GAAP: The rules for monetary reporting

Risk:

Risk by default has tow components; uncertainty and exposure. If both are not present, there is no risk. Definition of Risk as per Guidelines on Risk Management issued by State Bank of Pakistan is, "Financial risk in a banking organization is possibility that the outcome of an action or event could bring up adverse impacts. Credit Risk

Market Risk

Liquidity Risk

Operational Risk

Country Risk

Legal Risks

Compliance Risk

Reputational Risk

Broadly speaking there are four risks as per Risk Management Guidelines which surround Financial Sector i.e. Credit Risk, Market Risk, Liquidity Risk and Operational Risk. These risk are elaborated here under:

i. Credit Risk

This risk is associated with financing transactions i.e.:

Market Risk

This risk involves interest rate risk in all of its components: equity risk, exchange risk and commodity risk.

Liquidity Risk

Operational Risk

Need for Risk Management and Monitoring:

Risk monitoring in financial sector is very crucial and an inevitable part of risk management. Risk Monitoring is important in the financial sector due to the following reasons:

Bankruptcy of Barings Bank due to short selling / long position that is market risk.

Appetite of a financial institution to take risk is related with the capital base of the institute so it caries a huge risk of over exposure.

Components of Risk Management Frame Work

Risk Management Frame Work has five components.

The International Organization for Standardization (ISO) has defined risk management as the identification, analysis, evaluation, treatment (control), monitoring, review and communication of risk.

Structure of Risk Management

Depending upon the structure and operations of organization, financial risk management can be implemented in different ways. Risk management structure defines the different layers of an organization at which risk is identified and managed.

Risk Management

Corporate level Policies

Risk management strategy

Well-defined policies and procedures by senior management

Independent Risk review function

A bank can reduce its credit risk by getting to know its borrowers.

Functionally, there are four aspects of financial risk management.

No one can manage risk if they are not prepared to take risk. A positive risk culture is one which promotes individual responsibility and is supportive of risk taking.

Used correctly, procedures are powerful tool of risk management.

The primary role technology plays in risk management is risk assessment and communication.

D. Independence or risk management professionals

To get the desired outcome from risk management, risk managers must be independent of risk taking functions within the organization. Enron's experience with risk management is instructive. The firm maintained a risk management function staffed with capable employees.

Internal Controls

The system of internal controls includes financial, operational and compliance controls."

 Internal control is a process.

 Internal control is effected by people.

Internal control should assist and never impede management and staff from achieving their objectives. Senior management should set a good example about control compliance.

Components of Internal Controls

Risk Assessments,

Control Activities,

Tools for Monitoring of Risk

Management Information System

Asset-Liability Management Committee (ALCO)

Duties pertaining to key elements of the risk management process should be adequately separated to avoid potential conflicts of interest - in other words, a financial institution's risk monitoring and control functions should be sufficiently independent from its risk-taking functions.

c) A strong financial risk management function (independent of business lines), adequate internal control systems (including internal and external audit functions), and functional process design with the necessary checks and balances.

I. Credit Risk

Market

Financial Institutions should also have an adequate system of internal controls to oversee the interest rate risk management process. The institution's board of directors has ultimate responsibility for the management of interest rate risk. The board approves the business strategies that determine the degree of exposure to risk and provides guidance on the level of interest rate risk that is acceptable to the institution, on the policies that limit risk exposure, and on the procedures, lines of authority, and accountability related to risk management. The board also should systematically review risk, in such a way as to fully understand the level of risk exposure and to assess the performance of management in monitoring and controlling risks in compliance with board policies.

Risk Management and Risk Budgets

Once an annual risk budget has been established, a system of risk limits needs to be put in place to guard against actual or potential losses exceeding the risk budget. Stop-loss limits are set relative to the overall risk budget. Liquidity Risk

The ALCO has responsibility for setting and monitoring liquidity risk limits.

Risk-weighted Assets + (Market Risk Capital Charge x 12.5)

Operational Risk

To manage this risk documented policies and procedures are established.

Managing Risk in Financial Sector

In extra generally accepted accounting principles (GAAP) is a set of rules, conventions, standards and procedures, established by the financial accounting standards board for recording and reporting financial information.

Generally accepted accounting principles (GAAP) is implemented through measurement principles and revelation principles.