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Subsequently, followed by a fall in the valuations of banking stocks, Credit Suisse, a Swiss-based bank formerly regarded as a global systematically important bank (G-SIB), collapsed, leading to its eventual acquisition by UBS. The Bank of Namibia has since issued a media statement reassuring the resilience and soundness of the Namibian banking system and its ability to withstand the foreign banking crisis. But what causes banks to fail?
Banks, other financial institutions, and firms face different types of risks, which, for the sake of this article, refer to the likelihood that an undesirable event of a certain magnitude will occur. Some of the risks that banks encounter include the failure of borrowers to make repayments, the demand of money from the bank by depositors at a rate exceeding the bank’s reserves, the change in market interest rates which may hurt the value of the bank’s loans, the loss of value of investments made by the bank in the financial markets, the intentional or unintentional violation of a law or regulation which leads to the bank being fined, and fraud or human input errors in computer systems that lead to losses.
Banks and other financial institutions need a risk management function to manage these risks. This function continuously measures the risks related to a portfolio of assets and any other exposures, communicates the risk profile to the bank and the bank’s regulators, and mitigates the likelihood of loss.
As identified by the Basel III Accord, the cornerstone of international risk-based banking regulation, the several risks faced by banks can be categorised as either credit risk, market risk, operational risk or liquidity risk. Other risks faced by financial institutions, as with any other business, include business risk, reputational risk, and compliance risk.
Credit Risk
Credit risk refers to the risk that a borrower, or a counterparty, may fail to pay interest on loans and repay the borrowed amount, as agreed. For most banks, credit risk is the most significant risk arising from the likelihood that loans, as held in the banking book, will not be repaid partially or in full. Credit risk also affects depositors, which represents the risk that depositors cannot withdraw funds from their bank accounts when needed.
As part of risk management, the credit risk assessment associated with lending to a specific potential borrower is carried out through the loan underwriting process. Here, the process analyses the borrower’s financial capacity, which includes not only the borrower’s willingness to repay the loan but also their ability to do so.
Market Risk
The likelihood of loss to a bank or other financial institution or firm arising from movements in market prices as a consequence of changes in interest rates, foreign exchange, and equity and commodity prices is referred to as market risk. For banks, these losses are majorly realised in the bank’s trading book, which is the portfolio of its financial assets, including bonds, equity, foreign exchange and derivatives.
By holding positions in financial instruments, financial institutions undertake market risk as they trade as principles, risking their own capital. The inability to manage market risk can significantly affect an institution’s profitability and reputation.
As part of risk management, value at risk is one of the most commonly used concepts to measure market risk in a portfolio. Value at risk gives a qualified response to the extent of the possible financial losses within the portfolio over a specified time frame. For example, the Government Institutions Pension Fund (GIPF) determined, on a 90% funding level, the value at risk of N$16 billion over a one-year period, as reported in the GIPF Integrated Annual Report for 2022. In this case, there is a 10% chance that the funding level could decrease by more than N$16 billion, compared to the expected position of the N$131 billion Fund liabilities, as reported.
Operational and Liquidity Risk
The risk of loss as a result of inadequate or failed internal processes, people, and systems within a financial institution or from external events defines operational risk. Given that operational risk is the least understood and the most challenging risk to measure, manage and monitor compared to credit, market and liquidity risk, financial risk managers need to constantly identify new and modern risk management methods to stay abreast with the environment in which they operate.
Following the global financial crisis, which saw numerous banks needing government support to meet their obligations to repay bondholders and depositors, there has been an increased focus on liquidity risk. Liquidity risk refers to the possibility that a bank may be unable to repay its depositors or to continue financing its assets as agreed.
The Basel III Accord
To strengthen the overall management of financial risk in the banking and financial sector, the Basel Committee on Banking Supervision released a set of reform initiatives in 2010 referred to as the Basel III Accord. Basel III was a response to the shortcomings in financial regulation revealed during the global financial crisis, which aims to promote a more resilient banking and financial sector.
The Bank of Namibia decided to adopt Basel III in 2015 and to implement the framework in phases by 2021. And with the recent failure of multiple foreign banking institutions, the test of Namibia’s implementation of Basel III is here. The country’s central bank has asserted the liquidity and capitalisation of Namibia’s banking system, and not without figures. The state of current affairs in the financial marketplace then leaves one question:
What is next for banking regulation and financial risk management for the rest of 2023 and beyond?
*Tuhafeni Angula is a Master of Commerce in Risk Management of Financial Markets candidate at the African Institute of Financial Markets and Risk Management (AIFMRM) at the University of Cape Town.