Discussing the challenges faced by financial institutions in managing risk

Discussing the challenges faced by pecuniary institutions in managing chanceWhen disputeing the challenges faced by fiscal institutions in managing attempt, it is big to fix a consistent definition of the verge risk. Risk can be defined as the volatility of a corporations marketplace value. Risk counselling involves the protection of a firms assets and profits. More all over, not only does it provide profitability but too opposite advantages like being in line with obedience black market toward the rule, increasing the firms reputation and opportunity to attract to a greater extent customers in building their portfolio of fund resources. Cebenoyan and Strahan (2004) suggest that the benefits of advances in risk focussing in affirming whitethorn be greater credit availability, rather than reduced risk in the banking brass (p.19). This means that banks will have a greater opportunity to increase their productive assets and profit. Only those banks that have efficient r isk management system will survive in the market in the long run. They can follow a four-step routine to reduce their risk exposures and achieve their risk management objectives, as shown below.Figure 1 steps for implementing risk managementTo properly manage risks, the bank must firstly identify and classify the sources from which risk may arise at both transaction and portfolio levels. Risks inherent in lending activities include market risk, liquidity risk, credit risk and operational risk. Market risk is the risk arising from adverse movements in the level or volatility of market prices of equities, interest calculate instruments, currencies and commodities. Banks atomic number 18 al federal agencys facing the risk of losses in on and off-balance-sheet positions arising from undesirable market movements. The fundamental role of banks in transforming of short-term deposits into long-term loans blades them inherently vulnerable to liquidity risk. The FSA has defined liquidit y risk as The risk that a firm, though solvent, either does not have sufficient financial resources useable to enable it to meet its obligations as they fall receivable, or can secure them only at an excessive cost.Another risk that banks face is credit risk. It is the risk that can be incurred if the counterparty fails to meet its obligations in a timely manner. Loans be the most palpable source of credit risk in many of the banking systems however, other sources of this risk originate through other activities of banks such as acceptances, trade financing, interbank transactions, financial futures, foreign exchange transactions, swaps, equities, options, bonds, and in the extension of commitments and guarantees, and the settlement of transactions. Operational risk, as its name suggests, is a risk arising from execution of a companys business functions. The Basel Committee has defined operational risk as the risk of losses resulting from inadequate or failed internal processes, pe ople and systems, or external events, such as the failure of computer systems or error and fraud on the part of staff.Apart from those risks mentioned above, the federal Reserve System has recognised two other risks legal risk and reputational risk. Legal risk is the risk of loss caused by sanctions or penalties originating from court disputes due to breach of contract and legal obligation. Another legal risk relates to restrictive risk, i.e., the risk of loss resulting from sanctions and penalties pronounced by a regulatory body. Reputational risk may be defined as the risk of loss caused by a negative impact on the market positioning of the bank. It can be seen as the blowing up of an initial loss, arising from credit, market, liquidity or operational risks. However, banks hardly pay attention to these categories of risks.Once identified, the risks should be evaluated to determine their impact on the companys profitability and capital. This entails standard them by using variou s techniques ranging from transp arnt to sophisticated ones. For example, market risk can be measured by using Value at Risk. This full stop also calls for estimating three dimensions of each exposure the potential frequency of losses that exposures have produced or may produce, the potential impact on the organisation if a loss should occur and the potential variation in losses that will occur during the exposure period. Accurate and timely measurement of risk is necessary because with these types of selective information the risk manager can determine which ex stick tos argon most serious and which deserve the most immediate attention.After measuring risk, bank managers should establish and guide risk limits through policies, standards, and procedures that define responsibility and authority. In other words, these limits should serve as a means to control the risks associated with the banking institutions activities. There is a variety of mitigating tools that banks may employ to minimise the loss exposures. These tools may be diversification, securitization and even derivative such as withdrawal option, Bermudan-style return put option, return swap, return swaption and liquidity option.The final step involves appraising the operation of the program regularly to be sure that it is achieving planned results. It helps the managers to evaluate the wisdom of their decision-making. To efficiently monitor risk, all real(a) risk exposures should be identified and measured again. To facilitate this procedure, banks should put in place an effective management information system (MIS) that will provide directors and precedential managers with timely reports on the operating execution of instrument, financial condition and risk exposure of the firm. If corrective action is indicated at this stage, the first three steps should be repeated.2.1 bodily Governance in the banking sectorCorporate brass instrument is a term that is now universally invoked wherever busi ness and finance are discussed. Its purpose is to order a conflict of interest among all parties coincidenceship within the company and to develop a system that can reduce or eliminate the post worrys arising from the separation of ownership and control (OECD, 1997). Agency problem occurs when the agents of an organization (e.g. management) use their power to satisfy their own interests rather than those of the principals (e.g. shareowners). It may also refer to simple disagreement between agents and principals. For example, the mount of directors may disagree with shareholders on how to best invest the companys assets, especially when it wishes to invest in securities that would favour their interests.Not merely does the term corporate governance carries different interpretations, its analysis also involves diverse disciplines and approaches. One of the most quoted definitions of corporate governance is the one given by Shleifer and Vishny (1997) corporate governance deals wi th the ways in which suppliers of finance to corporations assures themselves of getting a return on their investment. The Cadbury Report, however, defined corporate governance as the system by which companies are enjoin and controlled (para 2.5). Additionally, it recognised that a system of good governance allows the board of directors to be free to aspire their companies forward, but exercise that freedom within a mannequin of effective accountability (para 1.1). The Hampel Report, whilst accepting the Cadbury definition of corporate governance, also noted that the single overriding objective of companies is the preservation and the greatest practical enhancement over time of their shareholders investment (para 1.16). In a similar vein, Charkham (1994) identified two basic principles of corporate governanceThat management must be able to drive the enterprise forward free from undue constraint caused by government interference, fear of litigation, or fear of displacement.That thi s freedom- to use managerial power or patronage- must be exercised with a framework of effective accountability. Nominal accountability is not enough.In the banking sector, however, corporate governance differs greatly with other economic sectors in damage of broader extent of claimants the banks assets and funds. In manufacturing corporations, the issue is to maximise the shareholders value but in banking, the risk involved for depositors assumes greater importance due to the fact that almost both bit of banks investment are financed by the depositors funds. If it goes bankrupt, it will be depositors savings that the bank will lose. Indeed, Macey and OHara (2001) states that a broader view of corporate governance should be espouse in the case of banking institutions, arguing that because of the peculiar contractual form of banking, corporate governance mechanisms for banks should encapsulate depositors as well as shareholders. Arun and Turner (2003) also nutrition this argument. Further, the involvement of government in banking is discernibly higher compared to other economic sectors due to the larger interests of the public (Caprio and Levine, 2002 Levine, 2004).Rational depositors require some form of guarantee to begin with depositing their wealth in banks. Yet, it is relatively difficult for banks to provide these guarantees to them because communicating the value of a banks loan portfolio is instead impossible and very costly to reveal. As a consequence of this asymmetric information problem, bank managers can have an incentive to invest in riskier assets than they promised they would ex ante. To assure depositors that they will not expropriate them, banks could wanton away investments in brand-name or reputational capital (Klein, 1974 Gorton 1994 Demetz et al 1996 Bhattacharya et al 1998), but these schemes give depositors little confidence, especially when contracts have a finite nature and discount range are sufficiently high (Hickson and Turne r, 2003). The opaqueness of banks also discombobulates it very costly for depositors to constrain managerial discretion through debt covenants (Capiro and Levine, 2002, p.2).As such, government noises provide the missing assurance to economic agents in the form of deposit insurance. Nevertheless(prenominal), although the government provides deposit insurance, bank managers still have an incentive to opportunistically increase their risk-taking, but now it is mainly at the governments expense. Apart from supporting the argument that a broader approach to corporate governance should be adapted to banking institutions, Arun and Turner (2003) also argue that government intervention do restrain the behaviour of bank management.The Bank for International Settlements has defined the governance in banks as the methods and approaches used to manage banks through the board of directors and elderberry bush management which determine how to put the banks objectives, operation and protect t he interests of shareholders and stakeholders with a commitment to act in accordance with existing laws and regulations and to achieve the protection of the interests of depositors. The confuse 1 below shows the general principles concerning corporate governance issued by the Basel Committee specifically for bank boards and senior management. pattern 1Board members should be qualified for their positions, have a profit understanding of their role in corporate governance and be able to exercise sound judgment about the affairs of the bank. linguistic rule 2The board of directors should approve and oversee the banks strategic objectives and corporate values that are communicated throughout the banking organisation.Principle 3The board of directors should set and enforce clear lines of responsibility and accountability throughout the organisation.Principle 4The board should ensure that there is appropriate oversight by senior management consistent with board policy.Principle 5The boa rd and senior management should effectively utilise the work conducted by the internal size up function, external scrutinizeors, and internal control functions.Principle 6The board should ensure that compensation policies and practices are consistent with the banks corporate culture, long-term objectives and strategy, and control environment.Principle 7The bank should be governed in a transparent manner.Principle 8The board and senior management should understand the banks operational structure, including where the bank operates in jurisdictions, or through structures, that impede transparency (i.e. know-your-structure).Table 1- Principles of corporate governance for bank boards and senior management2.2 Corporate Governance Mechanism check to agency theory, the corporate governance mechanisms reduce the agency problem between investors and management (Jensen and Meckling, 1976 Gillan, 2006). Traditionally, governance mechanisms can be classified as internal and external. Llewellyn and Sinha, (2000) states that internal corporate governance is about mechanism for the accountability, monitoring, and control of a firms management with respect to the use of resources and risk taking. The main internal monitoring mechanisms are the board of directors, the ownership structure of the firm and the internal control system (Gillan, 2006). Whereas, external corporate governance controls encompass the controls external stakeholders exercise over the organisation and its primary external mechanisms are the takeover market and the legal/regulatory system.However for the purpose of this paper, we will mainly focus on some internal corporate governance mechanism such as the board of directors, much precisely on its emancipation and financial intimacy. Corporate governance best practices have also stressed in particular the key role vie by the audit commissioning in reviewing a firms internal control system. Internal control systems contribute to the protection of inves tors interests by providing reasonable assurance on the reliability of financial reporting, the effectiveness of operations and the compliance with laws and regulations (COSO, 1994 2004). As such, we will also draw some attention on the importance of an audit direction.2.3 The boards libertyThe popular media as well as corporate governance experts have characterised boards largely as rubber stamps for management. They are the link between the shareholders of the firm and the managers entrusted with travail the day-to-day operations of the organisation (Monks and Minow, 1995 Forbes and Milliken, 1999). As stated in principle 4 above, bank boards should properly supervise the work of managers. Which type of directors performs ameliorate this responsibility than independent director? In fact, such directors can bring additional experience as well as clarity of thought to deliberations independent of views of management. Moreover, since their careers are not tied to the firms CEO, orthogonal directors are believed to be more powerful in keeping efficiently the firms top management (Fama, 1980 Fama and Jensen, 1983), and so could be associated with better performance.Some papers do support this theory. Baysinger and Butler (1985), being among the first studies, dominate that the relative emancipation of boards has a positive effect on the firms reasonable return on equity by comparing 266 major US businesses over a ten-years period. Kesner (1987) Weisbach (1988) Rosenstein and Wyatt (1990) Peace and Zahra (1992) Ezzamel and Watson (1993) MacAvoy and Millstein (1999) Brown and Caylor (2004) and Ho (2005) also show that shareholder returns are enhanced by having a greater proportion of extraneous directors on the board. Research by Brickley, Coles, and Terry (1994) shows meaning(a)ly higher returns to firms announcing poison pills(rights issued to shareholders that are worthless unless triggered by a hostile acquisition attempt) when outside directors domi nate the board. Other studies supporting the benefit of the boards independence are Dechow and Sloan (1996) Beasely (1996) and Klein (2002) who state that as outside membership on the board increases the likelihood of financial statement fraud decreases. There is also Black et al. (2006) who reports that firms with 50% outside directors have approximately 40% higher share price by studying 515 Korean firms. And more recently, Staikouras C. K., Staikouras P. K. and Agoraki M. K. (2006) find that the percentage of independent directors is positively related with performance measured by Tobins Q on a sample of European banks.On the other hand, others find no convincing distinguish that the level of outside directors on the board do add value to corporate performance. For instance, Fosberg (1989) finds that firms whose board is composed of a majority of outside directors do not have a higher performance as measured by the firms ROE or sales. Similarly, Hermalin and Weisbach (1991) find that non-executive directors have no impact on corporate performance in their sample of 142 NYSE firms. Pearce (1983) also find no relationship, as too Changanti et al. (1985) in their study of board composition and bankruptcy. The lack of relation between these two components has also been confirmed by Klein (1998), Bhagat and Black (2002) and Hayes, Mehran and Scott (2004). Other scholars refuting the effectiveness of outside directors on the board are Subrahmanyam et al. (1997) and Harford (2000) for the acquisition transactions, Core et al. (1999) for CEO compensation and Agrawal and Chadha (2005) for earnings restatements.It is normally the board of directors which overviews and approves the risk management policies. But, few papers have tried to link its independence to the firms risk management practices and hedging. By analysing a sample of bank holding companies, Whidbee and Wohar (1999) find that the likelihood of using derivatives seem to increase with the presence of ex ternal directors on the board but only when insiders hold a large proportion of the firms shares. Borokhovich et al. (2004) make that firms most active in hedging risk, especially when making use of interest rate derivatives usage, are those whose boards are dominated by external directors. Conversely, Dionne and Triki (2004) Mardsen and Prevost (2005) tier out that outside directors has no impact on the firms risk management policy.Given the mixed empirical findings, it is quite difficult to assert whether the board independence contribute to corporate performance and the effectiveness of risk management. Although Fields and Keys (2003) assert that there is overwhelming support for independent directors providing superior monitoring and advisory functions to the firm, a unique and clear sign concerning the effect of the boards independence on any decision including the risk management one could not be predicted.2.4 The financial knowledge of the boardTo adequately perform their s upervision role, the board of directors must have financial knowledge (which relate to principle 1). Indeed, when board members are generalists and lack the practiced financial knowledge to understand the complicated reports presented to them, they could vote for motions that increase the risks facing of the firm to a large extent. The company may collapse in this way and therefore hinder the shareholders interest. Because of the banks dominant position in the economy they should possess some financial expertise directors on its board so as to make better decisions that will not lead the firm to go bankrupt. However, given its importance, the research on the value of the boards financial knowledge is quite scarce. At times, reports recognising the benefits of the boards independence also recommend financial literacy/expertise for directors in monitoring the firms performance.In fact, Booth and Deli (1999) and Guner, Malmendier and Tate (2004) suggest that commercial bankers on boar ds provide the financial learning needed to enable the business to contract more debt. Thus, this states that financial directors do add value to the firm. There is also Rosenstein and Wyatt (1990) who provide evidence that positive unnatural returns associated with the addition of an outsider to the board are higher when the latter is an officer of a financial firm. Later on, Lee, Rosenstein and Wyatt (1999) do come to the same conclusion. However, they were unable to make any statistically difference among the reaction of the three categories of financial directors they consider commercial bankers, insurance company officers and investment bankers. Moreover, Agrawal and Chadha (2005) discover that the probability of earnings restatement is dismount in firms whose boards have accounting or financially knowledgeable independent directors.To the best of our knowledge, researches on the boards financial knowledge have only been related with the firms performance and not specificall y on its impact on risk management practices. As mentioned earlier in this study, the board of directors is usually liable for the firms risk management policies. In other words, risk management is at the core of any board members charter. Financially knowledgeable directors will obviously make better decisions on risk management practices since they will have the technical background to understand the sophisticated financial tools involved in the risk management transactions. As such, firms whose boards are composed of financially knowledgeable directors engage more actively in risk management.2.5 The audit commissionThe audit committee is intended to provide a link between the board and the auditor independent of the companys management, which is responsible for the accounting system (IOD, 1995). The chief objectives of an audit committee are to improve the quality of financial reporting, to reduce the potential authority for the non-executive director, to improve the channel of communication with the external auditor and, perhaps most authoritatively, to review the adequacy of the companys financial control systems. slicker (1984) defines audit committee as being an important vehicle for ensuring the supervision and accountability at board level. As such, audit committees are very important in banking to safeguard the shareholders interest as well as the public trust.Just as for the board of directors, independence is also considered important for audit committees because outside directors can exercise their voice and be seen to make a valuable contribution since they are free of any influence arising from the firms CEO. Thus, the reported empirical evidence supports this argument. Klein (2002) shows that independent audit committees reduce the likelihood of earnings management, thus improving transparency. In addition, Abbott, Park and Parker (2002) argue that firms with audit committees comprising entirely of independent directors are less likely to ha ve fraudulent or misleading reporting. Ho (2005) states that there is a strong positive link between independent audit committee and corporate competitiveness and also with return on equity after analyzing the international companies from 1997to 1999. Brown and Caylor (2004) do provide evidence that audit committees comprising of independent directors are positively related to dividend but not to operating performance.On the other hand, some authors find a negative relationship or simply no relation at all between independent audit committee and the firms performance. Hayes, Mehran and Scott (2004) prove that the firms performance measured by the market to book ratio is not affected by the proportion of outside directors sitting on the audit committee. Agrawal and Chadha (2005) do come to the same conclusion by indicating that independent audit committee members are unrelated to earnings restatement. There are also Beasley (1996) who finds no apparent correlation between audit commi ttees and financial statement fraud, and Klein (1998) who reports no relation between share prices and the audit committees composition. Yet, Carcello and Neal (2000) report a negative relationship between the probability of receiving a going-concern report and the proportion of outsiders on the audit committee.According to Bdard et al. (2004), each member of the audit committee should possess a certain level of financial competency. Moreover, corporate governance literatures argue that there should be at least one member of the audit committee with accounting background. Audit committees with such characteristics are expected to provide effective monitoring as they possess the skills needed to understand what is going on in the organisation. Agrawal and Chadha (2005) show that firms whose audit committees have an outside director with accounting background or financial knowledge are less likely to report earnings restatement while Abbott, Parker and Peters (2002) discover that the absence of a financially competent director on the audit committee is highly associated with an increased in financial misstatement and financial fraud. Xie, Davidson, and DaDalt (2003) find that the presence of investment bankers on the audit committee decreases discretionary accruals in a firm. Defond, Hann and Hu (2004) and Davidson et al. (2004) show that the market has a positive reaction following the appointment of directors with accounting /auditing experience on audit committees board.The audit committees are also responsible for evaluating the risk exposures and the measures taken to monitor and control these exposures. To our knowledge no paper has tried to link audit committees composition with risk management practices. Because of the mixed and irrelevant argument on independence, it is difficult to attest whether audit committees independence encourage more corporate hedging. Risk evaluation and risk management tools are quite difficult to use. Understanding them requ ires a good grasp of mathematics and statistics. Therefore, we expect firms whose audit committees members are qualified as financial expert to engage more actively in risk management practices.Furthermore, The Cadbury Report has insisted that all listed companies should have an audit committee comprising of at least three members. This is to encourage firms to devote significant director resources to their audit committees so that audit committees monitor the firms management more efficiently. However, several studies support the idea that large boards can be dysfunctional. Larger audit committees may be plagued with free rider, communication problem and monitoring problems. Therefore, as long as the increase in the audit committees size does not pose these types of problems, firms complying with this requirement are expected to report a higher hedging ratio.Often, corporations, especially financial ones, create another committee named risk monitoring committees. These types of com mittee are often responsible of the risk monitoring of the firm. However, this does not imply that audit committees are no longer responsible for evaluating and managing risks. They must still discuss and evaluate risk management processes. In other words, audit committees are there to review risk management processes proposed by the risk monitoring committees. As such, same characteristics as audit committees should be applied to these types of committees to fulfil their duties well.