RISK ANALYSIS Risk analysis is the systematic study of uncertainties and risks we encounter in business, engineering, public policy, and many other areas. Risk analysis is the process of identifying and analyzing potential issues that could negatively impact key business initiatives or critical projects in order to help organizations avoid or mitigate those risks. Performing a risk analysis includes considering the probability of adverse events caused by either natural processes, like severe storms, earthquakes or floods, or adverse events caused by malicious or inadvertent human activities; an important part of risk analysis is identifying the potential for harm from these events, as well as the likelihood that they will occur. Some institutions, such as banks and investment management firms, are in the business of taking risks every day. Risk analysis and management is clearly crucial for these institutions. One of the roles of risk management in these firms is to quantify the financial risks involved in each investment, trading, or other business activity, and allocate a risk budget across these activities. Banks in particular are required by their regulators to identify and quantify their risks, often computing measures such as Value at Risk (VaR), and ensure that they have adequate capital to maintain solvency should the worst (or near-worst) outcomes occur. Enterprises and other organizations use risk analysis to: • anticipate and reduce the effect of harmful results from adverse events; • evaluate whether the potential risks of a project are balanced by its benefits to aid in the decision process when evaluating whether to move forward with the project; • plan responses for technology or equipment failure or loss from adverse events, both natural and human-caused; and • Identify the impact of and prepare for changes in the enterprise environment, including the likelihood of new competitors entering the market or changes to government regulatory policy. Steps in risk analysis process The risk analysis process usually follows these basic steps: 1. Conduct a risk assessment survey: This first step, getting input from management and department heads, is critical to the risk assessment process. The risk assessment survey is a way to begin documenting specific risks or threats within each department. 2. Identify the risks: The reason for performing risk assessment is to evaluate an IT system or other aspect of the organization and then ask: What are the risks to the software, hardware, data and IT employees? What are the possible adverse events that could occur, such as human error, fire, flooding or earthquakes? What is the potential that the integrity of the system will be compromised or that it won't be available? 3. Analyze the risks: Once the risks are identified, the risk analysis process should determine the likelihood that each risk will occur, as well as the consequences linked to each risk and how they might affect the objectives of a project. 4. Develop a risk management plan: Based on an analysis of which assets are valuable and which threats will probably affect those assets negatively, the risk analysis should produce control recommendations that can be used to mitigate, transfer, accept or avoid the risk. 5. Implement the risk management plan: The ultimate goal of risk assessment is to implement measures to remove or reduce the risks. Starting with the highest-priority risk, resolve or at least mitigate each risk so it's no longer a threat. 6. Monitor the risks: The ongoing process of identifying, treating and managing risks should be an important part of any risk analysis process. The focus of the analysis, as well as the format of the results, will vary depending on the type of risk analysis being carried out BANK CAPITAL ADEQUACY The premise behind capital adequacy is that an entity should assess its risks and hold capital that is commensurate with its risk profile and control environment. In markets and sectors such as financial services where the risk of contagion or domino effect is high Capital Adequacy is used as a primary regulatory tool. Regulators use Capital Adequacy to ensure that new entrants as well as existing players have crossed a minimum threshold of required capital and that the threshold changes based on market conditions as well as balance sheet profile of the institution in question. While the thinking can be applied to any prudent business, it is enforced specifically for banking, brokerage and insurance industry under the ambit of Basel II, Basel II, The EU Capital Adequacy Directive (CAD) and the Solvency II regime for insurance industry. In calculating capital that is required the entity would need to consider all material risks in the business. Usually the level of capital to be held would be above the minimum requirements stated in regulation such as Basel II. The bank capital adequacy ratio (CAR) is a measurement of a bank's available capital expressed as a percentage of a bank's risk-weighted credit exposures. The capital adequacy ratio, also known as capital-to-risk weighted assets ratio (CRAR), is used to protect depositors and promote the stability and efficiency of financial systems around the world. Two types of capital are measured: tier-1 capital, which can absorb losses without a bank being required to cease trading, and tier-2 capital, which can absorb losses in the event of a winding-up and so provides a lesser degree of protection to depositors. BANK EARNINGS Bank Earnings typically refer to after-tax net income, sometimes known as the bottom line, or a company's profits. Earnings are the main determinant of a company's share price, because earnings and the circumstances relating to them can indicate whether the business will be profitable and successful in the long run. Bank earnings are perhaps the single most important and most studied number in a company's financial statements, because they show profitability compared with analyst estimates and company guidance. They can also be used to compare a company's performance over time and relative with its competitors and industry peers. Banks typically report earnings on both a quarterly and annual basis, and earnings reported that deviate from analysts' expectations can have large impacts on stock price. For instance, if analysts on average estimate that earnings will be $1 per share and they come in at just $0.80 per share, the price of the stock is likely to fall on that miss. Measures of bank earnings There are many different measures and uses of earnings. Some analysts like to calculate earnings before taxes. This is referred to as pre-tax income, earnings before taxes, or EBT. Some analysts like to see earnings before interest and taxes, or EBIT. Still other analysts, mainly in industries with a high level of fixed assets, prefer to see earnings before interest, taxes, depreciation and amortization, also known as EBITDA. All three measures provide varying degrees of measuring profitability. BANK SHEET MANAGEMENT A balance sheet is a financial statement that reports a company's assets, liabilities and shareholders' equity at a specific point in time, and provides a basis for computing rates of return and evaluating its capital structure. It is a financial statement that provides a snapshot of what a company owns and owes, as well as the amount invested by share-holders. It is used alongside other important financial statements such as the income statement and statement of cash flows in conducting fundamental analysis or calculating financial ratios. Balance Sheet Management covers regulatory policy for investment securities, Bank-Owned Life Insurance (BOLI), liquidity risk, and interest rate risk for national banks, as well as the assessment of interest rate risk and liquidity risk for the national banking system as a whole. The objective of managing a bank’s balance sheet is to optimize reward versus risk. It is a challenge to find the right balance in the contradicting objectives of short-term liquidity risk and lowering the long-term funding costs (e.g WACC) of the company. On the one hand, corporates are seeking sufficient financial buffers in order to mitigate liquidity risk, while on the other hand a more leveraged funding structure lowers the after tax funding costs and hence increases shareholder value. Next to these contradicting objectives, other prerequisites need to be taken into account, such as differing shareholder and stakeholder objectives, bank relationship management in order to determine the optimal composition of the balance sheet in a dynamic way. LIQUIDITY CONCEPT AND POLICIES Liquidity is the amount of money that is readily available for investment and spending. It consists of cash, Treasury bills, notes and bonds, and any other asset that can be sold quickly. High liquidity occurs when there are a lot of these assets. Low or tight liquidity is when cash is tied up in non-liquid assets. It also occurs when interest rates are high since that makes it expensive to take out loans. Capital is the amount available for investment by businesses or individuals. It includes highly liquid assets like cash and credit. It also includes non-liquid assets like stocks, real estate, and high-interest loans. Large financial institutions that make most investments prefer using borrowed money. Even consumers traditionally prefer credit and loans. High liquidity means there's a lot of capital. But there can be too much of a good thing. A liquidity glut develops when there is too much capital looking for too few investments. That leads to inflation. As cheap money chases fewer and fewer profitable investments, then the prices of those assets increase. It doesn't matter whether it's houses, gold, or high-tech companies. That leads to "irrational exuberance." Investors only think that the prices will rise. Everyone wants to buy so they don't miss out on tomorrow's profit. They create an asset bubble. Eventually, a liquidity glut means more of this capital becomes invested in bad projects. As the ventures go defunct and don't pay out their promised return, investors are left holding worthless assets. Panic ensues, resulting in a withdrawal of investment money. Prices plummet, as investors scramble madly to sell before prices drop further. That's what happened with mortgage-backed securities during the subprime mortgage crisis. This phase of the business cycle is called an economic contraction. A liquidity trap is when the Federal Reserve's monetary policy doesn't create more capital. It usually happens after a recession. Families and businesses are afraid to spend no matter how much credit is available. Workers worry they'll lose their jobs, or they can't get a decent job. They hoard their income, pay off debts, and save instead of spending. Businesses use liquidity ratios to measure their financial health. The three most important are: 1. Current Ratio - the company's current assets divided by its current liabilities. It determines whether a company could pay off all its short-term debt with the money it got from selling its assets. 2. Quick Ratio - The same as the current ratio, only using just cash, accounts receivable, and stocks/bonds. The company can't include any inventory or prepaid expenses that can't be quickly sold. 3. Cash Ratio - As the name implies, the company can only use its cash to pay off its debt. If the cash ratio is one or greater, the business will have no problem paying its debt and has plenty of liquidity. LIQUIDITY POLICIES A policy is a deliberate plan of action to guide decisions and achieve rational outcome(s) Stafford (2001). Liquidity policies are conscious effort made towards controlling the amount of money that is readily available for investment and spending. These policies are made by monetary authorities to effectively control the money in circulation to avoid disequilibrium, inflation, deflation and all sort of defects that would cause a country’s currency suffer unnecessary devaluation. The policy ranges from controlling for liquidity trap, liquidity glut, low or tight liquidity and liquidity ratio. LENDING POLICIES lending policy is an institution's statement of its basic lending philosophy, including standards, guidelines, and limitations that are to be observed and adhered to in the process of deciding whether to grant a loan. The policy must adhere to applicable law and regulations. The bank's lending policies shall address the business of lending comprehensively and shall be used as guidance for lending transactions. Each bank's lending policy shall cover the following, in consistency with the scope, nature and complexity of its lending transactions; • Levels of authority- The lending policy shall clearly identify the levels of lending authorities of each department and unit involved in lending transactions. The existing banking laws, expertise and qualifications of employees shall be taken into account when assigning decision-making and loan application assessment authorities to the bank's business units and individual employees. • Lending limits and loan concentrations- The bank's policy shall identify limits, regular monitoring and reporting requirements with respect to all known loan concentrations (loan types, related parties, economic sectors, geographic regions, etc.). Determination of limits should incorporate the required level of return on each type of loan and the outcomes of sensitivity evaluation of the loan portfolio as well as borrowed funds used to finance loans. • Types and areas of lending- Each bank shall develop and put in place individual lending, monitoring and control policies for each type of loan, in consistency with the lending strategy and nature of different types of loans. If a need arises for types of loans not covered by the bank's existing lending strategy, appropriate procedures shall be developed to this effect. • Loan maturities and terms- The maturity/term of a loan (principal and interest) shall be predicated on the purpose, type, source of repayment of the loan, seasonal/periodic nature of the borrower's business as well as realistic cash flow projections. The lending policy shall identify the criteria for loan roll-overs and the bank's request for early repayment, which shall also be specified in the underlying loan agreements. • Setting interest rates on loans- The lending policy shall identify the economic and market conditions as well as various factors used to determine the interest rates for individual loans and different types thereof. • Discounts- Banks shall define relevant criteria for discounted loans. Clear and precise procedures should be determined for discounted lending, i.e., for granting loans to borrowers at more favorable conditions as compared to other borrowers who take loans of the same type, and such procedures should not be in conflict with the bank's overall lending strategy as well as the existing banking laws. • Appraisal and acceptance of collateral (means of insuring performance of credit obligations). The collateral shall have a value sufficient to safeguard the bank from any losses and damages that may arise in connection with the underlying credit transaction, yet shall not be treated as the only or principal source of repayment for the loan. • Financial information on borrowers. The bank's policy shall require borrowers to submit financial statements in order to enable the bank to determine the borrower’s ability to repay the loan both before and after the loan are granted. For incorporated borrowers, this requirement shall include the audited financial statements for the last financial year ended, tax returns, cash flow statement and other reports. INVESTMENT INSTRUMENT AND POLICIES Investment instrument In general, this is a document such as a share certificate, promissory note, or bond, used as means to acquire equity capital or loan capital. Investors can choose from a wide range of assets for their investment portfolios. The two basic types of investment instruments are fixed-income and equity. Fixed-income assets provide relative safety of capital and regular interest payments, while equity provides the potential for long-term capital appreciation. The asset mix depends on short-term cash flow needs, long-term financial objectives and tolerance for market risk. Types of investment instruments include cash instruments, bond issues, equity investments, mutual funds and ETFs, commodities and precious metals, real estate and businesses, and derivatives. Cash instrument investments: Cash instruments include savings and checking accounts, certificates of deposit and money market accounts. These safe and liquid investments earn modest returns on investment. They also provide financial flexibility because you can use them for emergencies, living expenses and buying other assets at attractive prices. Company and Government bond issues: Companies and governments issue bonds to raise capital for operational and strategic needs. Bond investors receive regular interest payments and get the principal back on maturity. Bond prices rise when interest rates fall and fall when rates rise. Government bonds are safer than corporate bonds. U.S. Treasuries are risk-free because the U.S. government backs them. Credit rating agencies assign risk ratings to bonds based on several factors, including a bond issuer's financial strength and ability to fulfill its debt obligations. Low-rated bonds have to pay higher interest rates to compensate investors for taking on the higher risk. Stocks and equity investments: Companies issue stock to raise capital for various needs. Stocks trade on regulated exchanges, such as the New York Stock Exchange, or on over-the-counter markets. Investment portfolios benefit from rising stock prices but suffer during periods of market volatility. This is why diversification across different industries is so important. Some companies pay dividends, which are cash distributions to shareholders from after-tax profits. The main risk of equity investments is that deteriorating business conditions lead to falling profits and stock prices. Mutual fund and ETFs: Mutual funds offer diversification at reasonable costs because the fund companies are able to spread the fees and expenses over a large asset base. Stock funds invest in stocks, bond funds invest in bonds, and balanced funds invest in a mix of stocks and bonds. There is further specialization within these categories. For example, technology stock funds invest only in technology stocks, while international funds invest in certain regions of the world. The disadvantage is that you have no control over investment decisions but must pay fees and other expenses regardless of performance. Other investment: Other investment includes; instruments commodities and precious metal, real estate and small businesses. You can invest in gold, silver and other commodities. Residential and commercial real estate investments can offer investors attractive rates of return, especially during periods of economic expansion. Small businesses, such as franchise outlets or retail stores, could be a worthwhile investment of both time and money. You can also invest in derivatives, such as options and futures, to speculate or to hedge positions in stocks and other assets. INVESTMENT POLICIES An investment policy describes the parameters for investing government funds and identifies the investment objectives, preferences or tolerance for risk, constraints on the investment portfolio, and how the investment program will be managed and monitored. The document itself serves as a communication tool for the staff, elected officials, the public, rating agencies, bondholders, and any other stakeholders on investment guidelines and priorities. An investment policy enhances the quality of decision making and demonstrates a commitment to the fiduciary care of public funds, making it the most important element in a public funds investment program. The investment policy should be reviewed and updated annually and should include statements on the following: • Scope and investment objectives: Tailor the scope and investment objectives to the type of investment to which the policy applies (e.g., excess operating funds, bond proceeds, pension fund assets). • Roles, responsibilities, and standards of care: Identify the roles of all persons involved in the investment program by title and responsibility. Standards of care should include language on prudence (i.e., the prudent person rule), due diligence, ethics and conflicts of interest, delegation and authority, and knowledge and qualifications. • Suitable and authorized investments: Include guidelines on selecting investment types, investment advisors, interest rate risk, maturities, and credit quality, along with any collateralization requirements. • Investment diversification: State the government’s approach to investment diversification, identifying the method that will be used to create a mix of assets that will achieve and maintain the government’s investment objectives. • Safekeeping, custody, and internal controls: Develop guidelines to enhance the separation of duties and reduce the risk of fraud. • Authorized financial institutions, depositories, and broker/dealers: Establish a process for creating a list of financial institutions, depositories, and broker/dealers that will provide the primary services necessary for executing the investment program. • Risk and performance standards: Establish one or more appropriate benchmarks against which the portfolio should be measured and compared. • Reporting and disclosure standards: Define the frequency of reporting to the governing body and the government’s management team. COMPARATIVE FINANCIAL SYSTEM A financial system no matter how rudimentary is a complex system. It is complex in its operation such that neither the system itself nor its operation can be measured accurately. Because of this complexity a simple definition cannot adequately capture what a financial system is. A financial system comprises financial institutions, financial markets, financial instruments, rules, conventions, and norms that facilitate the flow of funds and other financial services within and outside the national economy. The financial system can be described as a whole system of all institutions, individuals, markets and regulatory authorities that exist and interact in a given economy. The institutions, government and individuals form the participants in various markets; money markets (including foreign exchange) and capital markets (including security) markets. The participant buy (borrow) and sell (lend) money to different parties at a price (interest or dividend) within the market, which is determined by the forces of demand and supply. In a broader aspect a financial system can also be defined as a system that allows the transfer of money between savers (and investors) and borrowers operating on a global, regional or firm specific level. According to Gurusam, it is a set of complex and closely interconnected financial institutions, markets, instruments, services, practices, and transactions. The components of financial system include; Money: Money is used as a medium to buy goods & services. It also is a standard unit of measurement and acts as a store of value. However, money may not be a good store of value since it loses value with inflation. Financial Instruments: Financial Instruments are formal obligations that entitle one party to receive payments or a share of assets from another party. Examples of tradable financial instruments include loans, stocks, and bonds. Financial Markets: A Financial Market is a place or network where financial instruments can be sold quickly & cheaply. Financial Institutions: Financial Institutions are firms that connect borrowers and lenders, provide savers and borrowers access to financial instruments & markets. There are two types of Financial Markets – the primary market and the secondary market. Central Banks: Central Banks are large financial institutions that handle government finances, they regulate the supply of money, and they serve as banks to commercial banks.