Best practice risk management for RI banks<\/p>\n
Anthony Brent Elam, Managing Director, Bank Central Asia, Jakarta<\/p>\n
Since the Asian Economic Crisis in 1997, the banking industry
\nin Indonesia has undergone tremendous changes. The government has
\nplayed a significant role in prompting these changes and in
\nrestructuring the banking industry by firstly, undertaking a
\nmassive recapitalization program; secondly, restructuring and
\nrehabilitating the banks; and finally, undertaking privatization
\nof the rehabilitated banks.<\/p>\n
Indonesian banks today, while having their loan portfolios
\nlargely \"cleaned up\" (thanks to the government recapitalization
\nprogram) still face tremendous challenges. In Indonesia, the
\nbanking system's loan to deposit ratio is low at about 38 percent
\nloans to deposits (loan to deposit ratio measures the amount of
\noutstanding loans granted by the bank compared to the amount of
\nthird party funds received).<\/p>\n
A large proportion of Indonesian banks' revenues today depend
\non the recapitalization bonds which make up an average of about
\n45 percent of total banking assets as at December 2002. With
\ncurrent central bank's one-month SBI promissory notes interest
\nrates declining to below 9 percent from an average of 13 percent
\nin 2002, banks have to adjust to a new environment.<\/p>\n
To overcome this challenge, banks have to start rebuilding
\ntheir loan portfolios and decrease their reliance on
\nrecapitalization bonds. This leads to a new challenge; in
\nincreasing and rebuilding their lending businesses, banks must
\nensure that they have proper risk management frameworks in place
\nto minimize the risk of a crisis similar to 1997 happening in the
\nfuture.<\/p>\n
Based on international best practice, a bank's risk management
\nframework should cover the following key risk areas: Credit Risk,
\nMarket Risk and Operational Risk. Credit Risk measures the
\npossibility that a borrower will default, by failing to repay its
\nloan in a timely manner.<\/p>\n
Market Risk measures the risk that the bank faces on the value
\nof its investments due to economic changes or other events that
\nimpact the market (e.g. interest rate risk and foreign exchange
\nrisk).<\/p>\n
Operational Risk measures the risk associated with the
\npotential for system failures in the bank or from external
\nfactors, like human errors.<\/p>\n
In Credit Risk Management, the two key fundamental principles
\nthat banks put in place are the independence of credit decision
\nmaking from marketing and customer credit risk ratings.
\nTraditionally, banks in Indonesia are organized by business units
\nwith each unit responsible for both the marketing as well as
\ncredit approving functions.<\/p>\n
This traditional setup can lead to conflicts of interest in
\nthe loan decision process. In a booming economic cycle, these
\nrisks usually go unnoticed as even highly risky ventures succeed
\nbut in an economic downturn, these risky ventures are the first
\nones to default.<\/p>\n
To prevent potential conflicts of interest, it is necessary to
\nsegregate the loan approving function from the marketing
\nfunction. Many international banks have a chief risk officer
\n(CRO) sitting on the board of directors and responsible for the
\ncredit risk management function thereby ensuring the independence
\nof loan approving functions from marketing.<\/p>\n
Another key principle is credit risk rating. Currently, most
\nIndonesian banks use Bank Indonesia's (BI) rating scale which is
\nmainly focused on categorizing non-performing loans. The BI
\nrating system has 5 grades comprising 1 grade for
\nperforming\/current loans and 4 grades for non-current loans. A
\nrisk rating system allows banks to separate within the performing
\nloans the low risk customers from the middle risk and high risk
\ncustomers.<\/p>\n
International banks have long been using credit risk rating
\nsystems in helping them assess credit risks as well as making
\ncredit decisions. These ratings are much like the risk ratings
\ncarried out by independent rating agencies such as Standard &
\nPoor's and Moody's.<\/p>\n
Credit risk rating systems enable banks to measure the risk
\nassociated with making a loan to the borrower.<\/p>\n
Secondly, the rating systems provide a standardized framework
\nfor measuring credit risk and thereby ensuring consistent credit
\nquality.<\/p>\n
Thirdly, the credit risk rating system allows the bank to
\nmanage the risk profile of its loan portfolio according to its
\nrisk appetite.<\/p>\n
Finally, a credit risk rating system enables the bank to
\ndetermine the appropriate interest rate to charge its customer
\nthus ensuring an adequate return for the risk the bank is
\nundertaking.<\/p>\n
Whilst the biggest area of risk faced by banks today is credit
\nrisk and much attention has been given to this topic, the other
\ntwo risk areas of Market and Operational Risk are increasingly
\nbecoming a significant area where banks should ensure proper risk
\nmanagement systems are in place.<\/p>\n
In Market Risk, the fundamental principle of having a market
\nrisk unit independent from the business unit (or traders)
\nprevails. In recent years, a number of big international banks
\nhave declared valuation losses on their trading portfolios and
\ninvestment holdings simply because the traders performed the
\nmarket valuations themselves and could hide losses.<\/p>\n
Proper procedures and systems to accurately identify and
\nmeasure market risk are becoming increasingly important for
\nIndonesian banks to manage their existing trading portfolio and
\nto more fully participate in the increasing sophisticated markets
\nof the future.<\/p>\n
With the reduction in supply of the recapitalization bonds and
\nthe continued decline in interest rates on the SBIs and other
\ngovernment bonds, banks are increasingly seeing their margins
\ndecline.<\/p>\n
With Bali and the Marriot Hotel bombings highlighting the
\ncontinued uncertainty and volatility of the market, coupled with
\nthe need of the banks for alternative higher yielding
\ninvestments, there is a need for Indonesian banks to enhance
\ntheir market risk capabilities.<\/p>\n
Implementing best practice market risk tools and
\ninfrastructure will enable the banks to measure their market risk
\nprofile and compare it to their over-all asset profile.<\/p>\n
Operational Risk is fairly new thing for international banks
\nglobally. The area of operational risk is also fairly wide and
\nsometimes loosely defined to encompass \"any risk which is non-
\ncredit and non-market risk related\".<\/p>\n
Examples of operational risks range from computer system
\nfailures to human errors and abuses such as fraud (one of the
\nmost infamous being the Barings downfall) and
\nexternal\/environmental disasters such as earthquakes.<\/p>\n
In order to manage operational risks, the first step a bank
\nshould undertake is to have an independent risk management unit
\nset up to monitor such risk. The second step needed is to put in
\nplace systems which are able to comprehensively capture, track
\nand monitor the various operational risks which a bank faces in a
\ngiven day.<\/p>\n
The consequence of putting such systems in place is the
\ninvestment costs particularly for the smaller banks where there
\nare no economies of scale to be garnered from such expenditures.<\/p>\n
The road ahead for Indonesian banks remain challenging. The
\nsuccessful restructuring of Indonesia's banking system and on-
\ngoing privatization programs will play a critical role in the
\nrecovery and continued growth of Indonesia's economy as well as
\nrestoring investor confidence in Indonesia.<\/p>\n
An important element to supporting the economic recovery is
\nthe development of sound risk management practices and procedures
\nin the Indonesian banking system and as the first step in a
\ncomprehensive financial safety net for the banking system.<\/p>",
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