INSIGHT :: FINANCE

Commercial banks, as per modern perspective, are considered to be risk management institutions. The central function of a financial institution is its ability to distribute risk across different participants. An extensive body of banking literature (Santemero and Babbel, 1997) argues that risk management influences financial performance of banking firms and is an important function in creating value for shareholders (Pagano, 2001).

The question is, do banks create wealth for shareholders in executing the primary function of risk management? In other words, how does a bank's risk management function influences shareholders wealth. Professor Jayadev of IIMB and Rudra Sensarma of the University of Hertfordshire Business School, UK examined the impact of risk management practices on stock prices of Indian banks for the period 1998 to 2006. In this paper, they integrate multiple issues from the literature of accounting and financial economics, while assessing if banks' risk management function influences shareholders wealth.

Traditional accounting methods define a number of financial ratios for analyzing a firm's health or performance. However, there is no explicit measure for a firm's risk management capability. The authors have evolved a framework to utilize the Return on Equity (RoE), a widely used measure for shareholders' return from a firm, as such a measure. The authors have through a series of identities reduced the RoE, as follows.

RoE = (Net Interest Margin + Non-Interest Margin - Provisions as % of Total Assets) x (Total Assets / Equity)

Each one of the terms on the right hand side are financial measures that can be derived from a firm's financial statements.

The risks that financial firms face include, among others, the following.

• Interest risk - refers to the risk of decline in net interest income of a bank due to a change in interest rates.
• Credit risk - refers to the risk of non-payment of interest and/or the principal amount by borrowers. Provisions as Percentage of Total Assets is considered as a measure of credit risk management capabilities of a bank. A high Provision as Percentage of Total Assets indicates better credit risk management capability.
• Solvency risk or capital risk - refers to the inability of a bank to pay depositors owing to lack of sufficient funds, in the event of a run. A long-term view for shareholders implies reduction in solvency risk, or higher Capital To Asset Ratio. For the purpose of this analysis, Capital Adequacy Ratio is used as a measure of a firm's solvency risk management ability.

Authors have developed risk management scores for banks by combining the above identified four risk variables into one single measure. Multivariate techniques – principal component analysis and discriminant analysis techniques are applied to develop risk management scores by the combining the identified four risk variables. Then the impact of these risk management scores on shareholder holder returns are measured by applying regression analysis.

Analysis:

The trend in risk scores shows that risk management capabilities improved during the period 1994-2004 but declined subsequently, this may be due to decline in fee based income and increased exposure to risk weighted assets or more credit risk. The principal component analysis shows that the risk awareness among banks has increased which is manifested by building of natural hedges through increased reliance on off balance sheet portfolio. The first principal component indicates the significance of credit risk management accorded by Indian banks. On the other hand, banks had relatively less leeway in interest rate risk management during the study period. Similarly low importance was given by banks for raising capital adequacy ratios and banks paid less attention to management of solvency risk, thus leverage ratio turns out to be a less important factor in the first principal component. The results of Multiple discriminant analysis also further strengthens the view that banks paid little attention to enhancement of fee based income and solvency risk.

Further the regression analysis shows that the coefficient of market returns is significant which indicate systematic risk assumes higher importance in determining stock returns. The risk management scores are found to be positive and significant indicating that banks with better risk management practices are rewarding the shareholders with enhanced wealth.

The original article Are bank stocks sensitive to risk management? by M. Jayadev and Rudra SenSarma, appeared in The Journal of Risk Finance, Vol. 10 No. 1, 2009.