Supporting Regional Capacities for Financial Asset and ...


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Supporting Regional Capacities for Financial Asset and ...

  1. 1. Technical Assistance Consultant’s Report TA‐6454  (REG):  Supporting  Regional  Capacities  for  Financial  Asset  and  Liability and Risk Management  Regional Forum on                Financial Asset and Liability   and Risk Management  26–28 November 2008  This consultant’s report does not necessarily reflect the views of ADB or the Governments concerned and ADB and the Governments cannot be held liable for its contents. The views contained in this report are related to, and built upon, the presentations and discussion topics in the Asset and Liability and Risk Management Forum held at the Asian Development Bank Thailand Resident Mission in Bangkok on 26–28 November 2008.
  2. 2. Regional Forum on Financial Asset and Liability                                                and Risk Management   26–28 November 2008  The turmoil in global financial markets which began in 2007 with the US sub-prime debacle continues to generate issues for governments, regulators and market participants with deleveraging and huge losses in every economy. It has not only highlighted the importance of ongoing vigilance over all facets of risk management, it has focused attention on the ongoing viability of the current financial system infrastructure. In a timely initiative by the ADB, a Mission led by the Treasury Department sponsored an asset and liability and risk management forum in Bangkok for twenty five bank and non bank financial institutions from countries across the region. This included representation from Afghanistan, Azerbaijan, Bangladesh, Maldives, Nepal, Pakistan, Samoa, Sri Lanka and Vietnam. The forum was opened by ADB’s Vice President Finance and Administration, Dr. Bindu N. Lohani, who framed the Asset and Liability and Risk Management challenge against the backdrop of the difficulties/crisis facing the global financial system, but with a specific and valuable emphasis on the likely issues and risks facing the emerging and developing economies in the region over the immediate term. Dr. Lohani proposed three regional initiatives of value in dealing with the current crisis. Firstly, the need to improve surveillance of the region’s financial markets, recognising the need to pay attention to the specific development needs of the different markets. This should include the formation of a forum consisting of regional governors, finance ministers and top market regulators - such forum to focus on the stability of the Asian financial system, monitoring possible financial vulnerabilities and engaging with the private sector in continuing the development of the financial markets. Secondly, an increase in co-operation and development of regional bond markets designed to deepen liquidity and strengthen capital markets. Thirdly, the further strengthening of legal and regulatory environments, the harmonisation of prudential standards, and the establishment of effective and appropriate standards for governance and transparency. Forum topics were focused around two large and broad areas – Asset and Liability Management and Risk Management. The agenda was structured to cover topics through a number of very interesting and detailed presentations by industry and subject experts from Standard and Poor’s, HSBC, PIMCO, KPMG, Standard Chartered and the ADB. It was designed to firstly, provide participants with an understanding of bank asset and liability management strategies, techniques and tools essential to the effective management of the organisations’ balance sheet exposures. Secondly, the broader risk management area was examined in the context of the Basle II Accord with application to the management of risk in the banking book and an emerging theme around enterprise risk management. Many aspects were examined which referenced the difficulties being faced in the current environment. Additionally, the final forum sessions conducted by ADB specialists provided participants with some practical knowledge and skills to assist with the management of their organisations’ risk exposures.
  3. 3. 1 Risk Management  We can define Enterprise Risk Management (ERM) as an approach for identifying, analysing, responding to, and monitoring and managing risks and opportunities, within the internal and external environment facing the enterprise. It became clear from forum presentations that financial institutions are increasingly focusing on ERM. Although many of the participating organisations are different in terms of core business focus, size and/or complexity, the pre-forum questionnaire confirmed that some form of specialised approach to both risk management and asset and liability management is apparent in all participating organisations, and that risk is an important area of current focus and investment generally. An important reality is that the presence of a sophisticated ERM approach (both processes and structure) within an organisation, does not guarantee that a firm can predict or avoid losses, however it is important as it helps to maintain a sound financial profile by identifying, selecting and mitigating a range of cross-functional and aggregated risks, and assists in establishing an environment to allow optimisation of the risk/reward equation. The rating agency presentation revealed that its approach to the rating of organisations includes a full analysis of risk management capability in the context of ERM. An outcome of the assessment is reward or penalty to the rating level based on material weaknesses or significant strengths. The drivers of the ERM approach are clearly consistent with the Basel accords which are designed support the safety and soundness of the financial system. The Basel II accord (which replaced the 1988 Basel I accord) uses a three ‘Pillars’ concept that focus on measurement, supervision and disclosure. Pillar 1 provides a framework for the measurement of risks faced in terms of credit risk, market risk and operational risk. It deals with the calculation and maintenance of minimum capital requirements and allows a bank to adopt one of a number of calculation approaches based on its size and/or complexity of risk profile. Pillar 2 deals with the regulatory response to the first pillar giving regulators tools and powers to oversee the various risks a bank runs. It includes the oversight of structures and processes within the bank – for example, it gives the regulator the ability to ensure that all material risks faced by the bank are addressed; that internal policies and processes are in place; that board and senior management oversight is satisfactory; and that risk taking capacity is aligned with organisational strategy and goals. Pillar 3 is designed to allow the regulators and the market to gain a better understanding of the overall risk position of the bank. It provides higher transparency of business and risk structures via better disclosure and sets positive incentives to strengthen the risk management and internal control systems. There has been much criticism of the Basel II framework resulting from the failures in risk management over the past eighteen months. Most attacks have been levied directly at Pillar 1 components such as the value-at-risk (VaR) and credit calculation methodologies, although it is also sensible to look at failures in the supervisory and disclosure areas. Looking closely, it seems more reasonable to draw the conclusion that it is not the framework at fault, but rather, the implementation of certain components together with the adoption of an overly static management approach with respect to the framework. With regard to the latter for example, it is clear that bank internal risk oversight has not been properly structured, with an over reliance on statistical measures that have provided ongoing comfort in the preceding benign environment. It is obvious from recent events that the models deployed are not sufficient to predict market meltdowns—a poignant lesson learned is that a robust ERM framework needs constant reassessment by both organisations and regulators as market
  4. 4. conditions and volatilities change, and that proper control of the organisations’ risk portfolio through an effective and accountable governance structure should be mandatory. 2 Asset and Liability Management (ALM)   The process of managing a financial institution’s assets and liabilities represents the central sub-set of the broader organisational risk management agenda. Within the structure of the Basel II Accord ‘interest rate risk in the banking book’ is recognised as being managed as part of the ALM process. Basel II categorises this risk as a Pillar 2 activity due to the heterogeneous nature of the underlying risks and processes for managing it across internationally active banks. However there is recognition that in some jurisdictions where there is sufficient homogeneity, regulators may classify it under Pillar 1. The key consideration here becomes the extent of the risk in the banking book and whether it can be mitigated by capital support. Of course interest rate risk in the banking book is only one component of the ALM process, and the forum concentrated, primarily, on three other components to varying degrees of detail. While the ALM process includes a far wider range of activities driven by a number of possible alternative paths, the focus on the particular components below was aligned to those of greatest industry and regulatory interest during the current crisis. (i) Governance and Oversight - the structure and nature of governance of the ALM process is linked to the overriding governance structure at the enterprise level and the decisions made with regard to the management and oversight of traded market risk as well as a number of related areas. There is no single governance structure applicable to all organisations and each should consider a structure best aligned to its particular requirements. Having said this, there is a high level of consistency in larger and more complex organisations where there is recognition that the scale and complexity requires a more discrete and granular management and oversight approach. In these organisations the most senior oversight is through a board risk management committee that oversees all enterprise wide risks. At the executive level an asset and liability management committee (ALCO) generally exists which is responsible for a number of key functions including oversight of formation and optimal structuring of the bank’s balance sheet, control over the bank’s capital adequacy and risk diversification, and determination of the bank’s liquidity policy. Additional management committees may also be structured to best align with the organisations strategic focus. Where a well diversified and complex business structure exists for example, separate committees may be apparent to manage areas such as traded market risk, credit risk, operational risk, new product development or underwriting risk. In smaller organisations where activities are substantially less complex, or in some cases mono line, the top risk management committee within the organisation may be an ALCO type committee (reporting to the board either directly or through the Chief Executive) that tends to bring all risk activities under its umbrella. From a management perspective responsibility almost always resides in the C-suite – most often the Chief Risk Officer (CRO) or Chief Financial Officer (CFO) who reports directly to the Chief Executive of the bank. (ii) Liquidity Management is also a central concern of the ALM function and has come acutely into focus as a result of the current global crisis that caused liquidity to evaporate in the interbank market and is yet to fully return. The emergence of interest rate and liquidity risk in banks results from the need to meet customer needs which
  5. 5. generate mismatches in the balance sheet. Volatility in both interest rates and liquidity both have positive and negative impacts on profits and need to be managed carefully, with banks needing to monitor and set limits against various liquidity metrics such as, for example, funding gap and liquidity ratios. A recent survey by the McKinsey risk management practice revealed that developing and emerging market banks face similar liquidity management issues around management of funding concentrations, lending concentrations, and complying with regulatory requirements. Additionally, emerging markets face a number of unique constraints which are driven by reserve requirements and the limitations and depth of capital markets in those countries. There are a number of general liquidity management principles and processes that need to be included within the liquidity management framework – for example, a clear articulation of risk tolerance; a well developed set of both strategic and tactical risk measures; a process to price for liquidity and to have this flow efficiently in support of the organisations strategic business units; an effective balance sheet planning process; a stress testing process; and an effectively developed set of liquidity contingency plans. (iii) Funds Transfer Pricing (FTP) is critical to an organisation's ability to create economic transparency of product and business economics and to immunize business units from financial risks. A properly configured system can also be used, for example, as a strategic tool to influence or modify balance sheet structure; to optimise asset portfolio performance; or as a tool to support protection of the franchise. The key components of FTP include the application of appropriate benchmark interest rates and an appropriate funding add-on margin representing the cost reality of the associated liquidity risk. 3 Implementation Challenges  The implementation challenge remains one of the most difficult aspects of both risk management and ALM. A series of complex areas and tasks need to be addressed, many of which are systems and infrastructure dependent, while others require difficult decisions and trade-offs around strategy and culture. Both industry participants and regulators agree that the process is not only time/resource consuming and costly, it is also ongoing as it requires an acceptance that constantly changing business and market conditions require constant evaluation and re-evaluation of risk and ALM requirements. As such it is important for each organisation to conduct a deep enough analysis of its own operations to ensure that the framework developed is flexible enough and scaled appropriately to its own particular requirements. The requisite diagnostic is multifarious and requires skills that most banks do not have in abundance, representing a further significant challenge in its own right. 4 Forum Conclusions  The forum represented a unique opportunity for participants to meet and examine the central themes and components of Risk Management and ALM against the backdrop of the current global crisis and developments in their own markets. Feedback from participants confirmed that the agenda covered the most appropriate areas of interest and best practice and that future activities led by ADB would be highly valuable in continuing to catalyse best practice in financial institutions in the region. While it is apparent that the subject areas are too large to cover all components in detail at a future three-day forum, participants suggested future topics should be mainly practically based around areas such as stress testing, scenario analysis, risk diversification and economic forecasting as well as examining aspects such as the ‘broken’ financial system in more depth.