“Top business risks in the banking industry” by Vicky Lee-Salas (October 25, 2010)

SUITS THE C-SUITE By Vicky Lee-Salas
Business World (10/25/2010)

Many executives believe that the industry’s heightened focus on risk governance is one of the most positive outcomes of the global financial crisis. Senior management had very little choice but to confront the situation and fundamentally rethink their strategic approach to risk.

Using the findings in the Ernst & Young Top 10 risks for Business report as a starting point (and which have been featured in previous columns), we approached key bank executives with a view towards deepening our understanding of the risks facing the local banking and finance industry. Our discussions revealed some common themes that these industry experts feel are significant to the banking sector, namely: credit risks, market risks, and operational risks.

Credit Risks

Credit risk remains on top of the list. Data released by the Bangko Sentral ng Pilipinas reveal that foreign investments reached almost $1 billion from January to July 2010. Foreign portfolio funds also reached nearly $1.4 billion from January to September this year, which is six times higher than the comparative period in 2009. While developing countries such as the Philippines often benefit from foreign investments, huge inflows of capital can complicate macroeconomic management. They push up the value of our currency, boost imports and slow down exports, and promote fast credit expansion which can cause inflation, blow up asset bubbles, and usually leave a pile of bad loans.

Many experts agree that these very same dynamics ultimately caused the 1997 Asian financial crisis. A local bank treasurer cautioned that, with huge inflows of foreign portfolio funds or “hot money”, dollar loans might appear cheaper due to sudden strengthening of the peso. Banks might be tempted to push Foreign Currency Deposit Units loans to borrowers that might not have the capability to manage foreign exchange risk. These and other concerns are raising red flags among bank executives who are hoping that we do not see a repeat of the 1997 debacle.

Even during stable market periods, credit risks have always been an area of concern for bank executives. The threats, however, grow even more critical when compounded by recent financial market volatility. As one bank CFO commented, “Management of credit risk is a key factor in the successful operation of a bank. It is possible for an institution to have indirect exposure through the investments of their clients, such that the collapse of one firm can impact a bank that wasn’t even directly doing business with that firm.”

Making sound credit approval and pricing decisions are even more critical in today’s environment. Philippine banks have been very prudent in their lending practices for the past five years as evidenced by the shift in preference for higher quality government and corporate bonds. With the renewed focus on consumer loans, banks are further strengthening their credit risk management by investing in I.T. infrastructure to support credit scoring techniques, and by hiring credit risk specialist and product controllers.

Market Risks

The extreme volatility of the market is gradually calming down. The contagion effect, however, or the extent of the crisis and the speed with which it swept through the industry, is still very much top-of-mind for most people.

Banks are now working to sharpen their tools and processes to better predict their individual sensitivity to market shocks and volatility. To better anticipate and prepare for problems that may arise, they are also starting to look at supplementing Value-at-Risk measures with stress testing and scenario analysis.

As a matter of fact, many institutions have begun conducting daily or weekly tests on their trading books. An observer commented that it might be good to focus on the correlation between market risk and credit risk, and the advantages of merging these two functions under the supervision of one senior executive.

Operational Risks

The industry is also becoming more attentive to the growth of operational risks. Banks, of course, have always managed operational risk. They have always understood the need for tighter controls and lower error rates. However, the heightened scrutiny from the regulators, the new operational risk management framework and measurements required under Basel II, and the sheer difficulty of managing today’s difficult business environment have intensified the focus on operations.

Banks are starting to look at systems and process risks embedded throughout the organization, notably in the areas of quantifying and defining the people, standardizing documentation of processes and controls, improving data gathering, and developing methodologies to quantify risks.

(As of publication, Vicky Lee-Salas is an Assurance Partner of SGV & Co.)

This article was originally published in the BusinessWorld newspaper. It is for general information only and is not a substitute for professional advice where the facts and circumstances warrant. The views and opinion expressed above are those of the author and do not necessarily represent the views of SGV & Co.