Risk Management and Basel III

Introduction

Organisations are exposed to risks of various kinds that require careful identification, assessment and response. Risks in today’s volatile environment, if not managed effectively, can have devastating effects on an organisation. Entities such as banks are exposed to several types of risks which are described as follows.

Discussion

Interest Rate Risk

Definition

Fluctuating interest rates may give rise to a risk most commonly known as interest rate risk (Choudhry 2011, p. 254). Such risk is generally experienced by bond owners. The level of risk is closely dependent upon the rate of interest prevailing in the market. The greater the price sensitivity a bond has in the market, the greater the interest rate risk it carries. The sensitivity of the bond is dependent upon two things, the coupon rate the bond carries and time remaining to bond maturity (Subramani 2011, p. 4). The greater the time left in the maturity of the bond the greater the risk it carries. For bond holders it is one of the most significant risks they need to worry about. More directly than stocks, the value of bonds is affected by the interest rate risk. Bond prices fall as and when the interest rate rises and vice versa. The logic behind this assumption is that as the rate of interest increases, opportunity cost associated with the possession of bond decreases. This is because other investments that reflect higher yields of interest attract more investor attention so they are more inclined to switch to that. To understand the definition of this concept with an example, it can be discussed that if interest rates decrease and are less than the interest rate offered by the Bond, the Bond’s attractiveness will increase as it is offering a higher rate of return than the market has to offer (Besley and Brigham 2012, p. 80).

Sources in relation to Basel Committee for Banking Supervision

1. Reprising risk

This risk arises due to the maturity timing differences of floating rate and fixed rate of bank assets and liabilities. Although such mismatches are a regular part of the Bank’s operations, they may expose the bank to unexpected fluctuations (Lawton and Jankowski 2009, p. 6).

1. Yield curve risk

The shape and slope of the yield curve may be changed by the reprising mismatches. When the bank’s income is adversely affected by the unexpected shifts in the yield curve, such risk arises (Geiger 2011, p. 43).

1. Basis risk

When the adjustment of rate is imperfectly correlated with instruments of similar reprising characteristics, such risks arise. Cash flows can change unexpectedly if the interest rate changes (Chatnani 2010, p. 151).

Measurement in relation to Basel Committee for Banking Supervision

Calculating and measuring interest rate risk is a complex task. Stimulating movements in yield curves is used to analyse interest rate risk. Heath-Jarrow-Morton framework is used to make sure that movement in the yield curve is consistent with current market yield values (Cesari 2009, p. 31). This is done to ensure that riskless arbitrage is not possible. David Heath of Cornell University, Robert A. Jarrow of Kamakura Corporation and Andrew Morton of Lehman Brothers developed the Heath-Jarrow-Morton framework in 1991. The impact of varying interest rates can be calculated by a number of standard calculations which are based on various liabilities and assets. Techniques include (Switzerland. Basel committee on bankking supervision, 2004):

1. Market to market: it includes computing the fair value of liabilities and assets.
2. The yield curve is shifted in a specific way to stress test this fair value.
3. Portfolio’s Value at Risk is calculated.
4. Cash flows and income and expenses for multiple periods are calculated to determine a set of future yield curves.
5. Redoing the previous step with random yield curve movements.
6. Liabilities’ and Assets’ interest sensitivity gap is measured to identify the mismatch with a predetermined criterion.
7. Rate Duration, Convexity, DV01and Duration are analysed.

Sources of interest rate risks and the way such risks affect the banks should be identified and therefore interest rate risk measurement is essential. Banks should have in place interest rate risk management systems depending in the range of activities and complexity of individual banks. Parameters and assumptions in measurement systems should be well documented. Risk measurement techniques should be acceptable and such systems should measure all material interest rate risks. Interest rate risk measurement is desirable for all activities of the bank that gives rise to risk. All material sources of interest rate risk should be addressed by the risk measurement systems. Validity of underlying assumptions determines the usefulness of risk measurement technique and should therefore be well understood by risk managers. Nature of activities and their complexity are two basic parameters to judge the scope of risk measurement systems (Greuning and Brajovic Bratanovic 2009, p. 231).

Risk management in relation to Basel Committee for Banking Supervision

In the management of OBS instruments, liabilities and assets four basic elements of interest rate risk management must be applicable; appropriate oversight of board and senior management; appropriate risk control, monitoring and measurement functions. Sufficient policies and procedures for risk management; independent audits and detailed internal controls.

The nature and complexity of the holdings bank has determined the manner in which the above mentioned elements are applied. So saying what constitutes an effective and efficient risk management system is indeed a subjective matter as it varies from case to case. Relatively basic risk management processes may be implemented by a bank whose operations and activities are less complex and whose senior management is actively involved in the day to day running of the bank. However if a bank has in place stringent risk management systems, it is crucial that regular internal control assessment and independent audits are carried out to ensure that the senior management has relavant, reliable and timely information to carry out and undertake other risk management procedures, as overseeing compliance with policies and procedures is critical. The Committee is of the opinion that interest rate exposures in subsidiaries should be monitored on a comprehensive and consolidated basis. The policies and procedures relating to risk management should be clearly defined and must be coherent to the complexity and nature of bank’s activities. The Committee also believes that in new activities and products the interest rate risk is inherent. An appropriate delegated committee or the board should in advance approve the risk management and hedging initiatives (Switzerland. Basel committee on banking supervision, 2004).

Liquidity Risk

Definition

In basic terms, liquidity risk is defined as the inability to sell an asset and convert it into liquid form (Matz 2011). Where investments or assets are harder to translate into cash terms, there is a presence of liquidity risk. The lack of marketability of investments is one form of liquidity risk, and it can be applied not just to the banking sector, but to stocks, real estate, art, and various other investments. However, liquidity also needs to be understood in the terms of cash flow, and thus can be considered as a flow concept. Thus, liquidity risk also entails the ability of realising these flows. There are several types of liquidity risk. Market liquidity risk arises when due to lack of liquidity a commodity cannot be sold. One of the possible reasons for this type of risk is the widening of bid and offer phenomena. Funding liquidity risk is another type of liquidity risk in which liabilities and obligations cannot be settled or discharged due to lack of liquid reserves (Athanassiou 2012, p. 187).

There are several causes of liquidity risk. It can arise if a party is committed to selling an asset in the market but simply cannot because there is no one in the market who wants to trade that commodity. In low volume markets or higher emerging markets this risk can be commonly found. At times of crisis, liquidity risk has the ability to affect the biggest stocks. This risk arose to extremely high levels during the 9/11 attacks and the 2007/08 global financial crisis.

Sources in relation to Basel Committee for Banking Supervision

Liquidity risk may spout from macro factors or in simple terms the external environment of the bank of which the bank has little or no control. It can also emanate from the operational and financing policies that are developed in-house by the bank itself. Liquidity risk can also arise due to the nature of banking business carried out by the bank itself. In the case of a bank, a bank may hold deposits that are immediately payable on demand or have a shorter maturity. Such maturity transformation exposes significant liquidity risks to the bank itself while the depositors enjoy the privilege of same investment. To address this maturity risk, banks almost always carry out pool depositing so that the cash inflows and outflows can be managed perfectly (Switzerland. Basel committee on bankking supervision, 2004).

Measurement in relation to Basel Committee for Banking Supervision

The liquidity risk should be controlled, identified, monitored and measured by a sound process formulated by the bank. For all jurisdictions, branches, entities and subsidiaries, liquidity risk should be appropriately identified and defined. In measuring the level of liquidity risk banks should be aware of the fact that obtaining liquidity from the capital markets is more risky than obtaining liquidity from traditional retail depositors. To measure such risk a bank should consistently monitor off and on balance sheet positions to gain an insight of what factors might arise that may cast significant liquidity problems. Determining relevant, reliable and realistic market values of assets held by the bank portrays a message that the liquidity risk is being measured appropriately. In measuring such a risk a bank should try to identify the relation and connections between other types of risks and liquidity risk a bank is exposed to (Matz and Neu, 2007). Liquidity measurement might sound simple but in reality it isn’t. It involves assessing the future net funding shortages by identifying and matching cash inflows against cash outflows and the value of the asset in liquidity terms. In relevance to various scenarios such as scenarios involving severe stress, range of stress and normal conditions a bank should measure and assess the forecasted cash flow position of derivatives, off balance sheet commitments, liabilities and assets. The risk measurement approach should incorporate several factors such as time horizons, daily funding capacity, changes in liquidity needs, daily liquidity needs and long term liquidity needs. Together with this it should also take into account the internal cash generation ability that can impose significant threat to liquidity. Risk measurement, as per the committee, should include the following (Switzerland. Basel committee on bankking supervision, 2004):

1. Future cash flow position for assets and liabilities.
2. Settlement, custody and correspondent activities.
3. The functional and operational currency of the bank.
4. Off balance sheet position associated with sources of contingent liquidity demand

Risk management in relation to Basel Committee for Banking Supervision

Under both stressed and normal conditions, a bank should proactively, and on a timely basis, manage its risk and liquidity position to meet settlement and payment obligations. This management will contribute to settlement and payment of systems more smoothly. The responsibility for the management of liquidity risk lies with the bank itself. A sound liquidity management framework should be established by the bank that enables it to mange its liquidity on an ongoing basis. As per the Basel Committee for Banking Supervision, following techniques can be adopted to manage liquidity risk:

• Liquidity-adjusted value at risk (VAR): It incorporates liquidity risk into VAR. The equation for such definition can be stated as “value at risk + exogenous liquidity cost”. The amount of time required to liquidate the portfolio divides the VAR over the period to incorporate another adjustment (Dowd 2002, p. 127).
• Liquidity at risk: It requires careful management of Forex reserves. Range of variables such as credit spreads; commodity prices and exchange rates are used to consider the liquidity position of the company.
• Contingency plans based on scenario analysis: Liquidity risk may arise due to several reasons. Scenario building helps to analyse how a particular reason will give rise to a liquidity risk in a particular scenario. Secured borrowings with restricted terms, tight collateral requirements and inability to securitize assets can affect a Bank’s liquidity. When such shortfalls in liquidity are anticipated contingency funding plans can be devised and formulated.
• Diversification: Proper liquidity management should not only be called upon at times of crisis. A bank should look to manage resources and look for ever green lines of credit as it will result in a better credit rating which might come in handy at tough times.

Operational Risk

Definition

Operational risk does not correlate with the macro-turned monetary, precise or extensive danger (Greuning and Brajovic Bratanovic 2009, p. 297). It is the danger staying in the wake of verifying financing and precise danger, and incorporates hazards coming about because of breakdowns in interior techniques, individuals and frameworks. Operational danger might be skimmed over as human hazard; it is the danger of business operations falling flat because of human blunder. Operational danger will change from industry to industry, and it is imperative to pay attention to it when looking at potential venture choices. Commercial enterprises with more level human connections are liable to have lower operational hazards. In simple terms operational risk is the risk that arises due to an organisation’s internal activities. Such risk can be created by the processes, people and systems which help in the smooth running and operation of the company. It is indeed a broad discipline and therefore incorporates in itself environmental, fraud, physical and legal risks. This is the risk that arises due to the operations and daily activities of the company. Basel II contains a wider and broad definition of operational risk. It states that such risk is risk of loss due to inappropriate and insufficient external events, systems, people and processes. Since it is not used to generate profit, it differs from other types of risk. In order to keep risk within the risk appetite, operational risk must be managed effectively. Risk appetite is the size of loss an organisation is willing to accept and tolerate (Switzerland. Basel committee on banking supervision, 2004).

Sources in relation to Basel Committee for Banking Supervision

There are several sources of operational risk. Most of them are discussed in turn.

1. Failed or inadequate internal processes

In order to deliver their product to the consumer, financial institutions operate several processes. Failure of a certain process can give rise to Process risk. Incorrect processing of transactions, sending bank statement to a different customer’s addresses etc. all amounts to process risk (Young and Coleman 2009, p. 101).

2 People

Discrimination claims, violation of employment or workforce health laws may all constitute to operational risk and failures. Insufficient training, lack of honesty and integrity, over reliance on key individuals, lack of segregation and human error all amounts to operational risk (Soprano 2009, p. 194).

3 Systems

With time technology is reaching new heights. With increasing dependency on IT and its over reliance, this has exposed organisations to significant operational risk. A simple network error or unconnectivity may mean that the transaction cannot be processed resulting in customer alienation. Other operational mistakes include data corruption problems (Tattam 2011, p. 10).

4 External events

The external macro environment of a business exposes organisations to operational risks. Business strategies that won’t work out and result in business failures are other relevant examples and sources of operational risk.

Measurement in relation to Basel Committee for Banking Supervision

Many banks these days, which are considering the existence of operational risk and its measurement, are those that are in the early days of their operation. Since they are new to the industry, they have very few risk measurement systems as per the Basel Committee. Others however are actively considering analysing and evaluating measurement techniques. With regard to operational risk, several banks have developed more advanced techniques although in most of the organisations methodologies are experimental and simple. While measuring operational risks, several banks have concluded that a simple cost benefit analysis has indicated that the cost of measuring that operational risk has exceeded the loss created by the operational risk. A deeper risk measurement approach has indicated that certain operational risk has lower probabilities but their impact can be significantly high. Measuring operational risk requires the measurement of probability of operational risk and the size of the loss. The risk factors are generally quantitative, but they too can be qualitative in nature. To measure operational risk, some banks have developed risk monitoring systems. Banks theses days monitors several variables such as delays, errors etc.

Risk management in relation to Basel Committee for Banking Supervision

Operational risk management process is a continuous process which involves risk identification, risk decision making and implementation of controls. Such risk than may be managed appropriately by either accepting, mitigating or avoiding risk. Operational risk management has four basic principles one of which is anticipate the risk and plan it accordingly. The operational risk management has a detailed process outlined as follows (Switzerland. Basel committee on bankking supervision, 2004):

In depth

It encourages the establishment of context. It encourages banks to identify, analyse and evaluate risk. It then goes on to treat risk appropriately and then continually monitor and review it.

Deliberate

This process defines the management in five models. Identifying and assessing hazards, take decisions regarding risk, implement system of internal controls and continuously supervise the process to identify and solve any deficiencies found.

Conclusion

To conclude it can rightly be stated that banks are exposed to risks of various kinds. Interest rate risk, operational risk, liquidity risk etc. all may have significant and devastating impacts on a bank if not managed effectively. Basel III is a useful publication and set of rules that guides banks on risk identification, assessment, management and mitigation. It will continue to play a pivotal role to manage risk in years to come.