The Risk Management and Monitoring Practices of Local and Foreign Banks in Taiwan: An Empirical Study

Article excerpt

This study examines the risk and capital management and monitoring practices of banks in Taiwan's banking sector, using VaR (Value at Risk) analyses in term of the Basel rulings of good practice. The purpose of the study is to these practices in the local and foreign banks that comprise the Taiwan banking industry. The main conclusions of this analysis are that support from top management is essential for the risk mechanism, and that providing global VaR and EaR (Earnings at Risk) summaries are essential for local banks.

Introduction

Based on a questionnaire survey of 26 local banks conducted at the end of March 2002 by the Central Bank in Taiwan, in relation to responses by local banks to the new 2001 Capital Accord model for managing risks, six banks plan to adopt the basic internal evaluation method when evaluating capital for credit risk, while the remaining twenty banks plan to adopt the standard method. Amongst the banks that were surveyed, thirteen said that they would be establishing credit risk models, while the remainder indicated they would not, because of the difficulties in establishing such a model. In principle, the policy of Taiwan's Ministry of Finance advocates using both mechanisms simultaneously and redefining categories of, and provisions for, bad debts so as to be consistent with international standards.

Bank Risk and Capital Adequacy Management

In 1988 the Basel Committee first adopted the Report on "International Uniformity for Capital Adequacy Assessment & Standards" (i.e. the 1988 Capital Agreement) submitted by the Bank Management Monitoring Committee of the International Clearance Bank, requiring banks to maintain a capital adequacy of at least 8% based on assets calculated by risk weighting. The Basel Accord in 1998 took into account the qualifying capital of a bank in taking on market risks and imposed certain restrictions: (1 ) Tier III risk-based capital may not exceed 250% of Tier I capital that has already been allocated to take on market risks (Tier III capital ≤ 250% × Tier I capital); (2) Tier I capital shall represent at least half of total basic risk capital. The Accord also applies to bank holding companies, so as to ensure that the risk of the entire financial group can be properly evaluated.

A proposal for a new Basel Accord was publicly announced on January 16, 2001. If adopted, contents of this proposal will be significant in the new accord. The Basel committee expects the new Accord to take force in 2005. The proposal for the new accord more accurately reflects the risks faced by financial institutions in their capital requirements, and will provide banks and monitoring institutions with different ways of evaluating capital adequacy. Some essential approaches in calculating the capital adequacy ratio are:

(I) The Standardized approach

The standardized approach was proposed by the Basel Committee in 1992 and is referred to as such, because its calculation method and determination of factors are all highly standardized and detailed. Taiwan has adopted this in its new capital adequacy regulations as one of the methods for calculating market risk. The model is based on a "building blocks" framework, where VaR's for interest risk, securities risk, exchange risk, and product risk are evaluated separately, applied as standard VaRs for different types of market risk capital, and then these types of market risk capital are aggregated to give the overall market risk-based capital.

(II) The Internal model approach

Evaluation of overall market risk using the internal model approach may be more accurate than values obtained from the standardized approach. The internal model approach is particularly appropriate for banks with a large number of transactions. In order to execute the internal model approach and maintain consistency, banks must comply with relevant requirements for "qualitative standards", including back testing and stress testing etc. …