Flow of Risk in Banks

Introduction:

The article highlights the risk in micro and macro perspective with an emphasis on systemic risk. At solitary level the banks are not only susceptible to failure but also spread the ripple effect of failure to the environment causing cascading failure of other institutions. At macro level, the systemic risk is originated from the broader canvas of socio-economic environment. The government policies and financial regulators play an important role in the prevalence and curtailment of the risk in the economy. The Banks and financial institutions are the fragments of the economic environment and cast significant impact on the magnitude of the risk. The impact of risk at such level travels through the banks and financial institutions and cripples the entire economy if not controlled effectively.

The systemic risk lies at various level of the economic hierarchy e.g. at industry level (such as banking, automobile), sector level (such as infrastructure, services) and at the apex economy level (the aggregated portfolio of risk).

The article has made an effort to analyse the origin of risk by observing two well-known incidents e.g. the Bankhaus Herstatt bankruptcy and the Asian crisis in 90’s. The liquidation of Herstatt had an impact on the banking companies located at various geographical locations whereas the Asian crisis which was the result of economic turbulence in the South-eastern Asian countries had a devastating impact on all the financial institutions in these economies.

*Picture from Internet

Bank as a Risk Manager:

The term risk in banking industry has a multidimensional expression and interpretation. At minuscule level the bank is inherently exposed to the operational risk involving execution of non-systematic or unstructured financial / non financial transactions or a mere human error. At a broader canvas of picture, the bank is prone to counter party risk, portfolio risk, liquidity risk and much other type of risks which may lead to the failure of the bank itself.

The banks fundamentally are in risk management business. It harnesses the balance between various risks by applying the techniques of diversifying the inherent and potential risk, deploying collaterals and even passing the risk to the other parties.

In Economics term the bank convert the savings of the depositors into the investment. In simpler words the bank takes the deposits from general public and lends it to the needy business houses and individuals who by themselves cannot arrange for such funds to fuel their business engines. In the process the bank exposes itself from various potential and inherent risks such as: from the deposit side it is exposed to: Money laundering and financial terrorism risk, regulatory non-compliance risk, reputational risk, operational risk, liquidity risk, risk of run on the bank etc. The credit risk is generally constituted of default risk and portfolio risk. The portfolio risk is again made of intrinsic risk (loss of value) and concentration risk.

Traditionally the credit risk was the predominant challenge for banks in India. With the progressive deregulations of the market norms, the adverse movements of interest rates, equity and bond prices, and foreign exchange rates have higher impacts on the bank’s profitability and the portfolio and also a risk to the going concern concept for the banks.

The overall risk of a bank depends on internal and external factors. The external factors are macro-economic scenarios such as state of economy, inflation, interest rates, foreign exchange rates etc. The bank does not have control over the external factors, however the bank can minimise the risk and the impact of it by addressing and strengthening the internal factors. The internal factors are policies and procedures, credit assessment framework, credit review and quality assessment, quality of collaterals, post sanction supervision, prudential limits and structured organisation to support the information flow to make informed and conscious decisions.

At the macroeconomic level, models such as those proposed by Minsky (1982) and Kindleberger (1978) embody the claim that the banking system is inherently unstable. Minsky argued that a capitalist economy, and especially its banking system, is inherently unstable. Furthermore, this instability is endogenous, originating within the system itself. - Federal Reserve Bank of Atlanta Economic review

Risk In a bank:

The banks are inherently unstable and that is why banks are into risk management business. The risk if not contained properly may engulf the mere existence of the bank itself. That is not all; the failure of a single bank may have a cascading effect on other banks and financial institutions which are dependent or having interrelation with the failed bank.

To put in a simpler approach, the run on bank let’s say “A” may have a cascading effect on other banks which are owed money by the bank in trouble, causing a cascading failure of other banks too. As depositors and lenders senses the ripple effects of default, and liquidity concerns torrent through money markets, a panic can spread through the market which will turn into run on all the banks.

We can discuss the risk in two perspectives based on its origin: 1) Risk originating from a bank and 2) Risk originating from environment

Risk originating from a bank

The banks are not solitary institutions, the general and money market operations expose itself to the dynamic economic and financial environment. The failure by a bank to honour a payment obligation may jeopardise the immediate liquidity position of another bank which owes the payment. In such scenario the receiving bank may approach money market to borrow short term fund to manage the asset liability mismatch. However such fund may put additional affliction on the profitability of the bank. In extreme case this may break the back bone of the fund management and bankrupt the entity.

The glaring example of such risk and consequences were observed in the form settlement risk in June 1974 as the privately owned bank in Germany Bankhaus Herstatt went into liquidation. In March 1974 Herstatt’s open exchange positions amounted to Deutsche Markes DEM 2 billion, eighty times the bank’s limit of DM 25 million. The bank was finally hit when due to time zone difference the bank could deliver payment in US dollar at New York for which it had received DEM in Frankfurt. The failure of this small German bank sent shock waves through the system. Since Herstatt was declared bankrupt at the end of the business day, many banks still had foreign exchange contracts with Herstatt for settlement on that date, costing banks from New York to Singapore some $620 million in losses.

Due to severity of the crisis, financial world now refers Herstatt risk as the risk arising from the time delivery lag between two currencies and also known as settlement risk. But, Herstatt risk was not a reason for the Herstatt crisis, it was the repercussion.

The Herstatt Bank was for many years regarded as the major example of failure where counterparties were hurt. It illustrates an example of counterparties not being paid" regardless of the circumstances. - Steven Schwarcz, professor of law and business at Duke University

Cause of the crisis: The Herstatt crisis took place shortly after the collapse of the Bretton Woods System in 1973. The Bretton Woods system of monetary management established the rules of exchange rate by tying its currency to gold.

The Herstatt bank had a high concentration of activities in the area of foreign trade payments. Under the Bretton Woods System, since exchange rates were fixed, this area of business offered a little risk. Post collapse of Bretton system the rates environment became volatile; this area of business was fraught with much higher risks. Herstatt was overleveraged in foreign currencies when that market was in its infancy; moreover the bank also had weak controls and for years enjoyed lax regulations by the government and financial regulators.

The flow of risk in the banking industry: German regulators withdrew its license at the closure of business day on June 26 and forced it into liquidation. However it was still morning in New York, where Herstatt's counterparties were expecting to receive dollars in exchange for Deutsche marks they had delivered. Herstatt's clearing bank, Chase Manhattan could not fulfil the orders. The New York interbank market came to a standstill; this triggered a chain of subsequent defaults. The impact of this event was so great that I had repercussions throughout the world.

Regulatory response: The Herstatt crisis had major implications for the regulatory framework. Shortly after the crisis, Principle Ia was introduced in order to limit the risk accumulated by a bank on its foreign exchange operations. In 1976, the Second Amendment to the Banking Act (KWG) came into force, which strictly limited risks in credit business and tightened the controls of the Federal Banking Supervisory Office.

Risk originating from environment

The systemic risk is defined as the risk of failure of the entire financial system or collapse of the entire market. The systemic risk is a complicated affair. The interrelation and dependence of financial institutions with one another has made a colossal and intricate environment of variables and cascading outcomes.

Systemic risk can also be defined as the likelihood and degree of negative consequences to the larger body.

A financial institution represents a systemic risk if it becomes undercapitalized, when the financial system as a whole is undercapitalized the magnitude of such risk increases manifold and may impact the existence of its banks and financial institutes. The risk at this level cannot be diversified. The banks can transfer the interest or exchange rate risk by participating in market with products such as derivatives, hedge funds etc. however the same mitigation tool also increases the exposure to the systematic risk as a whole. Within a certain range, financial interconnections serve as shock-absorber (i.e., connectivity engenders robustness and risk-sharing prevails). But beyond the tipping point, interconnections might serve as shock-amplifier (i.e., connectivity engenders fragility and risk-spreading prevails).

The impact of the Systematic risk depends on the inter-dependencies of the financial institutions and the size of the entities. According to the Property Casualty Insurers Association of America, there are two key assessments for measuring systemic risk, the "too big to fail" and the "too interconnected to fail" tests. The size of the entity is ascertained in terms of the size of the entity relative to the national or international market place. The market share of the entity also decides the potential risk its poses in case of any default. On the other hand, the smoothest labyrinthine interconnections between institutions become the speed lanes for ripple effects of any default.

The contagion spreads rapidly in banking industry compare to any other industries or financial institutions. Banks are too interconnected. The shock produced by one bank has severe impact on the business of a host of other banks. Moreover the bank by its structure and business activities is a risk producer. The risk is produced in an environment where the dynamic socio-economic factors amplify this risk causing the growth of chain reactions and unpredictable outcomes.

The economic policy, socio-geographical structure, the relationship and dependency on other economies, the approach of administrative services all have wide impact on the direction and severity of systemic risk. One of the main motives for regulation in the marketplace is to reduce systemic risk. However, regulation arbitrage, the transfer of commerce from a regulated sector to a less regulated or unregulated sector brings markets a full circle and restores systemic risk.  

The Asian crisis of 1997 was a product of Investment boom, unutilised excess capacity of production units, debt bomb and administrative mismanagement. The crony capitalism and fixed exchange rate regime charged the economy with side effects. First the economy benefitted with fixed exchange rate system and large inflow of foreign currency in the economy. Later the economy and financial market was crippled with run on the banks, lack of confidence in the institutions and never ending foreign debts. The foreign debt to GDP ratio reached astronomically at 100-167% in the four large Associations of Southeast Asian Nations (ASEAN).

Background: The economies of south East Asia in particular had kept the rate of interest high to attract higher investment flow into the economy. This indeed worked and by 1990 the south-eastern Asian countries have received large amount of investment and this led to a dramatic run-up in asset prices. The countries; Thailand, Malaysia, Indonesia, Singapore and South Korea experienced a high GDP growth rate (8-12%) within that period. This achievement was highly acclaimed my IMF and World Bank and was also known as part of “Asian economic miracle”. However the scenario changed. By 1997 the financial crisis gripped almost all the countries in South-east Asia. The economic downturn was so powerful that it spread fear of an economic meltdown on a global scale.

Causes and the impact of the crisis: Fixed exchange rate: it is also known as pegged exchange rate. In this exchange type, the value of a currency is fixed with another single currency or a basket of currency or in some cases with the gold price. In fixed exchange regime, the central bank of the country is obligated to buy and sell the currencies at the predefined ratio and hence there will be no market force applicable or comes into picture. For example if today Government of India decides to fix the INR with Dollar in 60 to 1 ratio. This means whatever the demand or supply of currency in the market; the RBI will exchange one dollar at Rs. 60 only.

During mid-1990s, Thailand, Indonesia and South Korea had large current account deficits. The coinciding maintenance of fixed exchange rates encouraged external borrowing and this led to the excessive exposure to foreign exchange risk. This risk was owned by both financial institution and corporates. The fixed exchange rate system at such extended period of time was a policy level mismanagement. In contrast to this, we also observed that in 1973 Bretton Woods system collapsed and transition of economies of European countries and the US to floating exchange rates was relatively smooth, and it was certainly timely. The flexible exchange rates made it easier for economies to adjust to more expensive oil, when the price suddenly started going up in October 1973. Floating rates have facilitated adjustments to external shocks ever since.

Crony Capitalism: The crony capitalism is a geo-political scenario where the success of business and economic operations largely depends on the networking with influential legislatures and government officials. In the Asian crisis, the crony capitalism went long way to disturb the flow of development funds in the economy. The fund flew to certain people / corporates not based on merit or credit worthiness but based on balance of power. Researchers explain that the Asian crisis was not merely based on failure of bank’s credit policy but the administrative and economic decisions.

Bad loans: The Thai financial companies and banks borrowed in US dollars which had a low interest rate, and leant in Thai Bhat at high interest rates. The only problem with this financing strategy was that when the Thai property market began to unravel in 1996 and 1997, the property developers could no longer payback the cash that they had borrowed from the banks and FIs. In turn, this made it difficult for banks and FIs to pay back its creditors. This only worsen the foreign debt situation.

Currency speculation: Currency speculation involves buying, selling and holding currencies in order to make a profit from favourable fluctuations in exchange rates. The 1997, the traders started to short sell the Asian currencies with an anticipation to make profit in future at higher dollar rates vs the Asian currency. For example, a trader might borrow Bt100 from a bank for a period of six months. The trader then exchanges the Bt100 for $4 (at an exchange rate of $1=Bt25). If the exchange rate subsequently declines to $1=Bt50 it will only cost the trader $2 to repurchase the Bt100 in six months and pay back the bank, leaving the trader with a 100% profit.

The government could not defend the exchange rates at such speculative market and had to allow free flow the currencies. Once floating the speculation pull the currencies down. The traders achieved what they planned for. However the situation of banks became worse, due to weak currency they’d now need to arrange additional local currency to buy dollar to pay the foreign debt.

The flow of risk in the banking industry: The resulting panic among the lenders led to large withdrawals of deposits from the Banks. The debts turned not performing. With higher currency exchange rates the banks failed to pay the foreign debts. The currency market collapsed with depreciating foreign currency reserves with the governments. Capital market faced free fall of indexes and share prices.

Global Regulatory actions for addressing the risk

As a regulatory response and an attempt to solve the “too big to fall” and “Too Interconnected to Fail" banks and their relation with the sovereign states, the Financial Stability Board (FSB) came up with the method of identifying Global – Systematically important banks (SIB).

The SIBs are important due to their size cross jurisdictional and time zone activities, complexity in structure, lack of substitutability and the share of market it commands. The failure of banks of such stature has the propensity to impact the banking industry and the economy at large.

With response to the global financial crisis and failures of banking companies, various reforms have been institutionalised under the umbrella guidelines: Basel III. The Basel III accord entails a bank to increase the quality and quantity of capital, enhanced risk coverage, introduction of leverage ratios, capital conversation buffer and counter cyclical capital buffer. These policies are applicable to all the banks; however these are not adequate to address the magnitude of risk the SIBs poses to the economy. The central banks of respective economies have prescribed various additional requirements for these SIBs.

Apart from the above steps, the Basel committee on Banking supervision has also issued guidelines and standards to the banks and banking regulators of countries on management risk data aggregation and risk management known as BCBS 239.

Improving banks’ ability to aggregate risk data will improve their resolvability. For recovery, a robust data framework will help banks and supervisors anticipate problems ahead. It will also improve the prospects of finding alternative options to restore financial strength and viability when the firm comes under severe stress. For example, it could improve the prospects of finding a suitable merger partner.

Systemic Risk forecast in Indian economy: The Reserve Bank of India at regular interval conducts market surveys and captures the perception of industry experts and market participants on the major risk faced by the financial system. The survey is also focused to comprehend the view points of the experts to understand and predict the movement of market variables and accumulation of risk in the broad macro-economic factors.

In the recently published survey report by RBI, the risk perception on macro-economic scenarios is categorised as medium whereas the Financial Market risk is perceived to be having low risk.

The report perceived the probability of occurrence of a high impact event at a global platform in the short term period as medium whereas the possibility of such event at domestic front is low.

The systemic risk is categorised into 5 major risk groups and mentioned in the below table. The sub categories of the Risk are provided under the group heads in vertical order along with the colour representing the severity of risk.

Sources:

1.      American Banker Search
2.      Wikipedia
3.      BCBS papers-Systematic Risk,Risk data aggregation
4.      Framework for Dealing with Domestic Systemically Important Banks(D-SIBs)-RBI
5.      Bank deposits and credit as source of systemic risk (Robert Aeisenbeis)
6.      Financial Stability Report December 2016-RBIhjnhn