David Roden on banking sector risk management

The CBSL’s directive issued last year, which takes into account credit, market, operational and liquidity risk, is very much in line with the recommendations of the Bank of International Settlements (BIS), which recommends in particular capital adequacy for government banks, said internationally-renowned risk consultant and CEO/Principal of Independent Global Research Ltd. David Roden.

Addressing the banking community at an event organised by Capital Alliance yesterday, Roden stated that BIS had set three pillars on risk management. “The first is the minimum capital requirement or the capital adequacy of bank,” he said. “Over the last 10 years two new pillars have been introduced to increase transparency in the banking sector and create industry pressure on weaker banks to improve their actions. The two new areas are information (or disclosure of risks) and market discipline (if banks are perceived to have weaker counterparts, they will have more trouble getting trade lines in to bank funding and running their day to day business.)”

Commenting on properties of risks, Roden stated that banks had a number of risks but the key solution in managing was to ask the right questions. “We need to ask if the risks are desirable, measurable, manageable and controllable. In market risks and credit risks, the answer is a yes to all questions. However, when it comes to operational risks, the first two is a ‘no’. It is a very different animal from market and credit risks.”

Listing the key risks faced by the market, he mentioned liquidity risks which could be measured in a stock approach or on a cash flow approach, interest rate risks which can be analysed by its parallel shift in the yield curve or the twisting of the yield curve and operational risks, the most important in the market. Acknowledging it as an “endless nightmare,” he also cited systematic risks.

Following are excerpts from an interview with the Daily FT following the event:

By Cheranka Mendis

Q: In which position is Sri Lanka at present, in relation to risk management and measurement?

A: Sri Lanka has a relatively simple position. They are not allowed to and it is difficult to sell short. The positions therefore are relatively straight forward.

But in my opinion, in the context of the economy, banks are quite important and need to get bigger with the economy. Banks will have to take on larger exposures like lending and US$-Sri Lankan Rupee exposure, along with a number of other factors that need to be managed.

Q: As banks invariably get larger, what should we look out for?

A: As banks get larger, understanding the size of the risk of the associates becomes very important because the key responsibility of a bank is to ensure they have sufficient capital at all times to support their positions and exposures.

They also have the responsibility to measure actual exposure and ensure that sufficient capital is in place. These are very important.

Operational risks fall under this because it is a risk to banks and minimalising it is a way of reducing economic capital in the business. If you are comfortable that you have operational risks under control, you don’t have to say we need a billion rupees just in case someone makes a mistake on a contract.

The culture of risk management – be it market risk, credit risk, operational risk or liquidity – is important to banks as they have to operate in an economy which is growing.

Q: What are the main risk issues for Sri Lanka?

A: I think the main factor they are looking for is understanding the liquidity risk.

I am not saying Sri Lanka does not know how to do it, but what I am saying is that they should look at it more. The US$-Sri Lankan Rupee risk, again, is very important.

On credit exposures, by and large Sri Lankan banks do not have big market risk exposures currently, which will inevitably come. At the moment it is credit liquidity and operational risks that take priority.

Q: What should local banks do to manage risks better?

A: There is a lot going down in terms of operational risks, which is very important. Proper process of managing operational risks needs to be in place, which we see happening. If you read the annual reports of the banks, a number of them focus on operational risk exposure now.

Risk management should be inculcated permanently into the culture of the bank with a bit of an understanding of a risk management culture.

Very often, and this not only in Sri Lanka but all over the world, it is very easy for employees in the bank to categorise risk management as something required by the regulator and put it in a particular box and forget about it.

It is important for people to know that risk management is not something that should just keep the regulator happy; it is very important for the success of the bank.

Q: If a bank has not implemented risk management and assessment, how should it start?

A: The first step is to appoint someone senior at the bank as risk manager or head of risk. It is also important to keep risk management independent over other functions, otherwise it is difficult to make it work.

The head of risk management should look at the operations and decide on the key areas of exposure. Some banks might have a lot of market risks, in which case they will need a value risk model and focus on market risk management.

Other banks may have other market risks and focus should then be on operational, liquidity and credit risks.

By appointing a head of risk management and putting in place operational risk controls, procedures and controls and market credit liquidity risk models under him would benefit the bank.

They also need to be given the full cooperation of the senior management of the bank.