Risk Management and Financial Performance in the Bank of China Finance Essay

Bank of China (Hong Kong) Limited (BOCHK) is the second-largestA commercial banking groupsA inA Hong Kong with more than 300 branches. In spite of its magnitude and systematic risk management, 2008 has witnessed a decline in operational income and a negative shock to BOCHK. In this report, I will first investigate the overall risk management of BOCHK followed with its measurement and management of credit risk, and finally compare the 2008 financial performance with previous year by utilizing ROE framework.

I. Overall Risk Management

"Principles for the Management and Supervision of Interest Rate Risk" published by Bank for International Settlements (2004), in 2004 provides not only a guideline on how to conduct interest rate risk management, but also principles that can be applied to manage the overall risk of a financial institution. This part will evaluate to what extent BOCHK meets this international standard. According to the report, the BOCHK's risk management governance structure is designed to cover the whole process of all businesses and embrace a swift and prudent manner to manage various risk exposures, which basically conforms to the requirements stipulated by BIS. The report shows that first, to align management strategies with the corporate interests, Chief Risk Officer (CRO) reports directly to Risk Committee as well as to Chief Executive (CE), whose responsibility is to ensure the proper implementation of the policies and procedures and oversee the effectiveness of managing and controlling risk. The regular basis reports guarantee a timely assessment of the effectiveness of risk control strategies, for which the Board of Directors has the ultimate responsibility to determine. In addition, the independent operation between business units and risk management units complies with the principle of segregation of duties since the independence is sufficient and necessary for risk management (Khambata &, Dara 2006). In accordance with BIS's requirement, however, risk control function (CRO) should report directly to the Board of Directors. Otherwise, some potential risk that CRO and CE may conspire to fake the risk management report would threaten the fairness of the risk management system. Secondly, BOCHK's principal banking subsidiaries Nanyang and Chiyu, executes their risk management strategy independently and share the consistent risk management policies with those of the Group, report to BOCHK's management on a regular basis. Thirdly as found in the 2004 report, BOCHK's stress testing is a risk management tool for estimating risk exposures under stressed conditions that arise from extreme but plausible macroeconomic movements. Fourthly, its information systems are well established to provide timely reports within different levels of management, while CRO stipulates specific procedures concerning the promotion of new products and activities. BOCHK also prudently enacts and administers operating limits so that risk exposures are consistent with internal policies. However, the mere existence of risk management mechanisms does not guarantee sufficiency or effectiveness. Enforcement of risk control policies should be applied to ensure an efficient risk management system.

II. Measurement and Management of Credit Risk

According to the note 4 of the BOCHK financial statement in 2008, BOCHK manages two broad classes of assets: loans and advances and debt securities and derivatives. The overall assets' exposure to credit risk in 2008 is HK$1,364,462 million, which includes HK$1,111,073m on-balance-sheet exposures and HK$253,389m off-balance-sheet exposures. To safeguard corporate interest, BOCHK should manage credit risk related to these assets in a prudent manner, especially during a financial crisis. This part of the report will investigate how BOCHK measures and manages credit risk of these assets. To minimize the credit risk, the 2008 report shows that BOCHK adopts credit approval policies and procedures that are reviewed and updated by the risk management department and other relevant departments. Regarding loans and advances, BOCHK not only adopts different credit control procedures and credit grading systems according to the level of risk associated with customers, but also utilizes bank scorecard for financial institutions, credit scoring system for retail credit transactions, and small business credit scorecard for small firms. BOCHK identifies credit concentration risk by industry, geography, customer and counterparty risk. For instance, 'classified or impaired' advances are HK$1,792m in Hong Kong, HK$323m in Mainland China, and HK$23m in elsewhere. Besides, loans and advances are classified into five categories to improve the ability to identify and assess credit risk: "pass", "special mention", "substandard", "doubtable" and "loss". For example, the total assets marked as 'substandard or below', the high risk category, account for 0.08% (HK$379m). As for debt securities and securitized assets, the 2008 report indicates that BOCHK adopts the external credit rating systems, such as Moody's, to manage the credit risk. Moody's ratings in 2008 showed that 19.34% of BOCHK's debt securities rated as 'Aaa' compared with 2.36% 'lower than A3' debt securities. Particularly, BOCHK applied a comprehensive methodology in determining whether a particular asset/mortgage backed security (ABS/MBS) is impaired is determined by such factors as the mark-to-market price, external rating, and delinquencies. Except these factors, ABS/MBS has to further pass the required credit enhancement coverage ratio set by BOCHK. To manage credit risk in a dynamic market environment, policies, procedures and appropriate credit risk limits have been established. The corporate organization structure defines a clear line of authority and responsibility for supervising compliance with relevant rules (Khambata &, Dara 2006). For instance, the Credit Risk Assessment Committee takes charge of assessing independently all credit scoring facilities and reviewing reports submitted by risk management units. In addition, Khambata &, Dara (2006) argues that collateral is another key element to manage credit risk. The value of collateral for a new loan is determined by an independent appraiser at the time of loan origination. Collateralized loans are subject to loan-to-value ratio limits. Collaterals are also revalued and managed periodically by BOCHK. BOCHK documents acceptance criteria, validity of collateral and revaluation of collateral on a regular basis to monitor the status of collateral.

III. Financial Performance Comparison

According to the 2008 reports, BOCHK's ROA and ROE were 0.26% and 3.56% in 2008, versus 1.48% and 16.64% respectively for 2007. BOCHK's Profit Margin also decreased to 5.97% in comparison with 24.24% in 2007. These substantial statistical decreases were caused mainly by the increase in impairment charges on the US non-agency residential mortgage-backed securities and other securities investment. Furthermore, significant increment in Provision for loan losses/Total operating income (2.22% to 24.95%) and dramatic decline in investment-related commission income both produced a negative impact on the profit in 2008. Increments in provision for loan losses were directly caused by the sluggish investment environment brought by the global financial crisis. As customers mostly steered clear of investment products, the investment and insurance fee income decreased by 34.3% to HK$2,964 million. Note 12 shows that net charge of impairment allowances increased from HK$1,448 in 2007 to HK$ 12, 573 in 2008. Despite of a bleak financial environment, the ineffective credit risk management was still to blame for the sudden increase in loan impairment losses. From the perspective of overall risk management, it can be suggested that BOCHK should conduct a more strict stress testing and scenario analysis to predict the sensitivity of risk factors with various degrees of severity.

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