Analysis Risk Management in Banking Activity

An Analysis of Risk Management in Banking Activity: The Case of Mauritian Banks

Financial deregulation, globalization and liberalization have heightened considerable banking risks. Moreover, banks necessitate effective risk management strategies to promote banking welfare, protect outside agencies transacting with banks and to ensure stable banking operations. Risk managers need to focus on the diversity of risks and secure the interests of the overall banking sector. Risk Management is nowadays segregated where there is "inconsistency in reporting, insufficient evaluation and low quality of management" and becomes ineffective due to lack of pertinent information and improper analysis of the risk factors (Prabir Sen, 2009).

Nonetheless, banks are unable to keep equilibrium in the situations of risks with huge losses and slight possibility of occurrence and risks of minimal losses with propensity of occurrence.  According to Talmimi and Hussein, Mazroezi and Mohammed (2007), risk management enables profits maximization and entails restrictions in risky activities. Risks can be averted by ordinary banking procedures, can be shifted to other institutions and can be managed "actively in banks" (Oldfield and Santemero, 1997).

1.1 Objectives of the Study

The core objectives of the study are:

• To probe into the methodologies and aspects of the risk identification, assessment, monitoring, management and mitigation in Mauritian banks.
• To ascertain the effects of risk management on Mauritian banks.
• To determine to which extent risk management strategies like Basel II, derivatives, stress testing and Asset and Liability Management are applicable in Mauritian banks.
• To analyze the factors which improve Risk Management Practices in Mauritian banks and the perspectives about Banking Risk Management.
• To explore the reasons for managing risks in Mauritian banks.

1.2 Statement of the Problem

There is an increasing awareness that the gradual intensification of banking risks impacts adversely on banking transactions which raises the concerns for risk management. The basis concern of this study is whether the Mauritian banks are using diverse risk management tactics and whether they are able to cope with the present and prospective challenges of risks and risk management requirements.

1.3 Significance and Contribution of the Study

Bank managers can be conversant with divergent risk management techniques, their implications, effects and their relevance in banks through the practical aspects of risk management application. Bank managers can analyze the mechanisms resulting in the increasing level of risk exposures. Business administrators and management practitioners can use this study as guide to design efficient measures to mitigate risks in the process of developing marketing tactics.

1.4 Structure of the Project

Chapter 2 elaborates on the literature review related to the risk management.

Chapter 3 uncovers the general overview of Mauritian Banking Sector.

Chapter 4 focuses on the detailed research methodology that has been used.

Chapter 5 discusses the analysis and interpretation of the Mauritian banking risk management information.

Chapter 6 probes on the recommendations to improve Risk Management practices in Mauritian banks.

Chapter 7 concludes the whole findings of the project.

PART 1- THEORETICAL ASPECTS

2.1 Introduction

The advent of technology, globalization and the competition has encouraged banks in risk taking activities exposing banks to risks. Regulatory and supervisory institutions have emphasized the need for banks to enhance their risk management practices. Risks arise from the probabilities of the occurrence of losses and usually emerge from the internal and external banking transactions.

2.2 Banking Failures determinants

The past decades have encountered numerous bank turbulences where high costs have been incurred on both local and overseas level (Gaytán and Johnson 2002, p.1), hindering the credit facilities, minimizing investment and consumption and generating bankruptcy cases (Demirguc-Kunt and Detragiache, 1998a, p.81). According to them, the expensive monetary policy was used to force the sound banks to sustain the failures of insolvent banks which dissuade risk management.

Fluctuations in interest rates post abolition of Brettons Woods System, higher banking competition, the non existence of "intermediation margins", unskillful lending and investment tactics (Hellwig 1995, p.724-726 ) , the diminishing role of the "oligopoly rents" as stated by Gehrig (1995 cited Hellwig 1995, p.726 ), the lower level of capital reserves in banks, companies' high reliance on banks for external finance mentioned by Rajan and Zingales (1998 cited Randall S. Kroszner 2007),systemic shocks caused by credit risks, the inability to diversify loans, "trade deterioration and decrease in asset prices caused bank failures" argued by Gorton (1988 cited Demirguc-Kunt and Detragiache1998b, p.85). Moreover, regime changes like "financial repression, liberalization and severe macroeconomic conditions" encourage the entry of "inexperienced players" and preference for the acquisition of useless loans stated by Honohan (1997 cited Gaytan and Johnson 2002, p.4) have generated banking turbulences.  Non-performing loans increase where the asset returns are less than the returns to be paid on liabilities. Banks borrow in international currency and lend in local currency where the latter depreciates if the foreign exchange currency risk is shifted to local borrowers if they loaned in foreign currency. Banks buy insurance protection which encourages risk taking activities in the absence of prudential supervision and regulation. Bank managers engage in fraudulent actions by taking a portion of money for their personal use (Demirguc-Kunt and Detragiache 1998c, p.85-87). Diamond and Dybrig (1983 cited Demirguc and Detragiache 1988d, p.86) argued that bank's portfolio assets can worsen and depositors believe that other depositors are removing their money. Obstfeld and Rogoff (1995 cited Demirguc and Detragiache 1988e, p.87) mentioned that an anticipated devaluation could occasion bank runs in local banks and these deposits are shifted overseas and render the domestic banks without liquidity.

2.3 Banking risks

alsamakis et al (1996 cited Young 2001, p.57) argued that risks can be classified as pure risks and speculative risks. Pure risks which embody market risks, credit risks, interest rate risks, liquidity risks, country risk and settlement risk are associated with the probability of occurrence of loss or no loss and can be curtailed by risk management strategies. However, speculative risks comprising of operational risks, technology risk, reputational risk, compliance risk, legal risk and insurance risks involve an opportunity for gain or loss which can be hedged.

2.3.1 Credit Risks

These major risks occur in banks when the borrower defaults on his obligation to reimburse the principal amount and the interest charged of the loan. Credit risks consist of three types of risks like (Arunkumar and Kotreshwar 2005, p.9):

Transaction risk emerges from the fluctuations in the credit type and capital depending on how 'the bank underwrites individual loan transactions'.

Intrinsic Risk is risk prevailing in some institutions and on granting credit to some firms.

Concentration risk is the average of transaction and intrinsic risk within the portfolio and encourages granting of loans to one borrower or one firm.

2.3.2 Interest rate risks

Koch (1995 cited Beets and Styger 2001, p.9) defined interest rate risk as the future changes "in a bank's net interest income and market value of equity due to changes in the market interest rates". Kropas (1998 cited Martirosianien) enumerated three types of interest rate risks like:

Reappraisal risk stems from the diverse periods of assets and liabilities

Profitableness curve risk entailselements affecting the 'reappraisal risk'.

Basic point risk concernsflawed association between the 'receivable and payable interest rate'.

Option risk is where the benefits of options can adversely affect the bank's equity.

2.3.3 Liquidity risks

Liquidity risks occur when the banks are unable to meet the demands of the depositors because of lack of funds and the illiquid assets resulting eventually in bank insolvency. Credit, strategic, interest rate and reputation risks build up liquidity risks (Gaulia and Maserinskieno 2006, p.49). 2 types of liquidity risks are (ADB Report 2008, p.9):

Funding liquidity risk is the potentiality to obtain money via the sale of bank property and by borrowing.

Trading Liquidity risk arises from making a constant entry in market activities and dealings.

2.3.4 Market risks

These risks arise when the value of the financial products changes negatively and consist of "currency risk, interest rate risk, equity or debt security price risk" (Gaulia and Maserinskieno 2006, p.49).

2.3.5 Operational Risks

Basel Committee (2004) which imposes a capital charge defined operational risks as "the risk of direct or indirect losses resulting from inadequate or failed internal processes, people, and systems, or from external events". "This definition includes legal risk, but excludes strategic and reputational risk".

2.3.6 Reputational Risks

These risks emerge when the number of clients decreases as they hold negative perspectives about the quality of services offered by the banks.

2.3.7 Strategic risks

Strategic risks arise when bad decisions and projects are undertaken to develop a special system in banks due to the lack of resources, technological tools and the expert staff.

2.3.8 Foreign Exchange Risks

These risks come when the prices of the currency fluctuate when engaging in foreign activities. There are 3 types of foreign exchange currency risks. (Deloitte Treasury and Capital Markets 2006)

Transaction risk entails the future of original cash flows like imports and exports.

Translation risk is concerned with the disparities between foreign exchange encountered when again transforming "a foreign exchange value into the functional currency of the company concerned". Translation risks are usually converted into transaction risks "on a late basis as earnings are repatriated or assets and liabilities are realized".

Economic risk arises when indirectly exposed to buying and selling of goods from someone who buys goods overseas.

2.3.9 Systemic risks

The bank cannot collect money from an organization it is dealing owing to the political, economic and social conditions prevailing in the country where the organization is situated. "Country risk includes political, economic risk and transfer risk" (National Bank of Serbia).

2.3.10 Legal Risks

Legal Risks are losses incurred when the bank is sanctioned by a court for the non-compliance with the lawful rules and regulations and on not fulfilling its obligations towards the other parties (National Bank of Serbia).

2.3.11 Financial Fraud

There is mismanagement of money and fraudulent actions from the members of the banks who embezzle some deposited money and when there is lack of security controls.

2.4 Bank risk management methods

Greenspan (2004 cited in Lam 2007, p.3) said that

It would be a mistake to conclude.....that the only way to succeed in banking is through ever-greater size and diversity. Indeed, better risk management may be the only truly necessary element of success in banking.

2.4.1 Risk Management in Banking Sector

Flaker (2006, p.4-8) proposes three methods:

2.4.1.1 Risk Identification

The board must set the risk profile of the bank and identify the risk-return tradeoff. The bank should understand and identify types of risks exposures, their sources and their effects on the overall banking stability.

2.4.1.2 Risk management and reduction

Risk management and minimization embody the following:

(1) Allow loans after considering their financial status of the borrowers.

(2) Comparison of the expected risks with the actual ones to diminish the "loan losses" in a bigger portfolio.

(3) Loan losses will decrease due to diverse borrowers in the lending transactions.

(4) Actual risks can be compensated through the opposite movement of other risks in particular financial activities.

(5) Insurance negotiations can be used to protect against diverse risks.

2.4.1.3 Risk Management System

This flexible system encompasses the combined structure of identification, evaluation and risk mitigation techniques. The Board must set up a strong risk culture and an effective governance structure where the risk management system aligns with the existing structure of the bank. Risk management procedures are possible when retaining higher level of capital to cushion the risks.

Furthermore, the risk management functions comprises of:

(1) Delegation of responsibilities to each banking segment

(2) Auditing system to deal with the "internal control" processes and proper execution of "risk controls" (Nikolis, 2009).

(3) Ongoing reviews, reporting, updating and the control of risk management system must be executed to ensure that they tailor with the banking aims

(4) Training courses gaining know-how about the design of the risk management system and "risk models" must be offered to avert banking failures.

(5) Establish rules and regulations and take necessary actions to those who contravene with them regarding risk management practices.

(6) Participation of the banks, regulatory and supervisory bodies where information is disseminated externally and internally in the banks (Kroszner, 2007).

2.4.2 Asset and Liability Management

Asset and Liability Management entails the design of "organizational and governance models" which define the risk approaches subject to the banking operations (ADB 2008, p.10).

2.4.2.1 ALM operations are as follows (ADB 2008, p.10-12):

1. ALM ensures a "risk and return management process" where the combination of expertise and risk appetite is needed.

2. ALM unit manages bank risks either through a passive or aggressive approach thus increasing its value.

3. ALM unit investigates upon the "static and dynamic mismatch; sensitivity of net interest income; and, market value under multiple scenarios -including under high stress."

4. The net interest income evaluates the sophisticated bank's operating results. It does not project the effects of risk compared to the economic value which can identify banking risks but is inaccessible to most banks.

5. Funds Transfer Pricing eradicates the interest rate risks by securing a spread in loan and deposits by allocating a "transfer rate" that mirror the repricing and cash flows of the balance sheet. Liquidity risks can be managed like diversification of financing sources, correlate the liquidity risks with other risks and use stress testing analysis.

2.4.3 Stress testing Practices

Stress testing is another risk management strategy where "Stress testing is a generic term used to describe various techniques and procedures employed by financial institutions to estimate their potential vulnerability to exceptional but plausible event" (Kalfaoglou 2007, p.1). It uses statistical data analysis to risk management techniques, interpret and control the unfavorable outcomes.

JP Morgan Chase has integrated stress testing equipment to manage and analyze the sources of possible banking risks, implement tests on the value of its portfolio, analyze its risk profile and contemplate the effects while applying diverse scenarios. An effective risk management scheme, stress testing project and bank staff expertise are requisite to tackle the statistical and economical fundamentals of stress testing with a data measurement tool. Board of directors should monitor the inputs of stress testing system (Seminar on Stress Testing Best Practices & Risk Management Implications for Egyptian Banks 2007, p.2-3). Furthermore, the 2 types of stress testing strategies in banks like:

(1) Simple Sensitivity Test deals with the rapid fluctuations of the portfolio value due to a "risk factor" on a short term basis.

(2) Scenario analysis is used by large complex banks and is associated with a realistic and econometrics approach towards shifts in portfolio value due to changes in many risk factors.

2.4.4 Basel II

Basel II published in June 2004, promotes banking supervision and emphasizes the specified capital requirements to cushion against potential losses. Basel II uses qualitative and quantitative requirements to monitor risk management strategies, to ensure compliance with regulations and reinforce corporate governance structure. The risk based supervision has enabled the supervisors to concentrate on the origins of banking risks.

2.4.4.1 Pillars of Basel II

Pillar 1 entails capital needed for credit risk, market risk and operational risk. Moreover, banks under this regime must have a capital adequacy of 8 %.

The methods for the computation of the capital charge to measure operational and credit risks (Ma, 2003)are:

Basic Indicator Approach- The size and capital requirements of the operational risk are estimated as "a fixed proportion of the bank's net interest income and non-interest income, measured as the average over the last three years".

The Standardized Approach –The activities of the banks are allocated risk ratios weights related proportionally to the quantity distributed to every category. The aggregate capital requirements are the addition of all the requirements for the categories.

Advanced Measurement Approach- Computation of credit and market risks and the capital requirements are founded on the "bank's internal system for the measurement and management of operational risk" for large banks

An Internal Rating Based System - The BIS stated that capital requirements must be founded on a "qualitative and quantitative" analysis of credit risk and must be used for diverse bank units. Founded IRB approach indicates that large banks should calculate probability default related to a borrower's grade to demonstrate the capital requirement level. However, under advanced IRB approach, these banks with an "internal capital allocation" can furnish the loss given default and exposure at defaults which are processed.

Pillar 2- A supervisor must ensure that the bank has the adequate capital requirements to deal with risks. Banks estimate the internal capital adequacy by adopting quantitative and qualitative techniques. On-site investigation and ongoing reviews probe in capital adequacy.

Pillar 3- Market discipline framework provides with detailed information about the bank's risk profile to evaluate and report capital adequacy where risk exposures can be analyzed through quantitative and qualitative approach regularly. The "risk based capital ratios" and qualitative information about the internal procedures are needed for capital adequacy purposes.

2.4.5 Derivatives

olatility of financial market, "the liberalization and deregulation in the 1980's and 1970's" has founded derivative markets (Hehn no date a, p.100). Derivatives are financial tools (like futures, commodities futures, options, swaps, forwards) whose returns, values and performance are derived from the returns, values and performance of the underlying assets. Hedging is covering against potential risk through an opposite position in the derivative markets. Bank International Settlements (2004 cited Bernadette A. Minton et al 2008, p.2) noticed that the quantity for derivatives has leveled from $698 billion in 2001 to $ 57,894 billion in 2007.

Proper derivatives trading can insure against market risks and interest rate risks without retaining additional capital requirements in the balance sheet (Kaudman no date a, p.85). The determinants of derivatives use are banking size, balance sheet constituents, aggregate risk exposures, profitability, performance and risk taking incentives. Jason and Taylor (1994 cited in Hundman b, p.86) argued that speculation used with derivatives to make profitable returns can engenders more interest rate risks.

Moreover, Tsetsekos and Varangis (1997 cited Roopnarine and Watson 2005a, p.9) argued that financial derivatives promote "increase in resource allocation" and increase the productivity of investments projects. Jorion (1995 cited Roopnarine and Watson 2005b, p.9) argued that in price discovery, market participants are offered information on balance prices that mirror the present demand on the supplies which enable effective decision making and reveal the position of the "cash prices". Besides, liquid funds are increased and transaction costs are reduced and the futures market reflects the large transactions at prevailing prices (Roopnarine and Watson 2005c, p.10). 

However, derivatives have generated enormous failures in "Barings Collapse, Merill Lynch and Procter Gambler" (Hehn b, p.101). Bank staff must be trained and educated about derivatives use. Derivatives trading can be constrained with the liquidity problems and legal uncertainties that emerged from the market price movement which is argued by Bhaumik (1998 cited Roopnarine and Watson 2005d, p.11). Pricing of assets becomes difficult if there is insufficient information about the derivatives use. Principal agent problem is aggravated (Roopnarine and Watson 2005e, p.12). The derivatives market must be regulated properly to avert fraudulent actions and insolvency. Partnoy and Skeel (2006 cited Minton et al. 2008a, p.2) claimed that derivatives intensify systemic risks as banks do not control the lending activities. Hunter and Marshall (1999 cited Roopnarine and Watson 2005f, p.28) argued that derivative markets attract investors whose private information are assimilated in the observable prices and diminish the bid ask spread. The underlying cash prices reduce the transaction costs and the demand for money thereby affecting the operations of the monetary policy.

Bedendo and Bruno (2009a, p.2-4) argued that credit transfer tools like securitization, credit derivatives and loan sales reduce "regulatory capital requirements", motivate lending and enhance the banking liquidity positions. Moreover, they remedy the issues of information asymmetries as stated by Greenbaum and Thakor (1987 cited in Bedendo and Bruno 2009b, p.2). Duffee and Zhou (2001 cited Minton et al. 2008b, p.11) mentioned that credit derivatives are used if the loan sales or securitization techniques become expensive due to moral hazard problem and can shift default risk where "information advantage" is insignificant and retain some portion of risks where "information advantage" is huge. Banks use credit transfer tools as they have little access to "inter-bank funding", huge funding expenses, low capital and want "loan transfer" (Bedendo and Bruno 2009c, p.8-9). CRT tools encourage banks to use "originate-to-distribute models" via aggressive lending occasions (Bedendo and Bruno 2009d, p.10). Pricing of CRT tools is preferred by large banks having higher skills. Some loans sales have loan characteristics like small size, asymmetric issues and standardization convenient for securitization (Bedendo and Bruno 2009e, p.11).

PART 2- EMPIRICAL REVIEW

There is a growing literature that examines the relationship of banking risks with other many economic and financial variables. Moreover, this section describes the diversity of banking literature where different types of risk management strategies were tested and criticized. Even the links between different types of risks were experimented using banking information and models derived from other authors' empirical work.

Peek and Rosengren (1996) found that the large users of derivatives for speculation purposes are the "troubled" organizations using derivative information of 25 active banks in the United States from 1990 to 1994 in the US dummy regression model.  Banks are unable to track the risky aspects of these derivatives and guide their risk profile because of insufficient derivative information which could jeopardize the overall banking system. The "onsite targeted examinations" can enable banks to "window dress" their derivatives. Regulatory rules and formal transactions must be imposed on the banks taking unfavorable speculation and to constrain the "moral hazard problem" related to the derivative transactions. The use of speculative derivatives constitutes a stringent criminal penalty for breaching the established rules and regulations.

Cebenoyan and Strahan (2001) used data of the sale and purchase of bank loans and "those loans sold or purchased without recourse" from all domestic commercial banks in the US from 1987 to 1993 in a regression model. They found that banks that engage in loan sales market to manage credit risks retained minimum level of capital which can be modified. Moreover, these banks retained more risky loans since they managed credit risks and were exposed to an unsafe position despite they endured lower level of risks compared to the other banks who manage risks without the loan sales market. Banks that employed the risk management techniques are more inclined to engage in risk taking activities. In fact, banks that manage credit risks lend to more risky loans depicting that complex risk management practices enhanced the bank credit position rather than minimizing the risks.

Gatev et al (2006) investigated upon the presence of liquidity risk from both sides of bank balance sheets using some aspects of the Kashyap, Rajan and Stein (2002) model ("that liquidity risks originating from the two fundamental businesses of banking promotes a diversification benefit") to analyze the link between deposit taking and commitment lending for large, publicly traded banks using regression analysis. "Pooling deposits and commitment lending" insure against banking liquidity risks and deposits activities insure against liquidity risk from idle loan activities. "Bank stock-return volatility" increases with idle loan transactions which is insignificant for banks with huge amount of depository dealings. The "deposit-lending risk management" becomes more reinforced when there is low level of liquidity and when troubled market participants deposit money in banks.

Shao and Yeager (2007) used information of large publicly traded U.S BHCs from 1997 to 2005 using regression models to find the link between credit derivatives and their risk, return and lending issues. Banks buy credit derivatives to hedge against risks, to increase their equity and to compensate for the risky loan losses. However, they sell credit derivatives exposing themselves to risks to gain a premium charge. Moreover, the credit derivatives users enjoyed minimal returns and increase risks which are compensated. Their findings implied that on a general basis, the impact of credit derivatives on risk relies on the risk management strategies.

Holod and Kitsul (2008) used panel data of stock returns from 53 U.S BHCs from 1986 to 2007. They found that after 1996, poor capitalized banks engaged in active trading transactions are more exposed to systemic risks compared to well capitalized banks. Banks cannot always have enough capital to cushion the market risks and must sell their illiquid assets or invest in the financial markets to compensate for the lack of capital to adhere to the "market-based capital requirements". Capital requirements in Basel II do not help to reduce banking risks totally but contribute towards increasing systematic risks.

Topi (2008) used a model of "Allen and Gale (2004) where banks offer deposit contracts to ex ante identical, risk averse depositors who face heterogenous liquidity shocks" for Bank of Finland which shows that the liquidity can impact on the bank's motivations to minimize the default losses. The bank runs encourage the banks to avert the credit losses after the sub-prime mortgage crisis. However, the bank runs without a signal of the credit risks will reduce the banks willingness to curb the incidence of credit losses. The central bank can mitigate the propensity of liquidity stress for solvent banks rather than insolvent banks. In addition, this research provides an area for further research where the "policy interventions and financial market innovations" can be integrated in the model to identify the impact on bank's motivations.

Achou and Tenguh (2008) used regression model for Qatar Central Bank by executing a time-series analysis of financial data from 2001-2005 to examine the correlation between profitability and loan losses. They showed that effective credit risk management improves the financial result of the bank with the aim to secure the banking property and to work in the welfare of the market participants. Besides, their study revealed that credit risk management infrastructures are used to minimize the credit losses. Banks with efficient credit risk management system have insignificant "loan default ratios", good revenues, minimal non-performing loans and are able to tackle credit losses.

Minton et al. (2008) investigated the use of credit derivatives using U.S BHCs (assets overtakes $ 1 billion) and "non-missing data on credit derivatives use from 1999 to 2005". Few companies use credit derivatives for dealer activities rather than for hedging against default losses. Credit derivatives use is constrained because the liquidity of credit derivatives market is favorable for "investment grade" companies since they can use derivatives to insure against the default losses. Therefore, the illiquidity of credit derivatives market affects the "non-investment grade" companies as they need confidential information for loans where higher cost of hedging will dissuade banks to hedge. Nevertheless, the bank borrowers get loans at a cheap price and banks are more on a competitive stance with the capital markets to provide loan facilities if the credit derivatives can help bank to retain capital. Credit derivatives can only promote the financial health of banks if they generate lesser banking risks. The sub-prime crisis prior to 2007 has shown that the dealer activities via the credit derivatives contain many risks and in 2008 generated systemic risks. This study provides an avenue to assess the risks posed by credit derivatives when engaging in dealer's transactions dealers.

Bedendo and Bruno (2009) differentiated between the application of loan sales, securitization and credit derivatives for a sample of US large domestic commercial banks (total assets greater than one billion USD) for June 2002-2008  They found that the most CRT users employ conservative tools and large international banking corporations utilize credit derivatives. They detected that highly capitalized banks with "less risky portfolios" purchase credit derivative protection to hedge against capital inadequacy.  Moreover, banks with "riskier loan portfolios, liquidity stress and higher asymmetric information" engage increasingly in loan sales market or securitization process. There is narrower liquidity but they rely on capital markets for financing purposes. A dislocation in the "inter-bank market linked with the freezing of the loan secondary market" can affect the bank liquidity. Regulators must restrict transactions in CRT markets where the capital market destabilizes.

Allen et al. (No date) applied a four factor APT framework using four diverse risk profiles from 11 Asia Pacific countries to study the impact of market, credit and interest rate risks exposures on the banking stock returns for 162 banks from 1992-2002. Well capitalized banks are rewarded with greater returns because of their current capital position and which engage in diversification activities choose to offset loan losses, benefit from minimal fluctuations in their returns, engage in risk taking activities, insure against market and credit risks and can lend loans to risky borrowers. Alternatively, banks can engage in profitable "non-interest income earnings" transactions to diversify their risks. However, if banks do not diversify risks, they must retain huge levels of capital to cushion. Asia Pacific banks can reinforce their position by complying with the "capital adequacy rules of the Basle Committee on Banking Supervision."

Fiordelisi et al.(No date) modelled the link between capital, risk and efficiency of 440 banks of 5 European countries from 1990 to 2000 basing on the work of Shrieves and Dahl (1992), Jacques and Nigro (1997), Kwan and Eisenbeis (1997) and Berger and De Young (1997). Inefficient banks engage in risk taking activities. Banking risk is caused by the increasing demand for loan which compels managers to increase their lending process. Furthermore, regulators direct banks to maintain sufficient level of capital to limit the risk taking activities. Highly capitalized banks function more effectively. Generally, regulators should account for effects of loan and efficiency on the risk taking motivations thereby reiterating the importance of Basel II. Banks are sound if the capital adequacy rules coupled with the regulatory requirements will determine the degree of loan growth and bank efficiency.

Hundman (No date) investigated the determinants of derivatives application using quarterly statistical information derived from the 38 Indian commercial banks having assets more than $500 million from 1995 to 1997 where a regression model is used. She found financial derivatives protect against interest rate losses. Moreover, larger complex banks which are exposed to credit risks increasingly use derivatives than smaller banks to enjoy greater capital to asset ratio. Her findings correspond with that of Brewer, Jackson, Moser and Saunders who found an adverse link between interest rate risk and derivative application. Conversely, these results are in opposition to Deshmukh, Greenbaum and Kanatas (1983) which found that banks deploying derivatives generate more profits and ultimately oppose to the results of Jason & Taylor (1994) which indicated derivative use can increase banking risks. Furthermore, the relationship between other derivative application and risk exposure in banks may extend the research.

Refer to Appendix 1 for tabular summary of empirical review.

3.1 Introduction to Mauritian Banking Sector

There are 18 registered banks in Mauritius. 2 largest state-owned commercial banks: Mauritius Commercial Bank and State Bank of Mauritius offer spot and forward activities in all major currencies where the latter holds nearly 75 % of the total banking assets and are among the 10 largest African banks. They have merged with the "syndicated loan activities" and lend to the non-resident institutions. 4 large banks work for the domestic and international markets; 3 large foreign banks for the non-residents; 5 small and medium for the non-resident market and 5 small and medium sized banks for the local market. The internationally banks can establish "wholly owned subsidiaries" and create joint ventures with local banks.

Since 2004, the legal system of separate classification of banks into onshore and offshore banks was modified where all banks now operates under a single banking license. Banking services in Mauritius are deposits, advances, foreign exchange and cash management, remittances, trade finance, investment management and custody, wealth management and private banking. Non-banking activities through the subsidiaries are leasing, stock brokering, insurance and portfolio management and trusteeship. Internet banking is home and phone banking. There is marketing of new products and services through wholesale cross border, investment and merchant banking.

3.2 Risk Management in Mauritian Banks

Derivatives markets in Mauritius are at a younger stage. The Insolvency Act has planned the "netting of financial contracts" with the international support to foster creation of a futures and forwards market in Mauritius due to huge foreign exchange inflows. Mauritian large banks employ better risk assessment systems. The application of stress testing in smaller banks enables them to overcome the effects of unforeseen adverse occurrences. The Scenario test assesses the loss quantity that each bank could take from the additional capital while preserving the capital adequacy ratios. Sensitivity tests deal with effects of capital reserves on the Capital Adequacy Ratios. Banks use their strong market standing to increase the spreads and charges to reduce risks.

Furthermore, onsite surveillances and offsite examinations for banks are conducted comprising of a "risk focused approach" for risk management. BOM confers a guidance framework for risk management where interaction with the senior management is needed. BOM established guidelines for Credit Risk Management as well as Liquidity Risk Management. BOM conducted onsite Anti-Money Laundering and Combating the Financing of Terrorism inspections in banks (IMF Report, 2008). BOM are aware of the types of risks and risk management practices of the banks to assess the risks that may emanate from their operations with affiliates that can/ cannot be regulated properly (Bheenick, 2009).

3.3 Basel II Framework in Mauritius

BOM adopted Basle I in 1993 and encouraged Mauritian banks to adopt Basel II by adhering to the Basle Committee 25 Core Principles by December 2008. Under a Special Banking Committee was held in 2007, Mauritius banks must disclose their Capital Adequacy Ratios under Basel I and Basel II on March 2008. BOM initiated "parallel run exercise" ending March 2008. BOM checked the activities of Mauritian Banks under the application of the "parallel run exercise" and evaluated the impact of Basel II on bank capital. Moreover, BOM inferred that they were well capitalized and some banks had adopted the advanced methods of risk managements, information systems and the internal processes. (Bank of Mauritius, 2009)

Subsequently, the Committee shifted towards the decision of implementation of Standardized Approaches ending March 2009. Banking Act 2004 raised the bank minimum capital to MUR 200 million. The risk weighted capital adequacy in Mauritian banks is around 12-13 % exceeding the 8 % recommended by BCBS.  Mauritian banks must follow the Guidance Notes pertaining to the Risk Weighted Capital Adequacy Ratio of Basel I and the Guidelines of BOM concerning the Basel II for the calculation of CAR.

Guidelines established since March 2008 (Mauritius Bankers' Association, 2008) are:

(1)  Guideline on Scope of Application of Basel II

Capital Adequacy requirements should be used for "parent holding of the banking group"

to track the risk impacts of the diverse institutions in the entire banking group.

(2) Guideline on Eligible Capital

Basel II sets the required capital to buffer risks and constitutes the New Capital Adequacy Framework. The CAR necessitates the split of the Bank Capital into Tier 1 Capital and Tier 2 Capital where the bank capital being the numerator of risk asset ratio shall be the addition of Tier 1 and Tier 2 Capital.

(3) Guideline on Standardized Approach to Credit Risk

Banks estimate the credit risks using Standardized Approaches and Internal Rating Based methods. There is matching of supervisory risk weights to each rating type where the Probability of Default aligns with the degree of the risks mirrored in the risk weights. Qualitative and Quantitative elements differentiate between the levels of risks of each rating category.

(4) Guideline on the Recognition and Use of External Credit Assessment Institutions

The Standardized Approach enables banks to use the credit evaluation issued by ECAI to ascertain the risk ratios. Direct Recognition stipulates that BOM shall evaluate the ECAI basing on recognition criteria like "objectivity, independence, international access/transparency, disclosure, resources and credibility". Indirect Recognition states that BOM shall acknowledge ECAI considering the recognition criteria of other "jurisdiction" where the standards comply with BCBS rules. The international credit rating agencies are used for risk weighting purposes.

(5) Guideline on Operational Risk Management and Capital Adequacy Determination

These guidelines entail Operational Risk Management procedures. The addition of the Risk Weighted Assets and risk assessment of off-balance sheet exposures are associated with capital and the "risk asset ratio" appraises the Capital Adequacy.

3 main methods for the calculation of the capital charges calculation for the Operational Risks are Basic Indicator Approach, Standardized Approach and Advanced Measurement Approach. The approaches and the pillars work under the same principles of BCBS. The calculation of the CAR entails the use of credit risk and operational risk.

(6) Proposal Paper on Measurement and Management of Market Risk

The measurement and management of market risk is stipulated where the market risk constitutes Interest Rate Risk, Equity Risk, Foreign Exchange Risk and Commodities Risk Capital charges are computed by the Standardized Measurement Method (SMM) and Internal Model Method (IMM). Same methods cannot be used for the same risks belonging to similar category. Market risk management system encompasses "board and senior management oversight, risk management procedures, risk measurement, monitoring, and control functions, internal controls and independent audits".

This chapter describes the methodology used to implement a study about the analysis of Risk Management in Mauritian banks.

4.1 RESEARCH PROCESS

Research is the process of gathering and analyzing information to identify and solve real life problems. Research process encompasses of:

• Clearly well defined research objectives
• Development of the Research Plan
• Data Collection
• Analysis and Interpretation of the Data Collected
• Summary of the Research Findings

4.2 RESEARCH OBJECTIVES

The core objectives of the study are:

(1) To probe into the methodologies and aspects of the risk identification, assessment, monitoring, management and mitigation in Mauritius.

(2) To ascertain the effects of risk management on Mauritian banks.

(3) To determine to which extent risk management strategies like Basel II, derivatives, stress testing and Asset and Liability Management are applicable and beneficial in the Mauritian banks.

(4) To analyze the factors which improve Risk Management Practices in Mauritian banks and the perspectives about Risk Management.

(5) To describe the reasons for managing risks in Mauritian banks.

4.3 DEVELOPMENT OF THE RESEARCH DESIGN

The research design stipulates the type of information to be gathered, the sources of data, the research approach, research instrument, sampling plan, contact methods and data collection procedures and analysis.

4.3.1 Data Sources

Primary data are "collected specifically for the purpose of investigation at hand."

Secondary data are published data that have been presented in some kind of report or publications.

Primary data was used for my project.

4.3.2 Research Approaches

Observation, focus groups, experimentation and surveys (Personal interview, Mail interview, Telephone interview) are primary data collection modes. A survey research was adopted for this project.

4.3.3 Research Instrument

A questionnaire was used for the project. A questionnaire contains questions in diverse formats like:

(1) Open ended questions enable respondents can reply in their own words and provide more insight for the study. However, they are difficult to measure.

(2) Dichotomous questions provide two choices of answers

(3) Closed ended questions offer 3 or more answer choices. Questions are fast to administer but they provide limited answers choices.

(4) Scales entail forms of statements where the respondents show their level of disagreement or agreement.

4.3.4 Sampling Plan

A sampling plan entails describing the sampling units, size and procedures.

4.3.4.1 Sampling Unit is "who is to be surveyed". The target population was all the registered banks in Mauritius.

4.3.4.2 Sampling Size

There are 18 registered banks (Refer to Appendix 2) in Mauritius which constitute the entire population for Mauritian banks but only 13 banks replied to the questionnaire.

4.3.4.3 Contact methods

The respondents were the Risk Managers/ Treasury Managers whose email addresses were asked by telephone contact. Subsequently, a copy of the questionnaire and a covering letter was forwarded to the email addresses of the respondents. The respondents were given 2 weeks to return the questionnaires. A continuous follow-up was done by telephone. Some banks respected the two weeks' time while the others were given two weeks more to answer the questionnaire.

4.4 QUESTIONNAIRE STRUCTURE

The questionnaire (Refer to Appendix 3) was divided into 4 sections namely:

Section A- Demographic Information which covers the personal characteristics of Mauritian banks.

Section B- Introduction to Banking risk Management which provides a general overview of Risk Management practices and its importance.

Section C-Analysis of Banking Risk Management practices which addresses issues related to the practical application of Risk Management in banks.

Section D- Other banking risk management issues which consider the other tools for Risk management.

The questionnaire comprises of 22 questions which were in both open-ended and closed questions such as Likert scale and rating scale. The questionnaire was designed to meet the objectives determined earlier.

4.5 DATA COLLECTION

Data collection which is a fundamental phase was done by online survey questionnaire.

4.6 ANALYSIS AND INTERPRETATION OF DATA

The data processing was done using SPSS 17.0 and presentation and analysis of findings using Microsoft Excel 2003.

4.7 PRESENTATION OF SUMMARY FINDINGS

Finally, the findings were presented followed by observations and suggestions.

4.8 LIMITATIONS OF THE SURVEY

• Some respondents refused to answer the questionnaire as it requires the disclosure of strict confidential information.
• One respondent was able to answer the questionnaire because of time constraints.
• A few respondents took too much time to fill in the questionnaire where a daily follow-up was made by telephone which was very costly.
• A few respondents have omitted some questions because their answers were too confidential and these issues were not applicable to their banks.

This chapter will display findings from the survey of analysis of Risk Management in Mauritian banks.

13 out of 18 banks participated in this survey, giving an overall response rate of 72.2 %.

Question 1

92.3 % of respondents come from the private sector and 7.7 % from the public owned sector indicating no such stringent and higher government control in Mauritius.

Question 2

It can be observed (Table 5.1) that the majority of banks (53.8%) possess banking assets greater than 50 MUR billion. This implies they take more deposits from both foreigners and locals and give advances in terms of short term and long terms loans to companies for financing purposes. The rest (46.2%) have less than 30 MUR billion which implies that perhaps either they have recently established in banking industry.

Question 3

61.5 % come from large banks serving the domestic and foreign markets that are beneficial for both the foreigners and Mauritian population and enrich the structure of the entire financial system. Others (7.7%) are those that belong to the small medium sized banks serving the foreign and domestic markets.

Question 4

It can be noted that 92.3% (Table 5.2) provide services in terms of Foreign Exchange, Remittances and Trade Finance that are advantageous to Mauritian population and foreign clients.

Question 5

46.2% (Figure 5.3) have chosen the definition of Goldman et al (1998) as this is a complete and clear definition of risk management which is implemented on a systematic basis. The rest have diverse perspectives about banking risk management. Table 5.3 also shows the same information.

Question 6

61.5% are agreeable about the presence of an efficient risk identification, risk assessment & evaluation, risk monitoring & controlling and risk management system. This proves that risks are inherent in all Mauritian banks and a complete risk management framework with appropriate adherence is obviously necessitated. It can be observed (Table 5.4) that on average the need to implement risk management shows that risks can bring many adverse consequences in the entire financial system if not managed the earliest possible.

Question 7

53.8% (Table 5.5) agree that the implementation of a formal risk management is necessary to promote a resilient banking industry without which the structure of the financial system and the banking mechanisms would appear simplified (Table 5.6).

Question 8

38.5 % and 30.8 % (Figure 5.5) believe that loss avoidance and compliance with regulations are two significant ways by which banks give relevance to Risk Management systems. 7.7% are others who stated that a Risk Management framework and internal audit regulations are needed in their banks. Table 5.7 shows on average that loss avoidance holds more value.

Question 9

61.5% (Table 5.8) indicate that operational risk is of utmost importance according to the survey. Liquidity risk, strategic risk and market risk are secondary risks in Mauritian banks. 23.1% specify reputational risks as being very important and 7.7% mentioned compliance risk as being important.

Question 10

46.2% agree that Risk elimination reduces risks while 69.2% feel that Risk Transfer is an important component for Risk Reduction. On the other hand, risk avoidance is favored by 30.8%. 61.5% believe that active risk management can mitigate risks. It can be deduced that these 4 important steps are practiced simultaneously but on a stepwise basis for effective risk reduction.

Question 11

69.2% (Table 5.13) agree that risks are managed due to the market volatility while 53.8% feel the same owing to complex calculation of derivatives prices at low cost and quickly. Besides, 38.5% argue that a favorable regulatory environment is a causative factor behind risk management. 53.8% stipulate that there is a need to generate an income fee through off balance sheet transactions whereas 53.8% accept the regulatory pressure for conducting risk management systems. It can be said that most banks definitely agree that these are concrete reasons for Risk Management that stimulate avenues of new developments in Risk Management techniques after identifying the sources and nature of banking risks.

Question 12

38.5% (Figure 5.7) engage in risk taking on a low basis, which implies that they adopt a precautious move about the risk taking activities, and are aware of their adverse consequences. Furthermore, degree of risk taking also depends on the size and structure of the banks. 23.1% engage in excessive risk taking in either trading decisions or new product development in order to benefit from the favorable profit -based rewards within their existing organizational culture. Table 5.14 shows that on average that risks are taken on a low basis by most banks.

Question 13

45.5% (Figure 5.8) of respondents strongly agree that Risk Function hold huge influence in banks but for those who disagree indicate that risk management function is underestimated in their banks.

In addition, 45.5% also feel moderately that Risk Management is too often stigmatized as a support function indicating that there is a long way ahead for banks to go where risk has to shed down its traditional image as a support function but for those who disagree depicts that risk management plays the role of a modern tool (Figure 5.8). There is an equal mixture of disagreement and agreement (25%) about Risk Management perceived as a source of competitive advantage.

From Table 5.15 and table 5.16, most banks consider risk management as having a great influence and stigmatized as a support function.

Table 5.17 shows a higher preference allocated to the idea of Risk Management viewed as a source of competitive advantage that enables banks to increase their degree of importance and their attention towards risk management.

Question 14

46.2% agree (Table 5.18) about the common understanding about risk management in banks that is a crucial aspect prior risk management. Moreover, there is a moderate agreement from 46.2% about the delegation of tasks well defined for risk management to facilitate the tasks of risk professionals across the business segments. 53.8 % strongly agree that Risk Management brings success and good performance thereby enabling the Mauritian banking industry to attain new heights. 38.5% are neutral regarding the adoption of advanced risk management techniques, which remains either an issue of uncertainty, or showing that Mauritian banking industry has a long way to go further. Besides, 46.2% strongly agree that there is continuous review and evaluation of the Risk Management strategies. This depicts that Risk Management tactics are updated regular to be flexible enough to deal with diverse risks. 46.2% strongly believe that Risk Management techniques reduce costs as well as potential losses in banks implying risks are managed in a cost-effective manner.

Question 15

53.8% (Table 5.19) feel that their banks analyze risks while meeting targeted objectives for effective and compliant Risk Management. 38.5% strongly agree that it is difficult to give importance to major risks perhaps due to the nature of these risks that can incur high costs for designing effective techniques to manage them. 46.2% agree that risks changes are identified and embedded within banks' responsibilities that enable them to track the positions of the risks and devise suitable strategies to deal with these detected positions. 46.2% state that they are aware of the strengths and weaknesses of the risk infrastructure of other banks they work with which motivate them to share their risk management expertise among themselves and collaborate together to promote sound banking stability. Furthermore, 46.2% strongly agree that their banks develop and use procedures for identification of risk opportunities that enable them to adopt a cautious move towards risk taking activities.

Question 16

46.2% (Table 5.20) agree that they appraise the likelihood of the occurrence of risks which help them to take necessary precautious to advert adverse consequences of these risks. 38.5% agree that their risks are assessed by quantitative methods and 53.8% by qualitative modes showing heavy reliance on qualitative models to make accurate predictions regarding risks. 46.2% agree that their responses to analyzed risks encompass an assessment of the effectiveness of the risk controls and risk management strategies, costs and benefit when dealing with risks, prioritizing risks and choosing those that need active management and eventually action plans for deciding about identified risks. This suggests that these banks adopt a stepwise outlook for Risk assessment in order to reap from advantageous risk management.

Question 17

53.8% (Table 5.21) strongly agree that checking the effectiveness of Risk Management is necessary for continuous reporting which enable the risk managers to make better-informed decisions. 46.2% are in favor about the level of bank control convenient for the banking risks encountered. This facilitates the tasks of risk management while simultaneous employing a precautious move. 46.2% strongly agree about the fact that better reporting and communication methods advocating effective risk management without which risk management would be done in a reckless manner with lack of decision making to meet changing conditions.

Question 18

50% (Table 5.22) agree that there is a continuous review of the risk management performance implemented by the executive management implying that strengths and weaknesses of risk management are considered and changes are done. 50% agree that they have better review of risk management techniques and performance perhaps due to financial innovations of Information Technology to address the weaknesses of risk management. 50% agree that the banks that conduct of risk management steps matches the bank's objective to avert cases of non-compliance with banking policies, rules and regulations. 50% strongly feel that the bank's risk management procedures are documented and guide bank staff about managing risks thereby increasing the risk expertise to enrich a strong risk governance and culture. 41.7% strongly believe that their banks' policy offers training sessions in the field of risk management that is advantageous for the staff to benefit from risk experience and uphold a resolution to combat future banking risks. 41.7% agree their banks recruit highly qualified people in risk management that facilitates effective risk management and these people are compensated depending on their risk expertise level. 41.7% agree that the bank takes sufficient actions to improve risk management practices which symbolizes that Mauritian banking industry are enough active and willing to update Risk management to meet flexible conditions. 50% are in favor of the adoption of Enterprise Wide Risk Management rather than using organizational silos to reduce risks. 58.3% strongly agree that their banks comply with the banking rules and regulations while managing risks indicating that they are conscious of the adverse consequences of breaching them and simultaneously meet targeted banking objectives. 50% admit efficient risk management is among their banks' objectives, which demonstrate that Risk Management contributes to resilient, banking stability.

Question 19

Half of the respondents (Figure 5.9) agree that Risk Management enables maximization of profits where an investment return is achieved. 58.3% (Figure 5.10) strongly believes that a value added function is derived thereby increasing the bank's image and ensuring that the stakeholders' interests are preserved. 66.7% (Figure 5.11) strongly feel that Risk Management brings sound banking stability as indicated in previous literature. There is higher and moderate agreement of 50% (Figure 5.12) for higher efficiency gained thereby reducing costs incurred in risk management. Besides, 50% (Figure 5.13) strongly feel that Risk Management enhances overall banking performance thus improving profitability of the bank. Furthermore, risk management has considerable positive impact on the Mauritian banking industry.

Table 5.23-5.27 show that there is an almost profound acknowledgement on average that risk management maximizes profit, adds value to the business, promotes overall banking stability, leads to higher efficiency and improves banking performance in Mauritian banking industry indicating that the risk management is a core function in banks and owing to its diversity of positive effects, it can ensure the sound growth of Mauritian banking industry.

Question 20

50% (Figure 5.14) specify that they depend moderately and 30% extremely reliant on Basic Indicator Approach and 72.7% depend on Standardized Approach. Moreover, 54.5% agree that they use Internal Rating Based models while the 30% rely and 40% do not use Advanced Measurement Methods which is a far fetched issue for these banks for cost that are incurred while using them within their risk management framework taking into consideration size aspects and lower infrastructure. Higher regulatory pressure had encouraged changes in Mauritian banks to comply particularly with Basic Indicator, Standardized Approaches and Internal Rating Based models.

55.6% (Figure 5.15) rely on options, 44.4% on futures, 66.7% on forwards and 75% on swaps. A few banks do not rely on these derivatives because of their size and structure of these banks and indicate they are slow to address the additional and important requirements for risk management purposes. The derivatives are perhaps expensive to manage risks. Bank of Mauritius is planning to construct or is constructing a derivatives market for furthering trade.

58.3% (Figure 5.16) admit that they rely on scenario analysis while 66.7% on sensitivity test analysis indicating the importance of stress testing practices to measure and manage risks. This greater interest on measurement as a precaution move have maybe pressurized on certain level of stress testing as minimum requirements in order to preserve capitalization and capital allocation volumes.

54.5% acknowledge moderately that Asset and Liability Management framework also reduce banking risks (Figure 5.17). 58.3% specify that capital stock is needed to bulwark against potential risks (Figure 5.18).

Table 5.28-5.31 shows that on average, most banks comply with the use of Basic Indicator Approach, Standardized Approach, Internal Rating Based models and Advanced Measurement Methods for Basel II framework following BOM guidelines.

Tables 5.32-5.35 demonstrate that on average, most banks use options, futures, forwards and swaps demonstrating the willingness to manage risks effectively.

Table 5.36-5.37 shows that the use of scenario analysis and sensitivity analysis are highlighted by most Mauritian banks demonstrating that stress testing framework is an oldest method used by banks.

Table 5.38 depicts that all the 13 banks rely on Asset and Liability Management, which enable effective risk management and which is also a long dated form of risk management.

Question 21

63.6% (Figure 5.19) feel that these tools have contributed highly to reduce risks which promote a sound banking stability and further positive developments in the realm of risk management. Table 5.40 shows that there is an acceptance on average that risk management becomes higher and effective through the application of these tools.

Question 22

Table 5.41 illustrates that 50% strongly feel that risk management practices can be innovated if there is better internal skills and expertise indicating that they have been rather quick to address shortage of risk professionals. 58.3% strongly agree that better communication between the risk function and business is a contributive factor behind improvement in risk management practices implying better info dissemination. Greater level of risk expertise at the top of the organization is approved moderately by 58.3% while 58.3% agree that strong organization risk culture, greater level of talent between business lines and risk function and more strategic role for risk function contribute to enhance Risk Management techniques. Better industry training to develop expertise in Risk Management is strongly accepted by 50%. Mauritian banks appear to be more confident and prepared to face challenges regarding improvement in risk management practices by addressing quickly the weaknesses embedded in risk management through effective decision making. They attempt to put in more policies, procedures and controls to make staff more aware of the risks prevailing and plans to tackle them efficiently. It can be noted that better technology, efficient use of resources, better information transmission, and specialized skills and people favor improvement in Risk Management.

Chi square hypothesis testing

H0: There is no association between the banking category and the variables found in Appendix 4- Table 5.42-5.46)

H1: There is an association between them.

The association between the two variables was tested using the chi square test at 5 % significance level but the p-values were higher than 0.05 implying that there is no association between the banking category and the variables and H0 is accepted.

Hypothesis testing (Test for Normality)

H0: Banking Assets Range follows a normal distribution

H1: Banking Assets Range does not follow a normal distribution

Using One Sample Kolmogorov-Smirnov test (See Appendix 5-Table 5.47) at 5 % significance level, it was found that the p-value exceeds 0.05 implying H0 is accepted where the banking assets range is normally distributed.

Correlation coefficient testing

H0: Correlation value between the variables found in Appendix 6-Figure 5.50-5.51 is equal to 0

H1: Correlation value between the variables is not equal to 0

The type of correlation coefficient test between the two variables found in Appendix 6 -Table 5.50-5.51 has been specified in Appendix 5-Table 5.49 depending on the test of normality (See Appendix 5- Figure 5.48). In Table 5.50, the correlation coefficient value between Q6 and Q7 is 0 and p-value is 0.05. H1 is rejected in favor of H0 at 5% significance level and it is concluded that there is no relation between Q6 and Q7 and is statistically insignificant.

In Table 5.51, the correlation coefficient between Q7 and Q12 is -0.573, which is not equal to 0, and the p-value is 0.020 less than 0.05. H0 is rejected in favor of H1 at 5% significance level where the test is statistically significant. There is a correlation between Q7 and Q12.      

5.1 SUMMARY OF FINDINGS

The majority of banks are private sector ones and are large banks serving the domestic and foreign markets. Services like foreign exchange, remittances and trade finance are offered by 92.3%. Different banks have different opinions about Banking Risk Management. Most banks (61.5%) have been positive about understanding risk and risk management, adopting an efficient risk identification, risk assessment and evaluation, risk monitoring and risk management system. Loss avoidance and regulations are two aspects by which most banks show the importance of Risk Management systems. Operational Risk is the most predominant risk in Mauritian banking industry according to the survey. Risk elimination, risk transfer, risk avoidance and active risk management reduce risks.

There is a moderate agreement that the reasons for managing are market volatility, complex calculation of derivatives prices, favorable regulatory environment, and generation of an income fee and the regulators' drive for implementing risk management system. A precautionary step is employed by 38.5% of respondents in risk taking. 45.5% agree that Risk Function holds greater impact in banks and is often stigmatized as a support function.

There is an acknowledgement that the effects of Risk Management are maximization of profits, value added function to banks, promotion of overall banking stability, leading to higher efficiency and improving overall banking stability. The majority of banks use Basic Indicator Approach, Internal Rating Based models and Standardised Approach. Very few banks use Advanced Measurement Methods. Derivatives like options, futures, forwards and swaps are used moderately by most banks. Few banks do not use derivatives for multiple reasons. Most banks use scenario analysis, sensitivity test analysis, asset and liability management and eventually capital reserves to make accurate predictions of risks and buffer risks. Furthermore, these tools have reduced risks on a rather high basis. Better in-house expertise, communication between the risk unit and business, higher level of risk knowledge at the top of the organization, good management support, a strong risk culture, higher talent between business lines and risk unit, more strategic role for Risk unit and higher training sessions in risk management contribute towards enhancing risk management practices in Mauritian banking industry. Moreover, the need to implement a formal bank risk management depends on the degree of risk taking incentives.

This part will consider how risk management can be improved further in Mauritian banks.

Mauritian banks have to continuously upgrade their risk management skills by offering training sessions to existing staff at senior levels including the Executive and non-executive directors where they are awarded with a certificate from qualified organizations to revise existing use of Risk Management and invest in risk professionals to deal with sophisticated risk management systems (Lam 2007a, p.12). International industry benchmarking exercises can be organized where different risk professionals share and learn from each other's best risk management practices (Lam 2007b, p.12). A compensation committee can be set up to retain qualified risk specialists like a Chief Risk Officer, a Board member or a senior executive with responsibilities clearly defined (Lam 2007c, p.12) with higher incentives based on "risk performance and matched with stakeholders' interests to ensure long term profitability" as argued in a special Committee on Market Best Practices (2008 cited KPMG 2009b, p.11). Bonuses payment should be based on risk adjusted rewards.

Stress testing framework should be updated and strengthened. A perfect Management Information system should be created to monitor risk performance efficiently. A framework must be installed where banks are penalized for excessive level of risks. Besides, Early Warning systems can be established to predict occurrences of risks in banks. Risk based performance indicators must be developed to help Board and Senior Management expect changes in Risk-return trade-off (Lam 2007d, p.15). A market can be created where participants can manage risks prudently and react wisely to diverse financial turbulences. Banking regulations can be enhanced to foster discipline in banks. New tools can be designed to manage risks and which provide indicators of banking performance. The existence of deposit insurance can reduce bankruptcy cases. Furthermore, sound fiscal and monetary policies and mechanisms can reduce banking risks. Bank supervision should assign more resources to banks that pose the greatest vulnerabilities.

There should be better board and senior management oversight where risk management techniques and models are reviewed and updated. Board and Management should study and understand current risks, risk management and interrelationship between risks and evaluate risk management costs against reward obtained. Better reporting of data infrastructure should be set up. Board and management should inculcate a strong risk culture and governance where the levels of disclosure and transparency codes regarding risk management are observed. This risk culture with the involvement of bank staff and senior management will enable proper communication between risk management team, regulatory bodies as well as different business lines like the Board, Audit Committee and Internal Audit to track risks, disseminate information about risks and design Risk Management plans, procedures and policies.

Banks need good judgments, analytic views and understanding about the interconnection of diverse market mechanisms to reduce risks effectively. Better internal controls and risk controls systems are necessitated. A prudential supervision approach is needed for evaluation of risks. Risk responsibilities should extend from Risk Function to the Board and Risk Committees where appropriate. Quantitative and Qualitative risk information should be transmitted to the Board and Senior Management and then to decision makers in a clear simplified format for further analysis (KPMG 2009c, p.10) through the application of a dashboard reporting (Lam 2007e, p.15). Other risk management information should be integrated into annual reports and reporting files.

A strong information circulatory system should be established and revised to ensure increasing awareness of other business unit tasks (KPMG 2009d, p.18). Banks should get information from diverse sources to provide a clear illustration of changing nature of risks. Bank staff should define and manage risk profile and appetite of the bank.

Economic capital should also be used with executive compensations where rewards are founded on the economic value of the institution (KPMG 2009e, p.29). Basel II should be strengthened to make banks resilient in face of financial turbulences by adopting a better approach to measure and manage risks. Bank of Mauritius should encourage necessarily all banks to adopt advanced approaches of Basel II and assign supervisors to supervise these banks. Compliance systems should be strengthened by management and staff.

An Enterprise wide risk management plan should be employed and reviewed annually by all Mauritian bank stipulating the ERM policies, systems and processes to identify loopholes in ERM and allocate resources to remedy them. Cost and benefit analysis for ERM needs to be implemented where the actual benefits are compared with the expected ones (Lam 2007f, p.16). Performance measurement needs to be reviewed and ensured staff is supported with information performance and financial rewards for attaining ERM objectives. Supervisors should check the banks that use advanced risk management techniques and instruct banks to adopt corporate governance principles in banks.

Bheenick (2009, p.1-2) stated that the emergence of the First Pan Derivatives Exchange can catalyze the financial development in Mauritius. Market participants can become part of GBOT if the foreign exchange market with hedging infrastructures ensures management of currency volatilities to eliminate arbitrage opportunities. Moreover, Mauritian banks can create derivative market and move towards the forward foreign exchange activities. Banks can supply derivatives products in Mauritius and increase the demand for them by innovating them to satisfy customer requirements. Financial markets can enjoy the expertise that come with the creation of derivatives markets and the introduction of international trade in Mauritius. Training of the bank treasurers about derivatives transactions is needed. BOM will have to track the activities of derivatives market and should assess its size and features.

The 3 lines of defense should be used to check if risks levels are approved within the bank's policies and risk profile for better function of risk management (KPMG 2008a, p.3).

• The first line of defense is concerned with the regular functions of risk management with appropriate processes and plans designed for risk controls.
• The responsibilities of the second line of defense lies in the hands of Finance, Treasury, Health and Safety, HR and IT segments and provide assistance and support in fields of risks where policies and procedures are prioritized.
• The third line of defense constitute the external and internal audit assuring that the systems of the 2 first lines of defense are functioning effectively as anticipated.

Banks must follow all these steps to meet the diversity of risk management requirements of the present and future.

Improved risk management framework encompasses:

Improved decision making, Risk based performance measurement, Greater confidence from compliance activities, Provides clarity on key organizational risks, revised organizational structure, Improved internal risk management policies, procedures and methodologies etc., Increased accountability (KPMG 2008b, p.3).

"Risk has always been present in banking and is the raison-d'être of the financial services sector" (Moody's 2003, p.1). Financial Intermediation is engaged in the business of giving deposits to corporations by keeping equilibrium between risk taking and risk management. Deregulation, volatility of financial markets, local and foreign competition, globalization, complexity of investment strategies, increase in supply of loanable funds, uncertainties in the banking transactions and nature of risks and dynamism pressurize bankers to resort to bad risk taking practices.

"Risk Management is the integral part of corporate governance framework, involving identification, assessment, communication and management of risk in a cost-effective manner" (KPMG 2008c, p.3). Three pillars of risk management are risk governance, strong risk culture; risk reporting and measurement. Stakeholders desire transparency around the bank's risk management policies and anticipate that Board of Directors ensures that their interests are secured (KPMG 2009f, p.5). Banks have in the past made huge efforts to measure and manage risks. Nevertheless, recent markets incidents have detected that a number of banks have not yet maintained satisfactory records of Risk Management practices. Bank supervisors and risk managers have learned from the past bitter experiences to actively manage, control and monitor risks. Banks cannot work effectively without sound risk management practices to meet modern regulatory and business requirements. Improvement in Risk Management depends upon the size, degree of sophistication and risk profile of banks. Risk Management needs to be strengthened to generate economic growth and stability of financial markets which becomes the highest priority. Innovations in Information technology and financial markets have encouraged the development and implementation of advanced risk management practices which seem rather challenging. Banks will take time to catch up with international standards of Risk Management.

In Mauritius, there is an increasing willingness for all banks to implement and improve Risk Management practices methodically. However, there is an acknowledgement that advanced measurement methods from Basel II and derivatives are not yet employed by few banks which indicate that the Mauritian banking industry has a long way ahead to go. There are diverse reasons that prompted risk management practices which have divergent effects in Mauritian banking industry. It is rather challenging for Mauritian banks to adopt advanced methods of Risk Management where they have to strive a lot to meet the additional requirements of Risk Management.

Mauritian banks should continue to endeavor towards implementing effective risk management practices to benefit from their positive aspects. Risk Management should be treated of a lesser compliance burden but more of a value added function (Lam, 2007). Risks must be taken wisely considering its potential implications. Mauritian banks have to focus on Risk Management fundamentals and by proving genuinely to the world that they understand the risks, they can demonstrate that they operate prudently. If this is done, confidence in the banking sector can be restored and the health of the financial system remains sound.

To conclude generally:

A resilient banking system is central to sound financial markets and growth. Supervisors cannot predict the next crisis but they can carry forward the lessons from recent events to promote a more resilient banking system that can weather shocks, whatever the source. The key building blocks to core bank resiliency are strong capital cushions, robust liquidity buffers, strong risk management and supervision, and better market discipline through transparency (Nout Wellink, Chairman of the BCBS and President of the Netherlands Bank, 2008, p.1).

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