Review of the literature on risk management

Review of the literary productions on essay wayThis chapter reviews the literature on the gamble precaution and integrated governing body in the margining squiffyament. ploughsh atomic number 18 of the literature besides attempts to provide a blood amidst the promiscuousdom and monetary companionship of the shape up of directors and canvas delegation, and put on the line watchfulness practices by referring to both empirical and analytical research.2.1 Risk Management in the banking sectorWhen discussing the challenges faced by financial institutions in managing assay, it is all important(predicate) to countenance a reproducible definition of the term danger. Risk lowlife be be as the volatility of a corporations mart value. Risk focusing involves the nurseion of a fasts assets and profits. Moreover, not only does it provide favorableness but as vigorous as different advantages like being in line with obedience be given toward the rule, increas ing the firms reputation and opportunity to attract more customers in expression their portfolio of fund resources. Cebenoyan and Strahan (2004) suggest that the pull aheads of advances in luck of exposure worry in banking may be greater credit availability, preferably than take downd find in the banking system (p.19). This means that banks get out develop a greater opportunity to increase their productive assets and profit. Only those banks that fall in efficient happeniness anxiety system pull up stakes survive in the market in the farsighted run. They tail follow a four- t mavin of voice routine to reduce their risk paintings and win their risk heed objectives, as indicaten below.Figure 1-Steps for implementing risk managementTo right on manage risks, banks must firstly identify and classify the sources from which risk may arise at both transaction and portfolio levels. Risks inherent in modify activities include market risk, liquidness risk, credit ris k and operational risk. merchandise risk is the risk resulting from adverse movements in the level of market prices of equities, currencies, sp ar-time activity rate instruments and commodities. Banks be always facing the risk of going awayes in on and off-balance-sheet positions arising from undesirable market movements. Banks argon inherently vulnerable to liquidity risk due to their fundamental role of trans degreeing of short-term deposits into long-term loans. The FSA has defined liquidity risk as The risk that a firm, though solvent, each does not have sufficient financial resources available to enable it to fill its obligations as they fall due, or bed secure them only at an excessive cost.An new(prenominal) risk that banks face is credit risk. It is the risk that can be incurred if the counterparty fails to meet its obligations in a seasonably manner. Loans are the nigh palpable source of credit risk in m either of the banking systems however, other sources of thi s risk originate through and through other activities of banks such(prenominal)(prenominal) as acceptances, concern financing, interbank transactions, financial futures, foreign exchange transactions, swaps, equities, options, bonds, and in the extension of commitments and guarantees, and the settlement of transactions. operative risk, as its name suggests, is a risk arising from execution of a lodges line of business functions. The Basel Committee has defined operational risk as the risk of mischiefes resulting from inadequate or failed internal processes, people and systems, or extraneous events, such as the failure of computer systems or error and fraud on the part of staff.Apart from those risks mentioned above, the Federal Reserve System has alike prize two other risks legal risk and reputational risk. Legal risk is the risk of loss ca practised by sanctions or penalties originating from court disputes due to breach of twitch and legal obligation. Another legal risk r elates to regulatory risk, i.e., the risk of loss resulting from sanctions and penalties pronounced by a regulatory body. Reputational risk may be defined as the risk of loss ca affair upd by a prohibit impact on the market positioning of the bank. It can be seen as the blowing up of an initial loss, arising from credit, market, liquidity or operational risks. However, banks hardly render attention to these categories of risks.Once identified, the risks should be evaluated to determine their impact on the companys profitability and capital. This entails measuring them by using various techniques ranging from simple to civilise ones. For example, market risk can be measured by using prize at Risk. This stage excessively calls for estimating three dimensions of each exposure the strength frequency of losses that exposures have produced or may produce, the potential impact on the organisation if a loss should occur and the potential random variable in losses that bequeath occ ur during the exposure period. Accurate and timely measurement of risk is necessary because with these instances of data the risk manager can determine which exposes are nigh serious and which deserve the most quick attention.After measuring risk, bank managers should establish and communicate risk limits through policies, standards, and procedures that define responsibleness and authority. These limits should serve as a means to pull strings the risks associated with the banking institutions activities. There is a variety of mitigating similarlyls that banks may employ to minimise the loss exposures. These tools may be diversification, securitization and even derivative such as detachment option, Bermudan-style return put option, return swap, return swaption and liquidity option.The final step involves appraising the operation of the program regularly to be sure that it is achieving be after results. It helps the managers to evaluate the wisdom of their decision-making. To efficiently monitor risk, all material risk exposures should be identified and measured again. To facilitate this procedure, banks should put in engineer an final resultive management information system (MIS) that will provide directors and cured managers with timely reports on the in operation(p) finishance, financial condition and risk exposure of the firm. If corrective action is indicated at this stage, the first three steps should be repeated.2.1 Corporate Governance in the banking sectorCorporate establishment is a term that is now universally invoked wherever business and finance are discussed. Its purpose is to coordinate a conflict of interest among all parties kindred deep down the company and to develop a system that can reduce or eliminate the agency problems arising from the separation of ownership and accommodate (OECD, 1997). elbow room problem occurs when the agents of an organization (e.g. management) use their power to satisfy their own interests rather t han those of the principals (e.g. shareholders). It may excessively refer to simple disagreement between agents and principals. For example, the senesce of directors may disagree with shareholders on how to best invest the companys assets, especially when the card of directors wishes to invest in securities that would favour their interests.Not merely does the term in corporald arrangement carries different interpretations, its analysis also involves diverse disciplines and approaches. One of the most quoted definitions of in unifiedd nerve is the one given by Shleifer and Vishny (1997) corporate governance deals with the ways in which suppliers of finance to corporations assures themselves of getting a return on their investment. The Cadbury Report, however, defined corporate governance as the system by which companies are directed and controlled (para 2.5). Additionally, it recognised that a system of good governance allows the age of directors to be free to drive their co mpanies forward, but bring that freedom within a framework of effective accountability (para 1.1). The Hampel Report, whilst accepting the Cadbury definition of corporate governance, also noted that the single overriding objective of companies is the preservation and the great practical enhancement over time of their shareholders investment (para 1.16). In a similar vein, Charkham (1994) identified two basic principles of corporate governanceThat management must be able to drive the enterprise forward free from undue constraint caused by government interference, dismay of litigation, or fear of displacement.That this freedom- to use managerial power or patronage- must be cased with a framework of effective accountability. Nominal accountability is not enough.In the banking sector, however, corporate governance differs greatly with other economic sectors in terms of broader utmost of claimants the banks assets and funds. In manufacturing corporations, the issue is to maximise t he shareholders value but in banking, the risk involved for depositors assumes greater importance due to the fact that almost all(prenominal) bit of banks investment are financed by the depositors funds. If it goes bankrupt, it will be depositors nest egg that the bank will lose. Indeed, Macey and OHara (2001) states that a broader view of corporate governance should be adopted in the case of banking institutions, arguing that because of the peculiar contractual form of banking, corporate governance mechanisms for banks should encapsulate depositors as well as shareholders. Arun and food turner (2003) also support this argument. Furthermore, the involvement of government in the banking sector is discernibly high compared to other economic sectors due to the larger interests of the public (Caprio and Levine, 2002 Levine, 2004).Rational depositors demand some form of guarantee before depositing their wealth in banks. Yet, it is comparatively difficult for banks to provide these gu arantees to them because communicating the value of a banks loan portfolio is sooner impossible and very costly to reveal. As a consequence of this unsymmetrical information problem, bank managers can have an incentive to invest in riskier assets than they promised they would ex ante. To assure depositors that they will not expropriate them, banks could make investments in brand-name or reputational capital (Klein, 1974 Gorton, 1994 Demetz et al, 1996 Bhattacharya et al, 1998), but these schemes give depositors little confidence, especially when contracts have a finite nature and discount rates are sufficiently high (Hickson and Turner, 2003). The opaqueness of banks also makes it very costly for depositors to constrain managerial discretion through debt covenants (Capiro and Levine, 2002, p.2).As such, government interventions provide the lacking authorization to economic agents in the form of deposit insurance. Neverthe slight, although the government provides deposit insurance, bank managers still have an incentive to opportunistically increase their risk-taking, but now it is primarily at the governments expense. Apart from supporting the argument that a broader approach to corporate governance should be adapted to banking institutions, Arun and Turner (2003) also argue that government intervention do restrain the behaviour of bank management.The Bank for internationalistic Settlements (BIS) has defined the governance in banks as the methods and approaches used to manage banks through the bestride of directors and ranking(prenominal) management which determine how to put the banks objectives, operation and protect the interests of shareholders and stakeholders with a commitment to act in accordance with existing laws and regulations and to strive the protection of the interests of depositors. The Table 1 below shows the general principles concerning corporate governance issued by the Basel Committee specifically for bank notices and older managemen t.Principle 1Board members should be qualified for their positions, have a clear reasonableness of their role in corporate governance and be able to exercise sound judgment about the affairs of the bank.Principle 2The get along with of directors should approve and oversee the banks strategic objectives and corporate values that are communicated passim the banking organisation.Principle 3The get on of directors should set and enforce clear lines of responsibility and accountability throughout the organisation.Principle 4The board should ensure that in that respect is appropriate oversight by senior management consistent with board policy.Principle 5The board and senior management should effectively habituate the work conducted by the internal analyse function, external inspectors, and internal control functions.Principle 6The board should ensure that compensation policies and practices are consistent with the banks corporate culture, long-term objectives and strategy, and co ntrol environment.Principle 7The bank should be governed in a transparent manner.Principle 8The board and senior management should image the banks operational structure, including where the bank operates in jurisdictions, or through structures, that impede transparency (i.e. know-your-structure).Table 1- Principles of corporate governance for bank boards and senior management2.2 Corporate Governance MechanismAccording to agency theory, the corporate governance mechanisms reduce the agency problem between investors and management (Jensen and Meckling, 1976 Gillan, 2006). Traditionally, these mechanisms can be classified as internal and external. Llewellyn and Sinha, (2000) states that internal corporate governance is about mechanism for the accountability, observe, and control of a firms management with respect to the use of resources and risk taking. Its main mechanisms are the board of directors, the ownership structure of the firm and the internal control system (Gillan, 2006). Whereas, external corporate governance controls enshroud the controls external stakeholders exercise over the organisation and its primary external mechanisms are the takeover market and the legal/regulatory system.However for the purpose of this paper, we will mainly focus on some internal corporate governance mechanism such as the board of directors, more precisely on its license and financial knowledge. Corporate governance best practices have also stressed in particular the key role played by the take stock committal in reviewing a firms internal control system. national control systems contribute to the protection of shareholders interests by providing reasonable assurance on the reliability of financial reporting, force of operations and compliance with laws and regulations (COSO, 1994 2004). As such, we will also draw some attention on the audit mission.2.3 The boards licenseThe popular media as well as corporate governance experts have characterised boards largely as rubber stamps for management. They are the link between the shareholders of the firm and the managers entrusted with undertaking the day-to-day operations of the organisation (Monks and Minow, 1995 Forbes and Milliken, 1999). As stated in principle 4 above, bank boards should properly supervise the work of managers. Which type of directors can perform better this duty than self-reliant director? In fact, such directors can bring additional experience as well as clarity of thought to deliberations independent of views of management. Moreover, since their careers are not tied(p) to the firms chief operating officer, outback(a) directors are believed to be more powerful in retentivity efficiently the firms top management (Fama, 1980 Fama and Jensen, 1983) and so could be associated with better performance. close to papers do support this theory. Baysinger and Butler (1985), being among the first studies, nonplus that the relative independence of boards has a positive effect on th e firms amount return on uprightness by comparing 266 major US businesses over a ten-years period. Kesner (1987) Weisbach (1988) Rosenstein and Wyatt (1990) Peace and Zahra (1992) Ezzamel and Watson (1993) MacAvoy and Millstein (1999) Brown and Caylor (2004) and Ho (2005) also show that shareholder returns are enhanced by having a greater equipoise of outside directors on the board. Research by Brickley, Coles, and Terry (1994) shows significantly higher(prenominal)(prenominal)(prenominal) returns to firms announcing poison pill1when outside directors dominate the board. Other studies supporting the benefit of the boards independence are Dechow and Sloan (1996) Beasely (1996) and Klein (2002) who state that as outside membership on the board increases the likelihood of financial statement fraud decreases. There is also Black et al. (2006) who reports that firms with 50% outside directors have approximately 40% higher share price by studying 515 Korean firms. And more recently, St aikouras C. K., Staikouras P. K. and Agoraki M. K. (2006) rule that the percentage of independent directors is positively related with performance measured by Tobins Q on a sample of European banks.On the other hand, others assure no convincing evidence that the level of outside directors on the board do add value to corporate performance. For instance, Fosberg (1989) images that firms whose board is still of a majority of outside directors do not have a higher performance as measured by the firms ROE or sales. Similarly, Hermalin and Weisbach (1991) find that non-executive directors have no impact on corporate performance in their sample of 142 NYSE firms. Pearce (1983) also find no comparisonship, as too Changanti et al. (1985) in their study of board composition and bankruptcy. The lack of relation between these two components has also been confirmed by Klein (1998), Bhagat and Black (2002) and Hayes, Mehran and Scott (2004). Other scholars refuting the effectiveness of outs ide directors on the board are Subrahmanyam et al. (1997) and Harford (2000) for the acquisition transactions, Core et al. (1999) for CEO compensation and Agrawal and Chadha (2005) for earnings restatements.It is normally the board of directors which overviews and approves the risk management policies. But, some papers have tried to link its independence to the firms risk management practices and hedging. By analysing a sample of bank holding companies, Whidbee and Wohar (1999) find that the likelihood of using derivatives seem to increase with the mien of external directors on the board but only when insiders hold a large equilibrium of the firms shares. Borokhovich et al. (2004) expose that firms most active in hedging risk, especially when making use of interest rate derivatives usage, are those whose boards are dominated by external directors. Conversely, Dionne and Triki (2004) Mardsen and Prevost (2005) point out that outside directors has no impact on the firms risk manag ement policy.Given the mixed empirical findings, it is quite difficult to importune whether the board independence contribute to corporate performance and the effectiveness of risk management. Although Fields and Keys (2003) assert that there is overwhelming support for independent directors providing fantabulous monitoring and advisory functions to the firm, a unique and clear sign concerning the effect of the boards independence on any decision including the risk management one could not be predicted.2.4 The financial knowledge of the boardTo adequately perform their supervision role, the board of directors must have financial knowledge2. Indeed, when board members are generalists and lack the technical financial knowledge to understand the manifold reports presented to them, they could vote for motions that increase the risks facing of the firm to a large extent. The company may collapse in this way and therefore hinder the shareholders interest. Because of the banks paramoun t position in the economy they should possess some financial expertness directors on its board so as to make better decisions that will not lead the firm to go bankrupt. However, given its importance, the research on the value of the boards financial knowledge is quite scarce. At times, reports recognising the benefits of the boards independence also recommend financial literacy/expertise for directors in monitoring the firms performance.In fact, cubicle and Deli (1999) and Guner, Malmendier and Tate (2004) suggest that commercial message bankers on boards provide the financial readiness needed to enable the business to contract more debt. Thus, this states that financial directors do add value to the firm. There is also Agrawal and Chadha (2005) who discover that there is visit earnings restatement in firms whose boards have accountancy or financially well-educated independent directors. However, Rosenstein and Wyatt (1990) provide evidence that positive abnormal returns asso ciated with the addition of an noncitizen to the board are higher when the latter is an officer of a financial firm. Later on, Lee, Rosenstein and Wyatt (1999) do come to the comparable conclusion. However, they were unable to make any statistically difference among the reaction of the three categories of financial directors they consider commercial bankers, insurance company officers and investment bankers.To the best of our knowledge, researches on the boards financial knowledge have only been related with the firms performance and not specifically on its impact on risk management practices. As mentioned earlier in this study, the board of directors is usually responsible for the firms risk management policies. In other words, risk management is at the core of any board members charter. financially knowledgeable directors will obviously make better decisions on risk management practices since they will have the technical background to understand the sophisticated tools involved i n risk management transactions. As such, firms whose boards are composed of financially knowledgeable directors engage more actively in risk management.2.5 The audit committalThe audit committee is intended to provide a link between the board and the auditor independent of the companys management, which is responsible for the accounting system (IOD, 1995). The chief objectives of an audit committee are to improve the caliber of financial reporting, to reduce the potential authority for the non-executive director, to improve the channel of communication with the external auditor and, perhaps most importantly, to review the adequacy of the companys financial control systems. Tricker (1984) defines audit committee as being an important vehicle for ensuring the supervision and accountability at board level. As such, audit committees are very important in banking to safeguard the shareholders interest as well as the public trust.Just as for the board of directors, independence is also considered important for an audit committee because outside directors can exercise their voice and be seen to make a valuable contribution since they are free of any influence arising from the firms CEO. Thus, the reported empirical evidence supports this argument. Klein (2002) shows that independent audit committees reduce the likelihood of earnings management, thus improving transparency. In addition, Abbott, Park and Parker (2002) argue that firms with audit committees comprising entirely of independent directors are less likely to have fraudulent or misleading reporting. Ho (2005) states that there is a strong positive link between independent audit committee and corporate competitiveness and also with return on equity after analyzing the international companies from 1997to 1999. Brown and Caylor (2004) do provide evidence that audit committees comprising of independent directors are positively related to dividend but not to operating performance.On the other hand, some authors find a negative descent or simply no relation at all between independent audit committee and the firms performance. Hayes, Mehran and Scott (2004) prove that the firms performance measured by the market to book ratio is not affected by the proportion of outside directors sitting on the audit committee. Agrawal and Chadha (2005) do come to the corresponding conclusion by indicating that independent audit committee members are misrelated to earnings restatement. There are also Beasley (1996) who finds no apparent correlativity between audit committees composition and financial statement fraud, and Klein (1998) who reports no relation between share prices and the audit committees composition. Yet, Carcello and Neal (2000) report a negative relationship between the probability of receiving a going-concern report and the proportion of outsiders on the audit committee.In addition to independence, the accounting and financial expertise of members of the audit committee has also receiv ed widespread attention from the media and regulators3. An audit committee with such characteristics is expected to provide effective monitoring as it possesses the skills needed to understand what is going on in the organisation. Interestingly, Agrawal and Chadha (2005) show that firms whose audit committees have an outside director with accounting background or financial knowledge are less likely to report earnings restatement while Abbott, Parker and Peters (2002) discover that the absence of a financially competent director on the audit committee is highly associated with an increased in financial misstatement and financial fraud. Xie, Davidson, and DaDalt (2003) find that the presence of investment bankers on the audit committee decreases discretionary accruals in a firm. Davidson et al. (2004) and Defond, Hann and Hu (2004) show that the market has a positive reaction following the contract of directors with accounting /auditing experience on audit committees board.The audit committee is also responsible for evaluating the risk exposures and the measures taken to monitor and control these exposures. To our knowledge no paper has tried to link audit committees composition with risk management practices. Because of the mixed and conflicting argument on independence, it is quite difficult for us to attest whether audit committees independence encourage more corporate hedging. Furthermore, risk evaluation and risk management tools are quite difficult to use and thus understanding them requires a good grasp of mathematics and statistics. As such, we expect firms whose audit committees members are qualified as accounting/financial expert to engage more actively in risk management practices.Besides independence and accounting/financial knowledge, the Cadbury Report has insisted that all listed companies should have an audit committee comprising of at least three members. This is to urge firms to entrust significant director resources to their audit committee s so that audit committees monitor the firms management more efficiently. However, several studies support the idea that larger boards can be dysfunctional since they may be plagued with free rider, communication problem and monitoring problems4. Therefore, as long as the increase in the audit committees surface does not pose these types of problems, firms complying with this requirement are expected to report a higher hedging ratio.Often, corporations, especially financial ones, create another committee named risk monitoring committees. This type of committee is often responsible of the risk monitoring of the firm. However, this does not imply that audit committee is no perennial responsible for evaluating and managing risks. It must still discuss and evaluate risk management processes. In other words, the audit committee is there to review risk management processes proposed by the risk management committee. As such, we assume that the same characteristics as the audit committee should be applied to this type of committee to fulfil their duties well.