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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