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The Ministry of Education and Science of the Russian Federation
Plekhanov Russian Academy of Economics
Chair of Foreign Languages
Project
“RISK MANAGEMENT IN BANKING”
(Reputational risk and its case studies)
Performed by
Ganbat Khaliun
Finance Faculty
Group 2509
Supervised by
Kovaleva E.B
Project defended on:
________________2013__
Evaluation:
______________________
Tutor’s signature:
______________________
Moscow 2013
Content
Introduction……………………………………………………………………………………………………….……2
Chapter 1. General theory………………………………………………………………………………….……4
1.1 Risk management: definition, history and its role in banking ………………………4
1.2 Types of risks in banking ……………………………………………………………………………5
· Credit risk ………………………………………………………………………………….……5
· Market risk ………………………………………………………………………………..……6
· Operational risk ………………………………………………………………………………6
· Reputational risk ……………………………………………………………...……….……7
1.3 Reputational risk as one of the main risks ………………………………….………………7
Chapter 2. Reputational risk cases………………………………………………………………..………11
Conclusion……………………………………………………………………………………………………………16
Bibliography…………………………………………………………………………………………………………17
Appendices………………………………………………………………………………………………….………18
Glossary…………………………………………………………………………………………………….…………19
Introduction
Taking risk is an integral part of the banking business, it is not surprising that banks have been practicing risk management ever since there have been banks - the industry could not have survived without it. The only real change is the degree of sophistication now required to reflect the more complex and fast-paced environment. Even today, however, some simple rules continue to be critical to risk management. By the simple act of separating front-office from back-office responsibilities, Barings could well have prevented the enormous losses that led to its failure.
Recent financial disasters in financial and non-financial firms and in governmental agencies point up the need for various forms of risk management. Financial misadventures are hardly a new phenomenon, but the rapidity with which economic entities can get into trouble is.
Banks and similar financial institutions need to meet forthcoming regulatory requirements for risk measurement and capital. However, it is a serious error to think that meeting regulatory requirements is the sole or even the most important reason for establishing a sound, scientific risk management system. Managers need reliable risk measures to direct capital to activities with the best risk/reward ratios.
Risk management is the process by which managers identify key risks, obtaining consistent, understandable, operational risk measures, choosing which risks reduce and which to increase and by what means and establishing procedures to monitor the resulting risk position.
Moreover, there are 4 major sources of value loss: market risk, credit risk, operational and reputational risks. As one of the main risks I chose reputational risk, to study more and in my work I also brought examples of reputational risks that caused an enormous loss for the banks.
Assessing reputational risk is not an objective process, but rather it is a subjective assessment that could reflect a number of different factors. "Reputational risk is the starting point of all risks, if you have no reputation, you have no business." Its major stakeholders can interpret reputation as a market or public perception of management and the financial stability of an institution. Stakeholders can include its customers, shareholders, and the board of directors. The media could also have a perception, either good or bad, of an organization.
Reputation is and could be perceived as an intangible asset, synonymous with goodwill, but it is more difficult to measure and quantify. Consistently strong earnings, a trustworthy board of directors and senior management, loyal and content branch employees, and a strong customer base are just a few examples of positive factors that contribute to a bank's good reputation.
The rewards can be great for an institution that has an excellent reputation. Establishing a strong reputation provides a competitive advantage over an organization's counterparts. A good reputation strengthens a company's market position and increases shareholder value. It can even help attract top talent and assist in employee retention. In short, reputation is a prized asset, but it is one of the most difficult to protect.
My paper consists of 2 parts, which are theory and cases, connected with reputational risk. The main target is to study risk management, in particular, reputational risk, which role is becoming more and more significant in banks future.
Chapter 1. General theory
1.1 Risk management: definition, history and its role in banking
Risk is inherent in any walk of life in general and in financial sectors in particular. Till recently, due to regulated environment, banks could not afford to take risks. But of late, banks are exposed to same competition and hence are compelled to encounter various types of financial and non-financial risks.
Risk management – is the process of measuring or assessing the actual or potential dangers of a particular situation. Risks have two components: uncertainty and exposure. In other words they come from uncertainty in financial markets, project failures (at any phase in design, development, production, or sustainment life cycles),legal liabilities, credit risk, accidents, natural causes and disasters as well as deliberate attack from an adversary, or events of uncertain or unpredictable root-cause.
The strategies to manage risk typically include transferring the risk to another party, avoiding the risk, reducing the negative effect or probability of the risk, or even accepting some or all of the potential or actual consequences of a particular risk.
Evolution of risk management:
· Used long before 1960’s
· Emerged as a discipline during the early 1990’s
· By the mid of 1990’s there appeared regulatory initiatives, concerns about derivatives and released Risk Metrics.
· Typically used to describe techniques for addressing insurable risks.
How was like risk management several years ago? First, risk was reduced through safety, quality control and hazard education. Moreover, purchasing traditional insurance products was the main solution to the problem of sudden financially negative changes. Derivatives were also used to hedge. But now they are treated as a problem as much as a solution. Mostly, recent risk management focuses on reporting, oversight and segregation of duties within the organization.
Risk management provides a clear and structured approach to identifying risks. Having a clear understanding of all risks allows banks to measure and prioritize them and take the appropriate actions to reduce losses. Risk management has other benefits for banks, including:
An effective risk management practice does not eliminate risks. However, having an effective and operational risk management practice shows an insurer that your organization is committed to loss reduction or prevention. It makes a bank a better risk to insure.
Till recently all the activities of banks were regulated and hence operational environment was not conducive to risk taking. Better insight, sharp intuition and longer experience were adequate to manage the limited risks. Business is the art of extracting money from other’s pocket, sans resorting to violence. But profiting in business without exposing to risk is like trying to live without being born. Every one knows that risk taking is failure prone as otherwise it would be treated as sure taking.
Hence risk is inherent in any walk of life in general and in financial sectors in particular. Of late, banks have grown from being a financial intermediary into a risk intermediary at present. In the process of financial intermediation, the gap of which becomes thinner and thinner, banks are exposed to severe competition and hence are compelled to encounter various types of financial and non-financial risks. Risks and uncertainties form an integral part of banking which by nature entails taking risks. Business grows mainly by taking risk. Greater the risk, higher the profit and hence the business unit must strike a trade off between the two. The essential functions of risk management are to identify, measure and more importantly monitor the profile of the bank. While Non-Performing Assets are the legacy of the past in the present, Risk Management system is the pro-active action in the present for the future. Managing risk is nothing but managing the change before the risk manages. While new avenues for the bank has opened up they have brought with them new risks as well, which the banks will have to handle and overcome.
1.2. Types of risks in banking
Credit Risk is the potential that a bank borrower/counter party fails to meet the obligations on agreed terms. There is always scope for the borrower to default from his commitments for one or the other reason resulting in crystallization of credit risk to the bank.
These losses could take the form outright default or alternatively, losses from changes in portfolio value arising from actual or perceived deterioration in credit quality that is short of default. Credit risk is inherent to the business of lending funds to the operations linked closely to market risk variables. The objective of credit risk management is to minimize the risk and maximize bank’s risk adjusted rate of return by assuming and maintaining credit exposure within the acceptable parameters.
Tools of Credit Risk Management
The instruments and tools, through which credit risk management is carried out, are detailed below:
a) Exposure Ceilings: Prudential Limit is linked to Capital Funds – say 15% for individual borrower entity, 40% for a group with additional 10% for infrastructure projects undertaken by the group, Threshold limit is fixed at a level lower than Prudential Exposure; Substantial Exposure, which is the sum total of the exposures beyond threshold limit should not exceed 600% to 800% of the Capital Funds of the bank (i.e. six to eight times).
b) Review/Renewal: Multi-tier Credit Approving Authority, constitution wise delegation of powers, Higher delegated powers for better-rated customers; discriminatory time schedule for review/renewal, Hurdle rates and Bench marks for fresh exposures and periodicity for renewal based on risk rating, etc. are formulated.
c) Risk Rating Model: Set up comprehensive risk scoring system on a six to nine point scale. Clearly define rating thresholds and review the ratings periodically preferably at half yearly intervals. Rating migration is to be mapped to estimate the expected loss.
d) Risk based scientific pricing: Link loan pricing to expected loss. High-risk category borrowers are to be priced high. Build historical data on default losses. Allocate capital to absorb the unexpected loss. Adopt the RAROC framework.
e) Portfolio Management The need for credit portfolio management emanates from the necessity to optimize the benefits associated with diversification and to reduce the potential adverse impact of concentration of exposures to a particular borrower, sector or industry. Stipulate quantitative ceiling on aggregate exposure on specific rating categories, distribution of borrowers in various industry, business group and conduct rapid portfolio reviews. The existing framework of tracking the non-performing loans around the balance sheet date does not signal the quality of the entire loan book. There should be a proper & regular on-going system for identification of credit weaknesses well in advance. Initiate steps to preserve the desired portfolio quality and integrate portfolio
Market Risk may be defined as the possibility of loss to bank caused by the changes in the market variables. It is the risk that the value of on-/off-balance sheet positions will be adversely affected by movements in equity and interest rate markets, currency exchange rates and commodity prices. Market risk is the risk to the bank’s earnings and capital due to changes in the market level of interest rates or prices of securities, foreign exchange and equities, as well as the volatilities, of those prices. Market Risk Management provides a comprehensive and dynamic frame work for measuring, monitoring and managing liquidity, interest rate, foreign exchange and equity as well as commodity price risk of a bank that needs to be closely integrated with the bank’s business strategy.
Scenario analysis and stress testing is yet another tool used to assess areas of potential problems in a given portfolio. Identification of future changes in economic conditions like – economic/industry overturns, market risk events, liquidity conditions etc. that could have unfavorable effect on bank’s portfolio is a condition precedent for carrying out stress testing. As the underlying assumption keep changing from time to time, output of the test should be reviewed periodically as market risk management system should be responsive and sensitive to the happenings in the market.
Operational risk
Operational risk involves breakdown in internal controls and corporate governance leading to error, fraud, performance failure, compromise on the interest of the bank resulting in financial loss. Putting in place proper corporate governance practices by itself would serve as an effective risk management tool. Bank should strive to promote a shared understanding of operational risk within the organization, especially since operational risk is often interwined with market or credit risk and it is difficult to isolate.
Over a period of time, management of credit and market risks has evolved a more sophisticated fashion than operational risk, as the former can be more easily measured, monitored and analyzed. And yet the root causes of all the financial scams and losses are the result of operational risk caused by breakdowns in internal control mechanism and staff lapses. So far, scientific measurement of operational risk has not been evolved. Hence 20% charge on the Capital Funds is earmarked for operational risk and based on subsequent data/feedback, it was reduced to 12%. While measurement of operational risk and computing capital charges as envisaged in the Basel proposals are to be the ultimate goals, what is to be done at present is start implementing the Basel proposal in a phased manner and carefully plan in that direction. The incentive for banks to move the measurement chain is not just to reduce regulatory capital but more importantly to provide assurance to the top management that the bank holds the required capital.
Reputational risk is the potential that negative publicity, whether true or not, will result in loss of customers, severing of corporate affiliations, decrease in revenues and increase in costs.
1.3. Reputational risk as one of the main risks
It takes 20 years to build a reputation and
five minutes to ruin it.
While building and maintaining a solid reputation is important for all types of organizations, it is especially important for financial institutions. It could be argued that protecting a financial institution's reputation is the most significant risk management challenge that boards of directors face today.
Reputation is a misunderstood concept, too often confused with a company's advertising or PR strategy. It is something much broader: the faith that outsiders — from counterparties, to shareholders, to regulators — have in a firm's ability to conduct itself well. It's difficult to measure, because it is related to everything a company does in the public eye.
Reputation risk has long been a neglected driver of new regulation, but it has taken on a much larger role in recent months. This has been a particularly bruising year in the court of public opinion. The recent notorious matters have been institution-specific — not systemic, as they were during the financial crisis — and have not been accompanied by a market panic. That dynamic can be quite dangerous, though less obviously cataclysmic, giving casual observers a story that is easy to understand and even easier to caricature. It serves up specific errors in close, sometimes lurid detail.
Reputational damage can be exacerbated by a stricter regulatory climate. Regulators too need the public trust. Gaining that trust means acting on public concerns and right now, concerns about banker behavior are at a fever pitch.
Importance of Reputation to Stakeholders
· Employees: Are more loyal to a company with good reputation. Help with recruiting
· Investors and business partners: Will take risk in a company that they can thrust based upon its reputation. (More than 90% think about reputation in investment decisions: 40% care about reputation, 50% care partially).
· Lawmakers and regulators: Reputation can help lessen the legal burden on a company.
· Public at large: Preserve ―social license‖ to operate
· Customers and suppliers: Support loyalty to company
· Competition: Barrier to entry
Moreover, reputation risk is number one risk for CRO’s (see pic.1): 
Value of reputation: The USA Corporate survey:
· Microsoft: 1stplace
· Johnson and Johnson: 2nd
· Google: 4th
· Berkshire Hathaway Inc. 21st
· American Express Company: 34th
· Wells Fargo & Company: 36th
Apart from restructuring the risk management framework, banks need to take a broader approach to managing risk, built on the following.
Vision Expansion
All this while, banks have followed regulatory procedure or the policies of other banks, when they’ve set their own reputation risk standards. It’s time they also drew upon the best practices followed by other risk-heavy businesses, say, companies in the consumer goods or automotive sector, which have large supply chains.
Employee Belief
Employee self-belief significantly affects the banks’ risk-fighting capacity. The quality of work of employees, either on the banks’ payroll or on that of their Direct Selling Agents, call centers and outsourcing partners has a direct bearing on organizational reputation as well. So, in addition to building confidence among employees, all staff members should be sensitized to the fact that any slip-up on their part could adversely affect goodwill.
Employee Satisfaction
Discontentment in the ranks will seriously jeopardize employee contribution to reputation building. Banks have to follow policies which are sensitive to the needs of the workforce and treat employees as partners in the task of organization development.
Knowledge Banks
Although banks can learn valuable reputational risk management lessons from the past, currently, employees have minimal access to ready reference material. They need to document and store historical cases and precedents in generic form in repositories. Banks must also conduct training programs on reputation risk management to transfer knowledge.
Technology is a vital enabler of reputation risk management.
Enterprise-wide Solution
Enterprise-wide risk management solutions facilitate a holistic view of organizational risks. These programs provide early distress signals enabling timely problem resolution.
Analytics
Though a lot of hype has been created around banks’ big data, not much has been done to harness its power for risk management purposes. Banks can use analytics solutions to sift through the mounds of information for managing reputation risk.
Social Media
Putting the damage to their reputations in social media behind them, banks must now leverage the same platform to initiate customer engagement programs as part of their reputation-building measures.
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