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ANALYSIS OF BANKING RISKS AND THE ROLE OF INSURANCE INDUSTRY FOR NATIONAL DEVELOPMENT
A PAPER PRESENTED AT THE FIRST NATIONAL CONFERENCEDEPT OF BANKING AND FINANCE – FED.POLY.OKO
SUNDAY C NWITE Ph.D, ACII, ACIB, IRDI.
ABSTRACTBanks are among the financial institutions that exist in our economy. The banking industry mobiles funds from individuals, households and corporate organizations. The money mobilized, part of it are always extended to borrowers with interest. This is the major ways banks make their profit. There are various activities of banks like giving out loans, leasing, ownership of property, vehicles, project financing etc. there are a lot of risks that are exposed to their activities like interest rate risk, volatility risk, inflation risk, risk of failure to pay debt, delay in payment of debt and sometimes government makes some policies against the bank which is a risk. These risks affects the performance of banks. The insurance industry on its own acts as a shock absorber by providing covers/polices to ensure adequate protection. It has been found that banks activities involves a lot of risks both systematic and unsystematic risks and that insurance industry provides some policies like fire insurance, theft insurance, legal expenses insurance, credit insurance, fidelity guarantee insurance. It is concluded that the banking risks need to be managed through insurance policy mechanisms. The implication is that banks are very volatile and if these risks are not property managed, may cause problems to these banks which can result to distress and distress may lead to total failure. Recommendations were made that banks should use the insurance industry to manage their risks and also receive insurance advise to help reduce the risks exposed to them by taking adequate insurance policies.KEYWORDSHazards, perils, risks, volatility, interest risk, credit risk.
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INTRODUCTIONThe banking industry is the hub of any economic development of
any nation. The banking practice started with Gold Smith, but the
modern banking industry practice started in 1890s. The introduction
of banking industry has helped in economic development in various
ways such as giving out loans, financing foreign business among
business men, given out money for agricultural development,
infrastructural provision and also in marriages, even buying vehicles.
Most of these activities of banks involve a lot of risks. These risks
includes credit risk, delay in payment risk, legal expenses risk,
fidelity. These risks arises from the banking transactions. The
insurance industry plays active role in providing some services to
the banking industry like advisory role, risk management, training
staff, training on risk management and also insuring some of their
risks. This work therefore wants to look at the risks involved in
banking activities and how such risks can be managed through
insurance process for national development.
THE CONCEPT OF BANKING
The concept of banking can be traced to Gold Smith, when he
started collecting money for deposit and realized that some of the
depositors do not collect them at the same time, he decided to give
out some as loan with interest (Cyole, 2000). Interest rate sends
signals to lenders, borrowers, savers and investors. Banking in its
own has no particular definition. This is because banking can be
seen as a profession, and institution, keeping deposit and other
important documents. Rather, a banker was defined in bill of
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exchange Act 1958 that a banker includes a body of persons
whether incorporated or not who carry out the business of banking.
Pagets (1972) Doyle, 1972 Hart (1931) all were given various
definitions of a banker not banking.
Today, the banking industry mobilizes savings from households,
individuals and pay them interest and then give out part of the
savings to investors at higher interest rate. Efficient financial
intermediation is an important factor in economic development
process as it has implication for effective mobilization of investible
resources (Nwite, 2009).
HISTORICAL DEVELOPMENT OF BANKING INDUSTRY
Banking is an institution for keeping, lending and exchanging
etcetera of money. It is a moneybox for savings, a stock of money,
fund or capital in game of hazard, (Odo, 2004)
The history of banking development in Nigeria can be traced back to
1890s. The African Banking Corporation was the first commercial
bank that opened its first branch in Lagos in 1892, whose founder
was Messrs Elder Dempsters and Co. a shipping firm based in
Liverpool.
This bank encountered different initial difficulties and eventually
decided to transfer its interest to elder Dempster and Co in 1893;
this led to the formation of new bank known as British Bank of West
Africa (BBWA) in 1893 with the initial capital of £10,000 which was
later increased to £100,000 the same year.
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The British Bank of West Africa (BBWA) was the first surviving bank
in Nigeria and registered in London as a Limited Liability Company in
March 1894, and the same year other branches started springing up.
The Barclay Bank Dominion Colonial and overseas (BBDC) was
established in Lagos in 1971 now Union Bank of Nigeria PLC.
Another bank, the British and French Bank in 1949, now called
United Bank of Africa PLC was established in 1949 making it the
third expatriate banks to dominate early Nigerian Commercial
Banks. The foreign banks came principally to render services in
connection with international trade, so their relation as at that time
was with company and with the government. These three banks
control closed up to 90% aggregate bank deposits from 1914 to
early 1930s, several abortive attempts were made to establish
locally owned foreign monopoly.
In Paton (1949), the indigenous sectors in 1929, industrial and
commercial banks were set up by a handful of patriotic Nigerians. It
folded up in 1930s due to their under capitalization, poor
management, aggressive competition from expatriate banks
(Emeka, 1999).
According to CBN (1970) many in indigenous banks were opened
and later dissolved or collapsed between 1947 and 1952, a total of
22 banks were registered in Nigeria. However a figure as high as
185 banks were quoted from government records in 2000, but from
2005 till date after banking reform, 22 banks was left for operation
and was licensed as commercial banks in Nigeria.
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Today, banking business or industry are licensed to operate as
follows;
Merchant bank, Commercial bank, Specialized banks.
The central bank of Nigeria repealed the universal banking
operations in September 2010 therefore, directed all commercial
banks to divert from non-banking business (Alawiye, 2011).
This reform measure effectively signaled the reversal of the
universal banking operations in the banking industry and making
banks to choose International, National or Regional banking licenses.
VARIOUS ACTIVITIES BANKS ENGAGE IN NIGERIA
Banking is the heart of economic development of any nation. The
following are the activities banks engage in Nigeria.
1. Granting consumer loans: Early in this century, bankers
began to rely more heavily on consumers for deposit to help
fund their large corporate loans. By the year 1920s and 1930s
several major banks led by one of the forerunners of New
York’s Citibank and by the bank of America, had established
strong consumer loan departments. This means consumer
loans were among the fastest growing forms of bank credit.
2. Financial advisory: This is a situation where banks engage in
many financial advisory services, from helping to prepare tax
returns and financial plans for individuals to consulting firms
about marketing opportunities at home and abroad for business
customers. They also provide financial advisory when it comes
to the use of credit and the saving or investing of funds. (Nwite,
2004)
3. Managing cash: This means that over the years, financial
institutions have found that some of the services they provide
5
for themselves are also valuable for their customers. And one
of the most prominent is cash management services in which a
financial intermediary agrees to handle cash collections and
disbursement for a business firm and to invest any temporary
cash surpluses in interest bearing assets until cash is needed to
pay bills.
4. Offering equipment leasing: This means that many banks
and finance companies have moved aggressively to offer their
business customers the option to purchase equipment through
a lease arrangement in which the lending institution buys the
equipments and rents it to the customer. These equipment
leasing services benefit leasing institutions as well as their
customers because as the real owner of the leased equipment,
the lessor can depreciate it for additional tax benefits.
5. Making venture capital loans: This means that banks,
security dealers and other financial conglomerates have
become active in financing the start-up cost of new companies.
This is because of the risk involved in such loans, it is generally
done through a separate venture capital firm, that raises
money from investors to support young businesses in the hope
of turning a profit when those firms are sold or go public.
6. Selling insurance policies: For many years bankers have
sold credit life insurance to their customers receiving loans,
guaranteeing repayment if borrowers die or become disabled.
Moreover, during the 19th and early 20th centuries, many
bankers sold insurance and provided financial advice to their
customers, though they do that through organized insurance
companies.
VARIOUS RISKS THAT ARISES IN BANKING ACTIVITIES
6
There are basic risks which are inherent in banking operations.
These forms of risk (Rose, 1999) are as identified and explained
below:
1. Credit risk: Banks make loans and take on securities that are
nothing more than promises to pay. When borrowing customers
fail to make some or all of their promised interest and principal
payments, these defaulted loan and securities result in losses
that can eventually erode the bank’s capital. Because owners
capital is usually no more than 10 percent of the volume of
bank loans and risky securities (and often much less than that),
it doesn’t take too many defaults on loans and securities before
capital become inadequate to absorb further losses. At this
point, the bank fails and will close unless the regulatory
authorities elect to keep it afloat until a buyer can be found.
2. Liquidity risk: There is also substantial liquidity risk in
banking the danger of running out of cash when cash is needed
to cover deposit withdrawals and to meet the credit requests of
good customers. If a bank cannot raise cash in timely fashion, it
is likely to loss many of its customers and suffers a loss in
earnings for its owners. If the cash shortage persists, this may
lead to runs on the bank and ultimate collapse. The inability of
a bank to meet its liquidity needs at reasonable cost is often a
prime signal that it is in serious trouble.
3. Interest rate risk: Banks also encounter risk to their spread –
that is, the danger that revenues from earning assets will
decline or that interest expenses will rise significantly,
squeezing the spread between revenues and expenses, thereby
reducing net income. Changes in the spread between bank
revenues and expenses are usually related to either portfolio
management decisions (i.e changes in the composition of
7
banks assets and liabilities) or interest rate risk. The
probability that fluctuating interest rates will result in
significant appreciation or depreciation of the value of and the
return from the bank’s assets. In recent years, banks have
found ways to reduce their interest rate risk exposure, but such
risks have not been completely eliminated.
4. Operating risk: Bank also face significant operating risk due
to possible breakdowns in quality control, inefficiencies in
producing and delivering services, or simple errors in judgment
by management fluctuations in the economy that impact the
demand for each individual bank’s services and shifts in
competition as new suppliers of financial services enter or
leave a particular banks market area. These changes can
adversely affect a bank’s revenue flows, its operating costs,
and the value of the owners investment in the bank, e.g its
stock price.
5. Exchange risk: Larger banks face exchange risk from their
dealings in foreign currency. The world’s most tradeable
currencies float with changing market conditions today. Banks
trading in these currencies for themselves and their customers
continually run the risk of adverse price movements on both
the buying and selling sides of this market.
6. Crime risk: Finally, banks encounter significant crime risk
fraud or embezzlement by bank employee or directors can
weaken a bank severally and in some instance, lead to its
failure. In fact, fraud and embezzlement from insiders
constitute one of the prime causes of recent bank closings.
Moreover, the large amounts of money that banks keep in their
vaults often proves to be an irresistible attraction of outsides.
The focus of ban robberies has shifted somewhat with changes
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in banking technology, theft from ATMs and from and from
patrons using those money machines has becomes one of the
moist problematic aspects of bank crime risk today.
THE ROLE OF INSURANCE INDUSTRY IN THE MANAGEMENT OF
BANKING RISK
The insurance industry from its creation, formation and operation
are expert in risk management.
The insurance industry usually conduct survey, to identify the
operational risks that arises from the environment and other risks.
First risks are first identified by the experts and if they are identified
they will be evaluated or measured to know the magnitude, to find
out if such risks can be retained by the organization or insured by
the insurance company. Then the final stage is the risk control
popularly called risk treatment will come in.
Nwite (2004) opines that the risk treatment can be financial or
physical organizations employ staff, train them organize seminars,
conferences, workshop all on the aim of training their staff.
They also provide safety gadgets for staff and ensure compliance.
The flow chart and the operations are always monitored. Sometimes,
tags, fences are used to protect places that are not meant for
visitors. In most cases depending on the type of organizations,
customers are trained that come to the banking premises.
In the banking industry, they own property, rent or build houses for
office use, electrical appliances are used staff of various categories
are employed. They own vehicles, have keyman, interact with the
general public, lend out money and also participate in some projects
jointly.
All these activities are the ways risks arises in insurance practice.
These various categories of risks are managed through avoidance,
9
reduction, retention, transfer, combination, research diversification
and hedging. These will be discussed in the course of the work.
DEFENSIVE MEASURES AGAINST RISK BEING HANDLED BY
OTHER INSTITUTIONS
There are other risks of banks which are being handled by other
institutions, these involves the use of the following measures;
1. Deposit with central bank of Nigeria: The deposit funds
with the apex bank is also a measure against the risks involved
in banking business. These deposits are funded through
liquidity reserve and cash reserve which are in many cases
compulsory as normally adjusted in terms of their ratios on
period basis. Such funds constitute safety reserve against a run
on the banks.
2. Deposit insurance with NDIC: In Nigeria, it is compulsory for
the banks to insure their deposits with the Nigeria Deposit
Insurance Corporation (NDIC). Hence, the commercial banks
and microfinance banks do insure their depositors funds with
NDIC so that in the event of failure, such customers can be
compensated the scheme is designed by the government to
prevent runs on other banks when any particular bank fails. The
scheme therefore promotes the public confidence in the
banking system. The NDIC in conjunction with the apex bank
does guarantee loans for other banks in the event of illiquidity
or insolvency.
3. Risk transfer: The banks do insure their operational assets
with the insurance for future compensation in the events of loss
occurring from their inherent perils. It implies that commercial
and microfinance banks do normally insure their physical
assets against operational hazards as well as environmental
10
hazards. Hence, the banks transfer some of the risks in banking
business to insurance companies with the payment of
premium. The payment is to guarantee reinstatement where
the risks insured against eventually occur.
VARIOUS POLICIES INSURANCE INDUSTRY OFFER TO BANKS
Insurance industry offer a lot of services to the banking industry.
Such services ranges from advisory role, credit management role,
risk management role and acceptance of risk role.
Mordi (1987) outlines such insurance services provided to the
banking industry, such are;
1. Theft insurance policy: Theft according to theft act of 1968
was defined as taking something which does not belong to you
without the intention of bringing it back. This type of risk is
exposed to the banks
2. Fidelity insurance policy: The Nigerian banking industry
engage in employment of staff. Most of the frauds that occur in
the banking industry do arise do to insider abuse among the
staff, hence, these evil practices need to be protected, because
of bad moral hazard infidelity to a keyman’s knowledge is
dishonesty.
3. Legal expenses insurance: Banks can be taken to court by
their customers and the fire, the bank may not pay or if they
pay it, it will have serious effect in the financial statement.
4. Professional indemnity insurance policies. Insurance
companies usually advise people on some financial
transactions because they are held for professional negligence.
5. Keyman insurance: Some staff are very important in any
operation, and that of banking is not exception. So if such
11
happens, the company will be idle for the period until they
employ another capable staff which is not always very easy.
6. Motor insurance: The banks have motor vehicles and these
vehicles has to be insured on any of the classes of motor
insurance like third party only, theft and fire and
comprehensive.
7. Accident insurance policy: The staff of the bank are also
exposed to accident; so they also need to protect the staff
against accident.
8. Life assurance policies like group life assurance and workmen
compensation are now made compulsory to enable efficient
operation and safeguard against any unexpected happening.
9. Credit insurance policies: Banks give out loans to
customers. There in any probabilities that such loan may not
be paid or delayed in payment. Aggregate of such loans may
also result to distress in the banks; hence it needs to be seen.
10. Health insurance scheme, contributory pension scheme. All
these are insurance practices and need to be appreciated by
banks to enhance efficient practice.
11. Cash in transit, money in safe insurance. Every time banks
carry money from one place to the other. They are also
exposed to risk and need to be insured. Even the police or
military following the money and the drivers need to be insured
because in most times, categories of people of this nature have
lost their lives.
PROBLEMS OF MANAGEMENT OF BANKING RISKS
Risk is one of the difficult things to manage. There are some
problems that rise on the process of managing risk. They are as
follows:
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1. Problem of owner’s capital: The owner’s capital or share
capital funds constitute the first line of problem in managing
risk in bank business. This is because capital fund of the bank
is normally used to provide a hedge against the risk of failure.
Hence, it is used to absorb financial and operating losses until
management can address the bank’s problems.
2. Problem of quality management: Recruitment of quality,
seasoned and experienced bank managers is one of the major
problems in managing risk in banking industry. Such quality
management of banks has to be proactive as well as reactive
in their posture so that they can deal with banks problems.
Managing of banking risks involves the ability of the top
managers to move shiftily to deal with a bank’s problems
before they overwhelm the institution.
3. Problem of diversification: The management of a bank can
use the bank can use the bank’s sources and uses of funds to
reduce operation risk. Generally, banks strive to achieve two
types problems in risk diversification, portfolio and
geographical diversification.
4. Problem of risk retention: This means that banks normally
do not take insurance policies on minutes items of operations
and ill experience in risk management.
5. Problem of mismatch of assets and liabilities: This is the
problem or the risk banking industry encounter when using
short term finance to finance long term investment. It will
connote serious problems.
CONCLUSION
The management of banking risk has been discovered as an
instrument for effective operation of banking industry. Though it is
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being handled by both the banks and other institutions through
appropriate measures, which involve the apex bank (CBN), Nigeria
Deposit Insurance Corporation (NDIC) and insurance companies.
Adequate risk management is the best way of handling risk in the
banking industry.
RECOMMENDATIONS
The recommendations of this work are as follows;
1. There is the need for banks to employ insurance professionals
in their corporate affairs departments to handle the insurance
of their physical facilities. Such professionals would pre-occupy
themselves with risk identification and treatment. They will also
liaise with insurance companies handling their banks insurance
policies. They will also be useful in credit risk analysis and
prediction.
2. There is the need for banks to engage in risk research in order
to reduce baking hazards. This is where the employment of
insurance professionals becomes very relevant.
3. The staff of banks should be appropriately remunerated to
eliminate human attitudes that can aggravate the occurrence
of some risks in bank business.
4. All banks should strive o make use of bullet proof billion vans in
order to eliminate hazards that can lead to attack on cash in
transit.
5. All banks should strive to install security doors in their premises
to checkmate the activities of hood hems on their banking
halls.
6. Insurance and risk management awareness seminars and
conferences.
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