HSBC Risk assessment

HSBC Risk assessment

In the United Kingdom (UK), banks such as the HSBC usually grapple with various types of risks in an economy where they have to pool savings and finance sustainable investments. In this regard, financial institutions have designed different kinds of approaches that would enable them to manage their risks by aligning their overall strategy to allow them to 9identify, measure, and manage any uncertainties (Zhang & Zhou, 2010). Risk management within a banking institution like HSBC is usually the responsibility of the control as they use their financial knowledge to vary the degrees, evaluate, and manage a combination of risks through a risk governance framework (RGF) (Maingot & Zéghal, 2012). An RGF provides for the compliance of banks to the Banking Act as well as the directives, determinations, and circulars issued by the licensing authority of the respective country (Ebnother,2015). This paper will assess the interest rate risk (IIR), the liquidity risk (LR), and the operational risks (OR) of HSBC bank. The Prudential Authority supervises the bank in the UK on a consolidated basis, which receives information In regards to the capital adequacy and sets the capital regulations for the bank.

Interest rate risk

Overview of HSBC IIR

Banks and other lending institutions are usually exposed to interest rate risks (IIR) in their process of giving credit to their customers and hence the need to manage this exposure. According to Liebenberg & Hoyt (2016), Interest rate risk (IRR) is the risk to the capital that arises from the fluctuating interest rates as the changes to interest rates affects the bank’s earning by shifting its interest income and the non-interest revenues. The changes in the IR affect the bank’s liabilities, underlying assets, and other financial instruments that are a result of the changing value of the cash flows (Solimun, 2010). In their bid to enhance their competitive advantage, HSBC has introduced various products and credit offers that have increased the complexity of service delivery, leading to the bank’s exposure to IIR, especially in regards to earnings and capital. Cordova (2012) asserts that the diverse movement in IR has exposed banks such as HSBC to operate and work towards mitigating IRR as a regular part of their activities to maximize shareholder value. IIR usually arise from traded and non-traded assets and liabilities such as deposits and loans.

Source of IIR

In line with the Banking committee on banking supervision report, there are primary sources of IRR that banks such as HSBC exposed to, and they include Optionality risk, Re-pricing risk, Yields curve risk, and Basis risk (Lee, 2017). The re-pricing risk considered as the primary source of IRR. It originates from the time difference between the maturity of the floating rate and the fixed rate of a bank’s liability, assets, and off-balance sheet (OBS) placement (Iqbal, 2012). The Yield curve risk originates when there is an unexpected shift on the yield cycle curve, which results in the company’s principal economic value and unexpected returns hence IIR (Chalhoub, 2010). On the other hand, the Basis risk arises when there is an imperfect correlation due to the adjustment in interest rates of assets and liabilities. In contrast, the Optionality risk embedded in agreed-upon banking assets, liabilities, and OBS (Warr & Pagach, 2011). The optional risk source provides the bank with the right to sell or buy or alter the financial contract, which may lead to IIR.

DIAGRAM 1

Measurement of IIR

The measurement of IRR utilizes a variety of methods depending on the level of complexity of the service being offered. Some of the ways of measuring IRR include the maturity and re-pricing tabling, also called the Gap analysis and the Price Value of a basis point (PVBP) (Roszbach & Lindé, 2016). The maturity method bases on the classification of IR sensitive assets, liabilities, and OBS items into time brands defined according to their maturity time and the period until the next re-pricing (Hoyt & Liebenberg, 2010). For instance, using the Gap analysis, the HSBC maturity gap presents a positive outcome. However, a high percentage is seen in more than five years of maturities. When these factors expelled, the maturity gap falls close to zero, which is a demonstration of high dependency on future timelines, and hence exposing the bank to IIR (Bali & Allen, 2017). Another method of measuring IRR is the PVBP, which captures the change in the price of the financial instrument where there is a higher interest rate.

Management of IIR

In the control of the financial tools in an ongoing fluctuation of the rates, the HSBC bank depends on over the counter derivatives such as futures contracts and interest-rate-swaps, devised to provide financial leverage among parties (Basal Committee, 2015). Examining the financial tools at HSBC, the report indicates a financial statement that is highly negative with an exposure of up to -$1,488, which is an indication of an imminent risk of IR (Rivas, 2011). Additionally, in managing IIR, matching a smoothing technique may be used by the HSBC, where the bank assesses its capacity to maneuver between variables and fixed rates hence controlling the fixed and variable loans leading to a reduction of IIR.

Liquidity risk

Overview of HSBC LR

The appalling economic conditions of a bank can lead to a decrease in the value of the bank. Managing the liquidity is crucial as it forms part of the more significant risk management of the banking sector, whether conventional or Islamic (FDIC, 2018). Free & Clinton (2015) defined Liquidity risks as the inability of a bank to match its inflows of cash to its outflow of money as a short term financial requirement. The sensitivity of LR is usually observed in a declining economic life cycle of the bank, which is the focal period of depreciation in a given economy hence the inability to meet the liquid demands. Other factors, such as the maturity gaps, the method of disbursement, and the focus on short-term tenors, have made internal factors a source of liquidity risk within a bank (Paletta, 2011). LR signifies the HSBC’s ability or inability to match it’s in and outflow of cash towards the bank’s short term financial requirements. Nevertheless, both external and internal LR has become consideration among regulatory requirements and best-practices globally.

Source of LR

LR originates from the type of banking activities from the macro factors that are exogenous to the financial and operational policies that are internal to the bank. The deposits that are callable on-demand and have a short maturity increase the risk of liquidity (Nicholls & Lehner, 2014). The maturity of an asset provides liquidity insurance to the depositors, but it also exposes the bank to LR (Razali & Tahir, 2011). The sources of LR classified as either internal or external, where Internal sources include the heavy reliance on short-term corporate deposits and more considerable attention to short-term tenor loans increasing liability and hence LR (Haynes, 2011). Whereas, the external sources of LR include unexpected withdrawals by the government and recession periods that lead to the removal of investors and depositors.

DIAGRAM 2

Measurement of LR

The measurement of LR can be done using three methodologies. First is the balance sheet analysis (BSA), which is a form of quantitative measurement where liquefiable liabilities and assets compared among industry averages (Yazid & Razali, 2016). The second method is the use of a maturity mismatch approach (MMA), which is a standard method of identifying the exposure to liquidity and depends on the evaluation of the periodic gap of liabilities and assets to detect in and outflow of cash (Akram, 2016). The third method that HSBC can use is the Stress test, which places the bank into different economically unfavorable situations such as recession to identify whether the bank has enough capital reserve to withstand the effects of severe economic changes. An example of the HSBC Stress test shown in figure 3.

DIAGRAM 3

Management of LR

The management of LR is a significant process for financial regulators due to the increasing complexity of financial markets as well as concerns related to the inadequate identification of economic crisis. At HSBC, the management of LR done on two fronts that are the stored liquidity management (SLM) and the purchased liquidity management (PLM) (IFC, 2012). In SLM, there is the raising of liquidity through the available assets such as deposits, bonds, and securities (Moosa, 2017). In PLM, the process is done through market funds and rates. The process is expensive and hence avoided. The development of the regulatory management process has made HSBC take full responsibility for its LR management approach as there is a precise level of tolerance to the market strategy and positioning (Hussaini & Umaru, 2018). A liquidity trap is another risk in LR where the public savings are high, and the interest is low (Banks, 2014). In management, HSBC can induce a substantial drop in prices to encourage more investment.

Operational risk (OR)

Overview of HSBC OR

In running an entity such as the HSBC, it involves a lot of operational activities that run from dealing with clients to managing the technological system and supervising the many employees. In a financial crisis, there is always a discussion of the different aspects that led to the failure of operations, of which the lack of insight into the operational risks being the first. Samad & Lai (2010) defines Operational risk (OR) as a risk of losing the results from inadequate internal processes, systems, people, or external events, including the legal risks. The notion that banks are too large to fall has led to many financial institutions coming down due to the lack of a clearly defined strategy that addresses the operational risks (Brycz, 2012). The relevance of OR has led to financial institutions identifying ways that would ensure coherence and efficient business management. Also, OR is a direct risk developed from exogenesis loss, system failure, corruption, and fraud (Concha & Astudillo, 2012). System failure due to acts such as corruption, human error, and fraud forms part of the operational risks, which is usually a residual risk.

Sources of OR

Identifying the sources of OR is essential in the understanding of the system and addressing the failures. At HSBC and other financial institutions, the causes of OR can be internal or external (Qadir & Ahmad, 2017). Internal sources of OR include the human resource factors such as the employee turnover due to reduced human resource evaluation, employee’s issues that result in poor work performance, misuse of power by senior staff, and accidental errors (Beck, 2010). Externally, the aspect of fraud is a source of OR and includes activities such as money laundering. Also, other external sources include inappropriate tax returns and an unexpected increase in tax expenditure, new regulations, political influences, and economic recession, among others (Andreatta & Mazza, 2013). In realization of the impeding operational risk, the HSBC has employed the use of enterprise-wide-risk management (EWRM) framework that has mitigated most of the risks.

DIAGRAM 4

Measurement of OR

Operations within any business setting portray unique features given the nature of services provided, the different cultural backgrounds of the employees, the external environment in which the business operates, and the company’s net worth. With this realization, the measurement of operational risk (OR) is also a unique undertaking as it encompasses all aspects of the organization, from behavioral evaluation to social and financial capabilities (Matz & Neu, 2016). It is challenging to measure independently of the risks involved as it spans in all the activities of the bank and is not easy to determine the amount, frequency, and the critical factors behind the threat. However, the Basel Committee has provided a regulatory framework of which international banks such as HSBC must uphold (Peters & Shevchenko, 2016). I this regard, the measurement techniques improvised to measure OR include the Basic indicator approach (BIA), the standardized approach (SA), and the advanced measurement approach (Lagner, 2016). In BIA, the credit risk analysis indicates the minimum reserve that should be upheld by a bank to mitigate its exposure to OR (Barros & Torre-Enciso, 2012). For example, in 2017, HSBC bank included a net income of 9,683 million dollars at the BIS rate of 15% as the minimum reserve to prevent against OR exposure (Kerbl, 2015). While utilizing SA, the technique bases on the amount of adequate capital reserve and includes various categories such as corporate finance, trading ad sales, as well as retail banking (Brechmann & Czado, 2014). AMA method is similar to the other measurements, but it is more sophisticated and provides banks with an opportunity to devise their internal model.

DIAGRAM 5

Figure 6: Management cycle of OR

In the management cycle of OR, the bank has to use the available data to come up with a method of identification, measuring, and mitigating any risk associated with the operations of the bank. There are several ways in which an international bank such as HSBC can use to minimize OR, and they include avoiding disastrous loses by regularly analyzing the financial statements, developing a more comprehensive understanding of the bank’s limitations and vulnerability to the external environment, and developing the bank’s ability to identify risks (Santos, 2011). Additionally, the bank should give objective performance measurements, alteration employee behavior, and the provision of viable information to help in decision making. Moreover, HSBC should ensure that every employee shows due diligence in their activities within the bank (Chernobai & Jorion, 2010). Therefore, the bank can utilize technology and develop monitoring systems that would ensure smooth operations and accountability.

Fraud Risk Framework

DIAGRAM 6

HSBC’s vulnerability to individuals capable of combining all three elements of the fraud triangle is a fraud risk. According to Chernobai (2012), the Donald Cressy’s fraud triangle identifies the causes of fraud in three ways, first is the pressure that drives an individual to commit fraud, secondly is the availability of the opportunity, and thirdly is the mindful capacity to rationalize the fraudulent act.

Sources of FR

The primary sources of fraud risk in a financial institution include the employees and criminal organizations. In this case, the HSBC’s employees are the direct cause of internal fraud within the bank such that the higher the responsibility, the greater the fraud exhibited (Al-Afeef, 2017). Similarly, exogenous risks seen as inherent risks by their nature of being less controllable. Therefore, to mitigate the fraud risks in this scenario, the HSBC has to put in place security measures such as the use of a transaction monitor that controls the limit of expenditure on credit cards or cash withdrawals (Jobst, 2014). Other measures include the use of multi-process authentication, which comprises a multi-layered structure of defense technologies that follow up with phone calls and pays more attention to the purchasing habits (Cope, 2012). The placement of triple controls consisting of more than one operative is also another measure where no single agent makes a transaction but has to share the process with other activists.

Fraud preventive controls

The FRF for HSBC involves three main areas; Employee misconduct, Risk of technological failure and cybercrime, and money laundering (Howells & Gordy, 2016). Employee misconduct includes the newly hired employees who are susceptible to theft, bribery, and fraudulent transfers primarily in the processing division. Currently, HSBC utilizes the triple control strategy, with the residual risk being employee cooperation (Hess, 2011). Technological scheme and cyber-attack within HSBC originate from the technology and security division with the available measure being the installed firewall and back-up servers. In this fraud, the residual risk is massive cyberattacks by criminal organizations. Hence, the fraud risk response would involve installing additional software and continue technological enhancements (Arlt & Neumann, 2013) Money laundering is another common type of fraud which occurs during compliance session between the manager and the client. Measure to curb money laundering include following due diligence, liquid checking, and credit bureau report check (Carrillo & Gzyl, 2012). The residual risk is the entry of new methods where criminals are pursuing the help of credible sources, and the HSBC bank should have additional auditing seasons and implement new control.

DIAGRAM 7