Risk management in banking unbanked people

Dhaka,  Thu,  21 September 2017
Published : 14 Jul 2017, 19:44:42

Risk management in banking unbanked people

Md. Saifullah Azad
Risk was, is and will be an integral part of modern financial system. This arises from uncertainty regarding an organisation's future losses and gains. Therefore, in simplified terms, there is a natural trade-off between risk and return. Risk is not necessarily related to the size of the potential loss. For example, many potential losses are large but are quite predictable. The more important concern is variability of the loss, especially a loss that could rise to unexpectedly high level or a loss that suddenly occurs, not anticipated. 

Understanding the linkage between risk concentration and capital is especially important since the concentration of risk of a given portfolio markedly affects the amount of capital that should be held against it. Heavy concentration can produce so-called fat tails in a loss distribution, meaning that considerably higher capital levels are required to support the risk taken. 

Many institutions, both globally and nationally, have adopted inclusiveness of un-banked people in banking arena as a policy priority. Various standard-setting bodies are increasingly involved towards greater inclusion of people through their must-do agenda. Banking un-banked people opens potential benefits to safety, soundness and integrity of the financial system. This can also bring potential risks to service providers and customers alike and entail the transfer of well-known risks to new players. Banking un-banked people significantly increases macroeconomic growth and broadens access to credit. This sometime can compromise macro financial stability when any poor quality of banking supervision prevails in the financial system at any level. Thus, there are risks associated with financial inclusion programme of banks and non-bank financial institutions in their endeavour to reach unserved and underserved customers due to lack of adequate prudential regulatory and supervisory approach.

Banking unbanked people refers to access to financial services which relates to ability of firms and households to use financial products and services, given in particular the constraints of time and distance. Common elements of financial inclusion include universal access to a wide range of financial services at a reasonable cost. In financial inclusion, relevant measures include the proximity of access points, the variety of access channels such as branches, ATM and POS networks, agent banking, mobile banking etc as well as socio-economic barriers limiting these uses. In a broader dimension, pricing and other terms and conditions of financial products and services can also be relevant factors limiting the scope for access to financial services for segregated groups.

To manage the risk-extensive exposure, regulators and policymakers have taken a variety of steps to support financial inclusion at both national and international levels. Many of them have also sought to enhance financial literacy while others have committed to achieving numerical inclusion targets. Measures are being taken in many countries to improve financial literacy as more households join the formal financial system. Financial education can help consumers manage their financial risks by ensuring that they can better determine their capacity to spend, save and borrow, as well as choose suitable financial services. For instance, Bangladesh Bank, the central bank, has an in-house centre integrated with its main website that provides information about the financial services available to small and medium-sized enterprises, students, bankers, general public and other stakeholders. 

Some national policymakers have committed to achieving financial inclusion targets. For example, internationally over 60 central banks, plus public sector institutions from more than 90 countries are part of the Alliance for Financial Inclusion (AFI), a member-driven peer learning network. Some have agreed to quantifiable goals by signing the Maya Declaration which is an initiative to unlock the economic and social potential of the two billion unbanked population through greater financial inclusion. There are many positive impacts of financial inclusion and financial development more generally, on long-term economic growth and poverty reduction, and thus on the macroeconomic environment. Access to appropriate financial instruments may allow the poor or otherwise disadvantaged to invest in physical assets and education, reducing income inequality and contributing to economic growth.

Implications for monetary and financial stability: Banking unbanked people has important implications for monetary and financial stability as well as the policy areas. Increased financial inclusion significantly changes the behaviour of firms and consumers, in turn influencing the efficacy of monetary policy. For instance, greater inclusion should make interest rates more effective as a policy tool which may facilitate maintenance of price stability. Thus financial inclusion also strengthens the case for using interest rates as the primary policy tool. At low financial inclusion level, a large share of the money stock is typically accounted for by currency in circulation, with many families saving in cash 'under the mattress'.

Banking unbanked people can help more consumers to make their consumption smooth over time that could potentially influence basic monetary policy choices, including which price index to target. Financial inclusion also encourages consumers to move their savings away from physical assets and cash into deposits which may have implications for monetary policy operations and the role of intermediate policy targets. Financially-excluded farmers can trade livestock or other income generating assets or they can adjust how much they work in response to shocks. Hence, as for borrowing, friends and families can act as important lenders in place of banks. However, access to the formal financial system does facilitate consumption smoothening at remarkable level. Financial stability too may be affected since the composition of savers and borrowers is altered. Broader base of depositors and more diversified lending could contribute to financial stability. On the other hand, greater financial access may increase financial risks if it results from rapid credit growth or the expansion of relatively unregulated parts of the financial system. 

Financing to various firms which were previously financially excluded may also lower the average credit risk of loan portfolios. An increased number of borrowers from small and medium-sized enterprises (SMEs) are associated with a reduction in non-performing assets and a lower probability of default by financial institutions. The repayment rates of borrowers from conventional microfinance institutions are much higher than any other traditional bank and non-bank financial institutions. However, the required risk rate of Islamic microfinance is much lower than any form of financial service providers. Some experts have opined that increased financial inclusion is no guarantee of improved financial stability. When financial inclusion is associated with excessive credit growth, or rapid expansion of unregulated parts of the financial sector, financial risks may rise on a large scale.

Unregulated and under-regulated areas of the financial flow are also another risk area in financial inclusion reflecting growth by institutions. Banks' attempts to reduce the overall risk of their business i.e. de-risking, or minimise regulatory compliance costs also contribute significantly. Also small unregulated institutions may pose little threat to financial stability. Their growth momentum and systematic risk prevail side by side. Microfinance institutions account for a disproportionate share of increased financial inclusion in some countries, highlighting the need for supervisors to identify and measure risks that are specific to this sector. Hence, financially-excluded households lack a financial history. So, the absence of a verifiable track record may be especially prevalent where personal identification systems are weak. There are speed limits to banks' ability to absorb new customers without seeing deterioration in credit quality, owing to limits in screening capacity. 

Empirical analysis shows that greater financial inclusion due primarily to increased access to credit could contribute to financial excesses in the economy. Here  variations between structural financial deepening, leading to a widening pool of borrowers, and an unsustainable lending boom that sees a smaller number of borrowers amassing large debts are pertinent. In fact, both phenomena could occur side by side. However, it is possible to nurture increased financial inclusion without a large increase in aggregate credit. For low-income populations, for instance, the most pressing financial needs may consist of having reliable savings and payment instruments rather than credit. 

risk assessment: As banking the unbanked is channelised via various evolving instruments like banks, non-banks, telco and other unrelated industries through participation in innovative financial services, the risk assessment area is pertinent to consider while devising any policy and procedure. The financial integrity, financial consumer protection as well as data protection and competition are also vital areas while accommodating financial inclusion strategies. Even anti-money laundering and combating the financing of terrorism (AML/CFT) need to be prioritised when extending the financial services to the underserved people of the society as such productive and constructive dialogue among all stakeholders such as regulators, supervisors and service providers is required while targeting unserved and underserved customers. 

Comprehensive risk management process as well as effective Board and senior management oversight is must to identify, measure, evaluate, monitor, report and control or mitigate all material risks on a timely basis related to the tools and techniques to financial inclusion. They also need to assess the adequacy of their capital and liquidity in relation to their risk profile and market and macroeconomic conditions and also to development and review of contingency arrangements which take into consideration the specific circumstances of the service providers. Thus, the risk management process will be   commensurate with the risk profile and systemic importance of the institutions. The financial institutions will systematically review the required procedure and policies while introducing new products or services or delivery channels, and also adjust their expectation of risk management processes for Strategic Business Units (SBU)/ branches/service points targeting unserved and underserved customers as required.  

Challenges faced by financial institutions targeting unserved and underserved people may relate to the lack of a comprehensive view of risks in a fast-changing environment, unavailability of qualified professionals in respective areas and deficient management information systems.  The banks should have proper policies and procedures in place as well as specialised knowledge of the specific dynamics of assets and liabilities in targeting underserved and unserved customers, particularly traditional microlending/ microfinance and the nature, structure and behaviour of funding sources. Traditional microfinance providers face the potential of rapid deterioration of capital in case of loan defaults due to over-reliance on their loan portfolio as their most important source of revenue. Thus, liquidity risk management needs to focus on comprehensively measuring and forecasting cash flows and maintaining an adequate minimum liquidity cushion for business-as-usual and stressed situations, taking into account the likely behavioural responses of relevant counter parties. 

Banks must have adequate 'risk-based approach' policies and processes including strict customer due diligence (CDD) rules to promote high ethical and professional standards in the financial sector and prevent the bank from being used, intentionally or unintentionally, for criminal activities. Increased financial inclusion could be beneficial for financial stability as well as the financial wellbeing of the people, particularly for low-income group. But these strategies related to inclusion of unbanked people in the banking arena may be sensitive to the nature of the improved financial access. Too strong a focus on improving access to credit could increase risks if it leads to deterioration in credit quality/exposure at default or too rapid growth in unregulated parts of the financial system as well as shortage of proper integrated policy at global and national levels. 

acceleration of financial inclusion: Last but not least, all interested parties/stakeholders need to collaborate and cooperate with each other for further acceleration of financial inclusion ensuring risk mitigation strategies, policies, programmes and procedures in proper place for a balanced socio-economic development. In addition to the three lines of defence, the four lines of defence model are meant to precisely address this 'deficiency'. A specific role has to be assigned to external parties namely, external auditors and banking supervisors in relation to the design of the internal control system, acknowledging that although they remain outside the bank's boundaries, they constitute a vital element of assurance and governance systems. The system prevails in the banking sector of Bangladesh.

Since the four-lines-of-defence model intends to enhance coordination between external parties and internal auditors, greater communication is at the basis of its success in the banking sector of Bangladesh. Communication works by reducing, if not eliminating, asymmetric information among the parties involved, provided, of course, that the treatment of information is such as to make risk control systems more effective in banks. The four-lines-of-defence model would entail a new set-up of processes especially in terms of information that internal and external auditors and supervisors are respectively required to share or not allowed to share. These processes set forth the categories of information, the procedures for obtaining documents and records, and the rules for limiting the release of exempt and confidential supervisory information and for protecting confidential information. 

An effective risk governance environment helps work more efficiently through effective teamwork, collaboration and open communication with a view to ensuring an optimum risk taking approach resulting in long-term viability of risk and return of a bank. Mentionable, at the developed stage of risk governance, Board and Board level Committees need to be actively involved in sketching broad risk issues to formulate a precise risk-balanced strategy for a bank. As such, the Board will be responsible for setting a well-defined risk appetite in both qualitative and quantitative aspect in synchronization with the bank's objectives.

Above all, banking the unbanked people requires prudent action plan which should be built-in approach rather than regulatory-imposed while addressing risk mitigation. As risk exists and banks must accept risk if they are to thrive and meet an economy's needs. But banks must manage the risks and recognise them as real in their own perspective and also in customised manner. Indeed, given globalisation, we must all adopt increasingly sophisticated risk management practices in the modern era of highly sophisticated banking practices. As such, the 'tone of the top' would be the greatest factor from where risk culture will be developed and fast forwarded for effective management of unbanked people while accommodating them in the banking arena.

The writer, a banker by profession is a Certified Expert in Risk Management (CERM) from Frankfurt School of Finance, Germany. The views expressed in the article are the author's own and not necessarily the organisation he represents.  


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