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Study On How To Effectively Manage Risk Finance Essay

In recent years, the issue of how to manage risk has been a source of concern in many financial institutions around the world due to the present economic uncertainty and business environment which was caused by the failure and weaknesses in corporate governance which did not serve their purpose in the prevention against excessive risk in a number of financial service companies (Actuaries, 2008). It is therefore important to understand the term risk, risk management and why it matters in financial sector especially to managers facing these challenges.

According to standard economic theory, managers have to maximise the expected profit of the firm not considering the possible inconsistency of reported earnings. Although, the growing literature since the early 1980s which Stulz (1984) provided the first practical economic reasons on why mangers are concern of the unpredictable financial performance which causes risk. Thereafter, several explanations and justifications have arisen on importance of active risk management in financial institution. Risk is therefore defined as the effect of uncertainty on objectives (ISO31000). Risk can also be defined as a threat, damage, liability or loss caused by an external or internal weakness which may have an adverse effect on an organisation’s performance to attain objectives and implement its strategies ( ). On the other hand Greene (2007) described risk as the realisation that a situation may cause harm which prompts the recognition of risk in association with the hazards. This has made financial institutions recognise risk management is an integral part of its business success.

Risk management can be considered as the process of identification, assessment and prioritization of risks which is essential for the maximisation of shareholder’s wealth at the same time reducing the probability of financial failure (John, et al., 1998). Risk management is defined with respect to its scope, nature and timing to ensure that the process is proactive rather than reactive. Moreover, the term risk management in financial institution is mostly associated with managing the firm’s exposure to financial risk where financial risk is defined as the inconsistency in cash flows and market values caused by economic variables (Damodaran, 1997). It has been argued that higher volatility in the international financial markets and in cases of derivatives losses has made risk management more important in the activities of company involved and that successful management of financial risks will advance to a crucial competitive advantage for firms in all industrial sectors (Bartram, no date). Although, Fairchild (2002; pp22) also raised an argument on whether risk management is value adding or destroying to a firm due to the cost associated with it such as time and resources. In addition, Fairchild also mentioned the fact that only the firms risk can be eliminated not the market risk, leaving the beta and cost of capital the same. Risk management becomes more important if the business decide to explore new opportunities, for example; launch of new products or entry into a new market. There are competitors in the same market and the breakthroughs in technology could make the new product redundant. The firm may benefit by implementing a risk management standard which could provide guidance and reduce impact on extreme events such as job loss and attack on reputation.

The presence of risk in the financial sector is very dominant. This dissertation will focus on how risk is being managed in the Nigerian banking sector. Recent development in the banking sector of the country has brought about a lot of changes in the risk management practice in the banks. Firstly, was the consolidation of banks in December 2005 which led to the reduction in numbers of banks from 89 to 25 banks. Most recent case was the issue of CEOs of five banks sacked by the Central Bank of Nigeria (CBN) in August 2009 due to ineffective risk management structures which the CBN governor described as “merely a part of the cycle of corruption and election rigging in Nigeria” (Finweek, 2009) which Standard and Poor a rating agency also agreed that the high risk of Nigerian banks was as a result of “unstable political, poor corporate governance and infrastructural deficiencies” (Reuters, 2008). Despite the apparent importance of risk management, it has been argued that various past events mostly in the financial sector have confirmed weakness in the risk management. There are still many evidence that indicates enterprise risk management is not a wild practise. Although, many authors have mentioned the expected benefits of ERM approach and why firms should view and analyse risk from a holistic perspective rather than being myopic (Kleffner,, et al., 2003: pp2).

The focus of this research will be done on Nigerian banks. This research topic was chosen as a result of my interest in the on-going policies reform and change of power in the country’s banking industry, on how banks can integrate both risk management into their activities without destroying the value of the shareholders wealth and also to find out if banks have or are preserving good corporate governance practices post-consolidation. The implication of this research will be to find out if there have been significant changes in the management, disclosure and frequency of risk occurrences in the commercial banks as a result of the recent development.

PURPOSE OF STUDY

The purpose of this research is to determine how Nigerian commercial banks manage risk compared to best international practices. Specifically, it aims to find practical minimising incidences of risk management in the Nigerian banking sector. The following are the objectives of the research:

Review existing literature, collect and collate information on risk management in banks.

Identify risks that affect financial performance in banks.

Identify various types of risk management lapses perpetrated in banks.

Determine magnitude and frequency of risk management incidences in Nigerian banks.

Determine effect of risk management on banking activities.

Recommend measures for reducing risk management incidences.

Identify means through which recommended measures can be effectively be implemented.

RESEARCH QUESTION

The goal of this research is to identify the risk management approach of Nigerian commercial banks. The research aims to answer the following questions:

What are the types of risk faced by banks?

What corporate strategies are used to manage risks by the banks?

When should risk be transferred to the purchaser of assets issued or created by the banks and when is it better absorbed by the bank itself?

How do the board and risk managers handle communication in banks?

Has risk reported or disclosed by the banks?

Have there been changes in risk management due to recent development?

LITERATURE REVIEW

In the past two decades, the nature of risk financial institution have been experiencing is significantly on the rise compared to the past. There has been much protest concerning actions of some firms which exposed themselves to corporate failures and the unfolding accounting scandals making the risk management activities of the firm subject to question (Iyiola, 2005). These changes occurring in the financial industry has proven that risk taking is a crucial part of any business (Schroeck, 2002). The services that financial institutions offer to their customer differ from each other. As a result of this firms are exposed to different types of risk depending on the nature of their different activities. Therefore, decisions on business strategies and objectives are linked or taken into consideration in respect to the type of risk firm can take and how to incorporate and manage this risk with their business activities (Dempster, 2000).

According to Penza and Bansal (2000) classifying the types of risk faced by banks and other financial institutions is difficult. However, the risks that are fundamental to financial institutions include credit risk, operational risk, market risk and liquidity risk (Basel, 1999).

Source: Penza and Bansal (2000). Measuring market risk with value at risk

Market Risk

Market risk is defined as the risk of loss due to unexpected changes in market prices or liquidity (Schroeck 2002, P 165). Past literature have specified that market risk is mostly caused by changes in foreign exchange rate, commodity and interest rate, equity prices, and financial instruments traded. The market is controlled by the law of supply and demand which makes it very volatile. Penza, and Bansal (2000, p.21) said that risk of losses sustained as a result of change in the control device of both traded or tradable assets can also be classified as market risk existing for any period of time earnings. However, market risk has minimal correlation with a firm’s strength but more on the world’s economy activity on the market (Bessis 1998) and it is expected that various banks should allocate their risk appropriately, especially matching the risk with capacity depending on their respective business activities. The assessment of market risk can be based on the instability of interest rate (Valentine and Ford 1999) which can be measured by market vitalities (Bessis, 1998). From past literature, it is evident that there are various tools available to quantify and control market risk, such as Daily Value at Risk, Stress Tests, Annual Earnings at Risk and Economic capital. One generally accepted method is Value at Risk (VAR) model and should be noted that VAR has limitation. Moreover, it worth pointing out that sensitivity captures the changes of value resulting from a given changes in the underlying market parameter. It anticipated that using both volatility of market parameters and sensitivity of instrument can be quantified changes in market value.

Credit risk

It is important to note that past literature and practices on banking has devoted an extensive amount of research on banking risk. However, credit risk as been argued to be one the most alarming risk facing banks and financial intermediaries. Banks are faced with different kinds of credit risk depending on their various business activities. Credit risk can be defined as the risk of customer or counterparty default; that is failure to meet its obligations in accordance with agreed terms (Schroeck, 2002). A situation that brought about the present economy crisis which started from the U.S mortgage companies with creditors not being able to pay up their loans as a result of ignorance on the increase in interest rate (adjustable rate mortgage) exposing many of the banks to bankruptcy due to reduce in their capital and also led to the squeeze in credit globally. Although Credit risk can also occur on unsecured loans on bonds and derivatives not traded in organized exchanged (Typically swaps, forwards and other over the counter (OTC) derivatives (Oldfield and Santomero 1997).

It has been argued that difficulties that financial institutions faced over the years for a multitude of reasons resulted mostly from credit risk. The Bank for International Settlement (2000) claimed that the major cause of serious banking problems continues to be directly related to careless credit standards for borrowers and counterparties, poor portfolio risk management, or a lack of attention to changes in economic or other circumstances that can lead to deterioration in the credit standing of a bank's counterparties. Currently, it’s been argued that flow of credit in global financial markets move from an unfriendly pace to a virtual standstill. However, the credit markets threaten to remain the same despite numerous efforts and support from the government and central banks injecting huge amount of cash. Nevertheless, it has been anticipated that better credit risk management practices will be required by banks to regain enough confidence in the financial system to get credit markets moving again (SAS, no date). Wharton (1996) stated that the banking world has not taken into consideration Jensen’s analysis “about the linkage between bank leverage, risk taking and investment decisions and inefficiencies”. Explaining that increase in capital makes managers with free cash flows take lag on operation and over invest taking on more risk thereby liable to bankruptcy.

It was discovered by CBN that risk management and credit checking processes of banks struggled to keep pace with its rapid growth, which indicated that there was little or no risk management infrastructure in place to monitor their credit risk which can be compared to the case of HBOs, the bank acquired by Lloyds TSB in the U.K (Financial Times, 2008). In quantifying and reducing credit risk, most banks usually adopt arithmetical modelling procedure all through its business in its credit rating systems (Carey et al 2006). It is anticipated that, it assists banks in frontline credit decisions on new commitments and in managing the portfolio of existing exposures. Moreover, banks will try to adequately control the credit risk before the difficulties occur by using credit derivatives, securitisations and asset sales (Chen cited Wang 2007).It is significant note that, with continuous development associated with the financial institutions, the longer-term certainty credit cycles in financial firms remains, and points to the need for continuing close examination and analysis of credit risk.

Liquidity Risk

This is described as risk of banks been short of funds to meet its obligations (Basel Committee, 2004). An institution might lose liquidity if its credit rating falls, it experiences sudden unexpected cash outflows, or some other event causes counterparties to avoid trading with or lending to the institution (Glyn, 2003). A firm is also exposed to liquidity risk if the markets it depends on, is subject to loss of liquidity. It is noted their other risk that form part of Liquidity risk such as market risk and credit risk and at times is difficult to separated them from it (Casu et al, 2006; Glyn, 2003).

Moreover, liquidity risk in banking has been attributed to transactions deposits and their potential to result in bankruptcy or panics (Gatev et al 2006).It is anticipated as failure of banks to meet its payment obligations and replace funds when they are required. The traditional functions of banks are noted to be transformation of maturity and the provision of liquidity. However, recent empirical studies have focused on liquidity risk coming from the asset side of the bank’s balance sheet. Harper et al. add that liquidity risk arise because the maturity of a bank’s assets significantly differ that of its liabilities (Chen, 1994 cited Wang 2007). Banks committed to lending are more exposed to the risk of unexpected liquidity demands from their borrowers (Bessis, 1998). In extreme cases bank liquidity problems can result into bankruptcy, when depositors withdraw their funds on a massive scale, such problems can be contagious, spreading in the banking system (Landskroner and Paroush, 2008). For this reason, liquidity risk is seen as a fatal risk. Besides, it is anticipated that disclosure of liquidity risk is also important to banks’ customers, by which both borrowers and lenders are able to reference the liquidity risk level of the banks. This has been realised by most financial institutions all over the world.

Operational Risk

Operations Risk has been term as risk of errors, unethical conduct, or other circumstances in conduct of operations. The Basel Committee (2004) defines operational risk as the risk of loss resulting from inadequate or failed internal processes, people and systems, or from external events (Casu et al, 2006). Nevertheless, it has been argued that operational risk in banking sector is difficult to define. Dunnett et al (2005) stated that financial institution's exposure to losses arising from mistakes (such as computer failure and breach of regulations) and conspiracies (including loan fraud and embezzlement) that affect its day-to-day business. Consequently, it is claimed that such losses upset shareholders and can lead to a decline in market value. A factor which is argued to be present in

Moreover, there is an anticipation of losses from external events, such as a natural disaster that damages a firm's physical assets or electrical or telecommunications failures that disrupt business, are relatively easier to define than losses from internal problems, such as employee fraud and product flaws. It is noted that this risks from internal problems are closely tied to a bank's specific products and business lines. Lopez (2002) mention that they should be more specific than the risks due to external events.

Basel II emphasis the important of operational risk regarding bank stability and called for its addition in the working out of capital adequacy of banking institutions (Wang, 2007, P15). The Basel committee’s core principle on banking supervision address operational risk in principle 15, which required supervisions to ensure that banks have risk management policy and processes to identify, monitor and control or mitigate operational risk (Greuning and Bratanovic, 2009,P 295). Moreover, it has been anticipated that, most international banks are increasing their operational risk covered so as to comply with the new capital requirements in Basel II. It is evident that, a number of banks in Nigeria lack extensive self-assessment methods to determine whether particular risks are effectively managed within business risk appetite. It has been anticipated that, there is few correlation between operational risk factors and operational losses and Basel Committee developed a proposed method to link the capital charge for operational risk to financial indicators in order to determine the relationship between operational risk and risk indicators (Wang, 2007).

Besides the above mentioned risks, there are still other risks faced by banks and other financial firms. For example; interest rate risk, currency risk, reputation risk and insurance risk and so on. Generally, It has been noted in financial institutions that , management of risk is to assess and address the causes and effects of uncertainty which enable an organisation to progress toward its goals and objectives in the most direct, efficient and effective path. This risk faced by financial firm as increase the quest for risk management in the sector. But before discussing financial institution and risk management, its development will be discussed.

Risk in Nigerian commercial banks

It has been argued that most organisational failures are mostly as a result of non-reliance on risk management and board oversights as well as challenges to shareholders’ right. Financial market and institution became too big to bail with government being pushed to devise methods of providing supports which causes the transfer of both losses and risk to the public sector, a situation which the Nigerian banking industry is experiencing.

In 2007, the Nigerian banking industry was forced to raise a capital of 25 billion naira, which led to the acquisition of some banks by the bigger ones, merger of some and complete shut down for those that could not come up with the capital. A case which Santomero (1988) argued that when a bank is forced to increase its capital the bank is encouraged to take more risk which puts the bank in danger (cited in Wharton, 1996). However, the raise in capital and consolidation of banks in the country has been argued to have made the banks grow in size and increased the competitiveness of the banks not only in the country but also globally.

Conversely to the positive development of the Nigerian banks, corporate scandals have been reported by the press outraging the financial community and have clearly revealing serious flaws in the Nigerian corporate governance system. The CBN reported after an audit of the banks the presence of huge debt profiles thereby leading to the replacement of the CEOs of such banks. A case which Yakassai (2001) explained causes complexity and trouble with most companies in Nigeria as a result of directors being the head of preparing their appraisal and also scoring themselves good grades and congratulating themselves on a job well done. Most recently, the CBN was forced to pump in 420 billion naira into five banks and still put about 200 billion naira in reserve for the 4 banks CBN took over when the last audit of banks was done with banks like Intercontinental bank, Oceanic bank getting an amount almost equal to their shareholder funds. A situation which brought about legal debates why the CBN governor should take such a decision and who this decision was going to affect in the long run. Although, the injection of money into these banks appears to be of debts but CBN claims its equity with a status of TIER 2, which means revaluation reserves and long term debts. Since the CBN governor sacked the CEOs and appointed new representative without the approval of shareholders but just simply stated that this was done as a regulatory body. Majority of the banks in the country are publicly listed companies.

The recent crisis in the Nigerian Banking sector shows that many banks had it wrong. The risk models were not robust. The scopes of assessment were too narrow and it excluded customers and close allies from proper assessment. Since banking is essentially a risk management business, there is a need to focus more on risk management which will enhance early detection and response to credit exposure that could result to systemic risks. Assessments were infrequent, causing management to operate with inaccurate and historic data. Professional advice was often not available or accessed by those taking these decisions. However, as part of on-going efforts to address risk management in banks, the Basel Committee on banking supervision has been active in drawing principles from the collective supervisory such as OECD with the experience of its members and other supervisors in issuing supervisory guidance to foster safe and sound banking practices by reinforcing the importance of risk management for banks while laying emphasises on its governance (Basel, 1999). According to Gupta (2009), Supervisors are seeking to draw upon industry best practice while encouraging the industry to advance the risk management frontier.

RESEARCH METHODS

This research will adopt a primary research method using a qualitative approach in order to answer and gain a proper understanding of the research questions raised therefore avoid generalising as argued in Bryman (2004: pp460) “that some quantification of findings from qualitative research can often help to uncover the generality of the phenomenon being described”. Data will be collected from the selected banks. The data collection process will involve conducting face to face interviews with officials in the banks in order to identify the types, causes, frequency, effects and measures of risk management. The face to face interview using semi-structured questions is preferred as succinct information can be gathered especially when you maintain eye contact with the interviewee (Saunders, et al., 2007) and also because responses of the interviewee are unpredictable and also “to compare the views and experiences” with best international practices and time-limit, it will benefit so have prepared questions (Fisher, 2004). The interviews will be recorded and the data will then be transcribed and analysed.

Data to be collected will be aimed at 8 banks out of the 24 banks present in the country. This is due to time constraint of the research and also possible accessibility constraints. Although, 8 banks is hardly a representative number of the 24 banks, operations can be compared being governed by the same policy excluding the factor of their respective culture which cannot be compared hence the sample chosen for collection of data. A representative number would have been used to ensure validity; which refers to the issue of whether an indicator(s) that is devised to test a concept really measures that concept (Bryman, 2004). The 8 banks will be chosen from the best 2 banks, least 2 banks and average 4 banks based on the CBN ranking which will be done to be certain that the characteristics of data collected will represent the total population (Saunders, et al., 2007).

The target participants of the interview will be Chief Risk Officer, Risk Management Officer, Head Stock Broking, Head of Control and Compliance, Strategic and Planning officer from the selected banks. These participants are perceived as appropriate tool for the research because they are involved in the decision making which can affect the bank either positively or negatively. In addition, other stakeholders will be interviewed someone not on the board of decision making either an employee or shareholder in order to know what has be declared to the public as suggested by Fisher (2004). The interviews will schedule to last between 30minutes and an hour.

The interviewee’s consent will be sought before each interview and also before it is recorded. Confidentiality will be assured and the interviewees will also be made aware that they can withdraw from the interview at any point if no longer comfortable. Data collected will be stored for a period of three months after the assessment and destroyed thereafter. It will only be made available to my supervisor, the examining officer and I to keep the information confidential and identity of respondents anonymous. Anonymity will be taken into consideration in order to avoid ethical issues which refer to the proper behaviour the researcher must execute in relation to the rights of subject used for sampling (Saunders, et al., 2007).

To conduct this research, I will have to obtain skills on how to conduct interviews effectively and get best results. To achieve these skills, an in-depth knowledge of types, causes, frequency, effects and measures of risk management will have to be gained which will help me ask relevant questions to my research. The skills needed to be acquired are interpreting, listening, communication, documentation.

PLAN OF STUDY

I expect this research to be completed by the August 2010.A detailed timetable for achieving this is given below:

PERIOD

End of April 2010

Complete project plan.

May 2010

Week 1

Week 2

Week 3 & 4

Approval of dissertation.

Hand in of introduction.

Complete Literature Review, devise interview schedule, and contact interviewees.

June 2010

Week 1

Week 2

Week 3 & 4

Review of both introduction and literature review by supervisor and necessary correction made.

Complete note making and start preparing on what questions to be asked in the interviews.

Conduct interviews, fieldwork and research methodology.

July 2010

Week 1

Week 2,3 &4

Round –up on interview and methodology as a whole.

Transcribe and analyse data collected.

August 2010

Week 1 & 2

Week 3 & 4

Complete recommendations and conclusion.

Work towards final report.

FORMAT

The dissertation will be divided into five chapters and these will cover entire topic. The final format of the dissertation is given below:

Chapter 1: Introduction -This will introduce the research.

Overview of risk management.

Banking in Nigeria.

Risk management in the Nigerian banking Sector.

Aims and Structure.

Chapter 2: Literature Review - This chapter will discuss the theory and model relevant to the study.

Introduction to risks in the banking sector

Types of risk fundamental to financial institutions

Introduction of enterprise risk management

Role of regulation

Findings from other research

Basel II- worldwide challenge

Risk management practices

Public demand and disclosure- what has been declared to shareholder?

Development of risk management in the Nigerian banking sector in the last five years.

Chapter 3: Research Methodology- This chapter will deal with the method used in gathering relevant data for evaluating the study.

Introduction

Research approach

Research design

Data collection process

Sampling and selected sample

Reliability and validity

Summary

Chapter 4: Research Analysis and Findings- This chapter will contain presentation, analysis and interpretation of data that will be collected for the study.

Risk Management Systems in Nigerian banks.

Frequency of occurrence.

Distribution of risks.

Comparison between international best practices and Nigerian Banks

Credit risk.

Regulatory risk.

Operation risk.

Systemic risk.

Business risk.

Strategic risk.

Frequency of occurrence.

Conclusion.

Chapter 5: Recommendations and Conclusion-

Reasons of deficiency in Nigerian banks.

Limitations.

Recommendations

Conclusion.

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