Financial Risk Management in Mauritius Banking Sector

Financial chance Management in Mauritius Banking atomic number 18naDuring the past 10 years, thither have been great varietys in the Mauritian billsboxing sector and this is a continuing process that will not stop here. This is almostly because of fast innovations in the fiscal markets and the internationalization of the financial flows. Other factors like technological development and deregulation have both triggered competitive pressures and also volunteerd new opportunities among banks. But these opportunities ar also subject to conglome account pre plays that challenge traditional approaches to banking seekiness charge. These factors have influenced the financial world on the international level and the Mauritian banking sector has not been left unaffected.The growth of international financial markets banks have been assailable to a goodr access to funds. As a result of which banks have been developing new products, services and techniques. The receipt of deposit s and granting of loans, being the traditional banking practice, is today only unrivalled break away of a banks activities.These new instruments have also drawn touch to aras where financial ventures were earlier thought to be relatively unimportant. Hence banks ar at once exposed to a greater variety of risks and their ability to measure, monitor and steer risks accordingly is becoming a decisive parameter for their survival.The aim of this project is to fork over an overview of the heed process of financial risks in our Mauritian banking sector as risk is the fundamental element that influences the financial behavior.Banking adjust on the linesBanks atomic number 18 faced with a wide array of risks in their course of their operations, as illustrated in the figure below. In general, risks are categorised into three different parts Financial adventures, Operational Risks and line of merchandise Risks.Figure 1 Categories of Banking RisksBanking RisksFinancial RisksOpera tional Risks Business RisksInterest Rate Risk 1) Business Strategy Risk1) Legal Risk.Foreign Exchange Risk 2) Internal dodging and Operational Risk 2) Policy Risk.Credit Risk 3) Technology Risk 3) SystemicLiquidity Risk 4) Management and Fraud (Country) Risk.Source Annual idea on Banking Supervision 2000 BOMFinancial risk concern the effective guidance and sway of the finances of an organisation and the effects of external factors such as handiness of address, foreign exchange rates, have-to doe with rate front line and liquidity risk. For this project only the financial side of Risk Management is going to be considered. centralise will be on the four main qualitys of risks which areInterest rate Risk is the risk borne by an interest-bearing plus, for example in this pillow slip a loan, callable to variation in interest rates.Foreign Exchange Risk is a form of risk that crop up due to the change in price of one currency against another.Credit Risk is the risk of loss d ue to a debtors non-payment of a loan.Liquidity risk is the risk to mesh arising from a banks inability to meet its obligations when they come due.Operational risks are related to a banks overall organisation and functioning of internal systems, including computer-related and other technologies, conformity with bank policies and procedures and measures against mis focussing and fraud. Although these types of risks are important, emphasis will not be put on them in this project.Business risks are associated with a banks business environment, including the macroeconomic and form _or_ system of government concerns, legal and regulatory factors and the overall financial sector infrastructure and payment system.Outline of ChaptersChapter 2Literature ReviewThis chapter will focus on forward studies and surveys carried step to the fore with respect to financial risks encountered by banking institutions around the world. It will also focus on the different techniques used to manage thes e types of risks.Chapter 3Overview of the Mauritian Banking SectorThis chapter aims at giving an overview of the current Mauritian banking sector and also information pertaining to risk solicitude.Chapter 4Research MethodologyIn this chapter an outline of the methods used to draw info and carry out the research is given. The way in which the interview questions have been set and how the data has been analysed using different techniques.Chapter 5 Presentation of findings and digestThis chapter which is the main one aims at presenting and explaining the answers received from the different interviews and data from the annual crosss of banks, in a structured way.Chapter 6 Recommendations and ConclusionThis last chapter consists of the suggestions regarding financial risk wariness for the Mauritian banking sector and also the answer to the main question.2. LITERATURE REVIEW2.1 Defining Financial RisksFinancial risks in the banking field are the chance that the result of an action or withalt could bring up unfavorable impacts. Such outcomes could either cause direct loss of remuneration or bang-up or may result in limitations on banks potentiality to meet its business objectives. Such constraints pose a risk as these could influence a banks capacity to perform its ongoing business or to take advantage of opportunities to advance its businessRisks are frequently defined by the negative impacts on profitability of numerous separate themes of uncertainty. While the types and degree of risks of an organization may be exposed to depend upon a number of factors such as its size, confusedity business activities, volume etc, it is believed that generally the banks face Credit, Market, Liquidity, Operational, Legal and Systemic risks etc.2.2 Definition of Financial Risks as Per Basel IIThe role of risk management in banking has changed from the simple insurance of identified risks, to a discipline that concentrates on complex econometric and financial homuncul us of uncertainty. Financial risk management has been defined by the Basel committee (2001) as a sequence of four processes the identification of events into more or broad categories of market, credit, operational and other risks and specific sub-categories the assessment of risks using data and a risk model the monitoring and reporting of the risk assessments on a timely basis and the control of these risks by senior management.The first Basel accede (1988) analysed only credit risks in the banking book the Basel Amendment (1996) extended this to market risks in the trading book and now the new Basel 2 Accord that will be adopted by all G10 and many other countries in 2007 refines credit risk assessments to become more sensitive and extends the calculation of risk capital to take operational risks.2.3 Distinction between Risk Management and Risk Measurement?Risk measurement is a key part of the general risk management process, but its certainly just one of the parts. Other, si milarly key parts complicate defining risks, setting policy risk limits and guidelines, and taking action when those limits are threatened of being breached. Risk management is as much about people, procedures, and communication, as it is about quantitative methods involved in risk measurement (Suren Markosov, 2001).Risk measurement, however, is important to the success of the risk management process. Part of the risk measurement task is to guarantee that the risk measures being used are suitable to the temperament of the risks, and since these risks groundwork be quite various in constitution, so can the required choices of risk measures.2.4 Why do Banks manage Risks?The analysis of risk management reported in Santomero (1995) gives us a lists of dozens contributions and at least four separate rationales considered for active risk management. These include managerial self-interest, the non-linearity of the tax structure, the cost of financial distress and the existence of capi tal market imperfections.Risk is a fundamental part of the banking business, it is not amazing that banks have been using risk management ever since there have been banks the industry could never have survived without it. The only modification is the degree of sophistication now necessary to reflect the new complex and fast moving environment (Laurence H Meyer, 2000).The Asian financial crisis of 1997 has submitn us that ignoring necessary risk management can also add to economy-wide difficulties. The long flow of extraordinary economic growth and prosperity in Asia had hidden weaknesses in risk management. Many Asian banks did not think about risk or conduct a cash flow analysis before giving way loans, but rather lent on the basis of their relationship with the borrower and the handiness of guarantee despite the fact that the security was often hard to seize in the event of default. The result was that loans including loans by foreign banks grew faster than the capacity of the borrowers to repay.Risk management is clearly not free. In fact its expensive in both resources and in institutional disturbance. The cost of delaying or avoiding proper risk management can be extreme failure of a bank and possibly failure of a banking system (Laurence H Meyer, 2000).3.4 Determinants of RisksWhen banks are exposed to risk, this implies that they are defenceless to financial distress and failure. Determinants of risk are thus causes of problem bank failure. The common causes of bank failure areManagement.Argenti (1984) attributed 17% of his A-scores to management style and composition. He attributed another 71% to considering deficiencies, poor response to change, over-gearing, over trading and large projects all of which hinge upon capabilities of management. Arguments that he put forward was that management is the essential and single most important cause of financial distress.Asset qualityLoan and advances comprise a substantial portion (50%-80%) of commerc ial banks arrive assets and they account for more than 70% of their income. This highlights the banks role as financial intermediary. Asset quality is the most important determinant of bank risk exposure. This was pointed out by Hefferman (2000), Gonzalex-Hermossilo (1999), and Hardy (1998). The asset quality of a bank is affected by various factors such as, over concentration, insider lending and political loans.Over-ExpansionBanks that grow quickly tend to have unjustified risks and often find that their administrative and management information system cannot keep up with the rate of expansion. Too much liquidity by way of rapid deposit growth could also be a problem in that management may on a lower floortake riskier credit proposals and this will adversely affect the asset quality.CapitalizationCapital adequacy ratio is a function of adjusted risk assets. A bank can either hold on this ratio by increasing its capital or reducing of adjusted risk assets. The prime objective of this control is to protect depositors. However Blum (1998) found that with the incentives for asset substitution, capital adequacy requirements may actually affix risk. This was found in the case of J.P Morgan and Deutsche Bank. In Mauritius the BOM has adopted a capital adequacy ratio of 10% to match international standards.FraudFraud is one of the key determinants of risk. However it is closely related with the management competence that some fraudulent activities have passed discharge as incompetence. The BCI and Barings Bank are good examples.2.5 HOW ARE findS MANAGED?As pointed out by Anthony M. Santomero (1997) there need to be essential procedures that must be put in place to carry out satisfactory risk management? In essence, what techniques are employed to both limit and manage the different types of risk, and how are they implemented in each area of risk control? The management of the bank relies on a series of steps to put into operation a risk management system. The se can be seen as containing the following four parts2.5.1 Standards and reports,2.5.2 Position limits or rules,2.5.3 enthronement guidelines or strategies,2.5.4 Incentive contracts and compensation.In general, these tools are used to measure exposure, define procedures to manage these exposures, limit individual positions to acceptable levels, and encourage decision makers to manage risk in a manner that is conformable with the firms goals and objectives (Oldfield and Santomero, 1995). To see how each of these four parts of basic risk management techniques achieves these ends, we elaborate on each part of the process below.2.5.1 Standards and ReportsThe first of these risk management techniques involves two unlike conceptual activities, i.e., standard setting and financial reporting (Santomero and Babbel, 1996). They are listed jointly because they are the sine qua non of any risk system. Underwriting standards, risk categorizations, and standards of limited review are all tradi tional tools of risk management and control. Consistent evaluation and range of exposures of various types are essential to understand the risks in the portfolio, and the degree to which these risks must be mitigated or absorbed (Hodgson, 1999).The consistency of financial reporting is the next ingredient. Obviously outside audits, regulatory reports, and rating agency evaluations are necessary for investors to measure asset quality and firm level risk. These reports have long been standardized, for better or worse. However, the need here goes beyond public reports and audited statements to the need for management information on asset quality and risk posture. Such internal reports need similar standardization and much more frequent reporting intervals, with nonchalant or weekly reports substituting for the quarterly GAAP periodicity.2.5.2 Position Limits and RulesThe use of position limits, and minimum standards for participation can be categorized as a second method for internal control of active management. According to Santomero (1995) risk taking is restricted to only those assets or counterparties that pass some prespecified quality standard. Then, even for those investments that are eligible, limits are compulsory to cover exposures to counterparties, credits, and overall position concentrations relative to various types of risks. While such limits are costly to set up and control, their prevarication restricts the risk that can be assumed by any one individual, and therefore by the organization as a whole.In general, each soul who can commit capital will have a well-defined limit. This applies to traders, lenders, and portfolio managers. Summary reports show limits as well as current exposure by business unit on a periodic basis. In big organizations with thousands of positions maintained, precise and well-timed reporting is difficult, but even more necessary (Lopez, 2003).2.5.3 Investment Guidelines and StrategiesInvestment guidelines and recommen ded positions for the instant future are the third technique commonly in use. Cummins et al (1998) provide that under this direction of management control, strategies are determine in terms of concentrations and commitments to particular areas of the market, the extent of desired asset-liability mismatching or exposure, and the need to hedge against systematic risk of a particular type.The limits described above show the way to passive risk avoidance and diversification, because managers generally work within position limits and prescribed rules. Beyond this, guidelines offer firm level advice as to the purloin level of active management, given the state of the market and the willingness of senior management to absorb the risks implied by the combined portfolio. Such guidelines lead to firm level hedge and asset-liability matching. In addition, securitization and even derivative activity are rapidly growing techniques of position management open to participants looking to reduce their exposure to be in line with managements guidelines.2.5.4 Incentive SchemesBanks can enter incentive compatible contracts with line managers and make compensation linked to the risks assumed by these individuals, and therefore the need for complex and costly controls is decreased. However, such incentive contracts require precise position valuation and proper internal control systems.Such tools which include position posting, risk analysis, the allotment of costs, and setting of required returns to various parts of the organization are not irrelevant. Despite the complexity, well designed systems align the goals of managers with other stakeholders in a most desirable way. In fact, most financial debacles can be traced to the absence of incentive compatibility, as the cases of the deposit insurance and so clearly illustrate. The association of managerial compensation to book net income can bring about acquisition of investments with negative convexity, duration mismatch risk, liquidity risk and credit risk, whose book salary are higher than their expected return (Cummins et al., 1998).STRATEGIES USED BY BANKS TO MANAGE RISKSINTEREST RATE RISKAll banks face interest rate risk. This type of risks occurs when long term mortgages are funded by short term deposits. Interest rate risk is like the blood pressure for banks and is vital for their survival.(Ron Feldman and Jason Schmidt)Furthermore, according to the Basel Committee (2001) interest rate risk is the exposure of a banks financial condition to adverse movements in interest rates. Accepting this risk is a normal part of banking and can be an important source of profitability and shareholder value.According to the Bank of Jamaica each banking institution needs to establish explicit and prudent interest rate risk limits, and ensure that the level of interest rate risk exposure does not exceed these limits. Interest rate risk limits need to be set within an institutions overall risk profile, which refle cts factors such as its capital adequacy, liquidity, credit quality, investment risk and foreign exchange risk. Interest rate positions should be managed within an institutions ability to offset such positions if necessary.Gap analysis, duration analysis and stimulation models are interest rate risk measurement techniques used by the Bank of Jamaica (2005). Each technique provides a different perspective on interest rate risk, has distinct strengths and weaknesses, and is more effective when used in junto with another.Gap AnalysisA simple gap analysis measures the difference between the amount of interest-earning assets and interest-bearing liabilities (both on- and off-balance sheet) that reprice in a particular time period. sequence AnalysisDuration is the time-weighted number maturity of the present value of the cash flows from assets, liabilities and off-balance sheet items. It measures the relative sensitivity of the value of these instruments to changing interest rates (the average term to repricing), and therefore reflects how changes in interest rates will affect the institutions economic value, that is, the present value of equity. In this context, the maturity of an investment is used to provide an indication of interest rate risk. The longer the term to maturity of an investment, the greater the chance of interest rates movements and, hence, unfavourable price changes.Simulation ModelsSimulation models are an important complement to gap and duration analysis. Simulation models analyse interest rate risk in a dynamic context. They evaluate interest rate risk arising from both current and future business and provide a way to evaluate the effects of strategies to increase earnings or reduce interest rate risk. Simulation models are also useful tools for strategic planning they allow a banking institution to effectively integrate risk management and control into the planning process.FOREIGN EXCHANGE RISKIt is the current risk to earnings and capital a rising from negative movements in currency exchange rates. It refers to the impact of adverse movement in currency exchange rates on the value of open foreign currency position.The use of hedging techniques by the Bank of Jamaica is one means of managing and controlling foreign exchange risk. Many different financial instruments can be used for hedging purposes, the most commonly used, being derivative instruments. Examples include forward foreign exchange contracts, foreign currency futures contracts, foreign currency options, and foreign currency swaps.Generally, few banks will need to use the full be sick of hedging techniques or instruments. Each bank should consider which ones are necessary for the nature and extent of its foreign exchange activities, the skills and experience of trading staff and management, and the capacity of foreign exchange rate risk reporting and control systems.CREDIT RISKCredit risk is the oldest and important risk which banks exposure and important of credit risk and credit risk management are increasing with time because of some reasons like economic crises and stagnation, company bankruptcies, infraction of rules in company story and audits (Dr.Adem Anbar, 2006).For the Norinchukin Bank in Japan (2006), transactions involving credit risk are one of the most important and strategic sources of earnings. In addition to assessments of the risks present in individual loans and other assets, the bank conducts comprehensive risk management from the perspective of its overall credit risk portfolio. In this way, the bank works to generate earnings proportionate with the level of credit risk it takes.While frequently strengthening its credit analysis capabilities, the bank conducts expert checks on the standing of borrowers, taking due account of their characteristics as cooperatives, private corporations, public entities, or non-residents. To conduct credit analysis on private corporations and public corporations, the bank has establi shed the Credit Risk Management Division, which is separate from the Corporate Business Management Strategy Division, to prepare credit analyses by industry, drawing fully on the expertise the bank has historically acquired. To achieve greater accuracy in assessments, each senior credit analyst in charge of a certain industry assesses each lymph node and business through comparisons with competitors in the same business, making use of industry research capabilities.Credit risk is measured for loans, guarantees, foreign exchange and securities, such as corporate bonds, as well as for swaps and other off-balance transactions. Measurement of risk volumes are conducted according to types of transactions partners, including domestic and overseas corporations and financial institutions.Based on estimates of the total credit extended, the bank uses information related to credit risk such as rating transition ratios that measure the probability of rating changes and are computed based on background history and future business prospects, default ratios by rating, recovery ratios in the event of default and correlations among the creditworthiness of corporations and other entities to conduct tens of thousands of fictitious scenarios, under various assumptions regarding defaults and rating changes for its customers and their productsto determine the distribution of potential losses.For the estimated potential losses, the bank calculates two risk volumes the expected loss that corresponds to the loss that can be expected on average over the next year and the probable maximum loss, which is defined as losses that can be expected under the worst case scenario. This enables the bank to check expected profitability against risk and determine the risk capital to be allocated for each business category.LIQUIDITY RISKLiquidity risk is the risk that could occur if an institution does not have enough funds accessible to meet all its cash outflow obligations as they become due. Liquidity risk management ensures that funds will be available at all times to honour the institutions obligations (Bank of Mauritius).A liquidity risk management involves not only analyzing banks on and off-balance sheet positions to forecast future cash flows but also how the documentation condition would be met (Bank of Pakistan). The latter involves identifying the funding market the bank has access, understanding the nature of those markets, evaluating banks current and future use of the market and monitor signs of confidence erosion.Banks use a variety of ratios to quantify liquidity. These ratios can also be used to create limits for liquidity management. However, such ratios would be meaningless unless used regularly and interpreted taking into account qualitative factors. Ratios should everlastingly be used in conjunction with more qualitative information about borrowing capacity, such as the likelihood of increased requests for early withdrawals, decreases in credit line s, decreases in transaction size, or shortening of term funds available to the bank. To the extent that any asset-liability management decisions are based on financial ratios, a banks asset-liability managers understand how a ratio is constructed, the range of alternative information that can be placed in the numerator or denominator, and the scope of conclusions that can be drawn from ratios. Because ratio components as calculated by banks are sometimes inconsistent, ratio-based comparisons of institutions or even comparisons of periods at a single institution can be misleading.Cash Flow Ratios and Limits.One of the most serious sources of liquidity risk comes from a banks failure to roll over a maturing liability. Cash flow ratios and limits crusade to measure and control the volume of liabilities maturing during a specified period of time.Liability Concentration Ratios and Limits.Liability concentration ratios and limits help to prevent a bank from relying on too few providers o r funding sources. Limits are usually expressed as either a percentage of liquid assets or an absolute amount. sometimes they are more indirectly expressed as a percentage of deposits, purchased funds, or total liabilities.Other Balance Sheet Ratios.Total loans/total deposits, total loans/total equity capital, borrowed funds/total assets etc are examples of common ratios used by financial institutions to monitor current and potential funding levels.EMPIRICAL tell ON FINANCIAL RISK MANAGEMENT TECHNIQUES USED BY BANKSCREDIT RISK MANAGEMENTCredit operations are traditionally the main source of income as well as risks for banks. I am going to elaborate on the result and analysis of market central bank meeting participants carried out by Ramon Moreno in 2005.It was found that 40% of the respondents to his survey cited credit to household as an important source of credit risk. According to Moreno, a distinct increase in credit to the household sector has altered risk exposures and he als o found that in some countries there is significant credit risks on the banking book associated with asset price fluctuation for example lending for residential real estate accounts for around 25% of total loans in Hong Kong and Korea, around 19% in Hungary, Poland and Israel, but lower in Colombia and Mexico.Another study carried out by Santomero in 1997 found that banks usually use a credit rating procedure to evaluate investment opportunities in order for credit decisions to be made in a consistent manner and to limit credit risk exposure.By using such a procedure banks were able to monitor the quality of its loan portfolio at any time. It was found that the credit quality report signals changes in expected loan losses, if the system is meaningful.Also many banks are starting to develop concentration reports, indicating industry composition of the loan portfolio. Moody had highly-developed a system of 34 industry groups that may be used to report concentrations. Reports such an i ndustry grouping to illustrate the kind of concentration reports that are emerging as stand in the banking industry.Moreover a credit risk survey study was done in the Turkish Banking by Dr Adem ANBAR, where he found that there is main quantitative credit risk measurer. There are expected loss (EL), unexpected loss (UL) and credit value at risk (CVAR). Although these credit risk measures are used for measuring credit risk of one asset, particularly they are used for measuring portfolio credit risk. moreover 35% of the bank used these measures.According to Dr Anbar, 30% of the banks said they measured credit risk using a portfolio credit risk model and package developed mostly by them.Furthermore 95% of the bank used internal credit rating system and a credit scoring model in credit risk analysis. This technique was used to determine credit limits, to determine problematic credit and credit risk measurement.According to the study there are 3 approaches in Basel II for credit measur ement. These are Standardised Approach (SA), Foundation Internal places Based Approach (FIRBA), and Advanced Internal Rating Based Approach (AIRBA). It was found that 60% of the banks used the first method and 20% the FIRBA and 20% the AIRBA.Dr Anbar found that in general the tools which are used by Turkish banks are collateral, credit limits and diversification but they dont use methods like loan selling, securitization, credit insurance for transferring credit risk. One reason for that was that these types of methods havent been developed in Turkish sector yet.INTEREST RATE RISK MANAGEMENTThe tradition has been for the banking industry to diverge somewhat from other parts of the financial sectors in the interference of interest rate risk.According to Santomero (1997) institutions that do not have active trading businesses, value-at-risk has become the standard approach. Many firms use this model but in some cases it is still in an implementation process.According to his analysis , commercial banks tend not to use market value reports and guidelines but rather, their approach relies on cash flow and bank values. This system has been traditionally been known as the GAP reporting system. This system has been supplemented with a duration analysis. (Hempel, Simonson and Coleman, 1994)Most banks, however have essay to move beyond this gap methodology, they have concluded that the gap and duration reports are static and do not fit well with the dynamic nature of the banking market.Furthermore, according to the survey, many banks are using balance sheet simulation models to find the effect of interest rate variation on reported earnings overtime. This system requires relatively informed repricing schedules as well as estimates of prepayments and cash flows. The simulation system being completed, reports the resultant derivations in earnings associated with the rate scenarios considered. Officials then make use of cash, futures and swaps to reduce this risk.2.7.3 L IQUIDITY RISK MANAGEMENTThe liquidity risk that does present a real challenge is the need for funding when and if a sudden crisis arises. Standard reports on liquid assets and open lines of credit, which are germane to the first type of li