CommercialBankRiskManagement

FinancialInstitutionsCenterCommercialBankRiskManagement:anAnalysisoftheProcessbyAnthonyM.Santomero95-11-CTHEWHARTONFINANCIALINSTITUTIONSCENTERTheWhartonFinancialInstitutionsCenterprovidesamulti-disciplinaryresearchapproachtotheproblemsandopportunitiesfacingthefinancialservicesindustryinitssearchforcompetitiveexcellence.TheCenter'sresearchfocusesontheissuesrelatedtomanagingriskatthefirmlevelaswellaswaystoimproveproductivityandperformance.TheCenterfostersthedevelopmentofacommunityoffaculty,visitingscholarsandPh.D.candidateswhoseresearchinterestscomplementandsupportthemissionoftheCenter.TheCenterworkscloselywithindustryexecutivesandpractitionerstoensurethatitsresearchisinformedbytheoperatingrealitiesandcompetitivedemandsfacingindustryparticipantsastheypursuecompetitiveexcellence.CopiesoftheworkingpaperssummarizedhereareavailablefromtheCenter.IfyouwouldliketolearnmoreabouttheCenterorbecomeamemberofourresearchcommunity,pleaseletusknowofyourinterest.AnthonyM.SantomeroDirectorTheWorkingPaperSeriesismadepossiblebyagenerousgrantfromtheAlfredP.SloanFoundationAnthonyM.SantomeroistheRichardK.MellonProfessorofFinanceattheWhartonSchool.1ThispaperwaspresentedattheWhartonFinancialInstitutionsCenterConferenceonRiskManagementinBanking,October13-15,1996.TheauthoracknowledgeshelpfulcommentsandsuggestionsreceivedatworkshopsatINSEAD,UniversitaBocconi,UniversityofKarlsruhe,StockholmSchoolofEconomics,andtheFederalReserve.SpecificthankstoR.Eisenbeis,D.Babbel,G.OldfieldandR.Herring.CommercialBankRiskManagement:AnAnalysisoftheProcess1ThisVersion:February28,1997Abstract:Throughoutthepastyear,on-sitevisitstofinancialservicefirmswereconductedtoreviewandevaluatetheirfinancialriskmanagementsystems.ThecommercialbankinganalysiscoveredanumberofNorthAmericansuper-regionalsandquasi-moneycenterinstitutionsaswellasseveralfirmsoutsidetheU.S.Theinformationobtainedcoveredboththephilosophyandpracticeoffinancialriskmanagement.Thispaperoutlinestheresultsofthisinvestigation.Itreportsthestateofriskmanagementtechniquesintheindustry.Itreportsthestandardofpracticeandevaluateshowandwhyitisconductedintheparticularwaychosen.Inaddition,critiquesareofferedwhereappropriate.Wediscusstheproblemswhichtheindustryfindsmostdifficulttoaddress,shortcomingsofthecurrentmethodologyusedtoanalyzerisk,andtheelementsthataremissinginthecurrentproceduresofriskmanagement.JELClassificationcodes:G2,G1,L2Keywords:riskmanagement,financialrisk,bankingAcompanionpaperreportsonriskmanagementpracticesforinsurancefirms.SeeBabbelandSantomero(1997).11I.IntroductionThepastdecadehasseendramaticlossesinthebankingindustry.Firmsthathadbeenperformingwellsuddenlyannouncedlargelossesduetocreditexposuresthatturnedsour,interestratepositionstaken,orderivativeexposuresthatmayormaynothavebeenassumedtohedgebalancesheetrisk.Inresponsetothis,commercialbankshavealmostuniversallyembarkeduponanupgradingoftheirriskmanagementandcontrolsystems.Coincidentaltothisactivity,andinpartbecauseofourrecognitionoftheindustry'svulnerabilitytofinancialrisk,theWhartonFinancialInstitutionsCenter,withthesupportoftheSloanFoundation,hasbeeninvolvedinananalysisoffinancialriskmanagementprocessesinthefinancialsector.Throughthepastacademicyear,on-sitevisitswereconductedtoreviewandevaluatetheriskmanagementsystemsandtheprocessofriskevaluationthatisinplace.Inthebankingsector,systemevaluationwasconductedcoveringmanyofNorthAmerica'ssuper-regionalsandquasi-moneycentercommercialbanks,aswellasanumberofmajorinvestmentbankingfirms.Theseresultswerethenpresentedtoamuchwiderarrayofbankingfirmsforreactionandverification.Thepurposeofthepresentpaperistooutlinethefindingsofthisinvestigation.Itreportsthestateofriskmanagementtechniquesintheindustry--questionsasked,questionsansweredandquestionsleftunaddressedbyrespondents.Thisreportcannotrecitealitanyoftheapproachesusedwithintheindustry,1norcanitofferanevaluationofeachandeveryapproach.Rather,itreportsthestandardofpracticeandevaluateshowandwhyitisconductedintheparticularwaychosen.But,eventhebestpracticeemployedwithintheindustryisnotgoodenoughinsomeareas.Accordingly,critiquesalsowillbeofferedwhereappropriate.Thepaperconcludeswithalistofquestionsthatarecurrentlyunanswered,oransweredimpreciselyinthecurrentpracticeemployedbythisgroupofrelativelysophisticatedbanks.Here,wediscusstheproblemswhichtheindustryfindsmostdifficulttoaddress,shortcomingsofthecurrentmethodologyusedThereareamplyreviewsoftheroleofbankswithinthefinancialsector.See,forexample,Bhattacharyaand2Thakor(1993),Santomero(1984),ormorerecentlyAllenandSantomero(1997).Therearemanysurveysandarticleshere.See,forexample,Economist(1993),SalomonBrothersandGoldman3SachsEquityResearchReportsonthebankingsector.2toanalyzeriskandtheelementsthataremissinginthecurrentproceduresofriskmanagementandriskcontrol.II.RiskAsaCentralIngredientTotheIndustry'sFranchiseA.WhatTypeofRiskIsBeingConsidered?Commercialbanksareintheriskbusiness.Intheprocessofprovidingfinancialservices,theyassumevariouskindsoffinancialrisks.Overthelastdecadeourunderstandingoftheplaceofcommercialbank