Analysis of banking risks and the role of insurance industry
1 ANALYSIS OF BANKING RISKS AND THE ROLE OFINSURANCE INDUSTRY FOR NATIONAL DEVELOPMENT SUNDAY C. NWITE Ph.D, ACII, ACIB, IRDI SENIOR LECTURER DEPARTMENT OF BANKING AND FINANCE EBONYI STATE UNIVERSITY – ABAKALIKI
2 PHONE NO: 080-37743134 E-MAIL: email@example.com ABSTRACTBanks are among the financial institutions that exist in our economy. Thebanking industry mobiles funds from individuals, households and corporateorganizations. The money mobilized, part of it are always extended toborrowers with interest. This is the major ways banks make their profit. Thereare various activities of banks like giving out loans, leasing, ownership ofproperty, vehicles, project financing etc. there are a lot of risks that areexposed to their activities like interest rate risk, volatility risk, inflation risk, riskof failure to pay debt, delay in payment of debt and sometimes governmentmakes some policies against the bank which is a risk. These risks affects theperformance of banks. The insurance industry on its own acts as a shockabsorber by providing covers/polices to ensure adequate protection. It hasbeen found that banks activities involves a lot of risks both systematic andunsystematic risks and that insurance industry provides some policies like fireinsurance, theft insurance, legal expenses insurance, credit insurance, fidelityguarantee insurance. It is concluded that the banking risks need to be
3managed through insurance policy mechanisms. The implication is that banksare very volatile and if these risks are not property managed, may causeproblems to these banks which can result to distress and distress may lead tototal failure. Recommendations were made that banks should use theinsurance industry to manage their risks and also receive insurance advise tohelp reduce the risks exposed to them by taking adequate insurance policies.KEYWORDSHazards, perils, risks, volatility, interest risk, credit risk. INTRODUCTIONThe banking industry is the hub of any economic development of any nation.The banking practice started with Gold Smith, but the modern banking industry
4practice started in 1890s. The introduction of banking industry has helped ineconomic development in various ways such as giving out loans, financingforeign business among business men, given out money for agriculturaldevelopment, infrastructural provision and also in marriages, even buyingvehicles.Most of these activities of banks involve a lot of risks. These risks includescredit risk, delay in payment risk, legal expenses risk, fidelity. These risksarises from the banking transactions. The insurance industry plays active rolein providing some services to the banking industry like advisory role, riskmanagement, training staff, training on risk management and also insuringsome of their risks. This work therefore wants to look at the risks involved inbanking activities and how such risks can be managed through insuranceprocess for national development.THE CONCEPT OF BANKINGThe concept of banking can be traced to Gold Smith, when he startedcollecting money for deposit and realized that some of the depositors do notcollect them at the same time, he decided to give out some as loan withinterest (Cyole, 2000). Interest rate sends signals to lenders, borrowers,
5savers and investors. Banking in its own has no particular definition. This isbecause banking can be seen as a profession, and institution, keeping depositand other important documents. Rather, a banker was defined in bill ofexchange Act 1958 that a banker includes a body of persons whetherincorporated or not who carry out the business of banking. Pagets (1972)Doyle, 1972 Hart (1931) all were given various definitions of a banker notbanking.Today, the banking industry mobilizes savings from households, individualsand pay them interest and then give out part of the savings to investors athigher interest rate. Efficient financial intermediation is an important factor ineconomic development process as it has implication for effective mobilizationof investible resources (Nwite, 2009).HISTORICAL DEVELOPMENT OF BANKING INDUSTRYBanking is an institution for keeping, lending and exchanging etcetera ofmoney. It is a moneybox for savings, a stock of money, fund or capital in gameof hazard, (Odo, 2004)
6The history of banking development in Nigeria can be traced back to 1890s.The African Banking Corporation was the first commercial bank that opened itsfirst branch in Lagos in 1892, whose founder was Messrs Elder Dempstersand Co. a shipping firm based in Liverpool.This bank encountered different initial difficulties and eventually decided totransfer its interest to elder Dempster and Co in 1893; this led to the formationof new bank known as British Bank of West Africa (BBWA) in 1893 with theinitial capital of £10,000 which was later increased to £100,000 the same year.The British Bank of West Africa (BBWA) was the first surviving bank in Nigeriaand registered in London as a Limited Liability Company in March 1894, andthe same year other branches started springing up.The Barclay Bank Dominion Colonial and overseas (BBDC) was established inLagos in 1971 now Union Bank of Nigeria PLC. Another bank, the British andFrench Bank in 1949, now called United Bank of Africa PLC was establishedin 1949 making it the third expatriate banks to dominate early NigerianCommercial Banks. The foreign banks came principally to render services inconnection with international trade, so their relation as at that time was with
7company and with the government. These three banks control closed up to90% aggregate bank deposits from 1914 to early 1930s, several abortiveattempts were made to establish locally owned foreign monopoly.In Paton (1949), the indigenous sectors in 1929, industrial and commercialbanks were set up by a handful of patriotic Nigerians. It folded up in 1930sdue to their under capitalization, poor management, aggressive competitionfrom expatriate banks (Emeka, 1999).According to CBN (1970) many in indigenous banks were opened and laterdissolved or collapsed between 1947 and 1952, a total of 22 banks wereregistered in Nigeria. However a figure as high as 185 banks were quotedfrom government records in 2000, but from 2005 till date after banking reform,22 banks was left for operation and was licensed as commercial banks inNigeria.Today, banking business or industry are licensed to operate as follows;Merchant bank, Commercial bank, Specialized banks.
8The central bank of Nigeria repealed the universal banking operations inSeptember 2010 therefore, directed all commercial banks to divert from non-banking business (Alawiye, 2011).This reform measure effectively signaled the reversal of the universal bankingoperations in the banking industry and making banks to choose International,National or Regional banking licenses.VARIOUS ACTIVITIES BANKS ENGAGE IN NIGERIABanking is the heart of economic development of any nation. The following arethe activities banks engage in Nigeria. 1. Granting consumer loans: Early in this century, bankers began to rely more heavily on consumers for deposit to help fund their large corporate loans. By the year 1920s and 1930s several major banks led by one of the forerunners of New York’s Citibank and by the bank of America, had established strong consumer loan departments. This means consumer loans were among the fastest growing forms of bank credit. 2. Financial advisory: This is a situation where banks engage in many financial advisory services, from helping to prepare tax returns and financial plans for individuals to consulting firms about marketing
9 opportunities at home and abroad for business customers. They also provide financial advisory when it comes to the use of credit and the saving or investing of funds. (Nwite, 2004)3. Managing cash: This means that over the years, financial institutions have found that some of the services they provide for themselves are also valuable for their customers. And one of the most prominent is cash management services in which a financial intermediary agrees to handle cash collections and disbursement for a business firm and to invest any temporary cash surpluses in interest bearing assets until cash is needed to pay bills.4. Offering equipment leasing: This means that many banks and finance companies have moved aggressively to offer their business customers the option to purchase equipment through a lease arrangement in which the lending institution buys the equipments and rents it to the customer. These equipment leasing services benefit leasing institutions as well as their customers because as the real owner of the leased equipment, the lessor can depreciate it for additional tax benefits.5. Making venture capital loans: This means that banks, security dealers and other financial conglomerates have become active in
10 financing the start-up cost of new companies. This is because of the risk involved in such loans, it is generally done through a separate venture capital firm, that raises money from investors to support young businesses in the hope of turning a profit when those firms are sold or go public. 6. Selling insurance policies: For many years bankers have sold credit life insurance to their customers receiving loans, guaranteeing repayment if borrowers die or become disabled. Moreover, during the th th 19 and early 20 centuries, many bankers sold insurance and provided financial advice to their customers, though they do that through organized insurance companies.VARIOUS RISKS THAT ARISES IN BANKING ACTIVITIESThere are basic risks which are inherent in banking operations. These forms ofrisk (Rose, 1999) are as identified and explained below: 1. Credit risk: Banks make loans and take on securities that are nothing more than promises to pay. When borrowing customers fail to make some or all of their promised interest and principal payments, these defaulted loan and securities result in losses that can eventually erode the bank’s capital. Because owners capital is usually no more than 10
11 percent of the volume of bank loans and risky securities (and often much less than that), it doesn’t take too many defaults on loans and securities before capital become inadequate to absorb further losses. At this point, the bank fails and will close unless the regulatory authorities elect to keep it afloat until a buyer can be found.2. Liquidity risk: There is also substantial liquidity risk in banking the danger of running out of cash when cash is needed to cover deposit withdrawals and to meet the credit requests of good customers. If a bank cannot raise cash in timely fashion, it is likely to loss many of its customers and suffers a loss in earnings for its owners. If the cash shortage persists, this may lead to runs on the bank and ultimate collapse. The inability of a bank to meet its liquidity needs at reasonable cost is often a prime signal that it is in serious trouble.3. Interest rate risk: Banks also encounter risk to their spread – that is, the danger that revenues from earning assets will decline or that interest expenses will rise significantly, squeezing the spread between revenues and expenses, thereby reducing net income. Changes in the spread between bank revenues and expenses are usually related to either portfolio management decisions (i.e changes in the composition of banks assets and liabilities) or interest rate risk. The probability that fluctuating
12 interest rates will result in significant appreciation or depreciation of the value of and the return from the bank’s assets. In recent years, banks have found ways to reduce their interest rate risk exposure, but such risks have not been completely eliminated.4. Operating risk: Bank also face significant operating risk due to possible breakdowns in quality control, inefficiencies in producing and delivering services, or simple errors in judgment by management fluctuations in the economy that impact the demand for each individual bank’s services and shifts in competition as new suppliers of financial services enter or leave a particular banks market area. These changes can adversely affect a bank’s revenue flows, its operating costs, and the value of the owners investment in the bank, e.g its stock price.5. Exchange risk: Larger banks face exchange risk from their dealings in foreign currency. The world’s most tradeable currencies float with changing market conditions today. Banks trading in these currencies for themselves and their customers continually run the risk of adverse price movements on both the buying and selling sides of this market.6. Crime risk: Finally, banks encounter significant crime risk fraud or embezzlement by bank employee or directors can weaken a bank severally and in some instance, lead to its failure. In fact, fraud and
13 embezzlement from insiders constitute one of the prime causes of recent bank closings. Moreover, the large amounts of money that banks keep in their vaults often proves to be an irresistible attraction of outsides. The focus of ban robberies has shifted somewhat with changes in banking technology, theft from ATMs and from and from patrons using those money machines has becomes one of the moist problematic aspects of bank crime risk today.THE ROLE OF INSURANCE INDUSTRY IN THE MANAGEMENTOF BANKING RISKThe insurance industry from its creation, formation and operation are expert inrisk management.The insurance industry usually conduct survey, to identify the operational risksthat arises from the environment and other risks. First risks are first identifiedby the experts and if they are identified they will be evaluated or measured toknow the magnitude, to find out if such risks can be retained by theorganization or insured by the insurance company. Then the final stage is therisk control popularly called risk treatment will come in.
14Nwite (2004) opines that the risk treatment can be financial or physicalorganizations employ staff, train them organize seminars, conferences,workshop all on the aim of training their staff.They also provide safety gadgets for staff and ensure compliance. The flowchart and the operations are always monitored. Sometimes, tags, fences areused to protect places that are not meant for visitors. In most cases dependingon the type of organizations, customers are trained that come to the bankingpremises.In the banking industry, they own property, rent or build houses for office use,electrical appliances are used staff of various categories are employed. Theyown vehicles, have keyman, interact with the general public, lend out moneyand also participate in some projects jointly.All these activities are the ways risks arises in insurance practice. Thesevarious categories of risks are managed through avoidance, reduction,retention, transfer, combination, research diversification and hedging. Thesewill be discussed in the course of the work.DEFENSIVE MEASURES AGAINST RISK BEING HANDLED BYOTHER INSTITUTIONS
15There are other risks of banks which are being handled by other institutions,these involves the use of the following measures; 1. Deposit with central bank of Nigeria: The deposit funds with the apex bank is also a measure against the risks involved in banking business. These deposits are funded through liquidity reserve and cash reserve which are in many cases compulsory as normally adjusted in terms of their ratios on period basis. Such funds constitute safety reserve against a run on the banks. 2. Deposit insurance with NDIC: In Nigeria, it is compulsory for the banks to insure their deposits with the Nigeria Deposit Insurance Corporation (NDIC). Hence, the commercial banks and microfinance banks do insure their depositors funds with NDIC so that in the event of failure, such customers can be compensated the scheme is designed by the government to prevent runs on other banks when any particular bank fails. The scheme therefore promotes the public confidence in the banking system. The NDIC in conjunction with the apex bank does guarantee loans for other banks in the event of illiquidity or insolvency. 3. Risk transfer: The banks do insure their operational assets with the insurance for future compensation in the events of loss occurring from their inherent perils. It implies that commercial and microfinance banks
16 do normally insure their physical assets against operational hazards as well as environmental hazards. Hence, the banks transfer some of the risks in banking business to insurance companies with the payment of premium. The payment is to guarantee reinstatement where the risks insured against eventually occur.VARIOUS POLICIES INSURANCE INDUSTRY OFFER TO BANKSInsurance industry offer a lot of services to the banking industry. Such servicesranges from advisory role, credit management role, risk management role andacceptance of risk role.Mordi (1987) outlines such insurance services provided to the bankingindustry, such are; 1. Theft insurance policy: Theft according to theft act of 1968 was defined as taking something which does not belong to you without the intention of bringing it back. This type of risk is exposed to the banks 2. Fidelity insurance policy: The Nigerian banking industry engage in employment of staff. Most of the frauds that occur in the banking industry do arise do to insider abuse among the staff, hence, these evil practices need to be protected, because of bad moral hazard infidelity to a keyman’s knowledge is dishonesty.
173. Legal expenses insurance: Banks can be taken to court by their customers and the fire, the bank may not pay or if they pay it, it will have serious effect in the financial statement.4. Professional indemnity insurance policies. Insurance companies usually advise people on some financial transactions because they are held for professional negligence.5. Keyman insurance: Some staff are very important in any operation, and that of banking is not exception. So if such happens, the company will be idle for the period until they employ another capable staff which is not always very easy.6. Motor insurance: The banks have motor vehicles and these vehicles has to be insured on any of the classes of motor insurance like third party only, theft and fire and comprehensive.7. Accident insurance policy: The staff of the bank are also exposed to accident; so they also need to protect the staff against accident.8. Life assurance policies like group life assurance and workmen compensation are now made compulsory to enable efficient operation and safeguard against any unexpected happening.9. Credit insurance policies: Banks give out loans to customers. There in any probabilities that such loan may not be paid or delayed in
18 payment. Aggregate of such loans may also result to distress in the banks; hence it needs to be seen. 10. Health insurance scheme, contributory pension scheme. All these are insurance practices and need to be appreciated by banks to enhance efficient practice. 11. Cash in transit, money in safe insurance. Every time banks carry money from one place to the other. They are also exposed to risk and need to be insured. Even the police or military following the money and the drivers need to be insured because in most times, categories of people of this nature have lost their lives.PROBLEMS OF MANAGEMENT OF BANKING RISKSRisk is one of the difficult things to manage. There are some problems thatrise on the process of managing risk. They are as follows: 1. Problem of owner’s capital: The owner’s capital or share capital funds constitute the first line of problem in managing risk in bank business. This is because capital fund of the bank is normally used to provide a hedge against the risk of failure. Hence, it is used to absorb financial and operating losses until management can address the bank’s problems.
192. Problem of quality management: Recruitment of quality, seasoned and experienced bank managers is one of the major problems in managing risk in banking industry. Such quality management of banks has to be proactive as well as reactive in their posture so that they can deal with banks problems. Managing of banking risks involves the ability of the top managers to move shiftily to deal with a bank’s problems before they overwhelm the institution.3. Problem of diversification: The management of a bank can use the bank can use the bank’s sources and uses of funds to reduce operation risk. Generally, banks strive to achieve two types problems in risk diversification, portfolio and geographical diversification.4. Problem of risk retention: This means that banks normally do not take insurance policies on minutes items of operations and ill experience in risk management.5. Problem of mismatch of assets and liabilities: This is the problem or the risk banking industry encounter when using short term finance to finance long term investment. It will connote serious problems. CONCLUSION
20The management of banking risk has been discovered as an instrument foreffective operation of banking industry. Though it is being handled by boththe banks and other institutions through appropriate measures, whichinvolve the apex bank (CBN), Nigeria Deposit Insurance Corporation(NDIC) and insurance companies. Adequate risk management is the bestway of handling risk in the banking industry. RECOMMENDATIONSThe recommendations of this work are as follows;1. There is the need for banks to employ insurance professionals in their corporate affairs departments to handle the insurance of their physical facilities. Such professionals would pre-occupy themselves with risk identification and treatment. They will also liaise with insurance companies handling their banks insurance policies. They will also be useful in credit risk analysis and prediction.2. There is the need for banks to engage in risk research in order to reduce baking hazards. This is where the employment of insurance professionals becomes very relevant.
213. The staff of banks should be appropriately remunerated to eliminate human attitudes that can aggravate the occurrence of some risks in bank business.4. All banks should strive o make use of bullet proof billion vans in order to eliminate hazards that can lead to attack on cash in transit.5. All banks should strive to install security doors in their premises to checkmate the activities of hood hems on their banking halls.6. Insurance and risk management awareness seminars and conferences.
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