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THE IMPACT OF RISK MANAGEMENT ON THE PROFITABILITY OF BANKS IN NIGERIA
CHAPTER ONE
INTRODUCTION
1.1 Background of the Study
Risk Management is the identification assessment and prioritization of risks. It is the effect of uncertainty on objectives, whether positive or negative followed by coordinated and economic of application of resources to monitor and control the probability and/or impact of unfortunate events or to maximize the realization of opportunities (Okeh, 2006).
The survival of every commercial bank depends on its ability to manage its risks and loans or advance portfolio effectively. However in the recent past, commercial banks in Nigeria witnessed rising non-performing credit portfolios and these significantly contributed to the financial distress in the banking sector.
Financial organization need to manage the credit risk inherent in the entire portfolio as well as the risk in individual credit or transaction. This is so because the survival and ability of financial institution to compete depend on their ability to profitability and manage credit risk. This is the reasons why lending is based on the two fundamental products of banking: money and information. Banks obtain these products from customers themselves by offering customer valuable services. They package money and information about their borrowers together with valuable banking services to create loan agreements and sell the loan agreements back to their customers (Hempel and Simonson, 2007).
As such, risk rating system in financial institution contains both objective and subjective elements. Objective aspect are based on financial statements and application of certain financial ratio that reflect liquidity, leverage and earnings. Despite the requirement that risk be quantified, risk rating systems always have a subjective dimension that attempts to capture intangibles such as the quality of management, the borrower’s status within the industry, and the quality of financial reporting. These subjective items may result in inconsistencies.
It is in this regard that many financial institutions have faced difficulties over the years arising from their inability to effectively manage credit risk. As such the major cause of serious banking problems continues to be directly related to tax credit standard for borrowers and counterparties, poor portfolio risk management, or lack of attention lead to a deterioration in the credit standard of a bank’s counterparties.
Hence, the need to investigate the subject matter of this research becomes imperative.
Concept of Credit
Credit is defined by the Economist Dictionary of Economics as “the use or possession of goods or services without immediate payment” and it “enables a producer to bridge the gap between the production and sale of goods” and “virtually all exchange in manufacturing, industry and services is conducted on credit”.(Colquitt 2007)
Consequently, credit generates debt that a party owes the other. The former is called a debtor or borrower. The latter is a creditor or lender. Certainly the debtor will have to pay an extra amount of money for delaying the payment. In that circle, both debtor and creditor expect a return which is worth their paying more and waiting, respectively.
Debtor Creditor: Pays the creditor extra money earned from reinvestments of the credit amount Gives the debtor time and takes back a return for supplying the credit So now it is clear why credit exists and how important it is to the economy. Firms or individuals that run short of capital need credit to continue or expand their businesses/investments. The ones that have excess money, on the other hand, never want to keep it in the safes. As a result, all are growing and making more money.
Demand and supply together exist but do they meet each other? Here borne financial intermediaries who act as the bridge between credit suppliers and clients.
Now in this innovative phase of the global financial-services industry, numerous types of financial institutions have joined the credit supplier group: insurance companies, mutual funds, investment finance companies, etc. (Colquitt 2007, 2)
Nevertheless, banks are still the dominant source that both individuals and corporates seek credit from.
In banking specifically, two primary kinds of credit services based on customer categories are offered: retail credit and wholesale credit. Lending in retail or personal banking are subject to individuals and may fall under: home mortgages, installment loans (e.g. consumer loans, educational loans, auto loans…), credit card revolving loans, revolving credits (e.g. overdrafts), etc. (Crouhy et al. 2006, 207-208). Wholesale lending, on the other hand, involves firms as the borrowers and therefore is of much higher value, more complicated and poses more threats to the banks.
Concept of Credit Risk
Quite often in the previous sections of this paper, credit risk has been mentioned or even defined. However, it still needs to be repeated from a deeper point of view. Basically, it is understandable that credit risk occurs when the debtor cannot repay part or whole of the debt to the creditor as agreed in the mutual contract. More formally, “credit risk arises whenever a lender is exposed to loss from a borrower, counterparty, or an obligor who fails to honor their debt obligation as they have agreed or contracted”. This loss may derive from deterioration in the counterparty’s credit quality, which consequently leads to a loss to the value of the debt. (Colquitt 2007) Or in the worst case, the borrower defaults when he/she is unwilling or unable to fulfill the obligations (Crouhy et al. 2006).
Risks in Banks
Risks are the uncertainties that can make the banks to loose and be bankrupt. According to the Basel Accords, risks the banks facing contain credit risk, market risk and operational risk. Credit risk is the risk of loss due to an obligator’s non-payment of an obligation in terms of a loan or other lines of credit. The Basel committee proposes two methodologies for calculating the capital requirements for credit risk, one is to measure the credit risk in a standardized manner and the other is subject to the explicit approval of the bank’s supervisor and allows banks to use the IRB approach. Market risk is defined as the risk of losses in on and off-balance sheet positions arising from movements in market prices. The capital treatment for market risk addresses the interest rate risk and equity risk pertaining to financial instruments, and the foreign exchange risk in the trading and banking books. The value at risk (VaR) approach is the most preferred to be used when the market risk is measured. Operational risk is defined as the risk of direct or indirect loss resulting from inadequate or failed internal processes, people and systems or from external events. There are three approaches applied to the operational risk measurement: Basic Indicator Approach (BIA), Standardized Approach (SA), and Advanced Measurement Approach (AMA).
The banking business, compared to other types of business, is substantially exposed to risks, especially in this ever-changing competitive environment. Banks no longer simply receive deposits and make loans. Instead, they are operating in a rapidly innovative industry with a lot of profit pressure that urges them to create more and more value-added services to offer to and better satisfy the customers.
Risks are much more complex now since one single activity can involve several risks. Risks are inside risks. Risks overlap risks. Risks contain risks. Scholars and analysts in recent decades have been trying to group banking risks into categories. The Basel Accords issued by the Basel Committee on Bank Supervision mention three broadest risk types in the first pillar: credit, market and operational risks. Then the second pillar deals with all other risks. Anthony (2009) categories risks into six generic kinds: systematic or market risk (interest rate risk), credit risk, counterparty risk, liquidity risk, operational risk, and legal risks. This categorization is based on types of services offered by banks. (The Wharton Financial Institutions Center 2007) But the risks seem to be insufficient and some overlapping can be found. Counterparty risk and credit risk are quite alike or the list lacks country risks, for example.
Another classification that is quite comprehensive though not particularly aims at banks only is introduced in “The Essentials of Risk Management” (2006) by Michel Crouhy, Dan Galai and Robert Mark.
Risk Management in Banks
As mentioned above, “risk is always bad as a false assumption and can mislead the way people deal with risks. Eliminating each and every risk definitely is not the way because risk is an unavoidable element of life. Moreover there is a special relationship between risk and reward. If you want a higher rate of return, be willing to take risks and be tolerant of risks is a must. “The greater the risk, the greater the gain.” (Spanish Proverb). “He who doesn‟t risk never gets to drink champagne.” (Russian Proverb) (Book Rags 2010)
The point is people know how to cope with, or in other words how to control risks properly, responsibly, and in a business context, profitably, beneficially and sustainably. That is the question risk management must answer. Ordinary people also manage risks in different ways. Nevertheless, risk management in organizations is more concerned. Like risk, risk management has been attempted to define in various ways. It may take pages to list all the definitions from the literature. But there is one definition from the International Organization for Standardization (ISO) that is typical and covers most of general issues: “Risk management is a central part of any organization’s strategic management. It is the process whereby organizations methodically address the risks attaching to their activities with the goal of achieving sustained benefit within each activity and across the portfolio of all activities.” (IRM, 2002: )
The three key phrases in the sentences above are in bold. First, risk management’s primary mission is to bring benefits to the companies and makes them sustainable. Second, risk management is at the heart of any firm’s strategy. The significance of risk management in an organization’s activities was surprisingly ignored for a long time. It used to be regarded as no more than insurance. It only started to catch attention from business top executives in the 1990s after the enormous derivatives disasters triggered in the United States that shook Barings Bank, Procter & Gamble, Gibson Greetings, government of Orange County – California, BankAmerica Corp. and many other giants with loss of billions of dollars. (Culp, 2001: ix; Markham, 2002: 198-201). Third, risk management is an ongoing and continuously developing process.
The need for risk management in the banking sector is inherent in the nature of the banking business. Poor asset quality and low levels of liquidity are the two major causes of bank failures. During periods of increased uncertainty, financial institutions may decide to diversify their portfolios and/or raise their liquid holdings in order to reduce their risk. In terms of credit risk management, the goal is to maximize a bank’s risk-adjusted rate of return by maintaining credit risk exposure within acceptable parameters and the maximization of shareholder value. Banks need to manage the credit risk inherent in the entire portfolio as well as the risk in individual credits or transactions. Banks should also consider the relationship between credit risk and other risks, for example, the relationship between credit risk, interest risk, liquidity risk, and market risk. The effective management on credit risk is a critical component of a comprehensive approach to risk management and essential to long-term success of any banking organization.
Undeniably banking risk management in the modern business world takes place in such a great scale and unexpected manner. On the one hand, the creation and development of a number of risk instruments allow higher risk diversification, better prediction and more effective solutions to the potential dangers in the global financial market. On the other hand, growing interactions among financial institutions in the world make room for a possible sequential effect if something goes wrong. The consequences might be “far beyond the doors of the banks and investors themselves”. (Utrecht University 2010)
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