Bank Risk Management and the Third Basel Agreement
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Introduction
Bank risk management refers to the logical development and execution of procedures to deal with potential losses. Aebi et al. (2012, p.3215) allude that bank risk management involves the identification and prioritization of risks followed by coordinated and economical application of relevant resources to minimize, monitor, and control impact or probability of unfortunate events. Risk management practices in the banking industry aim to manage institutions’ exposure to losses and to protect the value of their assets (Aebi et al. 2012, p.3217). The risk management process in banking raises different questions like what kinds of events can interfere with the banking business. How much damage can be incurred? What kind of actions should be taken by the relevant bank to manage these risks? Did the bank make the right decision? These questions, therefore, highlights the relevance of implementing risk management practices in banking.
Havas et al (2016) the common managed risks in banks include credit risk, liquidity risk, market risk, operational risk. Business risk as well as reputational risk. According to Dionne (2013, p.147), the idea of risk management in banking started in the 1990s. Besides, before the 1990s, risk management dealt with risk related to insurance. Therefore, the overall purpose of the bank risk management process is to evaluate the potential losses in the future and take precautions to solve these potential problems when they occur. This paper discusses types of risks managed by Barclays bank, regulatory relationship between Barclays bank and British central bank, and the impact of the Basel ii guidelines on Barclays bank’s risk management.
Barclays Bank Risks and Management
Liquidity
Liquidity is a bank’s financial capacity to meet its cash and collateral duties without realizing losses. Arif et al (2012, p.183) assert that liquidity risk in banking arises when the institution is unable to finance its operational and regulatory needs due to insufficient cash. When the bank does not have enough cash to finance these regulatory requirements, it is said to be illiquid. Illiquidity occurs as a result of excess withdraws from the bank, unexpected stop in financing from wholesale partnerships as well as collateral postings (Arif et al 2012, p.185). Barclays bank is a British multinational investment bank and financial services institution with its headquarters in London, managers its liquidity risks in various ways. Firstly, it employs proper setting and observing of rational liquidity limits. It is organized into four main businesses of personal banking, corporate banking, wealth management, and investment management. Each business section is given a level below which it ought to place in a requisition for more cash, or above which it is supposed to remit the excess cash to the relevant authorities. These limits are regulated by the British central authorities and are in line with the insurance policies set. The above liquidity management strategy incorporates different risk management instruments that limit the bank’s statement of financial position and reputational liabilities. The bank ensures that liquidity management strategy is included in the organizational decision-making mechanism.
Liquidity risk is the risk to an institution’s financial conditions arising from its inability to meet its legal obligations (Diamond and Rejam 2001, p.289). Hence, the main role of liquidity risk management by the Barclays bank in Europe is to access the need of funds to meet its obligations as well as ensuring the availability of collateral or cash to achieve these requirements at an appropriate time by partnering with different funding sources available to the bank under normal and stressed conditions.
Credit Risk Management
Credit risk is described as a loss of financial nature resulting from the company’s market counterpart or client’s failure to meet their financial obligations to the group. On the other hand, credit risk management involves mitigating losses by comprehending the adequacy of the bank’s capital and loan loss reserves at a specific time. The credit risk management process has been a challenge for Barclays bank for a long time although it has tried to manage it. Lending, interbank loans, dealings with counterparts, and reverse purchase loans are the major exposures of Barclays bank to credit risk. The bank, therefore, manages this risk by employing a credit default swap strategy (Stulz 2010, p.74). A credit default swap is an insurance-related where a buyer is allowed to purchase a credit contract and remit a regular payment to the credit bank (Stulz 2010, p.75). In a default event, for instance, the buyer is compensated by the seller. Barclays bank uses this strategy since the buyer is under no requirements to hold onto the asset. Besides, Barclays bank manager’s credit risk through credit liked notes. This happens when investors acquired a low level of return by crediting some determined risks and total return swaps. Thereafter, swapping faction remits total return amounts and the reference entity makes floating payments. Furthermore, Barclays bank enhances a complete comprehension of the bank’s overall credit risk by evaluating risk at the individual, customer, and portfolio levels.
Money Laundering Risk
Money laundering has been identified as significant threats to the international financial services community and therefore to Barclays. (Levi and Rauter 2006, p.291). Money laundering, therefore, refers to the illegal process of concealing the origin of money obtained illegally through criminal activities and by passing it through complex bank transfer (Levi and Reuter, 2006, p.292). Barclays bank and other EU banks have been responsible in the past for money laundering activities. These activities raised concerns to the EU to create regulatory rules and control in case of such cases.
The EU-UK legislations and rules on money laundering forms the cornerstone of AML obligations for all UK firms including the Barclays. The Barclays bank complied with the EU-UK regulations on money laundering by appointing a group money laundering officer (CMLRO) and Entity Heads of financial crime of sufficient seniority who are responsible for oversight of the business and legal entity compliance. The bank further established a risk-based approach to the institution. Generally, the principle obligations and penalties currently in force on Barclays anti-money laundering (AML) are contained in the Terrorism Act 2000 as (amended) the proceedings of crime Act 2002 (POCA) as amended group (JMLSG) guidance for the UK financial sector on the prevention of money laundering and terrorist financing. Besides, through bitcoin technology has been UK banking institutions, large banks worldwide are reluctant to partner with bitcoin companies since they are used to launder money. Thus, Barclays through its regulator needed to be sure that bitcoin and coin base technologies had the right systems to prevent money laundering. Barclay’s relationship between the AML and EBA has significantly money laundering issues. Anti-Money Laundering (AML) which refers to set of laws, regulations and procedures to objectively prevent criminals from concealing illegally obtained funds as lawful income have greatly helped Barclays bank in dealing with money laundering and other criminal activities. The European Banking Authority (EBA) on the other hand maintains the financial stability across the European Union (EU’s) banking industry (Ferran 2016, p.287). EBA is mandated to ensure integrity, transparency and ordinary execution of financial markets. EBA further ensures the development of the antimony laundering and combating the financial of terrorism (AML/CFT) policy and supporting its effective implementation by relevant authorities and financial companies across the EU. This support foster an effective risk-based framework to AML/CFT with compatible outcome. Ferran (2016, p.288) further assets that EBA coordinates across the EU’s banks and beyond by fostering effective cooperation and information exchange thus enhancing the development of a common AML/CFT supervision. It also makes sure that emerging banking risks are dealt with effectively in all financial institutions.
Artificial Intelligence Risks
Even as financial institutions increasingly shift to artificial intelligence technology to enhance effectiveness and efficiencies and to get a competitive advantage over their rivals, there are numerous risks and fears that come along with the adoption of this technological advancement (Lui and Lamb 2018, p.280). According to a report from the financial stability board (2017, p.45), there has been concerns that have been raised regarding the use of artificial intelligence (AI) in the banking sector and in particular, the technology has been triggering stability risks. Additionally, the report also presented that lack of proper explanation, interpretation and auditing of AT machines and learning processes could become a risk at macro-levels. Equally, the widely spread use of “opaque models” could yield consequences that the banking institutions do not desire. The board of financial stability (2017) also postulates that the replacement of humans with the artificial intelligence technology has the possibility of increasing financial shocks that a banking institution faces.
An interview with Ajwad Hashim, the vice president for innovation and new technology at the Barclays bank in 2018 presented the specific fears and risks that come along with the adoption of the artificial intelligences for the Barclays bank (Carey, 2018). According to Hashim, Barclays bank was assessing the use of AI in the institution’s sectors ranging from machine learning and projective analysis, to “Natural language processing”. The use of AT was being applied to front office, customer retention and service recommendation. For example “Natural Language Processing” was being used to access information from written forms. However the use of AI comes with risks to the business and Hashim identified four critical to the bank when it come to the use of AI.
Data Security
The biggest risk that artificial intelligence poses to Barclays bank is the data quality and its security. The risk that is posed have is that personal and confidential information to the business could be leaked out to unauthorized parties. This is a threat to the bank because, with this kind of information in the wrong hands, financial frauds will be prevent as depicted in the case of well Fargo company. Barclays bank however, has put in place measures to ensure that data is in a secure environment and there is no leakage. The measures put in place include the partnering with external parties like fintechs to ensure safe storage of information (Financial Stability Board, 2017). According to Hashim, transparency is the key managing aspect of this risk. The way Barclays bank handles the data and how customers have trusted them means that they should be careful and be clear with customers on what they intend to do with their data
Inherent Bias
Hashim opined that there are specific problems that may arise from the use of biased information and how Barclays bank managers that the data being entered into the models is not biased towards a certain outcome. He states an example of a loan application where the bank needs to be careful when using a credit score without segmenting the client base. In this case, it has a negative impact to some customers due to uneven data points that have been skewed towards a certain outcome.
Public perception
Use of artificial intelligence raises concerns of a public outcry from the customers. Events from Cambridge analytical and Facebook have earmarked the risk that bad data activities can bring to a well-reputational that if they do not enter the AI project with an eye wide open and with total transparency, then there is a risk and with total that the bank could be perceived to be using the data in a wrong way.
Foreign Exchange Risk
Bruno and Shin (2015, p.535) alludes that a “foreign exchange risk” is a financial risk that arises when a transaction is done in a currency different from the domestic currency of the bank. This risk arises when there is a possibility of unfavorable change in the exchange rate between the local currency and the denominated currency before the actual date of the transaction. Barclay’s bank being an operator in global markets, it faces a risk of liquidity exchange due to the several types of currencies used.
However, Barclays has been managing the foreign exchange risk through a sophisticated set of procedures that include “money market operation, futures contracts and pension plans”. In terms of futures contracts, the bank agrees with the customer about a price that is to be paid at a future date, but the price of which is projected, such that in the events the agreed price is higher than the future price, the customer gains but in case the current market price at the settlement date is lower than the future price, the bank gains Barclays Bank is also implementing strategies to overcome liquidity exchange risk through the adoption of pension schemes for workers where pension lump sum that is paid in the future is predetermined. In every nation, Barclays bank has an employee saving scheme, where money is paid to them in the future. Money market operations are also used to mitigate the foreign exchange risks where a hedging system is put into use.
Bank capitalization
Bank capital is the difference between a banking institution’s assets and its liabilities. The bank’s capital represents the net worth of the bank or the equity it has to investors. A risk may occur from a bank’s involvement in capital markets due to the unpredictability of capital markets, price of goods, interest rates as well as credit spreads. Barclays bank is more exposed if it heavily involves itself in investing in capital markets. If the bank has invested in companies that produce commodities, the commodity prices play a critical role because as the value of the commodities changes, so does the value of the companies and the value of the investment. In an effort to reduce this capital risk, Barclays Bank has embraced the diversification of investments and reduction of the same investments. In the current wave of COVID-19 pandemic, Barclays Bank capitalization has been at risk due to the economic recession caused by the low demand and supply of services and commodities. However the banks response has been significance with the introduction of measures for financial support. The measures included a “Covid-19 corporate finance facility, corona virus business interruption loan scheme, future fund and coronavirus job retention scheme” (Barclays, 2020). The central bank in the United Kingdom EU legislation demands that institutions should adequately control and mitigate risks that may arise from operations which is defined as the risk of losses originating from failed internal procedures, people and systems or from external activities (Levi 2013, p.51). Operational risk includes the legal risks and it exists in all banking products and activities. Through the publication of guidelines on operational risks, the European banking authority aimed at boosting the effectiveness of operational risk management and supervision across the addressed through changes in the market risk framework which is generally known as the “Basel 2.5”, have been introduced by Capital Requirements Directive (CRD III). The European banking authority through its strategies and guidelines aims to boost convergence in the implementation of new capital requirements that include “stressed value at risk and the increment risk charge” that were introduced to mitigate credit risk.
Basel III Regulations
The Basel iii design is a critical element of the Basel committee’s action towards countering the global financial crisis (Slovic and Cournede, 2011). The accord seeks to address several shortcomings in the pre-crisis regulatory design and lays a foundation for a stable and resilient banking system that helps reduce the probability of systematic susceptibilities. The Basel iii framework allows the banking system to support the real economy via the economic cycle. However, the Basel iii guidelines have had or impact on the banking institutions’ risk management in issues like liquidity, capitalization, cost factors, Human resource issues, structural change and strategic direction.
Strengthening the global capital framework
The Basel committee is raising the stability and framework. The committee is implementing macro prudential elements into the capital framework to help mitigate systematic risks (Basel committee, 2010). The committee articulated for the raising the quality, consistency and transparency of the capital base where the main form of Tier 1 capital must be the shares and accrued earnings. A major lesson from the financial crisis of 2007-2008 has been the need to stabilize the risk coverage, the committee introduced reforms such as; banks must evaluate their capital requirement for credit risk using stressed inputs, establishment of strong standards for financial structures and capital charge for possible market losses.
Transitional Arrangement
The accord has introduced transitional arrangements to execute the new standards that ensure that the banking sector can meet the capital requirements through substantial retained earnings and raising capital, while at the same time, supporting lending to the economy. The Basel committee was to put in place a comprehensive reporting procedure to track the ratios during the transition period and will keep renewing the implications of development as well as mitigating unintended outcomes as expected.
Global Liquidity Standard
Heavy capital requirements are a necessary condition for the stability of the banking sector. The Basel iii therefore introduced internationally harmonized global liquidity standards (De Waal 2013, p.779). With reference to the global capital standard, the liquidity standards stated in the Basel iii committee establishes a minimum requirements that promotes an international level playing field thus limiting a competitive race. Despite adequate capital levels in the past liquidity phases, many banks still experienced difficulties experienced by the bank were lack of basic principles of liquidity risk management. The Basel committee in 2018 therefore published principles for sound liquidity risk management and supervision in response to the liquidity risk experienced by the banks (De Waal 2013, p.782). Management and supervision of funding liquidity risk helps in promoting better risk management practices if only there is full implementation by the banks. The Basel iii committee further developed two minimum standards for funding liquidity. An additional liquidity component improves the international consistency principles. These standards were developed to fulfil complementary objectives of liquidity. The first objective aims at promoting short-term resilience of a bank’s liquidity risk principle by ensuring that it contain quality liquidity resources to survive an acute stress condition for approximately one month. The Basel committee thus developed a liquidity coverage ratio (LCR) to achieve this objective (games and Wilkins 2013, p. 38). Besides, the second objective aims promoting a long-term resilience by developing additional incentives for a financial institutional to fund its activities with more funding resources on current structural basis (Gomes and Wilkins 2013, p.39). The net stable funding ratio (NSFR) has a time limit of a year and thus its development aimed at enhancing a sustainable maturity structure of assets and liabilities. (King 2013, p.4144)
Conclusion
Today, the banking sectors experiencing an upward trend of risk that they face either from operations or the investments they choose. The banking managers different typed of risks, capital risks, liquidity, capitalization, credit risk as well as artificial intelligence risks. This risks may yield yet another form of risks that are attributed to reputation and operations. The bank may be at risk of losing its reputation among its customers based on the aforementioned risks. However, Barclays bank has had an upper hand in mitigating these risks and the success is majorly attributed to the relationship regulatory bodies as this has influenced the bank’s management. This essay has further analyzed the effect of the Basel iii guidelines on Barclay’s bank risk management with reference to both micro and macro prudential policies and regulations that were implemented by the Basel committee.