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Financial Management and Analysis of Projects : 6. Financial Institutions : 6.4. Assessing FI Performance
6.4.4. Assessing FI Risks
6.4.4.1. Introduction to FI Risk Management
6.4.4.1.1.
The main concern for FIs is risk management. World capital markets
are dynamic-their activities can generate rapid and dangerous
movements that need to be anticipated and managed. The ability of
traditional performance measurement criteria to indicate declining
or poor FI performance is limited.
6.4.4.1.2. Therefore, the capital
markets and their regulators and advisers [e.g., the Basle Committee
on Banking Supervision (BCBS) and the International Organization
of Securities Commissions (IOSCO)] have developed additional means
of measuring performance and, more importantly, to identify problems
in a timely manner.
6.4.4.1.3. In many cases, the FIs
that ADB deals with are attached to the public sector and have multiple
objectives (e.g., sectoral development objectives in addition to
profitability objectives). The risk factors associated with these
FIs are likely to be more significant than for single-objective
commercial banks. Consequently, it is essential that the financial
analyst (investment officer) should seek to: (i) identify the principal
potential risks that an FI is exposed to; and (ii) develop an appropriate
set of indicators that will provide FI management and ADB with an
early warning of problems.
6.4.4.1.4. The major risks to be examined
include: (i) market risk; (ii) exchange risk; (iii) maturity risk;
and (iv) contagion risk.
6.4.4.2. Market Risk and Value-at-Risk
6.4.4.2.1.
Market risk arises from the potential that a borrower or counterparty
will fail to perform on an obligation. The assessment of market
risk involves evaluating both the probability of default by counterparty,
obligor or issuer and the exposure or financial impact in the event
of default. The BCBS of the BIS (www.bis.org*)
makes recommendations on means to sustain the creditworthiness of
FIs.
6.4.4.2.2. The concept of Value-at-Risk
(VaR) is very important in risk management. VaR is a measure of
the maximum potential change in an FI's portfolio's
value with a given probability over a prespecified horizon. In simple
terms, the Value-at-Risk is meant to answer the question: "Over
a 10-day period, what is the dollar amount of V such that there
is only a 1% chance our portfolio will lose more than V?"
6.4.4.2.3. The main advantages of
VaR-based management are that: (i) it incorporates the mark-to-market
approach uniformly; and (ii) it relies on a short forecast horizon
of market variables. In some ADB DMCs, particularly in transitional
economies, some bank lending is government guaranteed. Financial
analysts should treat government-guaranteed bank lending as risk
free when estimating VaR.
6.4.4.3. Foreign Exchange Risk
6.4.4.3.1.
The Bank of International Settlements (BIS) document on Managing
Settlement Risk is included in the Knowledge Management part of
the web-based Guidelines. The document provides advice and guidance
on managing foreign exchange settlement risks. It also defines foreign
exchange settlement risk, advises on management practices, and includes
guidance on internal auditing.
6.4.4.4. Maturity Risk
6.4.4.4.1.
Maturity risk relates to mismatching of investments and borrowing
operations. To the extent possible, to avoid losses, an FI should
seek to match the maturities of subloans and borrowing operations
to minimize the risk of having to meet large outgoing interest payments
on borrowings and deposits with lower levels of interest receipts
from subloans.
6.4.4.4.2. Mismatching can be expensive
during times of increasing market rates, particularly when the FI
may have subloans extended over 4 to 6 years with no break or adjustment
clauses to address rising interest costs.
6.4.4.4.3. An FI should maintain a
running risk analysis of forecast forward transactions with alternative
scenarios of market (borrowing rates) to identify the date(s) when
it is most at risk, based on its current portfolio. Forecasts of
future portfolios can be similarly risk assessed.
6.4.4.5. Contagion Risk
6.4.4.5.1.
Contagion can arise in regions (such as Southeast Asia), in countries,
in regions within countries, or within a class or category of financial
institutions (such as agricultural FIs).
6.4.4.5.2. Contagion risk can arise
where declining economic conditions of depositors and subborrowers
simultaneously cause a shortage of funds and a rapid increase in
defaults on subloans. This condition can automatically trigger a
substantial rise in the risk premium of major lenders that prevents
an FI from covering shortfalls.
6.4.4.5.3. Anticipating and avoiding
contagion risk is best addressed by financial sector supervisors
and regulators because they should maintain a consistent, regular
overarching view of the financial sectors and of the local/national/international
economies with the objective of providing early warnings, not only
to the financial institutions, but to the appropriate ministries
that are charged with economic management.
6.4.4.6. The Role of Regulators in Risk Management
6.4.4.6.1.
The financial analyst (investment officer) should interview regulators
and receive assurances that the following matters are addressed:
- Market
surveillance for large positions;
- Cross-market
supervision;
- Setting
of capital reserves;
- Disclosure
of data on market value of financial instruments and risk
policies to achieve least-cost uniformity in the sector;
- Examination
of FIs' records and internal controls;
- Optimum
collaboration with FIs' auditors;
- International,
regional, and national linkages and exchanges of information;
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- A
set of rules and requirements that, at the lowest possible
cost, effectively contributes to prevent an isolated failure
or crisis of small proportions threatening the market as
a whole;
- To
the extent possible obtaining voluntary convergence and
agreement on the role of the regulator;
- A
complete set of emergency plans;
- That
the emergency plans are constantly updated; and
- That
the emergency plans are agreed between the central bank
and FIs.
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6.4.4.7. Other Key Risk Management Steps
6.4.4.7.1.
The following steps should be considered as means of supporting
the generation of useful and accurate performance indicators in
a FI:
- use
of a consistent set of accounting standards (IOSCO supports the
use of IASs);25
- efficient
netting agreements;
- segregation
of customers' accounts and protection of customers'
funds in event of bankruptcy; and
- ensuring
regulators are kept fully informed, and are efficient in their
reporting.
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25
Financial Analysts have discretion to agree alternative arrangements
(see paragraph 2.4.3).
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6.4.3. Applying the CAMEL Framework | Next
6.4.5. Determining FI Credit Ratings |
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