MANAGING CORE RISKS OF FINANCIAL INSTITUTIONS: A CASE STUDY ON BRAC BANK LTD. A Termpaper on Managing Core Risks of Financial Institutions: A Case Study on Brac Bank Ltd. Course Name:Management of Financial Institutions Submitted To: Dr. M. Baqui Khalily Professor Department of Finance University of Dhaka Submitted By: Md. Mustaquimur Rashid ID # 20609058 (9th Batch) Department of Finance University of Dhaka Submission date: 26th August, 2008 August 26, 2008 Dr. M. Baqui Khalily Professor Department of Finance University of Dhaka Subject: Submission of Termpaper Dear Sir,

I, the undersigned, student under your Management of Financial Institutions Course, have the pleasure to submit herewith the Term Paper on “Managing Core Risks of Financial Institutions: A Case Study on Brac Bank Ltd. ” for your kind evaluation. It is a matter of immense pleasure for me to have the opportunity to analyze this topic, one of the major areas of financial institutions. I also certain that the knowledge and experience acquired while conducting the study will help me in many ways in future. I have tried my best to present my ideas, findings as clear as I could within the time and resources available.

I would like to mention that there might be some unintentional error in this report and also some lacks of finding the actual position. I hope that you will consider my shortcoming while evaluate the report. Thanking you Sincerely yours, Md. Mustaquimur Rashid ID # 20609058 Table of Contents Executive Summaryv 1. Introduction1 2. Company Background2 3. Review of Theory3 4. Risk Exposures and Management by the Bank5 5. Findings, Recommendations & Conclusions9 Bibliography Appendix Executive Summary All the business activities in the world are subject to risk.

Financial institutes are not different, too. Financial institutes are special in nature and face some unique risks along with the general risks faced by other business entities. Generally financial institutes are exposed to interest rate risk, liquidity risk, market risk, credit risk, Foreign exchange risk, technology & operational risk, off-balance sheet risk, and insolvency risk. The performance of a financial institute depends on how well the management takes measures against these risks. A financial institute may collapse if these risks are not minimized properly.

The best example of this type of incident is the collapse of The Oriental Bank. This report aims to identify the risks and the steps taken by the FIs against these risks. The Brac Bank Ltd. is chosen as a sample of a FI. This report covers the interest rate risk, liquidity risk and credit risk management of the bank. This report finds that the bank is more exposed to liquidity risk in recent years than the other risks. Being a fast frowing bank, it should take strong steps to overcome this type of risk. The purpose of the report is to learn how the risks are identified and managed by a FI.

While conducting this report, some unintentional mistakes have occurred and due to inexperience some vital points may not be covered. But it may provide a brief idea about the risk management of financial institutions. Chapter – 1 1. 0Introduction 1. 1Background Every financial institution irrespective of its size generally exposed to interest rate risk and liquidity risk. Besides these risks there are some other risks namely credit risk, foreign exchange risk, insolvency risk, technology & operational risk etc. failure to take timely measures in giving a sense of direction threatens the existence of the institution.

It is, therefore, important that the structure of the institute’s business and the level of risks it assumes are effectively managed, appropriate policies and procedures are established to control the direction of the organization. 1. 2Objectives: The objective of this report is to identify the different types of risks a financial institute is exposed to and the ways of minimizing these risks. 1. 3Scope: This report will address the interest rate risk; liquidity risk and credit risk of Brac Bank Ltd. and identify the ways how they minimize these risks. 1. 4Methodology

The general methodology of the work includes analyzing already followed practices of the Financial Institutions of Bangladesh to manage risks. Annual report of 2006 of the Bank, Bangladesh Bank Guidelines, web site information of different financial institutions were used as primary input for this paper. Above all, the techniques studied in the course to assess and manage the risk was the major methods of preparing this report. 1. 5Limitations In the absence of information about Market risk, the evaluation of risk of the Financial Institute corresponding to the market could not be quantified at this stage.

Risks of the respective financial institutions would be unique to their own environmental conditions and the institutions would be the best judge of their remedial actions required for corrective actions. Moreover, inexperience on my part was one of the vital constraints to prepare this report. In spite of my sincerity, some mistakes might have been occurred. I admit my responsibility for those unexpected mistakes. Chapter – 2 Company Background Brac Bank started its operations on 4th July 2001.

The corporate vision of the Bank is building a profitable and socially responsible financial institution focused on Markets and Business with growth potential, thereby assisting BRAC and stakeholders build a ” just, enlightened, healthy, democratic and povert free Bangladesh”. Some of the major corporate Missions are: 1. Sustained growth in Small and Medium Enterprise Sector 2. Continuous low cost deposit growth with controlled growth in Retail Assets. 3. Continuous endeavor to increase fee based income 4. Manage various lines of business in a fully controlled environment with no compromise on service quality.

It was listed in the Dhhaka Stock Exchange on 24th January 2007 and in Chittagong Stock Exchange on 28th January 2007. It started trading share on 31st January 2007. Brac Bank is a fast growing bank and continuously increasing its online banking services across the country. Chapter – 3 3. 1Review of Theory Financial Institutions are generally exposed to the following Risks: 1. Interest rate risk 2. Credit risk 3. Liquidity risk 4. Market risk 5. Foreign exchange risk 6. Technology & Operational risk 7. Off-balance sheet risk 8. Insolvency risk 9. Country Risk Brief discussion about these risks is done in this chapter. 3. 1. Interest rate risk: Interest rate risk affects spread from lending business. Interest rate risk arises due to change in overall market interest rate structure both on borrowing and lending. 3. 1. 1. 1 Interest on borrowing Interest on borrowing has a significant bearing on the pricing of lending. It affects profitability of an organization and desired margin to the shareholders. 3. 1. 1. 2 Interest on Lending Interest rate risk arises due to reduction of interest rate on lending from time to time on several occasions. The Company has to reduce interest rate on several occasions to attract more clients and to compete with the competitors. . 2Credit Risk Credit risk can be classified into two categories as under: 3. 2. 1 Default Risk Default risk arises due to client’s failure to repay loan installment in due time. Default risk analysis help identify the reason of default, customer group of making default in respect of their profession and income status. Default risk is quantified in terms of loan being classified as SS, DF, and BL etc. 3. 2. 2 Credit Spread Risk Credit spread risk arises due to non-recovery of regular installment repayment, which ultimately decreases the overall effective lending rate and erodes margin from lending business.

Credit spread risk also arises due to stringent Income Recognition policy in respect of framing time for SS, DF, and BL. 3. 2Liquidity Risk: Liquidity problem arises when the difference between liquid assets and volatile liabilities is negative. This may force to borrow or sell assets in a very short period of time. 3. 3Market Risk: This risk incurred in trading of assets and liabilities & derivatives also. A financial institute may incur loss in trading such assets and liabilities. 3. 4Foreign Exchange Risk: This risk arises from the change in foreign exchange rate. Returns on foreign and domestic investment are not perfectly correlated.

Un-diversified foreign expansion creates foreign exchange risk. 3. 5Technology & Operational Risk: Operational risk is the risk of direct or indirect loss resulting from inadequate or failed internal process, people and systems or from external events. Technology risk is that the technology investment fails to produce anticipated cost savings or the technology may break down. It may not provide the expected economies of scale or economies of scope. 3. 6Off-balance sheet risk Speculative activities using off-balance sheet items such as LCs, loan commitments, derivative positions may create considerable risk. 3. Insolvency Risk: Risk of insufficient capital to offset sudden decline in value of assets to liabilities. It may be caused by excessive interest rate, market, credit, off balance sheet, technological, foreign exchange and liquidity risk. Chapter 4 Risk Exposures and Management by the Bank This chapter focuses on the various types of risks the bank is exposed to and how it performs against those risks related to the previous year. 4. 1Interest Rate Risk Management Interest rate risk can be managed by gap analysis. Gap is the difference between Rate sensitive Assets (RSA) and Rate Sensitive Liabilities (RSL).

So, we need to identify the RSA and RSL. The following table shows the status of the balance sheet items regarding rate sensitivity: Head of AccountsRate Sensitivity ASSETS: 1. CashNon-sensitive 2. Balance with Bangladesh BankNon-sensitive 3. Balance with other banks & FI’sSensitive 4. Money at Call and on short noticeSensitive 5. Investments: i) Govt. SecuritiesSensitive on maturity ii) Floating rate securitiesSensitive iii) Equity Shares, preference sharesNon-sensitive 6. Loans and AdvancesSensitive 7. Fixed assetsNon-sensitive LIABILITIES: 1. Borrowing from other banks & FI’sSensitive . Current depositNon-sensitive 3. Savings depositSensitive 4. Fixed depositSensitive 5. Current liabilities and provisionsNon-sensitive The funding gap is calculated as mentioned below: Funding gap = RSA – RSL Net Interest Income or NII is affected by the funding gap and the change in interest rate. We know that, DNII = Di * Funding gap So, when the funding gap is positive (RSA-RSL > 0), a bank can benefit from positive change (rising) in interest rate. Or, a bank can get benefit from declining interest rate if the gap is negative (RSA-RSL < 0). The funding gap of Brac bank Ltd. as as follows: Particulars20062005 Rate Sensitive Assets23,541,327,266. 0013,033,840,815. 00 Rate Sensitive Liabilities21,160,857,368. 0011,471,279,811. 00 Funding Gap2,380,469,898. 001,562,561,004. 00 We see that the gap is positive in both years, which means that the bank got benefit from positive change in interest rate. Also, we see that the gap was increasing, which reflect that the ALCO was performing better in managing funding gap that reduced the interest rate risk in both the years. 4. 2Liquidity Risk Management First we have to know the liquidity deficit or surplus of the bank. After hat we can take necessary steps to manage liquidity risk. Liquidity deficit is the difference between liquid assets and volatile liabilities. In this report I follow the time bucket of one month to measure the liquidity of asset and volatility of liability. Liquidity Surplus/ (Deficit) = Liquid Assets – Volatile Liabilities Using the formula, the liquidity position of Brac bank was found as follows: ParticularsWithin 1 monthWithin 1 to 3 monthsWithin 3 to 12 Months Assets: Cash in hand2,172,387,439– Balance with other banks and FI’s135,619,205669,581,6251,530,000,000 Money at call and short notice600,000,000–

Investments1,049,612,050213,014,234- Loans and advances92,951,763404,242,1612,016,426,274 Other assets35,691,89136,948,9771,007,404,569 Total4,086,262,3481,323,786,9974,588,662,085 Liabilities: Borrowing from other banks & FI’s954,574,000– Deposits6,074,034,6178,939,450,7126,287,334,041 Provisions & other liabilities3,299,875,17394,883,22799,602,946 Total10,328,483,7909,034,333,9396,386,936,987 Surplus/(Deficit)(6,242,221,442)(7,710,546,942)(1,798,274,902) We see that the liquidity position of the bank is vulnerable. It was not capable to meet its short-term obligations by its liquid assets.

For a financial institution, it is very risky. The bank is very much prone to liquidity risk. If we see the above table we can identify that loans and advances were so little but the deposit amount was very high. The bank must consider this issue along with the other asset and liability items in order to obtain a satisfactory liquidity position. Proper matching between the liquid asset and volatile liabilities can minimize liquidity risk. The bank must forecast about its position and then manage its balance sheet items accordingly. 4. 3Credit Risk Management

The bank’s classified loans to total loans & advances are 3. 04%. It is increased from the last year but it is usual to increase this rate because the total loans and advances increased. When the volume of loan increases, classified loans may also increases. But still the performance in this respect is satisfactory. Details discussion about managing this risk is discussed in th. e next chapter. Chapter 5 Findings, Recommendations and Conclusion 5. 1Findings: Brac Bank Ltd. is less vulnerable to interest rate risk because it has a positive funding gap.

When there is a positive gap, a bank can get benefit from the increasing interest rate. If interest rate decreases, NII decreases but even though the bank can generate positive NII. But the liquidity position of the bank is vulnerable. It is much more exposed to liquidity risk. It has so much volatile liabilities against its liquid asset. The bank has to generate profit from its loans and use this income to meet the depositors demand. But it is found that the loans are so little against the high volume of deposit. Credit risk management of the bank is also satisfactory.

Though the rate of classified loans was increased from the last financial year, it was able to manage a low ratio of classified loans to total loans and advances. 5. 2Management of Risks: The bak has its own procedures to manage its risks. It has an active Asset Liability Management Committee (ALCO), which monitor liquidity and interest rate risk and make recommendations for necessary action/change in composition of assets, liabilities and interest/pricing. These are discussed below: 5. 2. 1Credit Risk Management: The bank has segregated the duties of the officers/executives involved in credit related activities.

Separate divisions for corporate, SME and Retail has been formed which are entrusted with the duties of maintaining effective relationship with the customers, marketing of credit products, exploring new business opportunities etc. For transparency in the operations the following units have been set up: i)Credit Approval Committee ii)Loan Administration Department iii)Recovery Unit and iv)Impaired Asset Management The risk management included borrower risk analysis, financial analysis, industry analysis and historical performance of the customer.

The bank follows the Credit Risk Grading (CRG) of Bangladesh Bank in assessing credit eligibility. This includes: A. Know Your Customer (KYC): To assess a customer profile bank use 5 C’s model. These are: i)Capital ii)Character iii)Collateral iv)Capacity v)Condition B. Industry Analysis: Industry analysis is done to find whether the customer’s firm has sufficient: i)Market Share ii)Business Experience iii)Management Experience C. Financial Analysis: Financial analysis is done to assess the financial strength of the customer. It is the core of CRG. There are some parameters and each has a certain weight on which the bank rates its customers.

These are as follows: C. 1Financial Risk: It is based on the financial ratios. These are as follows: 1. Liquidity Ratio: Its weight is total 15%. 2. Leverage Ratio: Total weight is 15% which is segregated as mentioned below: i)Debt Service Coverage – 5% ii)Debt to Tangible Worth – 5% iii)Debt to Total Asset – 5% 3. Profitability: Total weight is15% 4. Coverage: Total weight is 5% C. 2Business/Industrial Risk:Total weight is 18% which comprises: size=5%,Age=3%, outlook=3%, industry growth = 3%, market competition = 2%, entry/exit barrier=2%. C. 3Management Risk: Total weight is 12%, which includes: i)Experience – 5% ii)Succession – 4% ii)Teamwork – 3% C. 4Security Risk : The total 10% weight is carried by Security coverage=4%, Collateral=4%, Support=2%. C. 5 Relationship Risk : Total weight is 10%. These includes: i)Account Conduct – 5% ii)Utilization of Credit – 2% iii)Compliance of Covenant – 2% iv)Personal Deposit – 1% The bank grades its customers out of total 100% and categorizes them. The customers, who meet the criteria, are considered eligible for the loan. 5. 2. 2Asset/Liability Management: Changes in market liquidity and or interest rate exposes Bank’s business to the risk of loss, which may, in extreme cases, threaten the survival of the institutions.

The ALCO of the bank monitors Balance Sheet risk and liquidity risk of the bank. ALCO reviews country’s overall economic position, Bank’s Liquidity position, interest rate risk, capital adequacy, deposit advanced growth, cost of deposit & yield on advance, F. E gap, market interest rate, loan loss provision adequacy and deposit and lending pricing strategy. 5. 2. 3Technology Risk Management: In order to ensure that information assets are protected against risk, there are controls over: a)Password control b)User ID maintenance c)Input control d)Network security e)Data encryption f)Virus Protection g)Internet & e-mail

The Business Continuity Plan (BCP) is formulated to cover operational risks and taking into account the potential for wide area disasters, data center disasters and the recovery plan. The BCP takes into account the backup and recovery process. Keeping this into consideration this covers BCP, Disaster Recovery Plan and Backup/Restore Plan. Conclusion Risks are part of running a financial institution. But FI’s should keep monitoring the risks and takes necessary steps against it. This is a case study on Brac Bank Ltd. so, the report covers the ways of managing risks in the viewpoint of Brac Bank Ltd.

But in reality, every financial institution is a separate entity and each has a unique style to minimize risk. Also, we should consider that all FI’s are not equally exposed to all types of risks. The FI’s should identify the major risks they exposed to and manage those effectively. Bibliography 1. Foundations of Financial Markets & Institutions (Third Edition) -Frank J. Fabozzi, Franco Modigliani, Frank j. Jones & Michael G. Ferri 2. Financial Institutions Management: A Risk Management Approach (5th Edition) – Anthony Saunders & Marcia Millon Cornett 3. Annual Report – 2006 of Brac Bank Ltd. Appendix