rahmanullah rasa measuring and managing risk in … · 2018-01-02 · measuring and managing risk...

Rahmanullah Rasa

Measuring and managing risk in financial

institutions in Afghanistan

Volume | 036 Bochum/Kabul | 2017 www.development-research.org | www.afghaneconomicsociety.org

Measuring and managing risk in financial institutions in Afghanistan

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Measuring and managing risk in financial institutions in

Afghanistan

Rahmanullah Rasa

Keywords: Measuring Risk, Managing Risk, Risk Management, Commercial Bank,

Afghanistan, Basel II

Abstract

The objective of this study is to find the main risk drivers, risk measurement approaches and

deficits in risk management procedures in the Afghan banking sector. To study risk management

in commercial banks in Afghanistan, all sixteen registered commercial banks with DAB (Da

Afghanistan Bank) have been selected for this research. Using descriptive statistics and sub-

sample analysis, it was found that the main risk drivers are credit risk-the most relevant risk factor,

liquidity risk and operational risk. Forty-three percent banks use simplified standardized approach

to measure credit risk exposure. In addition, 64% of banks use standardized measurement to

measure market risk. Regarding operational risk measurement, 54% of banks use a basic

indicator approach. Large banks use more sophisticated and advanced approaches in order to

measure risk. The main deficits in risk management procedures that negatively impact the whole

Afghan banking sector are the lack of technical knowledge, qualified and trained personnel in risk

management, difficulties in quantifying risks, quality of information and high cost of information

technology. The study also found that missing and lack of expertise in risk management have

adverse consequences on the stability and development of the financial sector in Afghanistan.

Description of Data

To find the main risk factors, risk management approaches and deficits in risk management

procedures in the Afghan banking sector, a survey based on a questionnaire for the whole target

population has been conducted. They were sixteen commercial banks consisting of eleven

domestic and five branches of foreign banks. All sixteen banks were the study sample. Four sets

of information were obtained from each bank. The first part of the questionnaire contains general

information, such as bank name, domestic or foreign bank, people working in risk management

department and risk tolerance. Second part of the questionnaire attempts to find risk awareness

and deficits. This section comprises importance of risks, challenges in credit risk management

policies, identification of credit worthiness of customers, risk management reporting and risk

management culture within the bank. A third part of the questionnaire was about risk

measurement approaches which includes credit risk, market risk and operational risk


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measurement approaches. The last part of the questionnaire had personal information, such as

number of years of experience in credit risk management and position in bank.

The primary data collected on the basis of the questionnaires was checked, coded and entered

into Microsoft Excel program for analysis. Some sort of descriptive analyses about general risk

measures and awareness in the sector were prepared to identify the differences and/or changes

among the banks. Furthermore, for the subsample analysis, Microsoft Excel was used to test

hypotheses that large banks use more sophisticated and advanced risk management procedures

to measure risk, and an implementation of Basel II improves risk management processes.

All sixteen commercial banks answered the same questionnaire. Each bank was selected to

answer only one questionnaire. One member of each bank answered the questionnaire. Before

answering the questionnaire, the purpose of the research was briefly made clear by providing

more details. Multiple hierarchical layers of the banks were chosen to answer the questionnaires.

It includes executive board members, heads of department, risk officers, senior executive

managers, chief risk officers, deputy chief officers and credit risk managers. Different hierarchical

layers could produce a more holistic and broader picture of factors.

Research Question/Theoretical contextualization

There are many factors that cause volatility of returns that could lead to unexpected losses. The

business universe has not been free of risk; it has been affected by different factors in various

ways. Globally, more than 50% of total risk elements in banks and financial institutions are credit

risk alone. Thus managing credit risk for efficient management of a financial institution has

gradually become the most crucial task (Bangladesh Bank, 2005).

The study focuses on answering the following questions:

1: What are the main risk drivers (risk factors) in the Afghan banking sector?

2: What are the central risk management approaches used?

3: What kinds of deficits exist in the risk management procedures and what are their implications

for the entire banking system and the Afghan economy?

The important task of risk management to accurately control risks is to take action where and

when risk arises and prevents rather than treat it (Carrel, 2010). The capital market in Afghanistan

is developing rapidly despite inadequacies in the legal framework, especially weak formal

mechanisms for contract enforcement (Pavlović & Charap, 2009). There are measuring problems

in some sectors in Afghanistan due to illiteracy and weaknesses in documentation of identity. The

lack of implementation and supervision of protective measures such as identification of customers

and proper testing did play a role in the creation of a major financial fraud in the most important


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commercial bank (IMF, 2011). Commercial banks in Afghanistan operate in the same

environment, but with different approaches to lending, and some of them have insignificant

lending activity, while others have a large loans portfolio for domestic businesses (Pavlović &

Charap, 2009).

Since it is difficult to forecast the future and the estimation of future events is tentative, risk can

be defined as “the volatility of returns leading to unexpected losses” with higher volatility indicating

higher risk (Crouhy, et al., 2006). There are several variables that negatively affect the volatility

of returns, which are called risk factors. Financial institutions face three types of risks: risks that

can be eliminated, those that can be transferred to others, and the risks that can be managed by

the institutions (Khan & Ahmed, 2001). Financial intermediaries can avoid certain risks by simple

business practices and will not take up activities that impose risks upon them. The practice of

financial institutions is to take up activities in which risks can be efficiently managed, eliminated,

or transferred to others (Khan & Ahmed, 2001).

All risk factors have to be identified at first, in order to understand which factors cause the volatility

of returns that may lead to unexpected losses. For instance, in the case of loans, the risk factor

will be the volatility of the interest rate (Crouhy, et al., 2006). Instability in interest rates, equity

prices, foreign exchange rate and commodity prices affect the financial markets regularly. If the

financial market is affected unfavorably by instabilities of these factors one can claim that a market

risk occurred (Jorion, 2003).

Having liquid assets in banks can be converted easily to cash to meet short-term obligations of

counterparties. However, in case of lack of liquid assets, banks will face assets liquidity risk

(Bessis, 2002). Therefore, the smaller banks are more vulnerable to failure on liquidity problems,

while the larger cross-border banks characteristically fail on inadequate capital buffers

(Vanzquesz & Federico, 2012). Regulatory and supervisory stress should be placed to ensure

that the capital buffers of the systemically vital banks are corresponding with their risk-taking

(Vanzquesz & Federico, 2012).

Very tight controls are an absolute necessity if a bank is to avoid large losses resulting from

inadequate systems, management failure, faulty controls, fraud, and human error (Crouhy, et al.,

2006). Fraud, employment practices, client relations, physical assets, business interference,

system failures, and business processes are the elements due to which operational risk takes

place in banks (Murphy, 2008). An operational risk is the risk of loss resulting from inadequate or

failed internal processes, people and systems or from external events (Committee, 2006). In

practice, risk measurement focuses on the negative aspect of outcomes rather than positive

aspect of outcomes. So measures of risk have a tendency to focus on the probability of losses

rather than differentiating the complete allocation of possible future outcomes (Lowe, 2002).


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The existence of different ways of lending in banks in Afghanistan show that they have different

possible sources of income, different attitudes toward risk or perceived risk or face different credit

risks. Moreover, the bank perceptions on risk may differ in lending practices and it may also show

some banks motivation to engage in riskier activities in pursuit of profitable lending opportunities

(Pavlović & Charap, 2009).

Despite having risk management in DAB, the nonexistence of enforcing security agreements is a

serious problem. There are no proper arrangements for valuing and enforcing collaterals (and

especially mortgages), as well as no information on credit history of the customers. These

shortages raise the transaction cost of the banks offering credits and other services to its clients

and increases the risk of undesirable selection (DAB, 2009). Despite the fact that DAB has

improved its capacity for banking supervision, the rapid growth of the banking sector still continues

to be challenging as illustrated by the Kabul Bank crisis in 2010. The collapse of Kabul Bank

threatened the stability of the whole banking system and consequently the trust of individuals on

banking system is decreasing (IMF, 2011).

The bank size is used to measure economies or diseconomies of scale in the banking sector. The

cost differences could cause a positive relationship between size and bank performance, if there

are significant economies of scale (Goddard, et al., 2004). In addition, size is closely related to

the capital sufficiency of a bank since relatively large banks tend to raise less expensive capital

and, for this reason, they seem more profitable (Chen, 2009). The size continues to be an

influential factor in driving bank’s performance (Fayman, 2009). The Basel Committee itself

expects that all banks, beginning with the larger ones, would enhance their information system in

terms of sophistication to meet rigidly accurate supervisory requirements. It is logical to think that

larger banks would aim to increase the degree of sophistication in their information system

(Bonson, et al., 2008). Using more sophisticated regulatory risk measurement approaches is

giving the banks an option to set aside less capital for covering risk exposures (Willesson, 2009).

Field research design/ Methods of data gathering

The selected area and target population of this study were all sixteen registered commercial

banks with DAB. For all of these banks, only one questionnaire was prepared. The same

questionnaire was answered by each bank. People who answered the questionnaire were

different. They were board members, heads of risk management departments, risk officers, senior

executives, risk managers, chief risk officer, deputy chief officer and credit risk manager.

Since we had only 16 banks, the data collection for the entire target population were possible.

The whole population were 16 commercial banks, 11 domestic and 5 branches; of foreign banks.

Different sources of data were sought and explored to complete the empirical impact study.


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Primary data and secondary data comprised the data sources. The survey was conducted at the

beginning of January 2013.

Primary data was the main and core data source for the empirical study on measuring and

managing risk in financial institutions. Therefore, the same questionnaire was sent to the risk

management departments of each bank be to complete. The secondary data was based on the

financial statements of all sixteen commercial banks, past researches in the field, publications

and annual reports. The sources of the secondary data were mostly the banks, DAB, IMF and

some institutions’ reports. The subsample analysis was based on financial statements of banks

for the years 2010 - 2012. The availabilities of the financial statements for all banks for the years

2009-2013 were limited. During the data collection, the financial statements for the year 2010 of

two banks, the financial statements for the year 2011 of eleven banks, and the financial

statements for the year 2012 of three banks were available. During the data collection, Shamsi

(solar) year was used as a fiscal year of banks to prepare financial statements and annuals

reports. Not all banks prepared financial statements for 2012, because the Shamsi year has not

been over1. The banks were supposed to publish financial statements and annual reports in the

middle of March 2013 for the year 2012, but the data collection took place at the beginning of

2013. Financial statements from 2009-2012 were needed for the study to analyze the relations

between profitability and risk management in the sector, as well as to test the theory that foreign

banks are more profitable than domestic banks in developing countries. To measure profitability

in banks, the financial statements for the same and chosen years for all banks were necessary.

To get the relevant secondary data, an appointment was made with each bank separately. Half

of the banks provided the missing data. The remaining banks had promised that it would be

published on their websites as soon as possible in the near future. Unfortunately, the financial

statements of all banks for the chosen years were not completely available. The financial

supervision department of DAB was the final source to get the financial statements of all

commercial banks for the years 2009-2012. The department rejected the request and said it was

confidential documents. Therefore, the subsample analysis was based on the latest available

financial statements of the banks. Due to the lack of consecutive financial statements for the

chosen interval and the missing of some important figures in the existed financial statements,

some important subsample analysis were not conducted.

Results

The study indicates that the main risk drivers in the Afghan banking sector are credit risk, liquidity

risk and operational risk. Additionally, with regard to credit risk, Figure 1 below describes that 75%

1 There is a difference between Shamsi and Georgian years. The time difference between these two years is around

three months.


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of the banks ensure a very high credit risk. Based on this evidence, it can be seen that credit risk

is one of the main risk drivers in the Afghan banking sector.

Figure 1: Risk Drivers

Liquidity risk arises during the inability of banks to meet and fulfill the counterparties obligations

and requirements. Speaking about the influence of liquidity risk, Figure 1 above explains that 50%

of the banks confirmed that liquidity risk is very high. Business intervention, management failures,

weak systems, client relations, fraud and human error are the most relevant factors of operational

risk. The figure shows that 44% of the banks confirmed that operational risk is very high in the

Afghan banking sector. One can argue that poor management and systems, lack of qualified staff

and fraud are the main factors of operational risk in the Afghan banking sector. Compare to credit

risk, liquidity risk and operational risk, the study demonstrates that market risk is not the main risk

driver in the sector. One can contend that there is no stock market in Afghanistan.

There are various approaches to calculate the capital requirements in banks for important risk

factors such as credit risk, market risk and operational risk. Figure 2 describes the approaches

that are used in the Afghan banking sector to quantify and analyze credit risk exposures in their

banks accordingly.

Figure 2: Credit Risk Measurement Approaches

Source: Author’s Data

75%

50% 44%

20% 29%

25%

42%

13% 25%

20%

50%42%

19%25%

33%

21%16% 13%6%

27%5%

0%

20%

40%

60%

80%

100%

Credit risk Market risk Liquidity risk Operationalrisk

Interest risk Foreignexchange risk

Very high High Medium Low Very low

43%29%

14% 14%

0%20%40%60%80%

100%

SimplifiedStandardized

Standardized Advanced InternalRatings-Based

FoundationInternatl Ratings-

Based



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The figure describes that 43% of the banks are using simplified standardized approach to

calculate capital requirements for credit risk. One can argue that technical knowledge and

qualification in risk management is low in the sector.

The market risk measurement approaches are depicted in the Figure 3 as following:

Figure 3: Market Risk Measurement

The figure identifies that 64% of the banks use standardized measurement to calculate capital

requirements for market risk.

Operational risk measurement approaches that use in the Afghan banking sector are specified in

Figure 4 below:

Figure 4: Operational Risk Measurement

Lack of qualified staff and technical knowledge in the risk management departments cause

internal process failure and weak management in the banks. The Figure 4 shows that 54% of the

banks use a basic indicator approach to measure operational risk. One can say there is no enough

qualified personnel and technical knowledge in risk managements in the sector.

Total assets were used as proxy to distinguish between large and small banks. Median was used

as a division point to group banks into small and large banks. The median gives a view of equal

distribution of the numbers. Table 1 identifies that 83% of small banks use standardized approach

to measure credit risk. In addition, 50 % of large banks use advanced approach to measure credit

risk. It seems that large banks use more sophisticated and advanced approaches to measure

credit risk.

Table 1: Credit Risk Approaches

Bank Type Standardized Internal

Small Banks 83% 17%

Large Banks 50% 50%




54%

23% 15% 8%

0%

50%

100%

Basic Indicator AlternativeStandardized

Standardized AdvancedMeasurement

64%

36%

0%

50%

100%

StandardizedMeasurement

Internal Models


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The findings of the study show that market risk does not seem to be the most relevant risk factor

at all. One reason might be that the capital market is not well developed in Afghanistan. However,

to some extent the importance of market risk is high in the sector. The measuring approaches are

varying among the banks. Eighty percent of the small banks use standardized approach while

67% of the large banks use internal and advanced models to measure market risk. It is decided

by reasoning that large banks in the Afghan banking sector use more sophisticated approaches

to measure market risk. Furthermore, operational risk measurement models are explained in the

Table 2 below.

Table 2: Operational Risk Approaches

The table demonstrates that 71% of the small banks use a basic indicator approach to measure

operational risk. In addition, 50% of the large banks use standardized approach to measure

operational risk in their banks. Compare to basic indicator approach, standardized approach is

more advanced. Hence, one can say that the large banks use advanced models to calculate

capital requirements for operational risk in the sector. In large banks more sophisticated risk

management procedures and advanced information system are required that have to be applied

in order to manage and control risk.

Having difficulties in risk quantifications has a negative impact on the entire performance of the

banks. The study indicates that 56% of the banks have difficulties in quantifying risks in their

respective banks. In order to quantify risks, adequate and quality information is needed. Thus,

lack of timelines and quality of information are another challenge faced by credit risk management

in the course of the policy making process. The study reveals that 44% of the entire banking

sector faces the challenge of timelines and quality of information problems. Moreover, business

priorities are often conflicting and in some cases, it is complicated to select an appropriate

business. Nineteen percent of the banks confirmed that they have faced challenges and clashes

during business selection. Integration capability, an appropriate database for credit risk,

insufficient budget, difficulties in data gathering, human resources and political infighting are the

major problems during the implementation of Basel II in Afghanistan. The study findings reveal

that 87.5% of the banks confirmed that implementation of Basel II will improve the risk

management processes. In general, the majority acknowledged the importance of Basel II in the

Afghanistan banking sector. Having qualified and professional staff will help the risk management

to answer many issues related to various types of risk in a proper time. Adequate knowledge

regarding the standards of Basel II Accord is necessary to be acquired by the staff of the banks.

Bank Type Basic Indicator Standardized Advanced

Small Banks 71% 29% 0

Large Banks 33% 50% 17%



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Discussion & Conclusion

The outcome of the study indicates that the main risk drivers in the Afghan banking sector are

credit risk, liquidity risk and operational risk. The findings show that credit risk is the most relevant

risk factor. However, market risk does not seem to be a relevant risk factor at all. One can argue

that the capital market in Afghanistan is in the primary stage as well as in the developing process.

Lack of qualified staff, technical knowledge, poor management and systems, and fraud are the

main factors of operational risk in the Afghan banking sector.

The capital requirements calculation for credit risk, market risk and operational risk are varying

among the banks. Majority of the banks use a standardized approach to calculate the capital

requirements for credit risk. The study demonstrates that 64% of all banks use standardized

measurements to measure market risk in their banks. In addition, 54% of all banks use the basic

indicator approach to measure operational risk.

The subsample analysis findings show that large banks use more sophisticated and advanced

approaches to measure different risks in the Afghan banking sector. According to the subsample

analysis, the findings claim that 83% of the small banks use a standardized approach while 50%

of the large banks use more sophisticated and advanced approaches for credit risk measurement.

Eighty percent of the small banks use standardized and 67% of the large banks use more

sophisticated approaches to measure market risk. Furthermore, 71% of the small banks use a

basic indicator approach and 50% of the large banks use advanced approaches for operational

risk measurement in the sector. The assumption that large banks use more sophisticated and

advanced approaches to measure different risks holds valid and confirmed in the Afghan banking

sector. It is also logically true that large banks increase the degree of sophistication in order to

meet rigidly accurate supervisory requirements.

The main deficits in the risk management procedures that negatively impact the whole Afghan

banking sector are lack of technical knowledge, qualified and trained personnel in risk

management, difficulties in quantifying risks, quality of information and the high cost of information

technology. Missing expertise in risk management may have adverse consequences on the

stability and development of the financial sector in Afghanistan.

Implementation of Basel II improves the risk management processes. This hypothesis was

checked and tested in the Afghan banking sector. The study findings revealed that 87.5% of the

banks confirmed that the implementation of Basel II in Afghan banking sector will improve the risk

management processes. As a result, the hypothesis is valid in the sector.

The study also indicates that it is vitally important to hire qualified and professional staff, and

provide adequate training for the employees. Besides that, implementation of technology,

documents records, support from the board of director/executive level and having an enterprise

risk data as well as infrastructure in place are significant aspects. This will greatly contribute to


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create a successful risk management culture within banks in the sector. Having effective and

efficient risk management requires responsibility and accountability allocated equally amongst

responsible staff. It also requires implementation of successful risk management culture in the

organizations.

Further researches on profitability analysis from risk measuring and managing perspective are

required. Besides that, the impact of credit risk on profitability in the Afghan banking sector is

highly important and recommended to be researched in the future.


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