The increasing demand for risk management on the part of organizations, businesses and government authorities has been identified as a general societal trend emphasizing public accountability and responsibility.
A bank has many risks that must be managed carefully, because it uses a large amount of leverage. Without effective management of its risks, it could very easily become insolvent. If a bank is perceived to be in a financially weak position, depositors will withdraw their funds, other banks won’t lend to it nor will the bank be able to sell debt
securities in the financial markets, which will exacerbate the bank’s financial condition even more. The fear of bank failure was one of the major causes of the 2007 – 2009 credit crises and of other financial panics in the past. Although banks share many of the same risks as other businesses, the major risks that especially affect banks are liquidity risk, interest rate risks, credit default risks, and trading risks. The risks also face some major challenges.
Liquidity is the ability to pay, whether it is to pay a bill, to give a depositor their money, or to lend money as part of a credit line. Liquidity risk arises when revenues and outlays are not synchronized, (Holmstrom and Tirole, 1998). A basic expectation of any bank is to provide funds on demand, such as when a depositor withdraws money from a savings account, or a business presents a cheque for payment, or borrowers may want to draw on their credit lines. Another need for liquidity is simply to pay bills as they come due.
The main problem in liquidity management for a bank is that, while bills are mostly predictable, both in timing and amount, customer demands for funds are highly unpredictable, especially demand deposits.
Another major liquidity risk is off-balance sheet risks, such as loan commitments, letters of credit, and derivatives. A loan commitment is a line of credit that a bank provides on demand. Letters of credit include commercial letters of credit, where the bank guarantees that an importer will pay the exporter for imports and a standby letter of
credit which guarantees that an issuer of commercial paper or bonds will pay back the principal.
Derivatives are a significant off-balance sheet risk, as evidenced by the collapse of American International Group (AIG) in 2008. Banks participate in 2 major types of derivatives: interest rate swaps and credit default swaps. Interest rate swaps are agreements where one party exchanges fixed interest rate payments for floating rates.
Credit default swaps (CDSs) are agreements where one party guarantees the principal payment of a bond to the bondholder.
It is therefore important to minimize liquidity risks by Liquidity management. This is achieved by asset and liability management. Asset management requires keeping cash and keeping liquid assets that can be sold quickly at little cost.
Challenges posed by liquidity risks
Without maintaining a constant pulse on their liquidity position, banks can quickly face serious reputational damage or, worse, insolvency. Liquidity for a bank means the ability to meet its financial obligations as they come due. Thus one of the main challenges to a bank is ensuring its own liquidity under all reasonable conditions. If there is any doubt about its credit, lenders can easily switch to another bank. The rate a bank must pay to borrow will go up rapidly with the slightest suspicion of trouble. If there is serious doubt, it will be unable to borrow at any rate, and will go under. In recent years, large banks have been making increasing use of asset management in order
to enhance liquidity, holding a larger part of their assets as securities as well as securitizing their loans to recycle borrowed funds.
Solutions to Liquidity Risk: Asset & Liability Management
Asset management requires keeping cash and keeping liquid assets that can be sold quickly at little cost. The primary key to using asset management to provide liquidity is to keep both cash and liquid assets. Liquid assets can be sold quickly for what they are worth minus a transaction cost or bid/ask spread. Hence, liquid assets can be converted
into a means of payment for little cost.
The primary liquidity solution for banks is to have reserves, which are also required by law. Reserves are the amount of money held either as vault cash or as cash held in the bank’s account at the Central/Reserve Bank. In Kenya, the Central Bank determines the amount of required reserves. A bank may ev en keep excess reserves at the CBK account for greater liquidity although they are non-interest bearing (the Federal Reserve started paying interest on these accounts from October, 2008)
The most liquid and safest assets are government securities of which banks are major buyers in Kenya. Banks can also sell loans, especially those that are regularly securitized, such as mortgages, credit card.
A bank can also increase liquidity by not renewing loans. Many loans are short-term loans that are constantly renewed, such as when a bank buys commercial paper from a business. By not renewing the loan, the bank receives the principal. However, most banks do not want to use this method because most short-term borrowers are business
customers, and not renewing a loan could alienate the customer, prompting them to take their business elsewhere.
A bank can increase liquidity by borrowing, either by taking out a loan or by issuing securities. Banks predominantly borrow from each other in the interbank market, where banks with excess reserves loan to banks with insufficient reserves. Banks can also borrow directly from the Central Bank, but they only do so as a last resort.
Banks are big users of a debt instrument known as a repurchase agreement (REPO), which is a short-term collateralized loan where the borrower exchanges collateral for the loan with the intent of reversing the transaction at a specified time, along with the payment of interest. Most repos are overnight loans, and the most common collateral is
Treasury bills. Repos are usually made with institutional investors, such as investment and pension funds, who often have cash to invest.
The major security that banks sell is the large certificate of deposit (CD), which is highly negotiable, and can be easily sold in the money markets. Banks also sell small CDs to retail customers, but these can’t be sold in the financial markets. Other major securities sold by banks include commercial paper and bonds.
Credit default risk occurs when a borrower cannot repay the loan. Eventually, usually after a period of 90 days of nonpayment, the loan is written off. Banks are required by law to maintain an account for loan loss reserves to cover these losses. Banks reduce credit risk by screening loan applicants, requiring collateral for a loan, credit risk
analysis, and by diversification.
Banks can substantially reduce their credit risk by lending to their customers, since they have much more information on them than on others, which helps to reduce adverse selection. Checking and savings accounts can reveal how well the customer handles money, their minimum income and monthly expenses, and the amount of their reserves to hold them over financially stressful times. Banks will also verify incomes and employment history, and get credit reports and credit scores from credit reporting agencies.
Collateral for a loan greatly reduces credit risk not only because the borrower has greater motivation to repay the loan, but also because the collateral can be sold to repay the debt in case of default. When banks make loans to others who are not customers, then the bank has to rely more on credit risk analysis to determine the credit risk of the
loan applicant. Credit risk analysis is the determination of how much risk a potential borrower poses and what interest rate should be charged. The potential risk of a borrower is quantified into a credit rating that depends on information about the borrower and well as statistical models of the business or individual applicant. There are credit rating agencies e.g Moody’s, Standard & Poor etc. Most of these credit reporting agencies assign a number or other code that signifies the potential risk of the borrower.
A bank will also look at other information, such as the borrower’s income and history. A bank can also reduce credit risk by diversifying making loans to businesses in different industries or to borrowers in different locations.
However there are major challenges associated with credit risks namely reputational risks, Lack of ample liquidity and poor planning among others. When creditors are unable to pay their loans as they fall due the bank is forced to borrow to finance this position and also incur costs in forcing th e customers to pay. This not only makes
business expensive but may also make the bank not to honor maturing obligations eventually straining the bank’s liquidity position. Credit risks can easily translate to huge non-performing loans.