RISK ANALYSIS AND ASSESSMENT IN NIGERIAN BANKS Outline Introduction.

Phases/Steps involved in Risk Analysis Approach to Risk Analysis Forms of risk Risk Assessment Using CAMEL Criteria Computation of ratios (Excel Format) Conclusion. References

INTRODUCTION Risk and Uncertainty are major factors to be considered in all types of decision making. They are of particular importance in investment appraisal because of the long time scale and amounts of resources involved in a typical investment decision. Risk is a probability of Variation in Outcome particularly with projects future cash flow. The greater the variability, the greater the risk Risk analysis is the systematic study of uncertainties and risks we encounter in business, engineering, public policy, and many other areas. Risk analysts seek to identify the risks faced by an institution or business unit, understand how and when they arise, and estimate the impact (financial or otherwise) of adverse outcomes. Risk managers start with risk analysis, and then seek to take actions that will mitigate or hedge these risks. In general, the word uncertainty means that a number of different values can exist For a quantity, risk means the possibility of loss or gain as a result of uncertainties. We have tended to use both terms interchangeably in this presentation, and indeed this is common practice by most practitioners. However, it is important to understand 1

the difference, as in some situations it may be necessary to apply the absolutely correct term to avoid ambiguity. According to society for risk analysis, Risk analysis is broadly defined to include risk assessment, risk characterization, risk communication, risk management, and policy relating to risk. It also includes risks to human health and the environment, both built and natural. It considers threats from physical, chemical, and biological agents and from a variety of human activities as well as natural events. It analyses risks of concern to individuals, to public and private sector organizations, and to society at various geographic scales. Steps Involved in Risk Analysis Identifying the risks: describes techniques used to get a list of possible risks, and how to determine which risks are appropriate for modelling; Quantifying the risks: this section looks at issues that arise when trying to accurately quantify risks, such as which distribution is appropriate for what type of process, what is correlation, etc. It also gives an overview of the issues that can arise when quantifying risks with clients;

Risk analysis: The how to" of Monte Carlo simulation approach within a spreadsheet model, from the impact upon model design to the generation of outputs; is mostly adopted.

presenting the results: describes the different ways of presenting the results of uncertainty and risk analysis, both graphically and in translating the results back into easily understood terms; and

Beyond presentation: this last section looks at how to take the outputs from the modelling and interpret them in the context of business decision making. Approach to Risk Analysis Any meaningful approach to risk analysis would be to optimize the vale of decision making arising from effective risk management strategy adopted.

Moreso, effective risk management strategy is an enterprise wide effort applied to enhance the transparent business process, which impact on the over all wealth creation chain. Some institutions, such as banks and investment management firms, are in the business of taking risks every day. Risk analysis and management is clearly crucial for these institutions. One of the roles of risk management in these firms is to quantify the financial risks involved in each investment, trading, or other business activity, and allocate a risk budget across these activities. Banks in particular are required by their regulators to identify and quantify their risks, often computing measures such as Value at Risk (VaR), and ensure that they have adequate capital to maintain solvency should the worst (or near-worst) outcomes occur. Risks Dimensions Operating and Technology Risk This is managing the possibility of ensuring uninterrupted processes. The Investor will review proposed operations to see if sufficient funds have been allocated for the operations and maintenance and that sufficient trained personnel are available to operate the plant. This is called Operating Risk. Technology risk can be a very significant factor for little understood or new technologies. The main concern of lenders is that technology under-performance will adversely affect plant operations to the extent that the project is unable to make its debt repayments. Technology risk is seen by lenders as a sponsor risk. Lenders do not like lending to new technologies and prefer tried and proven technologies that have been financed in the past. Even new applications of standard technology are of concern. Typically lenders feel comfortable with 3-6 previous plants of the same technology with at least 5 years of reliable operation. Construction and Sponsor Risk The key construction risks are: non-completion; late completion; and cost over-run. Of these the most obvious risk is the one where the project is never built. The loans could be completely drawn, the cash spent, but the project uncompleted. Without a completed project there is no cash flow and the loans will never be repaid and investors never receive a return. Sponsor risk relates to the risk that the company or 3

companies running the project (sponsors or project developers) are not substantial and reliable. Banks look for evidence (e.g. through strong joint venture partners) that the resources and skills necessary to help resolve any problems encountered in the project are available. Economic, Inflation and Environmental risks The economic risk or economic viability is an early benchmark used to judge a project. Lenders carry out financial modelling exercises to assess this risk and to satisfy themselves that the project revenues will be sufficient to cover the operating costs and loan obligations. The lender will look at all the project assumptions, consider if the projections are reasonable and then consider the likelihood that the project can maintain sufficient cash flow to meet its obligations. The cost of this process, which includes due diligence aspects, is one of the factors that contribute to the high fixed cost of loans. A bank measures the cash to loan ratio to gauge the ability of the project to meet the loan requirements. This compares the cash revenue that the project will generate with the amount loaned. Various terms are used by the banks. Country, Political, Legal, Foreign Exchange and Force Majeure Risks Country risk is important because international banks set lending limits on a country by country basis. If a bank is exceeding its country limit, it cannot lend to a new project, even a superior one. Obviously, a more unstable environment warrants a lower country limit. Political risks are inherent in doing business, especially in cross-border transactions. These risks come under sharp scrutiny especially in developing countries. The most basic risk is that of the change of government. Political risk can also be incurred through government inaction or direct action (of both national and local government). Inaction could be failure to issue permits as needed, or government failure to enforce local legal provisions. Examples of direct action include the following: preventing the local partner from making payments on foreign loans; changing the foreign-exchange or currency-use rules thereby preventing foreign banks from recovering their loans;

introducing regulations affecting the price or the mechanisms for the sale of electricity;

nationalizing, or privatizing, the industry or project; political violence, such as war or terrorism.

Legal risks exist where laws are uncertain or can change. Lenders will seek legal opinions from local counsel to ensure that all the project contracts are legal, valid, binding and enforceable under the relevant laws, and the manner in which the security taken by the lenders could be enforced. So long as the capital expenditures, revenues, operating expenses and loans are in the same currency, there is no foreign exchange risk. If this is not the case, the financiers will be asking the following questions: is the exchange rate likely to move against the project so that it will not be able to meet its payment obligations (to its debt or foreign suppliers), is the project guaranteed the ability to convert its local currency income into foreign currency (at a favourable rate) to meet the external obligations?

Force majeure risk means a risk that is beyond the control of all parties to the project, typically acts of God and severe weather, and possibly including industrial action. Often, a force majeure clause is used to excuse any partys performance in the face of occurrences beyond their control. Country, political, legal, foreign exchange and force majeure risks are by their very nature difficult to fully mitigate. However, they are also risks that are normally well understood by finance organizations as the basic principles (and impacts) of these risks are essentially equivalent to those in wider economy. Approaches that may be used to ensure that this risk is minimized and appropriately assigned include the following: Policies which encourage private sector involvement, particularly where this involvement will ensure risk management and promote risk transfer. However, basic market liberalization measures also help here, as it current orthodoxy suggests that once introduced such measures are difficult to repeal. 5

Clear and unambiguous statements of government support for the type of investment being made are very useful risk mitigants, especially if linked to some form of guarantee. Any such statement will, ideally, contain within it indications of the underlying benefits that the government wishes to accrue from supporting renewables. This will help potential investors ascertain the degree to which individual schemes are compatible with national programmes or aspirations.

Insurance against political risk can be obtained. Nigerian Investment Promotion Council and Nigerian Export Promotion Council as well Nigerian Export-Import Bank and other credit agencies (ECAs) provide this to their exporters, with limits. More extensive cover can be obtained from multilateral development agencies such as the World Bank and their Multilateral Investment Guarantee Agency. Political risk cover can also be obtained on the private market, such as from Lloyds of London.

To protect themselves against fluctuations in interest rates and currency exchange rates, the sponsor may be required by the lenders to enter into hedging contracts. These are financial devices used to reduce losses as a result of future price movements.

RISK ASSESSMENT I personally favour the concept of CAMEL as a dynamic measure of criteria and setting the benchmark for assessing Banks whether in developing economies or not and particularly with the global rating of institutions using an acceptable universally agreed/accepted standard. CAMEL is as acronym for Capital Adequacy, Asset Quality, Management Structure/Effectiveness, Earnings Capacity (Measure of Profitability) and Liquidity Profile (test of survival and progression into the future unimpaired by losses, and other red signals of future dangers) More importantly, due to the vital role Banks play in the economy, they are usually under intense surveillance and subjected to frequent scrutiny by the supervisory/regulatory authorities. The evaluation of the operational performance is carried out on international /global comparison. 6

Capital Adequacy. Capital adequacy of a bank is a function of the risk it is carrying or attached to it both in an existing capital and anticipates/unforeseen circumstances This is made up of the followings: Components, Structure (Tiers) and Measurement Components

Paid Up Ordinary Share Capital Preference Shares Debentures/Bonds/Loans Stock Share Premium General Reserves Revaluation Reserves Minority Interest Statutory Reserves Others such as Price Fluctuation reserves, and so on.

Total Qualifying Capital Structure (Tiers) The structure (Tiers) reveals the purpose of computing a Banks Capital. Its capital Funds is stratified into Tier I and Tier II.The sum total of both gives the Total qualifying Capital. Tier I Capital also known as Core Capital is made up of i) Paid Up Share Capital ii) Disclosed Reserves Tier II Capital or supplemental capital is made up of i) Debt Capital of Seven (7) Years Maturity ii) Loan Loss Reserve and Interest in Suspense. Measurement of Capital Two important ratios are very important in the measurement of a banks capital

Prescribed minimum risk weighted capital ratio is 8% which links a banks capital linearly with its assets structure. In Nigeria, this is 10%. i) Capital Adequacy ratio (Benchmark minimum allowable 10%) ii) Adjusted Capital to Net Credit ratio (Benchmark maximum 1:10)

Assets Quality The quality of a banks assets is a function risk of realization inherent in it. The lower the level of risk the lower the possibility of default and higher the assets quality. Components Some assets are considered to harbor no risks at all. That is Risk attached is 0% these include Cash Balance with other Banks including the CBN (This is debatable particularly with the dynamics of distresses, Bankruptcy, liquidation and Global financial meltdown) Treasury Bills/Certificates (This is also debatable in view of the decline in government revenues, unexpected shortfall and the timing of the collection of proceed of matured transactions of Governments and its supporting relationships in broader perspectives in relations with both local and international arrangements and exigencies. Risk attached Assets The Basel I Accord created four buckets with respects to the assets as Follows. The first category shown above have Zero risk and therefore zero weight. The Ones presented below have 20%, 50 and 100% risk attached accordingly. Particulars Bank Balance Outside Nigeria Rate % 20

Non-negotiable Certificate of Deposit Investments Bankers Acceptance Owner-Occupier residents Private Sector Commercial Real Estate Commercial Paper Loans and Advances Other Loans Net Fixed Assets Other Assets Contingent Liabilities

50 50 50 100 100 100 100 100 100 100 20

Evaluation of Loan Assets Loans and Advances Constitute between 60-80% of total assets of most banks. Thus, the quality of loan assets determines to s large extent risk assets portfolio. The prudential guidelines issued by the CBN provide an objective and subjective criteria for determining the quality loan asset. Assets quality ratios i) Concentration ratio: section 20 of BOFIA 1991 provides that a bank cannot grant to a single obligor credit in excess of shareholders funds as follows a) commercial banks 35%, Merchant Bank 50%. In view of the Universal banking environment or era, I am inclined to propose 20%.This is to check insiders abuses from insider credits. In arriving at this position, banks must remember to aggregate all advances, loans and credit facilities extended to subsidiaries or associated components. Concentration ratio is Total Loans and Advances to a single obligor/Shareholders fund unimpaired by losses. According to the new CBN requirement, the following must be obtained 9

Large exposure maximum Aggregate Large exposure Significant shareholding Director/ Significant shareholding limit Maximum credits to all insiders

10% of Shareholders fund Maximum. Shareholders fund X8% 5% of equity 10% of Paid up Capital 60% of Paid-up Capital.

ii)

Ratio of Non-performing Loans to Total Risk Assets.

Risks assets are funded credit risks. This represent best business practice as it is a self regulation of banks in evaluating the overall loan quality .The lower the ratio, the higher the presumed quality of risk assets. Delinquent/deficient assets quality is a reflection from the consequence of pronounced risks of default, interest rate risks, market risk, maturity risk, operational risk and country risk. Management structure/effectiveness The primary objective of evaluating bank Management is to determine the: Qualification Competence Efficiency and Effectiveness of the Management in superintending over the administration. Conforming to legal and regulatory provision for safety and soundness of the industry.

The criteria to appraise the objectives includes

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Balance of skills and attributes Management succession plan Clear definition of job function Clear definition of communication channels Comprehensive of Management Information System Effectiveness on Internal Control functions Quality, trend and future sustainability of Earnings. Effectiveness of fund Management policies/procedures

A more global issues in Management capability/effectiveness includes the followings Is the bank newly privatized from government ownership? What is the ownership structure of the bank? (Government support? Independently capitalized or a branch? Can rely on parent support implicit/explicit?) Is as small branch network a constraint on business? Loan portfolio management, credit administration, policy development, employee training, loan workout Is it possible to determine Governance, Audit oversight and Strategic planning?

Earnings Earning is another important parameter for evaluating a banks performance based on the following reasons Is an important source of capital growth through retention of undistributed profits Provides funding for expansion of operations Provides return on investment to shareholders Generates liquidity for operations

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As a source of Motivation to the banks workforce Guarantees the banks continuation as a going concern A mark of socially responsible corporate citizen Source of Earnings Bank source Non-Bank source

Bank source Interest bearing Bank Balances Interbank Placement Treasury Bills Investment

Non Bank Source Loans and Advances Leased Equipments Commissions Fees Service Charges and other credit related fee income

Banks Earning Evaluation Criteria Sources of Income Profitability Trend of earnings Expenditure Pattern 12

 Industry/Peer Performance Future potentials/prospects Cost of Funds/Pricing of Financial products and services.

Liquidity Liquidity is the ability to meet short term or maturing obligations as at when due. A banks ability to meet such obligations at the least cost is an important measure of its reliance and strength. On the other hand, solvency measures the long term health of an organization. It shows the Net Worth of the bank. A bank can be solvent and not liquid and vice versa. Source Customer Deposits Loan Repayments Sale of Bank Assets-marketable securities Sale of Non-deposit services Borrowing from Money Market

Banks Liquidity Evaluation Criteria Cash Reserve ratio Liquidity ratio Loan/Deposit ratio Deposit Structure /Mix Deposit trend

Cash reserve ratio is ratio is provided for section 15(1) of BOFIA 1991 Currently Cash reserve ratio is Cash deposit with CBN/Total deposit. 13

Liquidity ratio is also provided for in section 15 (1) of BOFIA 1991 and is expressed as Specified Liquid Assets/Total Deposits Section 15 (6) of BOFIA 1991 stipulates what constitute specified liquid assets. This includes Currency notes and coins which are legal tender in Nigeria; Balances at the CBN excluding Cash reserve & other mandatory deposit Net Balances at any licensed bank in Nigeria excluding uncleared effects Money at Call in Nigeria Treasury Bills and Certificates issued by the Federal Government. Inland Bill of Exchange and promissory notes rediscountable at the Bank Federal Government Stock Negotiable Certificate of deposit approved by CBN. such other negotiable instruments as may, from time to time, be approved by the Bank for the purpose of this subsection. stock issued by the Federal Government with such dates of maturity as may be approved by the Bank Loan to Deposit Ratio Loans and advances constitutes the largest earning assets of many banks Loans are the most illiquid earning assets. Hence, ability to realize loans is crucial in a banks effort to meet maturing obligation as they fall due.

Considering liquidity ratio of 40% and cash reserve ratio of 9.5%, the technical maximum loan to deposit ratio should be within the range of 50.5% for Banks.

It limits a banks ability to create additional non-liquid assets by tying its credit Expansion ability to its total deposit base.

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Case Study of First Bank Plc on the Risk Assessments based on the 2008/2009 Annual report & Accounts.

Conclusion

Banks are dealers in money and credits, upholding itself how to receive from public deposits and repayable on demand by cheque and /or other acceptable legal instrument of money. Hence, Banking Business is a serious business mainly due to the intermediary and fiduciary role of the financial industry particularly the banking sub-sector. Moreso, the heavy surveillance is required to ensure safe, sound and efficient banking culture and strengthen public confidence among other stakeholders interests

The risk analysis and assessment of banks in Nigeria is an on-going exercise in view of the both the roles played and the dynamism of the global business world.

Effective risk analysis and assessment requires in-depth knowledge of a business climate. Culture, operating processes, systems reporting framework, insider information as far as it is not illegal,continous education,experience,observance of due professional due and diligence as well as other oversight responsibilities and quality service delivery.

A word of caution goes thus: Uncertainty and risk analysis is not new however, as a tool in business it has historically been of limited use. This is surprising considering that many business decisions are based on a figure that has been calculated from analysis of some kind. A number on its own is only half the picture to fully understand the result it is necessary to have an estimate of the uncertainty related to that figure. For example, two projects may both have a value of N10m, but if we know that one has an uncertainty of +/N1m around the N10m and the other has an uncertainty of +/-N3m, this shows them in a very different light. References 15

Pharez Group Limited, Understanding banking Business

www.credfinrisk.com

www.greentie.org

www.solver.com

www.sra.org

First Bank Annual Report & Account for 2008/2009.

Chris Rodger and Jason Petch, Uncertainty & Risks, A practical guide to Business dynamics. Price Water House Corpers, MCS cal

guide from Business Dynamics

O.A.Lawal, Principle of Economics.

Submitted by group members: Mrs, Rita C Okorie Josephine isioma Ugbah Alaribe Ikechukwu B Ogburie Kevin Sunday Enwezor Chineze A Dare Adebowale Gbenga Matric No.08491125 (Group leader) Matric No.08491056 Matric No.08491140 Matric No.08491246 Matric No.08491046 Matric No.08491229

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