CHAPTER 3: IMPLICATION FOR BANK MANAGEMENT
In October 2007, Institute of International Finance’s Board of Directors established a committee to develop ways to address market weaknesses and rebuild confidence. The establishment of the Committee was also intended to facilitate the industry’s co-operation with the official sector, the need for which was recognized by both sides. In July 2008, the Committee concluded its work with the presentation of The Final Report of the Committee on Market Best Practices: Principles of Conduct and Best Practice Recommendations – Financial Services Industry Response to the Market Turmoil of 2007-2008. It represents the broad agreement of the Committee, endorsed by the IIF Board of Directors and other IIF member firms, on the need to address the many shortcomings highlighted by the market turbulence. The Principles of Conduct, Best Practice Recommendations, and Considerations for the Official Sector of the report cover six key topics with their more specific issues; longer-term proposal regarding market monitoring are presented at the end of the Report. Those six key topics are:
• Risk management issues
• Compensation policies issues
• Liquidity risk, conduit, and securitization issues
• Valuation issues
• Credit underwriting, ratings, and investor due diligence in securitization markets
• Transparency and disclosure issues
In the following chapters, each of the issues has been described from the perspective of bank management during the present financial crisis.
3.1 Risk Management Issues
“Who was managing the risk?” – After the recent financial crisis this question becomes very common in almost all organization as most of the institute failed to manage their risk. Many observers already tried to find out the shortcoming of existing risk management in Bank and they provide some recommendation. In order to cope with the current financial Crisis, Bank should undertake a critical review of their risk management practices, besides, Bank should improve the risk culture also (Shimpi, 2009). Shimpi (2009) also emphasize on appointment of a chef risk officer. Many banks already have a CRO, but the CRO’s responsibilities must be equal to what Bank is asking them to do. The CRO helps the company hold a mirror up to itself, to help management distinguish between the warts and beauty spots.
Institute of International Finance (2007) emphasize on the following issues relating to risk management:
- Governance and risk culture
- Risk appetite
- The role of
- The Chief Risk Officer
- Risk models and integration of risk-management areas,
- Securitization and complex structured products
- Stress testing.
The level of risk which any specific institution either wants or is allowed to engage in needs to be defined (‘pension fund vs. investment bank’), and this specific ‘risk appetite’ should become part of the corporate risk culture (Wehinger, 2008).
In order to risk culture embedded across the firm, bank should locate right people in right place. It is hard to put in the manual. Another piece is communication and action at the top. And how these things are seen and perceived by the rank and file.
According to Vartanian (2006), there should be an effective compliance program in bank consisting of the following four parts:
a) Chief Risk officers
2) Continuous monitoring
3) Effective auditing and
4) Board Involvement.
Using various risk models is very common while predicting future risks. But while using model, single risk methodologies should be avoided. Besides, over reliance on specific models should also be avoided. When the circumstances are extreme, some common senses should be applied in order to be able to assess the risk (Wehinger, 2008).
Supervisors should rigorously assess Basle II applications, including default loss estimates in downturns and the robustness of stress tests (President’s Working Group on Financial Markets, 2008)
3.2 Compensation policies issues
Institute of International Finance emphasize mainly on avoiding incentives for excessive risk taking.
Bank should make their compensation practices more reflective of both the risks and returns generated by their employees (Shimpi 2009). Since profit unfolds over time, rewards should be structured to recognize the fact.
Wehinger (2008) suggest that compensation at all management levels should be compatible with long-term shareholder interest and value of the firm, which could be achieved by including deferred and equity-related elements in compensation schemes.
The financial industry should align compensation models with long-term, firm-wide profitability. Regulators and supervisors should work with market participants to mitigate the risks arising from inappropriate incentive structures (The Financial Stability Forum, 2008).
3.3 Liquidity risk, conduit, and securitization issues
Underestimating the importance of liquidity risk is one of the important facts behind today financial crisis. In the past years liquidity risk has not been taken into account in stress testing, funding strategies, and portfolio management (Wehinger 2008). In large and complex institutions, benefits as well as challenges arises with a potential for internal liquidity provision to seem adequate but with harder to assess funding risks at the aggregate level.
According to Wehinger (2008), while designing funding strategies, risks under stressed market conditions with sever liquidity shortages should be included for secured funding. Bank should also consider about securitization of assets and the use of conduits as those can be subject to reputation risks. Central Bank should provide clear specification on the conditions under which it would work as a lender of last resort and Central Bank should consistently communicate those rules with the commercial banks. And most importantly, risk management of bank should take into account the fact that, there is a chance of liquidity to turn into insolvency if liquidity problems weigh on investors’ confidence and weaken the company’s equity base.
In the quarterly bulletin of Bank of England (2009), it has been mentioned that overall liquidity conditions have yet to normalise to any significant degree. In order to meet banks longer terms liquidity demands, UK government already extended the term of Bank of England’s Permanent Discount Window Facility.
3.4 Valuation issues
Institute of International Finance (2007) covers the following issues relating to valuation:
- Management and governance of the valuation process,
- Infrastructure for price discovery,
- Valuation in illiquid and volatile markets,
- The need for technical and high-level dialogues on these issues
According to the report on ‘Enhancing Market and Institutional Resilience’ by Financial Stability Forum (FSF) 2008, “International standard setters should enhance accounting, disclosure and audit guidance for valuations. Firms’ valuation processes and related supervisory guidance should be enhanced.” Apart from that, reasonableness and consistency tests should be applied for valuation and price verification.
In June 2008, The Basel Committee on Banking Supervision published ten principles related to Supervisory guidance for assessing banks’ financial instrument fair value practices. Those principles are influenced by considering value measurement and modelling challenges faced by banks during the present financial crisis. The main objectives behind publishing those principles are to help bank’s supervisor while assessing banks’ valuation processes and to promote improvement in banks’ risk management and control processes. Those principles are listed below:
Principles 1
The valuation governance structures and related processes should be embedded in the overall governance structure of the bank, and consistent for both risk management and reporting purposes. Controls and procedures should be designed to ensure fair value measurements are reliable. They should further ensure clear and robust production, assignment and verification of financial instrument valuations.
Principles 2
A bank is expected to have adequate capacity and capability to produce valuations and determine the appropriateness of valuations obtained from third-party pricing services.
Principles 3
Supervisors expect that a bank will initially categories and report financial instruments in financial reports in accordance with applicable accounting and regulatory reporting requirements.
Principle 4
Supervisors expect a bank to have in place sound processes for the design and validation of methodologies used to produce valuations.
Key characteristics of sound processes for valuation methodology design and validation include: (i) independence of the validation from the design function; (ii) rigorous validation; (iii) integrated control processes; and (iv) sufficiently resourced internal and external audit programmes.
Principle 5
Supervisors expect that a bank will maximize the use of relevant and reliable inputs and incorporate all other important information so that fair value estimates are as reliable as possible.
Principle 6
Supervisors expect a bank to have a rigorous and consistent process to determine valuation adjustments for risk management, regulatory and financial reporting purposes, where appropriate.
Principle 7
Supervisors expect that a bank will have valuation and risk management processes that explicitly assess valuation uncertainty and include this as part of information communicated to the board and senior management.
Principle 8
Supervisors expect that a bank’s external reporting will promote transparency by providing timely, relevant, reliable and decision-useful information.
Principle 9
Supervisors may require banks to provide supplemental information to assist them in assessing valuation and governance processes.
Principle 10
Supervisors should evaluate a bank’s financial instruments valuation practices including relevant governance, risk management and control practices; and incorporate their evaluation when assessing capital adequacy.
3.5 Credit underwriting, ratings, and investor due diligence in securitization markets.
Rating agencies plays a important role to influence the level of a banks capital. Most of the large local bank and international bank seems to set their economic capital solvency standard at a level they perceive to be required to maintain a specific external rating like AA (Bank for International Settlement, 2009). Some banks manage their capital structure according to the Credit Rating Agency Expectations.
Financial Stability Forum (FSF) recommends the following changes regarding role and uses of credit ratings.
- Credit Rating Agencies should take initiative to improve the quality of credit rating process. Apart from that, they should manage conflicts of interests in rating structured products.
- Ratings on structured finance and bonds should be differentiated.
- Quality of data input and performance on underlying assets should be monitored by Credit Rating Agencies strongly.
- Investor associations should develop standards of due diligence and credit analysis for investing in structured products rather then depending only on credit rating agencies.
- Authorities would review the use of ratings by investors and regulators in a supervisory framework.
Like Bank for International Settlement (2009) and FSF (2008), (2008) emphasize to reform rating processes of Credit Rating Agencies. Besides, PWG (2008) insist on encouraging Credit Rating Agencies to conduct reviews of structured credit methodologies.
Institute of International Finance (IIF) emphasize on improving credit rating process as like as FSF (2008), BIS (2009) and PWG (2008). IIF suggests introducing different rating symbols or a scale for structured products. IIF also recommend considering official sector to reduce investors over reliance on rating.
3.6 Transparency and disclosure issues
“One of the main amplifiers of the crisis was the lack of transparency regarding the risk profile of institutions and structured products.” – Wellink, 2009.
According to the Basel Committee on Banking Supervision (2009), economic capital model of a bank should be effectively documented and integrated in a transparent way and senior management should consider that model seriously while making business decision and for risk management of bank. For this purpose, bank should emphasize on achieving robust estimates of stand-alone risk on absolute basis and developing the flexible capacity for enterprise-wide stress testing.
In order to have transparency in securitisation processes and markets, market participants and securities market regulator should work together to expand information on securitised products and their underlying assets (Financial Stability Forum, 2008).
Reform of rating processes by Credit Rating Agencies can also enhance the transparency (US President’s Working Group on Financial Markets, 2008). PWG (2008) suggests forming a private sector group to ensure the integrity and transparency of reports.
Third Pillar of Basel II framework can help Bank to increase transparency (Wellink, 2009 & PWG, 2008). Pillar three of Basel II mainly focused on disclosures related to securitisation, off-balance-sheet exposures and trading activities.
CONCLUSION
This paper presents a review of the financial crisis on banking sector and implication of the bank management to cope with this crisis. Several reforms has been suggested in this paper following Institute of International Finance (IIF), Basel Committee on Banking Supervision, Financial Stability Forum (FSF), Bank for International Settlement (BIS), US President’s Working Group on Financial Markets. Some of the recommendations are already being implemented. However, the recent initiatives at the G-20 level are being considered as a first step towards encompassing reforms to help cope with present financial crisis (Wehinger, 2008). Wellink (2009) also support the initiatives taken by Basel Committee and hope that those initiatives should limit the risk that weaknesses in banks amplify shocks between the financial and real sectors.
REFERENCES
-
IIF, 2008. Final Report of the IIF Committee on Market Best Practices: Principles of Conduct and Best Practice Recommendations [Online] UK: Institute of International Finance. (Published 2009) Available at: http://www.iif.com/events/article+193.php [Accessed 10 April 2009].
-
Bank of England, 2009. Quarterly Bulletin. [Online] UK: Bank of England (Published 2009) Available at: http://www.bankofengland.co.uk/publications/quarterlybulletin/qb0901.pdf [Accessed 10 April 2009].
-
Bean, C., 2009. Is There a New Consensus in Monetary Policy? [Online] UK: Bank of England (Published 2009) Available at: http://www.bankofengland.co.uk/publications/other/monetary/bean070413.pdf [Accessed 10 April 2009].
-
Wellink, N., 2009. Basel Committee initiatives in response to the financial crisis? [Online] UK: Bank for International Settlement (Published 2009) Available at: http://www.bis.org/review/r090415a.pdf [Accessed 10 April 2009].
-
Bank for International Settlement, 2009. Supervisory guidance for assessing banks' financial instrument fair value practices? [Online] UK: Bank for International Settlement (Published 2009) Available at: http://www.bis.org/publ/bcbs145.pdf?noframes=1 [Accessed 10 April 2009].
-
Wehinge, G. 2008. Lessons from the Financial Market Turmoil: Challenges ahead for the Financial Industry and Policy Makers. [Online] France: OECD (Published 2008) Available at: [Accessed 03 March 2009].
-
Financial Stability Forum, 2008. Report of the Financial Stability Forum on Enhancing Market and Institutional Resilience: Follow-up on Implementation [Online] UK: Financial Stability Forum (Published 2008) Available at: http://www.fsforum.org/press/pr_081009f.pdf.1 [Accessed 10 April 2009].
-
PWG, 2008. Policy Statement on Financial Market Developments [Online] UK: PWG (Published 2008) Available at http://www.ustreas.gov/press/releases/reports/pwgpolicystatemktturmoil_03122008.pdf. [Accessed 10 April 2009].
-
Shimpi, P., 2009. Exposure Management Is Key, Says Risk Expert. [Online] Securities Industry News (Published 2009). Available at: [Accessed 10 April 2009].
-
Mizen, p. Understanding the Financial Crisis 2007-2009. [Online] Nottingham (http://74.125.77.132/search?q=cache:VO_sop6ubuQJ:www.nottingham.ac.uk/economics/cfcm/Understanding%2520the%2520Financial%2520Crisis%25202007-2009.ppt+understanding+the+financial+crisis+paul+ppt&cd=1&hl=en&ct=clnk&gl=uk [Accessed 10 April 2009].
-
Wignall, A. Atkinson, P. & Lee, S.H., 2008. The Current Financial Crisis: Causes and Policy Issues. [Online] France: OECD (Published 2008) Available at: [Accessed 03 March 2009].
