Short-sighted risk-management

Irina Velieva, Stanislav Volkov, Pavel Samiev

Risk-management and regulation in banks has been traditionally behind the level of real threats, although some progress in the area has been achieved. The largest gap to be bridged is in liquidity management — it is still the weakest point in the banking system, made manifest by the recent financial shake-up.

The banking sector stress-testing results show credit risks to carry the largest loss potential

Asked about most viable risks, bank risk-managers give priority to credit risks. Still, all risk-indicators (credit share in GDP, level of outstanding debts, level of debts per one employee etc.) testify to the fact that bad debts so far have been incapable of interfering with sustainable development of the banking system. On the contrary, recent events at the global and local financial markets prioritize liquidity risks (according to Expert RA, bank managers put them second) and stock risks (third place). The Central Bank stress-testing in the end of 2006 put credit risks in the lead (see diagram 1): in the worst case scenario Russian banks would lose 42.8% of the capital, and in case of the conservative development — 28.8%.

But you may look at risks from another angle. If you timely track and control their growth, the danger level would not look so sinister — forewarned, forearmed. The system weakest points may be tracked down — to do this you have to compare a real risk profile with current risk-management practices and adequacy of regulating activities aimed at reducing corresponding risks in the system. Discrepancies in the bank risk-management triad “risk current profile — methods of management — regulation” help you to track the weakest points and avoid crisis in the first place.

Multifaceted credit risks

From this angle credit risks are not to be afraid of: Expert RA bank risk-management studies have found the best results specifically in credit risk management. Increased level of credit risks (credits to individuals in the first place) had been timely recognized by both bankers and regulating authorities.

Corporate crediting has shown no increase of delayed payments, and the retail sector has been maturing. First, the market situation itself makes you be reasonable in your risk appetites and more conservative in assessing your borrowers. Second, the credit market information infrastructure has been on the rise. Many banks with 3-5 years accumulated statistics may now use working scoring models. True, the scoring is not “fine”, but for risk-management purposes it is a definite step forward. Besides, a system of credit bureaus and collectors agencies, capable of making relations with overdue debtors more efficient, has been progressing, too.

Imposing self-restriction on credit risks has not been an easy thing to do for banks, since it automatically implies decelerated growth of assets and revenues. Those indecisive were assisted by the regulator. The Central Bank has started setting more transparent rules of the game — to inspire maturing of the retail segment. Demands — effective from July 1, 2007 — to disclose an efficient rate for crediting individuals, and more rigorous rules for categorizing loans were supposed to contain retail credit risks.

Overdue debts of corporate clients go down, individual debts soar

Retail credit risks — discrepancies between risk-management level, regulation and current risk profile were left unattended. So far the population is capable of servicing its debt, 37 thousand rubles per one employed Russian citizen by July 1, 2007 — about three months' average salaries. Retail overdue debts frightening dynamics (see diagram 2) rather reflect increased fraudulent schemes together with bad quality of risk-management in some banks, not low ability of the population to pay.

But in mid-term perspective — if macro-economic situation turns for the worse — credit risks may pose a looming threat. Many experts are of the opinion — bad debts crisis in Russia is inevitable, sooner or later. We think it may happen at the cyclic decline period — realization of credit risks, accumulated in time of their fast growth, would turn into a large-scale crisis, or, at best, a critical retardation of the banking sector. Current regulation and risk-management are not prepared to meet such threats so far and there is a lot to be done for bankers and regulating authorities.

Liquidity grimaces

Liquidity crises, as distinct from bad debt crises, may happen against the background of successful real sector development. The local crisis of 2004 may be considered as a classical example — a number of erratic steps by the regulator (accompanied by the negative information flow) provoked shrinkage of the interbank credit market and caused panic among private depositors. Liquidity risks are usually to be dealt with suddenly, but it is not the only complicity in determining their levels. Liquidity prudential indicators, visibly above limits, may also be misleading. Still, high level of liquidity risks has been determined by non-reliable market mechanisms of short-term refinancing. One of the most vital sources of short-term funds — the interbank market — yet again proved to be quite volatile in 2007. The US mortgage crisis caused a steep wave of increased interest rates all over the world, including Russia. For instance, according to the Central Bank, the MIACR rate for one-day ruble interbank credits in the first half of August fluctuated in the annual range 2.9%-4.3%, but in the second half of the year it reached 5.8%-7.5% annually. Besides bank clients and obligatory bank payments, the reason is also in shrunk liquidity of the banking sector.

The interbank market nervous situation conceals the fundamental reason for high liquidity risks in the Russian banking system. The real reason is the time-shifted structure of assets and liabilities, causing demand for short-term refinancing. The reason for the time-shift is clear: trying to satisfy needs of their clients, banks prolong crediting periods, but the process of attracting resources takes much longer.

Small and medium-size banks, feeling most vulnerable, have to hold 20%-25% of their assets in high liquidity form. But even such a precaution can not secure them from problems in case of a large-scale liquidity default. Managing liquidity risks faces another problem, too — certain sources of additional liquidity, like support from owners or the regulator through REPO, are out of reach for many banks, and interbank credits and sale of securities are engaged only when the situation is quiet.

The regulator begins and wins

Under such circumstances a capable CB mechanism of refinancing has partly bridged the gap between the risk liquidity level and its practical management. Timely actions of the regulator (and not accumulated liquidity “cushion”) saved banks from serious losses in the time of the first deficit wave, rolled to Russia last August.

In the period between August 15 and September 13 the Bank of Russia secured the record liquidity inflow to the banking system — pawn credit debts increased by 1 100 bln rubles, 200 bln rubles worth of bonds were paid in advance. At certain days banks REPO auctions lent to banks up to 270 bln per day (see diagram 3). The lessons of 2004 were learnt well: the Central Bank has shown its readiness to use all available means to ensure the banking sector stability.

Record REPO deals had to be made despite liquidity “cushions” in the Central Bank (bank deposits)

The market would need to be supported in the future, too. Lack of stability at the global financial market is just one of numerous challenges for the Russian banking sector to be confronted with in the near future. Liquidity is known to be sensitive to decline of oil prices, cyclic recession, weakening of ruble, insecure external or domestic policy. It is hard to forecast economic set up at the raw material markets, but weakening of ruble and deceleration of economic growth are quite plausible in mid-term perspective. If the Central Bank is not right on time with its help (or event are provocatively covered in a negative light) — liquidity risks may easily be a cause for a local crisis.

Underestimation of the unknown

According to bank managers, questioned by Expert RA, operation, currency and interest risks were quite far from their main concern.

In case of currency risks it is clear — banks simply pass them to borrowers by giving credits in hard currency. In this way banks protect themselves from direct losses in case of both sharp strengthening and weakening of ruble. True, if ruble weakens, banks may have to deal with credit risks.

But lack of attention to interest risks should be explained. Quite recently Russky Standard and MDM -Bank had problems with realization of their market risks — they were forced to buy bonds, presented for offer, and propose to investors to buy new securities with yield in line with the market level. The point of worry for bankers was not direct losses from realizing interest risk — extra cost of financing, — but concurrent liquidity risks, since it is not too easy to accumulate necessary means for buying out under the conditions of deficient liquidity.

As to operation risks, the largest losses may be related to possible claims from the regulator. Not surprisingly, majority of banks minimize corresponding risks, often underestimating importance of other operation risks. And bank inherent operation risks may be practically uncontrollable — they can be neither diversified nor passed to somebody else. Anyway, operation risks tend to grow with scopes of activity of a financial institution. And real obstacles to extend your business today are credit and liquidity risks.