Bank Risk Management in Developing Economies. Addressing the Unique Challenges of Domestic Banks through Risk Management

608 Pages·2016·3.61 MB·English

by  Leonard Onyiriuba

Bank Risk Management
in Developing Economies
Addressing the Unique Challenges of
Domestic Banks through Risk Management
Leonard Onyiriuba

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I dedicate this book, with love, to my mother – Cyrina
Chijiago Onyiriuba – and children – Tobe, Ezzy,
Chub, Som, Ama and Chi
Preface
One of my intentions for this book is to address specific concerns of banking
stakeholders in developing economies. This is without prejudice to looking at
issues which underlie the cause of the book with a critical eye. Domestic and
foreign subsidiary banks in developing economies take on and manage risks
differently. The latter seem immune to financial crisis that often rock banks in
developing countries—ostensibly with support from their parent banks. Never
in the checkered history of Nigeria’s banking, for example, has the industry had
a foreign subsidiary bank that became distressed or failed. The implication is
that foreign subsidiary and domestic banks in developing economies are worlds
apart on risk management.
The domestic banks aspire to cater to the financial services needs of all
sectors—including the highly risky informal economy—apparently pitching
in with national economic development policies. Foreign banks subsidiaries,
in contrast to domestic banks, shun risky sectors. They adopt preconceived tar-
get markets definitions, risk acceptance criteria, and standardized risk models
targeted at structured and riskless sectors with which their well-honed exotic
risk models fit in. Thus their financial services are usually keyed to the vibrant
sectors—apparently in response to dictates of safety and the bottom line. This
explains why a foreign bank subsidiary in a large country, such as Nigeria
would perhaps have less than 10 branches when its domestic counterpart of
comparable asset size would have over 500.
I address, in this book, these departures and specific risk concerns at issue
that apply to developing countries worldwide and affect the banks cross the
board in this book.
BACKGROUND
Banking around the world is ever in a state of flux. Bank managements try, but
all to no avail, to be on top of risks in a rapidly changing world of modern bank-
ing. The problem is deepening, if anything. The increasing sophistication of
contemporary banking doesn’t help matters. Nowadays a host of change–driven
risks—most of which are novel in nature—threaten the survival of banks as go-
ing concerns. This is the troubling dimension which risks in modern banking
have assumed.
Banks in developing economies are particularly vulnerable. There is now—
more than ever before—snowballing concern with worsening risks in devel-
oping economy banking. Banks in developed economies seem to be making
xxv
xxvi Preface
progress on the control of novel risks, which the great march of revolution in
banking occasions. But the same cannot be said of their counterparts in devel-
oping economies. Of course banking in developing economies is still relatively
in embryo. As the industry matures, its future development and performance
will depend on how well risk is managed. Two main reasons justify this view.
First, risk impinges on the capacity of banks to do business. Second, developing
economies are nowadays unusually volatile.
Thus banks in developing economies must work with a painstaking prog-
nosis of the future of their business. Method in the way risk is managed—and
uncertainty is anticipated—should inform the prognosis. The starting point is
for the stakeholders to be fully apprised of the making of risk and uncertainty.
Needless to say, risk and uncertainty underlie the central dynamic of success in
banking. Thus learning deeply about risk and uncertainty and their implications
for bank management is pertinent. As bank managements, staff and other stake-
holders deepen their knowledge of risks and uncertainties, they will want to
hone their risk management abilities. That puts them right on top of their work
and investment in banking. This is the road map to managing banking risks in
developing economies, which this book furnishes.
Unfortunately the risk managers in developing economies seem to be defi-
cient in experience for managing novel risks. Their experience hardly provides
a clue about the dynamic, let alone control, of such risks. Yet they must get to
grips with the tide of novel risks in the wake of continued revolution in banking.
This will have significant positive implication for banking. Ironically banking
in developing economies seems to be booming—ostensibly debunking concerns
about possible threat of risk and uncertainty. Strange though this may seem, the
reality is that this fluke is usually truncated by either neglect of the unusual risks
and uncertainties or failure to anticipate them.
OVERVIEW AND TARGET AUDIENCE
This book is a practical text that furnishes a holistic approach to learning about
the creation and control of bank risks in developing economies. It is enriched
with tales and scenes of risk and uncertainty—as well as empirical examples
and illustrations—that have practical ramifications for banking in developing
economies.
The book situates bank management in the context of risk, uncertainty, and
revolution in banking—differently from the classical method. Doing so, it sheds
light on the creation, dynamics, and control demands of risks that have been
the bane of the industry. It posits—as its main thrust—that banking crisis in
developing economies is rooted in the interplay of, and failings in managing,
composite risks. It analyzes the paradigm shift which this approach informs. In
doing so, it defines risk management best practice in banking. It discusses best
practice inner workings. Then it pinpoints how risk management best practice
should power the success of banking in developing economies.
Preface xxvii
With this book, its target audience is equipped with an in-depth knowl-
edge of contemporary risks in developing economy banking, with implica-
tions for bank management and the future of the industry. The book leans
toward academic need of students and faculty. Yet practitioners and analysts
will find it quite insightful and useful. I have deliberately included topics and
chapters that help fulfill this expectation. For example, while giving students
and faculty insights into the practical demands of risk control in banking op-
erations, Chapters 27–30—covered in Part III that deals with Reinventing Risk
Management—are tailored more to the needs of practitioners.
This approach optimizes the appeal of the book without compromising
its strong orientation to student academic need. That orientation is evident in
the grammatical constructions of the chapter topics and is mirrored in a more
academic style of writing—typical of a college textbook. I adopted particular
features of this approach that usually stand out in academic textbooks. Each
chapter starts with Learning Focus and Objectives, followed by Expected
Learning Outcomes. There are end of chapter Summary, Questions for Discus-
sion and Review, References, and books for Further Reading.
STRUCTURE AND ORIENTATION OF THE BOOK
Banking is bedeviled by a myriad of risks. However, four of the risks—credit
risk, operational risk, liquidity risk, and market risk—stand out. In terms of
attention and emphasis, credit risk tends to get the lion’s share, underscoring
its complication and wider significance for banking all over the globe. In this
book, I adopted a holistic theme and approach. First, I subsume emerging mar-
kets under developing economies. Then I posit that banking crisis in developing
economies is rooted in the interplay of, and failings in managing, composite
risks.
This approach brings out clearly the commonality of risk types, character-
istics, and patterns of incidence in developing economies. It does not obliter-
ate emerging markets, but rather informs their standing as yet a part—but the
topmost tier—of developing economies. I analyze the paradigm shift which
this approach informs. In doing so, I defined risk management best practice
in banking. I discussed best practice inner workings. Then I pinpoint how risk
management best practice should power the success of banking in developing
economies. Underlying this approach is my conviction that every successful
business has its game plan all worked out—the things it does differently, or in
unique ways, through which it adds value, overcomes threats, optimizes oppor-
tunities, and beats competition.
The approach I adopted for this book represents a departure from the clas-
sical literature, which the competing books symbolize. The competing books
deal with the subject from the traditional perspective of assets, liabilities, and
balance sheet management under which banks in developing economies—like
their counterparts elsewhere—have not fared well. Ironically, the authors of the
xxviii Preface
competing books not only gravitated toward the classical literature, they were
oriented to the highly advanced financial economies of the developed nations—
ostensibly to solve some complex financial issues. The modeling of financial
functions to explain some banking behavior is typical. Incidentally, these issues
and the authors’ method are alien to practical banking in the developing World.
BENEFITS TO TARGET AUDIENCE
The book empowers its audience with new insights and competences necessary
for managing novel risks in banking. Specifically it solves the following five
main problems for its target audience:
l Lack of—and inability to apply—competence in a wide range of contempo-
rary risk management skills.
l Frustration of wealth creation for stakeholders of developing economy
banks due to inefficient or flawed risk management.
l Crisis in developing economy banking apparently caused by method in clas-
sical risk management literature.
l Dearth of practical texts on and guide to novel, peculiar, and change-driven
risks in developing economy banking.
l A craving for a simple structure, devoid of complex models, for dealing with
risks in developing economy banking.
UNIQUE SELLING POINTS
Deals practically with all known, felt, and anticipated developing economy
banking risks in one unparalleled volume
This book does not—unlike the competing books—compartmentalize or
deal with, or view banking risks in “silos” or in isolation from uncertainty. It
adopts a holistic theme and approach that meet target audience needs.
A simplified text, easy to understand, and use
The target audience needs a noncomplex text devoid of the technicalities of
the exotic literature on developed economy banking that are of no immediate
relevance now and in the foreseeable future for managing risks in developing
economy banking.
Devoted solely to the cause and course of managing risks peculiar to bank-
ing in developing and emerging economies
None of the competing books addresses novel and evolving risk issues
specific to banking in developing and emerging economies. The books, on the
contrary, deal with technical issues in highly developed financial markets.
Consistency in fulfilling curriculum-based learning programs and needs
The book comprehensively covers materials included in core academic and
professional basic, intermediate, and advanced practice of banking, bank man-
agement, and risk management in banking courses.
Topical theme and appealing chapter subjects targeted at a buoyant audience
Preface xxix
This feature ensures that the book has a long effective shelf life. The book
will enjoy this advantage for as long as lending institutions exist; universities
offer courses in banking, finance, and investment; and banking remains a funda-
mental business fraught with risks.
Propitious for evolving thinking on risk management best practice and good
corporate governance in developing economy banking
The book addresses banking stakeholders’ concerns bordering on neglect
of best practice and flawed corporate governance—both of which have been
fingered as culprits for crises in developing economy banking.
Tunes in to a paradigm shift that fits well with the Basel Accords—the widely
acclaimed international point of reference for risk management in banking
This book represents a departure from the classical literature which focuses
on assets, liabilities, and balance sheet management by which developing econ-
omy banks—like their counterparts elsewhere—have not fared well.
Leo Onyiriuba
Lagos
June 2016
Chapter 1
Risk, Uncertainty, and Banking
Dynamics in Developing
Economies
Chapter Outline
Learning Focus and Objectives 3 Conceptualizing and Defining
Expected Learning Outcomes 4 Risk and Uncertainty 11
Overview of the Subject Matter 4 Summary 16
Distinguishing Domestic Banks Questions for Discussion and
from Foreign Banks Subsidiaries 5 Review 17
Realistically Distinguishing Domestic References 17
from Foreign Subsidiary Banks 7
LEARNING FOCUS AND OBJECTIVES
It is not always that risk-taking in banking is informed by a sense of responsibil-
ity to protect the bank against financial loss. On occasion, some bank employees
may take on risk, careless of its consequences for the bank. Careless risk-taking
results in loss of income to the bank or exposure of its asset to harm. So bank
employees should be very knowledgeable about risk, and always take only cal-
culated risks. That way, risk consciousness is institutionalized and helps the
employees to stick with the bank’s risk acceptance criteria for all functions,
transactions, and deals. My objectives for this chapter are based on these views,
intended to teach the reader:
Definitions and applications of meaning of risk and uncertainty at different
l levels of learning and conceptual development.
Pioneering thoughts, evolving thinking, and contemporary perspectives on
l risk and uncertainty.
How risk situates in uncertainty—in theory and practice—and influences the
l fate of banking in developing economies?
The reality of risk to banks in developing economies, and risk contrasts
l between domestic and foreign subsidiary banks.
Bank Risk Management in Developing Economies
Copyright © 2016 Elsevier Inc. All rights reserved. 3
4 PART | I Background and Overview
EXPECTED LEARNING OUTCOMES
Bankers in developing economies—like their counterparts in the developed
world—need to be well versed in the dynamics of risk and uncertainty. This is
a critical success factor in a rapidly changing age of technological innovation
in banking. Thus, my intention for this chapter is to facilitate learning about the
phenomena of risk and uncertainty—in conceptual and practical ways. I also
want to regenerate interest in the effective management of risk as the foundation
of success in banking, especially in developing economies. The reader will—
after studying this chapter and doing the exercises in it—have learnt and been
better informed about:
Why there exists a divergence in definitions and constructs of risk and un-
l certainty found in the literature?
Pioneering thoughts, evolving thinking, and contemporary perspectives on
l risk and its relationship to uncertainty.
How risk can be defined from the perspectives of two opposing outcomes—
l opportunities and threats—with implications for banking?
Characteristics of risk and uncertainty and how they should inform business
l choices of banks in developing economies.
Insights into reasons domestic banks in developing economies—compared
l with their foreign subsidiary counterparts—face peculiar risks.
OVERVIEW OF THE SUBJECT MATTER
Every successful business has its game plan all worked out—the things it does
differently, or in unique ways, through which it mitigates risk, adds value, over-
comes threats, optimizes opportunities, and beats competition. It would seem
that this business strategy is either lacking or is the main challenge of banks in
developing economies. The problem, though, is more evident in domestic than
foreign subsidiary banks. Bankers in developing economies tend to be over-
whelmed by the magnitude of risks they face in their everyday work. This is
understandable given that banking in developing economies is still in embryo. It
is neither fully mature nor in the mold of banking in advanced financial markets.
However, as the industry matures and consolidates, its future development will
depend on how well risk is managed.
Bankers should have a clear picture of the cause and outcome of risk taking
in mind. They should work with confidence and sense of purpose to actualize
business objectives. These pragmatic attributes should then power their risk-tak-
ing appetite. Domestic banks in developing economies, in contrast to their for-
eign subsidiary counterparts, tend to take on risk sometimes to satisfy irrational
business motive. Lift the veil of their risk-taking and you would be shocked at
how they take risk to excess. Reckless risk-taking is a recipe for banking crisis
and bank managements must shun it. The path to success is for banks to follow
best practice founded on logic, calculation, and due process. Unfortunately, the