Abstract
Maintaining financial stability in the banking sector through a well-functioning risk management system is a strategic approach in today's global world where the risks have become much more diversified than ever. This chapter was undertaken in order to investigate the risk management topic by focusing on the experiences learned from the banking crises up-to-date and implications of the Basel Accords which outlined capital adequacy standards to prevent such crises. With paying special attention to the case of Turkish banking system, main challenges and possible solutions are also discussed.
TopBackground
Risks are usually defined by the adverse impact on the profitability arising out of several distinct sources of uncertainty (Bessis, 2010, pp: 3-12). Banks are subject to a wide array of risks in the course of their operations. Effective risk management comprises four phases: identification of risks, evaluation of risks, management of risks and controlling of risks. Risk Management provides protection against the possibility of damages on the investments of banks that can result from future uncertainties, by means of hedging or neutralizing the financial risks that result from one or a series of transactions.
The events in the Turkish economy during the crises of 1994, end-2000 and 2008 have shown the importance of proper and integrated risk management systems in the Turkish banking system. This was a period which ca be characterized by increasing vulnerability to the shocks and financial crises. For example, the weakness of banking system has caused the collapse of the previous International Monetary Fund (IMF)-sponsored plans. Especially, after the crises in 1994 and end-2000, there was better realization that a banking system may bear huge amount of losses, face insurmountable capital erosion and be a burden on the entire economy. Hence, the establishment of a more stable banking platform with proper risk management framework to withstand macro shocks is imperative. This contributes to stability of the overall economy because banking system is the backbone of the economic system of a country. An integrated risk management system constitutes effective market, credit and operational risk management. How Turkish banks can develop and enhance their market, credit and operating risk measurement and management capabilities is a critical strategic tool for creating and sustaining competitive advantage. Banking in today’s environment is the business of managing risk - not just the business of borrowing and lending funds as it used to be traditionally done in the past. Better risk management systems allow banks to deploy their capital more efficiently and provide a source of competitive advantage.
Key Terms in this Chapter
Risk Adjusted Profitability: The financial services sector uses two common risk-adjusted profitability measurement models; risk-adjusted return on capital (RAROC) and return on risk-adjusted capital (RORAC).
Domino Effect: Usually associated with financial crises, domino effect can be manifested as negative externalities diffused from one crashing market to another.
Value at Risk (VaR): VaR is a measure of how much money the bank might lose over a period of time in the future. It provides standardized measure of market risks and estimate better the risk/return profile of individual assets or asset classes.
Systemic Risk: Possibility that failure of one bank to settle net transactions with other banks will trigger a chain reaction, depriving other banks of funds and preventing them from closing their positions in turn.
High Yielding Uncovered Bond Arbitrage: This happens when banks sell foreign currency against domestic currency in order to benefit from high returns of government debt instruments. But this triggers the demand for foreign currency when their foreign currency denominated liabilities come due because their borrowings are in terms of foreign currency. The volatility of foreign exchange rate, hence becomes the core risk for Turkish banks.
Regulatory Capital: Capital required by the regulators and calculated by limiting the maximum level of a bank’s risk assets and off-balance sheet commitments to a fixed multiple of its capital.
Capital Adequacy: Requirement that banks maintain equity capital sufficient to protect depositors from losses and support asset growth. Capital adequacy measures financial leverage; as leverage increases, less capital is available to cover unexpected losses. Thus, highly leveraged banks have more volatile earnings than banks with adequate capital, and are more closely monitored by banking regulators.
Economic Capital: Aggregate amount of equity capital that is required as a cushion for a company’s unexpected losses due to all of its risks.
Basel Committee: Joint committee of banking supervisory agencies in the 12 major industrial countries organized in 1975. The Basel Committee promotes uniform policies for bank capital and supervision of financial institutions.
Deposit Insurance Scheme: Deposit insurance is a measure implemented in many countries to protect bank depositors, in full or in part. Deposit insurance in Turkey is handled by Savings Deposit Insurance Fund.
Bank for International Settlements (BIS): An international organization based in Basel, Switzerland that acts as a bank for central banks of major industrial countries.