Banking entails business activities that involve accepting, depositing and safeguarding capital owned by other entities and individuals. The activities of banking are facilitated by a network of financial institutions known as banks which are governed by particular rules and regulations. Banks are licensed by the government to receive money from customers and also offer financial solutions. The banking industry has evolved overtime and has included other services such as issuance of credit and debit cards, safe custody of precious and valuable items, ATM services, lockers, currency exchange, wealth management, insurance policies and international online fund transfer (Admati, 2014). There are two types of banks namely commercial banks and investment banks. Commercial banks mostly deal with receiving cash deposits, managing withdrawals, saving cash and offering loans. On the other hand, there are investment banks which provide services to corporate clients. Investments banks offer services which include assisting and underwriting of mergers and acquisition activities. Each country has a central bank that enhance currency stability, controls monetary policy and inflation and also oversees money supply in the country. Due to the modern technology banks have been able to maintain both brick and mortar location together with online presence (Luttrell, Rosenblum and Thies, 2012). The online presence has increased bank transaction as most clients carry out bank related activities at the comfort of their homes. Banks play a huge role in the economy by ensuring there is continuous money supply (Admati, 2014). Also, bank facilitate financial intermediation through pooling together of scarce funds and channeling them into various investments. The channeling is through risk and maturity transformations. This paper takes a major focus on various issues related to banking
Risks in Banking
The financial industry is a very active and sensitive industry that is faced by many risks. A major risk that highly affects banks is credit risk. Many banks offer financial solution in the form of loans that a client is expected to service over a period of time. Credit risk arises from non-repayment of the loans by the specific borrowers (Gewald, 2006). Defaulting in payment contributes to the banks making losses and cash flow is limited. Credit risk can be avoided by extensive background checks on borrower credit history to identify their creditworthiness. Also, the banks can insist on securitization in cases a borrower defaults the bank can distribute the risk in the capital market among other investors. Banks are subjected to market risks as the they hold a large amount of securities in the capital market. The securities are used as collateral for the loans that a bank has issued.
Banks are subjected to equity risk based on the equity they hold. In other instances, they are exposed to forex risks because they hold foreign exchange for transactions with foreigners (Papaioannou, 2006). Banks face commodity risks as some banks trade with value items such as silver, gold and real estate. To mitigate the commodity, risk the institutions should engage in hedging contracts by using financial derivatives that can be sold in any capital market. Also, market risks can be eliminated from the bank’s balance through options, swaps and forwards. Another common risk is operational risk which occurs due to failure in day to day activities of the bank (Bessis, 2015). The operational risk includes crediting wrong accounts or execution of wrong orders which is a result incompetent employee or IT systems breakdown (Chapman, 2011). Operational risks can be mitigated by employing qualified personnel and using appropriate technology.
Banks suffer from moral hazards experienced by their clients due to increase in taxes (Hellmann, 2000). The bank is subjected to make losses if risks they have engaged in such as loans are not paid back. Banks inherits liquidity risk when the its unable to meet it set obligations due to depositors withdrawing their funds from the bank. Currently the banks can mitigate liquidity risks as they receive backing from central bank. Business risks are encountered by banks when they select a wrong strategy to initiate in their operations. The wrong strategy leads to losses and can be solved through identification of major objectives and strategic planning. Banks suffer from reputational risks where they are associated with incompetency and negative attributes that scare away customers. The institutions can avoid the risk by providing extensive services that achieve customer satisfaction. In other instance systematic risks are experienced when there are problems in the financial industry which mostly is the failure of a counter party (Cerutti, 2012). To mitigate the risk the banking systems is encouraged to work as a team to overcome issues affecting their counterparties.
Banking regulation entails measures undertaken to monitor and control banking activities. The regulation is through a set of laws and policies by the central bank. Banking regulation is important in measuring a banks financial stability and soundness. The measures indicate a banks ability to offer financial solutions and ability to run its operations. Regulations help in mitigating risks likely to affect a bank as they prevent the bank from engaging in risky operations. The set principles and policies are put in place to protect the depositors by ensuring their money is kept safely and readily available when need be (Rochet, 2009). Also, the regulations prevent systematic risks that can affect other financial institutions who are counter parties in the industries. Through the law banks are able to select their management and banks members accordingly. The regulation directs how audits are conducted and ensures that the banks are in line with expected banking standards.
Risk, Minimum Capital Requirements and Risk Based Regulatory Framework
Risk entails the likely hood or possibility of financial institutions making losses. Financial institutions are affected by risk from various transactions and operations they engage in such as defaults from borrowers and other types of risks. The risks can mitigate through the implementation of minimum capital requirements and risked based regulatory framework. The minimum capital requirements in a financial institution are defined as the standardized requirements which financial institutions are expected to have. The requirements determine the amount of liquidity a bank is required to have against a certain amount of assets (Santos, 2012, p, 1930). The capital requirements ensure that banks do not engage in investments which might increase the risk of losses and defaults. The risk based regulatory framework entails the rules that illustrate the minimum regulatory capital for banks. The framework is in place to protect the financial institutions, clients, investors and the general economy. The requirements ensure that banks have enough funds at hand to maintain and sustains any operating losses incurred while still maintaining safety and efficiency in the market.
Traded Market Risk
Trade market risk is defined as the possibility of traders or investors in the financial industries experiencing losses that are as a result of the whole financial market performance. The market risks can also be called systematic risk that are inherent from counter parties in the industries. The sources of the risk include political turmoil, recessions, natural disaster, terrorist attacks and interest rates changes. The various types of systematic risks include, equity risk, interest rate risk, commodity risk and currency risks (Saunders, 2006). The risks can be measured, managed and mitigated through a set of procedures and rules. Companies are required to disclose their productivity metrics and activities that are related to their performance in the financial market. The information is vital in enabling traders and investors to make more informed decisions based on risk they will undertake.
Diversification is a management engagement that enables the investors to invest in different investments hence limits losses in case of a risk. Market risks are made more rampant by the price changes in an economy commonly know as price volatility. To prevent effects of price volatility, utilization of hedging strategies is relevant. Investors can engage in the purchase of options to prevent downside volatility. The market risks can be measured through value at risk method. The VaR method quantifies a portfolio potential loses together with probability of the losses occurring. The model is executed through implementation of assumptions which limit precision. The use of Beta can be incorporated in measuring risks as it compares the market risk of a portfolio to the whole financial market.
Market risks are a great threat to financial market hence require extensive management. The various management measures by the banks are effective but, in some cases, maybe ineffective. The marketing risks require intervention by the government and central bank which is through regulation. The government and the central bank provide regulation through the Basel 111. The base 111 is commonly referred to as the international regulatory framework for financial institutions. The framework contains a set of measures which were developed and put in place by the Basel committee which is responsible for Banking supervision (Aiyar, 2016). The framework was developed to respond to the financial crisis which was observed in 2007-2009. The set measures strengthen the supervision, regulation and also the risk management of financial institutions.
The Basel 111 standards provide a set of minimum requirements that are utilized by banks which transact internationally. The standards have a time frame in which the financial institutions and the members are dedicated in implementing within their jurisdictions. The standards help in limiting credits risks by indicating that a bank should maintain the indicate leverage ratios and also meet the minimum capital requirements. Basel 111 enables banks to have more resilience in order to minimize and mitigate risks. According to the standards a high assets credit risk has a high-risk weight. Basel 111 utilizes credit rating to establish various risk coefficients
Minimum Capital Requirements
Market risks are managed through capital requirements that are fostered by Basel 111 standards. Minimum capital requirements mainly focus on weighted risk in relation to the type of asset that a bank holds. The minimum capital requirements create capital ratios that compare and evaluate lending institutions’ ability based on their identified safety and strength (Santos, 2012). Minimum capital requirements help in managing risk by ensuring that financial institutions do not hold investments that are likely to increase the risk of borrower’s defaulting. According to the bank regulation on capital, there are three divisions which include three tiers. The division of tiers is relevant in defining security instruments. Tier 1 encompasses of common equity and capital with capital having the highest subordination. The capital tier comprises of equity instruments that have no maturity and discretionary dividends together with securities.
Treasury risks are possible losses associated to an enterprise holding management which ranges from equities trading to money market instruments. Most organization are faced by the four common treasury risks which include interest rate risk. Interest rate risk is a treasury risk experienced when a bank is exposed to various risk associated to interest rate changes. The risk is identified when an institution engages in offering credit and borrowing. In case a company has a floating rate debt and there emerges an increase in interest rate the borrower will experience an increase in interest expense.
Banks that hold portfolios may experience yield curve risk which is through a curve that compares bonds against their specific maturities. The foreign exchange risk in encountered when financial institutions trade in the purchase and sale of multiple currencies (Pasiouras, Tanna, and Zopounidis, 2009). The fluctuations in economies contribute to the depreciation of foreign money value leading to losses in the banks. The foreign risks can be mitigated through exchange controls, limiting the amount of foreign currency among residents and restricting the remittances of finances across borders. Another risk is the commodity risk which is encountered when there are fluctuations in the prices of a commodity that a bank trade with (Saunders, 2006). Counterparty risk is another treasury risk which is caused when counterparties fail to fulfil their obligations.
Measuring of treasury risk is through treasury management systems like the VaR and cash flow at risk (CFaR). The systems measure a company’s maximum loss over specific returns. In the VaR methods such as variance -covariance method, monte Carlo simulation and historical methods are used. Treasury risk can be measured through obtaining information from the company’s systems to determine the extent at which the company is exposed to risks. The risk can be measured through volatility that is obtained from the company’s market index mean. Volatility can be determined from previous or historical data and option prices that are traded in the banking industry. For effective management of the risk control of the risk is highly recommended. The risks are controlled through hedge funds, forwards, swaps and options.
A company should maintain its minimum capital requirements to ensure that it has the ability to mitigate risks when they occur. Treasury encompasses of a company’s revenue or funds. The funds are important in mitigating risk and also help in maintaining minimum capital. The treasury ensures that the capital requirements are maintained by providing a balance through ensuring sufficient cash flow in the bank on daily bases (Hellmann, 2000). The cash flows are expected from all the departments in the financial institution and the treasury facilitate the cash management for proper utilization. The treasury also ensures that the financial institution has sufficient funds that facilitate the daily operations of an institution to minimize cases of borrowing. The department monitors, reports and manages the liquidity position of the financial institutions. The reporting, monitoring and managing activities are relevant for the institution to ensure that all operations in the company run at minimal cost, at no added expense and that credits offered are within the company’s ability.
The treasury department defines the liquidity profile of a bank and reports on its findings, which the management utilizes to eliminate liquidity of the bank. The liquidity profile is created by the treasury through continues assessment of factors like long term and short-term debt, nature of debt whether it is at a floating or fixed rate, different currencies used and the capacity of liquidity buffer that the company will maintain. Maintaining of the capital buffer is relevant in achieving financial stability of the board’s total loss-absorbent capacity (TLAC). Among the crucial information that the treasury has to monitor includes unencumbered liquid assets, contingent and contractual liabilities together with cash at hand. The treasury ensures to fund various transactions at very low cost in order to retain the minimum capital. To maintain the minimum capital requirement the treasury is tasked with outlining a funding plan that takes into accounts secured and unsecured markets.
The treasury is tasked with ensuring that the capital structure of an organization together with capital actions are all in order for the capital requirements to remain standard. The various treasury functions are relevant in maintaining the minimum capital requirements because they help in reducing costs. Treasury functions detect added expenses hence minimizing the cross-bank transactions that decrease the capital (Hellmann, 2000). The functions reduce error thus reducing the increase of costs incurred in correcting the errors. The errors are reduced by the availability of actionable and detailed insights that help in the identification of inefficiencies and other opportunities that increase cash flow in the institution. Treasury provides banks with flexibility thus improving the management and utilization of capital. The treasury functions offer accurate and full audit control that offers details on specific payments. The payments are cupped at a certain amount to ensure that they do not utilize the minimum capital set aside.
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