The Risk Management and Monitoring Practices of Local and Foreign Banks in Taiwan: An Empirical Study
Wu, Chiou-Huey, Huang, Chien-Sen, International Journal of Management
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.
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.; and for "quantitative standards", including standards for calculation of VaR, requirements for capital provisions, and appropriate monitoring, management, and model validation.
A bank should have a procedure for evaluating its overall capital adequacy (given its exposure to risk) and strategies for maintaining its level of capital. A bank should have an internal procedure for effectively evaluating its own capital adequacy. Banks should also disclose their internal procedures for evaluating capital adequacy, so that banking information is public and transparent. Research by the Basel Committee finds that it is too narrow an approach to determine capital adequacy merely by using the concept of market risk. Future developments proposed include the application of the concept of VaRs - including credit risk, liquidity risk, and operation risk - within integrated risk management mechanisms.
Comparative study of foreign and local banks risk management systems
The 2001 Capital Accord was achieved in order to strengthen and stabilize international banks and the international financial market. The central goal is to develop an appropriate capital buffer mechanism. For this purpose, banks are particularly encouraged to develop their own mechanisms after examining the risk management systems foreign and local banks.
(I) Comparison of Foreign & Local Banking Risk Management Systems
Taiwan's financial regulations concerning risk management and monitoring by financial institutions are primarily based on regulations issued by the Basel Accord, and the Bank for International Settlement (BIS) concerning risk disclosure and management by financial institutions, with reference to traditional local practices. Figure 1 below sets out a flowchart of risk management. This study compares and explains different aspects of risk management, and discusses likely future developments for local banking systems in terms of capital adequacy and risk management.
Taiwan's banking risk management system has a number of similarities and differences compared to these international standards. For clarity, this study refers to these similarities and differences from the perspectives of support from senior management, personnel training, recruitment and training, risk management, risk evaluation model, credit rating, asset management, relevant VaRs, transaction procedures, laws and regulations, information framework, and reporting system.
(II) Future Developments in Risk & Capital Adequacy Management Systems
This study uses the example of a well-known multinational foreign bank to analyze the development of an internal model by a foreign bank, which can be used as a reference by local banks in the development of their own internal models. Foreign banks have been revising their internal models ever since the 1988 Basel ruling and therefore, they can be considered somewhat more advanced than Taiwanese banks in this respect.
(1) Risk Management
(i) Provision of regular reports by day, month, quarter, and year
The foreign bank in the questionnaire provides VaR information according to foreign currencies, every day, month, quarter, and year, and utilizes Internet and Intranet systems to communicate such information to global branches through its local information centers. Global branches must also report updated daily local VaRs, which are then compiled by local information centers before being passed on to the headquarters such as in Table 1.
(ii) Compilation of global transaction charts including profit VaRs and EaRs
The foreign bank in the questionnaire is a multinational bank with branches all over the world. Transactions conducted globally every day are compiled and provided to all global branches, so that local branches may analyze and adjust their positions at all times to account for risks and avoid the erosion of capital. From Table 2 we found that the foreign bank calculates VaRs and EaRs for all areas around the world, so that the risk management team are able to ascertain risk changes around the world.
(2) Risk management system
The risk management team of the foreign bank consists of the heads of various departments, and within the scope of authority granted by the board of directors the team can assign responsibilities to various departments. As the foreign bank has been developing its internal model for some years, it has also been steadily improving the model as set out in Figure 2 to add items such as Profit at Risk, Credit at Risk (CaR), Cash Flow at Risk (CFaR), Earnings Per Share at Risk (EPSaR), and so on.
In addition to the Variance-Covariance based VaR, the Historic Simulation approach, and the Monte Carlo Simulation approach to the calculation of VaR, the internal model also adopts credit risk calculation models, such as the credit transition matrix, the term structure of the interest rate approach and loss due to credit changes, as reference for the bank's evaluation of customer credit risk. In order to maintain the stability and liquidity of these indicators, the bank undertakes back testing, stree testing, and simulations to constantly update risk indicators, and to provide risk reports to departments as important policy references.
Conclusion & Recommendations
The 1998 Regulations concerning capital adequacy permit banks to develop their own internal models for the purposes of providing for market risk. The advantage of such an approach is that takes into account the connection between various asset types and can more accurately evaluate market risk for a whole combination of assets. As banks differ in individual characteristics, a tailor-made internal model is most suitable. Based on the example of the foreign bank presented in this study, the conclusions are that support from top management is essential for the risk mechanism; and that the provision of global VaR and EaR summaries are essential for local banks.
Based on the study of local and foreign banking practices on risk management and capital adequacy, it is recommended that banks carefully select a multiplier factor for capital adequacy, make asset combination data available, compile comprehensive historical market data, encourage local banks to adopt the internal model approach, and strengthen the role of the bank's risk management team.
At present local banks still adopt the standard model approach stipulated by Taiwan's Ministry of Finance, rather than develop their own internal models based on individual characteristics. As characteristics vary greatly from bank to bank, and banks are facing ever-greater market risk as a result of market globalization and liberalization, this study recommends local banks to develop internal models as soon as possible.
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National Chiao Tung University, Taiwan
Ming Chuan University, Taiwan…
Questia, a part of Gale, Cengage Learning. www.questia.com
Publication information: Article title: The Risk Management and Monitoring Practices of Local and Foreign Banks in Taiwan: An Empirical Study. Contributors: Wu, Chiou-Huey - Author, Huang, Chien-Sen - Author. Journal title: International Journal of Management. Volume: 24. Issue: 1 Publication date: March 2007. Page number: 61+. © International Journal of Management Dec 2008. Provided by ProQuest LLC. All Rights Reserved.
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