Risk Management in Banks

Introduction to banking sector

The banking sector plays a crucial role in the development process of Egypt. The banking sector consists of commercial banks, which are local banks and non-local banks. It also includes specialized banks and financial institutions operating in the fields of investment and credit for industry, agriculture, housing and rural development. In addition, there are branches affiliated to these banks and institutions. Deepening this sector and its reform would lead to higher rates of economic growth. This mechanism is achieved mainly through the role of the banking sector in mobilizing more savings and channeling them to better investment allocation. This, in turn, would lead to higher productivity and more capital accumulation. To achieve these results, an efficient banking system, prudential controls and a friendly, non-distorted macroeconomic framework are required.

The Banking industry in Egypt is amongst the oldest and largest in the region.

Banking reform started as part of the open door policies in the mid seventies when foreign banks were allowed to operate in Egypt. Later in the nineties, as part of Egypts economic and financial reform program, the banking sector was completely liberalized, while banking supervision was further strengthened in accordance to international standards.

The Government of Egypt has been currently undertaking a comprehensive reform strategy for the financial sector as a whole and the banking system in specific. The goal of banking reform was creating an efficient banking sector which offers better quality services .The financial reform measures taken in the early 1990s emphasized reform of the monetary and fiscal policies, not the revamping of financial institutions.

Egypt is currently moving steadily towards becoming the biggest financial center in the region. Owing to the flourishing privatization program and the prospering domestic bond market, banks have encountered new investment fields which helped them diversify their portfolios and lower their financial risks. Meanwhile, most banks expanded on providing non traditional services such as brokerage, investment consultations, asset valuation and sales, and mutual fund operations which also helped improving capital market services (source www.sis.gov.eg)

However, the repeated financial crisis and economic recessions throughout the last years have increased the importance of having efficient and effective risk management in order to avoid and minimize any possible risk of default.

Banking Risks:

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Risks are usually defined by the adverse impact on profitability of several distinct sources of uncertainty. Based on Joel Bessis in his book, "Risk Management in Banking," (p. 1-14), there are mainly 2 types of risks that any bank can face:

Financial Credit Liquidity Interest rate Market Foreign Exchange Solvency Technical Organizational

Operational

A) Financial Risks: 1) Credit risk Credit risk is dominant in terms of the importance of potential losses. Credit risk is the risk that customers fail to default, that is failing to comply with their obligation to service debt. Default triggers a total or partial loss of any amount lent to the counter party. Credit risk is also the risk of a decline in the standing of counter-party. Such deterioration does not imply default, but means that the probability of default increases. Capital markets value the credit standing of firms through higher interest rates on the debt issues of these firms, or a decline in the value of their shares, or by downgrading of agencies' rating, which is an assessment of the quality of their debt issues.

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Credit risk is critical since the default of a small number of important customers can generate large losses, which can lead to insolvency. It is normally monitored through

classical procedures in banks. Limits systems put a ceiling on the amount lent to any one customer &/or customers within a single industry and/or customers in a given country. The examination of credit applications is conducted by credit officers or credit committees, which should reach a minimal agreement before a risk taking decision is made. The delegation rules at various levels of the bank stipulate who is responsible for such commitments. Central reporting of outstanding loans to customers is required to ensure that those amounts stay within global limits, especially when several business units originate transactions with the same clients.

Even though such procedures have existed since banks started lending, credit risk management does raise several issues. First, the outstanding balances at the time of default are not known in advance. They are contractual only for those lines which have an

amortization schedule. For others, such as overdrafts, the future uses of these lines are unknown, since the usage is left, within certain limits, to the initiative of the client. Therefore, the amount "at risk" in the future, which can potentially be lost in the event of default, is uncertain in such cases.

The size of commitment is not sufficient to measure the risk. Risk has two dimensions; the quantity of risk, or the amount that can be lost, plus the quality of risk, which is the likelihood of default.

The quality of risk is often appraised through ratings. These ratings are internal to a bank and/or external when they come from rating agencies. Measuring the quality of risk would
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lead, ultimately, to quantifying the default probability of customers, plus the likelihood of any recovery under the event of default. The probability of default is obviously not easy to quantify. Historical data on defaults by rating class or by industry are available, but they can not easily be assigned to a given customer. The extent of recoveries is also unknown. The loss depends upon any guarantee, either from third parties or from any posted collateral, or recovery after bankruptcy and liquidation of assets. In short, credit risk, the oldest of all risks for banks, is actually the end result of multidimensional risks. It sounds like a paradox that the most familiar of all risks remains so difficult to quantify.

Market transactions also generate credit risk. The loss in the event of default depends upon the value of these instruments and their liquidity. If the default is totally unexpected, the loss is the mark-to market value at the time of default. If the credit standing of the counterparty declines, it is still possible to sell these instruments in the market, at a discount. For over the counter instruments, such as derivatives whose recent developments has been spectacular, sale is not readily feasible. The credit risk changes constantly with market movements during the entire residual life of the instrument. Therefore, the potential values of the transaction during the whole period are at risk. In addition, there is an interaction between credit risk and market risk during this period because these values depend on the market moves.

Finally, the cumulated credit risk over a portfolio of transactions, either loans, or market instruments, is difficult to appraise because of diversification effects. If the defaults of all customers tend to occur at the same time, for instance because they all belong to the same industry, the risk is much more important than if those default events are independent. All

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banks protect themselves against risk through diversification, which makes simultaneous defaults very, or totally, unlikely. However, the quantitative measurement of the impact of diversification has remained a challenge.

2) Liquidity risk

Liquidity risk is considered a major risk. It is often defined in different ways; extreme illiquidity, the safety cushion provided by the portfolio of liquid assets, or the ability to raise funds at a "normal" cost.

Extreme illiquidity results in bankruptcy. Hence, liquidity risk is a fatal risk. However, such conditions are often the outcome of other risks. For instance, important losses, due to the default of a big customer, can raise liquidity issues and doubts as to the future of the organization. These suffice to generate massive withdrawals of funds, or the closing of credit lines by other institutions which try to protect themselves against a possible default. Both can generate a brutal liquidity crisis which possibly ends in bankruptcy.

Another common meaning of liquidity risk is that short term asset values are not sufficient to match short term liabilities or unexpected outflows. From this standpoint, liquidity is the safety cushion which helps to gain time under difficult conditions.
2) Interest rate risk:

Interest rate risk arises when there is a mismatch between positions, which are subject to interest rate adjustment within a specified period. The banks lending, funding and investment activities give rise to interest rate risk. The immediate impact of variation in interest rate is on banks net interest income, while a long term impact is on banks net worth since the economic
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value of banks assets, liabilities and off-balance sheet exposures are affected. Consequently there are two common perspectives for the assessment of interest rate risk

a) Earning perspective: In earning perspective, the focus of analysis is the impact of variation in interest rates on accrual or reported earnings. This is a traditional approach to interest rate risk assessment and obtained by measuring the changes in the Net Interest Income (NII) or Net Interest Margin (NIM) i.e. the difference between the total interest income and the total interest expense.

b) Economic Value perspective: It reflects the impact of fluctuation in the interest rates on economic value of a financial institution. Economic value of the bank can be viewed as the present value of future cash flows. In this respect economic value is affected both by changes in future cash flows and discount rate used for determining present value. Economic value perspective considers the potential longer-term impact of interest rates on an institution.

Sources of interest rate risks:

Interest rate risk occurs due to (1) differences between the timing of rate changes and the timing of cash flows (re-pricing risk); (2) changing rate relationships among different yield curves effecting bank activities (basis risk); (3) changing rate relationships across the range of maturities (yield curve risk); and (4) interest-related options embedded in bank products
(options risk) (source:www.sbp.org).

3) Market risk

Market risk is the risk of adverse deviations of the mark-to market value of the trading portfolio during the period required to liquidate the transactions. Market risk exists for any
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arising from transactions. Any decline in value will therefore result in a market loss for the corresponding period equal to the difference between the beginning and the ending mark to market values.

4) Foreign exchange risk

The currency risk is that of observing losses due to changes in exchange rates. Variations in earnings are caused by the indexation of revenues and charges to exchange rates, or of the values of assets and liabilities labeled in foreign currencies.

FX risk is a component of market risk. For market transactions, foreign exchange rates are a subset of market parameters whose variations are considered together with other market parameters. A traditional way of dealing with foreign exchange risk is to manage risk on a currencyby-currency basis for the banking portfolio.

5) Solvency risk

Solvency risk is the risk of being unable to cover losses, generated by all types of risks, with the available capital. Solvency risk is therefore the risk of default of the bank.

Solvency is the end result of available capital and of all risks taken; credit, interest rate, liquidity, market or operational risks.

B) Operational risk

Operational risks are those of malfunctionings of the information systems, of reporting systems, and of the internal risk monitoring rules. In the absence of efficient tracking and reporting of risks, some important risks can remain ignored, do not trigger any corrective
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action and can result in disastrous consequences. levels:

Operational risks appear at two different

The technical level, when the information system, or the risk measures, are deficient The organizational level, reporting and monitoring of risk, and all related rules and policies.

Since malfunctionings can have a large number of causes, some basic principles can help build a sound system. Among these principles are the following:

The management rules should not constrain the risk taking process too much. Being too prudent slows down the decision making process and limits the volume of business.

Commercial business units which generate risks should be distinct from those whose mission is to supervise and limit risks.

There should be incentives to disclose risks when they exist, rather than encourage managers to hide them.

Thus, effective risk management should be a whole system within the bank. It is not a department or a policy, but rather it is a comprehensive system that should be based on effective risk management that is based on internal control to minimize risk and maximize profits.

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