Hedging the banks against risks

Stress testing has to be regarded as a complementary tool to major risk management instruments such as value-at-risk analysis. Banks perform stress tests for their internal needs in order to identify reaction of sectors to extreme events, assess the sensitivity of credit factors and approaches to extreme events in order to ensure appropriateness, and identify "hidden" correlations within portfolios. They also undertake such tests to support portfolio allocation decisions and strategy beyond normal current conditions, evaluate potential capital requirements under possible future credit environments, and identify benchmarks to create some awareness of the current market situation. According to the latest report of the Financial Sector Assistance Programme (FSAP) that was initiated by the International Monitory Fund (IMF) and the World Bank (WB), stress tests suggest that credit risks continues to have a larger impact relative to other single-factor shocks in Bangladesh. As per prevailing regulation, a bank can take maximum exposure (outstanding at any point of time) on a single customer (individual, enterprise, company, corporate, organisation, group) for the amount not exceeding 35 per cent of its total capital, subject to the condition that the maximum outstanding against funded facilities does not exceed 15 per cent of the total capital. However, for any single customer in the export sector, the maximum exposure limit will be 50 per cent of the total capital, subject to the condition total funded facility will not exceed 15 per cent of the total capital of the bank at any point of time. Besides, the banks can sanction large loan up to 56 per cent of their total loans and advances, provided their rate of classification is within 5.0 per cent which is perhaps one of the highest percentage compared to the situation at regional and international levels. This regulation -- in particular about large loan up to 56 per cent, was adopted by Bangladesh Bank (BB) in 2005 when the banking industry had a lower capital base. By this time, the capital base of the banking industry has increased manifold and the regulators may review this threshold so that the banking industry does not expose itself heavily to large loans. The regulators may link up this issue with banks' capital base as well as existing practice on classification rate will compel the banks to grow with more capital for a solid footing. The good risk management-practising banks by this time have set up their own threshold towards sanctioning large loans, in terms of single exposure vis-à-vis total exposure. The losses of the banking industry mainly arise from credit loss; a large part of such losses are large loans. This is proven across the nation, regional and global levels as well. Since the result of stress testing gives the hints where we are and where we will be, so banks must consider this as an early warning tool and appropriate strategy should be taken, as they deem fit, to retain their situation in a good shape. This is very much essential for any economic performance. Our banking industry did not undergo any major financial turmoil until now. Most of the banks are focusing more and more on making profits. Although we did not undergo any financial turmoil but the market is becoming competitive. Economists commented on the national budget for fiscal year (FY) 2011-12, that high dependence on bank borrowing to meet the need for deficit financing would crowd out private investment. They also commented that an increase in incentives and subsidies and pressure on exchange rate and inflation might pose an additional threat to the macroeconomic stability. Relaxation of statutory liquidity ratio (SLR) requirement by the BB is on a remote possibility at this stage as it wants to curb the rate of inflation. However, BB has allowed net inter-bank surplus deposit for calculating credit-deposit ratio (CDR) of the commercial banks in responses to the demand of Bangladesh Association of Banks (BAB) and Association of Bankers Bangladesh (ABB). Moreover, the BAB and ABB in a joint meeting agreed in principle to fix the highest ceiling at the rate of 12 per cent for deposits. The present macro-economic indicators are not showing the probability to ease down the volatility of the money market within a short span of time. The interest rate on deposit is absolutely market-driven. The hefty increase of cost of fund of the banks due to the recent tight money market situation has ultimately been translated into erosion of spread of the banks. Banks could not pass on the incremental cost of deposits to the borrowers in the same ratio as the percentage of deposit cost is much higher. The incremental interest expenses as pass-through to the borrower will be one of the concerns for the industry as well as for the economy as a whole. The borrowing company will distribute the said cost to their products and services and ultimately the end-user will be affected. Due to non-availability of utility services like gas and electricity many industries could not go for production whereas they need to count the interest expenses. Classification rate may further be deteriorated in the banking industry, considering all the afore-said reasons. Further, the rate of classification in retail segment may also deteriorate as many of the borrowers invested their high-cost fund in the stock market, in addition to the reduction of their individual purchasing power. Maximization of the stakeholders wealth is one of the top priorities of any organization. However, a bank will not take excessive risks to make hefty profits or to show performance to the stakeholders which may not sustain in the long run; rather, they will focus on calculative risk to make a win-win situation. The BB guidelines focused on liquidity stress test with stringent regulation, being comparable with international standard practices. This is a timely one. It is for sure that the capital of a bank is trivial an amount in the context of the total volume of its business. The main source of fund of the bank is the depositors' money. The depositors as a whole are the major contributors to the bank. On the other hand, the earning assets of a bank are mainly its loans and advances as a whole. Bank lending to the borrowers has got an inherent risk of not coming back to the bank to return it to the actual source i.e. to the depositors (on demand or at maturity). In case of need, as the capacity in terms of liquidity becomes the dire concern, there must be primary precaution to ensure liquidityconvertibility of loans and advances of the bank. Adoption of stringent credit risk management (CRM) policy based on industry best practices, adherence to the due process relating to selection of borrowers and nursing treatment, as and when required for repayment of credit will ensure good health of any bank. Thus, it is the prime responsibility of banks management to run the bank in such a prudent manner where the interests of the depositors are not hampered under any stress situation. If any bank faces any under severe liquidity crisis, the reputation of the banking industry as a whole will be damaged seriously. There will then be a very negative impact even on the performing cases with banks. Once the reputation is lost, it is very difficult to restore the same image. So, the vigilance of senior management, particularly the effective functioning of Asset-Liability Committee (ALCO), is a must for ultimate protection of depositors' money. Toxic assets must be identified by those in charge of executing stress testing for financial institutions. If such assets whose actual value is far less than their stated value, are being used as collateral for debt obligations, the consequences could be catastrophic. Financial stress testing must evaluate all of the possible weaknesses in an institution's entire portfolio of assets. By exposing the axes where the situation of an institution is most vulnerable, stress testing can provide the pathway to necessary improvements and corrections. Reckless lending with unscrupulous super rating, biased appraisal and processing of loans created by way of the so-called derivatives having no real asset backing, going beyond means being tempted by greed etc. are the key contributors for the red light of the financial system in the western world. Many analysts and policy-makers have raised the questions regarding reasons for failure of a good number of banks and financial institutions in recent years, despite stress testing in place. The reasons may be articulated as (i) failure to use appropriate risk matrix, (ii) faulty measurement of known risks; (iii) faulty measurement stemming from overlooked risks; (iv) failure in communicating risks to top management; and (v) failure in monitoring and managing risks. In this context the initiative of BB deserves high applaud. All concerned will expect that the reasons for failure, as noted in this write-up, will encompass the real areas of concern. That will greatly facilitate to take up timely steps so that future development of the country's banking sector as a whole can be ensured on a sustainable basis. Since BB has revised the guidelines recently, so this is the time to develop the understanding level across the senior management for better utilization of stress fest results in line with such guidelines. The management of the banks should place the results of stress testing to their respective Board of Directors which is the ultimate authority of any bank. The board will need to review the outcome of the stress test meticulously. This has to be followed up by necessary directives and formulation of suitable changes in policy, if required As per Basel II accord, banks should have strategic capital planning, in line with their business projections. Banks should take due note of the results of stress testing at the time of fixing their capital planning. This and the said planning should also be resilient enough to absorb, at least some shocks up to a maximum possible extent. The BB model has shown the level of shocks to be of three, categories i.e. minor, major and extreme level ones. A rigorous and forward-looking stress-testing regime will consist of a combination of both likely and unlikely events. Sufficient capital should be maintained by banks to ensure that no capital deficiency can occur under any of the likely scenarios. Capital need not be held against events judged to be possible but are not anyway unlikely. Where any capital deficiency is indicated, a plan should be developed to counter its effects. Stress tests remain now at the forefront of the ongoing debate about how to improve the health of the global financial system. Banks, regulators and supervisors will need to continue unstinted efforts to help to develop them as the tool for spotting emerging risks and financial markets will there be paying attention to the results. The writer is serving in Prime Bank in Risk Management area as Vice President and can be reached at e-mail: mjamil11974@gmail.com. The views expressed here are of the writer's own, and not necessarily of the organisation he represents