Risk Management In UK Banking - The Role Of Derivatives Hedging In Particular

Thesis (M.A.), 2010

53 Pages, Grade: 2,0


Table of Contents

Chapter I: Introduction

Chapter II: UK Financial system.
2.1. UK Financial Services and Banking at a Glance
2.2. Banks
2.2.1. Retail Banks
2.2.2. Wholesale banks
2.2.3. International Banks
2.3. Building Societies
2.4. Other Financial Institutions
2.4.1 Pension funds
2.4.2 Insurance funds
2.4.3. Finance houses
2.4.4. Unit trusts
2.4.5. Investment Funds
2.5. Regulatory Factors
2.5.1. Capital Adequacy Framework
2.5.2. Non-interest Bearing Reserves at Central Bank

Chapter III: Risk Management in UK Banking
3.1. Overview
3.2. Foreign Exchange and Interest Rate Risk
3.2.1. Foreign Exchange Risk
3.2.2. Interest Rate Risk
3.2.3. Derivative instruments Swaps Options Forwards and Futures
3.3. Credit risk
3.4. Market Risk

Chapter IV: Literature Review
4.1. Banking Institutions
4.2. Non-banking Institutions

Chapter V: Empirical Analysis
5.1. Theoretical Model
5.2. Data Characteristics
5.3. Empirical Results
5.3.1. First Stage
5.3.2. Second Stage

Chapter VI: Conclusion



Figure 1: UK banks: total lending to individuals and manufacturing (in £ mil.)

Figure 2: Total number of Building Societies and branches.12

Figure 3: Components of Tier 1 and Tier 2 capital and relevant regulatory limits..16

Figure 4: Swaps outstanding (in £ mil.)..22

Figure 5: Options outstanding (in £ mil.)..23

Figure 6: Forwards & Futures outstanding (in £ mil.)..24

Figure 7: Credit Derivatives outstanding (in £ mil.)26


Table 1: Concentration Analysis

Table 2: Autocorrelation and Heteroscedasticity test results

Table 3: Stage 1 regression results

Table 4: Stage 2 regression results


Risk management has been pivotal banking activity, particularly for the last 20 years. Volatile economic conditions and ever-growing competitive forces have compressed profit margins and forced UK banks to look up to sophisticated and more comprehensive methods of identifying optimal risk-return positions. Advanced technology and global business focus has presented opportunities to utilize comprehensive quantitative techniques to contain and manage risk exposure. Technology has played crucial role in establishing and dispersing electronic trading platforms giving access to equity and derivatives hence reshaping capital acquisition and risk management frameworks. The topic of risk management has been even more contextual in times of severe economic/financial crisis. Analysts have not only been critical of banks’ uncollateralized lending but also of their excessive trading with derivative instruments. Assuming that no arbitrage opportunities exist, the question remains as to whether banks attempt to hedge their risk exposure or purely speculate on the direction of price movements. In this context, central task of this dissertation is to examine the role derivative instruments play in the UK banking system through aggregately assessing risk position of largest UK banks relative to aggregate trading volumes. Empirical analysis is conducted utilizing a two-stage SUR technique. Results from first stage of empirical analysis confirm that risk premium on banks’ equity securities is strongly related to market risk premium. More importantly, findings illustrate that exchange rate exposure of UK banks has more significant impact on stock returns compared to interest rate risk exposure. Second stage of the analysis fails to provide comprehensive conclusion due and produces controversial results. Nevertheless, exchange rate derivatives are found to have impact on exchange rate risk albeit only marginally


According to Arnold (2002), the financial systems can be essentially split into two parts: financial institutions and financial markets. The approximate share of the one or the other classifies a financial system as a strictly market based, strictly bank-based or a relative mixture of both. Higher income countries tend to be characterized by active and efficient financial markets. Therefore financial systems in such countries are more market-based. This is also true for countries with stronger tradition of law and subsequently strong protection of shareholder rights, well established accounting standards, low levels of corruption. However, the opposite is not true. A country with bank-based financial system is not necessarily one categorized as a “developing economy” (Chakraborty , S., & Ray , T., 2006). According to this framework, the UK financial system can be categorized as market-based on the evidence of well-capitalized financial markets. Financial markets are divided into: money markets (i.e. markets where maturity of traded instrument does not exceed three months), bond markets, FOREX, stock markets and derivative markets. Considering the prime focus of this research, assessing financial markets is only of indirect importance. This is because derivative instruments are traded on the LSE, i.e. on the EDX London Ltd, which is managed by LSE and on the OTC market. In this context outlining the particular characteristics of the main types of financial institutions operating within UK’s financial system is of higher priority. According to their business area, financial institutions in the UK fall into seven categories. These are banks, building societies, pension funds, insurance funds, unit trusts, investment trusts, and finance houses. In the banking sector, further distinction is made between retail banks, wholesale banks and international banks. Pension and insurance funds are aggregated into “saving institutions with long term horizon” whereas banks fall into the “short-term saving institutions” category.

Next chapter of this dissertation paper gives an overview of the recent developments and structure of the UK financial system and banking system in particular. Furthermore, the main financial players will be discussed in brief. Although more attention will be put on banks, it must be noted that part of the services offered by each different institution have merged across institutional types in the last decade. Building societies for instance have assumed the traditional role of banking institutions of deposit taking and loan making and are therefore competing in the same market. Regulatory and capital adequacy issues are of prime importance and will also be given some attention in the next chapter.

Chapter 3 is concerned with the risk managements in banking. Similar to chapter 2, it provides a rather theoretical look into the different types of risks UK banks face and outlines the tools widely adopted to manage these risks. Consistent with the research goals of this paper, derivative instruments as risk management tool are discussed in detail. The mechanics of swaps, futures & forwards and options are briefly outlined. Increase in trading volumes by instrument is presented graphically.

Chapter 4 summarizes findings of relevant academic works including non-financial profit-maximizing firms. Geographical scope of research papers under review is broad with majority of analyses conducted using data on U.S. Results serve as benchmark for actual empirical analysis in part 5.

Chapter 5 is the main analytical piece of this work and hence is considered of particular importance for the validity of research. Theoretical framework at the beginning provides ground for econometric analysis later in the chapter. Data related issues are examined including composition methodology for situations where significant approximation is required. Last part of this chapter presents empirical findings and provides interpretation of results based on underlying economic principles.

Chapter 6 concludes this dissertation paper by summarizing key findings and discussing milestones achieved throughout it. Furthermore, concluding recommendation to future researchers are provided at the end of the chapter.


2.1. UK Financial Services and Banking at a Glance

Above all, it must be stressed that financial institutions play an ever increasing part in and matching customer liquidity preferences (i.e. savers and borrowers), assist in risk management processes, offer payment services to individual and corporate clients effectively facilitating business transactions hence decreasing transaction costs of conducting business. This is valid not only for the UK but also for most Western economies regardless whether characterized by market or bank-based financial systems. Financial services as an economical sector is critical for the UK economy. This is outlined by the enormous contribution to GDP and employment. Banks and financial services contribute £70bn to the UK's national output (6.8% of GDP) with over a million employed in the three major financial centres on the territory of the island - London, Edinburgh and Leeds. The government continues with its efforts to promote and maintain London and the UK as leading centre for financial and business services. This underlines a desire to further strengthen UK’s competitive advantage in the sector particularly in Europe. Despite turbulent 2007-2009, which has seen banks and other financial institutions run into severe difficulties ultimately resulting in governmental interventions (f.e. nationalization of Bradford & Bingley and quantitative easing), financial services remain sound and maintain high contribution to the economy. Retail banking business in the UK has changed responding to new opportunities and financial innovation in particular. Banks assets are funded not only by the traditional personal and corporate savings accounts but also from liquidity obtained on wholesale and interbank markets. Furthermore, the growth in importance of asset securitization, explicitly underlines the intention of banks to pursue a “originate and distribute” business model which allows effective spreading of credit risk across the broader financial system. These trends result in more complex and interconnected UK financial services sector (Adams, R., Antonacopoulou, E., and Neely, A., 2008).

Overall, banking in the UK is the most important subsector in financial services and has accounted for roughly 3% of GDP. It is the third largest banking sector in the world after the US and Japan. Until recently the British banking sector has been growing at 2.3% (up to 2005) outperforming the economy, which recorded 1.9% average yearly growth. This has not been the case last couple of years where risk management fragilities were exposed and RBS as well as Northern Rock were the most significant casualties. Critiques point out extensive derivatives exposure and funding of long term debt with liquid assets, i.e. short term deposits. Important trait of the sector is the ongoing consolidation albeit at a slower rate compared to the last decade. As a result of substantial number of mergers and acquisitions, the total number of incorporated banks in has fallen in the last 20 years.

Structurally, UK banking system is dominated by retail banks (some 80% of total assets). The main retail banks provide over 125m accounts, clear 7bn transactions a year and facilitate 2.3bn cash withdrawals per year from its network of over 30,000 free ATMs. The banking sector is characterized by well market-capitalized and highly competitive financial intermediaries. Banking sector is being considered very efficient on the basis of effective cost management. Concentration of assets is very high with about 78% being held at Royal Bank of Scotland Group (i.e. Lloyds Banking Group since the take over), Barclays Group and HSBC Group. If RBOS and Lloyds financial results are to be considered jointly, concentration of assets grows further to 81%. Top three banking groups recorded positive figures. Barclays and HSBC posted net income figures for 2008 of £ 5.2 bil. and £ 3.5 bil. whereas BoS posted net income of £ 3.6 bil. for 2007.

illustration not visible in this excerpt

Source: Bankscope

Table 1 presents concentration analysis of banking institutions in the UK ranked according to total assets. These top eight banks account for virtually all assets in the banking sector underlining the high level of concentration. In line with discussion above, the sector is dominated by retail banks with Goldman Sachs the only international bank, i.e. international investment bank in the list. Standard Chartered is an interesting example of an English bank with majority of revenues realized outside of the UK, in Asia and Africa in particular.

Capital cushions (in terms of assets to liabilities ratio) in the sector are thin, which could be considered an indicator of trouble. Partial explanation of the skyrocketing asset holdings at all top banks (e.x. 90% year to year growth at Barclays Group for 2008) could be attributed to the BAM21155 Statement of Recommended Practice (SORP) by Accounting Standarts Board (ASB), which effectively declassified derivative instruments as off-balance sheet item and classified them as “other earning assets”.

Net interest margins of leading banks have decreased substantially (f.e. by some 30% at RBS for 2007 compared to 2005) possibly due to increasing competitive pressures and unfavorable business and financial environment. New players have entered the markets such as non-financial services companies (f.e. retailers and motoring organizations). This has further intensified competition in the sector. Cost reduction has been important characteristic of UK banks that allowed them to maintain profitability and remain among the most efficient in the world. Considerable efforts have been made towards reduction of staffing costs which typically account for about half their operating expenses.

Net loans/total assets ratio has decreased for most banks top banks illustrating the declining importance of core banking business as lending. At the same time it illustrates the growing importance of non-core bank assets, most notably derivative instruments. Characteristically, leading domestic banks exhibit significant international exposure as measured by oversees assets/liabilities to domestic assets/liabilities

Role of domestic Investment banks has been fairly limited. Foreign investment banks (e.x. Goldman Sachs International; BNP Paribas; J. P. Morgan) hold majority of the assets in the sector. In this respect London is arena for more than 75% of international lending and is considered one of the three major financial centers in the world.

Role of Building societies has been important especially since their full integration in the banking system (1986). Building societies now offer not only mortgage but life insurance and pension as well as investment products. By March 2009 they held just over £ 7.5 bil. in deposits of different maturity.

2.2. Banks

Traditionally, banks’ core business is primarily concerned with accepting deposits and making loans. Hence, banks are serving as financial intermediaries between individuals/firms with different liquidity preferences (Goddard, J., Molyneux , P., Wilson , J.O.S., and Tavakoli , M., 2007). By doing so banks drastically reduce interaction or transaction costs between these individuals/firms in terms of searching counterparty, verifying information provided (credibility), and monitoring or/and enforcing the proper use of funds. Intuitively, banks profit from the spread, which is the difference between the interest charged on loans and deposits. This difference is also often referred to as the “net interest margin” (Hawtrey , K., & Liang , H., 2008) . However, banks also profit from fees charged on financial advice or services offered (f.e. credit cards, money transfers etc.). In fact, there has been a shift towards fee based business in the last decade with the spread revenues declining relative to fee-based revenues. Above all, this can be attributed to rapid technological advances leading to financial innovation and increased competition respectively.

The UK is the world's largest international banking centre, operating some 150 million accounts and contributing £ 50 billion annually to the UK economy. Figure 1 illustrates the substantial growth of output in banking activity thorough the last decade. Debt extended to individuals and manufacturing is representative of the core traditional revenue earning assets on banks’ balance sheets. Lending to the manufacturing sector has been rather constant characterized by limited growth. This can be attributed to the wide access to equity capital due to the strongly developed financial markets. Higher reinvestment rates attributable to effective cost cutting activities (f.e. outsourcing) could be pointed out as possible reason for non-growing demand for bank debt. Lending to individuals however has grown significantly. As numbers suggest, growth in total lending to individuals has been around 150% for the period 2000-2008. This serves to underline the role of UK banks as facilitator of economic growth through stimulation of consumer spending.

Figure 1: UK banks: total lending to individuals and manufacturing in £ mil.

illustration not visible in this excerpt

Source: ONS

2.2.1. Retail Banks

A simple and yet comprehensive definition of retail banking defines a retail bank as an institution that takes deposits of various maturity from the public, repackages those and lends them back to the public in businesses and households (Arnold, 2002). This type of business can be categorized as high- volume and low-value business. This is because of the high number of transactions and the low nominal value per transaction. Retail banks are operating through an extensive nationwide branch network and a subset of banks referred to as clearing banks that facilitate money transfers across accounts. Buckle and Thompson (1995) even argue that a bank is defined as a retail bank only if it operates through national branch network. The BoE defines a bank as a retail bank if it has an extensive branch network in the UK or directly participates in the clearing system within the UK. Financial intermediation is the main business area retail banks are engaged with, I.e. deposit taking and loan making. Most UK retail banks also offer payment facilities and cash distribution services. Payment transmission mechanisms such as direct debit are becoming an indispensible part of today’s transactions.

Technological advances in last decades have increased competition among banks. Retail banks have been forced to deviate from their traditional business focus and offer wholesale banking services. Arnold (2002) argued that as a result of that the distinction between wholesale banking and retail banking has become rather irrelevant or at least blurred. Partially, this can be attributed to availability of wholesale capital from UK’s financial markets. Late 1990es evidenced reduction in traditional bank liabilities as source of finance, i.e. current and time deposits, at the expense of alternative funding sources available on the financial markets. In other words, there has been a shift towards wholesale activities. According to Buckle and Thompson (1995) the off-balance sheet transactions of retail banks appear on their balance sheets only when contingency of these items arises. Since this is a feature of wholesale banking, this argument serves to illustrate how retail and wholesale banking activities tend to merge.

2.2.2. Wholesale banks

Unlike traditional retail banking, wholesale banking is characterized by a small in number but large in size customer base. So it can be described as low-volume and high-value business Wholesale clients are mostly institutional including but not restricted to corporations, institutional investors, and national governments. As Buckle and Thompson (1995) pointed out, minimum deposit per customer ranges between £ 250,000 and £ 500,000 per customer. Increasing trading activities in recent years would have pushed that figure even higher. Heffernan (2005) asserted that wholesale banking is primarily interbank which is consistent with the high value of transaction per customer. In other words banks operate on the inter-bank markets to facilitate borrowing or lending from/to other banks or take part in substantial debt, I.e. bond issues. Further difference to retail banking is that while wholesale banks do rely on the net interest margin as an income source their main revenue items are fee based generated from giving financial advice or facilitating M & A deals. Arnold (2002) classified wholesale banking activities in five categories according to profit contributions. It must be noted that the list is not exhaustive especially given the rate of innovation in financial services within the UK (1) Fund management. Wholesale banks and investment banks in particular offer wide range of investment expertise making up for the lack of time of expertise of their clients, i.e. their high opportunity cost of engaging in trading on their own. (2) Raining external finance for their clients. Some of the deposit liabilities is repackaged and lent back to governments or large companies to help fund their activities. However, wholesale banks do often arrange external finance for their clients with other institutions or assist in setting up of bank syndicates. (3) Brokerage. Apart from being market makers themselves, wholesale banks acts as intermediaries for the trade of securities on the financial markets. (4) Facilitating risk management. Wholesale banks serve as market makers and brokers for derivative instruments (f.e. futures, options, swaps etc.) and hence provide their corporate and institutional clients with tools to manage their market, credit, FOREX and interest rate risk exposure. The purpose of use of derivative instruments will be further discussed in next chapter. (5) Assistance in M & A activities. A major part of the wholesale banking business is shaped around industrial restructuring. This includes not only assessment and valuation of potential buyers and/or sellers but also facilitating transactions in terms of the legal aspects of such deals. Having outlined the traits of retails and wholesale banking in the UK, it is intuitive to see that the conversion of banking activities discussed before is one sided. While retail banks integrate wholesale banking activities in their product range, wholesale banks maintain their focus on high value businesses.

2.2.3. International Banks

International or foreign banks account for more than half the total assets of the UK banking sector (Kosmidou, K., Pasiouras, F., Doumpos, M., and Zopoutiidis, 2006). Bank of England defines international banks in the UK as banks whose cross-border as well as local transactions are all in foreign currency plus cross-border transactions in local currency (Buckle and Thompson, 1995). The definition of international banks presented in this way gives rise to further subdivision of banking businesses. The first “sub business” comprise of sterling foreign banking transactions with non-UK residents by UK banks. The second is referred to as Eurocurrency baking and includes transactions in currency other than the sterling. This incorporates transactions with both residents and non-residents of the UK. Arnold (2002) claimed that the majority of foreign banking revenue is traditional, i.e. generated by net interest margins accounted for by borrowing and lending in non-sterling currencies. Currently there are over 600 foreign banks operating only in London with American, Japanese and German banks with the strongest presence. Because of the multinational diversity in London, foreign banks were initially set up in order to cater for the needs of their respective residents, I.e. to assist import and export transactions. However, with the development and globalization of foreign exchange markets the focus of banking activities has shifted towards the Eurocurrency business. Majority of funds held within the UK are utilized in trading and speculative activities on the FOREX market.

2.3. Building Societies

Building societies represent another important player in the UK financial intermediation sector. They contribute significantly both to UK’s GDP and employment. Traditionally, building societies have started out as mutually owned specialist financial entities Buckle and Thompson (1995). Main business comprised of borrowing and lending back to individuals with the purpose of financing a mortgage. In this context, building societies are also referred to as mortgage institutions.

In terms of regulation features, it is worth mentioning that the Building Society Act introduced in 1986 is widely considered an important milestone in the industry. Under this legislation, building societies were allowed to offer wide range of services instead of specialize in mortgage funding solely. This includes money transmission, FOREX, insurance and personal equity plans, unsecured or subprime loans as well as mortgage products. Since the passing of the Building Society Act, building societies were effectively competing for business with retail banks in covering a variety of general finance needs. Since building societies were slightly hampered by the number of operational restrictions, the Building Society Act included a section on how to transfer institutional status to bank. Abbey National, Allience & Lecester and Halifax were some of the societies which did switch to bank status. As result, the number of building societies drastically fell within the last two decades. Figure 2 illustrates this trend

Figure 2: Total number of Building Societies and branches

illustration not visible in this excerpt

Source: BBA

Buckle and Thompson claim that since the Building Societies Act was a legislation of rather restrictive nature, regulatory authorities addressed and remedied some of its aspects in the 1990es. Focus was set on three core aspects. (1) Allowing building societies to fully own insurance providers which incorporate mortgage related products (f.e. property or contents insurance) in their product portfolio. (2) Raising the maximal share of wholesale funding to 50% from 40% previously. (3) Permit societies to set up subsidiaries with the purpose of extending unsecured debt. Those amendments served to further intensify the process of business overlapping between retail banks and building societies. Those two groups were effectively offering same product scope. The second point in particular is critical for the scale of operations for societies since it essentially allowed them to increase their exposure to the financial markets. As a result of these regulatory initiatives, the distinction between retail banks and building societies becomes irrelevant.

2.4. Other Financial Institutions

Attention will be briefly put on the remaining five players as part of the institutions-markets framework discussed formerly. Although not directly banking institutions, these have important implications for this research because of their high level of interaction with the UK banking sector particularly on the derivatives markets. Institutions to be outlined include: pension funds, insurance funds, finance houses, unit and investment trusts.

2.4.1 Pension funds

Main idea behind the establishment of pension funds is the provision of long term financial inflows to their members in the form of pensions. Pawley, Winstone and Bentley (1991) suggested that it is reasonable to divide pension funds in the UK to sate and private pensions or schemes. Public, i.e. state pensions are structured on a pay-as-you-go basis where current pension outflows are funded by state tax revenues. Pension fund liabilities mostly comprise of employee contributions that are invested in a relatively low-risk instruments earning close to the risk-free rate respectively. When a member of the pension fund retires he is entitled to perpetuity, I.e. to a fixed income for the remainder of his life.

2.4.2 Insurance funds

Insurance funds are effectively financial intermediaries enabling the link between policyholders and the financial markets Pawley, Winstone and Bentley (1991). In this role they can be considered as institutional investors serving as risk transfer tool. Insurance funds in the UK operate within two business types. Life insurance deals with insuring an individual’s life for a period of predetermined duration whereas general insurance is concerned with Insuring against specific events including natural disasters and incidents.

2.4.3. Finance houses

Arnold (2002) describes financial houses as financial institutions operating in the field of hire purchase agreements and instalment credit schemes (e.x. leasing contracts). In this context, finance houses can be perceived as specialized financial vehicles that intermediate instalment credit schemes to cater for personal needs. Such needs may include hire purchases, collateralized or uncollateralized personal debt, credit sales. Buckle and Thompson (1995) suggest that unlike banking institutions and building societies, the scale of operations of finance houses within UK’s financial system is rather insignificant.

2.4.4. Unit trusts

Roughly speaking unit funds provide means for individuals and firms to gains access to the financial markets. This opportunity would else not exist because of the high minimum transaction volume requirement for a variety of financial instruments. Insurance funds are effectively financial intermediaries enabling the link between policyholders and the financial markets Pawley, Winstone and Bentley (1991) described unit trust as investment vehicles enabling the acquisition of interest in a well diversified market portfolio. Such a portfolio in turn would offer relatively little risk assuming it is truly diversified, i.e. if the assets in the portfolio are not correlated with each other (Elton, J.E., Gruber, J.M., Brown, J.S., and Goetzmann, N.W., 2007). Unit trust liabilities are invested in a variety of assets ranging from equity to fixed income securities. In fact it is reasonable to assume that most of unit trusts invest is a combination of risky and risk-free assets. Investors or creditors in turn acquire a share in this portfolio and benefit from both capital gains on the portfolio and dividend payments that accrue.

2.4.5. Investment Funds

Essentially investment funds are similar to unit trust in the sense that both institutional types are organized according to the same business pattern. The fundamental difference as presented by Arnold (2002) exists in that investment funds are registered as companies and not trusts. This has implications for the liability side of their balance sheets since investment trusts are allowed to undertake share issues and hence are allowed a source of equity capital. Because of this particular feature investment funds are referred to as close-end. This means that the company is essentially closed for new investors, where new being referred to as those which did not acquire interest in a company on the primary equity markets. Potential investors must interact with the existing owners, i.e. shareholders, to acquire interest and not with the company itself which is the case with unit trust.

2.5. Regulatory Factors

Because of the nature of banking and its financial intermediation role within the UK economy, regulatory issues become of prime importance. Capital adequacy and non-interest bearing reserves at the BoE are identified as key regulatory constraints for banks in the UK. Those measures are necessary to ensure the effective functioning of the banking sector. This has

2.5.1. Capital Adequacy Framework

The capital of a bank is primarily utilized to finance its operational infrastructure and provide a cushion or insurance against losses incurred in day-to-day business operations. Furthermore, banking institutions are regarded as gearing firms because of the low level of capital as proportion of their total liabilities, i.e. high earnings to own capital ratio. This spells danger, which may arise from possible mass fund withdrawals from their creditors, I.e. banking run. In this context, it is feasible for banks to maintain minimum capital reserves in order to ascertain solvency in case of unexpected losses. Such losses arise from loan quality loans that result in write-offs. Buckle and Thompson (1995) argue that unexpected losses are first covered by banks’ profits and ultimately by banking capital. This view exemplifies the critical importance of reliable capital on banks’ balance sheets.

Widely considered as the milestone in capital adequacy, the Basle Accord (1988) requires banks to maintain capital to risk assets ratio of eight percent (Peura, S., Jokivuolle, E., 2003). As Hughes and McDonald (2002) explain banking capital was classified according to its reliability in meeting asset claims. Introduced were two main types of capital. Tier 1 capital comprises of paid in capital, retained earnings, and preferred stock. Hence Tier 1 can be referred to as core capital. Tier 2 capital consists but is not limited to subordinated debt, revaluation reserves, and general provisions. Tier 2 is referred to as supplementary capital. Figure 3 gives more detailed overview of the capital composition requirements for UK banks under Pillar 1. Pillar 1 refers to the minimum capital adequacy standards as introduced by the Basle Accord.

Figure 3: Components of Tier 1 and Tier 2 capital and relevant regulatory limits

illustration not visible in this excerpt

Source: FSA

The capital adequacy agreement required banks to maintain four percent of each Tier 1 and Tier 2 as part of the 8% reserve requirement outlined earlier. Hughes and McDonald (2002) define risk assets as such where significant possibility exists that expected returns does not match actual returns. Moreover, Buckle and Thompson (1995) explained that banks’ assets are categorized and weighted according to their perceived risk where risk factors are assigned. Each asset group is then multiplied by the risk factor to come up with risk-adjusted assets that in turn are assessed against banks’ capital. Higher risk factors are assigned as liquidity of assets decrease. In this line of though, cash assets would have a risk factor of 0 because of their perfect liquidity. Commercial loans on the other hand would be assigned a factor of 1 because of the high default risk associated with them. Residential mortgages would lie somewhere in between since they are collateralized by property and would only be risky in times of falling property prises. Interbank loans would also have low risk factor (possibly at about 0.2) since they are rather short term.

In must be said that the development and implementation of capital adequacy standard was initiated by the OECD countries. However, most countries have come to realize the importance of international framework and today most banking sectors across the globe operate according to the Basel Accord.

2.5.2. Non-interest Bearing Reserves at Central Bank

Roughly speaking, commercial banks in the UK are required to maintain a certain cash amount with the Bank of England. This is a minimum percentage of banks’ total demand deposits that must be held as a reserve at the BoE. The BoE is empowered to set the reserve requirements for banks at its discretion. This represents an important economic tool for controlling the size of the money stock and the level of existing interest rates. Lowering the reserve requirement increases the availability of capital to be lent and eventually expands the money supply and decreases interest rates resulting in increased investment and consumer spending. On the contrary, increasing reserve requirement translates into restricted lending ability of banks and possible calling in of existing loans. This in turn would reduce the money stock, raise interest rates and reduce levels of investment and consumer spending. Banks that operate only slightly above the capital reserve requirements are most likely to call in on their debtors prematurely.

From the perspective of the UK banking institutions, maintaining a certain level of non-interest bearing reserves increases the cost of funds. Intuitively, there is significant opportunity cost associated with cash reserves, since funds held up at the BoE can not be lent and are therefore non revenue item. This opportunity can be interpreted as the average return on interest earning assets foregone by holding deposits in cash.

Chapter III Risk Management in UK Banking

3.1. Overview

Risk defined is the volatility or the square root of the variance (i.e. standard deviation) of all future net cash flows to the firm (Heffernan, 2005). Contemporary economic theory is united on the notion that value maximizing firms face various types of risks (Santomero, 1997) both internal (structural) and external (within the business environment). As such, competitive firms need to manage both micro and microeconomic risks. Microeconomic risks arise from existing or emerging competitive threats. Macroeconomic risk is defined as the risk from unfavorable economic conditions. Today UK banks are exposed to severe macroeconomic risk and risk of banks runs. This is even more so because of the strongly developed equity and derivative markets and potentially available profit-optimizing opportunities. Apart from general risks faced by value maximizing firms(f.e. technological breakdown or supply chain failure), UK banks face a number of critical risks including credit risk; foreign exchange risk; interest rate risk; market risk (Heffernan, 2005). All four risks are strongly relevant for UK banks because of tight capital cushions (credit risk), mismatches in asset/liability maturities (interest rate risk), strong international exposure, primarily in North America (foreign exchange risk) and high volume of other earning assets (market risk). Settlement risk; global risk; leverage risk are not central to UK banking and operational risk is difficult to quantify and will not be included in this discussion. Market risk is not managed through derivative instruments and is hence of no prime consideration. In fact unfavorable movements of derivative instruments may create market risk exposure assuming that speculation is the purpose of trading.

3.2. Foreign Exchange and Interest Rate Risk

Foreign exchange and interest rate risk among UK banks is prime focus of research. These along with the underlying risk management instruments will be discussed in greater detail.

3.2.1. Foreign Exchange Risk

Hyde refers to foreign exchange risk as to the extent future cash inflows, i.e. value of the bank is disturbed by unfavorable movements of foreign exchange rates (Hyde, 2007). Leading UK banking institutions conduct huge amount of business internationally. Significantly large scale of foreign direct investment North America and Europe automatically exposes British financial intermediaries to GBP/USD; GBP/EUR and USD/EUR exchange rates. Movements of these rates are hugely significant but stochastically volatile in nature implying that UK banks must hedge arising risk. Equity of banks strongly exposed to foreign currency movements do require risk-premium because of the volatility of those currencies (Eitelman, Stonehill and Moffett, 2001, p. 152-172). As a result, foreign exchange risk does raise the cost of capital and lowers optimal debt ratios for banking institutions. Eitelman et.al distinguishes between four types of foreign exchange exposure that could arise from foreign currency movements. Those are transaction, operating, accounting and tax exposure. These are briefly outlined.


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Risk Management In UK Banking - The Role Of Derivatives Hedging In Particular
University of Portsmouth
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Dimitar Vasilev (Author), 2010, Risk Management In UK Banking - The Role Of Derivatives Hedging In Particular, Munich, GRIN Verlag, https://www.grin.com/document/180772


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