Question

1. What are some of the critical functions of the Bank Financial Manager and how do they impact the bank?
2. Identify the various types of risks that banks are exposed to and state where the risk exists (e.g. products, activities, and services).
3. How does risk management affect the internal and external policies of the bank?

Answer 1

1. Financial activities of a bank is one of the most important and complex activities of a bank. Therefore in order to take care of these activities a financial manager performs all the requisite financial activities.

A financial manager is a person who takes care of all the important financial functions of an organization. The person in charge should maintain a far sightedness in order to ensure that the funds are utilized in the most efficient manner. His actions directly affect the Profitability, growth and goodwill of the bank.

Following are the main functions of a Financial Manager:

1. Raising of Funds

In order to meet the obligation of the business it is important to have enough cash and liquidity. A bank can raise funds by the way of equity and debt. It is the responsibility of a financial manager to decide the ratio between debt and equity. It is important to maintain a good balance between equity and debt.

2. Allocation of Funds

Once the funds are raised through different channels the next important function is to allocate the funds. The funds should be allocated in such a manner that they are optimally used. In order to allocate funds in the best possible manner the following point must be considered

• The size of the bank and its growth capability
• Status of assets whether they are long-term or short-term
• Mode by which the funds are raised

These financial decisions directly and indirectly influence other managerial activities. Hence formation of a good asset mix and proper allocation of funds is one of the most important activity

3. Profit Planning

Profit earning is one of the prime functions of any business organization. Profit earning is important for survival and sustenance of any organization. Profit planning refers to proper usage of the profit generated by the bank.

Fixed costs are incurred by the use of fixed factors of production such as land and machinery. In order to maintain a tandem it is important to continuously value the depreciation cost of fixed cost of production. An opportunity cost must be calculated in order to replace those factors of production which has gone thrown wear and tear. If this is not noted then these fixed cost can cause huge fluctuations in profit.

4. Understanding Capital Markets

Shares of a bank are traded on stock exchange and there is a continuous sale and purchase of securities. Hence a clear understanding of capital market is an important function of a financial manager. When securities are traded on stock market there involves a huge amount of risk involved. Therefore a financial manger understands and calculates the risk involved in this trading of shares and debentures.

2. Risks faced by a Bank

Credit Risks

Credit risk is the risk that arises from the possibility of non-payment of loans by the borrowers. Although credit risk is largely defined as risk of not receiving payments, banks also include the risk of delayed payments within this category.

The profitability of a bank is extremely sensitive to credit risks. Hence, even if credit risk rises by a small amount, the profitability of the bank can get extremely impacted. Therefore, to deal with such risks banks have come up with a wide variety of measures. For instance, banks always hold a certain amount of funds in reserves to mitigate such risks.

Market Risks

Apart from making loans, banks also hold a significant portion of securities. Some of these securities are held because of the treasury operations of the bank i.e. as a means to park money for the short term. However, many securities are also held as collateral based on which banks have given loans to their customers. The business of banking is therefore intertwined with the business of capital markets.

Banks face market risks in various forms. For instance if they are holding a large amount of equity then they are exposed to equity risk. Also, banks by definition have to hold foreign exchange exposing them to Forex risks. Similarly banks lend against commodities like gold, silver and real estate which exposes them to commodity risks as well.

Operational Risks

Operational risk occurs as the result of a failed business processes in the bank’s day to day activities. Examples of operational risk would include payments credited to the wrong account or executing an incorrect order while dealing in the markets. None of the departments in a bank are immune from operational risks.

Operational risks arise mainly because of hiring the wrong people or alternatively they could also occur if there is a breakdown of the information technology systems. A lapse in the internal processes being followed could also lead to catastrophic errors. For instance, Barings Bank ended up bankrupt because of its failure to implement appropriate internal controls. One trader was able to bet so much in the derivatives market that the equity of Barings Bank was wiped out and the bank simply ceased to exist.

Moral Hazard

The recent bailout of banks by many countries has created another kind of risk called the moral hazard. This risk is not faced by the bank or its shareholders. Instead, this risk is faced by the taxpayers of the country in which banks operate. Banks have become accustomed to taking excessive risk. If their risk pays off, they get to keep the returns. However, if their risk backfires, then the losses are borne by taxpayers in the form of bailouts. This too big to fail model has caused banks to become reckless in their pursuit of profit. Although central banks are using audits to ensure that safe business practices are followed, banks nowadays indulge in risky business the moment they are not under regulatory oversight.

Liquidity Risk

Liquidity risk is another kind of risk that is inherent in the banking business. Liquidity risk is the risk that the bank will not be able to meet its obligations if the depositors come in to withdraw their money. This risk is inherent in the fractional reserve banking system. Therefore, in this system, only a percentage of the deposits received are held back as reserves, the rest are used to create loans. Therefore, if all the depositors of the institution came in to withdraw their money all at once, the bank would not have enough money. This situation is called a bank run. This has happened countless times over the history of modern banking.

Modern day banks are not very concerned about liquidity risk. This is because they have the backing of the central bank. In case there is a run on a particular bank, the central bank diverts all its resources to the affected bank. Therefore, the depositors can be paid back when they demand their deposits. This restores depositor’s confidence in the banks finances and the run on the bank is averted.

Many modern day banks have faced bank runs. However, none of them have become insolvent due to a bank run post the establishment of central banks.

Business Risk

The banking industry today is considerably advanced and diversified. Banks today have a wide variety of strategies from which they have to choose. Once such strategy is chosen, banks need to focus their resources on obtaining their strategic goals in the long run.

Hence, there is always a risk that a given bank may choose the wrong strategy. As a result of this wrong choice, the bank may suffer losses and end up being acquired or may simply collapse. Consider the case of banks such as Washington Mutual and Lehman Brothers. These banks chose the subprime route to growth. Their strategy was to be the preferred lender to people who have less than perfect credit scores. However, the whole area of subprime lending went bust and since these banks had heavy exposures to such loans, they suffered dire consequences too.

Reputational Risk

Reputation is an extremely important intangible asset in the banking business. Banks like JP Morgan bank, Chase bank, Citibank, Bank of America etc have all been in the business for hundreds of years and have stellar reputations. These reputations enable them to generate more business more profitably.

Customers like their money to be deposited at places which they believe follow safe and sound business practices. Hence, if there is any news in the media which projects a given bank in a negative light, such news negatively impacts the banks business. For instance Citibank was recently viewed as manipulating the Forex rates via conducting false trades with its own trading partners.

Systemic Risk

Systemic risk arises because of the fact that the financial system is one intricate and connected network. Hence, the failure of one bank has the possibility to cause the failure of many other banks as well. This is because banks are counter parties to each other in a lot of transactions. Hence, if one bank fails, the credit risk event for the other banks becomes a reality.

They have to write off certain assets as a result of the failure of their counter party. This writing off often leads to the bankruptcy of other banks and an unstoppable domino seems to take over. Systemic risk is an extremely bad scenario to be in. For instance when the subprime crisis happened in 2008, it seemed like the entire global financial system would collapse.

3. Factors affecting the credit risk

Internal factors

• Concentration of credit in particular geographical locations
• Excessive lending to particular industry
• Ignoring the purpose for which loan is sought to customer
• Poor quality or liberal credit appraisal while granting loan
• Absence of efficient recovery mechanism

External factors

• Fluctuation in exchange rates
• Change in government policies
• Fluctuation in interest rates
• Change in political environment of own country
• In case of foreign project change in country risk profile