Slide 1.

FINANCIAL MANAGEMENT OF
BANKS

Lecturer: Prince Kofi Nchira

Course Developer: Prince Kofi Nchira

UCC School of Business, Dept of Finance
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About The Course

 Course Name: Financial Management of Banks
 Course Code: FIN 302

 Credits: 3
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General Course Objectives

 This course provides introductory but detailed discussion about

the concept, theory, principles and analysis of financial
management as it relates to banks.

 It also deals with analysis of financial statement of banks,

liquidity, credit policy, and related regulatory issues
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Financial Management of Banks

Business Finance
 Business activity which is concerned with the acquisition and
conservation of capital funds in meeting the financial needs
and overall objectives of business enterprise – B.O Wheeler

 An
activity concerned with planning, raising, controlling and
administering the funds used in the business –Guthumann &
Douggall
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Financial Management

 The area of business management devoted to a judicious use

of capital and careful selection of sources of capital in order
to enable the spending unit move in the direction of reaching
its goals –J. F Bradely
 Operational activity of a business that is responsible for
obtaining and effectively utilising the funds necessary for
efficient operations –J. L Massie
 Financial management is concerned with the efficient use of an
important economic resources viz capital funds - Ezra Solamn
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Nature of Financial Management

 Financialmanagement is mainly concerned with the

proper management of funds.

 The financial manager must see that the funds are

procured in a manner that there is risk, cost and control
considerations are properly balanced in a given
situation and there is optimum utilization of funds.
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Scope of Financial Management

 It covers both acquisition & utilisation of funds – efficient and

wise allocation of funds to various uses.

 Financial mgt involves providing solutions for major financial

operations of a firm on
- Investment decisions
- Financing decisions
- Dividend policy decisions
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Importance of Financial Management

 Financial planning & successful promotion of enterprise

 Acquisition of funds as & when required at minimum possible
cost.
 Proper use and allocation of funds.
 Taking sound financial decisions.
 Improving the profitability through financial controls.
 Increasing the wealth of investors & the nation.
 Promoting & mobilizing individual and corporate savings.
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Objectives of financial management

Profit Maximisation
Profit is the main aim of every economic activity.
Arguments in favour of profit maximisation as the objective of
business:-
 Profitability is a barometer for measuring efficiency and
economic property of a business enterprise.
 Profits are the main source of finance for the growth of the
business.
Wealth Maximisation
 Financial theory asserts that wealth maximisation is the single
substitute for a stockholder’s utility. When the firm maximises the
stockholder’s wealth, the individual stockholder can use this
wealth to maximise his individual utility.
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Functions of financial systems

 Financial systems perform the essential economic function of

channeling funds from units who have saved surplus funds to units who
have a shortage of funds.
 Reasons for financial systems
• First, lender-savers (with excess of available funds) do not
frequently have profitable investment opportunities, while
borrower-spenders have investment opportunities but lack of
funds.
• Second, even for purposes other than investment opportunities
in businesses, borrower-spenders may want to invest in excess of
their current income or to adjust the composition of their wealth
(reconciliation of the preferences for current versus future
consumption)
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The structure of financial systems:

 A financial system comprises

 Financial markets – these are markets in which funds are moved
from people who have an excess of available funds (and lack of
investment opportunities) to people who have investment
opportunities (and lack of funds).
 Securities -(also called financial instruments) are financial claims on
the issuer’s future income or assets.
 Financial intermediaries- theseare economic agents who specialise
in the activities of buying and selling (at the same time) financial
contracts (loans and deposits) and securities (bonds and stocks).
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financial intermediation

 financial intermediation are basically carried out by depository

institutions, contractual savings institutions and investment
intermediaries
Depository institutions (Banks)
 A depository institution or a bank is defined as an establishment
authorized by a government to accept deposits, pay interest, clear
checks, make loans, act as an intermediary in financial transactions,
and provide other financial services to its customers. It basically deals
with deposits and advances and other related services
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Depository institutions

Commercial banks
 Commercial banks accept deposits (liabilities) to make loans (assets)

and to buy government securities. Commercial banking can also be

separated into retail and wholesale banking. The difference between
retail and wholesale banking is essentially one of size
 Savings and loan associations

 Community Banks are smaller than commercial banks. They

concentrate on the local market. They provide more personalized

service based on relationships.
 Credit unions are non-profit institutions mutually organized and

owned by their members (depositors) with the primary objective of

satisfying the depository and lending needs of their members
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Investment intermediaries

Mutual funds
 Mutual funds pool resources from many individuals and companies

and invest these resources in diversified portfolios of bonds, stocks and

money market instruments
 An open-ended mutual fund (the major type of mutual fund)
continuously allows shareholders to sell (redeem) outstanding shares,
and investors to buy new shares at any time.
main advantages
 mutual funds provide opportunities to small investors to invest in
financial securities and diversify risk. Second, mutual funds take
advantage of lower transaction costs when they buy larger blocks of
financial securities
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Investment intermediaries

 mutual funds take advantage of lower transaction costs when they

buy larger blocks of financial securities.
Finance companies
 Finance companies make loans to individuals and corporations by
providing consumer lending, business lending and mortgage
financing.
 Finance companies differ from commercial banks because they do not

accept deposits.
 They raise funds by selling commercial paper (a short-term debt
instrument) and by issuing stocks and bonds.
 Moreover, finance companies often lend to customers perceived as

too risky by commercial banks

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Investment intermediaries

Major types of finance companies

 Sales finance institutions that make loans to customers of a

particular retailer or manufacturer (e.g. Ford Motor Credit).

 Personal credit institutions that make loans to consumers

perceived as too risky by commercial banks (e.g. Household

Finance Corp).
 Business credit institutions that provide financing to companies,

especially through equipment leasing and factoring (purchase by

the finance company of accounts receivable from corporate
customers).
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Investment intermediaries

Investment banks and securities firms

 Investment banks assist corporations or governments in the issue of

new debt or equity securities. Investment banking includes:

 the origination, underwriting and placement of securities in primary
financial markets .The process of underwriting a stock or bond issue
requires the investment bank to purchase the entire issue at a
predetermined price and then to resell it in the market. The
investment bank then bears the risk that they are not able to resell
the entire issue in which case it will hold the unsold stock on its own
balance sheet. In return for taking on this risk the investment
company receives an underwriting fee from the issuing company.
 financial advisory on corporate finance activities (such as advising
on mergers and acquisitions).
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Investment intermediaries

 Securities firms assist in the trading of existing securities in the

secondary markets. There are two main categories of securities firms:
 brokers- agents of investors who match buyers with sellers of
securities. The main service offered by brokers is securities orders.
Orders are trade instructions specifying what traders want to trade,
whether to buy or sell, how much, when and how to trade, and on
what terms.They earn a commission for their service
 dealers- agents who link buyers and sellers by buying and selling
securities. They hold inventories of securities, and sell these securities
for a slightly higher price than they paid for them. They thus earn the
bid-ask spread, the difference between the best ask (lowest price
charged for immediate purchase of stock) and the best bid (highest
price received for an immediate sale of a unit of stock).
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Financial intermediation

Central Bank
 A central bank is an independent national authority that conducts

monetary policy, regulates banks, and provides financial services

including economic research. Its goals are to stabilize the nation's
currency, keep unemployment low, and prevent inflation.
The Role of Central Bank
 Primary duties for a Central Bank include:

 Implement a monetary policy that provides consistent growth and

employment
 Promote the stability of the country's financial system

 Manage the production and distribution of the nation's currency

 Inform the public of the overall state of the economy by publishing

economic statistics
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Financial intermediation

Fiscal and Monetary Policy

 Fiscal policy refers to the economic direction a government wishes

to pursue regarding taxation, spending, and borrowing.

 Monetary policy is the set of actions a government or Central Bank

takes to influence the economy in an attempt to achieve its fiscal

policy.
 Though Central Banks have several options they can use to affect

monetary policy, the most powerful tool is their ability to set

interest rates.
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Financial intermediation

How Central Banks Use Interest Rates to Implement Fiscal Policy

 Through supply operational capital to the country's commercial banks
 This ensures the banking system has sufficient liquidity for businesses and
individual consumers to borrow money, and the availability of credit has a direct
impact on business and consumer spending
 Central Banks use the relationship between the short-term rates at which it offers
loans, and the interest rate the banks charge, as a way to influence the cost for
the public to borrow money.
 If the Central Bank feels that an increase in consumer spending is needed to
stimulate the economy, it can lower short-term rates when providing loans to the
commercial banks.
 If a tightening of the economy is needed to slow inflation, the Central Bank can
increase interest rates making loans more expensive to acquire, which could lead
to an overall reduction in spending.
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Financial intermediation

 Supply and Demand of Currency

 Just like any commodity, the value of a free-floating currency is
based on supply and demand.
 To increase a currency's value, the Central Bank can buy currency and
hold it in its reserves. This reduces the supply of the currency
available and could lead to an increase in valuation.
 To decrease a currency's value, the Central Bank can sell its reserves
back to the market. This increases the supply of the currency and
could lead to a decrease in valuation.
 International trade flows can also influence supply and demand for a
currency. When a country exports more than it imports, foreign
buyers must exchange more of their currency for the currency of the
exporting country. This increases the demand for the currency.
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Bank Ownership and management structure of banks

 The relationship between owners and management of banks is

purely a principal-agent relationship.
 Principal-agent relationship is a legal arrangement in which one
entity appoints another to act on its behalf. In this relationship, the
agent acts on behalf of the principal and should not have a conflict
of interest in carrying out the act.
 For instance when an investor buys shares of an index fund, he is
the principal, and the fund manager becomes his agent
 In this sense, principal-agent relationship are entered into by willing
and able parties for the purpose of legal transactions.
 Managers of banks are therefore obliged to undertake their
obligations deviod of conflict of interest as long as that relationship
exist.
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Bank Ownership and management structure of banks

Management structure of banks

 Banks have two-tier management structure made up of the

Board of Directors, which mostly consist of non-executive

members that set forth the general principles on which the
Bank operates

 The Board of Directors then appoint an Executive Board

made up of the CEO who is an Executive Director, Chief
Internal Auditor and the Secretary to the board.
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Bank Ownership and management structure of banks

 The Executive Board/Management is responsible for the day-to-

day management of the bank.
 managing the overall balance sheet structure and setting of the
balance sheet development policy
 defining the overall funding structure
 setting the general principles for measuring, managing and
reporting the Bank's risks, including market, credit, liquidity, and
operational risks
 monitoring the effects of new regulation on the Bank's activities and
risks
 ensuring that the Bank's risk management structure is robust and
well functioning
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Chapter Two
Introduction to Risk Management in Banking

Meaning of Risk
 A probability or threat of damage, injury, liability, loss, or any

other negative occurrence that is caused by external or internal

vulnerabilities, and that may be avoided through preemptive
action.
 Risk can be defined as the possible variation in outcome from what

is expected to happen.
 Risk implies the extend to which any chosen action or an inaction
that may lead to a loss or some unwanted outcome. The notion
implies that a choice may have an influence on the outcome that
exists or has existed.
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Chapter Two
Introduction to Risk Management in Banking

However, in financial management, risk relates to any material loss

attached to the project that may affect the productivity, tenure, legal
issues, etc. of the project.
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Chapter Two
Introduction to Risk Management in Banking
Systematic Risk
 Systematic risk is due to the influence of external factors on an

organization. Such factors are normally uncontrollable from an

organization's point of view.
Market Risk
 Market risk is the possibility for an investor to experience losses due
to factors that affect the overall performance of the financial
markets in which he is involved.
 Market risk, also called "systematic risk," cannot be eliminated
through diversification, though it can be hedged against. Sources of
market risk include recessions, political turmoil, changes in interest
rates, natural disasters and terrorist attacks.
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Chapter Two
Introduction to Risk Management in Banking
Interest rate risk
 Interest rate risk is the potential variability of a Bank's financial

condition owing to adverse movements in interest rates.

 Interest-rate risk arises due to variability in the interest rates from

time to time. It particularly affects debt securities as they carry the

fixed rate of interest.
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Chapter Two
Introduction to Risk Management in Banking

 Price risk arises due to the possibility that the price of the shares,
commodity, investment, etc. may decline or fall in the future.

 Reinvestment rate risk results from fact that the interest or dividend
earned from an investment can't be reinvested with the same rate
of return as it was acquiring earlier.
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Chapter Two
Introduction to Risk Management in Banking

Equity risk
 Equity risk is the risk involved in the changing stock prices. It is

associated with consistent fluctuations seen in the trading price of

any particular shares or securities. That is, it arises due to rise or
fall in the trading price of listed shares or securities in the stock
market.
 Equity risk premium is defined as "excess return that an individual

stock or the overall stock market provides over a risk-free rate."

This excess compensates investors for taking on the relatively higher
risk of the equity market
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Chapter Two
Introduction to Risk Management in Banking

Foreign Exchange risk

 Foreign exchange risk - also called FX risk, currency risk, or

exchange rate risk - is the financial risk of an investment's value

changing due to the changes in currency exchange rates.
 This also refers to the risk an investor faces when he needs to close
out a long or short position in a foreign currency at a loss, due to
an adverse movement in exchange rates.
 In banking, foreign exchange risk defined as the potential variation
of the Bank’s earnings and capital through its on - and off -balance
sheet positions denominated in foreign currencies, as a result of
adverse movements in foreign exchange rates.
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Chapter Two
Introduction to Risk Management in Banking

Unsystematic Risk
 Unsystematic risk is due to the influence of internal factors

prevailing within an organization. Such factors are normally

controllable from an organization's point of view.
 it is a micro in nature as it affects only a particular organization. It
can be planned, so that necessary actions can be taken by the
organization to mitigate (reduce the effect of) the risk.
 Company- or industry-specific hazard that is inherent in each
investment and can be reduced through diversification
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Introduction to Risk Management in Banking

Types of unsystematic Risk

 Business or liquidity risk


Business risk is also known as liquidity risk. It is so, since it emanates
(originates) from the sale and purchase of securities affected by
business cycles, technological changes, etc.
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Chapter Two
Introduction to Risk Management in Banking

Business or liquidity risk

 Business risk is also known as liquidity risk. It is so, since it emanates

(originates) from the sale and purchase of securities affected by

business cycles, technological changes, etc.
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Chapter Two
Introduction to Risk Management in Banking

 Asset liquidity risk is due to losses arising from an inability to sell or

pledge assets at, or near, their carrying value when needed. For
e.g. assets sold at a lesser value than their book value.
 Funding liquidity risk exists for not having an access to the
sufficient-funds to make a payment on time. For e.g. when
commitments made to customers are not fulfilled as discussed in the
SLA (service level agreements).
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Chapter Two
Introduction to Risk Management in Banking

 Financial/Credit Risk
 Credit risk refers to the risk that a borrower may not repay a loan
and that the lender may lose the principal of the loan or the
interest associated with it.
 Credit risk arises because borrowers expect to use future cash flows
to pay current debts; it's almost never possible to ensure that
borrowers will definitely have the funds to repay their debts.
 Interest payments from the borrower or issuer of a debt obligation
are a lender's or investor's reward for assuming credit risk.



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Chapter Two
Introduction to Risk Management in Banking

Types of Credit Risk

 Credit default risk – The risk of loss arising from a debtor being unlikely to pay its
loan obligations in full or the debtor is more than 90 days past due on any material
credit obligation; default risk may impact all credit-sensitive transactions, including
loans, securities and derivatives.
 Concentration risk – The risk associated with any single exposure or group of
exposures with the potential to produce large enough losses to threaten a bank's
core operations. It may arise in the form of single name concentration or industry
concentration.
 Country risk – The risk of loss arising from a sovereign state freezing foreign
currency payments (transfer/conversion risk) or when it defaults on its obligations
(sovereign risk); this type of risk is prominently associated with the country's
macroeconomic performance and its political stability.
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Chapter Two
Introduction to Risk Management in Banking

Operational Risk
 Operational risks are the business process risks failing due to human errors. This risk
will change from industry to industry. It occurs due to breakdowns in the internal
procedures, people, policies and systems.
 Operational risk is "the risk of a change in value caused by the fact that actual
losses, incurred for inadequate or failed internal processes, people and systems, or
from external events (including legal risk), differ from the expected losses“
 The risk of loss resulting from inadequate or failed internal processes, people and
systems or from external events.
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Chapter Two
Introduction to Risk Management in Banking

Risk Identification
 Risk identification is the process of taking stock of an organization’s risks and
vulnerabilities and raising awareness of these risks in the organization
 Risk identification processes have traditionally centered on the key risk types of
credit, market, operational and liquidity risk.
 Within each, risk subtypes are defined and categorized, often through a process
that stays within the risk management organization.
 This approach to risk identification is aligned with the traditional, primary
mechanisms for measuring risk and capital adequacy; both Risk-Weighted Asset
(RWA) and economic capital approaches categorize risks similarly and implement
specific analytical approaches to each risk type.
 However, a new risk and capital management paradigm has emerged. This
paradigm is based on enterprise-wide stress testing rather than relying primarily on
traditional RWA and economic capital measures, which often use opaque models
that can be difficult to link to observed real world conditions.
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Chapter Two
Introduction to Risk Management in Banking

Risk Identification cont…

 The new paradigm instead involves defining a plausible but severe forward-looking
scenario, then conducting a comprehensive assessment of how an institution would
fare in this environment
 Though Supervisors design mandatory stress scenarios that test common firm-level
risks as well as key systemic vulnerabilities
 However, each firm is also expected to develop a comprehensive stress scenario
that is explicitly designed to target its own vulnerabilities.
 Traditional risk identification processes do not incorporate enough different
perspectives on risks from across the organization; effectively distinguish the most
significant risks from more minor risks; or sufficiently consider the underlying drivers
of risks and how they could interact and amplify risks, or how minor risks might
become severe in certain environments
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Chapter Two
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The need for Risk Identification

 Key downstream uses of risk identification include:
 Stress test scenario design: risk identification should inform stress test scenarios to
ensure the organization’s key vulnerabilities are tested. For example, where a bank
has a significant concentration of credit exposure to a specific industry, it may need
to include an additional stress on factors which drive that industry’s credit losses (e.g.
sharp decline in metals prices increases default risk for mining companies) to better
assess the extent of the risk.
 Risk modeling and measurement of “hard to model” risks: granular identification
of risks helps verify whether models are able to effectively capture risks. In cases
where complexity or data limit the ability to model a risk (e.g. reputational or
strategic risks), risk identification can aid measurement through identification of a
narrative of how the risks might materialize in a plausible event with severe
consequences.
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Chapter Two
Introduction to Risk Management in Banking

Risk Identification Methods

 Brainstorming is a technique that is best accomplished when the approach is
unstructured (the facilitator encourages random inputs from the group). Group
members verbally identify risks that provide the opportunity to build on others’
ideas. To achieve the desired outcome, it is essential to select participants that are
familiar with the topics discussed, relevant documentation is provided and a
facilitator that knows the risk process leads the group
 Surveys are a technique where lists of questions are developed to seek out risk in a
particular area. A limitation of this method is that people inherently don't like to
complete surveys and may not provide accurate information. The value of the
surveys may be difficult to determine due to subjectivity in the answers or because
of the focus of the questions themselves
 Interviews are an effective way to identify risk areas. Group interviews can assist in
identifying the baseline of risk on a project. The interview process is essentially a
questioning process. It is limited by the effectiveness of the facilitator and the
questions that are being asked
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Chapter Two
Introduction to Risk Management in Banking
Risk Identification Methods cont…
 Working Groups are great way to analyze a particular area or topic in a discussion
process to identify risks that may not be obvious to the risk identification group. The
working group is usually a separate group of people working a particular area
within the project that is conducting the risk identification.
 Experiential Knowledge is the collection of information that a person has obtained
through their experience. Caution must be used when using any knowledge based
information to ensure it is relevant and applicable to the current situation.
 Documented Knowledge is the collection of information or data that has been
documented about a particular subject. This is a source of information that provides
insight into the risks in a particular area of concern. Caution must be used when
using any knowledge based information to ensure it is relevant and applicable to
the current situation
 Risk Lists are usually lists of risks that have been found in similar municipalities
and/or similar situations. Caution must be used when using this type of information
to ensure it is relevant and applicable to the current situation.
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Chapter Two
Introduction to Risk Management in Banking
Risk Identification Methods cont…
 Risk Trigger Questions are lists of situations or events in a particular area of a
municipality that can lead to risk identification. These are situations or areas where
risks have been discovered within the organization. These trigger questions may be
grouped by areas such as performance, cost, schedule, software, etc.
 Lessons Learned is experiential knowledge that has been organized into information
that may be relevant to the different areas within the organization. This source of
information may guide you in identifying risk in your municipality. Caution must be
used when using this type of information to ensure it is relevant and applicable to
the current situation.
 Outputs from Risk-Oriented Analysis - There are various types of risk oriented
analysis. Two such techniques are fault tree analysis and event tree analysis. These
are top down analysis approaches that attempt to determine what events,
conditions, or faults could lead to a specific top level undesirable event. This event
with the associated consequence could be a risk for your program
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Chapter Two
Introduction to Risk Management in Banking
Risk Identification Methods cont…
 Historical Information is basically the same as documented knowledge. The
difference is that historical information is usually widely accepted as fact.
 Engineering Templates are a set of flow charts for various aspects of the
development process. These templates are preliminary in nature and are intended
as general guidance to accomplish a top down assessment of activities.
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The need for Risk Identification cont…

 Risk ownership and control: significant risks should be assigned owners – if they
do not exist already – responsible for measuring, reporting and controlling these
risks.
 Strategic planning: risk identification can inform the strategic planning process by
highlighting key risks to the plan and how alternative strategic actions might affect
the downside risk
Challenges and Pitfalls in Risk Identification
 Achieving organizational engagement: a robust risk identification process requires
broad participation from across the organization. Key stakeholders may be hesitant
to participate or honestly identify and assess risks – particularly if they perceive it
to be a pure compliance exercise. Involving senior management and business units in
reviewing, challenging and complementing the risk identification results helps drive
personnel to fully engage in the process and ensures that risks are better linked to
business activities.
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Chapter Two
Introduction to Risk Management in Banking
Risk Identification Methods cont…
 Risk Trigger Questions are lists of situations or events in a particular area of a
municipality that can lead to risk identification. These are situations or areas where
risks have been discovered within the organization. These trigger questions may be
grouped by areas such as performance, cost, schedule, software, etc.
 Lessons Learned is experiential knowledge that has been organized into information
that may be relevant to the different areas within the organization. This source of
information may guide you in identifying risk in your municipality. Caution must be
used when using this type of information to ensure it is relevant and applicable to
the current situation.
 Outputs from Risk-Oriented Analysis - There are various types of risk oriented
analysis. Two such techniques are fault tree analysis and event tree analysis. These
are top down analysis approaches that attempt to determine what events,
conditions, or faults could lead to a specific top level undesirable event. This event
with the associated consequence could be a risk for your program
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Chapter Two
Introduction to Risk Management in Banking

 Developing a robust assessment framework: while a single metric for assessing

the significance of risks is highly desirable, it is practically difficult. Under the
likelihood and severity approach described above, severity can be defined in
multiple ways. For other risk types, quantifying the severity may be extremely
difficult. Qualitative significance assessment criteria are therefore needed to
complement quantitative thresholds to ensure such risks are not missed. It is far
better to have an imprecise assessment of the size of a risk than to omit a risk due
to difficulty in quantification.
 Ensuring consistency: the risk identification process is necessarily very distributed,
touching virtually all areas of the institution. Consistency in how risks are defined
and assessed is therefore a challenge. An appropriately senior and well-resourced
central team should therefore oversee the process and work with key stakeholders
to ensure consistency across the organization. Tools such as common risk assessment
templates, guidelines for risk identification and assessment, clear and consistent
likelihood and impact definitions are also needed to provide additional guidance
and to ensure required information is consistently collected.
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 Ensuring comprehensiveness: ensuring all risks are identified is the core challenge
for risk identification. This includes risks outside of the traditional risk types owned
by risk departments (e.g. credit, market, operational and liquidity risks) to
incorporate revenue, expense and other components impacting financial statements.
The design of the process and selection of the participants in the process should take
this into account. A top-down process is led by senior management and should focus
on the organization’s most important risks, while a bottom-up process is conducted
by management across the entire organization, harnessing information already
gathered through processes such as the Risk and Control Self-Assessment (RCSA).
 Considering both position-driven and business activity-driven risks: institutions
often focus on today’s exposures as sources of potential loss and risk. This is only
part of the set of vulnerabilities. Strategic, business and operating activities also
result in structural risks that may be unrelated to today’s positions. For example,
long-term economic stagnation may lead to low investment and low trading volumes,
hurting earnings in sales and trading activities.
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 Aligning risk identification with Intermediate Holding Company (IHC) scope:

This new legal entity structure in most cases does not align with existing management
and reporting hierarchies, around which legacy risk assessment approaches have
been structured. Furthermore, institutions will need to identify and consider risks
arising from their position in a broader international organization – such as risks
related to revenue transfer agreements among legal entities
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END OF SESSION