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Emerging risk management challenges.

Centrality of Credit Risk to Banking

Both the theory and practice of banking recognise risk as the greatest threat to the continued existence of any bank. So much effort has been devoted to tracking and controlling the riskiness of banking and financial institutions. Regulatory concerns about banks revolve around the level of risk they carry and that to which they expose themselves from time to time. Capital, cash reserve and liquidity ratio requirements all attempt to curtail the riskiness of bank portfolios. The deposit insurer also gets concerned about banks' risks and ordinarily would attempt to price its insurance premium in relation to the degree to which a bank is exposed to risk. Although this is not being done now in Nigeria, it is the practice at least in the U.S.A. The deposit insurer has to pay attention to the riskiness of each insured bank's portfolio since in the event of distress, resulting largely from mounting deterioration in asset quality, it stands to bear significant liability that would arise. In fact, such liability would be borne by the taxpayers. Informed bank depositors also worry about the risks to which a bank exposes itself. This category of customers would tend to reflect their perceptions about the riskiness of a bank's portfolio in the interest rates they demand for their deposits. Presumably, in well functioning markets, a risk premium would be incorporated in the price of deposits negotiated with the bank.

None of the existing capital or other regulatory restrictions has been successful in taming risk in banks. Yet banks must take risks in order to play their intermediary role and in order to deliver good returns to their investors. Regulatory restrictions do not and will never substitute for the risk management function that has to be unique to each bank. In spite of the regulatory requirements, banks have been known to fail due largely to excessive risk-taking. This has happened not only in environments in which supervision is weak but also in strong supervision environments such as in the U.S.A. Many banks fail daily in the U.S. and in large part due to risk.

The difficulty is legislating control over risk in financial institutions is clearly reflected in the ongoing efforts by the Basle Committee to address substituting issues in the management of banking risk. While credit risk remains the most critical and potentially devastating source of risk to financial institutions risk is now being increasingly considered in the wider context. The debate on risk management will still continue and so will the debate on how to manage credit risk in particular.

The perceived gross inadequacy of the risk-based capital regulatory prescription a la Basle informed the development of Credit Risk Management Models by individual banks in the developed country banking markets. The trend today is quite interesting: rather than have regulators prescribe requirements for controlling credit risk in banks, it is being discovered that the internal risk management models of banks perform better, being better able to facilitate effective management of credit risk. Regulators would now have to learn, and get familiar with, the variety of internal risk management models being used by banks in those markets, as a basis for identifying the riskiness of bank portfolios and assessing the adequacy of the treatment of these risks on the part of the management of the banks. One of the main arguments against capital requirements prescribed by regulators for controlling banks' exposure to excessive risk is that too much capital is required to be provided by banks and this is very costly. The internal risk management models of banks now being favoured is shown to require banks to maintain much less capital for the level of risks they carry. This of course, is a development that would interest equityholders in banks. Credit risk remains the major source of risk in less developed banking markets. Loans still account for a sizeable portion of the assets of banks, even in Nigeria--hence the emphasis on credit risk management.

Emerging Trends in Nigeria's Financial System

When one examines published information on the balance sheet of Nigerian banks, it would be discovered that loan-to-asset ratios have been declining to a large extent. However, a closer look would reveal that at the same time, off-balance sheet engagements have been on the increase. The complete picture therefore will show that loan ratios are actually increasing and bank portfolios are becoming increasingly risky. While the aggregate portfolio grows, it does so within the context of a stagnating economy. This reveals more than anything else, the danger in the growth being recorded. For perhaps the larger majority of banks, the level of provisioning has increased markedly and in line with the growing rate of deterioration in loan portfolios. The changes in government have also introduced a notable dimension to risk associated with bank portfolios. Government patronage has reduced remarkably and beneficiaries of such have changed at least somewhat. This has adversely affected a number of bank customers leading to deterioration in quality of bank assets.

There is of course, intense competition between banks for virtually all categories of customers. The incursion of banks into the commercial category and more recently, consumer banking has come with it an increase in credit risk with a number of banks recording quite unpleasant experiences. Competition has brought a lot of pressure on bank margins, resulting also in pressure to expand their lending activity. Under credit expansion in the economic environment earlier described will surely not augur well for the banking industry. Competition has also affected the availability of, and access to, quality bank staff which has its implications for asset quality. High staff turnover on critical account relationships can lead to deterioration of such relationships and thus, the quality of the associated credit. There has also been the effect on bank portfolios deriving from the adoption of the relationship management structure in more and more banks. Relationship managers have been motivated by compensation structures tied to their ability to create risk assets and much less to the sustenance of the quality of such assets. Hence, risk asset growth becomes a central objective and unfortunately this tends to happen at the expense of quality. This is still with us today. Relationship managers are therefore, known to have been remunerated for losing money, so to speak. Finally, it is important to highlight a major change taking place now among financial institutions. Government patronage has increased with the release of government accounts to financial institutions. However, government parastatals and agencies have also been at liberty to finance their operations pending when their periodic votes are released. All tiers of government have, as a result, also begun to demand risk assets and banks now fall over themselves to respond to that demand. The government as a client is now making greater appearance on the asset side of banks' balance sheet by way of loans and the attendant credit risk. Governments never used to be good risks to banks but that seems to have changed now. Or perhaps, only in the mean time.

Credit Risk Management Challenges

From the foregoing, some challenges emerging and currently facing risk managers can be outlined


* Improve Understanding and Track Development in Economy and Key Industries

Credit risk managers must improve their understanding of market and economic dynamics. Developments in the economic environment in which credit is being granted are critical to the performance of such credits. When the economy is stagnant, banks cannot afford to be aggressive with credit growth. More importantly, while the general trend in the macroeconomy is important, developments in specific industries would be even more important. Policy developments in the economy affect industries in different ways and the resilience of industries differ from one to the other. In-depth industry studies need to be undertaken from time to time to track developments, which would then aid the risk manager in assessing credit requests related to such industries, more objectively. The sophistication being brought to business activity across industries today suggest that the days are gone when risk managers would assess credits on the basis of more general knowledge of economic trends and business developments.

* Capacity Building and Dearth of Experienced Hands

Just like the lack of experienced hands contributed to the widespread distress of financial institutions in the late 1990s, the same threatens banks today in the area of risk management. Whereas the demands for better management of credits continues to heighten in Nigeria, with continued growth in risk assets due to pressure of profits and competition competency is not growing as fast. There are already major gaps in a number of banks in the area of risk management. The industry cannot afford this trend. It could be potentially devastating. There must be a conscious effort to build capacity for effective risk management in financial institutions.

* Imperative of Commercial and Consumer Credit Growth

The focus of banks' activities has gradually shifted from the corporate segment to the commercial segment and ultimately, the consumer segment. With this shift, which is no longer optional but an imperative, will be greater exposure to credit risk. Risks here will also be of a different variety. Banks have no choice but to confront them if they are to remain in business. However, in confronting them, banks must also be prepared to effectively manage them. Risk managers have a big challenge guiding their banks into these areas with a view to minimizing losses arising from increased exposure to commercial and consumer credit risks. The future for banks lie in these segments and risk managers must brace up to confront the challenges.

* Dearth of Internal Risk Management Models

With the Basle Committee recommendations, increased emphasis is being placed on sophisticated internal risk management models of operating banks. Nigerian banks must seek to develop their own models in order to benefit from the advantages they offer. We need to build capability in this area too and some investment in this regard would serve each bank well and indeed, the entire industry.

* Forging Better Understanding Between Risk and Relationship Managers

A tug-of-war ranges between relationship and credit risk managers in banks. While this war is healthy for the development and growth of each bank, at the extreme banks lose out themselves through delayed decision-making and indiscretion with respect to credits. Both parties have no choice but to work together and for the same goal. They would do well to make effort to understand the perspective and views of the other party, such as would result in a compromise position that would benefit the bank itself.

* Re-examine the Risk-Weights for the Capital Adequacy Ratio

The risk-weights that we still use in the computation of the capital adequacy ratio remain those prescribed by the Basle committee with little or no adjustment for our local environment. Credit risk managers will have to take this regulation beyond the level of compliance to function. Risk weights should reflect the inherent risk associated with certain types or categories of assets. Using risk weight for an outstanding credit of 60 days in Nigeria as that used in the U.S.A. is not appropriate. It appears we need more stringent requirements here given the weak recourse banks have to recovery when loan beneficiaries default. This is a debate I would recommend that credit risk managers engage in. It would help the entire industry, and move us forward as we seek to keep credit risk under control.

* Problem of Collaterals

Banks make such a big deal about collateral. Yet they also have great difficulties realising them when customers default. But more importantly, the emphasis on collateral has hindered the industry from growing and exploring opportunities that currently present themselves. Overemphasizing collateral will also stunt our growth of commercial and consumer credits. Credit risk managers have to think up innovative ways of packaging these kinds of credits without sacrificing the bank on the platform of excessive risk. The reform of the judicial system and our quest for commercial courts would take a while to be realised. Pending when these happen, opportunities will continue to cry out that we must not allow to slip by if we must truly develop the economy and support its growth.

* Information Sharing and Increased Cooperation

All banks stand to gain by volunteering information on their borrowers. Banks continue to be ripped off by unscrupulous clients as a result of inadequate information sharing on the part of credit risk managers across banks. The need for information sharing is perhaps even more critical with credit risk managers than with bank inspectors, though both are very important. The Credit bureau of the Central Bank of Nigeria is still far from what would be of help to risk managers in banks going by the information sent into the database as well as the institution having responsibility for managing the bureau.

* Integrity of Accounting Statements

Faith in the accuracy of accounting statements published by businesses in the country also continues to diminish. Credit risk managers have a big challenge in this regard, unveiling what is the real picture of the health of such companies. Accounting statements can no longer be taken for granted, not even for some so-called blue chip companies. Moreover, within the industry in which some of these companies operate, the competitive dynamics have changed significantly and while they have grown volumes they have also lost much market share. More caution will be expected of risk managers to ensure that adverse financial engineering activities are duly reversed and the true position of companies revealed.

* Ethical Conduct and Insider Credits

We must continue to worry about Insider Dealings in Banks. Credit risk managers also have the responsibility of ensuring that insider-related credits are processed in ways that would not adversely affect the Bank.

Contributed by H. Belo-Osagie

* We are grateful to the management of united Bank for Africa PLC (UBA) and to the author for extending rewarding cooperation to Om Sai Ram Centre for Financial Management Research: Journal of Financial Management and Analysis (also see, January-June 2001 issue of UBA, Business & Economic Digest)--EDITOR

The author owns full responsibility for the contents of the paper.
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Author:Belo-Osagie, H.
Publication:Journal of Financial Management & Analysis
Geographic Code:6NIGR
Date:Jan 1, 2012
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