Banks and risk appetite determination
Bankers’ risk appetite determination is a topic most people find it hard to appreciate. I find it a favourite topic to examine students of bank risk management in this area as part of my desire to illuminate the factors behind most banks’ strategic initiatives.
How many times have non-bankers not asked why banks are not lending “enough” towards agriculture and real estates, for instance, to stem food insecurity or reduce the housing deficit in the country estimated to be around 1.5 million houses, respectively?
The paradox is that irrespective of the size, age, location and sophistication of any bank, directors in every bank’s boardroom, are busy strategizing on how to effectively deploy the capital provided by shareholders, depositors and other investors at their disposal to make optimum returns for these resource providers. So, why would they allow profitable opportunities to elude them?
The motivation to discuss this subject is credited to one of my mentee banking students who simply asked to be educated on strategies as to how to disburse more micro-finance loans and improve the bank’s deposits.
I could immediately sense that this is a middle manager charged to present a paper to his superiors on the subject. Drawing from my teaching experience and my avowed desire to promote critical thinking, instead of rote learning, I decided against just listing what the student might call strategies without tasking him to stretch his imagination. This is to ensure that we train managers to take a holistic instead of a capsule approach to the intricacies of the banking business.
The best approach, in my view, is to take this manager and his counterparts into the nuances of strategy formulation, illuminating the fact that strategies are not drawn in a vacuum but pivoted on what most business students remember as the PESTEL factors and SWOT analysis that most of us crammed in the ”chew, pour, pass and forget “ syndrome in our days in the university.
Now in the saddle as a middle-level bank management personnel where one is forced to apply these concepts practically, many managers begin to fumble as they cannot fully relate their earlier learning to the work environment.
To remind those business students who may have forgotten after obtaining their certificates, the acronym PESTEL stands for the basis for business decision-making underpinned by political, economic, social, technological, environmental and legal considerations.
These factors are usually what prevail outside the board room but critically influence strategies in virtually every facet of business management, whether this is profit-oriented or otherwise.
For instance, a multinational company desiring to invest in West Africa may consider the relative peace and security, population dynamics, social cohesion, economic growth, tax regime, infrastructure availability, the performance of the judiciary, availability of quality personnel, among other attractions, in deciding to pitch camp in Ghana while undertaking their feasibility studies.
In a nutshell, a bank’s risk appetite hinges on;
- the volume of capital, its mix, liquidity, sources and tenor of these elements.
- the bank’s mission and vision that anchor strategy in order to meet specific business objectives, particularly, expected returns.
- board risk culture and resource allocation dynamics
- The business climate and expected returns
- skills set and other core resources available to the bank or how these could be sourced externally, and against what costs and expected returns.
- The mode of communicating risk acceptance, measurement and reporting as vital components of the enterprise- wide risk management framework.
These factors permeate even the desire of an existing bank to open a branch in a particular area in the city or country at large. Ecobank Ghana Ltd’s branch in New Abirem to target the corporate and retail business arising from Newmont’s gold mine in an otherwise remote area is a typical strategy. Here, even micro issues such as the predominant economic activity, security, telecommunication and road infrastructure, reception of traditional authorities, are among the factors to be considered.
Conversely, the SWOT analysis represents the strengths, weaknesses, opportunities and threats to the firm and are basically an internal assessment made by the board and management to determine their competencies to face competition in the ever-evolving market space.
For instance, it will be brazen foolhardiness for a bank without internal competencies and inadequate capital to deploy its capital into lending in the oil and gas industry, whether this relates to the upstream or downstream strata in that sector.
It is for good reason that the central bank establishes maximum single obligor/borrower limits and would caution against sector concentration risks, generally.
Without wanting to make the topic too technical, I have taken up the challenge to serialize presentations to educate banking and finance students and the general public on primarily what determines a bank’s board or management’s risk appetite.
This risk appetite simply means on what and how the board collectively decides to handle the capital and other resources at their disposal to create incremental value, within a defined timeframe. This informs the entry into, or exit from particular economic domains and must be primarily anchored on permissible activities as defined in the Banking Act and other regulatory directives on prudential ratios that must be maintained.
This is a cyclical adjustment of strategies in the routine tasks of financial intermediation where we mobilize deposits, introduce products and services and grant various loans and advances types to which segment of the financial market, why, when and how.
At the basic level, it is worth emphasising the point that managers are not simply thrown into the financial arena to mobilize deposits and/or to expand or contract/recover outstanding loans and advances.
Every management initiative in any direction is a response to the dictates of available capital, the liquidity structure, available internal competencies in particular areas, experiences with non-performing loans, the complexities of competition, potential opportunities thrown by fiscal and monetary policies, and a host of critical factors gleaned from the PESTEL and SWOT analysis prevailing at any time.
Of particular concern is the need to operate with the primary objective of making profits while observing the regulator’s directives and positioning the bank as a responsible member of the economic and social network, as prescribed by economic and social governance imperatives.
Risk appetite is the balance of return and risk determined by the bank’s executive risk committee in consultation with the business units. It may be defined as the amount and type of risk a bank is willing to take in order to meet specific business objectives.
A range of risk appetites may exist for different risks and may also change over time in tandem with resource endowment and the general economic and political terrain in which the bank operates. For instance, if the business prospects in the real estates sector diminishes, a bank may make a strategic decision not to hold more than X% of its portfolio in that sector and adjust its risk appetite statement accordingly.
Let us therefore continue our discussion by understanding the key concepts of capital and liquidity since these pre-dominate all strategies emanating from the adequacy of these factors and how these tie into the regulator’s prescriptions.
A simple illustration is the bank’s ability to assemble the right mix of human expertise and the establishment of a technological platform to spearhead its objectives. These may be coupled with the adequacy of capital and the presence of an enabling economic environment that spurs innovation and growth, particularly in the banking space, acknowledging the multiplicity of taxes as a disincentive to capital growth.
A typical example can be drawn by the President’s call on the banks to do more for the economy. (B& FT issue No. 3984 dated 1st February, 2024) The President reiterated his government’s commitment to creating an enabling environment, noting that access to cost-effective credit will enable the private sector to drive economic growth.
“Government is committed to creating an enabling environment for businesses to thrive and believes that financial institutions have a pivotal role to play in achieving this objective. By working in tandem, government and banks can nurture a business ecosystem, bolster economic growth and pave the way for a prosperous future, “ he said.
The interesting observation in this call is that no rational bank board will sit on idle investible funds when they see an opportunity in the financial market and wait to be told to deploy resources.
The Managing Director of GCB Bank, Kofi Adomako, in his response “diplomatically” acknowledged that Ghana has one of the highest lending rates on the continent. He however, explained that the rate at which banks lend is influenced by multiple factors, some of which are beyond the banks’ control- believing that once government steps in to address the external factors, lower lending rates can be achieved.
Which bank executive does not know that high lending rates do not augur well for loan disbursement and recovery? But we cannot gloss over the cost of funds in determining the effective cost of credit, expressed in interest rates and the probability of default.
The MD’s response goes to buttress the view that bank strategies are not crafted in a vacuum but reflects a variety of factors as summarized above in the PESTEL and SWOT analyses.
If the business environment is not scorched by high inflation which itself is a reflection of perennial budget deficits and lower gross national output, over taxation and high costs of doing business, banks will be on auto pilot to become the engine of growth in the economy. Indeed, it will be in their own interest to lend towards all the permissible activities defined by regulation.
This writer recalls a period during President Kuffuor’s era when the macro variables were reasonable enough to make banks venture into loan expansion without any prompting. That was a time when bankers chased people with loan facilities and public workers could negotiate group loans for their members at preferential interest rates.
When the environment is right, with disciplined fiscal and monetary regimes, lower inflation, predictable exchange rates and most importantly, expectation of long-term economic stability, depositors will place funds in long-term instruments. The banks will hopefully, be availed of long-term resources to also lend to the productive sectors and respond positively to the call to be catalysts for growth.
As mentioned above, the board’s core function is to ensure that they meet objectives as defined by shareholders, with a view to upscaling value while ensuring the sustainability of the firm.
In executive boardrooms, risk aversion will be tempered and borrowers can borrow at fair rates. When non-performing loan ratios fall into single digits, customers will equally be gifted with lower borrowing rates.
With the improvement in customer identification, digitalisation and a credit referencing system, hopefully supported by a pro-business judiciary, banking risk will generally reduce and interest rates will fall simultaneously.
The two foremost determinants of risk appetite are capital and liquidity with their respective structures and tenors being paramount.
In this and subsequent articles, therefore, I intend to elaborate on what constitutes a bank’s capital, how its quantum and composition determine what the bank can do, and how capital may increase with profit retention or diminish with losses, compounded by over taxation.
To further elucidate this, it is helpful to underscore the difference between regulatory and economic capital of a bank. This will explain why a bank will exercise caution in expanding or contracting its credit portfolio, fixed assets acquisition, the exposure towards contingent liabilities, and other long- term ambitions.
Regulatory capital is the level of capital that the central bank expects each bank to hold at any point in time as a measure for determining the bank’s ability to absorb risks to its own internal sustainability and also to guard against the bank being a source of systemic risk to the entire banking system.
It is said that a bad bank anywhere is a risk to banks everywhere. This is even more pronounced in this era of globalization where financial intermediation creates interdependencies on other financial institutions within and outside a country’s borders.
Each central bank, to the extent that it is a member of the Basel Accords, holds sacred obligations towards each other by conforming to global standards aimed at ensuring the sanctity of the international financial system.
It is important to distinguish between regulatory and economic capital as we attempt to understand banks risk appetite.
Regulatory capital
This is the minimum capital level that the central bank obliges any bank operating under its licence to hold to become a credible member of the banking community. At present, the minimum capital is GHS. 400m.
Following the whirlwind that affected the banks on account of the DDEP, this minimum capital has been considered inadequate and has forced the central bank to demand credible recapitilisation schemes from the respective commercial banks.
The central bank is currently examining these plans in relation to the size, sophistication and risk exposures of the individual banks to determine the adequacy of the proposals and the timeframes within which each bank will be expected to concretize their proposals.
It is helpful to note that the more a bank makes profits, the more it solidifies its capital adequacy. Conversely the higher the losses a bank incurs, notably through an increase in its non- performing loans or other operational risks, the greater the ensuing capital depletion.
Regulatory capital is usually assessed in reference to Capital Adequacy Ratio, which is calculated, using the following formula;
Equity (Tier 1) + Permissible Reserves + Tier 2 (Eligible Surbordinated Debt capital)
Risk Weighted Assets (RWA) + Provisions for Market, Operational Risks.
Regulatory capital connotes a prudential requirement imposed on Banks by Ghana’s Banks and Specialised Deposit Institutions Act 2016 ( Act. 930) This capital is a measure of the adequacy of a bank’s cushions against financial losses and routine business operations. It must not fall below 10%. Risk Weighted Assets represent total advances, less Non- Performing Loans.
Regulators in different jurisdictions determine what constitutes eligible capital and also the measures adopted for discounting or risk weighting specified assets- (Loans and Advances). Depending on what the central bank perceives as risks to a particular bank’s loans portfolio, it may apply its own measures in determining the discount factor to arrive at a risk-based value for the entire asset portfolio.
A high or low capital adequacy ratio in the context of mandatory holdings of raw capital and liquidity plays a crucial role in whether a bank finds it comfortable to play around their own assessment of what constitutes optimal capital and how long a board considers it necessary to stay within defined capital adequacy bands, and the influence this positioning has on its profit generation capacities.
Economic capital is an internally derived measure of the capital required to support the inherent business risks to which an economically active bank is exposed. This measure is a capital level chosen by the Board to cover the bank’s losses or exposures with a certain probability or confidence level.
It is thus a ratio which the bank internally computes as being “adequate” for its internal evaluation purposes and may not be lower than regulatory capital.
An optimal regulatory capital for a typical commercial bank in Ghana must;
- must the regulator’s requirement and leave a buffer. (minimum 10%)
- must be dependent on the bank’s risk profile- the businesses they are predominantly engaged in and the specific risks associated with the individual sectors it is exposed to.
- reflective of its market share and what their peer group’s risk indicators are.
To be continued.
The writer is a Fellow of the Chartered Institute of Bankers, a former adjunct Lecturer at the National Banking College, a farmer and the author of “Risk Management in Banking” textbook.
Email; koriginal59@gmail.com Tel. 0244 324181