Developing a risk appetite is fundamental to scoping and managing a bank’s risks. In simple terms it represents the amount of risk that a bank is willing to assume. In order to do this the bank must first start with the business segments they are currently operating within and the asset exposures they have.
The process for defining risk appetite can be both quantitative and/or qualitative. On a quantitative level it involves calculating the level of provisions and the amount of equity that a bank will put aside for expected and unexpected losses by product. On a qualitative level, establishing the risk appetite involves a clear communication of the banks’ values and mission statement so that shareholders and employees are aware of the tolerance levels of the bank.
Risks that are not measured or planned should not be part of the banks business. A clear example of this could be treasury or proprietary trading business that most banks operate. To test this, a bank should determine if the risk appetite and guidelines around treasury activities are clearly outlined by the board of directors?
I was recently conducting a risk management diagnostic of a bank in the Middle East. During the diagnostic, while I was interviewing one of the branch managers I asked about their credit approval process. In this case it seemed that the bank had some basic steps for assessing a new client. What I found interesting is that a great deal of time was put into “getting to know-your-clients upfront.
Banks spend time having tea discussing financial requirements and business strategy with the clients. This is all good, but what I also found was that of all the loans made in the last three years, there was not any significant follow up or re-evaluation of the client. Since the bank was not planning to meet and have tea with its 1000+ clients each year, the clients were basically on auto-pilot once they received the loan.
Does your bank have a regular process for reassessing your existing clients? Has the bank looked at scoring or stress testing as part of its follow up activities?
Most bankers know that good management information is the key to good decision making, however the timing of information is equally important. A bank manager that is responsible for managing the bank’s performance will need up to date information. It is important to know the difference between indicators and whether they are leading or lagging.
Net income (after tax) is a good indicator of performance and one that shareholders appreciate, especially when profits are moving higher. However, net income does not tell you how things will do in the near future or how well the portfolio is performing or if there are corrective actions that are needed. Net income is a lagging indicator.
A leading indicator would be an indicator that gives you insight into how the loan portfolio is behaving and can be used to draw some early conclusions. New loan volumes or 30+ delinquencies are examples of leading indicators. To test this, every bank should take a look at what the board of directors and senior management team are reviewing and assess whether those are lagging or leading indicators.
There are many elements, other than those mentioned, that are important to successfully managing risk. Clearly a bank’s Chief Risk Officer (CRO) is the chaperone of a bank’s risk management process and integral to every bank senior management team.
At the end of the day, part of the bank’s culture should be making sure that it has all the basics in place. Spreading a common sense approach and understanding risk management throughout a bank is the best way to make sure that you have empowered your people – not just to follow a checklist, but to make the right decisions to protect a bank’s equity.
*Part I of this article ran in last month’s banking page, February 25, 2010.
James Gohary is Principal Operations Officer of International Finance Corporation’s Access to Finance business line for the Middle East and North Africa. He has over 20 years of experience in acquiring, integrating, and growing banks and non-bank financial institutions. This article was written exclusively for Daily News Egypt.The findings, interpretations and conclusions expressed in this article are the authors own and do not necessarily reflect the views of IFC, a member of the World Bank Group.
