CAR and risk management (I)

inSight

11 Mar 2004

CAR and risk management (I)

Capital Adequacy Ratio and Risk Management (I)

This first of two articles explores how banks manage risk and the use of the capital adequacy ratio as a tool to manage the credit risks taken by banks.

In everyday life we are all exposed to risks of one type or another. We risk being run down by a bus. We risk losing our jobs. We risk losing our money in investments. But we do not try and avoid risks by not living our lives. We walk on the streets and do our shopping and go to work. We work and earn a living. We invest our money. In other words, in life we take risks all the time. What is important is that we are in a position to identify what the risks are, assess whether we are able to assume those risks, and take measures to manage them in a manner that safeguards our interests.

Readers may have come across the expression that the business of banking is all about taking risk. A bank lends money deposited with it by depositors to borrowers. In doing so, the bank obviously takes on a risk - identified as credit risk - that the borrower may become unable to service or repay the loan. So, before making the loan, the bank has to assess whether the credit risk is worth taking and what price (lending rate) to charge for it. The bank therefore seeks relevant information from the borrower in order to assess whether he or she is creditworthy. In sophisticated banking centres, the organisation and the dissemination of such information has been institutionalised in the form of credit reference agencies or sharing arrangements. Hong Kong is moving in this direction. Credit risk assessment conducted on the basis of reliable information helps the efficient allocation and pricing of credit through the banking system. It helps those who are creditworthy to obtain bank loans more readily from banks and, if the system works well, more cheaply as well.

A good credit history of a borrower is not of course a guarantee that he will not default on his loan. Unforeseen events that suddenly change the financial viability of the borrower do occur. Banks therefore seek additional ways to protect themselves - through prudent credit risk management - by, for example, requiring security for the loans. In Hong Kong, a typical case is a mortgage loan secured upon the property. Given that the value of the security (property) fluctuates in accordance with market conditions, the bank demands a safety margin to protect against a fall in the value of the security - for example 70% loan-to-valuation ratio for mortgages - when making the loan. This is a credit risk management measure that is familiar to most of us.

But risk management in the conduct of banking business is much more sophisticated than that. Other than residential mortgages, the average bank in Hong Kong has many other ways of deploying money in order to make a profit, all of which involve careful identification, assessment and management of risks. And it is not just credit risks that are of concern to banks. When they choose to invest money in financial assets denominated in foreign currencies, they incur exchange risk as well. When investing in debt securities that pay a fixed rate of interest, they additionally incur interest rate risks that involve the price of the securities falling when interest rates rise. When investing in assets that cannot be readily sold, as in the case of many bank loans, they incur liquidity risks. There are many ways of managing these risks, for example by insuring or hedging the risk through the use of forward contracts or derivatives markets. But this is not always done, partly in view of the high costs of doing so and partly because the banking business is indeed a risk business. Banks take calculated risks and in the process make profits.

It is of course important that the banks do not take risks that they cannot manage. The banking supervisor has the responsibility, among other things, to ensure that this is the case by reviewing the risk management systems of the banks, by approving only people who are considered fit and proper to fill senior management position of banks and by other supervisory measures considered appropriate. But no matter how effective the risk management systems of banks and the banking supervisory measures are, risks do materialise - good loans can unexpectedly become non-performing, and eventually have to be written off. The fact that, notwithstanding having gone through some of the worst of circumstances in the history of Hong Kong, the banking system has a non-performing loan (NPL) ratio in low single digits speaks volumes for the robustness of the banking system of Hong Kong and its ability to manage risk.

When risks materialise in the form of bad loans that cannot be recovered, the banks have to write off those loans. When a loan is written off, the profit of the bank is correspondingly reduced. One prudential measure for ensuring that losses do not impair the viability of the bank, and the confidence of depositors (not only in that bank but in the banking system as a whole), is to require that the bank maintains adequate capital. Readers are familiar with the capital adequacy ratio (CAR) that we so often mention in our banking supervisory work. A global capital adequacy standard was introduced in 1988. Hong Kong was one of the first jurisdictions to adopt the standard, and this supervisory tool has served Hong Kong well.

 

Joseph Yam

11 March 2004

 

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