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Table of Contents

Banking Industry - Part 2


Chapter 2. Literature Review

2.1 Introduction

This chapter develops a comprehensive review of the literature related to the topic understudy. Literature review in the research can be defined as the foundation part in reference to which the research can be developed. The underlying chapter is aimed at covering the literature related to dynamic management of the exposure to the market risk.

In this section of study all the surrounding factors regarding the subject of report will be discussed. At the outset, the chapter also discusses about the understanding of the risk and the market risk in the banking sector. Afterwards, the components of risk in the banking industry have been discussed that are driving forces of the market risk. Role of staff and management in the banks in managing risk in operations has been discussed as well. The strategic managers' role in making policies and rules for reducing risk in the organization has been identified. The process of market risk management system will be discussed by a model along with a model of practical approach to defining appetite.

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2.2 Risk

Risk is defined as the possibility of loss and risk is present everywhere around and every activity or initiative is subject to risk with varying magnitude. Traditionally, shareholders and stakeholders were satisfied even in the extensive negative price volatility with explanation that some factors in the markets are unforeseeable and so deviations causing unfavorable movements in market prices from the expected prices or value are beyond the management control. In contrast to this traditional perspective, in the contemporary markets in general and financial market there are certain specific areas that require greater evaluation of the change possibilities (Bessis, 2011). In addition to this, there is an increased requirement for the managers to gain the insight and valuation of such risk exposures. Moreover, it is also expected that these risks are passed on to other parties or spread or even shared with other parties and hence it reduces the possible negative impact on single party (Bodnar and Gebhardt, 1998).

2.3 Risk Management in Banking Industry

Banking industry is dealing with risk and therefore risk taking and management of risk is extensively important domain for banking industry. This domain has gained an increased importance since the recent credit crunch of 2007-2008. Banks are required to take risk for generating competitive revenues for depositors. The risk taking in banking is required to develop mechanism where the returns are maximized with risks that are manageable within bank's capacity. Efficient mechanism are developed and used to deal with risk that these mechanisms help the banks in a sound financial position. The risk management systems in bank are concerned with developing sound strategy based on comprehensive system consisting of policies, procedures and tools for diversifying and mitigating risks (Jaafari, 2001). Combination of management insight, internal documentations, risk measuring, monitoring and controlling guideline followed by compliance check units are central units developed in every bank. Basel Committee in October 2006 developed international level guideline entitled “Core Principles for Effective Banking Supervision” as risk management framework for the banks to follow. The instructions are applied in the country specific scenario. After the economic down turn the Basel Committee issued revised version to enhance risk taking measures of banks. The revised version is entitled under the “Principles for Enhancing Corporate Governance” in October 2010 (Ernst & Young, 2012).

2.4 Components of Risks to Be Managed By Banks

There are many risks associated with each activity that financial institutions or banks do. Some of the core risks identified include market risk, credit risk, concentration risk, operational risk, model risk and settlement risk, counterparty risk and others. Market risk refers to the possibility of financial losses that arise due to market price movement in contrary to the anticipated direction. Factors contributing to the unexpected movement in prices can emerge from company specific, economic specific, exposure specific factors and other similar factors. Credit risk is the possibility of losses arising from the inability of debtor to meet the due obligation on time. Factors that contribute to this risk also range widely such as excessive debtor concentration, bankruptcy of the debtor etc. (Rosenberg & Schuermann, 2006).

Delayed or nonpayment from counter party affects the organizations' ability to meet its own liabilities as the company make payments as they receive payments. Concentration risk refers to the portfolio where big chunk of investment is invested in one category and hence the impact of any particular factors on that category has profound impact on the entire portfolio. Another category of risks to be accounted by the bank is the operational risk. The operational risk is related to the conduct of bank and it is immensely influence the bank and its operations (Bessis, 2011). Wide range of internal and external activities is concerned such as information leakages, communication issue and physical loss to the operational entity of the organization. Businesses including financial institutions use various models for financial assessment and assumptions made regarding the respective models; hence causing impact in valuation and resulting in risk. All these risks are influential on organizations' performance. Moreover, all these risks are not mutually exclusive and banks are prone to the mix of various risks all time (Iannotta, Nocera, & Sironi, 2007).

2.5 Managing Risk in Banking Industry

The risk management is a function that is to be followed across all departments in bank in one way or the other. The authorities and responsibilities delegated to the risk management staff and the strategic and middle level managers for controlling the factors of risk by working in coordination have its countable role in the risk management in banking. Irrespective of the format followed, the above sections and functions are present in every bank for developing the risk appetite assessment, implementation of strategies for risk management and evaluating the performance across the board on on-going basis.

2.6 Risk Management Framework

The risk management framework encompasses scope including the top management review followed by the development of internal policies and procedures. Based on these policies, the risk measurement system is developed constituting of sub sections accounting measurement, monitoring, reporting and evaluation processes for risk. To develop the concrete risk management system, the entire framework and respective activities are assessed by the compliance department (Cebenoyan & Strahan, 2004).


Management Oversight

Top management in banking industry alike other business is responsible for strategy development. Formulation of strategies in banks is extremely affected by the factors of market risk. The increased attention remains for the fact that impact on the products and services of the bank from risk factors are at higher magnitude than other industries. For instance, slight change in interest rate triggers greater impact on banking products of loan than other industries. Hence, top management of the bank is to set risk appetite for the bank for generating returns (McNeil, Frey, & Embrechts, 2010).

In addition to the core responsibility of setting the risk appetite the Basel committee has also defined the series of responsibilities for the top management to ensure that overall objective of the risk management is being pursued effectively.

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Internal Policies And Procedures

Banking industry is considered as one of the most regulated industries of the world. Importance of the effective and efficient policies and procedures was increasingly enhanced after the recent economic crisis. UK Chancellor of the Exchequer, George Osborne, stated about the importance of policies and procedures that policies and procedures are to be designed for the safeguard of businesses from uncertainties. George Osborne also clearly asserted the need of changing the policy and procedures in specific context to the banking businesses referring the losses made due to the banking decline for ensuring that instances like world banking crisis of 2007- 2008 does not happen again (Ernst & Young, 2012).

The policies and procedures for the banking business can be defined into two types; first the general practices and second being the specific considerations required. General considerations or practices for the risk management in banking requires employing and developing the set of objectives in order to ensure consistent alignment to the changing market as well as changing business dynamics. For this purpose, general practices require all banking setups to develop comprehensive tools and systems for ensuring continuous risk mitigation in due course and pattern as approved in the company plan. Banking industry uses general practice for risk mitigation to ensure that the entire banking operations such as all functional departments are aligned in driving the bank towards required return and at the same time with diversify the risk (Elsinger, Lehar, & Summer, 2006).

The other section requires developing policies and procedures referring to the risk mitigation systems in special consideration in the bank's context. Alike every industry banks can also be classified for their core areas of operations, size, products and so on. Based on these segregations and other characteristics of banks, the risk management system has to be aligned according to the specific needs of bank. The special considerations are centrally concerned for developing strategy for the banks to achieve the set rate of return from investment. The specific considerations also require banks to address the need of the bank with respect to level of sophistication in the risk assessment techniques, monitoring and evaluation systems. Some banks are required to integrate the multi-model assessment techniques such as stress testing, Monte Carlo, weighted systems and others. In addition to this, banks in order to ensure safety on the reputational risk level develop history of best practices to comprehend the market risk (Van Greuning & Bratanovic, 2009).

Under the above special considerations, banks set risk limits regarding exposures to be taken from the banking activity. The quantification of the risks provides bank with guidelines to develop revenue and return generating program while remaining within the defined limits.

Policies and procedures determine the bank's exposure at various levels. Levels in functional departments take exposures in various risk categories based on the limitations developed in the banking procedures and policies. These policies quantitatively ascertain the level of risk and respective limitations (Shen & Chih, 2005). Some of the risk exposure limitations are developed under the technique such as:

  • Value at risk (VaR) determines the risk limitation on the basis of sensitivity analysis for the maximum loss bearable as determined by the board of the bank.
  • With tenor of gap limit the risk is mitigated by imposing limitation on the level of exposure to be consistently taken in the similar avenue. The limitation controls the risk exposure for the volatility in cost and revenue from the investment and ensures smooth incorporation of market factors.
  • Risk mitigation policy determines the loss of control and it refers to taking over of charge from upper level management in case the excessive exposure than limit defined has been taken in the particular avenue. Such policies also ascertain the approval related information for taking exposure beyond the banks' policy.
  • Concentration of investment in any avenue is also well exposed in the policies of the banks. For instance, the option limit determines the tolerable level of investment in options and similarly the product concentration limit determines the level of risk exposure in set of products.

Hence, these limits as well as procedures provide guidelines to the functioning units of the banks. In addition, these limits are also to be developed in compliance with the regulatory authority of the country.


Systems and Processes

Banking industry by nature is regarded as high technicality orientation. This technicality and complexity of banking industry has increased in recent times due to the global financial crisis that has proved weak systems of banks as responsible for the crisis. Owing to these factors, banking industry has introduced more stringent tests to explore the sustainability of the system and its capacity to identify the tolerable level of risk being breached. The complex risk management systems of bank are required to have stringent capacity to deal with risk and efficient allocation across the diversified products. System integrates this efficiency in terms of setting software, techniques and reporting mechanisms ensuring compliance with the set rules and procedures (Saunders & Allen, 2010).

The system section accounts for the role of information technology for the effective and efficient mechanism for risk management in the banking industry. Risk management systems in banks are developed to incorporate detailed decomposition.

Market Risk Management and Information Systems

Banks to make an efficient risk decision require to cumulate information and reporting system that would be providing on time information and use data for reporting of various risks at work. It is essential for senior decision makers to make these capabilities possible when the administrative and financial environment becomes too complex due to increased pressure from role of banks in economic down turn in 2008. Market risk management information system is to be developed and sustained by the banks along with a capable support of technology and processing volume in order to deal with the market risk effectively which is being evident to the bank (García-Marco & Robles-Fernández, 2008). This system needs to be carried out wisely and effectively. Systematically designed information system that connects all concerned departments and information results in effective risk management.

The system of marker risk management relies on the nature and characteristics of the activities of the bank's business. The effective information system exhibits following characteristics (Embrechts, 2000):

  • Market risks of transaction or a product is measured in correspondence with the approved methods of measurement to be followed by the bank.
  • Data combination on a product, business venue, currency, business unit etc.
  • Within the bank, supporting the identification that is being customized and accumulation of risk applications.
  • Involvement of hedging and various actions that weaken the risk.
  • Reporting of overabundance to be limited and according to the policies. The system must generate regular and timely report for management informing about increasing risks.
  • Information to be generated on convenient intervals and must be quick and fast during the stress time.
  • Data flows to be easily approachable, clear and also provide an easy way towards the model terms and specifications being used.

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Like every other information systems that the banks use in their business activities managing risk information technology is also critical and requires accounting following factors (Embrechts, 2000):

  • Governance of Information Technology
  • Powerful certification and access control entity of security management.
  • Process of performance monitoring.
  • Involvement of third party vendor system reflects managing the technology service providers. For banks to develop their own information system or collaborate with third party vendors for the risk management system many aspects are required to be accounted such as cost, increased sophistication, time factors etc.
  • Audit feasibility.

The highly technically developed infrastructure of information technology in banks gives the capability to comprehensively and clearly communicate with the reporting requirements of the risk involved internally (Embrechts, 2000).

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