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Currently, there exist numerous opportunities for a rapid bank expansion due to globalization, and they are momentous for the development, success, and survival in a banking sector. One of such banks is Mainland Chinese bank that has established a branch in Hong Kong. However, an apparent outcome of this action is an increased risk that affects the internal and external environment of this branch and that can cause the failure of banking profitability in its entirety. Consequently, a piece of professional advice of how to manage risks is essential for Mr. Chen, the Chief Executive of this bank. This advice will give a clear understanding of what measures should be taken by the bank in order to diminish various kinds of risk. Moreover, effectively controlling risks can limit the probability of bank failure and reduce the domino impact. This advice should be applied by the bank’s top management due to the knowledge of such points as principal types of risks that international banks normally face in their day-to-day operations, international regulatory standards, and risk management practices, adopted by Hong Kong banks in managing credit and operational risks.
Major Types of Risks in the Daily International Bank Operations
The knowledge of the definition of term ‘risk’ is a relevant precondition of a theoretical analysis of risk management. It is important to understand what it means before giving an explanation of various types of risk, faced by banks. Thus, risk can be determined as the likelihood of maintaining a loss or incertitude about the future. The bank accepts this term merely to avoid breakdowns. There are four basic kinds of risk in bank operations, namely operational, market, credit, and liquidity risks.
The first is operational risk that is determined by the Bank for International Settlements (BIS). Lionel Pavey (2017) indicates that “The risk of loss resulting from inadequate or failed internal processes, people and systems or from external events.” A recently-established branch in Hong Kong can be exposed to operational risk before it even executes its first credit operation. In fact, such risk includes human, processes, and system risks. More to say, operational risk is widely spread in banks due to human inaccuracy or mistakes that are made unconsciously or wilfully. Such a risk appears when inappropriate information is processed as well as if information is hacked or data is processed incorrectly. The latter concerns possible losses due to programming errors and system breakdowns. The examples of operational risk are the incorrect input of information in a bank receipt or the outflow of confidential information due to system failures. Thus, operational risks are quite common for banks in their operations.
The second, market, risk is identified by Mehta, Neukirchen, Pfetsch, and Poppensieker (2012) as the “Risk of losses in the bank’s trading book due to changes in equity prices, interest rates, credit spreads, foreign-exchange rates, commodity prices, and other indicators whose values are set in a public market” (p. 1). Depending on its potential cause, it is categorized into four types, namely an interest rate risk, a currency risk, a goods risk, and an equity risk. Thus, interest rate risk is about potential losses that are caused by price oscillations in industrial, energy and agricultural goods such as natural gas, copper, and wheat accordingly. Equity and interest rate risks comprise fluctuations in a share price and in an interest rate respectively. Furthermore, as Willem Adrianus van den End (2011) indicates, “Changes in interest rates also affect the underlying value of the bank’s assets, liabilities and off-balance sheet instruments, because the present value of future cash flows changes when interest rates change (economic-value perspective).” For example, Hong Kong bank branch can be exposed to interest rate risk, when loan maturity dates and fluctuations in interest rates are not coordinated. Finally, currency risk occurs, when there are losses due to international currency exchange rates. Therefore, the market risk is observed mostly in investment banks, such as JPMorgan, Goldman Sachs, Bank of America and others, as they demonstrate their activity on capital markets.
The third type is credit risk that implies that a bank borrower will fail to meet their obligations according to arranged terms. Thus, Hans Wagner (2017) identifies it “as the potential that a bank borrower or counterparty will fail to meet its obligations in accordance with agreed terms.” Furthermore, many factors can induce credit risk, and among them are interbank operations, options, equities, swaps, financial futures, foreign exchange transactions, loans, trade financing, and bonds. Thus, credit risk arises when, for example, the bank branch in Hong Kong borrows a loan from a bank and it is not able to repay it because of insufficient income, death, failure in business, reluctance, or any other reasons. In addition, the bank faces credit risk, if one does not pay credit card bills. Therefore, this type of risk can influence activities of a bank significantly.
Finally, liquidity risk can prevent a bank from performing its daily cash transactions. Saul Perez (2014) gives the following definition: “Liquidity by definition means a bank has the ability to meet payment obligations primarily from its depositors and has enough money to give loans.” Such a risk can appear when one withdraws money in the bank but cash is absent temporarily at that moment. As a result, a risk emerges, and a bank must rescue itself from it. For example, the inability of small banks in Northern England and Ireland to repay the investors during the global financial crisis was the reason why the government had taken control of them. It was very clever of Societe Generale to launch the Enterprise Risk Management (ERM) program in 2011 since “this programme, which is closely monitored by the Executive Committee and the Audit, Internal Control and Risk Committee, is structured around: strengthening risk culture among all Group employees; continually improving the Risk Appetite exercise” (Societe Generale Group, 2013). Therefore, the program was effective because ERM had combined risk averting and control with the daily management of the bank’s businesses.
How International Banks Manage Their Risks in the Daily Operations
Risk management in banking transactions comprises three items, such as risk identification, measurement, and evaluation, and its aim is to decrease a negative impact on the financial outcome and the capital of a bank. Therefore, banks require to form a special department in charge of risk management and to issue procedures for these items as well as those for isk management. Thus, credit risk can be managed by the implementation of banking risk analysis solutions. Their aim is to find how loan losses influences the changes in the bank’s revenue. They involve credit risk evaluation, credit risk analysis, and credit risk mitigation assessment. Such a solution must propose the opportunity to set the measures for risk alleviation, the identification of market sectors, banking operations, portfolio sections, and clients. At the same time, it notifies about the necessity to change the limit, activate the instruments for protection from risks, and to change the strategic orientation in clients, in a product, in a market sector, and business processes. Thus, a bank can apply restrictions on the ratio of risks to entire assets, on the ratio of cash to total assets, and limits on the capital reserve ratio. Overall, the analysis of solutions should include credit risk evaluation, debt restructure analysis, portfolio credit exposure, non-performing loan analysis, credit risk mitigation assessment, involved party exposure, collections analysis, customer credit risk profile, outstanding analysis, and security analysis. Banks can also effectively manage credit risk by security instruments, the diversification of placement of loans in assets, and a meticulous selection of credit applications.
The key elements for managing market risk are to set limits for a maximum risk exposure and to set limits for loss rates. In order to minimize the level of a bank’s exposure to interest rate, it is relevant to monitor constantly the positions of selected short-term risk limits and interest rate risks. Thus, analysts should monitor interest rate risk by using two kinds of analysis, namely sensitivity analysis and gap analysis. The former estimates the effect of variations in return on the bank’s assets and liabilities, whereas the latter detects the inconsistency between interest rates. At the same time, they need to monitor the structure of instrument on both the assets and liabilities’ aspects of the balance sheet of the bank. This approach categorizes the interest sensitive segments of assets and liabilities that are more or less faced by the risk, and in such a way, banking specialists are able to calculate the size of discrepancy for each maturity group.
As for operational risk, the top management of a bank must try to initiate a powerful internal control culture, in which the essential part is the control among other regular banking activities. Moreover, using a suitable plan of actions, the bank should regulate their profile of operational risk and revise their control strategies and risk restriction. Furthermore, it is important for risk mitigation to invest in a proper security of information technology. Banks also have to provide plans of business continuity and marginal losses for contingency in the case of difficult business disturbance. The kind of operational risk, such as conduct risk, is difficult to reveal. Thus, employee’s fraudulence or product drawbacks can be mitigated via strong internal auditing procedures, or “by paying close attention to corporate culture and by making sure basic controls are in place: for instance, by making sure employees are fully aware of the consequences of poor behavior” (Risk.net Staff, 2016). For example, telecommunication failures can be reduced by establishing unnecessary backup facilities Therefore, operational risk can appear due to losses that can emerge from business failures.
Liquidity risk management involves several measures to be undertaken by banks. The first one is to establish a strategy of funding that provides an efficient diversification in the sources. The second one is to manage funding needs and liquidity risk exposures through business lines and currencies, legal entities, considering operational, legal, or regulatory restrictions to the displaceability of liquidity. The third measure implies sustaiting high quality, unencumbered liquid assets because it is the insurance against a scope of stress scenarios of liquidity that normally comprises accessible secured sources of funding or loss. The fourth measure presupposes the management of collateral positions, including differentiating between unencumbered and encumbered assets. The fifth one is to conduct stress tests regularly for a diversity of market-wide and institution-specific stress scenarios, which will give an opportunity to define the sources of possible liquidity tension and to assure that actual exposures remain according to a bank’s adopted tolerance of liquidity risk. The final measure is to manage risks and banking intra-day positions of liquidity, thus giving a possibility to contribute to the fluent functioning of payment and settlement systems by meeting payment and settlement obligations. In addition, a bank should have a Certified Financial Planner who is “a financial professional who meets the requirements established by the Certified Financial Planner Board of Standards, Inc.” (Farmers State Bank, 2013). The above-mentioned measures will help to define the strategies clearly in order to address liquidity shortage in urgent situations.
Risk Management Practices in Managing Credit and Operational Risks
in Hong Kong Banks
Currently, the banks of Hong Kong seek for a better lucidity concerning to capital requirements, mainly in credit risk and operational risk areas. The Basel Committee on Banking Supervision (BCBS) suggests tremendous changes of risk weighted assets calculation, specifically for the credit risk and restrictions, to which banks can employ models of credit risk. These offers are made to encourage confidence and financial stability in the worldwide banking segment. According to the opinion of skeptics, these risks cause slowing economic growth due to decrease of the ability of the bank to provide loans. Besides, there are divergent opinions, concerning to the BCBS’s suggestions between Europe and the US, particularly whether there should be rigorous limitations on the use of loan models. It is very relevant for banks in Hong Kong as most of them to apply the models of credit risk. Thus, pieces of advice from BCBS can raise an unofficial floor that will enlarge the capital demands for banks in Hong Kong, whereas the Hong Kong Monetary Authority (HKMA) locates that floor on the probable capital savings from applying these models. These proposals are to make capital requirements more risk sensitive, not to enhance the whole amount of capital in the banking sector. Consequently, banks with conservative portfolios have to hold less capital, and those with riskier portfolios will have more capital. It should be noted that there is no negative impact of higher capital requirements in Hong Kong, whereas there are potentially serious consequences for the branch and for other banks in Hong Kong. This problem, which is combined with incertitudes, remains in the global economy and stresses the need for the branch and banks to evaluate their portfolio mix and capital requirements studiously. Hong Kong’s financial conduct regulators pay more attention to questions, providing that financial organizations treat consumers honestly and preserve the entirety of the market. Such a conduct was a big concern in Europe and the UK, and it rapidly became such in Hong Kong. Thus, banks in Hong Kong should begin to think about whether they uphold market integrity and fair treatment of their clients. It means conduct’s inclusion into all business transactions, namely in hiring, training and promotion of employees as well as in design and sales, and after-sales services. The main key that defines the conduct is the bank’s organisational culture. That is why the Hong Kong branch should consider the development of it.
Conclusion
The implementation of risk management by senior managers is an important approach for the global growth of a banking segment because it presents a significant opportunity to establish banking branches in new areas. The knowledge of various types of risks, to which banks are exposed, the management of them, and risk management practices in managing two main risks in the banks of Hong Kong, such as credit and operational risks, can help a new banking division in Hong Kong to survive and make progress. Before managing risks, the top management should be advised on the explanation of four main risks - market, operational, liquidity, and credit ones. The management should be performed by applying efforts in risk assessment, identification, and measurement. Each kind of risk requires special tools of mitigation that are analyzed and launched by professional risk advisers and analysts. The examples of methods are limits on certain business activities, early warning indicators, contingency funding plans, stress testing, and others. The effect is a profound quality bank performance and fewer failures in business process. The expertise of international regulatory criteria of HKMA, BCBS standards, opinions of naysayers can give possibilities for specialists to present advice and consult the Chief Executive of bank regarding risk management for newly established branch in Hong Kong.
References
Farmers State Bank. (2013, March 1). What is a certified financial Planner? Retrieved from https://www.fsb1879.com/news/articles/what-is-a-certified-financial-planner-.aspx
Mehta, A., Neukirchen M., Pfetsch S., Poppensieker, T. (2012) Managing market risk: Today and tomorrow. McKinsey Working Papers on Risk, 32, 1-17. Retrieved from https://www.scribd.com/document/126126511/Working-Papers-on-Risk-32
Pavey, L. (2017, March 21). Managing treasury risk: Operational risk (part VII). Retrieved from https://www.treasuryxl.com/news-articles/managing-treasury-risk-operational-risk-part-vii/
Perez, S. (2014, September 1). Overview: What you need to know about banking risks. Retrieved from http://marketrealist.com/2014/09/overview-need-know-banking-risks/
Risk.net Staff. (2016, January 20). Top 10 operational risks for 2016. Retrieved from http://www.risk.net/risk-management/2441306/top-10-operational-risks-2016
Societe Generale Group. (2013). Registration document. Retrieved from https://www.societegenerale.com/sites/default/files/documents/Societe-Generale_DDR2013_UK.pdf
van den End, W. A. (2011). Credit and liquidity risk of banks in stress conditions: Analyses from a macro perspective. Retrieved from http://www.rug.nl/research/portal/files/10468036/14complete.pdf
Wagner, H. (2017, January 20). Analyzing a bank's financial statements. In Investopedia. Retrieved from http://www.investopedia.com/articles/stocks/07/bankfinancials.asp
