risk, and examining the credit, market and operational risk management for IBs. They also explain the unique mixes or risk for each financial contracts in IBs. Moreover, Iqbal and Mirarkhor (2007) explain that the context of risk management in IBs covering the aspect of the needs for risk measurement, management and controls in IBs and highlight the comprehensive risk management framework for each unique risk with the references of IFSB standards. Greuning and Iqbal (2007) discuss the three major modification of theoretical balance sheet of an Islamic bank that has implications on the overall risk free of the banking environment. Apart from that, the contractual role of various stakeholders in relation to risk is also been highlighted.

According to IFSB, the primary aim of releasing its risk management standard stems from the recognition that although “certain issues are of equal concern to all financial institutions” (IFSB, 2005) some risks are localized to IBs and as such, these principles “serve to complement the BCBS guidelines in order to cater the specificities of IBs” (IFSB, 2005). In addressing the various forms of risk that IBs are exposed to, the guiding principles set forth the methodologies required in order to balance concerns between both the internationally agreed standards of the BCBS and Shari’ah compliance issues that are fundamental to the operation of these specialized institutions.

In general, according to IFSB (2005), IBs shall have in place a complete risk management and treatment process, including proper board and senior management oversight, to recognize, measure, observe, report and control related categories of risks and, where suitable, to hold sufficient capital against these risks. The process shall take into account appropriate steps to comply with Shari’ah rules and principles and to ensure the adequacy of relevant risk reporting to the supervisory authority

“Theory of financial explains that the risk control has become the main concerns of financial institutions. They require for sufficient arithmetical tools to compute and foresee the amplitude of the probable moves of financial markets is visibly expressed, in exacting for derivative markets., however, classical theories are based on easy assumptions such as Gaussian statistics and lead to a regular dryness of real risks.”(Bouchaud and Potters 2000)

“This article guide to take financial risk management decisions. Theis is based on two important principles, a “Sharpe rule” assess prospective changes in a in fianacial sector and portfolio’s expected risk of return profile and the imporvement of a constant chances of default, that evaluate the financial sector or portfolio’s leverage. Rules can not be restricted to thel return distributions; they are also collected a variety of abnormal distributions. This approach could be applied with value at risk as the measure of risk or portfolio standard deviation”.(Dowd 1999)

“This article explain the use of credit derivatives by corporate treasurers. Financial Corporations have in recent years, become grown with the idea of using traditional derivative products to hedge their exposure. e.g, foreign exchange risk. Credit risk, interest rate and on the other side, has to approven a more difficult tame. And avenues for the credit risk management do exist, e.g, the use of traditional insurance products and (LOC) letters of credit, that means are not always be convenient”.(Freeman, Cox et al. 2006)

“This article represent that the most of Firms and the financial institutions are good viewed as ongoing entities, whose required renewed injections of liquidity. This artical suggest a contract theoretic framework. That represent three dimensions of prudential regulation and corporate financing”.

(Holmström and Tirole 2000)

“This article testing the hypothesis that the banks with additional risky loans and high interest-rate risk disclosure would select loan and deposit rates to attain high interest rate limits. Call Report information relating to banks for 1989–1993 show that the net interest rate limits of commercial banks imitate the default and interest-rate risk. The net interest rate limits of money center banks are exaggerated by the default risk, but not net interest rate risk, which is constant with their better attention in short term assets and (OBS)off balance sheet hedge instrument. Through disparity, super regional banking firms are responsive to interest rate risk other than default risk. The information illustrate that off-balance sheet actions encourage a more diversified, , and cross-sectional differences in interest-rate risk and liquidity risk are linked to differences in of balance sheet disclosure”(Angbazo 1997).

Risk management conceptual model:

This conceptual model examines the relationship between risk management practices and the four aspects of risk management process i.e. (1) understanding risk and risk management; (2) risk identification; (3) risk analysis and assessment; and (4) risk monitoring as in Figure 2. By making reference to the model adopted by Al-Tamimi and Al-Mazrooei (2007), the function of risk management practices is as follows:

RMP = f (URM, RI, RAA, RM)

Where:

RMP = risk management practices;

URM = understanding risk and risk management;

RI = risk identification

RAA = risk analysis and assessment

RM = risk monitoring

Conceptual model:

Risk Identification

Risk analysis and

Assessment

Risk Monitoring

Risk

Management

Practices

Understanding

Risk and Risk

Management

The conceptual framework suggests there is a positive relationship between risk management practices and the aspect of risk management process.

Secondly, it suggests the category of risk management processes that influence most of the practice of risk management to be examined.

There are many conceptual studies that shows the important aspects of risk management process that firms need to have in order to practice risk management (e.g. Tchankova 2002; Kromschroder and Luck, 1998; Luck 1998; Fuser et al, 1999; Barton et al, 2002). Some empirical findings (e.g. Al-Tamimi and Al-Mazrooei, 2007) show positive relationships between risk management practices and the various aspects of risk management process, and some findings (e.g. Boston Consulting Group, 2001; Al- Tamimi, 2002; KPMG, 2003; Parrenas, 2005; Al-Tamimi and Al-Mazrooei, 2007) show the important aspect of risk management practices by various financial institutions.