Poor Risk Management

Question: recent studies cite poor risk management as the main evil that causes serious damage to a banking system of an economy as a whole. Discuss this phenomenon using recent corporate failures that have been experienced in Zimbabwe (100 marks). Introduction The persistent failure of banks in the Zimbabwean financial system has been a major concern of all stakeholders, the government itself, depositors, investors as well as the general public because of the important roles banks play in the economy. An efficient payment mechanism is jeopardized by distress of banks or the banking system. In the economic development of any country, banks play crucial role by way of mobilizing savings and in turn channel such savings into investments for economic development. These roles could only come into effect if banks and the banking system are functioning efficiently. Economic growth and development is hindered where these financial institutions fail to provide timely and quality services. Governments have thus, paid particular attention to their banking systems as they are catalysts for economic growth. A safe and sound system is necessary in which depositors and consumers have protection for monetary stability. Laws, policies as well as regulatory institution are put in place with a view to extensively regulate financial institutions so as to mitigate risk as well as cost of failure. In spite of all efforts by the government to protect the financial system, banks continue to fail. Such failures pose grave repercussions for the banking system and by extension the whole economy. Risk is defined as a hazard, likelihood of danger, loss or injury, probability of loss or possibility of bad outcomes or being exposed to misfortune (BusinessDictionary, 2015). It is a possibility of an unwanted and uncertain event, which may result in financial loss. It has two things in common; uncertainty and loss. It could be the likelihood that an event may occur that may have unfavorable results or a potential for gain in some cases. It should be possible for the loss to be expressed in a measurable economic unit such as the Dollar. According to Robert (2002), risk management can be described as a two-step process which seeks to determine risks existing in an investment and then designing best ways to handle such risks in a way most appropriate to the investment. Okehi (2014) notes that the essential components of risk management encompass risk identification, risk assessment to evaluate their impact, risk mitigation as well as setting aside capital for likely losses. It proceeds from the identification of risks imminent to the entity. A crucial step then follows on devising ways to avoid, transfer or accept the risk and reduce the impact of risks. Main aim is to ensure the entity is not caught unawares by a certain tragedy. History of Bank failures in Zimbabwe The country is said to have witnessed more than twenty cases of bank failure since the year 1980. The banking industry in Zimbabwe has gone through a marked process of transformation since the turn of the millennium. A considerable crisis was witnessed in 2003/2004 culminating into the placement under curatorship of banks such as Trust Bank, Barbican Bank and Royal Bank, among others, while some were summarily closed. In due course this led to combination of banks like the Trust Bank, Barbican Bank and Royal Bank to form ZABG; CFX Holdings and Interfin Bank to form Interfin Bank, and Century Holdings and CFX Financial Services Limited to form CFX Bank. Institutions such as Barclays Bank, Standard Chartered Bank and Stanbic Bank chose to remain conservative, in spite of locally owned banks like Trust, Barbican and NMB aggressively developing new products. The old guard lost it clients together with staff to the new institutions which had taken advantage of up-to-date banking technologies and competitive remunerations policies. The central bank tightened liquidity in the market in December 2003 which resulted in innovators collapsing just like a deck of cards immediately. An indelible mark was left which can be felt even in the present day as a result of tightening of liquidity. Speaking on the reasons for the collapse of some banks, like the Royal Bank, Gono (2006) the then Reserve Bank governor cited poor risk management as another contributing factor. Prior to the crisis, indigenous banks which were newly established had successfully countered traditional institutions in numerous areas like in product offerings, customer service, balance sheet sizes and profitability. The Zimbabwean economy is said to have been over-banked as banks engaged in severe dog fights over deposits escalated with inability to meet minimum statutory capital requirements. The deposit levels proved to be a too small cake for banks in Zimbabwe. Consequently, individual banks applied frantic efforts to gain hold of a larger portion of that small cake. Such efforts resulted in poor risk management, like the issue of lending money to clients without proper assessment of creditworthiness. Some banks could not also assess ability to generate sufficient revenues in some projects brought forward for granting business loans. Some collateral offered by borrowers were not properly evaluated such that the net worth of the collateral could not cover the amount of the loan together with anticipated interest payments. Types of Risks Inherent in Banks Five groups are evident of inherent risks faced by banks in their operation: credit risk, liquidity risk, market risk, operational risk and solvency risk. Credit Risk Credit risk refers to the risk of loss that may result from a borrower failing to repay the amount owing together with interests as they fall due. Okehi (2000) is of the view that credit risk is due to the refusal or inability of a borrower to pay the amount owed when required. Some borrowers genuinely fail to repay while others take advantage of a lax in the bank’s credit risk management. Banks are predominantly occupied in the acceptance of deposit as well as granting credits and this exposes them to credit risk. Banks s+hould thus measure the credit risks at portfolio levels with a view to ascertain level of amount of capital necessary to hold as a cushion against extreme losses. Credit risk deals with bank’s exposure due to borrowers defaulting in settling debt obligations as they mature. The combined effect of such defaulting leads to financial distress of a bank where they are not properly managed. This is what actually transpired in the Royal Bank saga where the bank advanced material, unsecured loans to insiders, which is a deviation from sound risk management and corporate governance practices (Gono, 2006). A curator appointed for the bank found out that poor risk management was a contributing factor together with corporate governance issues, amongst a multitude of issues and called for the sale of the bank’s assets to Zimbabwe Allied Banking Group (ZABG). Gono (2011) argues that banks should strive to maintain their credit risk exposure to very low levels through maximization of their risk adjusted rate of return so that they may improve their profit. Financial institutions having a high credit risk exposure are susceptible to liquidity and probable solvency problems. Liquidity Risk Liquidity is the capability of an institution to finance additions in assets while simultaneously meeting obligations as they fall due, without the bank having to incur intolerable losses. Liquidity risk thus refers to the likelihood that with specified time period, the bank will fail to meet settle obligations on time Okehi (2014). In other words, liquidity risk is the current and prospective risk of earnings on capital arising from a bank’s inability to meet its obligations when they come due without incurring unacceptable losses. The bank’s vulnerability to liquidity risk depends on the funding as well as the market risk. According to Okehi (2014), funding liquidity risk results from the maturity disparity that may manifest between inflows and outflows. It may be due to the sudden as well as unexpected liquidity needs as a result of contingency condition. Market liquidity risk emanates from the bank failing to sell assets at or near the fair value. Bank failure to manage unforeseen decreases in financing sources may cause liquidity risk together with the banks’ inability to deal with changes in market conditions affecting the liquidation of assets without losing its value. Market Risk It is the risk of incurring loss in case of movements in market prices. Invetopedia defines market risk as the likelihood for an investor to incur losses as a result of factors affecting the financial markets’ overall performance. It is the risk of incurring losses in on and off balance sheet positions which emanates from fluctuations in market prices (BCBS, 2001). Market risk includes interest rate risk, exchange rate risk, and equity as well as commodities risk categories. It is the risk of losses resulting from movements in prices of financial assets. The collapse of major international banks Barings Bank, for instance, in the 1990s revealed that there is a possibility for other financial risks apart from credit risk, which could result in failure seemingly strong banks. The Barings Bank case revealed the importance of consideration of market risk particularly for institutions participating in international operations. Such firms are exposed to interest rate risks, foreign exchange risks since they can create liabilities and assets in multi-currencies. Operational Risk Operational risk is described as the risk of monetary losses due to insufficient or failed internal processes, people as well as systems or even from external events (Okehi, 2014). It principally encompasses human error in the operation of the bank, monetary fraud and natural mishaps causing losses to banks thereby leading to their collapse. Baring Bank collapsed in 1995 due to unauthorized speculations which proved to be shortcoming of the human nature. Seven types of operational risks were identified by the BCBS in its Basel II document which are: internal fraud, external fraud, employment practices and workplace safety, clients, products, and business practices, damage to physical assets, business disruption and system failures and execution, delivery, and process management. All the above named types of operational risk identified by the BCBS in Basel 11 document shows that human error contributes a great deal towards operational risk. Solvency Risk Solvency refers to a situation whereby an entity has enough value in the form of assets which can assist in meeting all the business’ liabilities. Solvency risk is the likelihood of a person or an entity that it might fail to service its debts (Farlex Financial Dictionary, 2012). It is greater when an entity has little or no cash flow or when assets are being poorly managed. Banking institutions assess the risk of being insolvent or bankrupt when contemplating offering a loan or not. It remains a secondary classification of risk in the operations of banks, which hinges on capital adequacy to cushion any unforeseen losses resulting from primary risks faced in banking business. Risk of this nature is induced by human attitude. Gono (2006) argues that “experience in (bank) supervision and dealing with problem banks shows evidence that mismanagement plays a major role in bank insolvency. A context of poor bank supervision, as well as political interference with banks in the areas of lending and recovery also plays a significant role”. It is not a direct risk from the operation of a bank, but rather it results from inefficient management of other risks inherent in the banking industry. It is therefore imperative that banks be eager to identify such risks measure them appropriately as well as finding methods and opportunities for mitigating and controlling them. The aim of all such effort is for the bank to report substantial profit at year end regularly so that it can continue in existence as a business entity. Such efficient level of operation assist the bank in making expected reserves and provisions so that it might be able to absorb future losses as they occur. Equity capital stands in to safeguard the Bank in cases where reserves and provisions become inadequate. Solvency risk is not an irrelevant risk classification as the level of solvency protection inevitably has a determining effect on bank survival. Poor Risk Management and Bank Failure in Zimbabwe Failed banks in the Zimbabwean economy were noted as having faced severe challenges ranging from protracted liquidity challenges, deep-rooted risk management deficiencies as well as poor corporate governance practices (Dhliwayo, 2015). Such banks usually took too much risks thereby engaging in over-trading. More also, they experienced mounting pressure from escalating competition which resulted in narrowing of margins thereby reducing profitability against a background of increasing credit defaults. Credit risk management seemed to be non-existent in this period as entities invigorated their activities at whatever cost to capture clients. Dhliwayo (2015) notes that failure to manage risks contributed to bank failures to a greater extent. Failure by boards and senior management to establish robust risk management practices commensurate with the size and complexity of bank operations was rampant in banks including Barbican bank. Such failure to put in place robust risk management practices was compounded by rapid expansion in operations without suitable policies and controls. Weak corporate governance structures characterised by absence of policies, inability to enforce compliance with policies together with inability to interrogate management reports was rampant in failed banks. Dhliwayo (2015) contends that such cases are common in owner-managed institutions, in which the owner managers frequently exert overbearing influence daily bank operations, in the absence of proper consideration for risk management best practice standards. This was the case in Trust Bank saga, where myriad related party transactions were utilized to siphon cash out of the institution’s coffers. No one could question as such transactions were perpetrated by those at the helm of the bank’s hierarchy. RISK MANAGEMENT BEST PRACTICE Management can choose between a decentralized and centralized risk management structure. Generally, worldwide, entities tend to prefer a centralized structure of risk management whereby banks establish integrated treasury management functions to enhance flow of information on natural netting of exposures, total exposure, economies of scale as well as easier reporting to higher level management (Okehi, 2014). The board is responsible for formulating risk management policies for the bank, which should clearly states the bank’s risk appetite as well as ensuring adequate management of risks. Risk limits are set by the board through ascertainment of the risk bearing capacity of the bank. An independent risk management committee should be put in place and given a mandate to oversee the total risk the bank is exposed to and the committee should regularly report to the board (BCBS, 2001). The main aim is the empowering of certain executive personnel by giving them responsibility of assessing overall risks faced by the bank as well as a suitable risk level that a bank could bear. Line managers would always be held liable, by the committee, for the risk under their control as well as the ultimate performance of the bank in their section. The key role to be played by the committee is the identification, monitoring as well as measuring the banks’ risk profile. This will see the risk management committee developing policies and procedures, verifying models used in determining prices of complex products, to review risk models in compliance with changes in the market together with the identification of new risks (BCBS, 2001). The profiles of companies’ balance sheets differs from company to company, thus it may not be possible to adopt a uniform risk management framework in Zimbabwean banks. Adeusi et al. (2013) notes that the design of risk management function normally is dependent on bank size, complexity of the functions as well as use of technical expertise and quality of Management Information System. Okehi (2014) add in weight by noting that broad parameters are normally provided and individual banks should ascertain their own approach compatible with their view of risk management. Globally, entities tend to favor committee approach which they deem to be acceptable generally. Adeusi et al. (2013) notes that another approach is to set up an asset-liability management committee (ALCO) to deal with various forms of market risk, whilst the credit policy committee (CPC) is responsible for overseeing the credit as well as counterparty risk together with country risk. Consequently, market and credit risks management in banks will be through a parallel two-track approach. Banks have also an option to establish a single committee with a mandate for integrated management of market and credit risks. In general, the ALM policies articulate the policies and procedures for market risk while credit risk is addressed in loan policies and procedures (BCBS, 2001). According to Okehi (2014), the economic crises in several nations revealed a strong relationship between credit risks and market risks that are not hedged. The credit risk of banks is increased where Foreign Exchange exposures they assume lack natural hedges. The quality of the loan book is significantly affected by the volatility in the prices of collateral. It is therefore crucial that banks integrate the activities of the ALCO as well as the CPC. Also the process of consultation, thus ought to be set up to assess the effect of credit and market risks on the bank’s financial strength. Enterprise Risk Management in Banks According to Dhliwayo (2015), Enterprise Risk Management (ERM) is now an obvious necessity for the prevention as well as nourishment of financial stability in local and foreign banks. Hitherto, banks engaged in management of the individual risks which failed to yield intended outcomes. ERM came in handy, assisting in alleviating the weaknesses of individual management of risks. ERM refers to a holistic approach in the evaluation and management of risks (Okehi, 2014). All the risks are analysed, evaluated and managed for the organization as a whole in line with set aims and targets of the institution. Okehi (2014) noted as was earlier on cited in COSO (2004) defines ERM as a process, put in place by the board of directors, or other personnel, which is applied in the setting of strategy and enterprise wide, designed with the aim of identifying possible events that may affect the organization. It goes on to note that risk is managed within the entity’s risk appetite, with the view to provide reasonable assurance concerning the accomplishment of its objectives. For an entity to achieve its goals it should have proper procedures for managing inherent risks. Banks therefore should effectively anticipate, measure, assess and manage risks in a proactive way if desired goals are to be achieved. This calls for the adoption of ERM culture into the corporate culture of all financial institutions. Okehi (2014) notes that in some countries like Nigeria, South Africa and to some extent in Zimbabwe, banks are now recognizing the importance of this route by way of appointing top management members to be in charge of risk management operations as the Chief Risk Officer (CRO). This creates a culture where risk awareness cascades downwards from top to bottom of bank hierarchy. Dhliwayo (2014) cited that a number of bank failures in Zimbabwe are a result of weak risk management. Risk management weaknesses Dhliwayo (2014) noted includes: Ineffective boards lacking focus on risk management. These do not question management decisions together with information presented; Systems of Risk management not reflecting the changing operating environment; Myopic risk management approach. The bank focuses on credit risk with the argument that it is mainly a lending institution disregarding other financial risks like liquidity risk. Lack of risk culture; and Managing risks in silos which is ineffective. Basel Accords: Basel I, Basel II & Basel III According to Okehi (2014) bank losses in most cases are directly linked to lax credit standard, weak/poor portfolio management. For banking institutions, credit risk stands the largest source of risk which needs to be properly managed. For this to be possible banks should measure such credit risks at the portfolio level with a view to ascertain suitable amount of capital to be held as cushion against extreme losses. The BCBS introduced in 1988, Basel 1 Accord, a capital measurement system in which banks were required to set aside 8% capital reserve on credit risks to cover for probable losses resulting from credit transactions. The Basel II Accord released in June 2004 is an entirely new code of regulations with regards to risk management for financial institutions. It is based on three pillars in which Pillar 1 deals with new minimum capital requirements. Pillar 2 seeks to put in place enforceable qualitative standards on risk management whilst Pillar 3 encourages risk management information disclosures thereby enforcing market discipline (BCBS, 2004). Basel III is a complete code comprising measures for reform, which BCBS developed with a view to strengthen the regulation, supervision and risk management in banks. This document came directly in response to the financial crisis. It is a way of strengthening the financial regulatory framework internationally. Regulatory Protections against Bank Failures Globally, governments create two strategic safety retreats for distressed banks seeking to cushion the impact of bank failures. The first concerns the establishment of the Central Bank which plays the function of lender of last resort, a key source of loss for depositors who have huge deposits in an ailing bank. Governments also set up the deposit insurance which has the aim of protecting funds of depositors against likely losses associated with a bank becoming insolvent. Importance of Risk Management in Banks An analysis of bank failures before the global financial crisis of 2008 and the era after the crisis reveals that failure to effectively manage inherent risks is a contributing factor to bank failures (Sanusi, 2013). Many banks in the developed economies globally suffered huge and the developing nations were not immune to this crisis. The Basel Committee on Bank Supervision (BCBS), for the aforementioned crisis, formulated wide supervisory standards and guidelines, recommendations and best practices on matters concerning bank risk management as noted in Basel I, II, &III from 2008 to 2013. Risk management and corporate governance are said to be interrelated and they depend on each other (Okehi, 2014). Proper risk management and sound corporate governance is crucial for the purposes of stabilizing and improving a bank’s performance. Notwithstanding that, Adeyemi (2011) argues that other factors may be responsible bank failures such as capital inadequacy, lack of transparency, and huge nonperforming loans. Nonetheless, he further notes other factors which point to poor risk management including weak or ineffective internal control system ownership structure and poor management. Hoyt and Liebenberg (2011) notes that banks constantly engaged in financial intermediation, so they are confronted with numerous financial as well as non-financial risks. Such risks were noted as including interest rate, credit, foreign exchange rate, equity price and commodity price, liquidity, legal, regulatory, operational and reputational risks. The aforementioned risks are greatly interdependent. An event affecting one area of risk normally has repercussions for other risk classifications. It is thus crucial for managers in banks to pay special attention to process of risk management. Okehi (2014) argues that the fundamental guidelines for the management of risk in banks ought to encompass its organogram, the risk measurement methodology, board’s approved risk management policy, prudential limits structure, sound management information system for reporting, risk monitoring and controlling, operational framework for risk control and risk management together with periodical review and evaluation of the process. Banking operations by their nature leaves them with fiduciary responsibility towards depositors outside bank duties to their shareholders. Entities in the banking sector owe responsibility to all people and organizations who deposit their funds and shareholders together with taxpayers who, in case the bank becomes illiquid, bear the cost of bailout. It is therefore imperative for bank managers to ensure establishment of a very high standard of risk management and control. Such is a crucial component for banking supervision to establish to come up with guaranteed bank survival. Governmental initiatives like the Sarbanes-Oxley Act as well as other anti-money laundering rules put in place by numerous governments strengthen the need for a sound control environment. Bank Failure and Systemic Risk Systemic risk in the banking sector refers to a scenario in which failure of a bank or a major bank significantly impacts the entire sector. It is brought about by the fact that banks are linked to each other through interbank operations allowing banks to borrow from each other. Efforts to design public policies that assist in avoiding systemic risk in the banking industry, it is crucial to make an analysis of likely causes of individual bank failures which could result in systemic risk. The collapse of United Merchant Bank significantly impacted on the operations of the Universal Merchant Bank in 2003 and ended up being taken over by CFX (Zimbabwe Independent, 2015). The interconnectivity of banking institutions causes systemic risk and financial shocks are thus passed on from one bank to another due to this fact (Okehi, 2014). Consequently, a call is made on banks that they ought to avail themselves of the collective initiatives that were established by BCBS and regulators. The aim is to assist in the reduction of operations in local and international currencies, the treat from interbank transfer and settlement risk. Conclusion Risk management is crucial for the continuing existence of banking institutions. Depositors need protection and security when it comes to their funds. Investors would not dare place their funds at the mercy of unscrupulous entities. Failure to manage risks results in the collapse of banking institutions as they at times caught unawares culminating into collapse of such a business. Banks tend to depend on each other in numerous ways, like in the case of bank indebtedness, hence failure of one bank affects operations of other banks as well. Banks have an essential role in facilitating trade amongst companies and individuals, for instance payments can be made through the banking system. They are a catalyst of economic development, hence their failure retards economic growth of a nation. Therefore robust risk management processes are a requisite if the banking system is to progress smoothly and if the economy is to move forward in development. References Adeusi, S. O., Akeke, N. I., Adebisi, O. S., &Oladunjoye, O. (2013). "Risk Management Financial Performance of Banks in Nigeria". Journal of Business and Management. Adeyemi, B. (2011). Bank failure in Nigeria: A consequence of capital inadequacy, lack of transparency and non-performing loans? Banks and Bank Systems, 6(1). BusinessDictionary (2015), Risk perception, retrieved on 26 July 2015 from www.businessdictionary.com/definition/risk-perception.html Dhliwayo C. L. (2014), 1st Internal Control Congress for Africa Held at Elephant Hills Resort, Victoria Falls 30-31 October 2014. Reserve Bank of Zimbabwe Dhliwayo C. L. (2015), Limiting the Risk of Failure in Financial Institutions. Reserve Bank of Zimbabwe. Farlex Financial Dictionary (2012), The free dictionary by Farlex, Insolvency risk, retrieved on 27 July 2015 from www.financial-dictionary.thefreedictionary.com/Insolvency+Risk Gono G (2006), Reflections on: What went wrong at Trust and Royal Bank. Reserve Bank of Zimbabwe. Hoyt, R. E., & Liebenberg, A. P. (2011). The value of enterprise risk management. Journal of Risk and Insurance, 78(4). Okehi D. O. (2014), Modelling Risk Management in Banks: examining why banks fail? Walden University Robert (2000) Risk Management, 3rd Edition, Willey and Sons, New York, USA Sanusi, L.S (2010).The Nigerian Banking Industry in the Aftermath of the Recent Global Financial Crisis. Retrieved on 27 July 2015 from: http://www.cibng.org/admin/publications. Zimbabwe Independent (2015), History of Zimbabwe’s Banking sector, retrieved on 27 July 2015 from www.theindependent.co.zw/ 11