Banking Risk 4

Posted: August 25th, 2021

Banking Risk 4

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Banking Risk 4

Part A: International Banking Regulation

Basel 11 refers to collective banking regulations introduced by the bank for international settlement in 2007.The rules were designed to curb the risk appetite of commercial banks, which in their effort to increase profitability, take on excess risks, hence affecting the general economy(Gindin & Panitch, 2012).The 2007 economic meltdown necessitated the introduction of Basel 11 rules.

Key Takeaways from Basel11 Rules

The basis 11, also known as the reinforced Basel 1, was legislated to strengthen the loopholes experienced as the Basel 1, was being implemented (Gindin & Panitch, 2012). The major takeaway of the Basel 11 is the capital requirement 1of commercial banks. Therecommended capital requirement for commercial banks is 1:4, or capital to risk ration of 4 % (Stiglitz, 2016).

Market discipline is another significant component of the Basel 11.The financial sector should conduct its business is a transparent and honest manner (Rhee & Posen, 2013). Thus, in the course of business, commercial banks must disclose all the charges and deductions to help customersarrive at an informed choice.Supervisory review of the internal operations and strengthening internal structures is another pillar of the Basal 11.To ensure full compliance with the Basal accord, commercial banks must be scrutinized by an external authority as the need arises (Rhee & Posen, 2013).

Is the Basal Based on Prescriptive Rules or Discretionary Application of Principle?

One of the significantcriticisms of basal 11 is the application of prescriptive rules in regulating banks (Kawai & Lamberte, 2010). Rigid rules are mainly inclined towards rules formulation and little emphasis on implementation (Rhee & Posen, 2013). Accordingly, it is noted that when the rules are imposed on people, they tend to rebel, thus creating a confrontational relationship between the regulators and the financial institutions.The confrontation can push financial institutions to develop internal compliance systems out of fear of getting in trouble with the regulator (Rhee & Posen, 2013).

Evidence of Prescriptive Rules in the Basal 11 Document is witnessed in Several Pillars

The three common points are;

• Treatment of insurance players, both buyers and sellers equally. Note that naturally, sellers are more prone to risk; hence deserve a higher return level (Mayntz, 2012). By treating the players alike, Basal 11 assumes that the risk level is similar.
• Basal 11 doesn’t permit financial institutions to investigate the relationship between internal risks using their mechanism (McGeehan, Moyer & Harris, 2008).By their nature, the business orcommercial institutions face diverse risks and should be allowed to conduct an internal investigation.
• Basal does not provideexcellent institutions for aggressive extermination of risk. This implies that the regulator has a limited understanding of the impact of conflicted marketing.

Successful regulation of financial institutions requires the combined effort of both the regulator and the players(OECD, 2013). The regulator should motivate the players to comply by outlining the potential benefits of the regulations to their business. Rather than acting as an enemy, the regulator should serve as a partner to the financial institutions providing training, mentorship, and capacity building geared towards improved riskmanagement(Moloney & Moloney, 2014). Toachieve this, the regulator should adopt a discretionary application of the principle.

The fines which have been paid by financial institutions since the launch of Basal 11 are another indication of the application of prescriptive rules (Ajami, 2006). According to the IMF, the regulator imposed a fine amounting to 10% of the total turnover for failure to comply. In the last three years, an estimated 3 million dollars has been paid by financial institutions globally as charges for non-compliance(Slovik, 2011). Moloney & Moloney (2014) asserts that, other than being punitive, this is unrealistic and uneconomical for most banks. In some cases, banks risk facing sanctions for non-compliance. These punitive measures defeat the spirit and objective of the G20 leaders who were signatories to the Basal 11 agreement (Ajami, 2006). While adopting the basal 11 rules, according to Burley (2010), the leaders’ main aim was to cushion the global economy from the impacts of the financial crisis.

IMF Recommendation

To end the stalemate, the IMF stepped in to provide sound policies that can ease the burden of compliance to Basal 11 and make increase its acceptability to the financial institutions. With the help of the government, the banks should focus on improving the banking infrastructure in the whole economy (Hacioğlu & Dinçer, 2014). Financial institutions shouldchampion policies like anti-money laundering, disclosure, and transparency as part of their objectives.Also, financial institutions should upgrade their human resource capacity to handle the Basal 11 regulation (Hacioğlu & Dinçer, 2014).To achieve this, banks should develop a learning manual for capacity building and ensure all employees are trained thoroughly.

Further, the IMF has stepped in to assist host countries who want to strengthen their internal supervisory capacity. Today, most financial institutions have created a compliance department with the primary role being ensuring full compliance to the Basal 11 requirements (Sirionin, 2000).

Part B: Market Risk – Portfolio Risk Analysis

A portfolio refers to the aggregate collection of the investments that an institution or individual holds (Connor, Goldberg & Korajczyk, 2010). It may include stocks, real estate, futures, options, or bonds, among other forms of investment like diamond or gold. Usually, portfolios are diversified to help curb against risks emerging from single security (Rad & Levin, 2006). According to Swensen (2009), a portfolio analysis encompasses analyzing the whole collection instead of relying on a security analysis that focuses on particular security types. Whereas return on security relies on the security itself, the portfolio risk-return is influenced by the component security and the constituent mixture as well as the degree of correlation (Reilly & Brown, 2012). The following analysis examines the five (5) asset portfolio from the banking industry. Market risk performance analysis is done to asses VAR, that is, Variance-Covariance, Historical Simulation, and Monte-Carlo.

Compounded Annual Growth Rate (CAGR)

It is a rate of return that that is required for the growth of investment from the initial balance to the ending balance (Rist & Pizzica, 2015). The measure enables the investor to compare across the portfolio and establish the most profitable one before deciding on investment (Hull, 2015). Taking a case of the five portfolio from Qatar banking sector companies. The selected companies areQatar Islamic Bank, Al Khaliji Commercial Bank, Doha Bank, Qatar International Bank and Barwa Bank, the following figure is a graphical demonstration of the CAGR for each of the shares of the five companies;

Figure 1: Annual CAGR (%) for the five portfolio Source: Excel Analysis

From figure 1 above, it can be shown that the best shares to invest are Khaliji Commercial Bank, which has an annual growth rate of 12.7% compared to the rest. Barwa Bank shares come second with a yearly growth rate of 11.7% followed a distant by Qatar Islamic Bank with 6.53%. Both Qatar International and Doha Banks exhibit low returns and are likely to depreciate across the year, hence unfavorable for investment.

Historical Value at Risk Simulation

Chart 2: Historical Analysis

Chart 2 above displays the historical trend for the share prices of the five portfolios over twelve months between 14^th November 2018 and 14th November 2019. As shown in the graph, Qatar Islamic Bank reveals the highest growth in prices over time compared to the other four companies. Both Al Khaliji and Qatar International Bank companies have a stable increase in prices over time. Besides the stability experienced by Doha and Barwa Banks, the two companies exhibit low performance in prices.

Figure 3: Historical Simulation

Under figure 3, historical simulation is performed over the five assets within one year of investment to ascertain their profitability. Historical simulation is aimed at stimulating the performance history of the assets to establish their worthiness (Choudhry, 2011). As shown in figure 3, the historical simulation reveals a negatively skewed performance of the portfolio returns over the two years.  As a result, it implies that the portfolio has a high chance of underperforming (See Excel Exhibit).

Variance-Covariance Analysis and Monte-Carlo Simulation

Table 1 below is an analysis of Variance-Covariance and Monte-Carlo Simulation for the portfolio returns. Variance helps show the spread of the data from its mean (Markowitz, Todd & Sharpe, 2000). The variation is calculated based on the weighted mean of the squared standard deviations. The distance between the mean average value and the average mean of the asset implies a higher variation in the portfolio performance. The size of the variance indicates the closeness between one value and the mean, such that the more significant the difference, the larger the dispersion and vice versa.

On the other hand, covariance measures the change in variables when they are compared. Covariance can be positive or negative (Bhat, 2008; Francis & Kim, 2013). A positive covariance implies the tendency of a variable moving up, while negative covariance suggests that the variable is likely to deviate more from the mean (Francis & Kim, 2013). Monte-Carlo simulations are used to establish a set of probabilities and compute the uncertainties in the set portfolio (Wang, 2012; Mooney, 1997). The two approaches are used to ascertain the most appropriate combination that the portfolio should use to optimize returns.

	Qatar Islamic Bank	Al Khaliji Bank	Doha Bank	Qatar International Bank	Barwa Bank
Qatar Islamic Bank	13.40502164	13.25162	13.12130721	13.33425	13.04664
Al Khaliji Commercial Bank	13.25161962	13.96083	13.19120987	13.30144	13.17516
Doha Bank	13.12130721	13.19121	13.18931134	13.43783	13.02726
Qatar International Bank	13.3342485	13.30144	13.43782877	16.92799	13.27616
Barwa	13.04664209	13.17516	13.02725781	13.27616	13.66275

Table 1: Variance-Covariance Matrix

Table 1 is a summary of variance-covariance table analysis, evaluation of the performance of the selected portfolio.  The diagonal line indicates the variance of each asset, while the values in the extremes indicate covariance. Observing asset performance over time, the covariance analysis reveals that all assets are likely to increase in returns, as shown by positive covariance. Among the five assets, Qatar Islamic Bank, Al Khaliji Bank, Doha Bank, and Barwa Bank are uniformly and widely spread from the mean except for Qatar International Bankassets. Hence, Qatar International Bankindicates low risks compared to other assets as it is most likely to experience stability price stability over time.

Part C: Discuss and Illustrated Foreign Exchange Risks Faced by Financial Institutionsand their internal foreign hedging

Foreign Exchange Risks Faced by Financial Institutions

Foreign exchange risks are associated with the risks that a company faces as a result of conducting business in different countries (Bruni, Fair & Brien, 1996). The transactions involve the use of currencies in a different denomination, and hence when there is a currency appreciation in one country, it affects the operations in other countries. Foreign exchange risks affect companies that are domiciled in different countries (Kidwell, Blackwell & Whidbee, 2017). Besides, Cassard & Landau (1997) avers that some manufacturing companies which import raw material from foreign countries can be affected by foreign exchange risk.

Types of foreign exchange risks

There are three categories of foreign exchange risks that a company can face

Transactional risk. A transactional risk is also known as short-term economic risks (Cfa, 2013).Transactional risks are the most common type of foreign exchange risks. Transactional risk occurs when a company engages in business with an international domiciled company. For instance, if a Europe based company imports raw material from the US-based company and agrees to make the payments in 30 days (Papaioannou & Rochon, 2006). If the Euro weakens in the month, the company will require more euros to buy the dollars.The transaction nature or type is an indication that a company will make payments in foreign currency. In the event of appreciation or devaluation of the foreign currency, the home company will suffer significant losses (Imad, 2003). Transactional cost is accounted for in financial statements as a loss. The accountant will expense the loss due to foreign exchange alongside other expenses. Transactional risk can affect a company’s operations in three ways, namely;

• Trade transactions mainly imports and exports
• Financial services majorly lending or borrowing in overseas markets
• Payment and receipt of dividends and interest

Translation risk. Translation risk is also known as consolidation risks. The risk occurs when a company has a subsidiary in a foreign country. When consolidating the financial statements of the subsidiary, the figures must be translated to home currency hence resulting in translation risk (Mügge, 2014). For instance, a US-based company might have a subsidiary company in Europe. The parent company must prepare the statement of the financial position of the company at the end of every fiscal period based in the US (Vij, 2006).  Hence, the Europe based subsidiary must be accounted for in terms of dollars resulting in translation risk.

The most common approach for accounting for a subsidiary is the current method of accounting (Hacioğlu & Dinçer, 2014). In this case, the closing exchange rate is used for converting existing assets and liabilities, while the historical rate is used for converting non-current assets and liabilities (Keith, 2006). The historic rate is the exchange rate that was prevailing when at the time of purchase of assets (Vij, 2006).On the other hand, closing rate is the exchange rate prevailing at the end of the financial period.

Economic risk. The economic risk is the most profound type of foreign exchange risk since it affects the value of the company. The economic risks impact the future cash flows and assets of the company, hence referred to as economic exposure risk (Papaioannou & Rochon, 2006). The economic risks affect the future costs and revenue of a company, therefore making it hard for a company to forecast profitability and net worth(Goldstein, 1993).Accounting for economic risks is difficult since one must include the prevailing inflation rate. International companies are forced to adjust production and marketing to remain profitable in the wake of appreciating foreign currency. For instance, a company based in Brazil, supplying goods to the American market, might incur losses as a result of an increase in the value of the dollar (Pykhtin, 2005). The reason is that as the dollar appreciates compared to the local currency, the US-based brands seem cheaper in the market.

Internal Hedging Strategies Used For Foreign Exchange Risk

Currency invoicing. By invoicing the exports in home currency, a company can transfer the foreign exchange risks to other parties (Pykhtin, 2005).For instance, a lending company based in the UK has a franchise conducting lending in Africa. At the end of the financial period, the Europe based parent company can invoice the subsidiary using the British pound currency (Bennett, 1997). Thus, in the event of currency depreciation in the African market, the losses will be borne by the subsidiary.

Leading and lagging. This strategy involves delaying payments or making early payments depending on market perception (Lietaer, 1971). If a lender in the US expects to earn interest income from a lender in Brazil, the US-based company will delay the receipt of interest income if the local currency in Brazil is expected to depreciate. On the other hand, if the currency is likely to appreciate in Brazil, The US-based Company might demand interest income early. Delaying receipt of money is known as leading while making the request

Part D. Credit Risk and Counterparty Credit Risk

            Loans are classified based on the potential of the borrower being delinquent (Bekaert & Hodrick, 2009).The financial institutions use a system of categorizing loans known as the 5C’S of credit. The 5 C’s determine the risk level of a borrower and basing n the analysis, andbanks can decide whether to lend or decline the loan application.

Character

The character of a borrower is determined to baseon their borrowing history (Saunders & Allen, 2002)).Banks use the credit score in determining the borrower’scharacter.In most countries, the credit report can be generated through the National credit bureaus.For instance, in the US, the credit report generated through the FICO model is a combination of credit reports from three bureaus; TransUnion, expatriate, and Equifax. For example, a credit score varies, ranging from 300 to 850, with a higher score indicating the best repaymenthistory. A borrower with an 800 score is less risky compared to a borrower with a 300 score. In most financial institutions, borrowers are classified based on the credit report; and this is how the effective interest rate is determined(Pykhtin, 2005).

Credit rating score

A score of 800 and above is considered excellent, and the borrower gets the lowest interestrate. A score above 750 is generally good, and the borrower receives an interest rate that is better than the average interest rate. According to Baker & English (2013), rating between 650 and 740 is to be good and acceptable, but such borrowers can become delinquent in the future. Thus, the lending decision should not overly depend on the character, but the other 5 C’s(Saunders & Allen, 2002). For example, a score ranging from 580 to 670 is a fair score, and the borrowers with a score in this range are considered as submarine borrowers. For instance, credit ratings ranging from 300 to 579 are the riskiest borrowers, and applicants in this category might not get approved for the loan. According to Philip (2011), in some cases, such borrowers are required to make a deposit or attach their assets as security for the loan.

Capacity

In terms of credit risk analysis, the function is the ability of a borrower to repay the loan (Kawai & Lamberte, 2010). Theposition of a borrower is determined by the comparison between income and expenditure and computing the debt to income ratio. Different financial institutions have different acceptance rates and based on this ratio, and a lender can decide whether to lend or not (Richelson & Richelson, 2011). Financial institutions are required by law to fund borrowers with a DIR of 43% or lower (Mayntz, 2012). This way, the borrower can afford t0 comfortably make the monthly installments (Kawai & Lamberte, 2010).The capacity of a borrower is determined by examining the bank statements, business invoices, receipts, and other crucial documents. The lender should rely on the information obtained from the accounting documents as opposed to asking the borrower questions.

Capital

Before approving a loan, the lender will consider the capital that a borrower invests in as an investment. The rule of thumb is that an immense contribution by the borrower is an indication of a lower risk of default and vice versa (Kawai & Lamberte, 2010). Thus, lenders use capital investment by borrowers as an indication of the level of seriousness and commitment to repaying the loan. Most banks require a 2-3% down payment on most loans includingmortgages (Cesari, 2009). Also, the amount of down payment can affect the interest rate and the loan amount that a borrower gets.

Collateral

Collateral or security is an asset that a borrower is willing to use as security for the loan (Gregory, 2010). Whenever a borrower defaults on the loan, the bank can auction or sell the assets to recover the investment. Most banks require collateral that is worth at least 50% of the loan amount (Kimber, 2004). The government has an established laid down procedure to be used in auctioning a borrower’s assets (Bekaert & Hodrick, 2009). Hence, the most acceptable form of security ismotor vehicles and land.

Conditions

The conditions refer to the general economic, environmental, or government policies that can affect the loan repayment by a borrower (Brigo, Morini & Pallavicini, 2013). The bank must conduct a SWOT analysis of the borrower’s business environment before making a decision. The intended purpose of the loan can also determine the conditions of issuance (Canabarro, 2009).  According to Canabarro’s view, in most cases, a loan with a specified purpose like asset finance and business working capital gets approved as compared to a general-purpose loan.

In summary, the 5 C’S of credit provides a guideline for banks to decidewhether to lend or decline the loan. The general principle regarding 5C’s is that the lending decision should be made at every step of the 5C’s.

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