August 22, 2008
Beneficial dialogue : Supervisory Risk Review Process in the Banking Sector :
The banking sector performs a crucial intermediation in the economy – it mobilises funds from those who have funds without avenues to utilise them to those who want to use it for business but do not have them. This is the basic process of banking, which gets manifested in diverse forms of deposit attracting and disbursal activities. In this process, banks acquire expertise on various types of business financing and start several advisory and underwriting services.
As they allocate such funds, banks take a variety of risks — while giving loans there is a lurking fear that the beneficiary will not return the money (credit risk ); while investing in assets such as stocks and bonds, there is a probability that the asset prices will crash (market risk), there is a risk that the exchange rates of currencies will change (currency risk) or there can be a sudden demand from the depositors to withdraw money leading to a cash crunch( liquidity risk). Other key risks that the bank faces are from faulty operational processes (operational risk), from damages to its reputation (reputation risk) and from wrong strategic thrust (strategic risk).
The global financial turmoil of 2007 that originated from the sub-prime crisis in the United States is a stark reminder to every financial institution that no matter how strong their systems are and no matter how convincing their business strategy, they are not immune to adverse shocks. The unfolding financial turmoil has thus prompted financial institutions to reconsider policies, business models and risk management practices.
When the going is good, risk management is seen as a burden on business expansion in an organisation. 'Why fix, if something is not broken' seems to be a common argument. There are other reasons for putting aside risk management issues as the business chugs along. Setting up a risk management framework and monitoring risks on a daily basis implies costs in terms of physical and human infrastructure. The management and monitoring of risks require specialised technical skills. Thus, the sector needs the rude shock of the reality of billions of dollars of net worth getting eroded by financial shocks such as the financial turmoil of 2007 to revisit the archaic risk management systems.
It therefore hardly comes as a surprise to see the growing consciousness about risks in banks as well as among regulators worldwide. As a matter of fact, one observes that the obsession with profits gets tempered by a combined assessment of risks and returns in the banking sector. Unbridled business growth is contained and a more prudent business model becomes the preferred choice.
There is thus a resurgence of interest in risk management systems and practices across the world, cutting across financial and non-financial enterprises. In the banking sector, the risk management systems are guided by the prescriptions of Basel II accord, the global benchmark for risk management practices for the banking sector.
While Basel II sets the minimum standards for risk management for internationally-active banks, it gives national regulators (the central banks) the discretion to tweak the rules to suit country specificities. As is evident from the implementation of Basel II accord globally, regulators have also applied such standards for local banks, with a view to enhance the robustness of the financial systems.
Pillars
The three pillars of Basel II, aimed at measuring the capital adequacy of banks ( Pillar 1), managing enterprise-wide risks ( Pillar 2) and disclosing appropriate risk-related information ( Pillar3), are accepted as industry benchmarks of best practices for the banking sector.
In a survey conducted by the Professional Risk Managers' International Association (PRMIA), it was observed that 86 per cent of finance professionals felt that the application of Basel II norms promoted better risk management, of which 74 per cent of respondents believed that Basel II implementation will make the banking system more stable and less prone to shocks.
Briefly, the three pillars of Basel II are being implemented right under the nose of the supervisor, the central banks or the financial services authorities of different countries. In Pillar I, the bank assesses and measures its minimum capital requirements, for credit, market and operational risks. In Pillar II, active capital management by bank and regulatory review of bank's risk profile ensures that banks have systems, processes and funds to manage its risks. In Pillar III, the bank discloses risk information to the market, which in turn rewards sound risk management or penalises banks with weak risk monitoring framework.
Basel II is an improvement over the earlier Basel I accord of 1988, where only Pillar I existed. Basel II adds two more pillars and also refines Pillar I considerably (chart 1).
As supervisors of the financial system, the central banks are interested in maintaining the stability of the financial system to ensure that the economy moves on a steady growth path. As adverse financial conditions are detrimental to economic progress, risk management systems are seen as crucial preventive mechanism.
To ensure financial stability, therefore, the banking supervisor makes an active entry into the risk management scene in the Pillar II Supervisory Review Process (SREP).
The objective is to ensure the robustness of the risk management framework, comprehensive coverage of all the material risks faced by the bank and adequacy of the supporting functions with respect to the size, nature and complexity of the operations of the bank.
SREP aims to enhance the link between an institution's risk profile and its capital. It is essentially based on a dialogue between the supervisor and individual banks, with the intention of ensuring that the institutions have sufficient capital to support all its risks. The dialogue, as the Committee of European Banking Supervisors (CEBS) has noted, '...should embrace all aspects of business risk and control risk, including risk management systems, internal control systems and internal governance'.
The Financial Services Authority in the UK observed, "Our dialogue (in Pillar 2) will be of sufficient depth for us to come to a view on the appropriateness of risk management practices and capital adequacy of each firm in a group." The Australian Prudential Regulations Authority explained that, while conducting the risk assessment exercise, it 'will draw upon all the relevant information sources and analytical tools at their disposal'. The assessment process will include analysis of 'the inherent risks facing the institution, the effectiveness of management and controls and the extent of capital support to meet the unexpected losses'.
The process of risk assessment therefore encompasses all the material risks faced by the bank. In such an assessment materiality and proportionality of risks play key roles. While assessing the risk profiles of the banks, the supervisor asks two questions: (i) how material are the risks faced by the bank; (ii) how important is the bank to the overall financial system?
The depth of the supervisory risk assessment is greater for banks that are inherently riskier and also for banks important in the systemic context.
Finally, the Supervisory Review Process interfaces itself with the internal capital calculation of banks to cover all its material risks (ICAAP). In ICAAP the banks come out with their own assessment of the material risks faced by them. Being the bank's assessment of their own enterprise wide risk, the ICAAP is therefore thoroughly assessed by the supervisor in their risk assessment of banks, involving a detailed flowchart
of functions.
The International Monetary Fund in its latest (July 2008) assessment of world output growth has pointed at Asia and the Middle East as economies where robust growth is expected in the few years to come. As the economy grows, there will be more demand for investments in economic sectors, housing development and greater consumption. Banks will have to do more business in meeting the demands from both investors and consumers. Hectic activity in the banking sector in the Middle East is thus likely in the near future.
SREP has already been initiated in Gulf economies. In Bahrain, the supervisor, the Central Bank of Bahrain, is pro-actively looking at the risks faced by the banking sector in Bahrain. While the ultimate outcome of the process is still not known, this has put banks in Bahrain in an 'alert' mode, in terms of revisiting their risk management models and aligning their framework to the best practices.
The Supervisory Review Process has not only set the ground rules for risk management processes in banks, but initiation of such a dialogue is definitely bringing banks closer to the much-needed enterprise-wide risk management practices, where all risks are discussed not in isolation, but under a single structure.
While the process enables the banks to understand their risks better, it empowers the central banks in their management of financial system, thereby improving financial stability. A robust risk management framework at the bank level, a proactive regulator with necessary information on risks to the banking sector and greater awareness among the masses through improved disclosures — the supervisory assessment of the risks in banks is likely to craft a win-win situation in the financial sector.
-- Recently published in Gulf News Banking Quarterly ( Q3)and targeted at non-risk professionals who are working or interested in the financial sector.
Posted by sunandoroy at 09:59 AM
