Risk management at banks

Risk management at banks

Bank Indonesia, the central bank, is moving forcefully to
improve risk management at banks as part of a more concerted
effort to improve the effectiveness of its banking supervision
and prevention of banking fraud.

The central bank's director of bank supervision Aris Anwari
warned last Wednesday, one day before the central bank decided to
close down two insolvent banks, that banks that failed to
implement an effective risk management system within nine months
would be restricted from expanding operations and be liable to
heavy fines.

The directive means that all commercial banks should submit to
Bank Indonesia their respective action plans on risk management
and implement them by next January at the latest. As of now only
28 of the 138 commercial banks have submitted such action plans
to Bank Indonesia, which imposed the requirement almost a year
ago.

Effective risk management is indeed vital for banks because
banking inherently entails the taking of a wide range of risks.
On the other hand, the central bank, as supervisor of the banking
industry, needs to understand these risks and, in order to be
able to carry out effective supervision, should be well-apprised
of the decision-making structure, business, operations and risk
management at all banks.

Only well-informed bank supervisors will be capable of
assessing, from time to time, the integrity and competence of
bank management and understanding the risks taken by banks and
their current and future profitability and earnings, to determine
the adequacy of their capital and monitor their liquidity.

Lending fraud at several major banks last year, such as the
$200 million export credit scams at the country's second-largest
bank, publicly listed Bank BNI, remained undetected for almost a
year because of a lax risk management system at the bank and an
inadequately apprised central bank.

Using the core principles for effective banking supervision of
the Basle-based Bank for International Settlement (BIS) as its
main reference, Bank Indonesia has required all commercial banks
to implement the effective management of risks related to credit,
market, operations, liquidity, legislation, interest rates,
compliance, strategy and reputation.

Operational risks are one of the greatest threats to a bank's
soundness. The most devastating type of risk involves breakdowns
in internal controls and corporate governance, which inflict
financial losses through errors and fraud.

Credit risk is one of the largest of all the risks inherent in
banking operations. Hence, this risk requires the most careful
analysis. Wrong judgments related to the creditworthiness of
borrowers, or connected and collusive lending, can give rise to
bad loans and consequently erode a bank's capital base.

Banks also face risks of losses in on- and off-balance sheet
positions arising from movements in market prices, notably the
foreign exchange market. Likewise, banks are always exposed to
adverse movement in interest rates at the risk of slashing their
earnings or even the economic value of their assets, liabilities
and off-balance sheet instruments.

Bank Indonesia should indeed act firmly to enforce its policy
directive on risk management because it will force banks to
maintain fully documented strategy and operation policy manuals,
detailing business objectives and procedures that are very
helpful to internal and external auditors as well as bank
supervisors.

Such a well-documented management information system will
greatly help auditors and supervisors to make an accurate
assessment and management of the risk position of a particular
bank and account for all its claims and liabilities.

The development of an effective risk management system within
the banking industry should be welcomed as one of the building
blocks to construct the Indonesian national banking architecture,
which was launched earlier this year. It will further accelerate
operational restructuring within the banking industry.

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