Assignment on:

“The Stock Market & Bank Risk-Taking”

Course Code: FIN 3301
Course Title: Financial Institution and Market

Submitted To:

Afroza Parvin
Assistant Professor and Coordinator, IPP
Department of Business Administration
Northern University Bangladesh

Submitted By:

Md. Abdul Owadud

ID: BBA 01170105847
Section: A, Semester: 11th

Md. Tanvir Mahtab Jamil

ID: BBA 01170105875
Section: A, Semester: 11th
Group Number: 05
Department of Business Administration
Northern University Bangladesh

Date of Submission:
20 September 2020
1. Introduction
It is now well understood that excessive risk taking by financial institutions is one of the
main causes of financial crises and severe recessions. Yet, we still know relatively little
about what gives rise to such risk-taking in the first place. Numerous authors have posited
that part of the problem is tied to management compensation, which is often structured so
that managers benefit from good performance but bear only a small share of the costs of
bad performance. Others have argued that explicit or implicit debt guarantees by the
government allow firms to take socially excessive risk without bearing the private costs .
In this paper, we put forth and empirically examine another explanation – namely that
pressure from the stock market induces financial institutions to take more risk. Our
explanation is motivated by the observation that the growth of the Bangladesh banking
sector over the past two decades or so years was concentrated among publicly-traded
banks.

Our explanation for the role of the stock market in increasing bank risk, which shows that
when firms place weight on short-term stock prices they will take difficult-to-observe
actions that boost current earnings at the expense of long-run profitability. Stock market
investors rationally interpret higher current earnings as attributable in part to better long-
run fundamentals and value.

To measure bank risk taking, we use confidential information on bank safety and
soundness ratings as assessed by bank supervisors.

2. Objectives of the study

The main objective of this paper is to analyze the reasons regarding why banks,
capital market should maintain a distance in a financial system. The others crucial
objectives are the following:

1. To analyze the effect of bank-based finance on the capital market;

2. To overview the risks of bank-capital market interrelation;

3. To analyze the underlying reasons behind the bank’s over exposures issues;

4. To determine which exposure limit is good for the market, in keeping with the
global standard;
5. To draw a forward looking plan how to keep two markets in safe distance.

3. Methodology
Basically, descriptive research, which has highlighted the recent events namely
bank’s exposure in capital market of Bangladesh’s. The study is the based on the
primary data. The primary data, on types of risk, techniques to measure risk etc. have
been collected through a structured questionnaire. In the questionnaire, only closed ended
options have been considered. Five profitable commercial banks, namely Mercantile Bank
Ltd., Dhaka Bank Ltd., Bank Asia Ltd., Prime Bank Ltd. And Jamuna Bank Ltd. Have
been selected for the study. A total number of twenty five bankers, five from each bank
have been interviewed. The status of each respondent (banker) is senior officer or above
who carries out risk management activities of the banks under study. The collected data
have been processed with the help of the computer by using statistical software.

4. Discussion

4.1 Risks faced by banks

The commercial Banks usually face the following risks:

I. Credit Risk

It is the potential loss arising from the failure of a borrower to meet its obligations in
accordance with agreed terms. Credit risk is one of the oldest and most vital forms of
risk faced by banks as financial intermediaries (Broll, et al., 2002). Commercial banks
are most likely to make a loss due to credit risk (Bo, et al., 2005). Generally, the greater
the credit risk, the higher the credit premiums to be charged by banks, leading to an
improvement in the net interest margin (Hanweck and Ryu, 2004).

II. Market Risk

The risk of loss from adverse movement in financial market rates (interest and exchange
rate) and bond, equity or commodity prices. A bank’s market risk exposure is
determined by both the volatility of underlying risk factors and the sensitivity of the
bank’s portfolio to movements in those risk factors (Hendricks and Hirtle, 1997).
 The risk of changes in income of the bank as a result of movements in market interest
rates. Interest rates risk is a major concern for banks due to the nominal nature of their
assets and the asset-liability maturity mismatch (Hasan and Sarkar, 2002).

It arises from potential change in earnings resulted from exchange rate fluctuations,
adverse exchange positioning or change in the market prices managed by the Treasury
Division.

III. Equity Risk

It is the risk of loss due to adverse change in market price of equities held by the bank.

IV. Operational Risk:

The potential financial loss as a result of a breakdown in day-to-day operational

processes. Operational risk does not mean only failures in the bank’s operations, but also
the causes of the failures, such as terrorist attacks, management failures, competitive
actions and natural disasters (King, 1998).

V. Money Laundering Risk

It arises from the practice of disguising the origins of illegally-obtained money (drug
dealing, corruption, accounting fraud and other types of fraud, and tax evasion, etc.)
through banking channel and the proceeds of crime are made to appear legitimate
(Wikipedia).

VI. Information Technology Risk

It is related to IT, such as network failure, lack of skills, hacking, virus attack and poor
integration of system.

VII. Liquidity Risk

It generates from the failure or inability to meet current and future financial obligations
by bank due to shortfall of cash or cash equivalent assets. Banks are exposed to liquidity
risk where the more liquidity is generated, the greater are the possibility and severity of
losses associated with having to dispose of illiquid assets to meet the liquidity demands of
depositor (Diamond 1999; Allen and Jagtiani, 1996).

VIII. Marketing Risk

This risk is related to the different aspects of the promotion and branding of the bank,
including image management, product promotion and advertising.

IX. Human Resource Risk

This type of risk is generated within the bank from failure to recruit the right people in
the right place, inappropriate means of recruitment, failure to provide feedback to the
employees on performance, over-reliance on key personnel, inappropriate training and
development etc.

Risk Management Process

Risk-Return Trade-Off
Balancing of Risk against Return

Risk Monitoring Supervise the Risks Reporting on Progress

Compliance with Regulations Follow-up

Risk Control
Recommendations for Risk Control Risk
Mitigation through Control Techniques

Deputation of Competent Officers to Deal with the Risks

Risk Assessment and Measurement

Assess the Risk Impact
Measure the Risk Impact

Risk Identification
Identify Risks
Understand and Analyze Risks

Risk Origination within the Bank

Credit Risk
Market Risk
Operational Risk

(As per Basel II Capital Accord)

Source: Annual Report of Mercantile Bank Ltd. -2009
4.2 Techniques of Risk Management
4.2.1 GAP Analysis
It is an interest rate risk management tool based on the balance sheet which
focuses on the potential variability of net-interest income over specific time
intervals. In this method a maturity/ re-pricing schedule that distributes interest-
sensitive assets, liabilities, and off-balance sheet positions into time bands
according to their maturity (if fixed rate) or time remaining to their next re- pricing
(if floating rate), is prepared. These schedules are then used to generate indicators
of interest-rate sensitivity of both earnings and economic value to changing interest
rates. After choosing the time intervals, assets and liabilities are grouped into these
time buckets according to maturity (for fixed rates) or first possible re-pricing time
(for flexible rates). The assets and liabilities that can be re-priced are called rate
sensitive assets (RSAs) and rate sensitive liabilities (RSLs) respectively. Interest
sensitive gap (DGAP) reflects the differences between the volume of rate sensitive
asset and the volume of rate sensitive liability and given by,

GAP = RSAs – RSLs

The information on GAP gives the management an idea about the effects on
net-income due to changes in the interest rate. Positive GAP indicates that an
increase in future interest rate would increase the net interest income as the change
in interest income is greater than the change in interest expenses and vice versa.
(Cumming and Beverly, 2001).

4.2.2Duration-GAP Analysis:

It is another measure of interest rate risk and managing net interest income derived
by taking into consideration all individual cash inflows and outflows. Duration is
value and time weighted measure of maturity of all cash flows and represents the
average time needed to recover the invested funds. Duration analysis can be
viewed as the elasticity of the market value of an instrument with respect to
interest rate. Duration gap (DGAP) reflects the differences in the timing of asset
and liability cash flows and given by,

DGAP = DA - u DL

Where DA is the average duration of the assets, DL is the average duration of

liabilities, and u is the liabilities/assets ratio. When interest rate increases by
comparable amounts, the market value of assets decrease more than that of
liabilities resulting in the decrease in the market value of equities and expected net-
interest income and vice versa. (Cumming and Beverly, 2001)
4.2.3 Value at Risk (VaR):

It is one of the newer risk management tools. The Value at Risk (VaR) indicates
how much a firm can lose or make with a certain probability in a given time
horizon. VaR summarizes financial risk inherent in portfolios into a simple
number. Though VaR is used to measure market risk in general, it incorporates
many other risks like foreign currency, commodities, and equities. ( Jorion, 2001)

4.2.4 Risk Adjusted Rate of Return on Capital (RAROC):

It gives an economic basis to measure all the relevant risks consistently and gives
managers tools to make the efficient decisions regarding risk/return tradeoff in
different assets. As economic capital protects financial institutions against
unexpected losses, it is vital to allocate capital for various risks that these
institutions face. Risk Adjusted Rate of Return on Capital (RAROC) analysis
shows how much economic capital different products and businesses need and
determines the total return on capital of a firm. Though Risk Adjusted Rate of
Return can be used to estimate the capital requirements for market, credit and
operational risks, it is used as an integrated risk management tool (Crouhy and
Robert, 2001).

4.2.5 Securitization:

It is a procedure studied under the systems of structured finance or credit linked

notes. Securitization of a bank’s assets and loans is a device for raising new funds
and reducing bank’s risk exposures. The bank pools a group of income-earning
assets (like mortgages) and sells securities against these in the open market,
thereby transforming illiquid assets into tradable asset backed securities. As the
returns from these securities depend on the cash flows of the underlying assets, the
burden of repayment is transferred from the originator to these pooled assets.
4.2.6 Internal Rating System:

An internal rating system helps financial institutions manage and control credit
risks they face through lending and other operations by grouping and managing the
credit-worthiness of borrowers and the quality of credit transactions.

5. Findings and Analysis:

5.1 Categories of bank risks:
In order to get the perception of bankers regarding various types of bank’s
risks. Table: 02 which reveals that credit risk occupies first rank and weighted
average score being 4.08; followed by market risk; operational risk; interest rate
risk; foreign exchange risk; equity risk; liquidity risk; money laundering risk;
marketing risk & human resource risk, weighted average scores being 4.04; 3.96;
3.72; 3.60; 3.56; 3.40; 3.32; 3.20; 3.16 & 3.08 respectively.

TABLE- 02

PERCEPTION OF BANKERS REGARDING BANKS RISK

Risk Very Lo Neut Hig Very WAS Ranks

Low w ral h High
(%) ( (% (% (%)
% ) )
)
Operational Risk 0 4 16 60 20 3.96 3rd
Credit Risk 0 8 24 36 32 4.08 1st
Human Resource
0 32 36 24 8 3.08 11th
Risk
Market Risk 0 8 28 32 32 4.04 2nd
Information
8 12 28 44 8 3.20 9th
Technology Risk
Equity Risk 4 16 36 12 32 3.56 6th
Foreign Exchange
4 12 24 40 20 3.60 5th
Risk
Interest Rate Risk 0 12 28 36 24 3.72 4th
Liquidity Risk 0 12 36 32 20 3.40 7th
Money
0 24 32 32 12 3.32 8th
Laundering Risk
Marketing Risk 0 8 24 44 24 3.16 10th

Source: Field Survey, 2010

Note: WAS stands for Weighted Average Score. Weighted average score is
 calculated using weights
5.1.1 Credit Risk Management:

Rreveals that among 11 measures regarding managing credit risk, bank uses the
updated credit policy approved by the Board of Directors occupies first rank,
weighted average score being 4.04; followed by credit risk management division
and credit administration division perform their activities separately weighted
average score being 3.9; Law & recovery team monitor the performance of the
loans & Internal Control & Compliance Division directly report to the Board/
Audit Committee about the overall credit risk, in bracket weighted average score
3.68 each; bank follows the central bank’s instructions in determining the single
borrower/ large loan limit; bank professionally follows five Cs principles in the
credit evaluation stage; Performance of loans is regularly monitored to set up early
warning system; bank maintains provision & suspension of interest; bank
diversifies its loan exposure to different sectors; bank takes initiatives to encourage
the borrowers of the bank for rating by External Credit Assessment Institutions;
bank measures its loan portfolio in terms of payment arrears ,weighted average
scores being 3.44; 3.32; 3.24; 3.12; 3.08; 2.88 & 2.80 respectively.

5.1.2 Operational Risk Management:

Table-03 depicts that among three steps regarding managing operational risk,
operational risk is monitored & controlled within the bank through an operational
risk management framework occupies first rank, weighted average Score being
4.24; followed by bank comply with the regulatory requirements and appropriate
training is arranged for the employees for becoming aware of the regulations,
weighted average score being 2.76 & 1.32 respectively.

TABLE-03

OPINIONS REGARDING OPERATIONAL RISK MANAGEMENT

Steps Never Seldom Sometimes Often Always WAS Ranks

(%) (%) (%) (%) (%)
Bank complies 0 48 28 24 0 2.76 2nd
with the
regulatory
requirements.
 Operational 0 0 20 36 44 4.24 1st
risk is
monitored &
controlled
within the Bank
through an
operational risk
management
framework.
Appropriate 68 32 0 0 0 1.32 3rd
training is
arranged for the
employees for
becoming
aware of the
regulations.
Source: Field Survey, 2010

5.2 Techniques for Managing Risk

Table -04 reveals that among 10 techniques regarding risk management in the
selected banks, Internal rating system occupies the first position, weighted
average score being 4.04; followed by the risk adjusted rate of return on capital; gap
analysis; value at risk; duration gap analysis and sensitivity analysis, weighted
average scores being 3.96; 3.76; 3.68; 3.32 and 3.12 respectively.

TABLE 04

OPINIONS REGARDING USING OF TECHNIQUES FOR MANAGING RISK

Specific Not used Frequently Neutral Average Highly WAS Rank

Techniques at all (%) Used (%) (%) Used (%) used (%)
Risk Adjusted 0 4 24 44 28 3.96 2nd
Rate of Return
on Capital
Sensitivity 0 28 36 32 4 3.12 6th
Analysis
Internal Rating 0 4 24 36 36 4.04 1st
System
Value at Risk 0 16 24 36 24 3.68 4th
Duration 0 28 32 20 20 3.32 5th
Analysis

Note: Weighted average score is calculated using weights as follows: not used at all=1, frequently used=2,
neutral=3, average used=4, and highly used=5.

5.2.1 Maintenance of Guidelines of Bangladesh Bank for Managing Risk

Table -05 depicts that out of five Bangladesh Bank Guidelines regarding risk
management, asset liability management occupies the first position, weighted
average score being 4.44; followed by investment risk management and foreign
exchange risk management in bracket weighted average score being 4.20 each;
prevention of money laundering and establishment of internal control and
compliance, weighted average score being 1.40 and 1.24 respectively.

TABLE 05
OPINIONS REGARDING USING OF BANGLADESH BANK GUIDELINES
FOR MANAGING RISK
Guidelines Not Frequently Neutral Average Highly WAS Rank
followed followed (%) followed followed
at all (%) (%) (%) (%)
Foreign Exchange Risk 0 8 32 24 36 4.20 2.5th

Management

Asset Liability 0 0 16 24 60 4.44 1st

Management

Investment Risk 0 8 16 24 52 4.20 2.5th

Management
 Establishment of 76 24 0 0 0 1.24 5th

Internal Control and

Compliance

Prevention of Money 60 40 0 0 0 1.4 4th

Laundering

Note: Weighted average score is calculated using weights as follows: not followed at all=1, frequently followed=2,

neutral=3, average followed=4, and highly followed=5.

6. Conclusion

On the basis of sample bankers’ opinions the following (statistically significant)

results can be concluded:

i) Of the various types of risks faced by the selected banks, credit risk,
market risk and operational risk are the major risks to the bankers.

ii) Regarding risk management oversight, it is seen that the Board of

Director performs the responsibility of the main risk oversight, the
Executive Committee monitors risk and the Audit Committee oversees all
the activities of banking operations.

iii) Regarding credit risk management, it is revealed that bank uses the
updated credit policy approved by the Board of Director Credit risk
management division and credit administration division perform their
activities separately, law and recovery team monitors the performance of
the loans. Internal control and compliance division directly reports to the
Board/Audit Committee about the overall credit risk status.

iv) In terms of opinions as to operational risk management, it is found that

operational risk is monitored and controlled within the bank through an
operational risk management framework.

v) Regarding money laundering risk management, it is noticed that the

Central Compliance Unit looks after the overall compliance with money
laundering regulations.

vi) Regarding equity risk management, bank follows market–to-market

valuations of the share investment portfolio in measuring and identifying
 risk.

7. References:
 Allen, L. and Jagtiani, J. (1996). Risk and Market Segmentation in Financial
Intermediaries’ Return. Wharton Financial Institutions Center, 1-32.
 Bo, H., Qing-Pu, Z., and Yun-Quan, H. (2005). Research on Credit Risk
Management of the State-Owned Commercial Bank. Proceedings of the
Fourth International Conference on Machine Learning and Cybernetics, 1-6.
 Crouhy, Michel, Dan Galai, and Robert Mark (2001), Risk Management,
McGraw Hill, New York. pp. 543-48
 Cumming, Christine and Beverly J. Hirtle (2001), “The Challenges of Risk
Management in Diversified Financial Companies”, Economic Policy Review,
Federal Reserve Bank of New York, 7, 1-17.

 Hanweck, G., and Ryu, L. (2004). The Sensitivity of Bank Net Interest
Margins to Credit, Interest Rate and Term Structure Shocks. [Online].
Available: http://www.fdic.gov/bank/analytical/cfr/2004/sept/CFRSS_2004-
02_Hanweck.pdf

 Jorion, Phillippe and Sarkis J. Khoury (1996), Financial Risk Mangement

Domestic and International Dimensions, Blackwell Publishers, Cambridge,
Massachusetts. P.2

 Jorion, Phillipe (2001), Value at Risk, The New Benchmark for Managing
Financial Risk, McGraw Hill, New York.

 Pyle, H. David (1997); Bank Risk Management Theory, Working paper RPF-
272, Haas School of Business, University of California, Berkeley.Page-2.

 Santomero, Anthony M. (1997), “Commercial Bank Risk Management: An

 Analysis of the Process”, Journal of Financial Services Research, 12, 83-115.

 Wikipedia, Money Laundering, Available: http://en.wikipedia.org/

wiki/Money_ laundering. Retrieved on 12.30 PM, 9/20/11.