RISK MANAGEMENT IN TWO NIGERIAN BANKS OKOYE IFEOMA PG/M.SC/06/45978

Transcription

1 RISK MANAGEMENT IN TWO NIGERIAN BANKS BY OKOYE IFEOMA PG/M.SC/06/45978 BEING A RESEARCH DISSERTATION PRESENTED IN PARTIAL FULFILLMENT OF THE REQUIREMENTS FOR THE AWARD OF MASTERS OF SCIENCE (M.SC) DEGREE IN BANKING AND FINANCE DEPARTMENT OF BANKING AND FINANCE FACULTY OF BUSINESS ADMINISTRATION UNIVERSITY OF NIGERIA ENUGU CAMPUS SUPERVISOR: DR. B. E. CHIKELEZE SEPTEMBER, 2010.

2 APPROVAL This dissertation has been approved for the department of Banking and Finance, faculty of Business Administration, University of Nigeria, Enugu Campus by DR. B. E. CHIKELEZE Date DR. J.U.J. ONWUMERE Date

3 CERTIFICATION I, Okoye Ifeoma, a post graduate student of the department of Banking and Finance with Registration Number PG/MSc/45978, has satisfactorily completed the requirements of research work for the masters degree in Finance. This work embodied in this dissertation is original and has not to the best of my knowledge, been submitted in part or in full for any other diploma or degree of this or any other university. Okoye, Ifeoma (Student) Date

4 DEDICATION This work is dedicated to God Almighty, who made this work a reality. I also dedicate this research work to my husband and my sons.

5 ACKNOWLEDGEMENT My gratitude goes to my supervisor, Dr. B. E. Chikeleze for his commitment in this work. My appreciation also goes to Dr. J. U. J. Onwumere who was the source of my inspiration and motivator that made this work a reality. I also thank him in a most special way for his support and concern for this work. My appreciation also goes to all members of my family for their support, financially, morally and above all their prayers for me. My regards goes to friends like Afamefuna Joseph, Gibson Eze and others for their contributions in various degrees towards ensuring the success of this dissertation. I pray that the good Lord reward you all abundantly.

6 ABSTRACT This study examines the impact of risk management in two Nigerian Banks. Data were obtained from the annual accounts and reports of the two banks (AfriBank Nigeria PLC and Fidelity Bank Nigeria PLC). An event study methodology was employed to examine the effects of deposit, asset quality and credit risk exposures on the growth and profitability of Nigeria commercial banks. Similarly, results shows the significant impact of asset on profit. On a whole, the study finds the need for banks in Nigeria to devote enough attention to the management of financial risks in the banking industry.

7 TABLE OF CONTENTS Title Page Approval Certification Acknowledgment Abstract Table of Content CHAPTER ONE INTRODUCTION 1.1 Background of the Study Statement of Problem Objectives of the Study Research Questions Research Hypotheses The Scope and Limitations of the Study Significance of the Study Definition of the Terms References CHAPTER TWO REVIEW OF RELATED LITERATURE 2.1 Introduction Business Risks and Economic Globalization Meaning and Concept o risk Management Types of Risks Providing Banking Services Classification of risks Financial Risks Facing Nigerian Commercial Banks Design and Selection of Risk Management Strategic Portfolio Risk Analysis Management Implication of Banking Risks on the Stability and Soundness of the Financial System and the economy in General Procedures for Adequate Bank Risk Management i ii iii iv v vi

8 2.11 Method of Monitoring Bank Risk Risk Control and Financing in Commercial Bank Regulatory and Supervisory Frameworks Overview of the 1988 Accord Causes of Credit Risks to Commercial Banks The Role of Liquidity in Commercial Bank Portfolio Management Lending Polices of Commercial Banks Summary of Literature Review References CHAPTER THREE RESEARCH DESIGN AND METHODOLOGY 3.1 Introduction Research Design Population and Sample Size Models of the Study Sources of Data Techniques of Data Collections Data Analysis Techniques References CHAPTER FOUR DATA PRESENTATION AND ANALYSIS 4.0 Introduction Data Presentation Analysis of Data CHAPTER FIVE CONCLUSION AND RECOMMENDATIONS 5.1 Conclusion and Recommendations Recommendations References Bibliography Appendix

9 CHAPTER ONE INTRODUCTION 1.1 BACKGROUND OF THE STUDY The Nigerian Banking Industry for the past decades has witnessed series of Banking distress and subsequent failures. Banks that had been doing well suddenly announced large losses due to credit exposures that turned sour, interest rate position taken or derivate exposures that may or may not have been assumed to hedge balance sheet risk. In response to this, there is indeed urgent need for banks in Nigeria to devote enough attention to the management of financial risks in the Nigerian Banking Industry. The 1989 annual report and statement of account of NDIC revealed that classified loans and advances or bad debts amounted to 9.4 billion which contributed 40.8 percent of total loans and advances and 280 percent of shareholders funds (Hall, 1991:8). It is the development of his nature that have led to the introduction of the CBN prudential guidelines for banks. Cooker (1989:115), observes that the main function of a bank is the collection of deposits from those with surplus cash resources and the lending of these cash resources to those with an immediate need for them in fulfilling this: It must be easily understood It must be permanent It must be able to absorb losses These three features are expected to guide member countries, including Nigeria, in assessing instruments to be used in raising bank capital. The bottom line in the debt capital is a risk instrument for financing bank operations and should be discourage as much as possible. The Basel Committee on banking supervision also introduced the New Capital Accord which was implemented in The New Capital Accord required capital charges to be made for credit, market and operational risks. This is aimed at protecting depositors, consumers, and the general public against losses arising from bank fragility and failure (Umoh: 2005). Ever since 1988, captains of the Nigerian Banking industry have shown keen interest in improving the risk analysis, measurement and management capacity of firms in the banking sector. Recently risk managers of major banks came together in Lagos to form an organization named Credit Risk Association of Nigeria (CRAN). It is hoped that CRAN will offer them

10 opportunities for networking on issues of bank risk management. Concerted efforts are also being made by captains of banking industry to reduce the risk exposure of banks in lending to borrowers generally but especially to commercial bank, which is traditionally prone to market and credit risk. Coincidentally to this activity, and in part because of our recognition of the industry s vulnerability to financial risk, the Wharton Financial Institutions center with the support of the Slon Foundation, has been involved in an analysis of financial risk management processes in the banking sector. In the banking sector, system evaluation was conducted covering many of North America s super regional and quasi money center commercial banks as well as a number of major investment banking firms. The Nigerian economy is increasing begin globalized by the deliberate government actions since July 1986 when the federal government began the implementation of the Structural Adjustment Programme (SAP). The SAP sought to deregulate and free the economy from government control with a view to allowing market forces determine the production and consumption decisions of economic agent within the country. The deregulation process which was accompanied by privatization and commercialization government enterprises, had far-reaching impacts on the entire economy. In particular, deregulation of interest rates affected bank lending to the real sectors of the economy. In more recent times, government adopted business consolidation strategies viz: merges, acquisitions and taken over as part of its efforts to facilitate the ability of firms in financial services industry to become global market Players. According to the governor of the Central Bank of Niger (CBN), business consolidation in the banking sector was to, among other things; make Nigeria banks complete favourably in the global financial market and to generate a high capital base that will provide banks with the resources to met the cost of compliance in the areas of credit and market risk management (Soludo, 2005:98-99).

11 1.2 STATEMENT OF PROBLEM Risk management is at the core of lending in the banking industry. Many Nigerian banks had failed in the past due to inadequate risk management exposure. This problem has continued to affect the industry with serious adverse consequences. Banks are generally subject to wide array of risks in the course of their business operations. Nwankwo (1990:15) observes that the subject of risks today occupies a central position in the business decisions of bank management and it is not surprising that every institution is assessed an approached by customers, investors and the general public to a large extent by the way or manner it presents itself with respect to volume and allocation of risks as well as decision against them. Other risks include insider abuse, poor corporate governance, liquidity risk, inadequate strategic direction, among others. These risks have increased, especially in recent times as banks diversity their assets in the changing market. In particular, with the globalization of financial markets over the years, the activities and operations of banks have expanded rapidly including their exposure to risks. 1.3 OBJECTIVES OF THE STUDY Basically; the main objective of this is to determine the effect of deposit on banks lending and risk management. Others are: (i) To determine how asset quality can be efficiently and effectively monitored. (ii) To examine the effects of credit risk exposure on growth and profitability of Nigeria commercial banks. 1.4 RESEARCH QUESTIONS The study will seek to answer the following questions: (i) How does deposit of banks affect the portfolio of credit by banks? (ii) How does the quality of banks assets in terms of risks exposures affect banks profitability? (iii) What are the effect of credit risk exposures on growth and profitability of banks? 1.5 RESEARCH HYPOTHESIS The following alternative and null hypotheses will be formulated such as to uphold or reject the preposition of the risk management in two Nigerian commercial banks. (i) H o : Deposit does not have a significant positive impact on

12 bank loans (ii) H o : Asset quality does not have a significant positive impact on profitability of a bank (iii) H o : Credit risk exposures do not have a significant positive impact on profitability of banks. 1.6 SCOPE OF THE STUDY This study covers risk management in AfriBank Nigeria PLC and Fidelity Bank Nigeria PLC. Pre and Post banking consolidation in Nigeria, specifically between 2003 and SIGNIFICANCE OF THE STUDY This study has a number of significant dimensions. (i) The result of this study should provide information to the commercial banks risk management department on the progress so far made in identifying and evaluating risks as to enhance growth and profitability of the financial institutions. (ii) The result of this study should also reveal how much such progress has impacted on the growth of the entire commercial banks in Nigeria. (iii) Essentially, this work is a step in a right direction to assist and enlighten the general public on what risk management in commercial banks is all about and hence guide them in their immediate decision of handling risks. (v) Furthermore, there is need to provide a reference document for further researchers and evaluation of risk management conducted by other Nigerians/other Nations. This research work will go a long way to increase the availability of literature in the field of risk management in the banks and other related business associates that involve risk in the day-to-day running of the businesses. (vi) Finally, the study is of immense benefit to policy makers, investors, financial managers lecturers and the general public.

13 1.8 DEFINITION OF THE TERMS Portfolio Management: The process of making and carrying out a decision to invest in securities (Anyafo, 2001 : 93). Portfolio - Akinsulire (2002:357). Defined portfolio as the combination or collection of several securities on behalf of an investor. Hedging: According to (Ebhalaghe, 1995 : 161) defined hedging as a system employed to smoothen out unpredictable fluctuations in financial variables so as to aid planning and avoid embarrassment induced by cash shortfalls. Forward Contracts: This is a contract usually between a bank and customer to buy or sell a specified quantity of foreign currency at an agreed future data (Akinsulire, 2002: 467). Tenor Mismatch: Involves matching the tenor of an investment with the tenor of the borrowed funds, so invested or a mismatch is said to occur when the tenor of investments in aggregative exceeds the contractual tenor of the borrowed funds (Ebhalaghe, 1995:144). Currency Swap: This is a simultaneous borrowing and lending operation whereby two parties exchange specific amount of two currencies on the outset at the sport rate (Akinsulire, 2002:474).

14 REFERENCES Anyafo, A. M. O. (2001), Investment Risk Evaluation: The State of the Art in Investment and Project Analysis, Enugu: Banking and Financial Publication. Akinsulure, O. (2002), Financial Management, Second Edition, Lagos, El-Toda Ventures Limited. Ebhalaghe, J. U. (1995), Corporate Financial Risk exposure Management, Lagos, Ronald Printing Company Limited. Hall J. A. (1999), Banking Prudential Guidelines and their Impact on the Banking Industry, being paper presented at the Bankers forum organized by CBN, June 5. Nwankwo, G. O. (1990) Prudential Regulation of Nigerian Banking Institute of European Finance, Lagos: University of Lagos publication. Nigerian Deposit Insurance Corporation (1988), Annual Report and Statement of Accounts. Soludo, C. (2005), Opening Remarks to Conference Participants, in CBN (ed), Consolidation of Nigerian s Banking Industry: Proceeding of Fourth Annual Monetary Policy Conferences, Abuja, FCT.

15 CHAPTER TWO REVIEW OF RELATED LITERATURE 2.1 INTRODUCTION The review of related literature in this chapter will be reviewed under various sections covering meaning and concept of risks, business risk and globalization, types of risks managed by financial institutions (commercial banks), overview of the 1988 Accord concerning risks, management, causes of credit risk to commercial banks, the role of liquidity in commercial banks portfolio management, financial risk implication of securities, lending policies of commercial banks. The regulatory and supervisory framework of CBN concerning risk management in banks, risk control and financing in commercial banks, financial risks facing commercial banks as a corporate body and techniques for monitoring and managing financial risks exposure. 2.2 BUSINESS RISKS AND ECONOMIC GLOBALIZATION In its general form, risk refers to variability around an expected value. The probabilities of occurrence of the different outcomes are known, some of which are less desirable than others and may entails a loss. Expected value is the outcome that would occur on average over time if an individual or firm were repeatedly exposure to identifiable conditions, decision or scenarios. Economists make a distinction between risk, in which a random set of out comes can occur for which one known the probabilities, and uncertainty, in which a random set of outcomes can occur for which one does not know the probabilities. For a business enterprise, risk implies any thing that can cause variability in business value such as unexpected increase in cash outflows or unexpected reduction in cash inflows. In effect, business risk refers to variability in cash flow. The major business risks that give rise to variability in cash flow. They are: price risk, credit risk. In recent times, these risks have greatly increased as a result of economic globalization. Globalization is the process by which national economics increasingly integrated and dependent on one another. It is rooted in three technological revolutions. In transportation, communication and information technology. Globalization has drastically reduced economic transaction costs from afar and has tended to swallow up

16 inefficient production systems in developing countries with cheap imports from industrialized nations (Shah, 2002). Globalization ahs created huge concerns among government officials especially in low-income countries as they lose sovereignty over their national economic policies. Also, the combination of huge financial markets and flexible exchange rates makes it possible for national economies to receive large shocks from abroad, some of which tend to be destabilizing as demonstrated by the shocks in Indonesia and Argentina in the late 1990s. for instance, the 1997 Asian currency crisis precipitated by hyper inflation and a 12% decline in Indonesia GDP the following year (Friendman and Livensolhm 2002). This globalization has capacity to greatly, increase the incidence of business risks, are sometimes classified in economic literature as financial risks (Trieschamann et al, 2001). 2.3 MEANING AND CONCEPT OF RISK MANAGEMENT Commercial banks are in the risk business. In the process of providing financial services, they assume various kinds of financial risks. Over the decade our understanding of the place of commercial banks within the financial sector has improved substantially. Over this time, much has been written on the role of commercial banks in the financial sector both in the academic literature (Santomero, 1997). Suffice it to say that market participants seek the services of these financial institutions because of the ability to provide market knowledge, transaction efficiency and funding capacity. In performing these roles they generally act as a principal in the transaction. As such they use their own balance sheet to facilitate the transaction and to absorb the risks associated with it. To be sure, there are activities performed by banking firms which do not have direct balance sheet implications. These services include agency and advisory activities such as: Trust and investment management, efforts or facilitating contracts, standard underwriting through sector 20 subsidiaries of the holding company or the packaging, securitizing, distributing and servicing of loans in the areas of consumer and real estate debt primarily. According to the Longman Dictionary of the English Language (1984 : 1284), risk is the possibility of loss, injury, damage or peril. Defined in this way, risk is an inevitability of life. No aspect of human endeavour is devoid of or can escape it. It is inherent in every day

17 lie and more so in the life of a banker because his business has business has been and continues to be taking risks (Nwankwo; 1990:62). Managing risks like managing capital and liquidity has therefore been the centre peace of banking (Nwankwo, 1990:63). Umoh (1998:69), defined financial risk as the chance or probability that some ufnavourable event will occur such that the financial position or cash flow stream of an organization is adversely affected. One way of identifying the financial risks of an organization is to recognize the sources of such risks. Another way is to see the risks as either those the corporation can control and those that cannot. Once a risk has been identified, the next stage is to estimate these frequency and sovereignty of potential losses. In this way, risk managers obtain information for determining the risks and selecting particular methods for managing them. In some cases, no particular problems would arise if losses were incurred regularly (example, delay repayment on small loans) because the potential size of each loss is small. But loses that occur imprudently, yet are relatively large when they occur, need to be treated differently. It might be a prudent policy to refuse loan application of the borrowers collateral of sufficient high value that can be disposed without any legal entanglement. A good risk evolution system should produce data on the following estimate: A good risk evaluation system should produce data on the following estimate: Frequency of loss, maximum problem loss, maximum possible loss expected loss, probability distribution of loss and standard deviation of loss. Risks in technical definitive terms to a situation where a project or investment decision has a number of alternative possible outcomes and the probability of each occurring is known. What is not known is which of the alternative outcomes will actually materialized (Brown, 1988: 45 58). the banking industries recognizes that an institution need not engage business in a manner that unnecessarily imposes risk upon nor should it absorb risk that can be efficiently transferred to other participants (Santomero, et all 1997).

18 2.4 TYPES OF RISKS PROVIDING BANKING SERVICES In view of Nnanna (2003 : 30) observed that the risks associated with banking sector can be grouped into the following types: Credit risk, Liquidity risk, interest rate risk, market risk, currency risk, balance sheet structure, income structure and capital adequacy country and transfer risk, legal risk. He further restated that the above type of risk, captures almost all the risks arising from the normal day-to-day activities of a bank and are applicable to bank that operate both internationally and locally. The based committee, however, noted that the fundamental requirement for a good management of the above risks is the ability of banks to identify and measure them accurately. The risks associated with the provision of banking service differ by the types of services rendered (Santomero; 1984:60). For the sector as a whole, however the risk can be broken into five generic types: systematic/market risk, credit risk, counter part risk, liquidity risk, and legal risks. a. SYSTEMATIC RISK: This type of risk is referred as the risk arising from asset value change associated with systematic factors (Old field et al, 1997: 61). It sometimes referred to as market risk, which is infact a some what imprecise term. According to (Nnanna 2003:1) observed that market risks is the risk arising from capital loss resulting from adverse market price movement. By its nature, this risk can be hedged but cannot be diversified complete away. Infact, systematic risk can be thought of an undiverasifiable risk. All investors assume this type of risks, whenever assets owned or claims issued can change in value as a result of broad economic factors. Because of the bank s dependence on these systematic factors, most try to estimate the impact of these particular risks on performance. b. CREDIT RISK: Credit risk refers to delinquency and default by borrowers, that is, failure to make payment as at when due or make payment by those owing the firm. The need to include delinquency derives from the importance usually attached to the time of money in financial analysis: one naira received today is worth more than one naira received in

19 the future. While delinquencies indicate delay in payment, default, denotes non payment and the former is unchecked, leads to the latter (Padmanaghan, 1988:14). The exposure to credit risk is particularly large for financial institutions such as commercial and merchant banks. When firms borrow money, they in turn, exposes under the credit risk. However, credit risk arises from non-performance by a borrower. It may arise from either an inability of unwillingness to perform in the precommitted contracted manner. This can affect the under holding the loan contract as well as other lenders to the creditors. As a consequence, borrowing exposes the firm s owners to the risk that the firm will be unable to pay its debt and thus be forced into bankruptcy, and the firm generally will have to pay more to borrow money because of credit risk (Harrington and Niehaus, 1999:45). It reduces the business value of the bank that granted the loan and destabilizes the credit system. Cost of administration of overdue local tends to the very sundry and defaults push up lending costs without any corresponding increase in loan turnover. Default reduces the resources base for further lending, weaken staff morale, and affect the borrower s confidence (Padmanabhan, 1998: 16) The identification of credit risks and exposure to loss is perhaps the most important element of the credit risk management process. Unless the sources of possible losses delinquencies and defaults are recognized, it is impossible to consciously choose appropriate, efficient methods for dealing with those losses when they occur. The credit risk management unit of the bank will need to draw a checklist of causes of delinquencies and default in commercial bank financing.

20 c. COUNTER PARTY Nnanna (2003:31) referred this type of risk arising from the economic, social and political environment in the borrower s home country (Country risk) and the risk present in loans that are not denominated in the borrower s local currency (Transfer risk). Moreover, counterparty risk comes from non performance of a trading partner. The non performance may arise from a counter party s refusal to perform due to an adverse price movement caused by systematic factor or from some other political or legal constraint that was not anticipated by the principal (Smith, 1990:59). Diversification is the major tool for controlling non systematic counterparty risk. Counterparty risk is like credit risk, but generally viewed as a more transient financial risk associated with trading than standard creditor default risk. d. LIQUIDITY RISK. Nnanna (2003:31) defined liquidity risk as the risk arising form bank having insufficient funds on hand to meet its current obligation. In view of Santomero (1984:10) described liquidity risk as the risk of funding crisis. While some would include the need to plan for growth and unexpected expansion of credit, the credit here is seen more correctly as the potential for a funding crisis. Such a situation would inevitably be associated with an unexpected event, such as a large chares off, loss of confidence or a crisis of national proportion such as a currency crisis. One of management s fundamental responsibilities is to maintain sufficient resources to meet liquidity requirements, as when cheque are presented for payment, deposits mature and loan request are funded. Managing liquidity risk forces a bank to estimate potential deposit losses and renew loan demanded.

21 e. LEGAL RISK: Legal risks are endemic in financial contracting and are separate from the legal ramification of credit, counter party and operational risk. Risk that a bank s contract or claims will be enforceable or that court will impose judgment against them. It covers the risk of legal uncertainty due to the lack of clarity of laws in localities in which the bank does business (Nnanna, 2003:31); examples of legal risk is fraud violation of regulation or laws and other actions that can lead to catastrophic loss. 2.5 CLASSIFICATION OF RISKS Generally, banking risks can be classified broadly into four categories: These are financial risks, operational and event risks. Business risk and event risk. a. Financial Risks: Financial risks are further disaggregated into pure and speculative risks. Pure risks which include liquidity, credit and solvency risks can result in a loss for bank, if they are not properly managed. Speculative risks, based on financial arbitrage, can result in a profit if the arbitrage is positive or a loss, if it is negative. The main categories of speculative risks are interest rate, currency and market price (or position) risks. b. Operational risks: Operational risks are related to a bank s overall organization and functioning of internal systems, including: computer related and other technologies, compliance with bank policies and procedure and measures against management and fraud. c. Business risks Business risk are associated with a bank business environment including: macroeconomic and policy concern, legal and regulatory factors and the overall financial sector infrastructure and payment system. d. Event risks: Event risks includes all type of exogenous risk which, if they are to materialize could jeopardize a bank s operations or undermine its financial condition and capital adequacy.

22 2.6 FINANCIAL RISKS FACING NIGERIA COMMERCIAL BANKS Umoh (1988: 95) stated that one way of identifying the financial risks of an organization/corporate body such as commercial bank is to categorize the sources of such risks. He further observed that another way is to see the risks as either those the corporation can control and those they cannot control consistent with these methods one can classify financial risks into following sources: credit, interest rate, inflation, exchange rate, investment, capital adequacy, liquidity, management and concentration of asset risks: here the writer will examine sources of these financial risks briefly as followings: a. EXCHANGE RATE RISK Exchange rate risk arises from the potential loss emanating from the inherent fluctuation nature of exchange rates, particularly, since the Naira started depreciating steadily against the major international currencies, cooperate bodies that require foreign productive inputs have been exposed to loss arising from changes in the relative value of the Naira vis-à-vis foreign currencies. For the banking industry, exchange rate risks would arise if the naira rises in value before a bank sell off its stock of foreign exchange. Conversely, exchange gains are realized as the naira depreciates. b. INFLATION/PURCHASING POWER RISK: This risk arises from the changes in the price level. Since the Udeoji awards or early 1970s the Nigerian economy, for the most part has lived with double digit inflation. The inflation in the country has been linked mainly to excess demand pressures, monetary and fiscal factors. One implication of purchasing power risk for banks is that more funds must be raised to replace assets resulting replacement. c. INTEREST RATE RISKS: Interest rate risk arises from changes in the prevailing rates of interest. For example, if a merchant bank buy funds from a commercial bank at 27% and before the merchant bank can place the funds, the market rate of interest falls and the merchant bank can only get 25% of the funds placement, then a financial loss will be sustained by a merchant. Bank s interest rate risk are common in times of tight liquidity to financial market.

23 d. CAPITAL ADEQUACY RISKS: This risk is particularly relevant in the banking business, where supervisory authorities (CBN & NDIC) are demanding certain levels and types of capital in order to maintain stability in the banking system and ensure the confidence of depositors. e. CONCENTRATION OF ASSETS RISK: This is the probability that a corporate entity especially a financial house would sustain financial losses if its funds are concentrated in one or only a few asset portfolios. An example is that of a bank giving primarily real estate loans and advances. If the market for real estate suffers a downturn, the bank takes losses on the loans and advances portfolio. This kind of risk was responsible for the much published savings and loan crisis in the Untied States of America. f. MANAGEMENT RISK: This type of financial risk usually occur where the key management staff are either incompetent or are pursuing goals other than those set for them by the owners (shareholders) of the bank. Business literature has identified other goals management may pursue to include market share, expense preference and satisfying behaviour. g. INVESTMENT RISK: This is the change that the cash inflow from a given investment project when put on a present value basis and aggregated may not be sufficient to cover the cost of the project. Investment risk may arise from a number of factors most of them may be outside the control of the investing bank (systematic risk). For example, a down turn in the national economy may turn an otherwise proof investment opportunity into a very risky one unpredictable government policy such as ban on raw materials, importation can mar an otherwise profitable investment opportunity. However, credit and liquidity risks have been highlighted in our early discussions.

24 2.7 DESIGN AND SELECTION OF RISK MANAGEMENT STRATEGIES This is the critical stage of fusion of risk management process and strategy. Three basic strategies commonly employed in dealing with risks are: loss control, loss financing and internal risk reduction. Loss control and internal risk reduction involve decisions by firm to invest (or forego investing) resources in order to increase business value. They are other conceptually equivalent to other decisions made by firms. For instance, under loss control there are two basic methods loss prevention and loss reduction. A commercial bank involved in Agriculture financing can only bring its loss exposure to zero by refusing to grant loans to farmers. This is called risk avoidance, the main cost being foregone benefits form agriculture financing. But this is a non option in an environment where government insists that banks must grant credit to their borrowers and provides the banks with incentives to do so. The plausible option, therefore is one of loss reduction, whereby banks seek to reduce the magnitude of losses from financing risks. The goal here is to make a safer and thus reduce the frequency and severity of losses from delinquencies and defaults. Investment in information on loan applicants, market research and diversification of loan portfolio by funding different enterprises are internal risk reduction strategies available to banks increased precaution in credit administration is very important and can be achieved through two means: - Demand for appropriate collateral security by banks before granting loan, and - Effective loan supervision ad monitoring by credit officers of lending agencies. Loss financing refers to methods used to obtain funds to offset or pay for risks related losses: retention, hedging and insurance. With retention, the bank assumes obligation to pay for part or all of the credit risk losses from available bank funds. Hedging is employed to smoothen out unpredictable fluctuations in financial variables so as to aid planning ad avoid embarrassment induced by cash shortfalls. Unlike in diversification where securities/projects which are not closely correlated in returns are sought. In hedging efforts should be made to find securities which are perfectly correlated in returns. When one security is bought and other security with

25 perfectly correlated returns is sold so that the net position is safe. Hedging is used to minimize interest rate risk and exchange rate risks. Insurance is the third method for financing credit losses, and which tends to spread out risk and consequently minimize the burden an individual lender/investor has to bear. 2.8 PORTFOLIO RISK ANALYSIS MANAGEMENT A portfolio is defined as a combination of assets and portfolio. A portfolio is not merely a collection of unrelated assets but a carefully blended asset combination within a unified framework. When investors make decisions with reference to their wealth positions, they rationally should make them in a portfolio context. What constitutes a portfolio would depend on whose perspective from which you are looking at it for an investor in the stock market, the portfolio will be a collection of shareholdings in different companies. For a real estate investor, his portfolio will be a collection of buildings. To a financial manager from the industrial sector, his portfolio will be a collection of real capital projects. The process of making and carrying out a decision to invest in securities is called portfolio management. Proper portfolio management reduces investment risks. Portfolio management has become a profession for delivery of investment counseling and management services. Management of a portfolio of significant size is a time-consuming and painstaking job. Historically, portfolio management progressed form traditional to modern approach. Traditional portfolio management expressed investment risk and its relationship to returns in qualitative rather than in quantitative terms. Under the approach, past returns could not be compared through the use of generally accepted common denominator of risk. The uncertainty of expected return could not be expressed with any degree of quantitative assurance. Modern portfolio theory treats risk in quantitative terms. It focuses attention beyond the tradition exhaustive analysis and evaluation of individual securities to the problems of overall portfolio composition predicated on explicit risk return parameters and on the identification and quantification of client objective.

26 Institutional investment polices are often a combination of the traditional and modern approaches to portfolio management. The basic elements of modern portfolio theory emanates form a series of propositions concerning relational investor behaviour set forth in 1952 by Dr. Harry Marketwise of the Rand Corporation and later in a more complete monograph sponsored by the Cowls Foundation of the United States of America. Whether the investor is an individual or an institution, the following factors influence investment behaviour: Security of capital invested: How secure is the investment given the state of the economy? Liquidity: the ease of convertibility of the capital invested into cash at short notice Return: The reward potentials of the investment Risk: The risk content of the investment and the extent of its diversificability. Growth prospects: The growth potentials of investment companies wishing to attract investor s funds must ensure sufficient securities, liquidity, return and growth prospects in order to enhance the marketability of the securities in the capital market. 2.9 IMPLICATION OF BANKING RISKS ON THE STABILITY AND SOUNDNESS OF THE FINANCIAL SYSTEM AND THE ECONOMY IN GENERAL Risks could result to bank distress, failure and financial crisis in an economy. The worst problem associated with a bank crisis is that of contagion in which the problems in one bank result to a run on the entire banking system. (Hilbers et al, 200: 52) depositors and other creditors who are worried about the safety of their money are worried compelled to move their funds form those banks which are perceived to be unhealthy, to the banks that are solvent. The panic withdrawal may not only be from one bank to another, it could lead to total withdrawal of funds from the banking system. Consequently, the loss of confidence of banks depositors on the banks can establish the banking system and hence the economy as a whole.

27 2.10 PROCEDURES FOR ADEQUATE BANK RISK MANAGEMENT It seems appropriate for an discussion or risk management procedures to being with why these firms manage risk. According to standard economic theory, managers of value maximizing firms ought to maximize expected profit without regard to the variability around its expected value. However, there is growing literature on the reasons for active risk management including in the work of Stulz (1984), Smith, Smithson and Wolford (1990). Infact, the recent review of risk management reposted in Santomero (1995) list dozen of contributions to the area and at least four distinct rationals offered for active risk management. These include managerial self interest, the non linearity of the tax structure, the costs of financial distress and the existence of capital market imperfections. In the light of the above, what are the necessary procedures that must be in place to carry out adequate risk management? And how they are implemented in each area of risk control? The management of the banking firm relies on a sequence of steps to implement a risk management system. These can be seen as containing the following four parts: - standards and reports - position limit or rules - investment guidelines or strategies - incentives contracts and composition In general, these tools are established to measure exposure, define procedures to manage these exposures, limit individual positions to acceptable levels, and encourage decision makers to manage risk in a manner that is consistent with the firm s goals and objectives. To see how each of these four parastatals arts of basic risk management techniques achieves these ends, we elaborate on each part of the process below: a. STANDARD AND REPORTS: This involves two different conceptual activities, that is, standard setting and financial reporting. They are list together because they are the sine qua non of

28 my risk system. Underwriting standards, risk categorizations, and standards of review are all traditional tools of risk management and example is the great depression of the 1930s, which originated in USA and affected many countries across the world. The origin of the great depression is said to be traceable to the initial crisis that began in the U.S. financial industry. Empirical studies have shown that bank distress could affect the economic growth of a country through the savings investment channel. For instance, it has been proved that the mismanagement of contingent risks could lead to panic withdrawals in the ailing bank, which could further deteriorate into a run on the banking sector. The withdrawal of funds from the financial sector implies a leakage in the system. According to (Haynes, 2003:45) stated that in the process of managing financial risks, and to safe-guard the banking industry in their business there is need for banks to maintain and guide against risks losses as to ensure sound and stable financial system in the following manners: a. THE PURPOSE OF PRUDENTIAL REGULATIONS AND SUPERVISION The basic objectives of prudential regulation and supervision of banks are to prevent systematic banking distress, protection of depositors, savings and the encouragement of financial intimidation, specifically, the objectives of prudential regulation as to: enhance prudent portfolio management ensure optimal risk diversification prevent adverse selection and risk aversion promote sound and stable financial system b. REGULATORY AND SUPERVISORY FRAME WORKS The international financial crisis of the second half of the 1990s provoked much reflection on ways to strengthen the global financial system. The international community identified a number of priorities including the

29 need to enhance its own ability to monitor the health of the financial system. The ability to monitor the financial sector soundness presupposes the existence of valid indicators which can measure the health and stability of the financial systems. The general macro-prudential indicators as developed by the IMF for assessing and supervising banks is embedded in the CAMELS frame control. Consistent evaluating and rating of exposures of various types are essential to understand the risk in the portfolio and the extent to which these risks must be mitigated or absorbed. Obviously, outside audits, regulatory reports and rating agency evaluations are essential for investor to gauge asset quality and firm level or risk. b. POSITION LIMITS AND RULES A second technique for internal control of active management is the use of position limits, and minimum standards for participation. In term of the latter, the domain of risk taking is restricted to only those assets or counterparties that pass some pre-specified quality standard. Then even for those investment that are eligible limits are imposed to cover exposures to counterparties, credits and overall position concentration relative to various types of risks. c. INVESTMENT GUIDELINES AND STRATEGIES Investment guidelines and recommended positions for the immediate future are the third technique commonly in use. Here the strategies are outlined in term of concentration and commitments to particular areas of the market, the extent of desired asset/liability mismatching or exposure and the need to hedge against systematic risk of a particular type. The limit described above lead to passive risk avoidance and/or diversification, because managers generally operate within position limits and prescribe rules. d. INCENTIVE SCHEMES To The extent that management can enter incentive compatible contracts with the line managers and make companion related to the risk born by these individuals, then the need for elaborate and costly control is lessened. However, such incentive contracts require accurate position valuation and

30 proper internal control system (Santomero, 1995:4). Such tools which include posting, risk analysis, the allocation of costs and setting of required returns to various parts of the organization are not trivial. Notwithstanding the difficulty, well designed system aligns the goals for managers with other stakeholders in a most desirable way (Babble, et al, 1996:10). Infact, most financial decades can be traced to the absence of incentive compatibility as the cases of deposit insurance and maverick traders METHODS OF MONITORING BANK RISK The banking industry has long viewed the problem of risk management as the need to control four of the above risks mentioned earlier which make up most, if not all, of their risk exposure, credit, interest rate, foreign exchange and liquidity risk. While they recognize the counterparty, and legal risks, they view them as less central to their concerns (Trester et al, 1997:45). Where counterparty risk is significant. It is evaluated using standard credit risk procedures, and often within the credit department itself. Likewise, most bankers would view legal risks as arising from their credit decisions, or more likely, proper process and not employed in financial contraction. Accordingly, the study of bank risk management process is essentially an investigation of how they manage these four risks. To illustrate how this is achieved, this review of firm level risk management begins with a discussion of risk management controls in each area as follows: a. We begin with standards and reports. As noted earlier, each bank must apply a consistent evaluation and rating scheme to all its investment opportunities in order for credit decisions to be made in a consistent manner and for the resultant aggregate reporting of credit risk exposure to be meaningful. To facilitate this, a substantial degree of standardization of process and documentation is required. The form reported here is a single rating system where a single value is given to each loan, which relates to the borrowers underlying credit quality. At some institution, a dual system is in place where both the borrower and the credit facilities are rated.

31 There are various ways of trying to keep bad debts on loan to a tolerable low level including: avoiding loan to risky customers monitoring loan repayment and renegotiating loan when customers get unto difficulties. Loans should be made only to borrowers who are likely to be able to repay and who are unlikely to become insolvent. Credit analysis of potential customers is carried out in order to judge the credit risk with the borrower and to rich a lending decision. Loan payments are monitored and action taken when a customer defaults. There is some credit for customers in their dealing with bank more commonly, borrowers are at some risk from the lending decisions of their banks. The risk arises from taking credit rather than form giving it. The borrower s risks can be listed briefly. The interest rate charged by the bank will be dependent on the bank s view of the borrower s credit worthiness A bank might decide to reduce a customer s borrowing facility by reducing an overdraft facilities Lending covenants on an existing loan could restrict the ability of the borrower to obtain further loans A bank might refuse to extend a loan to support a company with temporary cash flows. Generally, accepted accounting principles require this monitoring. The credit portfolio is subject to far value accounting standards, which have recently be tightened by the financial Accounting shares board (FASB). Commercial banks are required to have a loan loss reserve account (A contra asset) which accurately represents the diminution in market value from known or estimated credit losses. Bank loans have three sources