2.6.4. RISKY-SHIFT THEORIES
Michael and Frenkel Ulrich Heemmet (2000) argue that a trade
off between risks and returns has always exists so much so that more risks
yield more returns. If a bank takes more risks by investing in a credit
facility, the bank might have returns to the extend of the degree of risk they
have taken. But this will only be done when there is a good risk management
strategy to alleviate the effect of pure risks. For that reason banks must
avoid the following situation in order to earn higher returns:
a- risk concentration
This means making loans representing a high proportion of
banks capital to one single borrower or group of borrowers or to given sector
of the industry (Foundations of banking, 2005). This practise may by the result
of pour lending policies or of the free will of the banker (who believes in the
external health of a given borrowers).
b- connected lending
This means a situation where the bank lends to companies owned
(totally or partially) by the banker or by the bank (Foundations of banking,
2005). Lending to connected borrowers to the banker beyond certain limits is
fraudulent. In most cases, that kind of lending contains a high risk because of
the banker's tendency to use the bank as an instrument to finance his
businesses irrespective of their ability to repay and concentrate large
proportion of the bank lending on them.
c- Overextension
This means lending sum on money that are not in proportion of
the bank's capital (as a cushion for potential losses), or diversifying
activities to geographical or business areas. The bank is not well equipped to
manage (Ndenka Aaron, 2005).
An effective management of banks and financial institutions
requires a careful handling of possible risky outcomes. In order to handle
this, the management should summarize policies and strategies in a guideline
for business management. The policies which a manager can refer are as
follows:
- develop actions to fight the risks
- insurance or reinsurance
- evaluating control put in place to manage risks
- using short dated investment appraisal methods
- The use of capital rationing and ratio analysis.
(Managing Banks, 2005 by Aaron Ndenka)
2.7. EMPERICAL EVIDENCE
In empirical literature review, we examine some empirical
analysis made in risk and liquidity management and then consider the
performance of banking under the growing influence of globalisation.
In a research carried pout on the guiding principles of risk
management for U.S. commercial banks (2002), by the sub-committee on risk
management principles of a financial service roundtable aimed at testing how
active management of credit risk (as proxies by loans sales and purchases)
affects financial institutions growth (capital structure, sending profits ad
risks) detailed loan level data for a broad cross section of U.S. banks was not
from aggregate data and aggregate actions the data obtained includes the sale
and purchases of all loans originated by banks from June 1987-1995 including
residential real state and consumer loans.
The dependant variables were capital and liquidity
variables (capital/assets ratios, liquidity ratio).
The lending variables were commercial and individual
real state lending to asset ration.
The risk variables were time series standard
deviation of each banks return on equity (ROE), loan loss provision to total
assets.
The profit variables were time series mean of each
bank's ROE. The researchers came to the conclusion that large internal capital
markets do allow banks to operate with a smaller liquidity level. Thus the risk
management plays a role in the growth of financial institutions according to
that committee.
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