Financial Times

Banking: From financial intermediation to risk management

By Dr Shantha P. Yahanpath

The origins of banking, borrowing and lending, have remained the same for a long time until recently. But the methods we use to bring savers and borrowers together have changed significantly in the recent past. Moreover, the proliferation of hybrid and derivative products has moved the risk scale upwards for banks and other financial institutions.

What is the role of banks? Traditionally the answer would have been “financial intermediation” but this “traditional role” appears to have expanded to cover much more than just “financial intermediation”.
This is the new challenge.

Increased competition has reduced net interest margins and, consequently, banks have looked elsewhere to earn their revenue. Therefore, increasing reliance on fee income has been a major objective for banks and this has changed the banking landscape.

Fee income is attractive as long as risks of alternative products/instruments have been priced accordingly. This calls for new skills in risk management. Technological advancements have also changed the way we do our banking. Technology has brought banking to our offices, homes, supermarkets, etc. at a fraction of the over the counter transaction costs. While this cost reduction is welcome news with that a new breed of risk factors has also emerged.

In developed countries, technological progress and increasing competition from non-bank financial institutions have forced banks to take additional risks to remain competitive and profitable. And, to remain competitive banks have invested more in technology, branch development, product development, marketing and human resources etc. and to derive profits banks have to increase revenue. In a competitive environment increasing revenue often results in compromises in risk management largely due to lack of metrics to measure the emerging risks.

With these new challenges and opportunities a disturbing series of threats have also emerged. How we manage these challenges and opportunities will decide the future of global financial system. The risk of a second Global Financial Crisis (GFC 2) in the medium term cannot be ruled out yet. This is the challenge for effective risk management.

Bank profitability will be ultimately driven by quality risk assessment and management, not by government intervention. Accurate assessment of risk and corresponding adjustment of margins are critical for loan profitability. There is no other activity more important than prudent risk management. The Asian banking crisis, Orange County, Baring Bank, etc. had the same hallmark – poor risk management.
The recent problems of Citibank, Bank of America and Royal Bank of Scotland also have the same hallmark – poor risk management. In the case of Royal Bank of Scotland one could argue that the “trigger” of the demise was the acquisition of ABN AMRO. With the new business paradigm and the advancements in the Technology Media and Telecommunication (TMT) sectors, risk assessment has become even more challenging than in the past.

Closer to home, the Seylan Bank debacle is a case in point. Only a prudent and timely move from the regulators coupled with timely investments from state-owned financial institutions averted a potential crisis that could have adversely affected the wholefinancial system in Sri Lanka.

Left unchecked the problems of Seylan bank and other troubled Ceylinco Group companies could have triggered a contagion effect that could have pushed the country into “distress” similar to what Iceland experienced.

Therefore, it is crucial for banks and financial institutions to think beyond their role as financial intermediaries because financial intermediation is only part of the new banking paradigm. And, as a result, risks have also changed well beyond traditional asset liability management and quantitative models.

These emerging risks warrant a new breed of “early warning radars” and “pre-emptive strikes”. One of the radars is likely to be effective intelligence gathering within banks and encouraging “whistle blowing”. Sophisticated quantitative modeling of risks has not delivered the desired results recently.

A multibillion-dollar debt default by two of Saudi Arabia’s biggest family-owned companies is a case in point. The so-called name lending – extending credit based on the reputation and standing of a company’s owners rather than on prudent risk assessment – has ultimately been instrumental in a default that could exceed US $20billion.

This disturbing corporate debacle unfolding in Saudi Arabia is likely to affect the whole region. Two of the country’s most prominent family-owned conglomerates – Saad Group and Ahmad Hamad Algosaibi & Brothers – have shaken the industry’s trust and confidence. Credit risk management procedures and rules have no value if they are not followed by the lenders at the levels. Management metrics, incentives and rewards appear to have been out of sync with the demands of potential risks.

Against this background, Risk-Adjusted Performance Measurements (RAPM) introduced by the Bank for International Settlement (BIS) may need to focus more on “early warning radars” and “pre-emptive” strikes as opposed to historical analysis and quantitative modelling.

The writer is a director of Sydney-based Agape International and a visiting lecturer in Banking, Finance and Strategic Management. He is a fund manager, strategist, management consultant and a visiting lecturer at postgraduate business schools in Australia.

 
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