Intuitively,
we are all well aware that the banking and financial system of a country plays a
key role in mobilizing savings from the society and channelling them into
productive investments. It is this intermediation that ultimately defines the pace
of a country’s economic development and the quality of life of its citizens.
Indeed, society often takes for granted this critical function of transforming
society’s savings into investments by banks. But, financial intermediation is
fraught with many risks. Hence, a well-functioning banking and financial system
is a must for a country’s long-term economic prosperity.
To
accomplish the task of efficient intermediation, there is a real need for a
sound institutional framework duly supported by an equally effective legal
system that can induce households to save a part of their current income and
entrust it to financial institutions for safekeeping. In the whole process of
entrusting their savings to the banking system, the households would be
interested in an adequate compensation for the quantum of risk they are taking
under the exchange. And, for banks to fulfil this requirement, they must enjoy
a wide array of safe investment avenues. Thus, the assets side of a bank’s
balance sheet becomes equally important for financial intermediation. Any
non-prudent lending exposes a bank to losses. Such losses on the assets side
are certain to result in banks’ defaulting, under their obligations to
depositors. If a bank’s ability to honor its deposit obligations is doubtful,
then its very ability to retain deposits comes under question. Once depositors
lose confidence in a bank, it becomes difficult for banks not only to retain
the existing depositors, but also to mobilize new deposits. No wonder, if such
a predicament generates a “run” on bank. Such a run on a single bank is
potential enough to generate a contagion effect that can ultimately cripple the
very financial system of a country. An efficient banking system, besides
impacting the costs of financial intermediation and the overall stability of
the financial markets, facilitates efficient allocation of the scarce financial
resources, particularly in developing countries, paving the way for an
integrated economic development. Thus, to have a sustainable economic growth
the banking system of a country must be sound. An extension of this analogy
asserts that prudent risk management systems are a must for a sound banking
system. In other words, it is the management of balance sheet risks by the
intermediaries that ultimately ensures a sound financial system in a country.
It
is in this context that it has become a challenging task for every bank to
formulate its “expectations” about macroeconomic indicators that are known to
impact a bank’s business, and accordingly draft its risk management policies
and practices. It is all the more aggravated with the kind of wild fluctuations
noticed under various macroeconomic indicators such as rate of inflation, rate
of interest, price of primary commodities, price of crude oil, etc., during the
last two decades. Despite such wild fluctuations, the role of ‘expectations’ in business decisions is gaining more
importance. Today, a bank must be able to formulate its expectations about the
conditions likely to prevail in the future, their impact on business prospects,
and the counter-measures that can safely steer its investment plans in
consistence with the expectations. A need thus arises for these expectations to
be rational for averting any untoward shocks. But, expectations about the
future behavior of economic variables such as rate of inflation, rate of
interest, exchange rate, rate of primary commodities, etc., remained an enigma
despite the evolution of statistical techniques such as the time-series
analysis, econometric models, and survey of intentions of the concerned agents
and organizations. The empirical literature about the accuracy and rationality
of ‘expectations’ made about economic variables is quite limited. It is in this
context that the article, “Do Bankers make Rational Economic Forecasts?”,
attempts to evaluate the accuracy of the economic forecasts made by Malaysian
banks and the rationality of survey data. The findings revealed that Malaysian
banks do make rational economic forecasts for gross revenue and employment but
not for capital expenditure.
As
seen earlier, it is the credit portfolio that enables a bank to discharge its
obligations to depositors and thereby ensures its sustainability. It is in this
context that the article, Post-merger Banks’ Efficiency and Risk in Emerging
Market: Evidence from Malaysia”, evaluates the effectiveness of the banking
system in Malaysia in general and the impact of the mega-mergers in the banking
system on the overall efficiency of the domestically incorporated commercial banks.
The authors have used the non-parametric method of Data Envelopment Analysis to
measure the effectiveness of mergers. They have also attempted to identify
factors that determine the efficiency of banks by employing the Tobit
regression analysis in the second stage regression. The results indicate that
there is a minimal mean input waste among Malaysian banks during the
post-merged phase. The results also suggest that a bank’s size has a negative
impact, while market power has a positive impact, on the overall and technical
efficiency of Malaysian banks.
In
line with the central objective of managing the risk embedded in the balance
sheet of banks for ensuring efficient financial intermediation, the article,
“Duration Approach to Measure Bank’s Risks”, proposes a model to measure the
risk that a bank faces in the discharge of its intermediation using duration
gap between assets and liabilities. The article considers duration gap as a
better approach to measure banks’ risk exposure since it factors in the impact
of interest rate changes, and other shocks like market risk and exchange rate
risk. The article, using a sample data collected from 16 banks to work out a
duration ratio by using two proxies—one based on assets and liabilities, and the other on interest revenues and
expenses—concludes that the duration is measured based on interest revenues and
expenses as a more reliable measure of a bank’s risk. This study throws open a
larger scope for further research on the reliability of duration ratio as a
measure of banks’ risk using time-series data over longer periods.
Greater
attention is being paid towards infrastructure development in the country
today. Private participation is encouraged even in sectors such as roads,
ports, airports, etc. Simultaneously, new avenues for financing infrastructure
projects are being thrown open. Even commercial banks are encouraged to lend to
infrastructure projects in spite of the long gestation periods of such
projects. At the same time, banks are also being subjected to rigorous
regulatory supervision in terms of risk-based capital, identification of bad
debts and provisions thereof. These conflicting demands have placed banks in a
quandary, and thus, risk management has emerged as the prime requirement for
the success of banks. Against this backdrop, the article, “A Model for
Risk-based Pricing of Infrastructure Financing by Banks”, attempts to prescribe
a model risk-pricing mechanism under infrastructure financing, by considering
various macroeconomic factors that are prone to influence cash flows of the
financed infrastructure projects.
In
order to perform the role of financial intermediation in a country’s economy
successfully, the commercial banking system must strive to strike a balance
between risk-taking and the need to maintain public confidence. It is in this
context that a well functioning government securities market including a viable
secondary market can provide a set of safe assets that can support, at least, a
certain quantum of intermediation with no risk. Simply put, a safe government
debt essentially functions as collateral for financial intermediation by banks.
That is the prime reason why the balance sheets of banks, particularly in
developing economies, show large amounts of government debt on the assets side.
Government debt also plays an important role as a benchmark for private sector
bond markets. However, there is also a flip side: Too much exposure to
government debt constrains the flow of credit to enterprises. Ever since Indian
banking system has been subjected to rigorous prudential norms, banks have been
found to maintain high exposure to government debt vis-à-vis private lending,
as the latter is perceived as more risky. In this context, the article,
“Government Debt: A Key Role in Financial Intermediation”, attempts to get as
many plausible answers as there could be for the question, “Does
state-contingent inflation on government debt represent an optimal way to
conduct fiscal policy in response to shocks?”
Courtesy: IJBM Vol 4 No.4
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