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Credit Risk Management

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A RISK-BASED ASSESSMENT OF ECOBANK GHANA LIMITED (EGH) Master’s Thesis towards the award of Master of Science degree in Economics and Business Administration (CMFSM – Finance & Strategic Management) at Copenhagen Business School Author of paper: KWASI MENAKO ASARE-BEKOE Masters Thesis: A risk-based assessment of Ecobank Ghana Limited October, 2010 DEDICATION To the only true God, His only son Jesus Christ and His Holy Spirit. You have brought me this far, giving me strength and guidance through the journey. To You be all the glory and adoration now and forever more.

Amen To my wife, children and parents. God bless you for your support. You have been my encouragement. 1 Masters Thesis: A risk-based assessment of Ecobank Ghana Limited October, 2010 ACKNOWLEDGEMENT I wish to express my sincere gratitude to the Copenhagen Business School for sponsoring my participation in this graduate programme.

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It is an opportunity I will forever cherish. I am grateful to Mr. Jens Borges, my supervisor. Your counsel was very valuable. I thank all my friends and well-wishers. God be with you all. 2 Masters Thesis: A risk-based assessment of Ecobank Ghana Limited

October, 2010 TABLE OF CONTENT DEDICATION …………………………………………………………………………………………………………… 1 ACKNOWLEDGEMENT …………………………………………………………………………………………… 2 TABLE OF CONTENT ………………………………………………………………………………………………. 3 LIST OF TABLES ……………………………………………………………………………………………………… LIST OF FIGURES ……………………………………………………………………………………………………. 8 EXECUTIVE SUMMARY …………………………………………………………………………………………. 9 CHAPTER ONE – INTRODUCTION…………………………………………………………………………. 11 1. 0 1. 1 1. 2 1. 3 1. 4 1. 5 1. 6 1. 7 BACKGROUND OF STUDY ………………………………………………………………………. 11 JUSTIFICATION OF CHOICE OF INSTITUTION………………………………………… 2 INTRODUCTION OF COMPANY……………………………………………………………….. 14 STATEMENT OF THE PROBLEM ……………………………………………………………… 14 OBJECTIVE OF THE STUDY …………………………………………………………………….. 15 SIGNIFICANCE OF THE STUDY ……………………………………………………………….. 15 SCOPE AND LIMITATION OF THE STUDY ………………………………………………. 16 ORGANISATION OF THE STUDY …………………………………………………………….. 6 CHAPTER TWO – LITERATURE REVIEW ………………………………………………………………. 17 2. 0 2. 1 2. 2 2. 3 2. 4 2. 4. 1 2. 4. 2 2. 4. 3 2. 4. 4 2. 5 INTRODUCTION ……………………………………………………………………………………….. 17 RISK MANAGEMENT IN BANKING …………………………………………………………. 17 RATIONALES FOR RISK MANAGEMENT IN BANKING ………………………….. 18 CATEGORIES OF RISK MANAGEMENT …………………………………………………… 9 KEY BANK RISKS ……………………………………………………………………………………. 20 Credit Risk …………………………………………………………………………………………… 21 Market Risks ………………………………………………………………………………………… 22 Operational Risk …………………………………………………………………………………… 26 Strategic Risk ……………………………………………………………………………………….. 7 VAR: A TOOL FOR MEASURING MARKET RISKS …………………………………… 29 2. 6 INTEGRATED RISK MANAGEMENT: AN ULTIMATE GOAL OF A FORWARD-LOOKING RISK MANAGEMENT FRAMEWORK …………………………….. 31 2. 6. 1 Enterprise Risk Management: A useful tool for integrating risks ………………… 33 3 Masters Thesis: A risk-based assessment of Ecobank Ghana Limited October, 2010 2. 7 THE PLACE OF CORPORATE GOVERNANCE IN THE MANAGEMENT OF BANK RISKS ………………………………………………………………….. ………………………………….. 5 CHAPTER THREE – METHODOLOGY ……………………………………………………………………. 38 3. 0 3. 1 3. 2 3. 3 INTRODUCTION ……………………………………………………………………………………….. 38 DATA SOURCE …………………………………………………………………………………………. 38 BENCHMARKS …………………………………………………………………………………………. 38 ANALYSTICAL TOOLS …………………………………………………………………………….. 9 Ratios ………………………………………………………………………………………………….. 39 Graphs and Charts …………………………………………………………………………………. 40 3. 3. 1 3. 3. 2 3. 4 ANALYTICAL TECHNIQUES ……………………………………………………………………. 40 Ratio Analysis ………………………………………………………………………………………. 41 Common-Size Analysis …………………………………………………………………………. 1 Trend Analysis ……………………………………………………………………………………… 42 3. 4. 1 3. 4. 2 3. 4. 3 3. 5 ANALYTICAL COMPONENTS ………………………………………………………………….. 42 CHAPTER FOUR – ASSESSMENT OF BANK RISK PROFILE ………………………………….. 44 4. 0 4. 1 INTRODUCTION ……………………………………………………………………………………….. 44 BALANCE SHEET RISKS ………………………………………………………………………….. 4 Assets ………………………………………………………………………………………………….. 44 Liabilities …………………………………………………………………………………………….. 45 Equity and Capital Adequacy …………………………………………………………………. 47 4. 1. 1 4. 1. 2. 4. 1. 3 4. 2 4. 3 INCOME STATEMENT RISKS …………………………………………………………………… 48 CREDIT RISK ……………………………………………………………………………………………. 1 Size……………………………………………………………………………………………………… 51 Concentration ……………………………………………………………………………………….. 52 Product distribution……………………………………………………………………………….. 54 Customer loans distribution by tenor ……………………………………………………….. 54 Loan Quality ………………………………………………………………………………………… 5 Related Party Dealings …………………………………………………………………………… 56 4. 3. 1 4. 4. 2 4. 3. 3 4. 3. 4 4. 3. 5 4. 3. 6 4. 4 LIQUIDITY RISK ………………………………………………………………………………………. 57 Liquidity Mismatches ……………………………………………………………………………. 57 Structure of funding ………………………………………………………………………………. 58 Cashflows and ratios ……………………………………………………………………………… 0 4 4. 4. 1 4. 4. 2 4. 4. 3 Masters Thesis: A risk-based assessment of Ecobank Ghana Limited 4. 6. 4. 7. October, 2010 INTEREST RATE RISK ……………………………………………………………………………… 62 CURRENCY RISK ……………………………………………………………………………………… 63 CHAPTER FIVE – ASSESSMENT OF RISK MANAGEMENT FRAMEWORK …………… 65 5. 0 5. 1 INTRODUCTION ……………………………………………………………………………………….. 5 CREDIT RISK ……………………………………………………………………………………………. 65 Organisation …………………………………………………………………………………………. 65 Risk identification …………………………………………………………………………………. 66 Risk Measurement ………………………………………………………………………………… 67 Risk Monitoring and Control ………………………………………………………………….. 68 Risk Reporting …………………………………………………………………………………….. 69 5. 1. 1 5. 1. 2 5. 1. 3 5. 1. 4 5. 1. 5 5. 2 MARKET RISK ………………………………………………………………………………………….. 69 Organisation …………………………………………………………………………………………. 69 Risk Identification …………………………………………………………………………………. 71 Risk Measurement ………………………………………………………………………………… 1 Risk Monitoring and Control ………………………………………………………………….. 74 Risk Reporting ……………………………………………………………………………………… 74 5. 2. 1 5. 2. 2 5. 2. 3 5. 2. 4 5. 2. 5 5. 3 OPERATIONAL RISK ………………………………………………………………………………… 75 Organisation …………………………………………………………………………………………. 75 Risk Identification …………………………………………………………………………………. 5 Risk Measurement ………………………………………………………………………………… 76 Risk Monitoring and Control ………………………………………………………………….. 76 Risk Reporting ……………………………………………………………………………………… 77 5. 3. 1 5. 3. 2 5. 3. 3 5. 3. 4 5. 3. 5 5. 4 SUMMARY ……………………………………………………………………………………………….. 77 CHAPTER SIX – CONCLUSION AND RECOMMENDATIONS ………………………………… 9 6. 0 6. 1 6. 2 INTRODUCTION ……………………………………………………………………………………….. 79 CONCLUSION …………………………………………………………………………………………… 79 RECOMMENDATIONS ……………………………………………………………………………… 81 Interest Rate Risk Management ………………………………………………………………. 81 Adopting an integrated approach to risk management ……………………………….. 82 6. 2. 1 6. 2. 2

APPENDIX A: Glossary of key financial terms and ratios …………………………………………….. 85 APPENDIX B: Comparative Financial Statements of EGH for 2007 – 2009 ……………………. 86 APPENDIX C: Bloomberg L. P ratings and Stock Trends …………………………………………….. 89 5 Masters Thesis: A risk-based assessment of Ecobank Ghana Limited October, 2010 APPENDIX D: Tables and Charts for Risk Profile Assessment ……………………………………… 90 APPENDIX E:International Recommended Principles for ensuring Sound Risk Management ….. 01 REFERENCES ………………………………………………………………….. ………………………………….. 109 6 Masters Thesis: A risk-based assessment of Ecobank Ghana Limited October, 2010 LIST OF TABLES Table 1. 1: Summary of EGH‘s performance in Ghanaian banking industry ……………………… 13 Table 3. 1: Ratios in assessing bank risks ……………………………………………………………………… 39 Table 4. 1: Capital adequacy and off-balance sheet measures………………………………………….. 47 Table 4. : Customer loans distribution by borrower group …………………………………………….. 53 Table 4. 3: Loan loss coverage ……………………………………………………………………………………. 56 Table 4. 4: Maturity Ladder ………………………………………………………………………………………… 58 Table 5. 1: EGH‘s internal risk rating system………………………………………………………………… 66 Table 5. 2: VAR limits at various levels ……………………………………………………………………….. 72 7

Masters Thesis: A risk-based assessment of Ecobank Ghana Limited October, 2010 LIST OF FIGURES Figure 1. 1: Performance of Ecobank Ghana Limited on Ghana Stock Exchange ………………. 13 Figure 3. 1: Diagrammatic representation of components of the bank‘s risk profile …………… 43 Figure 4. 1: Changes in the composition of assets over the past three years. ……………………… 45 Figure 4. 2: Changes in the composition of liabilities over the past two years. ………………….. 46 Figure 4. 3: Profitability & efficiency indicators ……………………………………………………………. 0 Figure 4. 4: Sources of Income versus Operating Costs ………………………………………………….. 50 Figure 4. 5: 50 largest exposures …………………………………………………………………………………. 52 Figure 4. 6: Sectoral allocation of loans ……………………………………………………………………….. 53 Figure 4. 7: Customer loans by products ………………………………………………………………………. 54 Figure 4. 8: Distribution of Customer Loans per Tenor and Borrower Group ……………………. 55 Figure 4. : Loan Quality ……………………………………………………………………………………………. 56 Figure 4. 10: Related party information ………………………………………………………………………… 57 Figure 4. 11: Funding soucres ……………………………………………………………………………………… 59 Figure 4. 12: Customer deposits by type ………………………………………………………………………. 59 Figure 4. 13: Trend of Cash flows ……………………………………………………………………………….. 0 Figure 4. 14: Trends in liquidity ratios …………………………………………………………………………. 62 Figure 4. 15: Interest rates repricing gap ………………………………………………………………………. 63 Figure 4. 16: Currency Structure of Loan Portfolio and Customers Deposits …………………….. 64 Figure 4. 17: Currency Risk : Currency Exposure as % of Qualifying Capital …………………… 64 Figure 5. 1: A diagrammatic illustration for measuring expected loss ………………………………. 68 8

Masters Thesis: A risk-based assessment of Ecobank Ghana Limited October, 2010 EXECUTIVE SUMMARY The global financial crises over the past three years should make everyone concerned about recent significant levels of bad debts on the books of banks in the Ghanaian financial sector. It calls for thorough assessments of the structure and components of the risk management frameworks and practices of banks by regulators, analysts and financial watchers from time to time, to ascertain the adequacy of the systems, policies and procedures for managing risks as well as their conformity to current best practices.

As a contribution to this exercise, this study is focused on Ecobank Ghana Limited (EGH) with the aim of evaluating the bank‘s risk profile as well as assessing its risk management framework to ascertain its soundness and conformity to international best practices. Both the computational based and analytical based approaches were adopted in assessing the risk condition of EGH. By applying analytical tools such as ratios, tables and charts, to the bank‘s 2009 financial statements, and those of years 2007 and 2008 serving as references for comparison.

Trends and relationships in the financial statements and other financial data were also established. This helped in making well-reasoned analysis of the bank‘s capital adequacy, balance sheet structure and composition, profitability and reliability of earnings, credit exposure size and quality, liquidity, interest rate and currency risks situations. A review of the EGH‘s risk management structure and policies, vis-a-vis recommendations by the Basel Committee on Banking Supervision, helped in establishing the soundness or otherwise of the bank‘s risk management practices.

The study revealed that EGH‘s has a good risk profile in the face of challenging global economic and business environment. This is because the significant expansion of its balance sheet size did not result in the absorption of more risk but rather lead to a healthy asset mix balancing liquidity with profitability. The assets were efficiently applied to generate high profit margin which was powered by stable income sources. The bank‘s asset quality as well as its capacity to absorb credit losses had improved in the face of general levels of asset deterioration in the Ghanaian banking industry.

The high level of loan portfolio concentration to few large corporate bodies was however the weak point in the bank‘s credit risk condition. Also, with the majority of its cash flow obtained from operational activities, coupled with large portion of deposits provided by core deposit customers, the prospects of EGH encountering liquidity challenges was minimal. In addition, the bank had adequate funding in 9 Masters Thesis: A risk-based assessment of Ecobank Ghana Limited October, 2010 foreign currency to back foreign currency loans and meet demands for foreign currency transactions, shielding it from adverse foreign currency risk exposure.

EBH lost some interest income as a result of maintaining more short term sensitive assets than short term sensitive liabilities during the year 2009 when there was a general decline in interest rates. The study also revealed that EGH had adequate risk management structures to ensure sound management of financial and operational risks. There was an appropriate environment in place for managing risk, in that; the governance structure was solid with clear obligations and lines of authority set out. Policy documents containing procedures, processes and techniques for handling various risks had also been approved by the board.

Relevant tools and management information systems as well as effective controls were in place to ensure adequate and consistent identification, measurement, monitoring and controlling as well as reporting on the various risks the bank is exposed to. These structures were also in line with internationally accepted principles for managing risks as put forward by the Basel Committee for Banking Supervision and expected to be implemented by all banks operating in Ghana as they have incorporated in the Ghana Banking Act 2004, Act 673. 10 Masters Thesis: A risk-based assessment of Ecobank Ghana Limited

October, 2010 CHAPTER ONE – INTRODUCTION 1. 0 BACKGROUND OF STUDY Developments in the global financial sector within the past decade have given stakeholders in the Ghanaian banking industry cause to not only consider the returns made in the sector but also critically examine frameworks used to manage risks in the sector and safeguard their interests. This is because the failures faced by the industry in recent times have been blamed largely on the weaknesses of the regulatory frameworks and the risk management practices of the financial institutions1.

The greatest impact of the crisis has been on the banking industry, where some banks which were hitherto performing well suddenly announced large losses with some of them going burst. Some reasons put forward for the failures in risk management in this regard include the limited role of risk management in the granting of loans in most banks as they are unable to influence business decisions and the fact that their considerations are subordinate to profitability interests and lack of capacity to adequately make timely and accurate forecasts.

This has resulted in the flouting of basic risk management rules such as avoiding strong concentrations of assets and minimising the volatility of returns. The impact of the global financial crisis on the banking sector in Ghana has been quite minimal such that it did not threaten the survival of banks in the sector. This is largely because the sector has little exposure to complex financial instruments and relies mainly on low-cost domestic deposits and liquidity. However, the deterioration of asset quality (impairment charge / gross loans and advances) of the banks in Ghana, from about 1. % to 4. 2%2, in the past three years due to significant balances of bad and doubtful debts on their books is an indication that all is not well with the sector. Various reasons have been put forward by analysts as accounting for the deterioration in the quality of bank‘s loans and advances. These include increased cost of funds, inflation, depreciation of the Cedi and the delay by government in paying contractors and other service providers. Unlike the case in developed countries, questions have not been raised about weakness or otherwise of the risk 1

As put forward by some professionals and scholars such as Dr Rakesh Mohan, Deputy Governor of the Reserve Bank of India, at the 7th Annual India Business Forum Conference, London Business School, London, 23 April 2009 and Gabriele Sabato (August, 2009). 2 Contained in the 2010 Banking Survey Report by PriceWaterhouseCoopers, Ghana. 11 Masters Thesis: A risk-based assessment of Ecobank Ghana Limited October, 2010 management practices of the Ghanaian banks which have resulted in significant financial losses, although there have been a few reported cases of fraud, theft and other operational occurrences.

The general believe is that banks in Ghana have good risk management structures since there have not been any complaints or adverse findings against them by the regulators, that is, Bank of Ghana and Securities and Exchange Commission of Ghana (in the case of listed banks) concerning significant weaknesses in their risk management systems. The banks are believed to be generally compliant with major regulatory requirements which are basically in line with international standards set by the Basel Committee on Banking Supervision.

These requirements include rigorous risk and capital management requirements designed to ensure that the banks hold capital reserves appropriate to the risk they expose themselves to through its lending and investment practices. However, in order to ascertain the resilience of the Ghanaian banking sector to withstand serious economic shocks, there would be the need for thorough assessments of the structure and components of the risk management frameworks and practices of the banks from time to time.

This study was therefore a contribution to this exercise with a focus on Ecobank Ghana Limited (EGH). 1. 1 JUSTIFICATION OF CHOICE OF INSTITUTION Ecobank Ghana limited was chosen for this study because of its reputation as being among the top four banks in Ghana. It is also listed on the Ghana Stock Exchange and therefore has its financial and other regulatory reports published, ensuring that the public has access to some basic information. Over the past decade EGH has won several banking awards in various categories including the coveted ?

Bank of the Year Award? for five consecutive years. According to the 2010 Banking Survey Report3 released by PricewaterhouseCoopers Ghana in collaboration with the Ghana Association of Bankers, EGH is ranked the fourth largest bank in terms of total assets contributing 10. 1% to total assets of the banking industry. The bank was the third largest contributor to both industry deposits and gross loans and advances with 10. 5% and 7. 7% respectively. EGH‘s share of industry assets, deposits, and loans and advances, over the last three years, are indicated below. http://www. pwc. com/en_GH/gh/pdf/ghana-banking-survey-2010. pdf 12 Masters Thesis: A risk-based assessment of Ecobank Ghana Limited Table 1. 1: Summary of EGH‘s performance in Ghanaian banking industry 2009 2008 Category % Contribution 10. 1 Ranking % Contribution 8. 5 Ranking October, 2010 2007 % Contribution 8. 8 Ranking 4 4 3 Share of Industry 4 4 Assets Share of Industry 10. 5 3 8. 7 4 8. 9 Deposits Share of Industry 7. 7 3 7. 3 4 7. 8 Gross Loans and Advances Source: 2010 Ghana Banking Survey Report issued by PricewaterhouseCoopers Ghana

As a further indication of public confidence in the bank‘s performance, its shares have performed considerable well on the Ghana Stock Exchange since it got listed (Figure 1. 1 gives an illustration of the bank‘s performance on the Ghana Stock Exchange). Analysts also rate EGH quite favourably, with Bloomberg L. P. rating its short term local currency A1+ and Global Credit Rating Company (a reputable international rating agency) rating the banks long and short term credits (exposures) AA- and A1+ respectively4. These give an indication of the soundness of its credits.

In the light of the above, I consider the bank to be an appropriate case for this study. Figure 1. 1: Performance of Ecobank Ghana Limited on Ghana Stock Exchange Source: Own construction with data compiled by Gold Coast Securities Limited 4 Refer to Appendix C1 for Bloomberg’s screen print of ratings 13 Masters Thesis: A risk-based assessment of Ecobank Ghana Limited 1. 2 INTRODUCTION OF COMPANY October, 2010 Ecobank Ghana Limited (EGH) is one of the thirty one (31) subsidiaries of the Ecobank Group which is the leading Pan African banking group in Africa.

It was incorporated under Ghana‘s Companies Code on January 9, 1989 as a private limited liability company to engage in the business of banking. EGH was initially licensed to operate as a merchant bank by the Bank of Ghana on November 10, 1989 but following the introduction of Universal Banking by the Bank of Ghana in 2003, it became the first bank to be granted the license to do general banking business. This action cleared the way for it to embark on its medium term strategic shift of moving from being a predominantly wholesale bank to one with a retail focus.

In June 2006, EGH went public and was listed on the Ghana Stock Exchange. The bank operates four (4) subsidiaries: Ecobank Investment Managers Limited, Ecobank Leasing Company Limited, Ecobank Venture Capital Limited, and EB Accion Savings & Loans Company Limited. Together with its subsidiaries, EGH provides corporate banking, investment banking and retail banking products and services to wholesale and retail customers in Ghana. 1. 3 STATEMENT OF THE PROBLEM There is the general belief that the banking sector in Ghana is relatively stable with individual banks having healthy risk profiles and sound risk management frameworks.

This belief stems from the fact that, with the exception of worsening asset quality which is blamed on internal macro economic factors; the industry has not experienced major losses in the face of the global financial crises. Also, the supervisory and regulatory bodies have not found any of the banks in Ghana culpable of flouting prudential arrangements aimed at protecting the interests of clients and shareholders as was experienced in Nigeria5. There has, however, not been any major internal test to ascertain the resilience of the banking industry to withstand major shocks.

So there is a vacuum between the general belief on the risk position of the Ghanaian banking industry and the evidence to bank this belief. To do this requires thorough assessment of the risk profiles of banks in Ghana as well as evaluate the adequacy of the risk 5 The Governor of the Nigeria Central Bank have had to sack directors and chief executive officers of some Nigeria banks for breach of prudential arrangements and mismanagement in addition to recommending the injection of funds into those banks by the central bank to safeguard the interest of clients and shareholders. 4 Masters Thesis: A risk-based assessment of Ecobank Ghana Limited October, 2010 management frameworks employed by the banks to handle the various risks they are exposed to. 1. 4 OBJECTIVE OF THE STUDY The objectives of the study were two fold, which were to assess : I. the bank‘s risk profile as at the end of the 2009 financial year. This involved an assessment of the income statement and balance sheet to identify inherent risks in their components and structure.

It also involved using various tools (ratios, charts and tables) to ascertain the level of credit and market (liquidity, interest rate, foreign currency) risks the bank is exposed to. II. the effectiveness of the bank‘s risk management framework for managing credit, market and operational risks it is exposed to. This involved an assessment of: a. the strong governance structure in place, b. the adequate policies, procedures, tools and skills, c. the effective control measures, and d. the information management systems to support timely and accurate information delivery in place to manage risk.

The assessment here also included an evaluation of the bank‘s risk management practices visa-vis current recommended standards and best practices by the Basel Committee on Banking Supervision. 1. 5 SIGNIFICANCE OF THE STUDY An assessment of EGH‘s risk management framework provided the state of the bank‘s ability to handle the inherent risks in its operations. Also deviations from international best practices were also identified and alternatives recommended. The bank‘s ability to deal with significant shocks and avoid losses during crisis periods was also tested.

Since there is not much structural and operational difference amongst the banks in Ghana, it is hoped that this study will provide an indication of how the risk management landscape looks like in Ghana‘s banking sector. In addition, it will provide a guide for further studies on risk management in the industry. 15 Masters Thesis: A risk-based assessment of Ecobank Ghana Limited 1. 6 SCOPE AND LIMITATION OF THE STUDY October, 2010 In conducting a risk-based analysis of Ecobank Ghana Limited, information was mainly gathered from financial statements and other disclosures contained in the bank‘s annual reports.

In this regard, annual reports of the last three years (2009, 2008, and 2007) were considered to ensure consistency in the value used. This is because the bank shifted from the use of International Accounting Standards (IAS) to International Financial Reporting Standards (IFRS), in conformity with requirements by The Institute of Chartered Accountants (Ghana), Ghana Stock Exchange and the Securities and Exchange Commission for listed companies to prepare their financial statements for the year ended 31st December 2007 and beyond.

The bank‘s risk management policy manuals and other independent reports on its financial performance was used to gather relevant information concerning the bank‘s current health and capacity to remain stable in the face of instability in the industry and the global economy as a whole. However, the bank considers most information, except those contained in the annual report and official releases, sensitive and for that matter detailed but relevant information was not available for use.

Also, due to lack of adequate comparable data on other players in the Ghanaian banking industry, the study was unable to provide a complete picture of the performance EGH‘s risk in relation to peer group trends and industry norms in all cases. However, in cases where industry data was available comparative analysis was undertaken. 1. 7 ORGANISATION OF THE STUDY The study has been organised into six (6) chapters. Chapter One deals with the introduction of the study. It focuses on the background, introduction of company, objectives, significance, scope and limitation of the study.

Chapter Two discusses the existing literature on the subject matter. This included theoretical and empirical literature. Chapter Three provides a framework (methodology) for assessing the bank. The assessment of the bank‘s risk profile is presented in Chapter Four, whiles Chapter Five contains the assessment of the risk management framework of the bank. Chapter Six includes conclusion and proposed recommendations, based on the assessment done. 16 Masters Thesis: A risk-based assessment of Ecobank Ghana Limited October, 2010 CHAPTER TWO – LITERATURE REVIEW 2. 0 INTRODUCTION

This chapter reviews the literature on risk management in banking. It discusses issues on risk management from different perspectives and with the view of giving a theoretical foundation to the study. It starts with an exposition on risk management, followed by reviews of literature on the rationales and categories of risk management activities as well as the kinds of risk faced by banks, VaR as a risk management tool, Integrated Risk Management as the ultimate goal for risk management framework, Enterprise Risk Management and the place of Corporate Governance in bank risk management are also discussed in this chapter. . 1 RISK MANAGEMENT IN BANKING Risk management is described as the performance of activities designed to minimise the negative impact (cost) of uncertainty (risk) regarding possible losses (Schmidt and Roth, 1990). Redja (1998) also defines risk management as a systematic process for the identification and evaluation of pure loss exposure faced by an organisation or an individual, and for the selection and implementation of the most appropriate techniques for treating such exposure.

The process involves: identification, measurement, and management of the risk. Bessis (2010) also adds that in addition to it being a process, risk management also involves a set of tool and models for measuring and controlling risk. The objectives of risk management include to: minimise foreign exchange losses, reduce the volatility of cash flows, protect earnings fluctuations, increase profitability, and ensure survival of the firm (Fatemi and Glaum, 2000).

To ensure that banks operate in a sound risk management environment, where there is reduced impact of uncertainty and potential losses, managers need reliable risk measures to direct capital to activities with the best risk/reward ratios. They need estimates of the size of potential losses to stay within limits set through careful internal considerations and by regulators. They also need mechanisms to monitor positions and create incentives for prudent risk taking by divisions and individuals.

According to Pyle (1997), risk management is the process by which managers satisfy these needs by indentifying key risks, obtaining consistent, understandable, operational risk measures, choosing which risks to reduce, which to increase and by what means, and 17 Masters Thesis: A risk-based assessment of Ecobank Ghana Limited October, 2010 establishing procedures to monitor resulting risk positions. Bessis (2010) indicates that the goal of risk management is to measure risks in order to monitor and control them, and also enable it to serve other important functions in a bank in addition to its direct financial function.

These include assisting in the implementation of the bank‘s ultimate strategy by providing it with a better view of the future and therefore defining appropriate business policy and assisting in developing competitive advantages through the calculation of appropriate pricing and the formulation of other differentiation strategies based on customers‘ risk profiles. According to Santomero (1995), the management of the banking firm relies on a sequence of steps to implement a risk management system.

These normally contain four parts which are standards and reports, position limits or rules, investment guidelines or strategies, incentive contracts and compensation. These tools are generally established to measure exposure, define procedures to manage these exposures, limit individual positions to acceptable levels, and encourage decision makers to manage risk in a manner that is consistent with the firm’s goals and objectives. 2. 2 RATIONALES FOR RISK MANAGEMENT IN BANKING The main aim of management of banks is to maximise expected profits taking into account its variability/volatility (risk).

This calls for an active management of the volatility (risk) in order to get the desired results. Risk management is therefore an attempt to reduce the volatility of profit which has the potential of lowering the value of shareholders‘ wealth. Various authors including Stulz (1984), Smith et al (1990) and Froot et al (1993) have offered reasons why managers should concern themselves with the active management of risks in their organisations. According to Oldfield and Santomero (1995), recent review of the literature presents four main rationales for risk management.

These include managers self interest of protecting their position and wealth in the firm. It is argued that due to their limited ability to diversify their investments in their own firms, they are risk averse and prefer stability of the firm‘s earnings to volatility because, all things being equal, such stability improves their own utility. Beyond managerial motives, the desire to ensure the shouldering of lower tax burden is another rationale for managers to seek for reduced volatility of profits through risk management. 18 Masters Thesis: A risk-based assessment of Ecobank Ghana Limited

October, 2010 With progressive tax schedules, the expected tax burden are reduced when income smoothens therefore activities which reduce the volatility of reported taxable income are pursued as they help enhance shareholders‘ value. Perhaps the most compelling rationale for managers to engage in risk management with the aim of reducing the variability of profits is the cost of possible financial distress. Significant loss of earnings can lead to stakeholders losing confidence in the firm‘s operations, loss of strategic position in the industry, withdrawal of license or charter and even bankruptcy.

The costs associated with these will cause managers to avoid them by embarking on activities that will help avoid low realisations. Finally, risk management is pursued because firms want to avoid low profits which force them to seek external investment opportunities. When this happens, it results in suboptimal investments and hence lower expected shareholders‘ value since the cost of such external finance is higher than the internal funds due to capital market imperfections. This undesirable outcome encourages managers to actively embark upon volatility reducing strategies, which have the effect of reducing the variability of earnings.

It is believed that any of the above mentioned rationales is sufficient to motivate management to concern itself with risk and embark upon a careful assessment of both the level of risk associated with any financial product and potential risk mitigation techniques. 2. 3 CATEGORIES OF RISK MANAGEMENT As Merton (1989) noted, a key feature of the franchise of financial institutions (including banks) is the bundling and unbundling of risks. However, not all risks inherent in their business should be borne directly by them; some can be traded or transferred whiles others can be eliminated altogether.

It is therefore useful to defragment the risks inherent in their activities and assets into three distinctive subgroups in accordance with their nature so that the appropriate strategies can be adapted to mitigate them. Oldfield and Santomero (1995) argue therefore that risk facing financial institutions can be segmented into three separable categories from a management perspective. These are risks that can be eliminated or avoided by simple business practices, risks that can be transferred to other participants, and risk that must be actively managed at the firm level.

Avoiding risk altogether by business practices has the goal of ridding the bank of risks that are not essential to the services provided or absorbing on the optimal quantity of a particular 19 Masters Thesis: A risk-based assessment of Ecobank Ghana Limited October, 2010 kind of risk. This is done by engaging in actions such as underwriting standards, diversification, hedging, reinsurance and due diligence investigation to reduce the chances of idiosyncratic losses by eliminating risks that are superfluous to the bank‘s business purpose.

After this is done, what will be left is some portion of systematic and operational risks which should be minimised to the greatest extent possible and their level and costs communicated to stakeholders. This is because an attempt to aggressively avoid these risks will constrain risks alright but will also reduce the profitability of the business activity. Some risks can also be transferred by the bank, when there is no value-added or competitive advantage associated with absorbing and/or managing them, to other parties who are in better positions to manage and benefit from them.

There is yet another class of risks which should be adsorbed and aggressively managed at the originating bank level because good reasons exist for using further resources to manage them. Some activities whose inherent risks have to be managed by the bank include those where the nature of the embedded risk may be complex and difficult to reveal to non-firm interests. For instance, banks holding complex illiquid and proprietary assets may find communicating the nature of such assets more difficult or expensive than hedging the underlying risk6. Moreover, revealing information about customers or clients may give competitors an undue advantage.

Internal management of some risks may also be necessary because it is central to the bank‘s business purpose because they are the raison d‘etre of the firm. This includes propriety positions that are accepted because of their risks and expected return. In all these circumstances when risk is absorbed, risk management activity requires the monitoring of business activity risk and returns and it is considered as part of doing business. In effect, banks should accept only those risks that are uniquely a part of the bank‘s array of unique value-added services (Allen & Santomero, 1996, Oldfield & Santomero, 1995). . 4 KEY BANK RISKS The risks associated with the provision of banking services differ by the type of service rendered. Different authors have grouped these risks in various ways to develop the frameworks for their analyses but the common ones which are considered in this study are credit risk, market risks (which includes liquidity risk, interest rate risk and foreign exchange risk), operational risks which sometimes include legal risk, and more recently, strategic risk. 6 This point has been made in a different context by both Santomero and Trester (1997) and Berger and Udell 1993) 20 Masters Thesis: A risk-based assessment of Ecobank Ghana Limited 2. 4. 1 Credit Risk October, 2010 Greuning and Bratanovic (2009) define credit risk as the chance that a debtor or issuer of a financial instrument— whether an individual, a company, or a country— will not repay principal and other investment-related cash flows according to the terms specified in a credit agreement. Inherent to banking, credit risk means that payments may be delayed or not made at all, which can cause cash flow problems and affect a bank‘s liquidity.

The goal of credit risk management is to maximise a bank‘s risk-adjusted rate of return by maintaining credit risk exposure within acceptable parameters. More than 70 percent of a bank‘s balance sheet generally relates to credit risk and hence considered as the principal cause of potential losses and bank failures. Time and again, lack of diversification of credit risk has been the primary culprit for bank failures. The dilemma is that banks have a comparative advantage in making loans to entities with whom they have an ongoing relationship, thereby creating excessive concentrations in geographic and industrial sectors.

Credit risk includes both the risk that a obligor or counterparty fails to comply with their obligation to service debt (default risk) and the risk of a decline in the credit standing of the obligor or counterparty. While default triggers a total or partial loss of any amount lent to the obligor or counterparty, a deterioration of the credit standing leads to the increase of the possibility of default. In the market universe, a deterioration of credit standing of a borrower does materialise into a loss because it triggers an upward move of the required market yield to compensate the higher risk and triggers a value decline (Bessis, 2010).

Normally the financial condition of the borrower as well as the current value of any underlying collateral are of considerable interest to banks when evaluating the credit risks of obligors or counterparties (Santomero, 1997). According to Greuning and Bratanovic (2009), formal policies laid down by the board of directors of a bank and implemented by management plays a vital part in credit risk management. As a matter of fact, a bank uses a credit or lending policy to outline the scope and allocation of a bank‘s redit facilities and the manner in which a credit portfolio is managed— that is, how investment and financing assets are originated, appraised, supervised, and collected. There are also minimum standards set by regulators for managing credit risk. These cover the identification of existing and potential risks, the definition of policies that express the bank‘s risk management philosophy, and the setting of parameters within which credit risk will be 21 Masters Thesis: A risk-based assessment of Ecobank Ghana Limited October, 2010 ontrolled. There are typically three kinds of policies related to credit risk management. The first set aims to limit or reduce credit risk, which include policies on concentration and large exposures, diversification, lending to connected parties, and overexposure. The second set aims at classifying assets by mandating periodic evaluation of the collectability of the portfolio of credit instruments. The third set of policies aims to make provision for loss or make allowances at a level adequate to absorb anticipated loss. 2. . 2 Market Risks Market risk is generally considered as the risk that the value of a portfolio, either an investment portfolio or a trading portfolio, will decrease due to the change in value of the market risk factors. Pyle (1997) defines market risk as the change in net asset value due to changes in underlying economic factors such as interest rates, exchange rates, and equity and commodity prices. There are three common market risk factors to banks and these are liquidity, interest rates and foreign exchange rates. 2. 4. 2. Liquidity Risk Greuning and Bratanovic (2009), indicate that a bank faces liquidity risk when it does not have the ability to efficiently accommodate the redemption of deposits and other liabilities and to cover funding increases in the loan and investment portfolio. These authors go further to posit that a bank has adequate liquidity potential when it can obtain needed funds (by increasing liabilities, securitising, or selling assets) promptly and at a reasonable cost. The Basel Committee on Bank Supervision, in its June 2008 consultative aper, defined liquidity as the ability of a bank to fund increases in assets and meet obligations as they become due, without incurring unacceptable losses. Bessis (2010) however considers liquidity risk from three distinct situations. The first angle is where the bank has difficulties in raising funds at a reasonable cost due to conditions relating to transaction volumes, level of interest rates and their fluctuations and the difficulties in finding a counterparty. The second angle looks at liquidity as a safety cushion which helps to gain time under difficult situations.

In this case, liquidity risk is defined as a situation where short-term asset values are not sufficient to match short term liabilities or unexpected outflows. The final angle from where liquidity risk is considered as the extreme situation. Such a situation can arise from instances of large losses which creates liquidity issues and 22 Masters Thesis: A risk-based assessment of Ecobank Ghana Limited October, 2010 doubts on the future of the bank. Such doubts can result in massive withdrawal of funds or closing of credit lines by other institutions which try to protect themselves against a possible default.

Both can generate a brutal liquidity crisis which possibly ends in bankruptcy. Liquidity is necessary for banks to compensate for expected and unexpected balance sheet fluctuations and to provide funds for growth (Greuning and Bratanovic, 2009). Santomero (1995) however, posits that while some would include the need to plan for growth and unexpected expansion of credit, the risk here should be seen more correctly as the potential for funding crisis. Such a situation would inevitably be associated with an unexpected event, such as a large charge off, loss of confidence, or a crisis of national proportion such as a currency crisis.

Effective liquidity risk management therefore helps ensure a bank’s ability to meet cash flow obligations, which are uncertain as they are affected by external events and other agents’ behaviour. The Basel Committee on Bank Supervision consultative paper (June 2008) asserts that the fundamental role of banks in the maturity transformation of short-term deposits into longterm loans makes banks inherently vulnerable to liquidity risk, both of an institution-specific nature and that which affects markets as a whole.

A liquidity shortfall at a single bank can have system-wide repercussions and hence liquidity risk management is of paramount importance to both the regulators and the industry players. The price of liquidity is however a function of market conditions and the market‘s perception of the inherent riskness of the borrowing institution (Greuning and Bratanovic, 2009). So if there is a national crisis such as acute currency shortage or decline, or perception of the bank‘s credit standings deteriorates, or fundraising by the bank becomes suddenly important and recurrent or has unexpected fluctuation, funding becomes more costly.

Financial market developments in the past decade have increased the complexity of liquidity risk and its management. 2. 4. 2. 2 Interest Rate Risk In general, interest rate risk is the potential for changes in interest rates to reduce a bank‘s earnings or value. Most of the loans and receivables of the balance sheet of banks and term or saving deposits, generate revenues and costs that are driven by interest rates and since interest rates are unstable, so are such earnings. Though interest rate risk is obvious for borrowers and lenders with variable rates, those engaged in fixed rate transactions are not exempt from 23

Masters Thesis: A risk-based assessment of Ecobank Ghana Limited October, 2010 interest rate risks because of the opportunity cost that arises from market movements (Bessis, 2010). According to Greuning and Bratanovic (2009), the combination of a volatile interest rate environment, deregulation, and a growing array of on and off-balance-sheet products have made the management of interest rate risk a growing challenge. At the same time, informed use of interest rate derivatives— such as financial futures and interest rate swaps— can help banks manage and reduce the interest rate exposure that is inherent in their business.

Bank regulators and supervisors therefore place great emphasis on the evaluation of bank interest rate risk management, particularly since the Basel Committee recommends the implementation of market risk– based capital charges. Greuning and Bratanovic (2009) posits that banks encounter interest rate risk from four main sources namely repricing risk, yield curve risk, basis risk, and optionality. The primary and most often discussed source of interest rate risk stems from timing differences in the maturity of fixed rates and the repricing of the floating rates of bank assets, liabilities, and off-balance sheet positions.

The basic tool used for measuring repricing risk is duration, which assumes a parallel shift in the yield curve. Also, repricing mismatches expose a bank to risk deriving from changes in the slope and shape of the yield curve (nonparallel shifts). Yield curve risk materialises when yield curve shifts adversely affect a bank‘s income or underlying economic value. Another important source of interest rate risk is basis risk, which arises from imperfect correlation in the adjustment of the rates earned and paid on different instruments with otherwise similar repricing characteristics.

When interest rates change, these differences can give rise to unexpected changes in the cash flows and earnings spread among assets, liabilities, and off-balance-sheet instruments of similar maturities or repricing frequencies (Wright and Houpt, 1996). An increasingly important source of interest rate risk stems from the options embedded in many bank asset, liability, and off-balance-sheet portfolios. If not adequately managed, options can pose significant risk to a banking institution because the options held by customers, both explicit and embedded, are generally exercised at the advantage of the holder and to the disadvantage of the bank.

Moreover, an increasing array of options can involve significant leverage, which can magnify the influences (both negative and positive) of option positions on the financial condition of a bank. Broadly speaking, interest rate risk management comprises various policies, actions and techniques that a bank uses to reduce the risk of diminution of its net equity as a result of adverse changes in interest rates from any of 24 Masters Thesis: A risk-based assessment of Ecobank Ghana Limited October, 2010 the sources mentioned above.

Risk factors related to interest rate risk are estimated in each currency in which a bank has interest-rate-sensitive on and off-balance sheet positions. Since interest rate risk can have adverse effects on both a bank‘s earning and its economic value, an approach which focuses on the impact of interest rate changes on a bank‘s net interest income is combined with another which takes a more comprehensive view of the potential long-term effects of such interest rates changes on its economic value is used to assess the interest risk exposure. 2. 4. 2. 3 Foreign Exchange Risk

Bessis (2010) defines foreign exchange risk as incurring losses due to changes in exchange rates. Such loss of earnings may occur due to a mismatch between the value of assets and that of capital and liabilities denominated in foreign currencies or a mismatch between foreign receivables and foreign payables that are expressed in domestic currency. According to Greuning and Bratanovic (2009), foreign exchange risk is speculative and can therefore result in a gain or a loss, depending on the direction of exchange rate shifts and whether a bank is net long or net short (surplus or deficit)in the foreign currency.

In principle, the fluctuations in the value of domestic currency that create currency risk result from long-term macroeconomic factors such as changes in foreign and domestic interest rates and the volume and direction of a country‘s trade and capital flows. Short-term factors, such as expected or unexpected political events, changed expectations on the part of market participants, or speculation based currency trading may also give rise to foreign exchange changes.

All these factors can affect the supply and demand for a currency and therefore the day-to-day movements of the exchange rate in currency markets. Foreign exchange risk is generally considered to comprise of transaction risk, economic risk and revaluation risk. Transaction risk is the price-based impact of exchange rate changes on foreign receivables and foreign payables, that is, the difference in price at which they are collected or paid and the price at which they are recognised in local currency in the financial statements of a bank or corporate entity.

Alternatively known as business risk, economic risk relates to the impact of exchange rate changes on a country‘s long-term or a company‘s competitive position. With increasing globalisation, capital moves quickly to take advantage of changes in exchange rates and therefore devaluations of foreign currencies can lead to increased competition in both overseas and domestic markets. This phenomenon makes this component of foreign 25 Masters Thesis: A risk-based assessment of Ecobank Ghana Limited October, 2010 xchange risk very critical for its management. The third component, revaluation or translation risk arises when a bank‘s foreign currency positions are revalued in domestic currency, and when a parent institution conducts financial reporting or periodic consolidation of financial statements. Banks conducting foreign exchange operations are also exposed to foreign exchange risk in forms of credit risks such as the default of the counterparty to a foreign exchange contract and time-zone-related settlement risk. 2. 4. Operational Risk The Basel Accord (2007) defines operational risk as the risk of direct or indirect loss resulting from inadequate or failed internal processes, people and systems or from external events. Malfunctions of the information systems, reporting systems, internal monitoring rules and internal procedures designed to take timely corrective actions, or the compliance with the internal risk policy rules result in operational risks (Bessis, 2010). Operational risks, therefore, appear at different levels, such as human errors, processes, and technical and information technology. Because operational risk is an ? vent risk? , in the absence of an efficient tracking and reporting of risks, some important risks will be ignored, there will be no trigger for corrective action and this can result in disastrous consequences. Developments in modern banking environment, such as increased reliance on sophisticated technology, expanding retail operations, growing e-commerce, outsourcing of functions and activities, and greater use of structured finance (derivative) techniques that claim to reduce credit and market risk have contributed to higher levels of operational risk in banks (Greuning and Bratanovic, 2009).

The recognition of the above-mentioned contributory factor in operational risk has led to an increased attention on the development of sound operational risk management systems by banks with the initiative being taken by the Basel Committee on Banking Supervision. The Committee addressed operational risk in its Core Principles for Effective Banking Supervision (1997) by requiring supervisors to ensure that banks have risk management policies and processes to identify, assess, monitor, and control or mitigate operational risk.

In its 2003 document, Sound Practices for the Management and Supervision of Operational Risk, the Committee further provided guidance to banks for managing operational risk, in anticipation of the implementation of the Basel II Accord, which requires a capital allocation for operational risks. Despite all these efforts by the regulators at addressing operational risk, 26 Masters Thesis: A risk-based assessment of Ecobank Ghana Limited October, 2010 practical challenges exist when it comes to its management.

In the first place, it is difficult to establish universally applicable causes or risk factors which can be used to develop standard tools and systems of its management since the events are largely internal to individual banks. Moreover, the magnitude of potential losses from specific risk factors is often not easy to project. Lastly, it is difficult designing an effective mechanism for systematic reporting of trends in a bank‘s operational risks because very large operational losses are rare or isolated.

Because of the data and methodological challenges raised by operational risk, the first stage of developing an effective framework to manage it is to set up a common classification of loss events that should serve as a receptacle for data gathering process on event frequency and costs. The data gathered is then analysed (risk mapping) with various statistical techniques such as graphical representation of the probability and severity of risks. This helps to find the links between various operational risks.

The process then ends with some estimates of worst-case losses due to events risks. Modelling of loss distributions due to operational risks will enable the right capital charges to be made for operational risk as required by current regulations (Bessis, 2010). In order for the objectives of setting up an operational risk management framework to be accomplished, it may require a change in the behaviour and culture of the firm. Management must also not only ensure compliance with the operational risk policies established by the board, but also report regularly to senior executives.

A certain amount of self-assessment of the controls in place to manage and mitigate operational risk will be helpful. 2. 4. 4 Strategic Risk

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