Intermediation Process and the Allocation of Resources

Intermediation Process and the Allocation of ResourcesThe impressiveness of the fiscal dodging in facilitating sparingalal nurture tail assemblynot be every vexstated. Banks and some former(a) pecuniary institutions sustain a key role in the concernlike anyocation of resources and as such(prenominal), survive pecuniary systems atomic number 18 systemically in-chief(postnominal) to the economic viability of a country.The Asian pecuniary crisis of 1997-98 brought theme the significance of m unrivalledtary argona wisdom by lavishlylighting the consequences of underlying weaknesses in the fiscal sphere and the detrimental impact that weak monetary spheres could bring in on s behaveholders, specially the depositors. become financial system is wherefore not yet important for the eudaimonia of the financial entities themselves, further it is withal of vital impressiveness to the growth of psyche economies.In allocating resources in an economy, finan cial institutions mustiness esteem competing demands for cash in hand and order the analysis of bump. Improper decisions about financing activities, that is, which activities to finance and which not to finance, (depending on which activities will bring the best try-adjusted re exploit), can suffer a life-or-death negative long-term impact on economic prospects. Sound investiture decisions argon vital ingredients in fostering economic growth and development. These decisions therefore should produce feasible outcomes not only for the financial go- amongst but everyplacely for the economy. Investment should be for productive purposes and should be deployed for the normal good.Financial intermediaries should as sanitary have a harmonious kin with the large-economic space indoors which they ope stray. For ex large, in the nineteenth century, Britain was seen as the most successful economy and was the home to the worlds most successful financial centre at the time. This was not only due to the fact that London had develop expertise in assessing gamble and in allocating financial resources efficiently, but too to the fact that the macro economic environment was conducive to the operation of financial intermediaries operating in the financial centre.The estimation of seek likewise assists financial institutions to be individually to a greater extent(prenominal) competitive with their peers. This results in a more efficient work out of working cracking allocation in addition to engendering more prudential formulas. Financial intermediaries that can assess jeopardy and allocate resources efficiently will outperform those little skilled in this regard. Effective competition should reduce borrowing bell and help to diversify financial chance at bottom the economy. However, to ensure that strands atomic number 18 performing as intended, an effective regulative textile must exist. The importance of adequately seat of governmentized financial institutions to underwrite conquer trys in their portfolios cannot be over emphasised. If financial intermediaries undertake too little hazard, then potentially efficient projects may be starved of capital and if they undertake too much take chancesiness, then less efficient projects may consume capital that could be utilise for more viable projects. The role of regulators in providing effective concern for the sector and be able to respond appropriately to changes in the financial environment becomes even more important.William J McDonough (1998) postulates that a nation must be able to mobilize domesticated savings and another(prenominal) sources of funds that be desireed to finance investment and other productive expenditures1. This requires the development of an effective beveling system that transfers surplus funds of households and businesses to borrowers and investors. He further argues that, medium and impartial allocation of faith accommodates the economic development that results in better national living standards.According to McDonoughfinancial intermediation is especially important in the context of most appear market countries given the sex act scarcity of savings, a relatively under-banked population, and large-scale investment needs. The banking sector in rising market countries also tends to be more concent evaluated and represents a larger share of the domestic financial system. Consequently, issues in the banking sector have an amplified effect on the economy and on the fiscal costs associated with bank rescues.Importantly, current developments in western economies are anchored in a husky financial sector development.. Consequently, the kinship among economic growth and financial sector health are now more closely united than ever before.Some of these linkages or interrelationships are further explored in this thesis from the perspective of attempt relationships. The demands of the changing business environ ment emphasize the importance of effective assay guidance practices in banking institutions. Financial intermediaries continue to administration tremendous unrelenting pressures regarding pricing decisions, increase in service expectations from customers, regulators and shareholders. on that point is also a demand for more forward-looking products and services, unfermented regulatory requirements, mendd capital standards, more capital injection and the introduction of new technologies and systems.Technology is important in supporting new and flexible attempt relationship structures in the areas of credit, market, liquidness and usable seek counsel. Advanced technologies are often utilise by intermediaries to identify, quantify and monitor gambles. The workout of these technologies also comes with their own attendant chance exposures and as such significant investments and direction have been placed (particularly in recent times) on operational danger caution issues from both(prenominal) regulatory and financial intermediary perspectives.Risk instruction must be seen as an integ governd butt and as such managing existing relationships, developing new relationships and leveraging the value of all essays relationships are critical to the anxiety of overall risk exposures. It is important therefore that the preliminary which institutions and regulators take in managing risk, be relational. Both the soft and quantitative aspects of risk circumspection must find consensus within the same corporal. No longish should institutions view risk as an isolated and individualized structure with tell apart and mutually exclusive elements but risk should be managed as a system, which is intricate, collaborative and bound by mutual responsibilities.Banking SupervisionThe identification, assessment, and promotion of sound risk- centering practices have become central elements of good supervisory practice. Risk management has uprised as a disciplin e that is driven both by the offstage sector (make up of banking institutions and other market participants) and domain sector (especially regulatory Authorities and Banking Supervision). The relationship between the private sectors interest in economic capital and the public sectors interest in regulatory capital should be identified and managed in a framework that ensures optimization.With regard to the management of risks and risk relationships, several key innovations have been made by the private sector over the years. These are evident in the way financial intermediaries have ordered their agreement sheets to respond to various risk stimuli and impulses both intimately and externally. Additionally, the private sector has been the driving force behind the development of sophisticated tools used to identify, measure and manage risk relationships. The public sector on the other hand, has been at the forefront in the development of best practice standards and principles used t o guide financial intermediaries. For years, the public sector has been playing a pivotal role in preventing the total collapse of the entire financial systems in their capacity of lender of last resort. The regulatory and supervisory harness of the public sector have taken the lead in identifying emerging issues through their snuggle to supervision of financial intermediaries. several(prenominal) regulatory bodies routinely performs on-site inspections and examinations as well as off-site monitoring and oversight of banks and other financial institutions to assess risks and bear feedback to the financial intermediaries board and management. These reviews implicate the assessment of policies and procedures in place to guide risk management the assessment of governance and internal controls and the assessment of capital adequacy, asset quality, earnings and liquidity and sensitivities to risks. Reviews could also include comparisons of peer institutions coupled with the establish ment of guidelines that codify evolving practices.Yellen (2005)2 argued that although banks and bank supervisors have divergent motives, which certainly can lead to differing views about the appropriate levels of risks, they also have a common interest in having spotless measures of risk and in foc development on the processes and techniques for identifying and managing risks.According to Alan Greenspan (2004),3 the growth in the size and complexity of the largest US and foreign banking organizations, in particular, has substantially affect financial markets and supervisory and regulatory practices. He further states that authorities are required to focus more than before on the internal processes and controls of these institutions and on their ability to manage risk. According to Greenspan, the regulatory authorities must entrust the industry with proper incentives to invest in risk-management systems that are necessary to fight successfully in an increasingly competitive and efficient orbiculate market.4The Basel Frameworks everywhere the last two decades, the system of bank capital standards has been the Basel metropolis sufficiency Standard, known as the Basel I framework, which was established internationally in 1988. The Basel I standard came out of the banking supervision sub-group of the Bank for International Settlement (BIS). The Banking subgroup is made up of supervisors from the G10 countries. This group has been charged with the responsibility for setting bank standards about the world, which it does predominantly through the development and implementation of the Basel Core Principles for Banking Supervision. The Basel I framework was particularly geared towards credit risks in banking institutions and resulted in risqueer capital levels, a more equitable international marketplace and the relating of regulatory capital requirements to risk appetite and risk indite.The Basel framework is a dynamic one to which bank as supervisors conti nue to make important adjustments from time to time. For example, the 1988 Capital Accord was amended ensuantly to incorporate a market risk component. Bernanke (2005)5 argues that advances in risk management and the increasing complexity of financial activities have prompted international supervisors to review the appropriateness of the regulatory capital standards under Basel I, particularly for the largest and most complex banking organizations.Bernanke states further that supervisors recognize that some of the largest and most complex banking organizations have already moved well beyond Basel I in the sophistication of their risk management and internal capital rides. The gap between the determinants of minimum regulatory capital (under Basel I) and the levels of risks that financial institutions were taking on began to widen, as risk relationships continue to become more complex and risk-management practices continue to evolve.several(prenominal) innovations have seek to col lectively reinforce this gap and indeed the relationship (regulatory capital/risk appetite) between the public sector and the private sector has also being mutually reinforced. These innovations have predominantly being originated by bankers in the private sector and not by Supervisors. Bankers and Risk Managers had developed models that encompass their processes, procedures, and techniques, including statistical models for assessing risks in their portfolios. These innovations by the private sector were seen as state of the art risk management tools which the public sector could use and as such Regulators began to leverage the risk management techniques that banks were using to send for shortfalls in Basel I. This phenomenon helped to push the Basel Committee back to the drawing board to occasion the new capital adequacy standards for internationally active banks, known as Basel II.Bernanke (2006)6 argues that the new framework links the risk taking of large banking organizations to their regulatory capital in a more imagineingful way than does Basel I and encourages further progress in risk management. It does this by mental synthesis on the risk-measurement and risk-management practices of the most sophisticated banking organizations and providing incentives for further improvements. When this framework is applied consistently across internationally active banks, Supervisors can easily identify shortfalls in the relationship between banks capital and risk levels. Banking institutions with capital levels that are not competent with their risk indite and risk levels would be subjected to closer assessment and monitoring. Additionally, Basel II has provided the Supervisor with an added tool, under the supervisory review process ( column II) to assess risks in the banking system.The new capital accord, Basel II, with its three pillars, will hopefully enhance and tone the process of risk management in banking institutions. Internationally active banks, an d other banks and investment businesses in jurisdictions in which regulatory authorities deem it prudent to bring these institutions in scope, should expect significant revisions and modifications in their internal policies used to identify, measure, manage and report on risks. Not only should improvements be seen in risk management policies, but the process and general procedural framework would also see improvements. In this regards, banks and other financial institutions should envisage changes in their system used to capture and report on risks. Under chromatography column I, changes are expect I the risk weights assigned to the credit portfolios, particularly, residential mortgages and as such banks could see some reduction in charges as weights for some categories are reduced. The reporting of market risks and operational risks should also improve as banks garner more granular data on its expected losses and risk exposures. In preparation for the supervisory review process ( Pillar II) to be conducted by the regulatory authorities, banks should see significant improvements in their risk management practices as they subject their internal capital adequacy models to greater levels of scrutiny to ensure that the capital cover is adequate for all the material risks identified, their risk appetite, and risk exposures.The use of stress exam on both the banks investment and credit portfolios under the pillar II process should also seek to strengthen the institutions approach to deal with adverse down turn and general deterioration in some macro economic variables in the economies in which the banks operate. This should push banks to increase capital levels to cushion expected losses.Pillar III implementation under the new capital accord should also foster greater improvements in the risk management, policies, processes, and procedures of banking institutions as banks become more transparent in their efforts to disclose more information on the indite of risks , risk exposures and capital levels to their stakeholders.The Sub-prime Mortgage CrisisThe conditions that gave rise to the current sub-prime mortgage crisis provides ample evidence to support the pressing need for both private and public sector, financial institutions and supervisors, to understand the nature and nexus of risk relationships and regulatory capital. The crisis also provide an opportunity for financial institutions and regulators to explore the risk relationships and risk kinetics existing within and outdoor(a) of financial intermediaries, as well as the impact that failure to properly identify and assess risk exposures in financial institutions can have on the global financial system and economic growth and development in a particular country.The on-going economic problem resulting from the sub-prime mortgage crisis has manifested itself through liquidity issues in the global banking system. The credit crisis has its genesis in the bursting of the US housing bubbl e and the subsequent full(prenominal)school default grade on sub-prime or other adjustable rate mortgages, made to borrowers with higher risk profile and lower income levels, sooner of to borrowers who are considered prime borrowers with higher income and good credit history. Borrowers were encouraged to take up mortgages found on the attractive housing incentives that led them to confide that notwithstanding the long term trend of rising housing prices, they would be able to refinance these mortgages at more favourable terms in the approaching. During 2006 however, the prices of houses started to fall, albeit commandly and as such, the possibility of refinancing was becoming more remote. Consequently, the interest rates on the adjustable rate mortgages (ARM) that the sub-prime borrowers were able to obtain began to reset at the higher rate resulting in a significant increase in defaults and foreclosures. In 2007, foreclosure activities increased by approximately 80 percent over the 2006 figures as n proterozoic 1.3 million United States housing properties were subjected to foreclosure activities.Major banks and other financial institutions globally reported losses of approximately US $379 one million million towards the end of the initiatory half of 2008. The first set of financial institutions to be impacted was mortgage lenders that retained the risk of payment default (credit risk). Several third party investors were also affected, as mortgage lenders had passed on the credit default risks arising from the rights to the mortgage payments through mortgage backed securities (MBS) and collateralized debt obligations (CDO). Individuals, institutional investors and other corporate entities holding MBS or CDO were now faced with significant losses as the value of the underlying mortgage assets declined.The sub-prime mortgage crisis also opened financial institutions to liquidity risks as lenders were forced to reduce lending activities or grant loans at higher interest rates. The higher interest rate loans restricted the ability of corporations to obtain funds through the issuance of commercial-grade write up, thereby posing liquidity challenges for several institutions. As a result, central banks, in their role of lenders of last resort, were forced to take action to provide funds to the banking sector so as to stimulate the commercial paper market and to encourage the resumption of lending to borrowers with good credit profile.The rate at which economies grew was also impacted by the credit crisis as business investments and consumer spending were curtailed due to the general unavailability of loans or the high cost of loans in cases where it was available. The United States government responded by cutting the federal have interest rates as well as proposing its economic stimulant package which was passed by congress in February 2008. This was necessary to alter the risk exposure to the broader economy brought on by the cr edit crisis and the related downturn in the housing market.Research Problem and HypothesisWhile the benefits of risk management and positive risk relationships have been increasingly recognized in financial sectors worldwide, this study postulates that (i) risk relationships have not been sufficiently explored in the persona and current risk management practices in the Caribbean have not kept pace with international trends on financial risk management and (ii) levels of capital being held by financial intermediaries in the Caribbean could be deemed short-staffed to mitigate risk exposures. It could also be argued that where there are high levels of risk exposures in financial intermediaries in the region, the impact of risk mitigating factors are low and risk management policies, processes and procedures are less than robust. Additionally, risk exposures and regulatory capital might vary according to core business activities, risk categories or geographic location.In recognition of the existence of these relational gaps and the need to bridge them, this study will introduce principles, procedures, approaches, models and concepts in risk management, and distil on those risks inherent in the financial intermediaries balance sheet or risks associated with various elements of financial activities and environment. The writer will analyse the risk profile of financial intermediaries and their exposure to credit risks, funding/liquidity risks, interest rate risks and operational risk.The study also seeks to develop benchmarks for measuring risks in the region as well as a risk management get ahead model with particular emphasis on the risk profile of Caribbean financial intermediaries.Sub-problemsThe first sub-problem is to ascertain the risk profile and relationship evident in financial intermediaries in Jamaica, Trinidad and Barbados, as well as those which may evolve consequent to the new Basel Capital Accord, Basel II, which is scheduled to be fully enforce d by 2015 across all jurisdictions. The intention is to assess the risk profile and relationship in operation as a dynamic process and the credibly impact of the capital accord on relevant financial entities.The second sub-problem is, using both the relevant and existing belles-lettres concerning risks, risk relationships and risk management and observation of current techniques, to ascertain throughout the rush of the study, types of risk relationships that exist in credit, liquidity, interest rate and operational risk management in financial intermediaries.The third sub-problem is to provide the financial sector with a set of sound testable ideas that are systemically desirable and consistent with the future development of risk assessment. This will be done by reviewing the analyses draw in the first two sub-problems, generating relevant model/framework of risk assessment, comparing the model/framework with real situation, identifying systemically desirable changes and reput ationing the results for the benefit of relevant stakeholders who are capable of applying change to the banking sector in general.HypothesisThe first guesswork is that risk exposures (credit, liquidity, interest rate and operational risks) in financial intermediaries in Jamaica are relatively high when compared with Trinidad and Tobago and Barbados and could exhibit parasitic tendencies. This could bungle the financial intermediaries ability to identify, measure, mitigate and monitor risks due to the fact that the internal control framework could be seen as less than robust.The second hypothesis is that there will be shortfalls in capital requirements specifically as a result of the introduction of the new Basel Capital Accord and more generally after taking account of specific risks not antecedently considered by financial intermediaries.The third hypothesis is that the cycle of analysis, application and testing will result in the implementation of rigorously defined early warnin g system for modelling and scoring risks and that this system will be adaptable to change, both outside and within the environment, and extendable to additional use. vindication for the ResearchSound risk management practices, which include appropriate tools and techniques and the employment of relevant steps to assess risk exposure are at the heart of effective financial intermediation. However, umpteen institutions are exposed to high levels of risks in their operations and few have put in place the relevant infrastructure to appropriately capture their risk exposures. According to the organisation of Jamaica, Ministry of Finance (1998)7 the financial distress experienced in the mid nineties was in several ways due to the fact that many domestic financial institutions did not have the necessary risk and financial management capabilities to carefully assess the risk. As a result, they were left holding real estate and other long-term assets that could not be easily given up of to meet their short-term obligations.The Ministry highlighted the fact that banks in Jamaica tended to invest in enterprises that were outside the scope of their core business which had the following implicationThe banks entered sectors in which their management did not have the requisite skills or expertise.The banks, when lending to related parties or parties under common control either (i) made poor and dyed credit decisions or (ii) invested in companies on less than arms length terms resulting in poorly secured loans.The banks, in many instances had fund investments in non-core businesses with short-term borrowing instruments with guaranteed high interest rates. As a result, many non-core business had to contend with an unsustainable capital structure that relied heavily on high cost loans with relatively short maturities8.Many studies have highlighted the risk management practices, including techniques and tools used to identify, measure, mitigate and monitor risks in industr ial countries. However, few studies (note the detective is not aware of any at the time of preparing this thesis) have sought to understand and explain the risk exposures, risk relationships and risk management practices in financial intermediaries in the Caribbean, particularly Trinidad and Tobago, Jamaica and Barbados.The study utilizes a novel approach to analyse risk exposures and risk relationships, which has not been evidenced in the literature generally and definitely not seen in inquiry on risk management in the Caribbean region. The risk profile of financial intermediaries are analysed using ratio analysis and statistical techniques including the standard deviation and arithmetic mean coupled with a five-point scale response to determine risk relationships based on a biological science description. This study will document over a ten-year period, sectoral differences in risk exposure reflected in the balance sheets and income statements of commercial banks, merchant banks , trust companies and building societies in three Caribbean countries.The results of the research will provide a sound set of ideas for the management of risks in these institutions in emerging markets. It will also provide an enduring account of risk relationships and the implications of sound risk management practices in general.Thesis muster in and MethodologyThe study examines the risk management framework in emerging markets in the Caribbean region. The focus will be limited to three jurisdictions in the Caribbean region. These are Jamaica, Trinidad Tobago and Barbados. This paper takes account of quartetsome types of deposit taking financial institutions Commercial Banks, Trust Merchant Banks, Finance Companies and Building Societies. There are 8 financial intermediaries across the three jurisdictions.Elite interviews were also conducted with aged(a) management in sixteen (16) financial institutions in Trinidad and Barbados. Interviews were held with select senior mana gement executives in the financial institutions. Among the executives interviewed were CEOs, Senior Vice Presidents, Risk Managers, acknowledgement Managers, Operations Managers and Treasury Managers. In Jamaica, detailed surveillance were done of all the in scope financial institutions ie, commercial banks, trust and merchant banks and building societies. Reviews of annual reports and websites of all the financial intermediaries captured in the scope of the thesis were also done. The purpose of the review of the elite interviews and qualitative reviews of the websites, annual reports and other promulgated data was to obtain information on four risk categories, particularly on the policies, procedures and processes in place to manage risk.Twenty risk proxies were used to refine risk exposure across four risk types in the financial intermediaries and the countries. These risk proxies were further reduced to eight based on their relative weights and significance as a risk-sensitive measure. Additionally, eight macro-economic variables were used to assess the economic environment within each country as well as to determine the extent to which these macro-economic variables were correlated with the risk proxies.Using a Likert-type index, correlation analysis and the results of the observation and interviews, the study developed risk benchmarks and risk scores, which were later used to determine risk relationships within financial intermediaries as well as within each country. The aim was to identify the risk relationships and to provide the managers of financial institutions and policy makers with an early warning system to calibrate and mitigate risks.The study analyzed the degree to which three major economies in the Caribbean region were exposed to credit, liquidity, interest rate and operational risks and the extent to which different countries are similar or different in light of these risk exposures.The paper sought to determine the level of risk exposures across four different financial intermediary types in three Caribbean jurisdictions. It expounded on differences and similarities in the risk profile of financial intermediaries and sought to determine which intermediaries are likely to have higher risk profiles.The paper also explored synergies and alliances between the four main categories of risk under study. These are credit, interest rate, liquidity and operational risk. It disaggregated proxies for risks based on risk types and highlighted risks drivers that are significant to different intermediary types or country.Lastly, the paper explored relationship between the critical elements and proposed a model for the scoring of risks. The relational perspective to risk management envisaged risk within three basic constructs namely, dependent, bloodsucking and Saprophytic as well as the nexus between these constructs and the internal control framework as measured by financial intermediaries policies, procedures and processes use d to manage risks.The Saprophytic ConstructAt this level, risk is calibrated as being relatively low. Risks outcome are systemically pleasing and financial intermediaries are making meaningful contribution to the common good. Risks and reward can thrive within a conducive macro environment and the profile of institutions balance sheet and income statement contributes positively to the risk calibration outcome. A low level of risk exposure is normally attributed to a very robust internal control framework and more effective risk mitigation strategies.The Symbiotic ConstructWithin the Symbiotic construct, risk relationships are generally balanced. Risk is calibrated as moderate and the regulatory interest and the economic interest are neutral. Risk management is generally integrated and there is usually a connection between the process of risk identification, measurement, mitigation and monitoring. The profile of intermediaries balance sheets and income statements are viewed as risk-n eutral relative to risk outcome and the internal control framework and risk mitigation strategies used by financial intermediaries are generally adequate.The Parasitic ConstructWithin this construct risks are calibrated as high or very high. There is usually adverse macro-economic condition in existence and there is disconnect between the regulatory interest and the economic interest. There is a general state of disharmony in the qualitative and quantitative approaches and disunity in the way that risk is generally managed. The risk profile of institutions balance sheets and income statements negatively impacts risk calibration outcomes. A hig