Risk Management Report: Saint Charles Bank

Executive Summary:

This report focuses upon the financial risk management of Saint Charles Bank. When analyzing the bank’s financial statements it is evident that the bank is in an adequate financial position without many evident financial threats. The bank has not majorly succumbed to operational and market risk but has a high rate of credit and liquidity risk in certain areas. However, when comparing the bank’s performance with Barclay’s Bank, it is evident that Barclay’s bank has also succumbed to the same types of risk and this may be common for banks who give loans and advances to other banks and customers. Thus, this report recommends that Saint Charles Bank adopt the same policy as Barclays Bank and adopt a rigorous credit rating system to manage its credit risk and reduce its level of short-term loans and advances to manage its liquidity amongst other recommendations.

Introduction:

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After the completion of the year 2011, it is essential to analyze the financial statements of Saint Charles Bank and determine whether there are any financial risks that the bank may be potentially facing in the future. If there are certain risks that the bank is likely to face, it is best for the bank to devise an appropriate plan to mitigate against those risks. Thus, this risk management report will analyze the financial performance of Saint Charles Bank and then commence with an analysis of various risks including capital risk, operational risk, liquidity risk, and market risk of Saint Charles Bank from the years 2008 to 2011 respectively. The report will also aim to compare the financial performance of Barclays Bank with that of Saint Charles Bank in order to determine what areas Saint Charles Bank is comparatively strong in and what areas may be posing a potential threat in the future (McNeil, Frey, & Embrechts, 2010).

This report will begin with an analysis of the financial statements of Saint Charles Bank from the years 2008 to 2011 and then commence with an analysis of the different risks that the bank is facing including various forms of the bank’s credit risk followed by its liquidity risk. The report ill then conclude with a summary of the main findings of the report and brief recommendations regarding how the bank an mitigate against the perceived threats to its financial security (if any).

Financial Performance of Saint Charles Bank:

Saint Charles’ Bank’s operating income and profit statement from 2008-2011 shows progress over the years as the bank has been able to increase its net interest income steadily from 2008 to 2011. While the increase in net interest income from 2010 to 2011 was minimal as income rose from $7,387 million to $7,623, there was still improvement which eliminates concern for financial risk in this area. Similarly, the bank improved in the areas of net trading income, net fees and commissions income, and other operating income. As a result, the bank also had a higher operating income before impairment losses and taxation than previous years. The only area of concern was that the bank’s impairment losses on loans and advances to other credit risk provisions got higher in 2011 compared to the years 2008 to 2010 amounting to $2,000 million. However, the bank had less other losses from 2010 in 2011 was showed an improvement in the bank’s financial risk position. The bank showed an increase in earnings before taxation in 2011 compared to 2010 as earnings amounted to $5, 151 compared to previously being at $4,568.

Upon analysis of the bank’s balance sheet, it is evident that the bank’s cash and balances at the central banks has increased considerably from 2007 but has decreased to a substantial extent from 2010 at $24,161 million to $18, 131 million in 2011 which may jeopardize the bank’s liquidity position. The bank’s financial assets held at fair value amount to $22, 446 million from $ 15, 425 million-+ in 2010 which shows that the bank is investing more in financial assets than it previously was which may be a reason for its reduced cash balance. However, the bank has reduced its investment in derivative financial instruments from 2010 to 2011. A slight area of concern may exist in the fact that the bank has increased its loans and advances to banks and loans and advances to other customers as in 2010 , loans and advances to banks amounted to $46, 583 million and in 2011 it amounted to $50, 885 million. The increase in loans and advances to customers was greater as it was at $174,178 million in 2010 and increased to $198, 292 million in 2011. This may be an area of concern for the bank in the realms of increasing its credit risk. The bank’s investment securities have increased from 2010 to 2011 but the bank has decreased its other assets, current tax assets, and prepayments and accrued income. The bank has increased its asset value in the area of interests in associates, goodwill and intangible assets, property plant and equipment, and deferred tax assets. Overall, the bank’s total assets have increased over the years from 2008 to 2011 and amount to $436, 653 million.

Another slight area of concern when analyzing the bank’s financial position is that the bank’s liabilities have increased over the years in certain key areas which include deposits by banks, increase in customer accounts, debt securities in issue, current tax liabilities, deferred tax liabilities, provisions for liabilities and charges, and retirement benefit obligations. However, the bank’s liabilities have also decreased in a few areas which include financial liabilities held at fair value, derivative financial instruments, other liabilities, accruals and deferred income, and subordinated liabilities and other borrowed funds. The bank’s total liabilities at the end of 2011 was less than the total amount at the end of 2010 as it amounted to $408, 773 million in 2011compared to $ 412, 373 million in 2010. Another sign of the bank’s strong financial position is its increase in equity from the year 2008 to 2011 as the bank’s share capital increased from $948 million in 2010 to $1, 013 million in 2011 and the bank’s reserves also increased from $21, 192 in 2010 to $ 26, 327 in 2011. Similarly, the bank’s minority interests increased from $555 million to $ 580 million from the years 2010 to 2011. The bank’s total equity has also increased over the years and amounted to $27, 920 in 2011 compared to $ 22, 695 in 2010.

The bank’s financial position seems to be strong on the whole but there are a few key areas which may pose a concern for the bank’s risk management in the future. The bank’s deteriorating cash balances may pose as a concern for an increase in liquidity risk and the fact that the bank has increased loans to customers and other banks may pose as a concern for credit risk in the future. As the bank has diverted many of its assets from cash and other equivalents form to investments in financial securities and other assets, the bank has also increased its market risk to a certain degree (Andersen Bollerslev, T. Christoffersen, P. F & Diebold, 2012).

However, as the bank has a deteriorating amount of liabilities from year to year and an increasing amount of assets, the bank seems to be in a strong financial position presently and the implications of upcoming risks may not be as prominent or prevalent. The next section of this report will analyze the bank’s various risk levels individually and determine whether the bank is facing a serious threat to succumbing to any of the mentioned risks.

Operational, Credit, and Market Risks:

The most prominent risk that the bank is currently facing is credit risk as the bank’s risk-weighted assets holding a degree of credit risk are substantially higher than the bank’s regulatory capital requirement and amount to $173, 315 million in 2011 with a regulatory requirement of $13, 865 million, compared to $ 161, 276 million in 2010 with a regulatory requirement of $ 12, 902 million. This increase in credit risk can most likely to be allocated to the bank’s increase in loans to other banks and customers which also increases the risk that these banks and customers may default on their payments and may not be able to pay their loans back. The bank is also facing a certain degree of market risk although the market risk is not as severe as the credit risk as the bank’s regulatory capital requirement stands at $ 1,593 million and the bank’s risk-weighted assets amount to $ 19, 912. However, the bank’s market risk has substantially increased from 2010 as regulatory capital requirement amounted to 735 million while the bank’s risk-weighted assets amounted to $ 9, 205 million. This may be because the bank has increased its investment in financial assets which have increased the bank’s exposure to market risk (Cornett, McNutt, Strahan, & Tehranian, 2011).

Saint Charles Bank is also faced with a certain degree of operational risk as the regulatory capital requirement in 2011 is $1, 656 million and the bank holds risk-weighted assets amounting to $ 20, 696 while the bank’s regulatory capital requirement in 2010 was $1,467 million and the bank held risk-weighted assets amounting to $18, 340 million. However, the bank’s operational risk is still significantly less than the bank’s credit risk and may not pose as serious a threat to the bank as the bank’s credit risk may. Overall, the bank’s total risk level with inclusion of credit risk, market risk, and operational risk is greater in 2011 than 2010 and the bank’s risk-weighted assets have also considerably increased from $ 188, 821 million to $ 213, 923 million.

Barclay’s Bank also faces a certain degree of risks in each risk category which is evident from the bank’s risk profile. Barclay’s holds risk-weighted assets amounting to $ 283, 308 million which hold credit risk while the bank’s credit risk capital requirements amount to $ 22, 665 million. Barclay’s also holds a higher degree of market risk than Saint Charles Bank as the bank’s capital regulatory requirements amount to $5,756 million while the bank’s risk-weighted assets amount to $71, 951 million. Similar to Saint Charles Bank, Barclay’s operational risk seems to be the least as the bank’s capital regulatory requirements measure up to $ 2, 859 million and the bank’s risk-weighted assets amount to $ 35, 740 million.

The bank’s total credit risk has substantially decreased from 2010 as Barclay’s credit risk amounted to $304, 861 million in 2010 but has decreased in 2011 which shows that the bank may be controlling its level of credit risk adequately. Moreover, the credit risk of Barclay’s bank is significantly more than that of Saint Charles Bank. This may be attributed to the fact that Barclay’s holds more capital and has more customers than Saint Charles Bank which means that they offer more customers and financial institutions loans than Saint Charles Bank does. However, Barclays’ operational and market risk are more or less the same from 2010 to 2011 and have not shown significant changes. Hence, similar to Saint Charles Bank, Barclays also holds a significant amount of credit risk which means that the bank must mitigate against these risks in these future to prevent major defaults in loans (Barclays Pillar 3 Report, 2011).

Barclay’s Bank’s high credit risk rating can be attributed to the fact that the bank gives out substantial wholesale and retail loans and advances, and indulges in derivative contracts with various clients. Other reasons for the bank’s high credit risk rating are caused by the bank’s trading activities, debt securities, settlement balances, available for sale assets and reverse repurchase loans. However, the bank aims to manage these risks by establishing a framework of controls to ensure credit-risk taking is based on appropriate credit risk management principles, measuring and managing credit risk appropriately in each of the bank’s businesses, controlling and planning credit-risk taking with external stakeholder expectations and the avoidance of undesirable concentrations. The bank aims to monitor credit risk and appropriately follow the relevant controls set by central banks and the government, and ensures that all risk and reward objectives are met properly (Barclays Pillar 3 Report, 2011).

As there are differing rates of exposure to credit risk in various businesses or with various clients, it is important for the bank to determine where credit risk is the highest and to apply appropriate policies to curb and mitigate against this risk. It is evident from Exhibit 4.2 that credit risk is highest in short term loans and advances which are for a duration of 1 year or less as their credit risk exposure amounts to approximately 62.6%. It is evident that credit risk decreases as the maturity period of a loan or advance increases and the lowest credit risk exposure is for loans over five years. This trend was also seen in 2010 which means that it is a continuous trend showing that loans which have a longer maturity level are likely to default less than loans with shorter maturity periods. Moreover, it is evident that loans and advances given to institutions, corporate, and retail sectors are the heaviest defaulters, while loans and advances given to the retail sector are likely to default the most after a period of 5 years. However, corporate and institutions are likely to default more when the loan maturity period is of 1 year or less or when it is in the range of 1 to 5 years. It is important for the bank to devise an appropriate credit risk management strategy accordingly in order to decrease the chances of credit risk

Barclay’s Bank also faced a maximum amount of credit risk exposure from loans and advances to the corporate and retail sectors as they amounted to $3,227 million in 2011 for the corporate sector and $1, 571 million for the retail sector. However, Barclay’s Bank did not seem to have as much credit risk exposure from institutions as Saint Charles Bank had faced.

There are also different levels of credit risk exposure in different countries and it is thus essential for a bank to manage its credit risk appropriately, in order to prevent a high default rate in any country which would affect the bank’s financial risk overall. Saint Charles Bank is exposed to the highest credit risk exposure rate in Asia as that amounts to $257, 197 million in 2011 from $ 232, 202 million in 2010. This is followed by a high credit risk exposure rate in the USA, UK, and Europe, Middle East and South Asia, and the lowest credit risk exposure in Africa. This can be attributed to the fact that Saint Charles Bank does not provide customers in Africa with a large amount of loans and advances and does not necessarily have to be attributed to the reason that people in this geographical region do not default upon loans as frequently. However, the high credit risk exposure rate in Asia may be subject to the fact that the bank gives more loans and advances in Asia than in other regions and Asians are also probably higher defaulters than people living in other geographic regions.

The next section of this report will analyze the bank’s liquidity position in terms of the bank’s perceived liquidity risk and the implications of this.

Liquidity Risk:

Saint Charles Bank’s liquidity risk increased slightly from the year 2010 to 2011 which shows that the bank has not substantially increased its state of illiquidity. The assets that posed the highest degree of liquidity risk in 2011 included loans and advances to customers and investment securities. Followed by these categories of assets, the highest degree of liquidity risk existed in loans given to banks. In the year 2010, the total liquidity risk in 2010 amounted to $ 435, 068 million while the total liquidity risk in 2011 amounted to $ 436, 653 million in the company’s assets.

In the liability section, customer accounts held the highest value in posing a liquidity risk followed by deposits by banks, debt securities in issue, and other liabilities. The bank faces the highest amount of liquidity risk in the short-term and in the category of 3 months or less because liabilities exceed assets substantially in this time period and the net liquidity gap amounts to approximately -$150, 958. This trend was observed in the year 2010 as well as liabilities exceeded assets with a net liquidity gap of $-117, 591. All subsequent maturity levels showed a positive trend as assets exceeded liabilities and showed no problems in liquidity or an increase in liquidity risk. Thus, it is evident that the bank has to improve its short-term liquidity position in order to reduce its financial risk.

Analysis:

The bank’s financial position seems to be adequate and well-managed and the bank does not seem to be under major financial threats as the bank’s market risk and operational risk appear to be under control and are not cause for major concern for the bank. In comparison to Barclay’s bank, Saint Charles Bank is also performing adequately in the fields of operational and market risk. However, the bank’s performance has shown considerable concern in the realms of credit risk. This situation also holds true for Barclay’s Bank as well (Barclays Pillar 3 Report, 2011) and can thus be attributed to the fact that banks do hold an immense amount of credit risk when they give loans and advances to customers and other banks (Hermann, 2011). The bank holds the maximum amount of credit risk when offering loans to the retail sector, corporate sector, and institutions. Moreover, the bank holds the highest exposure to credit risk in the geographic region of Asia which means that the bank must focus upon this area more specifically when attempting to mitigate against credit risk. Thus, it is necessary for the bank to apply certain policies which will help the bank curb and mitigate against credit risks in these key areas of concern (Drehmann & Nikolaou, 2012).

Moreover, the bank does not show a high degree of concern in the area of liquidity risk. The bank has a substantial amount of assets to cover for its liabilities at most maturity levels but is suffering in terms of liquidity in the short term. The bank has a very high net liquidity gap in the category of 3 months or less in both the years 2010 to 2011. This may pose as a major area of concern to the bank if customers begin to demand their deposits back or the bank is in need of some cash quickly. It may also cause the bank to go temporarily bankrupt if it is unable to raise cash immediately (Hartmann, 2010).

Another major area of concern for the bank is the current financial scenario in the contemporary business environment in the years 2008-2011. As the number of bank defaulters have substantially increased and due to the global economic crisis, the whole business environment is in a major state of decline. This means that it is essential for the bank to review its policies adequately as many customers are likely to default in their bank loans and advances. Moreover, the economic crisis has hit certain areas harder than it has hit others, thus it is also essential for the bank to revise its policies in certain geographic regions in order to ensure that no particular area causes the bank immense financial concern (Brownless & Gallo, 2010). Moreover, as the bank’s short term liquidity position is in jeopardy, it is also essential for the bank to devise certain policies which will help it improve its short-term liquidity position and prevent the bank from experiencing problems in generating cash flow in the short run (Gillet, Hubner, & Plunus, 2010).

The next section of this report will recommend specific policies for the bank to use in order to improve its financial position.

Conclusion and Recommendations:

Saint Charles Bank must focus upon improving its credit risk and liquidity risk position in order to ensure that its financial performance is up to the mark. The first risk that the bank must mitigate against is the credit risk. Accordingly, Saint Charles Bank may follow the policy of Barclay’s Bank and adopt an adequate credit rating policy while anticipating and measuring credit risk of different customers and also different areas. Barclays Bank adopts a rigorous credit rating policy which assesses the degree of risk associated with providing loans and advances to various customers. The bank then allows these customers to be provided with loans and advances from the bank on the condition that they meet the bank’s strict requirements (Van Deventer, Imai & Mesler, 2013). Saint Charles Bank can improve its credit risk position by asking lower rating customers to provide extra collateral to make their loans secure. Moreover, they can also adopt a more rigorous rating policy in the areas of Asia, USA, UK, and Europe, and perhaps the Middle East as well. The bank may also reduce the number of loans it gives to the retail sector or reduce the maturity time of these loans in order to reduce the credit risk. The bank may increase the maturity time of loans given to other customers in order to improve the credit risk as it was found that shorter maturity times substantially increased the bank’s credit risk in other customer categories besides retail stores (Hoyt & Leinberg, 2011).

In order to improve its liquidity position in the short run, the bank can reduce its investment in long-term securities in order to ensure that it has enough cash available in the period of time of 3 months or less. The bank can decrease its level of investment securities and opt for keeping more cash deposits in the central bank. Moreover, offering less short-term loans may also improve the bank’s short-term liquidity level (Aebi, Samato, & Schmid, 2012).

Thus, this report concludes that Saint Charles Bank does not have a high degree of risks embedded in the bank’s financial performance and is performing adequately in comparison to its counterpart, Barclays Bank. The bank’s liquidity and credit risk may be areas of concern for the bank in the future but do not pose a great threat to the bank’s financial statements.

References

Aebi, V., Sabato, G., & Schmid, M. (2012). “Risk management, corporate governance, and bank performance in the financial crisis.”Journal of Banking & Finance. Vol. 36(12) pp. 3213-3226.
Andersen, T. G., Bollerslev, T., Christoffersen, P. F., & Diebold, F. X. (2012).Financial risk measurement for financial risk management(No. w18084). National Bureau of Economic Research.
Barclays Bank (2011) Barclay’s Pillar 3 Report.
Brownlees, C. T., & Gallo, G. M. (2010). “Comparison of volatility measures: a risk management perspective.”Journal of Financial Econometrics. Vol. 8(1) pp.29-56.
Cornett, M. M., McNutt, J. J., Strahan, P. E., & Tehranian, H. (2011). “Liquidity risk management and credit supply in the financial crisis.”Journal of Financial Economics. Vol. 101(2) pp. 297-312.
Cornett, M. M., McNutt, J. J., Strahan, P. E., & Tehranian, H. (2011). “Liquidity risk management and credit supply in the financial crisis.”Journal of Financial Economics. Vol. 101(2) pp.297-312.
Drehmann, M., & Nikolaou, K. (2012). “Funding liquidity risk: definition and measurement”. Journal of Banking & Finance.
Gillet, R., Hubner, G., & Plunus, S. (2010). “Operational risk and reputation in the financial industry.”Journal of banking & finance. Vol. 34(1) pp.224-235.
Hartmann, P. (2010). “Interaction of market and credit risk.”Journal of Banking & Finance. Vol. 34(4) pp. 697-702.
Herman, R. D. (2011).The Jossey-Bass handbook of nonprofit leadership and management. John Wiley & Sons.
Hoyt, R. E., & Liebenberg, A. P. (2011). “The value of enterprise risk management.”Journal of Risk and Insurance. 78(4) pp.795-822.
Jorion, P. (2010). Financial risk management handbook.Global Association of Risk Professionals.
McNeil, A. J., Frey, R., & Embrechts, P. (2010).Quantitative risk management: Concepts, Techniques, and Tools. Princeton University Press.
Van Deventer, D. R., Imai, K., & Mesler, M. (2013).Advanced financial risk management: tools and techniques for integrated credit risk and interest rate risk management. John Wiley & Sons
Glossary of Terms

Operational Risk: A risk incurred by an organization’s activities which may include risks associated with systems, people, and processes. These risks include fraud, legal risks, and environmental risks (Jorion, 2010).

Market Risk: The risk of financial losses arising from movements or changes in market prices. It includes equity risk, interest rate risk, currency risk, and commodity risk (Jorion, 2010).

Liquidity Risk: The risk that assets cannot be traded in quickly enough without preventing a loss to cover a company’s current liabilities (Jorion, 2010).

Credit Risk: The risk that a borrower will default on his/her payment in any manner (Jorion, 2010).

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