RISK MANAGEMENT IN BANKS
Risk management as a whole is the process of analyzing, recognizing and taking or mitigation of uncertainty as a result of an investment decision. Once investment objectives have been set and the level of risk tolerance set there is need for the investor or the fund manager to carryout analyses so as to the degree of exposure the business is towards lost and set up appropriate actions to stop or reduce the level of risk. It has been shown by the recession that started in 2008 due to loose credit management in the different firms offering financial services that if there is inadequate risk management; it will result to sever concerns to both the companies on one side and individuals on the other side. The concept of risk management is a call for concern in the financial world as a whole.
More especially in banking risk management has been undergoing transformation over time, which is as a result of the emerging financial crisis over the years and the fines imposed in its wake. Nowadays, out of the staff that make up a bank, about 50 % of them are based on risk-related operational processes like the credit administration and 15% for work analysis. A research was carried out by McKinsey and suggests in his results that by the year 2025 this number are going to change to 25% and 40% respectively.
The management of risk on credits
This is the bank’s internal mechanism to approve and monitor the issuing of credit. This kind of risk arise from the default ethic that a borrower might fail to do a required payment. In such a situation the lender (bank) is directly affected negatively because there is disruption in cash flow, increase in collection cost, lost in principal and interest. As a result of this the higher the cost of borrowing in the bank the higher will be the risk on credits. Yield spread can be used in such a situation to study the risk of the person or the kind of business the money is given to. The lender to also reduce the level of risk can ask the borrower’s security such as an insurance.
Risk management in Markets
Banks that deal with investment have the habit to make use of the stock market by buying and selling securities (bonds and shares). Fluctuation of prices of securities in the stock market makes it a place where a bank makes an increase of money like in the case where the securities bought increases but in the case where the currency losses value the bank undergoes a lost. In such a transaction the risk is high because the variable range of securities and that they extend over a variety of countries. The various securities that constantly change are equity risk, risk on interest rate, risks on currency and risk on commodities.
Risk management on investment
This kind of risk comes into play in a situation where the bank comes into possession of another company either through an absorption or an amalgamation. As a result of this a whole new sets of risk will be now put on the management of the bank to make sure the acquired company runs in success. This involves managing the new companies tax rates, share its operation in order to continue making profits from the company, handling the employees of the new company and assuring their benefits just to mention a few. Also the new company’s risks are to be managed alongside that of the bank.
Operational risk management
This is the department that sees that day after day the bank meets up with the various services it offers. There is a range of challenges that the bank face and hence different operational risk some of which can be associated to hacking, failure of modern technology including heists by ATM and banking fraud. Below is a list of operational frauds likely to occur in banks
This refers to the potential of the bank to pay on demand. Transactions on demand like the transfer of funds from a saving account to a check which is the act of the bank making payment for the exchange of goods and services on the behalf of the customer makes them operate as a liquid asset. Other services include when a borrower want money from his line of credit, the need of money in order to settle bills. The main problem with liquidity is that the bank cannot predict the amount and the timing of the customer’s need for money.
Another category of liquidity risk is the off-balance sheet risks for example derivatives, loan commitment and letters of credit. A letter of credit is a situation in which a bank assures an exporter will receive money from the importer upon delivery of a good in what is known as a commercial letter of payment. When a bank is able to provide a line of credit it is referred to as a loan commitment.
In the case of derivatives, the bank comes in play in two different ways: credit default swap and interest rate swap. Interest rate swap is the coming together of two parties in which one party accepts to exchange fixed interest rate payment against floating rates by the other party. Credit default swaps is when a person guarantees that he will accomplish a principal payment on a bond to the holder of the bond. The problem of liquidity is solved through asset and liability management.