Analyzing and Managing Banking Risk

This is the second edition of this book which considers issues involved in the assessment, analysis, and management of financial risks in banking. It highlights risk-management principles and the accountability of key players in corporate governance process, as well as discussing transparency in bank's financial statements. It also contains new material including chapters on the management of the treasury function, management of a stable liquidity investment portfolio, and a discussion of proprietary trading activities and asset management liability components. A hardback version is also available (ISBN 0821354655) containing illustrative prototype software and Excel spreadsheets which can be adapted for banking diagnostic processes.

Sonja Brajovic Bratanovic is a senior financial sector specialist in the World Bank. Hennie van Greuning is currently a Senior Adviser in the World Bank's Treasury and has previously worked as a sector manager for financial sector operations in the Bank.

Foreword to the Second Edition

xiii

Acknowledgments

xv

1 Analyzing and Managing Banking Risk

1

(14)

1.1 Introduction: The Changing Bank Environment

1

(2)

1.2 Bank Exposure to Risk

3

(2)

1.3 Corporate Governance

5

(3)

1.4 Risk-Based Analysis of Banks

8

(3)

1.5 Analytical Tools Provided

11

(4)

2 A Context for the Risk-Based Review of Banks

15

(16)

2.1 Introduction: Why Banks Are Analyzed

15

(2)

2.2 Banks as Providers of Financial Information

17

(1)

2.3 A Framework for Financial Sector Development

18

(6)

2.4 A Holistic View of the Entire Financial System

24

(3)

2.5 Disclosure and Transparency of Bank Financial Information: A Prerequisite far Risk-Based Analysis

27

(4)

3 Key Players in the Corporate Governance and Risk Management Process

31

(28)

3.1 Introduction: Corporate Governance Principles

31

(2)

3.2 Regulatory Authorities: Establishing a Corporate Governance and Risk Management Framework

33

(2)

3.3 Supervisory Authorities: Monitoring Risk Management

35

(3)

3.4 The Shareholders: Appointing the Right Policymakers

38

(2)

3.5 The Board of Directors: Ultimate Responsibility for a Bank's Affairs

40

(6)

3.6 Management: Responsibility for Bank Operations and the Implementation of Risk Management Policies

46

(5)

3.7 The Audit Committee and Internal Auditors: An Extension of the Board's Risk Management Function

51

(2)

3.8 External Auditors: A Reassessment of the Traditional Approach of Auditing Banks

53

(3)

3.9 The Role of the General Public

56

(3)

4 Balance Sheet Structure and Management

59

(22)

4.1 Introduction: Composition of the Balance Sheet

59

(3)

4.2 Asset Structure: Growth and Changes

62

(5)

4.3 Liabilities Structure: Growth and Changes

67

(5)

4.4 Overall On- and Off-Balance-Sheet Growth

72

(4)

4.5 Managing Risk Effectively

76

(5)

5 Profitability

81

(20)

5.1 Introduction: The Importance of Profitable Banks

81

(2)

5.2 Income Statement Composition

83

(6)

5.3 Income Structure and Profit Quality

89

(7)

5.4 Profitability Indicators

96

(1)

5.5 Profitability Ratio Analysis

97

(4)

6 Capital Adequacy

101

(34)

6.1 Introduction: The Characteristics and Functions of Capital

102

(2)

6.2 Constituents of Regulatory Capital (Current Methodology)

104

(4)

6.3 Coverage of Risk Components by Constituents of Capital (Current Methodology)

108

(5)

6.4 Basel II: Proposed Changes for Determining Capital Adequacy

113

(8)

6.5 Implementation of the Basel Accord

121

(2)

6.6 Assessing Management Information with Respect to Capital Adequacy

123

(7)

Annex to Chapter 6

130

(5)

7 Credit Risk Management

135

(32)

7.1 Introduction: Components of Credit Risk

135

(1)

7.2 Credit Portfolio Management

136

(4)

7.3 Review of Lending Function and Operations

140

(2)

7.4 Credit Portfolio Quality Review

142

(4)

7.5 Nonperforming Loan Portfolio

146

(5)

7.6 Credit Risk Management Policies

151

(3)

7.7 Policies to Limit or Reduce Credit Risk

154

(5)

7.8 Asset Classification

159

(5)

7.9 Loan Loss Provisioning Policy

164

(3)

8 Liquidity Risk Management

167

(22)

8.1 Introduction: The Need for Liquidity

167

(2)

8.2 Liquidity Management Policies

169

(3)

8.3 The Regulatory Environment

172

(3)

8.4 The Structure of Funding: Deposits and Market Borrowing

175

(2)

8.5 Maturity Structure and Funding Mismatches

177

(4)

8.6 Deposit Concentration and Volatility of Funding

181

(1)

8:7 Liquidity Risk Management Techniques

182

(7)

9 Treasury Organization and Risk Management

189

(32)

9.1 Introduction: Overview of Treasury Functions

189

(3)

9.2 Establishing the Overall Policy Framework

192

(7)

9.3 Market Operations

199

(2)

9.4 Risk Analytics and Compliance

201

(6)

9.5 Treasury Operations

207

(6)

9.6 Corporate Governance and Operational Risk Assessment

213

(8)

10 Management of the Stable Liquidity Investment Portfolio

221

(10)

10.1 Nature of the Stable Liquidity Investment Portfolio

221

(2)

10.2 Investment Policy

223

(1)

10.3 Eligible Instruments

224

(1)

10.4 Credit Risk

224

(1)

10.5 Market Risk

225

(1)

10.6 Benchmark Portfolio

225

(2)

10.7 Active Management

227

(1)

10.8 Risk Management and Risk Budgets

228

(1)

10.9 Management Reporting

229

(2)

11 Market Risk Management and Proprietary Trading

231

(18)

11.1 Introduction: Market Risk Characteristics

231

(3)

11.2 Portfolio Risk Management Policies

234

(3)

11.3 Trading Book and Management of Trading Activities

237

(3)

11.4 Market Risk Measurement

240

(4)

11.5 Value at Risk

244

(2)

11.6 Stress Testing

246

(3)

12 Interest Rate Risk Management

249

(12)

12.1 Introduction: Sources of Interest Rate Risk

249

(3)

12.2 Risk Management Responsibilities

252

(1)

12.3 Models for the Management of Interest Rate Risk

253

(5)

12.4 The Impact of Changes in Forecast Yield Curves

258

(3)

13 Currency Risk Management

261

(20)

13.1 Introduction: Origin and Components of Currency Risk

261

(2)

13.2 Policies for Currency Risk Management

263

(7)

13.3 Currency Risk Exposure and Business Strategy

270

(4)

13.4 Currency Risk Management and Capital Adequacy

274

(7)

14 Transparency in the Financial Statements of Banks

281

(16)

14.1 Introduction: The Importance of Useful Information

281

(2)

14.2 Transparency and Accountability

283

(2)

14.3 Transparency in Financial Statements

285

(5)

14.4 Disclosure in the Financial Statements of Banks

290

(3)

14.5 Deficiencies Found in Bank Accounting Practices

293

(4)

15 The Relationship between Risk Analysis and Bank Supervision

297

(26)

15.1 Introduction: The Bank Supervisory Process

297

(1)

15.2 The Analytical Review Process

298

(6)

15.3 Banking Risks and the Accountability of Regulatory/Supervisory Authorities

304

(3)

15.4 The Supervisory Process

307

(7)

15.5 Consolidated Supervision

314

(5)

15.6 Supervisory Cooperation with Internal and External Auditors

319

(4)

Appendixes

1 Background Questionnaire to Facilitate Analysis of Banks

323

(36)

2 IAS-Required Disclosure in Financial Statements, by Risk Category

359

(6)

3 Deficiencies Found in Accounting Practices

365

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Analyzing and Managing Banking Risk

Summary

Author Biography

Table of Contents

Supplemental Materials