Analyzing Banking Risk: A Framework for Assessing Corporate Governance and Financial Risk, 3rd Edition

Contents......Page 7
Foreword to the Third Edition......Page 15
Acknowledgments......Page 17
1.1 Introduction: The Changing Bank Environment......Page 19
1.2 Bank Exposure to Risk......Page 21
1.1 The Banking Risk Spectrum......Page 22
1.4 Risk-Based Analysis of Banks......Page 25
1.5 Analytical Tools Provided......Page 28
2.1 Financial Management......Page 31
2.2 Why Banks Are Analyzed......Page 34
2.3 Understanding the Environment in Which Banks Operate......Page 35
2.4 The Importance of Quality Data......Page 42
2.5 Risk-Based Analysis of Banks......Page 45
2.6 Analytical Tools......Page 47
2.7 Analytical Techniques......Page 52
3.1 Corporate Governance Principles......Page 59
3.2 Major Developments in Corporate Governance Principles......Page 62
3.3 Regulatory Authorities: Establishing a Risk-Based Framework......Page 64
3.4 Supervisory Authorities: Monitoring Risk Management......Page 66
3.5 The Shareholders: Appointing the Right Policy Makers......Page 69
3.6 The Board of Directors: Ultimate Responsibility for a Bank’s Affairs......Page 71
3.5 Accountability of Bank Management......Page 77
3.8 The Audit Committee and Internal Auditors: An Extension of the Board’s Risk Management Function......Page 82
3.9 External Auditors: A Reassessment of the Traditional Approach of Auditing Banks......Page 84
3.10 The Role of the General Public......Page 85
Annex 3A: National Initiatives to Improve Corporate Governance......Page 89
4.1 Introduction: Composition of the Balance Sheet......Page 99
4.2 Bank Assets......Page 102
4.3 Bank Liabilities......Page 106
4.4 Equity and Other Items......Page 110
4.5 Growth and Changes in the Balance Sheet......Page 112
4.4 Structural Change and Growth of Capital and Liabilities......Page 114
5.1 Profitability......Page 119
5.1 Income Statement Composition......Page 121
5.3 Analyzing the Sources of Banking Income......Page 125
5.2 Restructured Income Statement......Page 127
5.4 Operating Income Ratios......Page 131
5.6 Assessing Internal Performance......Page 136
6 Capital Adequacy......Page 139
6.1 Introduction: The Characteristics and Functions of Capital......Page 140
6.2 Capital Adequacy Standards and the Basel Accords......Page 141
6.2 Overview of Qualifying Equity Instruments......Page 145
6.4 Risk-Based Regulatory Capital Allocation: Pillar 1......Page 149
6.5 Supervisory Review: Pillar 2......Page 161
6.6 Market Discipline: Pillar 3......Page 163
6.7 Management of Capital Adequacy......Page 164
6.8 Analysis of a Bank’s Capital Adequacy......Page 165
Annex 6A: Credit Risk–Related Weight Assignments Under the Basel I Accord, Covered by Tier 1 and Tier 2 Capital......Page 171
Annex 6b: Calculation of the Capital Adequacy Ratio to Include Market Risk (Tier 3 Capital)......Page 174
7.1 Establishing Policies for Managing Credit Risk......Page 179
7.2 Regulatory Policies to Limit Exposures......Page 180
7.3 Management Policies to Reduce Credit Risk......Page 184
7.4 Analyzing Credit Risk......Page 189
7.5 Asset Classification and Loan Loss Provisioning......Page 195
7.6 Assessing Credit Risk Management Capacity......Page 205
8.1 The Need for Liquidity......Page 209
8.2 Liquidity Management Policies......Page 213
8.3 The Regulatory Environment......Page 216
8.4 The Structure of Funding......Page 219
8.5 Cash Flow Analysis......Page 221
8.6 Volatility of Funding and Concentration of Deposits......Page 225
8.7 Liquidity Risk Management Techniques......Page 227
9.1 Nature of the Liquidity Portfolio......Page 233
9.2 Investment Policy......Page 234
9.3 Strategic Asset Allocation......Page 235
9.4 Benchmark Portfolio......Page 237
9.1 Examples of U.S. Dollar Market Indices......Page 239
9.2 Credit Risk in Liquidity Portfolios......Page 240
9.8 Active Management......Page 241
9.9 Risk Budgets......Page 243
9.3 Market-Risk Management Tools......Page 244
10.1 Sources of Market Risk: Selected Concepts......Page 245
10.2 Measuring Interest Rate Sensitivity......Page 249
10.3 Portfolio Risk Management......Page 253
10.4 Market Risk Measurement: Value at Risk (VAR) as a Possible Tool......Page 256
10.5 Risk and Performance Measurement......Page 264
10.6 Stress Testing and Scenario Analysis......Page 269
11.1 Introduction: Origin and Components of Currency Risk......Page 273
11.2 Policies for Currency Risk Management......Page 275
11.3 Currency Risk Exposure and Business Strategy......Page 282
11.4 Review of Currency Risk Management Procedures......Page 286
12.1 Objective of Asset-Liability Management......Page 295
12.1 ALM Objective......Page 298
12.3 Models for the Management of Interest Rate Risk in the Balance Sheet......Page 300
12.3 Current and Forecast Yield Curves......Page 308
13 Operational Risk Management in a Treasury Environment......Page 311
13.1 Operational Risk Management and the Basel Committee Initiatives......Page 312
13.2 A Framework for Managing and Reporting Operational Risk......Page 318
13.3 Identification of Business Line Functions and Activities......Page 324
13.1 Trade Process Flow—From Risk-Analytics Perspective......Page 326
13.5 Risk Assessment: Contribution of People, Processes, Systems, and External Events......Page 327
13.6 Control Assessment......Page 330
13.7 Difference between Metrics and Indicators......Page 333
13.8 Operational Risk Reporting: Analysis, Actions, and Accountability......Page 338
Annex 13A. Overview of Functions and Activities in a Treasury Environment......Page 343
14.1 Introduction: The Importance of Useful Information......Page 357
14.2 Transparency and Accountability......Page 359
14.3 Transparency in Financial Statements......Page 361
14.1 Transparency in Financial Statements......Page 365
14.5 Application of Accounting Standards......Page 370
15.1 Introduction: The Bank Supervisory Process......Page 375
15.2 Banking Risks and the Accountability of Regulatory/Supervisory Authorities......Page 379
15.3 The Supervisory Process......Page 382
15.4 Consolidated Supervision......Page 391
15.5 Supervisory Cooperation with Internal and External Auditors......Page 395
A Questionnaire: Analytical Review of Banks......Page 397
B Summary of Core Principles Evaluation......Page 431
C Basel Core Principles for Effective Banking Supervision October 2006......Page 435
3.1 Corporate Governance for Banking Organizations......Page 63
3.2 A View Opposing On-Site Examination of Banks......Page 68
3.3 Board of Directors: Effective Exercise of Duties......Page 73
3.4 The Board’s Financial Risk Management Responsibilities......Page 76
3.6 “Fit and Proper” Standards for Bank Management......Page 79
3.7 Management’s Responsibilities with Regard to Financial Risk......Page 80
3A.1 OECD Principles of Corporate Governance (Revised)......Page 90
7.1 Contents of a Loan Review File......Page 193
7.2 Signs of a Distorted Credit Culture......Page 199
8.1 Principles for Sound Liquidity Risk Management and Supervision – Draft for Consultation......Page 210
8.2 Typical Liquidity Regulations or Internal Liquidity Guidelines......Page 218
10.1 VAR Calculation......Page 261
13.1 Basel Committee on Banking Supervision – Core Principle 15 – Operational Risk......Page 314
14.1 Criteria for Evaluating International Financial Reporting Standards......Page 362
2.1 A Framework for Financial Sector Development......Page 38
2.3 Trends in Asset Growth, by Period......Page 51
2.4 Assets Deployed versus Income Earned......Page 55
3A.1 COSO – Enterprise Risk Management Framework......Page 93
4.1 Composition of Bank Assets and Liabilities......Page 101
4.3 Changes in the Structure of a Bank’s Assets......Page 113
4.5 Total Growth of a Bank’s Assets and Capital......Page 116
4.6 Low-Earning and Nonearning Assets as a Percentage of Total Assets......Page 117
4.7 Off-Balance-Sheet Items as a Percentage of Total Assets......Page 118
5.1 Structure of Gross Income......Page 128
5.2 Assets Invested Compared with Income Sources......Page 129
5.3 Sources of Income versus Costs......Page 130
5.6 Return on Assets (ROA) and Return on Equity (ROE), Adjusted for the Cost of Capital......Page 135
6.1 Conceptual Framework for the Basel II Accord......Page 143
6.2 Basel II: Menu of Credit Risk Assessment Options......Page 150
6.3 Supervisory Review: Pillar 2 Components......Page 162
6.4 Components of a Bank’s Capital Structure......Page 166
6.5 Risk Profile of On- and Off-Balance-Sheet Items......Page 168
6.6 Actual versus Required Capital......Page 169
6.7 Estimating Potential Capital Requirement......Page 170
7.1 Exposure to Top 20 Clients......Page 182
7.1 Related Party Lending......Page 183
7.3 Sectoral Analysis of Loans......Page 186
7.4 Customer Profile: Who We Are Lending To......Page 190
7.5 Customer Loans by Product......Page 191
7.6 Maturity of Loans to Customers......Page 192
7.7 Loan Portfolio Statistics......Page 198
8.1 Statutory Liquidity Required versus Actual Liquid Assets Held......Page 217
8.2 Deposit Sources......Page 220
8.3 Liquidity Mismatches......Page 222
8.4 Maturity Profile of Deposit Base......Page 223
8.5 Cash Flows (Derived from Cash Flow Statement)......Page 224
8.7 Funding Concentration......Page 226
8.3 Liquidity Ratios......Page 230
9.1 Benchmarking: Link between Strategic Asset Allocation and Portfolio Management......Page 238
9.2 Portfolio Management Styles......Page 242
10.1 Illustration of Nonparallel Shifts in the Yield Curve......Page 250
10.2 Duration as an Indicator of Interest Rate Risk in a Portfolio......Page 251
10.3 Monitoring Market Presence......Page 255
10.1 Simplistic Calculation of Net Open Positions......Page 259
11.1 Currency Structure of Assets and Liabilities......Page 283
11.2 Currency Structure of Loan Portfolio and Customer Deposits......Page 284
11.3 Freely Convertible Currency Deposit Maturities as a Percentage of Total Customer Deposits......Page 290
11.5 Maximum Effective Net Open Foreign Currency Position as a Percentage of Net Qualifying Capital and Reserves......Page 291
12.1 Net Interest Income Sensitivity......Page 306
12.2 Equity Sensitivity to Interest Rates (EVE)......Page 307
12.4 Potential Effect on Capital as a Result of a Movement in Interest Rates......Page 309
13.2 Sample Operational Risk Management Report......Page 340
15.1 The Context of Bank Supervision......Page 377
15.2 Supervisory Tools......Page 385
1.2 Partnership in Corporate Governance of Banks......Page 24
1.3 Possible Uses of Tools Provided......Page 30
2.1 Balance Sheet Structure: Common Size Analysis......Page 54
2.2 Cross-Sectional Analysis of Two Different Bank Balance Sheet Structures......Page 56
2.3 Balance Sheet Growth, Year-on-Year Fluctuations......Page 57
3.1 Key Players and Their Responsibilities......Page 61
3.2 Shareholder Information......Page 70
3A.1 COSO Enterprise Risk Management Framework......Page 95
4.1 Balance Sheet Assets......Page 103
4.2 Balance Sheet Liabilities......Page 107
4.3 Components of a Bank’s Equity......Page 111
4.4 Total Growth of Balance Sheet and Off-Balance-Sheet Items......Page 115
5.3 Profitability Ratios......Page 132
6.1 Summary of the Basel II Accord......Page 144
6.3 Standardized Approach: Risk Weights under the Basel II Accord......Page 152
6.4 IRB Approach: Risk Weights for Unexpected Losses (UL) for Specialized Lending......Page 154
6.5 Operational Risk: Business Lines and Operational Loss Events Types......Page 160
6A.1 Credit Risk Multiplication Factors for Derivative Instruments......Page 173
6B.1 Calculating the Allowable Portion of Tier 3 Capital......Page 177
7.2 Loan Portfolio Statistics......Page 197
7.3 Recommended Loan Loss Provisions......Page 204
8.1 Maturity Profile of Assets and Liabilities (Liquidity Mismatches)......Page 214
8.2 Maturity Ladder under Alternative Scenarios......Page 228
10.2 Reporting Performance and Market Risk: Portfolio versus the Benchmark......Page 265
10.3 Interest Rate Sensitivity of a Portfolio versus the Benchmark......Page 267
10.4 Sensitivity of a Portfolio to Widening of Credit Spreads versus the Benchmark......Page 268
10.5 Current Portfolio Price Movements during Major Historic Market Crises......Page 270
11.1 Currency: Reporting Net Effective Open Position......Page 288
12.1 A Repricing Gap Model for Interest Rate Risk Management......Page 302
13.1 Basel II Operational Risk Business Lines and Risk Event Types......Page 317
13.2 ERM Model Expanded to Include Enterprise Functions Required to Complete the Life Cycle of a Transaction for a Business Line......Page 319
13.3 Operational Risk Management......Page 322
13.4 Securities Trading (Business Line) Functions and Activities......Page 325
13.5 Risk Assessment: Questions for Each Functional Activity—Linked to Basel and ERM Models......Page 329
13.6 Control Assessment Questions......Page 332
13.8 Determination of Metrics for Inclusion as KPIs and KRIs......Page 337
13.9 Design of Dashboard—Input Table to Facilitate Analysis......Page 342
14.1 Measurement of Financial Assets and Liabilities under IAS 39......Page 367
14.2 Financial Risk Disclosure Requirements under IFRS 7v......Page 369
14.3 Public Disclosures by Banks......Page 373
15.1 Stages of the Analytical Review Process......Page 378
15.2 Banking Risk Exposures......Page 380
15.3 Off-site Surveillance versus On-site Examination......Page 386
15.4 Generic Features of Early Warning Systems......Page 390