Managing Risk Appetite of a Financial Institution

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Table of Contents

Retail banking in the UAE
Bank risk appetite
Bank ALCO Analysis
Conclusion
Reference List

Retail banking in the UAE

Retail banking concerns the transaction of banks with consumers without relying on corporate intermediaries. Here, the services on offer include savings or transacting accounts, loans, credit and debit cards, and mobile or internet banking facilities. A common thing about retail banking in the UAE is that all banks offer Islamic banking.

As a result, many of their loans to consumers are interest free and the banks provide a variety of instruments that help small businesses to grow. When loaning out money to retail clients, banks rely on the relationship they have with the client, the financial statement of the client, and the credit score. Banks exist mainly because of their credit offering business.

As banks lend out money, they run the risk of not getting it back because they do not control the circumstances that face the borrower. The UAE banking sector has 23 domestic banks and 28 foreign banks serving both the retail and corporate markets (Moukahal 2011).

The central bank of the UAE took over the operations of the Currency Board through the enactment of Federal Law 10, which gave it the mandate to advice government on monetary and financial issues (Hashmi 2007). The central bank also deals with currency issuing, credit policy formulation, and maintenance of foreign and gold currency reserves (Hashmi 2007).

Under the role of monitoring and formulating a credit policy, the central bank also acts as the supervisor for the entire financial sector. It licenses banks and obliges them to use International Accounting Standards (IAS).

Hashmi (2007) explains that banks need UAE nationals as their majority shareholders and they must have vivid corporate structures. In addition, they must be shareholding companies and maintain a risk weighted asset ratio of at least 10% (Moukahal 2011).

Bank risk appetite

Risk appetite concerns the exposure to potential adverse effects that could arise from an event to which the particular organization expressing the appetite is willing to accept. Consequently, after meeting its risk appetite threshold, a bank will proceed to initiate and implement risk management procedures and business control measures so that it lowers the exposure to accepted and manageable levels.

A number of reasons can affect a bank’s risk appetite. They include the demand for favourable returns by equity investors, the desire of rating agencies and consultants to minimize risk as a default, the demands by regulators and consumers on an uninterrupted service, and the need for the bank to offer a predictable and steady return for shareholders.

Pursuing opportunities that have potential high rewards forces banks to take on high risks. When setting the risk level that could be accepted, a bank will seek to balance its loss potential with its profit potential. In this regard, banks will concern their business activities with the allocation of time and resources to activities that minimize risk exposure.

They will consider whether they need to take any immediate action concerning their risk exposure and rely on their formal response strategies to erode the impact of the risk event. Finally, banks will rely on the history of the bank itself or the industry in the country and throughout the world to evaluate options for reducing effects of risk events.

When banks have a high-risk appetite, they advance more loans to borrowers. Therefore, the indicators of a favourable economy for lending will also work as indicators for increased risk appetite for banks. A growing economy provides citizens with a variety of ways to earn money and pay back loans from banks.

In return, banks find it increasingly profitable to increase their loan offerings because there are many people capable of repaying them back. When the favourable environment for lending changes and banks realize that the credit worthiness of its clients is plummeting, they reduce their lending activities.

However, the transition period could be hectic and the bank could end up with a large amount of non-performing loans on its asset books. Writing off the loans would then expose the bank to losses and they could lead to collapse of the bank when they are too much.

In the UAE, bank risk appetite follows the performance of the economy as indicated by the rate of economic growth, the level of consumer confidence, and the level of risk aversion in the financial industry. Banks can borrow money for subsequent lending and their ability to borrow will affect their lending ambitions.

Therefore, when they are evaluating their risk appetite, banks will also include their capital base and shock-absorption capacity. As the regulator of banks, the central bank compels the banks to disclose their credit exposures periodically and maintain a considerable amount of their assets within the central bank deposit facility.

The move ensures that an individual bank’s high-risk appetite does not jeopardise the stability of the entire banking industry and, in extension, the economy when a risk event occurs (Hull 2007).

Bank ALCO Analysis

General overview of a bank ALCO Assets and Liability Management committee

A bank will usually have Asset/Liabilities Committees (ALCO), which is a risk-management unit in the bank that works to evaluate, monitor, and approve risk related practices. Banks need a considerable amount of liquid assets for them to handle expected and unexpected financial balance sheet fluctuations.

A bank will be in a favourable liquidity option when it is able to obtain needed funds promptly and at reasonable costs (van Greuning & Bratanovic 2009). Banks can obtain funds by increasing their liabilities, selling assets, and securitizing. The susceptibility of banks to liquidity risk is increased by their desire to have short-term deposits become loans of a long-term nature.

They would have to manage the risk arising both internally and externally. Any financial commitment that a bank gets into has implications for its liquidity position, thus it is risky.

With an effective liquidity risk management, a bank retains its ability to meet its cash flow obligations. In essence, the bank would be cushioning itself against effects of external events and behaviours of other agents such as its clients (Burton et al. 2010).

Having a liquidity management team in a bank is not only beneficial to the particular bank, but it also helps to maintain stability and predictability in the entire industry. Moreover, financial markets are not stagnant; instead, they are ever evolving and end up increasing the liquid risk (van Greuning & Bratanovic 2009). The essence of liquidity risk management would be to address market liquidity, rather than legislative liquidity.

The bank’s ALCO comes in handy as the manager of liquidity risk and it needs adequate expertise on liquidity and other market factor-relationships or their influences, such as credit risk exposure on the balance sheet. The committee examines the bank’s approach in obtaining funding and being afloat in different situations.

Central banks and other regulatory institutions for banks on their part concentrate on the maturity structures of banks assets and liabilities because they yield a more accurate position of the health of the bank than statutory liquid asset requirements do.

One bank will have liquidity requirements that are different from another bank. At the same time, in a particular bank, liquidity will vary from adequate to inadequate depending on the changes in demand for funds. The ALCO judges the liquidity position of the bank by looking at its anticipated future financial needs, its present liquidity position, and its historical funding requirements.

Other features of concern to the ALCO would include the options available to the bank for reducing funding needs or getting additional funds and sources for the additional funds.

When banks have small, stable accounts, then they will need low liquidity. On the other hand, a high liquidity position would be necessary when the bank has many long-term loans and a high concentration of deposits. At the same time, it must get into a high liquidity position as soon as it realizes that its large corporate or large household accounts are reducing.

The activities of the ALCO mainly consist of decision-making through relevant structures, relevant approaches to funding and liquidity operations, as well as a set of limits that risk appetite of the bank. The ALCO also has a set of procedures that allow it to plan for liquidity positioning of the bank in different scenarios.

The planning will cater for crises where the maintenance of liquidity positions becomes too challenging to accommodate certain procedures. Because of these functions and the importance of risk management in banks, the ALCO remains an institutionalized unit of banks. It holds the responsibility of making policy and reviewing the decisions made by the bank’s leadership and management team on liquidity (Ruozi & Ferrari 2013).

Monitoring of risk appetite

Upon approval by the board of directors, the ALCO oversees the implementation of the funding and liquidity operations strategy for the bank. The strategy sets specific policies for use in different risk management aspects. For example, it defines the way the bank would use a given financial instrument or the pricing of its deposits (van Greuning & Bratanovic 2009). In general, banks only set out to fulfil their liquidity needs after they determine them and the task of determination would fall under the ALCO activities.

The source of liquidity problem can be outside the bank. For example, when there low market liquidity, banks face challenges of obtaining funds to offset their deposit obligations. When this happens, they go into banking crises. Dealing with multiple foreign currencies also puts banks at risk due to difficulties in selling assets that are in foreign currencies when the domestic monetary and foreign exchange policies are uncertain.

For UAE banks, this risk is low because their domestic currency’s value is pegged to the US dollar. The ALCO function in relation to foreign currencies is to measure, monitor, and control the liquidity positions of the bank in all major currencies that the bank deals with. It should also have separate analyses for each currency to manage currency specific risks.

Other than liquidity positioning, the ALCO can also work on the bank’s interest-rate policy. The policy aims to keep earnings volatility low. The members of the ALCO review risk and position reports of the bank and evaluate them together to determine their compliance with the laid out risk policy.

The ACLO will act to remedy the situation. When there are moves made within the loaning and interest rate aspects of the bank’s business that deviate away from the interest-rate policy as represented by relevant reports. Here, the solution could be a remedial action or a review of the policy (van Greuning & Bratanovic 2009).

ALCO’s formation

The importance of the ALCO in the bank’s activities compels it to meet regularly; for most banks, the duration is monthly. At the same time, its composition must reflect the decision structures and level of the bank’s corporate structure to give the committee enough power of strategizing and executing various policies for the bank’s risk management needs.

An effective ALCO would consist of various departmental heads of the bank. It will generally have its members include the heads of treasury, trading, risk management, and finance departments. Some banks will also see it fit to have representatives from their loan syndication departments and credit committees.

Based on the changes in appetite, how does it influence overall profitability and any other requirements?

The world continues to witness an increased internationalization of financial systems. Consequently, banks are entering into a period of high competitive pressures and they have to work on ideal maturity structures for their assets and liability. However, without a high-risk appetite, the banks may enter into periods of low profitability. A high-risk appetite prompts banks to find assets and liabilities that will yield the most profits for the bank.

Consequently, it drives banks to maintain low levels of liquid assets, sometimes to the bare minimum required by law. At the same time, a given bank would go on to maximize the degree of maturity transformation.

On their part, regulatory authorities such as the central bank realize that banks are exposing themselves to high levels of risk and they proceed to modify their policies to ensure that banks are behaving prudently, without depressing their ability to earn profits and retain their competitiveness (Hull 2007).

A bank benefiting from a high liquidity through lower risk premiums can only do so to a certain limit, where its gain would be offset by low returns on its assets. Exercising a high-risk appetite by a bank implies that the bank is opting to have much of its liquidity transform into assets that would eventually translate to profitable earnings when market conditions remain favourable and predictable.

In the traditional banking sense, where the bank’s business model is to collect deposits from non-financial customers and provide loans with the originate-to-hold model, the benefits of maintaining high liquidity positions cease earlier than those of banks pursuing new business models.

The relation of risk appetite to profitability, therefore, depends on the business model used by the bank. The originate-to-hold model provides the bank with only one predictable avenue for earning profits; its interest income from loans held minus the interest paid on deposits.

In the newer originate-to-distribute business model for banks, high liquidity allows the bank to lend and then package its loan portfolios for subsequent disposal to hand over the credit risk to third party investors.

The practice known as securitization allows a bank to improve its profitability incredibly by harnessing high levels of risk appetite. Unfortunately, for a bank, a high-risk appetite puts it at loggerheads with various legislative requirements that are aimed at cushioning the banking sector against liquidity related challenges.

In this regard, authorities will seek to limit the amount or types of loan assets that banks can hand over to third parties. They can also increase the deposit ratio such that banks have to sacrifice a significant portion of their liquidity to minimize their exposure to risk. Still, the number of options available for increasing its liquidity in the future would influence the bank’s profitability as a factor of its risk appetite.

Here a bank’s high-risk appetite would promote lending and securitization behaviour. With the appropriate guidance and intervention of the ALCO, the bank would be able to minimize short-term liquidity obligations and be able to earn high interest incomes in the long term (Hull 2007).

Conclusion

Banks have to balance their risk appetite and risk exposure as they implement strategies for profitability. In the UAE, banks face relatively low currency-related liquidity risks and they operate under statutory liquidity requirements of the central bank.

With a well functioning asset/liability management committee, banks are able to pursue their profitability intentions and periodically alter their business activity paths to limit their exposure to risk events.

As they do this, they concentrate on particular business models for realizing revenue growths from their sale of securities and earnings of interest income. In the end, the risk appetite of a bank affects its profitability, but it depends on the banks obligations to authorities, customers, and shareholders at the same time.

Reference List

Burton, M, Nesiba, R, & Brown, B 2010, Intro to financial markets and institutions, M. E. Sharpe, Inc., New York, NY.

Hashmi, AM 2007, ‘An analysis of the United Arab Emirates banking sector’, International Business & Economics Research Journal, vol. 6, no. 1, pp. 77-88.

Hull, JC 2007, Risk management and fnancial institution, Pearson/Prentice Hall, Trenton, NJ.

Moukahal, W 2011, ‘The banking industry in the UAE’, A Middle East Point of View, pp.16-19.

Ruozi, R, & Ferrari, P 2013, Liquidity risk management in banks: Economic and regulatory issues, Springer, London.

van Greuning, H, & Bratanovic, SB 2009, Analyzing banking risk: A Framework for assessing corporate governance and risk management, 3rd ed., The World Bank, Washington, D.C.

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