1.1 BACKGROUND OF THE STUDY
Risk could simply be defined as a situation involving exposure to danger. In other words, according to NASDAQ, financial risk is the risk that the cash flow of an issuer will not be adequate to meet its financial obligation. It also refers to as the additional risk that a firm’s stakeholder bears when the firm uses debt and equity (NASDAQ, 2016). The etymology of the word “Risk” can be traced to the Latin word “Rescum” meaning Risk at sea or that which cuts (Raghavan, 2015). Risk is associated with uncertainty and reflected by way of charge on the fundamental basic i.e. in the case of business it is the capital, which is the cushion that protects the liability holders of an institution. These risks are inter-dependent and events affecting one area of risk can have a ramifications and penetration for a range of other categories of risks (Centre, 2017). The financial system and banking in particular are exposed to certain inherent risks which include: credit risk, interest rate risk, market risk, liquidity risk, market liquidity risk, operational risk, risk of fraud, reputation risk, legal risk, systematic risk and many more. Even though this work pays special consideration on measuring credit risk and liquidity spill over. Failure to adequately manage these risks exposes banks not only to losses, but may also threaten their survival as business entities, thereby, endangering the stability of the financial system (RISKS AND RISK MANAGEMENT IN THE INDIAN BANKING, March 2014).
Financial services organizations around the world face extraordinary challenges related to profitability, complexity and new regulations in an economic environment we refer to as one of “permanent volatility”. With return on equity below historic norms, many firms are undergoing fundamental restructuring of their business models while trying to deal with the impact of regulations such as Dodd- Frank, Base iii, and solvency ii, which can increase both capital requirement and compliance cost (Accenture consulting, 2018). These pressures may force some firms to exit particular lines of business or specific geographies. Many firms are also dealing with layers of complexity – a legacy from years of rapid growth – and with the consequences of under- investment in technology during the recent years of cost-cutting. In this challenging environment, the integration of risk and finance can be a source of competitive advantage for financial services firms (consulting, 2017). Risk Analysis and Risk Management has got much importance in banking today. The foremost among the challenges faced by banking sector today is the challenge of understanding and managing risk. The very nature of banking business is having the threat of risk imbibed in it. The banks main role is to intermediation between those having resources and those requiring resources. Globalization has resulted in pressure on margins. The lower the margin, the greater is the need for risk management. As a result, risk management has become a key are of focus. Additionally, due to the failure of many banks/financial institutions in recent past, it has attracted the attention of regulators (Centre, 2017).
The banking sector has a pivotal role in the development of an economy; it is a key driver of economic growth of the country and has a dynamic role to play in converting the idle capital resources for their optimum utilization so as to achieve maximum productivity (Set, 2016). In fact the foundation of any strong economy depends on how sound the banking sector is (KISHOR, 2014). Generally, banking is considered to be very risky business. Financial institutions must take risk, but must do so consciously (carey, 2001). However, it should be noted that banks are fragile institutions which are built on costumers trust, brand, and reputation, above all dangerous leverage. In case something goes wrong, banks can collapse and failure of one bank is sufficient to send shock waves right through the economy (Rajadhyaksha, 2004).
1.1.1 CREDIT RISK
Credit risk occurs when a debtor defaults on a loan or other line of credit. It may also arise from a change in the credit quality of a counterparty resulting from a market- base revaluation; perhaps following a rating agency downgrade, or from actual default (Qiao Liu, 2013). This type of risk is largely that of the financier and includes the loss of principal and interest and the loss may be complete or partial. Credit risk can result in the erosion of a bank’s capital. For instance, the recent experience in the Nigerian credit market, where provisioning caused from losses by banks on margin loans threatened their capital (Audu, 2014). One of the important functions of banks is to advance loans to its customers (Maheshwari, 1997). Banks charge interest from the borrowers and this is the main source of their income. Banks advance loans not only on the basis of the public rather they also advance loans on the basis of depositing the money in the accounts of borrower, in other words, they create loans out of deposits and deposits out of loans (Maheshwari, Principles of Business Studies, 1997). This is called credit creation by commercial banks. Modern banks give mostly secured loans for productive purposes. In other words, at the time of advancing loans, they demand proper security or collateral. Generally, the value of security and collateral is equal to the amount of loan. This is done mainly with the view to recover the loan money by selling in the event of non- refund of the loan. At times, banks give loans on the basis of personal security also. Therefore, such loans are called unsecured loans. Banks generally give the following types of loans and advances such as: Demand loans, Short-term loans, Over-Draft, Discounting of bills of exchange, cash credit amongst others. Special consideration is made on the cash credit. Cash credit is the kind of scheme; banks advance loans to its customers on the basis of bonds, inventories and approved securities. Under this scheme, banks enter into an agreement with its customers to which money can be withdrawn many times during a year. Under this setup, banks open account for their customers and deposit the loan money (Leonard J. Brooks, 2011). With this type of loan, credit is created.
Credit risk is most likely caused by inadequate income, loss in business, death, unwillingness or any other reasons. Similarly, if bank customers do not pay their credit card bills, the bank faces a credit risk. Macro-economic forces can induce credit risk by affecting the economy or specific markets or even specific individuals. There is an important risk that can be classified under credit risk: this is the risk of deliberate fraud that is usually borne by the banks who issue credit products such as credit cards (Aboli, 2015).
1.1.2 LIQUIDITY RISK
The possibility that cash available to a bank could be exceeded by customers call on it, or the income generated by a corporation, along with the fund it can raise through equity or debt issuance and or/ borrowing are insufficient to cover operating obligations ( suppliers, employees, operations) forcing the bank to cease operations (Credfinrisk.com, 2016). It can also be caused through thin market sometimes resulting from disruptions, which result in the unavailability of hedging instrument at economic prices or the inability to sell assets without a reduction in their value. Most institutions face two types of liquidity risk. The first relates to the depth of the market for specific products and the second to funding the financial- trading activities of the firm. When establishing limits for various major risk types and products, senior managers must factor in the size, depth and liquidity of a particular market or product, because the liquidity of the market/instrument affects the ability of the firm to alter its risk profile quickly and at reasonable cost. Some firms, for example, even have contract limit for every futures contract based on the volume turnover and outstanding (Elliott, Bank Liquidity Requirements: An Introduction and Overview, 2014). Senior managers must also develop procedures to identify and monitor the firm’s liquidity sources to ensure it can meet the funding demands of its activities. This is achieved by monitoring the differences in the maturities between assets and liabilities and by analyzing future funding requirement based on various assumptions, including the firm’s ability to liquidate positions quickly in adverse conditions (Credfinrisk.com, 2017).
Liquidity risk is inherent in banking: financial institutions hold long-term pledges that cannot be easily be collected or sold. Liquidity risk also collate with credit risk as the more questionable the ability of the borrower to pay the more difficult it is to sell the securities or loan. During 2008/2009 liquidity risk became a real issue: banks would not lend to each other due to the concerns of the quality of the other banks loan portfolio (banks were holding on to liquidity). Secondly, investors would not purchase securitization due to the concerns of the quality of the underlying assets thus financial institutions ended up holding assets on balance sheet that could not be priced due to an inactive market (the asset could not be sold to raise cash). The only way to resolve the situation was for central bank to make billions of dollars available to commercial banks and then ease the terms of borrowing, and to guarantee the value of certain on-balance sheet assets of various institutions.
1.1.3 RISK BASED BANKING SUPERVISION
Risk-based banking supervision is a supervisory approach that has either been implemented, or is in the process of being implemented, by many supervisory authorities. In addition, risk-based supervision concepts are embedded in the Basel core principle for effective banking supervision and are part of the IMF and World Bank’s Financial Sector Assessment Program (FSAPs) of countries (Helsinki, Finland, 2014). In today’s fast moving and interconnected world, along with carrying on-site and off-site activities at banks, supervision need to be forward-looking, and develop plans for intervening early. The role of supervisory authorities undertaking potential supervision is to promote the maintenance of efficient, fair, safe and stable insurance market for the benefit and protection of policymakers. An effective supervisory authority is able to require an insurer to take timely preventive and corrective measures if the insurer fails to operate in a manner that is consistent with sound business practice or regulatory requirements (Randle, Risk Based Supervision, 2009).
Traditionally, authorities have performed this role by the way of compliance based supervision. Under this style of supervision, insurers must comply with a set of prudential rules generally written into the law or the subordinate legislation. The role of supervisory authority is to ensure that insurers do, in fact, comply with these rules. In recent years, supervision has been evolving and moving from a style that is compliance based to one that is risk based. This progression has also been a feature of the activities of bank supervision and pension supervision (Randle). The risk based banking supervision comprises of supervisory perspective and pre- requisite for the success of risk based supervision.
1.1.4 SUPERVISORY PERSPECTIVE
There are fundamental issues that need to be understood and appreciated not only by the supervised entities but also the regulatory and supervisory community, for ensuring a vibrant banking sector (Dr. K. C. Chakrabarty, 2013). No amount of supervision or regulation can save an institution if the Board/ Top Management are not sensitive enough about what is good for their bank. The board and the senior management are the first line of defense at the banks and we, as supervisors, place a lot of faith in them to identify, manage and mitigate risk in banks’ day to day affairs. Therefore, i would emphasize that ensuring readiness of the bank for success RBS is a management function (Chakrabarty, 2013). The pre- requisite for the success of risk based supervision include: Effective management system, the need for a management information system, risk based pricing of product and services, role of auditors and risk focused internal audit, role of the board, HR issues, Allocation of supervisory resources and capacity building among supervisors.
The perquisite for the success of the risk based supervision include: effective management systems, the need for an effective management information system, risk based pricing of products and services, role of auditors and risk focused internal audit, role of the board, HR issues, allocation of supervisory resources and capacity building among supervisors amongst others.
1.1.5 EFFECTIVE MANAGEMENT SYSTEMS
At the core of supervisory monitoring under RBS is an assessment of quality of a banks’ procedure for evaluating, monitoring and managing risk, and of the banks internal models for determining economic capital. These models link capital to risk- taking and help banking for determining economic capital. These models link capital to risk- taking and help banking organization compare risk and returns across diverse business lines and locations. Since under the RBS supervisors, essentially, rely on the inputs provided by banks risk management system, the RBS can only be as only as effective as banks risk management systems. It is, indeed true that true that the risk management challenge for the banks has been steadily growing over the last two to three decades. This can be attributed to several developments in the financial sector like the deregulation of the financial market, banks diversifying into new business lines such as providing custodian services amongst others. For the success of RBS, it is imperative that, as part of their risk management frame work, banks are oriented towards identifying the path and passage of risk and towards pricing such risk appropriately.
1.1.6 THE NEED FOR AN EFFECTIVE MANAGEMENT INFORMATION SYSTEM
Talking about identification of risk their management and mitigation. But how many banks today can tell me the numbers of products and services they offer at their branches? Also, do they have an idea of the number of customers they have? I am not talking about numbers of accounts here. The difference between the two is that an account or ledger whiles the customer is a live individual. Can the customers tell me how many products and service each customer of their uses? If you don’t have such basic information, what kind of a risk management system can you develop? Unless you have a fair idea of the number products, numbers of customers, numbers of products and services per customer, cost of providing each customer each product/service, returns from providing each product/ service and the risk involved in each product or service, how do you decide on activity is remunerative and which is not? How do you decide on you product promotion and pricing strategies unless this information are readily available? Why certain products when there is no demand for them, after all there is a cost attached to product promotion. As banks are perceived to offering identical problems and services, how do the board / top management set about differentiating their banks from others, unless they have such basic granular details?
Under RBS, it is essential for banks to have capability and infrastructure to support a robust and reliable MIS infrastructure, with data integrity. A data warehouse wherein data flows from the transactional system without manual intervention and is capable of generating various MIS reports on all major activities of the bank (including activity- wise/segment- wise analysis) is one of the prerequisites for effective risk management. In the absence of a reliable MIS, it would be a near impossible task for the bank management to get a true and fair picture of the quality of assets, earning, etc.
1.1.7 RISK BASED PRICING OF PRODUCT AND SERVICES
Risk- based pricing means determining loan pricing based on the expected loan risk. Typically, a borrower’s credit risk is used to determine whether a loan application should be accepted or declined. The same risk level could be used to determine the optimal pricing, this, essentially, translates to higher interest rate for a borrower with higher risk and a lower rate for a lower risk borrower. Most large banks with suitable risk management and measurement architecture normally have some forms of risk- based pricing strategies based on the measure of probability of default. This is often and not apparent in small and middle sized banks due to lack of strategy process and technology to drive consistent result across various loans portfolios. Banks without a formal risk- based pricing approach, typically, use a flat- rate pricing models. The inherent problem with pricing with flat- rate pricing is that the bank will end up having a higher share of lower credit quality loans since the higher credit quality borrowers can obtain better pricing at other banks (those offering risk- based pricing).
Banks are required to maintain capital to cover the risk they assume (Elliott, Bank Liquidity Requirements: An Introduction and Overview, 2014). As capital always comes at a cost, they need to have a differentiated risk- based framework for pricing of products and services. This involves costing, a quantitative assessment of revenue streams from each segment, activity product and services, and an efficient transfer pricing mechanism, which will determine capital allocation. Each business unit in the enterprise would have to aim at being a profit center with the overall risk return framework (Garry Stone, 2014). In essence, it will mean accountability for profit tempered by discipline of risk- return, within an embedded culture of governance, the tone of which is set by the bank’s top management. From a business perspective, pricing of asset assets should be non- discriminatory, and in line with risk rating of customer. A lower rated customer should not get a better than a higher rated customer.
1.1.8 ROLE OF AUDITORS AND RISK FOCUSED INTERNAL AUDIT
The global financial crisis has under scored the need for financial statements to contain information that is absolutely unbiased and reliable so as to provide transparency to all stakeholders (Hassan, 2010). High quality financial reporting is of critical importance to prudential regulators and this has been emphasized by the Basel Committee of Banking Supervision (BCBS) in the guiding principles enunciated by it in august 2009. Transparency in financial statements is a pre- condition for financial stability and is the lack of transparency that allowed the building up of huge risk in of balance sheet position of many institutions during global financial crisis (Kohn, 2011). In this context the role of auditors becomes very crucial in ensuring in ensuring that the financial statement reflects a true and unfair picture of the affairs of the entity and that they declare the appropriate risk profile as required by certain accounting standards (Chakrabarty K. C., 2013).
1.2 RESEARCH PROBLEMS
Banking supervision is implemented to ensure an efficient and safe financial system in the economy. The measures are mainly concerned with the quality of risk and asset in the banks, compliance with key ratios such as liquidity ratio, Cash reserve ratio, capital adequacy ratio amongst others, but this study gives special considerations are to liquidity ratio and credit ratio. As liquidity is essential in the operations of any bank and lack of liquidity is a big problem which can lead to the liquidation of the bank. Credit is also essential in banking activities as it the process of stimulating the economy, leading to growth and development, but credit- spillover is a big challenge for the banks. The quality of management and other corporate governance is another problem. However, inadequate supervisory framework and lack of an effective risk asset data base and information sharing system has contributed in no small measure in disrupting the activities of the banks, thereby leading to the often distasteful incidence of banking distress and liquidation by the regulators.
In accordance with the this problem, various banking legislation/act acts have been promulgated as well as the introduction of different strategies all aimed at increasing the efficiency of banking regulatory supervision. Amongst them are on site and off site regulatory banking examination, routine examination, special examinations aimed at increasing the public confidence in the banking system by ensuring credit facilities are paid in due time which fuels liquidity and ensure smooth running of the banks.
1.3 SIGNIFICANCE OF THE STUDY
This study is significant in the sense that it will help the financial institutions know the impact of banking supervision/regulation on the banks credit and the liquidity ratio of the banks, which are fundamental in the efficient running of any bank. It is also imperative to state that a study of this nature provides an independent platform through which the regulators can appraise fundamental tools for supervision in a bid to make reasonable adjustment where necessary. The significance of this study will be of great benefit not only to the Nigerian banking industry and related institution but also to the public the economy as a whole (BRENDAN, 2012). According to ADEKOLA who checked the impact of banks profitability on the Nigerian gross domestic product arrived with the conclusion that a direct relationship exist between interest rate and GDP (ADEKOLA, 2016). This which simply means that higher interest rate implies bank profitability and a robust economy while high GDP means high increase in the total production in the country in a year.
