Shooting the lights out of risk appetite: the dilemma of out- performing a predecessor

Bank liquidity management(Part I): Defying the 2:1 current ratio in accounting
Photo: Francis Owusu-Achampong,

Flowing from the gradual implementation of the Corporate Governance Directives of the Bank of Ghana, various changes have been made to the boards and management of banks in Ghana over the last few years.

Of particular significance has been the retirement of some seasoned board chairpersons and Chief Executive Officers who had been at the helm of their respective banks for the mandatory six and twelve years respectively.

A new breed of board chairpersons and chief executive offices with admirable qualifications and the advantage of youthful energies have taken over the huge tasks of managing the banks against the backdrop of an economy gravely battered by internal and external forces.

With a Debt to GDP ratio hovering over the 80%-mark, inflation trying to outrun Usain Bolt, exchange rates refusing to respond to unrelentless motherly cuddling from Bank of Ghana, and fiscal and monetary regimes tilting towards inflation targeting schemes via rising interest rates, and high taxation, the operating environment in the banks specifically become quite challenging for an aggressive risk appetite posture.

Add to the grim statistics, the daunting challenges intense competition poses in an economy attempting to recover from shocks over the last two years. It becomes quite onerous for dedicated, relatively young bank CEOs intent on outperforming their predecessors perhaps, too quickly. But they must still defend the confidence reposed in them by their appointing authorities and particularly impatient shareholders who will justifiably compare their respective returns on equity to prevailing rates on government securities amid the ubiquitous diminishing in values caused rising inflation.

During a programme that I facilitated for a group of directors of some Rural Banks, I appealed to them to increase their shareholding in their respective banks to enable the RCBs take advantage of emerging technologies to accelerate growth in their institutions. A director lamented about the non-receipt of dividends for some years.

While I appreciated his concern, I had to explain quickly why this has come about because of new regulations on the payment of dividends. I also explained how retained profits bolster the banks’ capital, reduce the pressure for fresh capital injection, while enabling the RCBs to operate sustainably.

My “aggrieved” director toned down his disappointment when I mentioned the key role capital adequacy plays in asset expansion, bank solvency, the relationship between earning and non- earning assets and risk appetite determination.

Seeing the positive glow in his eyes after the elaboration, I pointed out to the participants that even the Tier 1 banks faced similar challenges.  When the minimum capital requirement for these banks was raised to GHS. 400 million in 2019, assuming an average exchange rate of 5.217 cedis to the dollar, this GHS.400 million was equivalent to about $77 million at the time. Compared to prevailing rates, the same GHS. 400m fetches only $54 million, gravely diminishing balance sheets and shareholder value in dollar terms by $23 million over the 3-year period.

For a bank to merely maintain its balance sheet on a sustainable basis, therefore, it must have generated enough profits over the same period which must cumulatively exceed the equivalent of $23 million. Doubtlessly, this basic scenario poses a challenge with value addition viewed from a going concern basis.

Therein lies the potential temptation to get into a risk overdrive……..the propensity for a new  CEO to change the bank’s growth trajectory immediately and significantly, to drive home the point that there is a new kid on the block whose competence must be applauded.

For banks that have made reasonably strong waves over the last two decades in the banking space, expectations of what the future holds with changed leadership can be very high and seemingly daunting for the respective new chief executive officers and their boards.

Importantly, this is the period that a strong board of directors must ensure that prudence and conservatism must prevail and any accounting gymnastics aborted. This is against the backdrop of the reality that the country’s economy has not changed fundamentally over the last few decades to create new opportunities that a bank could boldly align their risk appetite considerations with, irrespective of the additional capital infusion and the relative liquidity across the industry now.

While prospects still abound for individual banks, it is worth emphasizing that aggressive risk appetite cannot be pursued in a vacuum. Unbridled expectations, especially when these are tied to executive remuneration packages have a tendency to breed irresponsible corporate behaviour, including manipulation of financial statements, with or without the connivance of external auditors.

Contemporary dynamics in risk appetite management emphasizes the place of conduct risk in corporate governance. Conduct risk relates to how financial services firms describe risks associated with the way their firms and their staff, relate to customers and the wider financial markets. This connotes the idea that firm’s collective behaviour will result in poor outcomes for customers and other stakeholders, if not checked under a robust corporate governance regime.

Handsome perks of office, while desirable, should not influence bank CEOs to compromise fiduciary duties to shareholders, the state and other stakeholders as we witnessed in some of the failed Ghanaian banks in 2019.

The infamous case of Wells Fargo and its CEO’s fake account scandal in 2016 which led to the US Securities and Exchange Commission banning the CEO for life in all banking and financial business is a pointer to how remuneration can breed recklessness, greed and false accounting.

It is clear from the above examples that compensation schemes with excessive short- term incentives can drive bad behaviour. Executive profit- sharing schemes, though well-intended, can motivate greed and less than full disclosures, often hidden in creative accounting practices.

The Wells Fargo case and other practices that precipitated the American financial crisis of 2006-2009 clearly underscore the perception that how an individual is incentivised, evaluated and compensated, is pivotal in shaping their professional /ethical conduct. Negative outcomes can spill from unrealistic or unsustainable market share or ROE objectives.

Unacceptable corporate practices are particularly pervasive in performance- based remuneration systems that focus exclusively on profit targets, accounts opened, deposits mobilised, among other metrics.

These can create incentive to compromise Credit loss provisioning, Know Your Customer policies, and Anti- Money Laundering /Countering Terrorist Financing rules.

In many cases, the desire to balloon profits comes with cost cutting measures. Commonly Risk and Audit departments, respectively, become victims of understaffing, hindering their watchdog roles in identifying and remedying thematic risk problems. Staff training and development may be pushed to the backburner against the principles of the Balanced Score Card performance management system.

Professional development programmes that do not adequately incorporate training in values, ethics and proper conduct can exacerbate risk, especially, in the Treasury, Finance and Credit Management spaces.

Similarly, idolizing employees of the sales department or credit expansion units can breed recklessness in the absence of effective risk appetite threshold monitoring.

Conduct risk is largely a peopled- centred concept. It defines the way the company, through its staff, particularly its executives, meets the needs of customers while ensuring shareholder value in a fair, honest, transparent and ethical way as enshrined in Ghana’s Banking Code of Conduct, for instance.

The banking environment that created immense opportunities for the entry of foreign banks, particularly the Nigerian, South and North African banks in Ghana, and the incentives for branch opening by other local and international banks over the same decades have changed significantly.

Competition brought on by technology, especially mobile money transfers, and the shrinking of margins as a result of regulations that enforce higher levels of transparency in interest and fees computations, have also changed the dynamics of profit generation. Covid has added new cost lines to banking operations.

Regulatory focus to stem wrong- doing is also more robust and intrusive now in view of past experiences with failed financial institutions.  A re-energised Banking Supervision Department in Bank of Ghana is poised to avoid weaknesses in the regulatory regime through new units created, reinforced with software, and new modalities regarding on- site supervision.

Brick and mortar expansionary strategies are no longer the best options in view of the acceleration in the use of technology, electronic banking, collaborations with Fintech companies, other facilities and general customer experiences.

It might be strategically suicidal to compare the number of branch network that was bequeathed to you as the basis for doubling or tripling this to make a bold statement. Negative outcomes can spill from unrealistic or unsustainable market share or return on equity goals.

Similarly, it may not serve any purpose to say that on your assumption of leadership, the bank had a staff strength of say one thousand but you desire to push this by additional five hundred within a year, when reality enjoins you to find a way to make voluntary disengagement a viable option.

The reversal of the central bank’s relaxation of the rules on reserve requirements, capital adequacy ratio and computation of loan impairments that were targeted to ameliorate the effects of covid 19 have their peculiar implications in a post covid period.

Realistically, though, the economy is yet to diversify significantly to the point where risk takers can boldly exercise their appetite without burning their hands. At least, we are yet to re-create the industrial vibrancy that characterized the period before the 1980s with reasonably functioning industrial firms, active ports, harbours and railways, vehicle assembly plants, among others that created high employment levels.

What we have now is the conversion of factories into magnificent church buildings where congregants converge in wild expectations of miracles ceaselessly.

The current environment presents a huge challenge for various bank board of directors to find new niches for sustainable revenue generation, amidst the history of the recent bank failures and the renewed focus on good governance.

It is said, though, that the greatest risk is the decision to do nothing. Also, when the going gets tough, it is the tough that gets going.

AfCFTA, with its innovative payment system, singularly presents new financing opportunities for firms that look beyond traditional boundaries, provided member countries will deal fairly and transparently with each other.

That leads us into a discussion of what constitutes risk appetite and its key determinants. This would remind our bank CEOs and their boards on the extent to which they can change the profile of the bank’s balance sheet and within what time frame.

Risk appetite determines the amount and type of risk a bank is willing to take in order to meet specific business objectives, particularly, expected returns. Risk appetite determination, communication, measurement and reporting are vital components of the enterprise wide risk management framework. It is dictated by the board, either quantitatively and/or qualitatively, with varied indices, including environmental and social governance, for control purposes.

Risk appetite and tolerance levels are generally set by the board and/or executive management. They are linked with the bank’s strategy and generally capture its philosophy for taking and managing risks responsibly.

A risk appetite statement is usually captured in a policy document and defines the organization’s expected risk culture and importantly, guide overall resource allocation.

A bank’s risk capacity is the amount of risk it can actually bear. This is dependent on how well the bank is capitalized, the availability of skilled personnel, and the structure and tenor of alternative financial leveraging mechanisms permitted by the regulator.

A bank’s board and management could have a higher risk appetite but not enough capacity to handle a risk’s potential volatility or impact due in part to the array of skills available internally. This could relate to the sectors it desires to shift focus on, the structure of its assets and liabilities and their sensitivities to interest and exchange rate volatilities, among others.

One of the key factors that caused the failure of one of the collapsed banks was the decision to finance a cargo of crude oil and the resultant liquidity crises this generated from the counter party’s inability (refusal?) to redeem obligations.

The lack of expertise in structuring the facility to protect the bank’s interest caused the phenomenal loss.  A situation like this could have been prevented by a strong, independent board with regular oversight of assets and liability management, expertise in oil and gas field, among other functions.

One of the peculiarities of banking business is that it is one of the most heavily regulated sectors in any economy. Per the local central bank’s rules, a bank cannot just enter any sector unless it is permitted by the regulator. Even opening and closing a branch in a specific area, or the introduction of exotic products must be sanctioned by the regulator.

The quantum of a facility that may be granted to a particular customer is also limited to a proportion of the bank’s capital…..the single obligor rule. Thus, notwithstanding a bank’s risk appetite, it may not engage in certain sectors or transactions, unless with regulatory approval.

A bank with an aggressive appetite for risk might set aggressive goals, while a bank that is risk averse, with a low appetite for risk, might set conservative goals. With the experience we all witnessed at the height of covid 19, some might see the environment as fertile for fresh risk- taking initiatives, perhaps hoping for “first mover advantage”.

Others may adopt a “wait and see attitude” while they seek to consolidate gains of prior periods and solidifying their balance sheets.

A range of risk appetites may exist for different risks and may also change over time in tandem with resource endowment and the general economic and political terrain in which the bank operates.

Strategic considerations must be underlined by a determination of whether the strategy aligns with the bank’s risk appetite or shareholders’ expectations, juxtaposed against returns within a stated time period. The board must be quick in exercising control and exact disciplinary measures for infractions of established thresholds to avoid the Nick Leeson episode.

The board, properly constituted under the “Fit and Proper Person” criteria, must be sufficiently convinced of the potential efficacy of new strategies before implementation, and even more so, exercise the necessary oversight functions to avoid any surprises which might mar their individual and collective reputation.

Properly communicated, risk appetite guides management in setting goals and making decisions likely to achieve these goals to sustain business, especially, capital and liquidity considerations in a bank.

For our new CEOs thirsting for fame, we all need to be reminded that the times and seasons for one’s accomplishments may never be the exact replica of one’s predecessor’s tenure.

It is futile to want to operate in the shadow of one’s predecessor, however successful the latter was.  One has to exude confidence to step into new roles but it is equally important to cultivate  a fertile disposition to learn routinely.  What worked well under previous dispensations would obviously need to be replicated but it is equally wise to acknowledge that there will always be different circumstances that may require new approaches.

The writer is a Fellow of the Chartered Institute of Bankers, an adjunct Lecturer at the National Banking College, a farmer and the author of “Risk Management in Banking” textbook.

Email; [email protected]  Tel. 0244 324181

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