Management of Risk and Crises in Nigerian Banking Industry

MANAGEMENT OF RISK AND CRISES IN THE NIGERIAN BANKING INDUSTRY 

ADOGA[1], Suleiman Umar &  YAKUBU, Shammah 

Abstract 

Recently, report has shown that commercial banking analysis covered a number of Nigerian super-regional and quasi-financial institutions. The information obtained covered both the philosophy and practice of financial risk management. This paper outlines the results of this investigation. It reports the state of risk management techniques in the industry. It reports the standard of practice and evaluates how and why it is conducted in the particular way chosen. In addition, critiques are offered where appropriate. We discuss the problems which the industry finds most difficult to address, shortcomings of the current methodology used to analyze risk, and the elements that are missing in the current procedures of risk management. The purpose of the paper is to outline the findings of this investigation. It reports the state of risk management techniques in the industry -- questions asked, questions answered and questions left unaddressed by respondents. This paper can not recite a litany of the approaches used within the industry, nor can it offer an evaluation of each and every approach. Rather, it shows the standard of practice and evaluates how and why it is conducted in the particular way chosen. But, even the best practice employed within the industry is not good enough in some areas. Accordingly, critiques also will be offered where appropriate. The paper concludes with a list of questions that are currently unanswered, or answered imprecisely in the current practice employed by this group of relatively sophisticated banks. 

Introduction 

The past decade has seen dramatic losses in the banking industry. Firms that had been performing well suddenly announced large losses due to credit exposures that turned sour, interest rate positions taken, or derivative exposures that may or may not have been assumed to hedge balance sheet risk. In response to this, commercial banks have almost universally embarked upon an upgrading of their risk management and control systems. 

Coincidental to this activity, and in part because of our recognition of the industry's vulnerability to financial risk, the central bank of Nigeria with the support of the national deposit insurance corporation has been involved in analysis of financial risk management processes in the financial sector. Through the past research were conducted to review and evaluate the risk management systems and the process of risk evaluation that is in place. In the banking sector, system evaluation was conducted covering many of the commercial banks, as well as a number of major investment banking firms. These results were then presented to a much wider array of banking firms for reaction and verification. 

Banking business thrives on the understanding and assurance that the banker will be able to meet its obligations to depositors whenever the latter makes demand on it. Individuals, businesses, corporate institutions and governments keep their money with banks in the form of deposits based on mutual thrust and confidence that the banker will manage the deposits and other funds at its disposal without exposing them to undue risk of loss. 

All over the world it is this confidence that sustains banking business. Confidence itself derives from the known character of a bank’s board and management. This explicit character of management is what we call reputation and image. Image is the impression an individual or corporate entity gives to the public. In our context, image is a reflection of bank’s attributes and appearance in the view of the public. It is for this reason that banks should strive to maintain positive images of them by managing their reputational risk on a holistic and consistent basis. It is based on this that the Association of Corporate Affairs Managers in Nigerian banks was formed in further pursuit of this pivotal and very sensitive role. 

The purpose of this paper is to outline the findings of this investigation. It reports the state of risk management techniques in the industry- questions asked, questions answered and questions left unaddressed by respondents. This paper can not recite a litany of the approaches used within the industry, nor can it offer an evaluation of each and every approach. Rather, it presents the standard of practice and evaluates how and why it is conducted in the particular way chosen. But, even the best practice employed within the industry is not good enough in some areas. Accordingly, critiques also will be offered where appropriate. The paper concludes with a list of questions that are currently unanswered, or answered imprecisely in the current practice employed by this group of relatively sophisticated banks. Here, we discuss the problems which the industry finds most difficult to address, shortcomings of the current methodology used to analyze risk and the elements that are missing in the current procedures of risk management and risk control. 

Commercial banks are in the risk business. In the process of providing financial services, they assume various kinds of financial risks. Over the last decade our understanding of the place of commercial banks within the financial sector has improved substantially. Over this time, much has been 

analysis of financial risk management processes in the financial sector. Through the past research were conducted to review and evaluate the risk management systems and the process of risk evaluation that is in place. In the banking sector, system evaluation was conducted covering many of the commercial banks, as well as a number of major investment banking firms. These results were then presented to a much wider array of banking firms for reaction and verification. 

Banking business thrives on the understanding and assurance that the banker will be able to meet its obligations to depositors whenever the latter makes demand on it. Individuals, businesses, corporate institutions and governments keep their money with banks in the form of deposits based on mutual thrust and confidence that the banker will manage the deposits and other funds at its disposal without exposing them to undue risk of loss. 

All over the world it is this confidence that sustains banking business. Confidence itself derives from the known character of a bank’s board and management. This explicit character of management is what we call reputation and image. Image is the impression an individual or corporate entity gives to the public. In our context, image is a reflection of bank’s attributes and appearance in the view of the public. It is for this reason that banks should strive to maintain positive images of them by managing their reputational risk on a holistic and consistent basis. It is based on this that the Association of Corporate Affairs Managers in Nigerian banks was formed in further pursuit of this pivotal and very sensitive role. 

The purpose of this paper is to outline the findings of this investigation. It reports the state of risk management techniques in the industry- questions asked, questions answered and questions left unaddressed by respondents. This paper can not recite a litany of the approaches used within the industry, nor can it offer an evaluation of each and every approach. Rather, it presents the standard of practice and evaluates how and why it is conducted in the particular way chosen. But, even the best practice employed within the industry is not good enough in some areas. Accordingly, critiques also will be offered where appropriate. The paper concludes with a list of questions that are currently unanswered, or answered imprecisely in the current practice employed by this group of relatively sophisticated banks. Here, we discuss the problems which the industry finds most difficult to address, shortcomings of the current methodology used to analyze risk and the elements that are missing in the current procedures of risk management and risk control. 

Commercial banks are in the risk business. In the process of providing financial services, they assume various kinds of financial risks. Over the last decade our understanding of the place of commercial banks within the financial sector has improved substantially. Over this time, much has been 

written on the role of commercial banks in the financial sector, both in the academic literature and in the financial press. These arguments will be neither reviewed nor enumerated here. Suffice it to say that market participants seek the services of these financial institutions because of their ability to provide market knowledge, transaction efficiency and funding capability. In performing these roles they generally act as a principal in the transaction,. As such, they use their own balance sheet to facilitate the transaction and to absorb the risks associated with it. 

To be sure, there are activities performed by banking firms which do not have direct balance sheet implications. These services include agency and advisory activities such as (i) trust and investment management, (ii) private and public placements through "best efforts" or facilitating contracts, (iii) standard underwriting through Section 20 Subsidiaries of the holding company, or (iv) the packaging, securitizing, distributing and servicing of loans in the areas of consumer and real estate debt primarily. These items are absent from the traditional financial statement because the latter rely on generally accepted accounting procedures rather than a true economic balance sheet. Nonetheless, the overwhelming majority of the risks facing the banking firm is in on-balance-sheet businesses. It is in this area that the discussion of risk management and the necessary procedures for risk management and control has centered. Accordingly, it is here that our review of risk management procedures will concentrate. 

The objectives of this study are to determine commercial bank risks that can be eliminated or avoided by simple business practices, determine commercial bank risks that can be transferred to other participants, and ascertain bank risks that must be actively managed at the firm level. The paper addresses the following research questions: 

i) What kind of risks that can be eliminated or avoided by simple business practices by commercial banks? 

ii) What type of risks can be transferred to other participants in the banking industry?  

iii) What risks must be actively managed at the banking level? 

Literature Review and Theoretical Framework 

Banks have been the most important financial intermediaries in the economy, by providing liquidity transformation and monitoring services. The mal-functioning of the banking system can be extremely costly to the real economy, as illustrated in a number of financial crises in both industrial and developing economies in the past few decades, including the current global credit-liquidity turmoil. Therefore, financial regulators and central banks have devoted much effort to monitoring and regulating the banking industry. 

Such regulation has been traditionally focused on assuring the soundness of individual banks.  

More recently, there has been a trend towards focusing on the stability of the banking system as a whole, which is known as the macro-prudential perspective of banking regulation (see Borio (2003) and Crocket (2000)). For instance, Aspachs. (2007), Goodhart. (2005, 2006) and Lehar (2005) propose measures of financial fragility that apply at both the individual and aggregate levels. At the international level, the Financial Sector Assessment Program (FSAP), a joint IMF and World Bank effort introduced in May 1999, aims to increase the effectiveness of efforts to promote the soundness of financial systems in their member countries. 

In order to assess the health of a financial system, two related questions need to be addressed. First, how to measure the systemic risk of a financial system, where systemic risk defined as multiple simultaneous defaults of large financial institutions? Second, how to assess the vulnerability of the financial system to potential downside risks?  Traditional measures have focused on banks’ balance sheet information, such as non-performing loan ratios, earnings and profitability, liquidity and capital adequacy ratios. However, given that balance sheet information is only available on a relatively low-frequency (typically quarterly) basis and often with a significant lag, there have been growing efforts recently to measure the soundness of a financial system based on information from financial markets. For example, Chan-Lau and Gravelle (2005) and Avesani (2006) suggest to treat a banking system as a portfolio and use the nth-to-default probability to measure the systemic risk by employing liquid equity market or CDS market data with a modern portfolio credit risk technology.  

Similarly, Lehar (2005) and Allenspach and Mon- nin (2006) propose to measure systemic risk, defined as the probability of a given number of simultaneous bank defaults, from equity return data. The market-based measures have two major advantages. First, they can be updated in a more timely fashion. Second, they are usually forward-looking, in that asset price movements reflect changes in market anticipation on future performance of the underlying entities. 

The risks contained in the bank's principal activities, i.e., those involving its own balance sheet and its basic business of lending and borrowing, are not all borne by the bank itself. In many instances the institution will eliminate or mitigate the financial risk associated with a transaction by proper business practices; in others, it will shift the risk to other parties through a combination of pricing and product design. 

The banking industry recognizes that an institution need not engage in business in a manner that unnecessarily imposes risk upon it; nor should it absorb risk that can be efficiently transferred to other participants. Rather, it should only manage risks at the firm level that are more efficiently managed there than by the market itself or by their owners in their own portfolios. In short, it should accept only those risks that are uniquely a part of the bank's array of services. Elsewhere, Oldfield and Santomero (1997), it has been argued that risks facing all financial institutions can be segmented into three separable types, from a management perspective. These are: (i) Risks that can be eliminated or avoided by simple business practices, (ii) risks that can be transferred to other participants, and (iii) risks that must be actively managed at the firm level. 

 

In the first of these cases, the practice of risk avoidance involves actions to reduce the chances of idiosyncratic losses from standard banking activity by eliminating risks that are superfluous to the institution's business purpose. Common risk avoidance practices here include at least three types of actions.  

 

The standardization of process, contracts and procedures to prevent inefficient or incorrect financial decisions is the first of these. The construction of portfolios that benefit from diversification across borrowers and that reduce the effects of any one loss experience is another. Finally, the implementation of incentive-compatible contracts with the institution's management to require that employees be held accountable is the third.  

 

In each case the goal is to rid the firm of risks that are not essential to the financial service provided, or to absorb only an optimal quantity of a particular kind of risk. This point has been made in a different context by both Santomero and Trester (2007) and Berger and Udell (2003). 

 

There are also some risks that can be eliminated, or at least substantially reduced through the technique of risk transfer. Markets exist for many of the risks borne by the banking firm. Interest rate risk can be transferred by interest rate products such as swaps or other derivatives. Borrowing terms can be altered to effect a change in their duration. Finally, the bank can buy or sell financial claims to diversify or concentrate the risks that result in from servicing its client base. To the extent that the financial risks of the assets created by the firm are understood by the market, these assets can be sold at their fair value. Unless the institution has a comparative advantage in managing the attendant risk and/or a desire for the embedded risk they contain, there is no reason for the bank to absorb such risks, rather than transfer them. 

 

However, there are two classes of assets or activities where the risk inherent in the activity must and should be absorbed at the bank level. In these cases, good reasons exist for using firm resources to manage bank level risk. The first of these includes financial assets or activities where the nature of the embedded risk may be complex and difficult to communicate to third parties. This is the case when the bank holds complex and proprietary assets that have thin, if not non-existent, secondary markets. Communication in such cases may be more difficult or expensive than hedging the underlying risk.4 Moreover, revealing information about the customer may give competitors an undue advantage. The second case included proprietary positions that are accepted because of their risks, and their expected return. Here, risk positions that are central to the bank's business purpose are absorbed because they are the raison d'etre of the firm. Credit risk inherent in the lending activity is a clear case in point, as is market risk for the trading desk of banks active in certain markets. In all such circumstances, risk is absorbed and needs to be monitored and managed efficiently by the institution. Only then will the firm systematically achieve its financial performance goal. 

 

It seems appropriate for any discussion of risk management procedures to begin with why these firms manage risk. According to standard economic theory, managers of value maximizing firms ought to maximize expected profit without regard to the variability around its expected value. However, there is now a growing literature on the reasons for active risk management including the work of Stulz (1994), Smith, Smithson and Wolford (1990), and Froot, Sharfstein and Stein (1993).  

 

In fact, the recent review of risk management reported in Santomero (2005) lists dozens of contributions to the area and at least four distinct rationales offered for active risk management. These include managerial selfinterest, the non-linearity of the tax structure, the costs of financial distress and the existence of capital market imperfections. Any one of these justifies the firms' concern over return variability, as the above-cited authors demonstrate. 

 

Risks in Providing Banking Services 

How are these techniques of risk management employed by the commercial banking sector? To explain this, one must begin by enumerating the risks which the banking industry has chosen to manage and illustrate how the four-step procedure outlined is applied in each area. The risks associated with the provision of banking services differ by the type of service rendered. For the sector as a whole, however the risks can be broken into six generic types: systematic or market risk, credit risk, counterparty risk, liquidity risk, operational risk, and legal risks. Here, we will discuss each of the risks facing the banking institution, and will indicate how they are managed. 

 

Systematic risk is the risk of asset value change associated with systematic factors. It is sometimes referred to as market risk, which is in fact a somewhat imprecise term. By its nature, this risk can be hedged, but cannot be diversified completely away. In fact, systematic risk can be thought of as undiversifiable risk. All investors assume this type of risk, whenever assets owned or claims issued can change in value as a result of broad economic factors. As such, systematic risk comes in many different forms. For the banking sector, however, two are of greatest concern, namely variations in the general level of interest rates and the relative value of currencies. 

 

Because of the bank's dependence on these systematic factors, most try to estimate the impact of these particular systematic risks on performance, attempt to hedge against them and thus limit the sensitivity to variations in undiversifiable factors. Accordingly, most will track interest rate risk closely. They measure and manage the firm's vulnerability to interest rate variation, even though they can not do so perfectly. At the same time, international banks with large currency positions closely monitor their foreign exchange risk and try to manage, as well as limit, their exposure to it.  

In a similar fashion, some institutions with significant investments in one commodity such as oil, through their lending activity or geographical franchise, concern themselves with commodity price risk. Others with high single-industry concentrations may monitor specific industry concentration risk as well as the forces that affect the fortunes of the industry involved. 

 

Credit risk arises from non-performance by a borrower. It may arise from either an inability or an unwillingness to perform in the pre-committed contracted manner. This can affect the lender holding the loan contract, as well as other lenders to the creditor. Therefore, the financial condition of the borrower as well as the current value of any underlying collateral is of considerable interest to its bank. The real risk from credit is the deviation of portfolio performance from its expected value. Accordingly, credit risk is diversifiable, but difficult to eliminate completely. This is because a portion of the default risk may, in fact, result from the systematic risk outlined above. In addition, the idiosyncratic nature of some portion of these losses remains a problem for creditors in spite of the beneficial effect of diversification on total uncertainty. This is particularly true for banks that lend in local markets and ones that take on highly illiquid assets. In such cases, the credit risk is not easily transferred and accurate estimates of loss are difficult to obtain. 

 

Counterparty risk comes from non-performance of a trading partner. The non-performance may arise from a counterparty's refusal to perform due to an adverse price movement caused by systematic factors, or from some other political or legal constraint that was not anticipated by the principals. Diversification is the major tool for controlling nonsystematic counterparty risk. Counterparty risk is like credit risk, but it is generally viewed as a more transient financial risk associated with trading than standard creditor default risk. In addition, counterparty’s failure to settle a trade can arise from other factors beyond a credit problem. 

 

Liquidity risk can best be described as the risk of a funding crisis. While some would include the need to plan for growth and unexpected expansion of credit, the risk here is seen more correctly as the potential for a funding crisis. Such a situation would inevitably be associated with an unexpected event, such as a large charge off, loss of confidence, or a crisis of national proportion such as a currency crisis. In any case, risk management here centers on liquidity facilities and portfolio structure. Recognizing liquidity risk leads the bank to recognize liquidity itself as an asset, and portfolio design in the face of illiquidity concerns as a challenge. 

 

Operational risk is associated with the problems of accurately processing, settling, and taking or making delivery on trades in exchange for cash. It also arises in record keeping, processing system failures and compliance with various regulations. As such, individual operating problems are small probability events for well-run organizations but they expose a firm to outcomes that may be quite costly. 

 

Legal risks are endemic in financial contracting and are separate from the legal ramifications of credit, counterparty, and operational risks. New statutes, tax legislation, court opinions and regulations can put formerly well-established transactions into contention even when all parties have previously performed adequately and are fully able to perform in the future. For example, environmental regulations have radically affected real estate values for older properties and imposed serious risks to lending institutions in this area. A second type of legal risk arises from the activities of an institution's management or employees. Fraud, violations of regulations or laws, and other actions can lead to catastrophic loss, as recent examples in the thrift industry have demonstrated. All financial institutions face all these risks to some extent. Non-principal or agency activity involves operational risk primarily. Since institutions in this case do not own the underlying assets in which they trade, systematic, credit and counterparty risk accrues directly to the asset holder. If the latter experiences a financial loss, however, legal recourse against an agent is often attempted. Therefore, institutions engaged in only agency transactions bear some legal risk, if only indirectly. 

 

Our main interest, however, centers around the businesses in which the bank participates as a principal, i.e., as an intermediary. In these activities, principals must decide how much business to originate, how much to finance, how much to sell, and how much to contract to agents. In so doing, they must weigh both the return and the risk embedded in the portfolio. Principals must measure the expected profit and evaluate the prudence of the various risks enumerated to be sure that the result achieves the stated goal of maximizing shareholder value. 

 

Risk Management Practices in Nigerian Banks 

The Nigerian banking sector has been characterized by poor risk management and weak corporate governance. The bedrock of any risk management structure is the risk management framework upon which such structure is based. 

 

The banking sector consolidation programme provided an opportunity for Nigerian banks to key into developments in the global financial system e.g. leveraging on innovations in financial markets and access to cross border funds flows. In addition access to technological innovations also provided new opportunities for and increased competitive pressures among banks and non-banks alike. 

 

Banks everywhere are generally becoming more involved in developing new instruments, products & services and techniques. Traditional banking practice based on receipt of deposits and granting loans is today only part of a typical bank’s business. Trading in financial markets and income generation through fees are now major source of banks’ profitability (loan swaps and sales, securitization, Off-Balance-Sheet engagements, guarantees, Letters-of-Credits, derivative instruments, futures and options). Many of these products pose complex problems in terms of risk measurement, management and control. The situation is worsened by the poor corporate governance climate in the banks. This militates against the establishment of a risk-conscious environment in the banking sector. 

 

With very volatile markets for financial assets, declining profitability and changing economic philosophies, every business organization has to effectively manage the ensuing risks in the changing environment. The CBN has adopted a risk-based approach to the supervision of the institutions under its purview. A key aspect of the new approach is the requirement that banks keenly manage the risks they face. They are expected to put measures in place to identify measure, monitor and control those risks. CBN has provided the best-practice guidance in the form of the Guidelines for Developing Risk Management Frameworks.  

 

Consistent and effective management is the best way of building and preserving the reputation of a company. In fact, reputation management is an important element of strategic risk management. In managing reputational risk, risk managers should understand the relationship that exist between hazard (objective probability of harm, which is the standard definition of risk) and outrage (public sense of discomfort, which is the basket of factors that make people upset, angry or frightened about something). The reality had always been that risk managers address hazards and the public respond chiefly to factors that prompt outrage. 

 

The banking consolidation strengthened the financial base of banks but cannot shield them from significant losses arising from unbridled appetite for risk, weak risk management framework and poor corporate governance