Running Head: International Banking System

International Banking System: Risk Analysis

Baitshepi Tebogo Institute of Development Management, Botswana btebogo@idmbls.com

Abstract The international banking system plays a major role in the economic success of many countries around the world- hence it is important that it retains sustainable growth. On the other hand, risks are threats and barriers to the development of international banking. Similarly, banking risks are significant as they threaten the financial security of billions of people. This paper looks into those major risks faced by the international banking system, and how the system mitigates them. Keywords: International Banking, Credit Risk, Market Risks, Operation risks May 2012

Electronic copy available at: http://ssrn.com/abstract=2060774

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Introduction Banking is a fast growing industry and since its inception, has been growing exponentially over the years. Globalization and technological advancement have been instrumental in the growth of the banking system in the late 20th century as well as the 21st century; and have facilitated the expansion of banks scope of work. Notably, banks were instituted to securely store peoples money and make it available to them when they required it, although they have since expanded the scope of their services beyond the mere fulfilment of this early requirement. Most banks are now specialising in different fields, making them more productive and adding to the value they deliver to their clientele, and are beginning to reach clients in areas that were initially thought as inaccessible (Chan-Lau, Mitra & Ong, 2007). Perhaps the most remarkable development in banking is the globalisation of their operations; hence, formerly, local and national banks have started operations in countries abroad. There are different ways in which banks expand their operations internationally with the most popular of these being partnerships with local banks abroad- the major reason behind most of these partnerships is the need to access clientele from abroad. Collaborations with foreign banks work in a myriad of ways; common among these is lending. When banks lend to each other internationally, quite often, the loans are broken down and lent to corporate and individual customers. It has also become common for banks to raise funds internationally for their operations

Electronic copy available at: http://ssrn.com/abstract=2060774

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through borrowing. The trend of going global to look for funds has been quickly spreading thus making the international banking scene a major part of international finance for countries that want to develop infrastructure but cannot borrow from international commercial banks as well as developmental banks such as the World Bank (Elsinger, Lehar & Summerc, 2006). While the growth in international banking is admirable, there are potential difficulties with systemic implications on a global scale. Consequently, as is usually the case with any other growing economic sector, the growth of banking has been accompanied by difficulties, barriers and increased risks. However, it should be noted that there have been commendable improvements in the international banking scene, lately, in comparison to earlier periods during its development. Notably, banking deals with sensitive issues of finance and is an industry that affects almost all civilizations and their citizens. Often banks fail due to various reasons, key among these, being debt and default- that is, if a bank is unable to collect the loans it has lent out and avail money to the customers who have current accounts, it ultimately fails. When one bank fails, in a local setting, there is usually widespread panic often facilitated by the media hence people scramble to withdraw all their deposits. However, the fact is that most banks do not have enough money for all their customers- at once; in the past this has been the cause for various banking crisis around the world (Brigham & Ehrhardt, 2010). International banking not only magnifies the advantages and performances of banks but also scales up risks associated with the banking industry. As a result, a bank

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crisis in one country can cause a crisis in many other countries abroad. This was observed during the 2008 economic melt downs when the credit crisis in the US was responsible for instigating financial disasters in Europe and other international markets (Campbell, 2011). Recently in 2011, the debt crisis in the Euro Zone caused turbulence in the banking sector, especially in the US where many banks had issued bonds held by Europeans (Haidar, March 2012). Risks in the international banking sector are significant enough to cause economic calamities around the world, such as those brought through contagion1. The international banking sector is highly connected and these connections make the system efficient in terms of customer service; however, they also increase contagion risk (Dirk Schoenmaker, 1996). A failure in one bank in a remote part of the globe can cause a domino effect leading to failure of many more banks. This is the Achilles heel of international banking; its connections are its weakness. The regulation of the international banking sector by individual country authorities should be emphasised to reduce contagion risks in the banking sector; part of the reason for international banking crisis is that banks were allowed to operate without the oversight of governments and other regulatory agencies. Bankers took on too many risks until the system, in some places, could not hold. The international banking system will, therefore, fail if sufficient risk analysis and management is not carried out by authorities on a local and international level.
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A contagion risk is one where failure occurring in one of the parties of a group of institutions will cause failure in the other parties in the group.

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International Banking Risks It has been established that one of the major issues of concern in the growth of international banking is risk. International banking has had over a century to evolve and for a major part of that period, institutions and regulators collected information and made analysis; scholars and other analysts drew models and came up with conclusions of the behaviour of international banking. They came up with game theory models that showed the risks that were eminent in international banking as well as those risks that were considered very unlikely to materialize. Banks across the world functioned within these analyses and flourished. However, just like other industries were developing in the 21st century, so was international banking. Situations that were thought improbable started occurring with risks increasing for financial institutions around the world; even the unimagined risks started to develop. All through, banks were operating with the same principles developed decades earlier. The culmination of this was the 2008 economic meltdown that saw a record number of financial institutions go insolvent (Garratt, Mahadeva & Svirydzenka, 2011). New risks have been developing in the international banking scene. Traditionally, the one major risk associated with banking was credit risk, which is the risk that borrowers will be unable to pay back their loans, thus creating liquidity crisis in the banking system. Apart from credit risks other risks thought to be highly unlikely have now become a reality (ATIK, 2009). New operational risks such as fraud and theft have put financial institutions at risk of failing. These new risks have been instigated

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and magnified by development in technology. Technology, while an advantage to banking systems, creates high risks for the banks and has accounted for high expenditure in security systems. There are risks that are considered minor but continue to grow in magnitude: for instance, many institutions did not have much consideration for reputation risk in the past, but now have significant budgets covering these risks (Walter, 2006). Banking risks are mostly mitigated against by the reserves and even derivatives, however, extreme situations are responsible for causing banking crisis all over the world. It is important, therefore, for banks to continuously analyse their risks and develop new ways of mitigating them. Although, there are several types of risks affecting international banking only three main ones will be discussed in this paper: Credit Risk, Market Risk, and Operational Risk.

Credit Risk Credit risk is the greatest and longest lasting among all the other risks faced by the international banking industry- and it has two main aspects: the probability of it occurring and the magnitude of its occurrence. Because it is a risk common to all financial institutions, there has been extensive study and research in the subject; almost all lending financial institutions in the world have credit departments that calculate and determine the risk level of the banks associated to loans they give to their customers. It is the job of the credit officers to check into the financial history and predict whether the customer will be able to pay back the principal plus the interest on the loan. They also

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maintain a favourable level of credit risk to ensure that the bank has contingency measures in case of defaults; ideally, that is what is supposed to happen in financial institutions. Regulations in most countries require banks to maintain a certain level of capital relative to the amount of debt they lend out. This is supposed to leverage against the risk of default forcing the bank to go bankrupt, however, there is no one agreed upon method of calculating the level of capital to be maintained. Banks around the world have exploited this deficiency to exploit the system; even in places where there are formulas, banks have been observed to create new ways to circumvent the system. In the 21st century, many banks began to take on vast debt from international investors and other financial institutions. This meant that, they had the money to lend out to their customers as well as keep some to maintain the legally set proportion of capital. Common lending, especially in the US, was in the Mortgage market; banks took up loans from foreign financial institutions and lent them to US citizens to buy homes. Under normal conditions the banks exposure to credit risk could have been maintained at normal levels, however, due to reckless lending to non-creditworthy borrowers, the risk was magnified. If borrowers are unable to service their loans, the bank would become insolvent and possibly close down, as happened to Lehman Brothers. Consequently, foreign banks that had loaned to local banks had to cover the losses as local banks were unable to pay. Hypothetically, therefore, if foreign financial institutions had loaned several banks in the local economy, the foreign banks would

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likely collapse. Due to the absence of appropriate legislation, there was no basis for the regulators to prosecute these delinquent institutions. These magnified credit risk was by a big part caused by failure in regulation since actions of banks were not checked by the authorities. Ideally, authorities are supposed to analyze market risks and then mitigate them by closer oversight of banks lending activities and the composition of the minimum capital they maintain. It should be noted that stricter rules and better risk analysis could have reduced the impact of the financial crisis, if not stopped it (Scot, 2008). There are various ways of mitigating credit risk in the international banking system; these have managed to keep credit risk at bay in the international market. What bankers did not anticipate was the magnitude of default that would occur in 2008 (Gorton, 2009). Risk based pricing is common to most financial institutions; they charge interest depending on the level of credit risk associated with the loan and this reduces the loss in case of default. When a customer borrows money, and in particular corporate client, the bank draws up an agreement known as a covenant with the company detailing some actions that the company will undertake over the period of the loan. This keeps the risk low as clients are able to pay up. Tightening involves reducing the amounts or the customers allocated debt, it reduces risk by eliminating customers considered risky to lend to. In addition, credit insurance has been a developing method to mitigate credit risk, it involves passing on the credit risk to another party and is popular with financial

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institutions because it significantly reduces the credit risk. Though effective in mitigating credit risk, it was largely responsible for the credit crisis in 2008. Passing on the risk, only reduces the credit risk to individual banks but maintains it in the international banking system. Consequently, banks continued to lend money and sell the debt- while the risk of default built up in the system until it would not hold. This case shows that the methods used to mitigate credit risk should also be regulated to ensure that banks do not cause crisis internationally through contagion.

Market Risks A banks market risks arise from the probability of negative change in the value of its investment and trading assets due to change in various aspects of the market. These aspects comprise equity, interest, currency and commodity risks. Past banking practices heavily depended on banks holding assets constant- that is, banks would usually hold the price of their assets constant. However, current practices allow the banks to value their assets as per the market value (ATIK, 2009). Development of banking also meant that banks carried out other activities apart from the usual banking practices- hence banks today are fond of trading assets to profit from the fee they get. As mentioned before, mortgage loans in the US were sold to foreign banks as assets that would be tradable from one individual or bank to another. The value of these assets was quite volatile although most of the banks buying were not aware of these; the mortgages sold were called sub-prime loans. This meant that banks were lending mortgage loans to individuals who were not creditworthy; these individuals did not

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need to even be checked for their ability to pay back. Local banks then packaged these loans as assets and sold them off to foreign banks. The buying banks valued these assets in consideration of the market value of housing in the US, meaning that part of the banks capital was these assets. The risks associated with these assets were considerably higher than other assets, but the banks were reassured by the higher returns from these assets. As this took place, lending banks had sold hundreds of thousands of these loans to foreign banks, while the interests on the mortgages had been lowered for some period to attract buyers, and when this period ended, the buyers could not afford to pay back their loans as the interests soared and the instalments went up. Market risks materialise when the price of assets goes down. In the case mentioned here, assets prices for the foreign banks started to decrease considerably when the buyers could not pay back their loans; causing a significant fall in assets values, eventually sparking a capital crisis for the banks (Fisher, 2007). Because of the international nature of these transactions, the connected banking industries started to experience capital crisis emanating from a single market (International Swaps and Derivatives Association, 1998). Banks experiencing capital crisis were forced to obtain expensive capital from elsewhere to avoid insolvency- and the capital came mostly from government bailouts. Once again this case shows the importance of risk assessment by international banks even when buying assets from other affiliate banks. Failure to evaluate the risks the banks were taking on caused banks in Europe to become bankrupt as they had heavily invested in US assets.

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Market risks can be mitigated by diversification of assets. Ideally, diversification means that when some assets value reduces, the bank can still depend on the other assets to reduce the fall in capital value (Varotto, 2011). This is however not air tight since during a crisis, assets prices across the economic board fall. Perhaps the best way to protect the bank against the market risks is to be thorough and vigilant when acquiring assets.

Operation Risk Operation risks comprise of risks not categorized under Credit or Market risks that are still faced by the banking system; they include internal and environmental risks. Internal factors include the possibility of mismanagement or losses caused by negligence, while environmental risks include risks emanating from factors that the bank does not have control over such as fraud, natural calamities or terrorism. These factors affect the banking system internationally. In the wake of the bombing of the World Trade Centre in the US, the international banking system felt the effects as panic spread through populations and companies. The resulting panic had a wide effect on the banks involved by depleting money reserves and threatening financial security in terms of diminished liquidity (Diamond & Dybvig, 2000). Operation risks can also include risks that have not yet been conceptualisedwhich unfortunately are hard to mitigate because there are no known ways of doing so.

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Conclusion The international banking sector is very important to the world economy; it facilitates the flow of funds from one country to another. Although the growth of the industry has been impressive; the risks have also grown. A failure in one country can now cause a domino effect in several countries through a connected system. And, the practice of selling credit assets has affected the banking system since it involves systemically passing risks from one bank to the other with limited knowledge of the possible outcomes. It is fit to infer, therefore, that if the international banking system is not sufficiently regulated, it will continue to face major challenges through exposure to major risks. The risks discussed here have a great significance to the success of the international banking system. Recent events in the banking system have shown the adverse effects of a banking industry that is loosely regulated and takes up significant risks it cannot possibly cover.

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Fisher, L. (2007). Major Risks of International Banking. LAW AND ECONOMICS OF RISK IN FINANCE, 121-127. Garratt, R. J., Mahadeva, L., & Svirydzenka, K. (2011). Mapping systemic risk in the international banking network. London: Bank of England. Gorton, G. (2009). Slapped in the Face by the Invisible Hand: Banking and the Panic of 2007. New York: Yale University. Haidar, J. I. (March 2012). Sovereign Credit Risk in the Eurozone. World Economics, 13(1), 123-136. International Swaps and Derivatives Association. (1998). CREDIT RISK AND REGULATORY CAPITAL. International Swaps and Derivatives Association. Scot, K. (2008). International Banking: Country Risk. New York: White and Case LLP. Varotto, S. (2011). Liquidity Risk, Credit Risk, Market Risk and Bank Capital. Reading: University of Reading. Walter, I. (2006). Reputational Risk and Conflicts of Interest in Banking and Finance. New York: New York Universtiy.