Managing Risk in Financial Sector

Law Of Diminishing Returns Definition - Managing Risk in Financial Sector

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Risk supervision is a hot topic in the financial sector especially in the light of the new losses of some multinational corporations e.g. Collapses of Britain's Barings Bank, WorldCom and also due to the incident of 9/11. Rapid changes in firm condition, restructuring of organizations to cope with ever increasing competition, improvement of new products, emerging markets and growth in cross border transactions along with complexity of transactions has exposed Financial Institutions to new risks dimensions. Thus the view of risk has captured a growing importance in contemporary financial society.

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Law Of Diminishing Returns Definition

By facilitating transactions and making reputation and other financial products available, the financial sector is a crucial construction block for incommunicable as well as social sector development. In its broadest definition, it includes all from banks, stock exchanges, and insurers, to reputation unions, microfinance institutions and moneylenders. As an efficient assistance provider, the financial sector simultaneously fulfils an important function in the comprehensive economy. Assorted types of Financial Institutions actively working in Financial Sectors comprise Banks, Dfis, Micro Finance Banks, Leasing Companies, Modarabas, Assets supervision Company, Mutual Funds, etc.

Thus today's operating environment demands systematic and more integrated risk supervision approach.

Risk:

Risk by default has tow components; uncertainty and exposure. If both are not present, there is no risk. Definition of Risk as per Guidelines on Risk supervision issued by State Bank of Pakistan is, "Financial risk in a banking assosication is possibility that the outcome of an operation or event could bring up adverse impacts. Such outcomes could either supervene in a direct loss of wage / capital or may supervene in imposition of constraints on bank's capability to meet its firm objectives. Such constraints pose a risk as these could hinder a bank's capability to conduct its ongoing firm or to take advantage of opportunities to improve its business."

Types of Risks:

Risks are commonly defined by the adverse impact on profitability of some inescapable sources of uncertainty. More or less all financial institutions have to administrate the following faces of risks:

1. Credit Risk

2. Market Risk

3. Liquidity Risk

4. Operational Risk

5. Country Risk

6. Legal Risks

7. Compliance Risk

8. Reputational Risk

Broadly speaking there are four risks as per Risk supervision Guidelines which surround Financial Sector i.e. reputation Risk, market Risk, Liquidity Risk and Operational Risk. These risk are elaborated here under:

i. Credit Risk

This is the risk incurred in case of a counter-party default. It arises from lending activities, investing activities and from buying and selling financial assets on profit of others. This risk is related with financing transactions i.e.:

a. Default in refund by the borrower and

b. Default in obliging the commitment by another Financial institution in case of syndicated arrangements.

It is the most principal risk in banking and one that must be managed carefully. It is also the risk that requires the most subjective judgment despite constant efforts to improve and quantify the reputation decision process.

ii. Market Risk

Market risk is defined as the volatility of wage or market value due to fluctuations in underlying market factors such as currency, interest rates, or reputation spreads. For commercial banks, the market risk of the carport liquidity investment briefcase arises from mismatches between the risk profile of the assets and their funding. This risk involves interest rate risk in all of its components: equity risk, replacement risk and commodity risk.

iii. Liquidity Risk

The liquidity risk is defined as the risk of not being able to meet its commitments or not being able to unwind or offset a position by an assosication in a timely fashion because it cannot liquidate assets at uncostly prices when required.

iv. Operational Risk

This risk results from inadequacies in the conception, organization, or implementation of procedures for recording any events about bank's operations in the accounting system/information systems.

Need for Risk supervision and Monitoring:

There are a amount of reasons as to why there is so much emphasis given to Risk supervision in Financial Sector now a day. Some of them are listed below: -

1. Present structure of joint stock companies, wherein owners are not the mangers, hence risks increase; therefore proper tools are required to accomplish the desired results by outside the risks.

2. The financial sector has come out of straightforward deposit and lending function.

3. The world has become very complex so the financial transactions and instruments.

4. Increase in the amount of cross border transactions which caries its own risks.

5. Emerging markets

6. Terrorism Remittances

Risk monitoring in financial sector is very crucial and an inescapable part of risk management. Risk Monitoring is important in the financial sector due to the following reasons:

1. Deals in others' money

2. Direct stake of deposit holder.

3. Much riskier sector than trading and manufacturing.

4. Previous / new problems faced by banks i.e. Stuck briefcase that is reputation risk.

5. Bankruptcy of Barings Bank due to short selling / long position that is market risk.

6. Operational risk does not has immediate impact, but important for continuity and expand of organization.

7. Appetite of a financial institution to take risk is related with the capital base of the invent so it caries a huge risk of over exposure.

Components of Risk supervision Frame Work

Risk supervision Frame Work has five components. First of all risk is Identified, then it is Assessed to classify, seek clarification and management, after assessing quick Response and implementation of clarification and the last phase is Monitoring of the risk supervision expand and learning from this taste that such question never occur again. Whole process is to be well Communicated during the whole process of risk supervision if it is to be managed efficiently.

The International assosication for Standardization (Iso) has defined risk supervision as the identification, analysis, evaluation, medicine (control), monitoring, impart and communication of risk. These activities can be applied in a systematic or ad hoc manner. The presumption is that systematic application of these activities will supervene in improved decision-making and, most likely, improved outcomes.

Structure of Risk Management

Depending upon the structure and operations of organization, financial risk supervision can be implemented in dissimilar ways. Risk supervision structure defines the dissimilar layers of an assosication at which risk is identified and managed. Although there are dissimilar layers or level at which risk is managed but there are three layers which are tasteless to all. I.e.

Risk Management

For managing risk there are inescapable basic principles which are to be followed by every organization:

1. Corporate level Policies

2. Risk supervision strategy

3. Well-defined policies and procedures by senior management

4. Dissemination, implementation and compliancy of policies and procedures

5. Accountability of individuals heading Assorted functions/ firm lines

6. Independent Risk impart function

7. Contingency plans

8. Tools to monitor risks

Institutions can reduce some risks naturally by researching them. A bank can reduce its reputation risk by getting to know its borrowers. A brokerage firm can reduce market risk by being knowledgeable about the markets it operates in.

Functionally, there are four aspects of financial risk management. Success depends upon

A. A inescapable corporate culture,

No one can administrate risk if they are not ready to take risk. While personel initiative is critical, it is the corporate culture which facilitates the process. A inescapable risk culture is one which promotes personel accountability and is supportive of risk taking.

B. Actively observed policies and procedures

Used correctly, procedures are fine tool of risk management. The purpose of policies and procedures is to empower people. They specify how habitancy can accomplish what needs to be done. The success of policies and procedures depends critically upon a inescapable risk culture.

C. Effective use of technology

The former role technology plays in risk supervision is risk evaluation and communication. Technology is employed to quantify or otherwise summarize risks as they are being taken. It then communicates this facts to decision makers, as appropriate.

D. Independence or risk supervision professionals

To get the desired outcome from risk management, risk managers must be independent of risk taking functions within the organization. Enron's taste with risk supervision is instructive. The firm maintained a risk supervision function staffed with capable employees. Lines of reporting were reasonably independent in theory, but less so in practice.

Internal Controls

Para one on first page of the 'Guidelines on Internal Controls' issued by Sbp provides:

"Internal control refers to policies, plans and processes as affected by the Board of Directors and performed on continuous basis by the senior supervision and all levels of employees within the bank. These internal controls are used to provide uncostly insurance about the achievement of organizational objectives. The principles of internal controls includes financial, operational and compliancy controls."

The current official definition of internal control was advanced by the Committee of Sponsoring assosication (Coso) of the Treadway Commission. In its influential report, Internal control - Integrated Framework, the Commission defines internal control as follows:

"Internal control is a process, effected by an entity's Board of Directors, supervision and other personnel, designed to provide uncostly insurance about the achievement of objectives in the following categories:

 Effectiveness and efficiency of operations.

 Reliability of financial reporting.

 Compliance with applicable laws and regulations.

This definition reflects inescapable underlying concepts:

 Internal control is a process. It is a means to an end, not an end in itself.

 Internal control is effected by people. It is not policy manuals and forms, but habitancy at every level of an organization.

 Internal control can be staggering to provide only uncostly assurance, not absolute assurance, to an entity's supervision and board.

Internal control should aid and never impede supervision and staff from achieving their objectives. control must be taken seriously. A well-designed principles of internal control is worse than worthless unless it is complied with, since the assemblance of control will be likely to transport a false sense of assurance. Controls are there to be kept, not avoided. For instance, irregularity reports should be followed up. Senior supervision should set a good example about control compliance. For instance, corporal entrance restrictions to gain areas should be observed equally by senior supervision as by junior personnel.

Components of Internal Controls

Components of internal control also depend upon the structure of the firm unit and nature of its operation. The Coso record describes the internal control process as consisting of five interrelated components that are derived from and integrated with the supervision process. The components are interrelated, which means that each component affects and is affected by the other four. These five components, which are the principal foundation for an efficient internal control system, include:

I. Control Environment,

Control environment, an intangible factor and the first of the five components, is the foundation for all other components of internal control, providing discipline and structure and encompassing both technical competence and ethical commitment.

Ii. Risk Assessments,

Organizations exist to accomplish some purpose or goal. Goals, because they tend to be broad, are commonly divided into specific targets known as objectives. A risk is whatever that endangers the achievement of an objective. Risk assessments is done to decide the relative possible for loss in programs and functions and to invent the most cost-effective and efficient internal controls.

Iii. Control Activities,

Control activities mean the structure, policies, and procedures, which an assosication establishes so that identified risks do not forestall the assosication from reaching its objectives.
Policies, procedures, and other items like job descriptions, organizational charts and supervisory standards, do not, of course, exist only for internal control purposes. These activities are basic supervision practices.

Iv. Information and Communication, and

Organizations must be able to gain reliable facts to decide their risks and impart policies and other facts to those who need it. facts and communication, the fourth component of internal control, articulates this factor.

V. Monitoring

Life is change; internal controls are no exception. Satisfactory internal controls can become obsolete through changes in external circumstances. Therefore, after risks are identified, policies and procedures put into place, and facts on control activities communicated to staff, superiors must then implement the fifth component of internal control, monitoring.

Even the best internal control plan will be unsuccessful if it is not followed. Monitoring allows the supervision to recognize either controls are being followed before problems occur. In the same way, supervision must impart weaknesses identified by audits to decide either related internal controls need revision.

Tools for Monitoring of Risk

Management facts System

M.I.S or supervision facts principles is the variety and diagnosis of data in order to reserve management's decision with respect to the achievement of objectives mentioned in the policies and procedures and the control of Assorted risks therein.

It is this area i.e. M.I.S, where I.T can play a vital and efficient role as with the help of I.T large facts may be analyzed efficiently and with accuracy, so that efficient decision may be taken by the supervision without the loss of any time.

Asset-Liability supervision Committee (Alco)

In most cases, day-to-day risk evaluation and supervision is assigned to a specialized committee, such as an Asset-Liability supervision Committee (Alco). Duties pertaining to key elements of the risk supervision process should be adequately separated to avoid possible conflicts of interest - in other words, a financial institution's risk monitoring and control functions should be sufficiently independent from its risk-taking functions. Larger or more complex institutions often have a designated, independent unit responsible for the invent and supervision of balance sheet management, together with interest rate risk. Given today's comprehensive innovation in banking and the dynamics of markets, banks should recognize any risks possible in a new goods or assistance before it is introduced, and ensure that these risks are right away carefully in the evaluation and supervision process.

Corporate Governance Principles

Corporate governance relates to the manner in which the firm of the assosication is governed, together with setting corporate objectives and a institution's risk profile, aligning corporate activities and behaviors with the anticipation that the supervision will control in a safe and sound manner, running day-to-day operations within an established risk profile, while protecting the interests of depositors and other stakeholders. It is defined by a set of relationships between the institution's management, its board, its shareholders, and other stakeholders.

The key elements of sound corporate governance in a bank include:

a) A well-articulated corporate strategy against which the comprehensive success and the gift of individuals can be measured.

b) Setting and enforcing clear assignment of responsibilities, decision-making authority and accountabilities that are acceptable for the bank's risk profile.

c) A strong financial risk supervision function (independent of firm lines), sufficient internal control systems (including internal and external audit functions), and functional process invent with the principal checks and balances.

d) Corporate values, codes of conduct and other standards of acceptable behavior, and efficient systems used to ensure compliance. This includes extra monitoring of a bank's risk exposures where conflicts of interest are staggering to appear (e.g., relationships with affiliated parties).

e) Financial and managerial incentives to act in an acceptable manner offered to the board, supervision and employees, together with compensation, promotion and penalties. (i.e., compensation should be consistent with the bank's objectives, performance, and ethical values).

f) Transparency and acceptable facts flows internally and to the public.

Tools mentioned above can be utilized in identifying and managing dissimilar risks in the following manner:

I. Credit Risk

It is managed by setting thrifty limits for exposures to personel transaction, counterparties and portfolios. Due limits are set by reference to reputation rating established by reputation Rating Agencies, methodologies established by Regulators and as per Board's direction.

o Monitoring of per party exposure

o Monitoring of group exposure

o Monitoring of bank's exposure in contingent liabilities

o Bank's exposure in clean facilities

o Analysis of bank's exposure goods wise

o Analysis of concentration of bank's exposure in Assorted segments of economy

o Product profitability reports

Ii. Market

Financial Institutions should also have an sufficient principles of internal controls to oversee the interest rate risk supervision process. A underlying component of such a principles is a regular, independent impart and evaluation to ensure the system's effectiveness and, when appropriate, to advise revisions or enhancements.

Interest rate risk should be monitored on a consolidated basis, together with the exposure of subsidiaries. The institution's board of directors has extreme accountability for the supervision of interest rate risk. The board approves the firm strategies that decide the degree of exposure to risk and provides guidance on the level of interest rate risk that is acceptable to the institution, on the policies that limit risk exposure, and on the procedures, lines of authority, and accountability related to risk management. The board also should systematically impart risk, in such a way as to fully understand the level of risk exposure and to compare the doing of supervision in monitoring and controlling risks in compliancy with board policies. Reports to senior supervision should provide composition facts and a sufficient level of supporting detail to facilitate a meaningful evaluation of the level of risk, the sensitivity of the bank to changing market conditions, and other relevant factors.

The Asset and Liability Committee (Alco) plays a key role in the oversight and coordinated supervision of market risk. Alcos meet monthly. investment mandates and risk limits are reviewed on a regular basis, commonly annually to ensure that they remain valid.

Risk supervision and Risk Budgets

A risk allocation establishes the tolerance of the board or its delegates to wage or capital loss due to market risk over a given horizon, typically one year because of the accounting cycle. (Institutions that are not sensitive to every year wage requirements may have a longer horizon, which would also allow for a greater degree of leisure in briefcase management.). Once an every year risk allocation has been established, a principles of risk limits needs to be put in place to guard against actual or possible losses exceeding the risk budget. There are two types of risk limits, and both are principal to constrain losses to within the prescribed level (the risk budget).

The first type is stop-loss limits, which control cumulative losses from the mark-to-market of existing positions relative to the benchmark. The second is position limits, which control possible losses that could arise from future adverse changes in market prices. Stop-loss limits are set relative to the comprehensive risk budget. The allocation of the risk allocation to dissimilar types of risk is as much an art as it is a science, and the methodology used will depend on the set-up of the personel investment process. Some of the questions that sway the risk allocation comprise the following:

* What are the principal market risks of the portfolio?

* What is the correlation among these risks?

* How many risk takers are there?

* How is the risk staggering to be used over the policy of a year?

Compliance with stop-loss limits requires frequent, if not daily, doing measurement. doing is the total return of the briefcase less the total return of the benchmark. The determination of doing is a principal statistic for monitoring the usage of the risk allocation and compliancy with stop-loss limits. Position limits also are set relative to the comprehensive risk budget, and are branch to the same considerations discussed above. The function of position limits, however, is to constrain possible losses from future adverse changes in prices or yields.

Iii. Liquidity Risk

The Basel Committee has established inescapable quantitative standards for internal models when they are used in the capital adequacy context.

a. Allocation of capital into Assorted types of firm after taking into list the operational risks i.e. Disruption of firm activity, which has especially increased due to inordinate Edp usage

b. Allocation of the capital is also made amongst Assorted products i.e. Long term, short term, consumer, corporate etc. Inspecting the risks complex in each goods and its life cycle to avoid any liquidity crunch for which gap diagnosis is made. This is the job of Alco

c. For instance Contingent liabilities not more than 10 times of capital,

d. Fund based not more than 6 times of capital

e. Capital market operations not more than 1 time of capital

f. However these limits cannot exceed the regulations.

g. Parameters of controls

o Regulatory Requirements

o Board's directions

o Prudent practices

For liquidity supervision organizations are compelled to hold reserves for unexpected liquidity demands. The Alco has accountability for setting and monitoring liquidity risk limits. These limits are set by Regulatory Bodies and under Board's directions retention in mind the market condition and past experience.

The Basel Accord comprises a definition of regulatory capital, measures of risk exposure, and rules specifying the level of capital to be maintained in relation to these risks. It introduced a de facto capital adequacy standard, based on the risk-weighted composition of a bank's assets and off-balance-sheet exposures that ensures that an sufficient amount of capital and reserves is maintained to safeguard solvency. The 1988 Basel Accord primarily addressed banking in the sense of deposit taking and lending (commercial banking under Us law), so its focus was reputation risk.

In the early 1990s, the Basel Committee decided to modernize the 1988 accord to comprise bank capital requirements for market risk. This would have implications for non-bank securities firms.

Thus, the formula for determining capital adequacy can be visible as follows:

= Tier I + Tier 2 + Tier 3 *- 8% .

Risk-weighted Assets + (Market Risk Capital payment x 12.5)

Iv. Operational Risk

To administrate this risk documented policies and procedures are established. In addition, regular training is in case,granted to ensure that staffs are well aware of organization's objective, statutory requirements.

o Reporting of major/ unusual/ exceptional transactions with respect to ensuring the compliancy of the principles of Kyc and Anti-money laundering measure

o Analysis of principles problems

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