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MBA7065 CAPSTONE PROJECT

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Business Report

1. Introduction

This chapter will present a brief overview of the research report. It discusses the study’s context, intent, goals, research questions, rationale, and study significance. Additionally, it outlines the methodology that has been put to use to undertake the research and derives the conclusions. Finally, this section presents the report’s structure/layout. 

1.1 Study Background  

Risk management is essential for any business seeking to expand significantly in the near future. This is because the future, though analysis could provide insights into what it could look like, is still uncertain. Anything unexpected involves several risks, and uncertainties are what lead to an unforeseen challenge. Risks are typically characterized in terms of their adverse effect on profitability caused by a variety of distinct sources of uncertainty. Uncertainty may originate from the economy, the customer, or procedures. Poor governance of these sources of revenue may result in the formation or destruction of a business’s value (Pyle, 1999).

Risk management in the banking sector: According to Carey (2001), risk management is essential throughout the banking industry than in some other economic sectors. Banks, notwithstanding their financial intermediation role, stimulate the capital formation and economic growth. However, banks’ capacity to promote economic development and growth is contingent upon the risk management system’s fitness, adequacy, and stability. This establishes banking as a high-risk industry. Risk management has been described theoretically in banking as the rational formulation and implementation of a strategy to mitigate potential losses.   Generally, risk management activities in the banking sector are centered on minimizing an institution’s exposure to liability or risk and on protecting the interest of the business’s resources. Banking is widely regarded as a high-risk business. Macroeconomics asserts that there are two basic underlying units – deficit and surplus – and these economic units often interchange funds via banking firms (intermediaries). While this mechanism undoubtedly increases the monetary value of financial intermediaries, it also presents some threats to these institutions. Due to the difficulties inherent in anti-symmetric information, the vast majority of people rely on intermediaries. Organizations are employing qualified professionals and systems to resolve information asymmetries issues. As a result, finances are directed toward more valuable services that benefit the country. However, this ability to exchange funds from one system to another is not without inherent risks. Typically, banks manage such risks as part of their routine operations. These issues emphasize the need to analyze the significance of the risk management process in the banking sector.

Pyle (1997) listed the following significant banking risks:

  • Market risk is asset value fluctuation caused by changes in macroeconomic variables such as interest rates, currency rates, prices of stock and commodity
  • Credit risk is a change in market capitalization caused by the assumed failure of financial institutions to fulfill contract agreements
  • The operational risk stems from transaction-related losses such as failed settlements, non-compliance with legal requirements, and late transactions.
  • Performance risk refers to damages caused by a failure to track workers properly or implement suitable methods (including “model risk”).
  • Interest rate risks: Following deregulation, policymakers and authorities revoked the majority of interest rate caps and limitations. Market dynamics dictate interest rates on the market.  Interest rates nowadays vary significantly in response to supply and demand conditions. In these conditions, changes in the interest rates at which banks conduct their business have an impact on the banks’ revenues and expenses. Certain assets of banks generate interest income, such as deposits and security investments, while certain liabilities incur expenditures, such as deposits. As a result, shifting interest rates mainly affected bank earnings.
  • Risk of solvency: The Company’s overall long-term sustainability, which is due to the banks’ financial health or loss, should be the main priority of banks and their institutions. If the banking system has many bad loans in their credit card account, or when their investment assets significantly deteriorate in value, leading to substantial financial loss, these are two crucial circumstances that may lead to solvency issues (Tursoy, 2018).

1.2 Study Rationale

Figure 1.1 Financial services economic impact

1.3 Research Aim and Objectives

This research aims to study the Risk Management framework for the banking sector in the UK. Additionally, the study intends to address the following research objectives:

1. To review the need for risk management in the banking sector in the UK

2. To prepare a risk map for a variety of risks

3. To compare various drivers of risks in 2019 and 2020 for the banking sector in the UK

4. To identify the impact of various risks on the working of the banking sector

1.4 Organization of the Report

This report is organized using the following structure. The report started with a brief background on the risk management process, specifically in the banking sector, along with the research objectives that the study intends to answer and the methodology that the report adopted to find a suitable answers to each of the goals. Then section 2 briefed the risk management guidelines and principles that have evolved in the UK banking sector. This section primarily aims to evaluate the diverse aspects of risk management procedures as perceived by the different authors; risk measurement, risk identification and risk analysis, risk monitoring and control, management of the different types of risk stated in the previous section. It also presents theoretical pieces of evidence on the significance of banking risk management role and its association with the bank performance. This is followed by section 3 that shows a detailed insight on the answers to each and every research objective stated above. And finally, the subsequent section concludes the report along with suggestions for future researches. 

1.5 Research Methodology

Considering the research objectives, the current report has utilized a pragmatic philosophical viewpoint as the study purposes to identify the key drivers of risk in the UK banking sector in 2018 and 2019 and its impact on the industry’s performance. In this study, the emphasis is on gaining deeper insight into the UK banking sector and risks management practices to ensure its effective functioning. Moreover, the study has adopted an inductive approach to explore the topic under investigation and detect patterns and themes to generate unapproved conclusions. Furthermore, the study has utilized a qualitative approach to evaluate risk management procedures in the UK banking sector and deliver more comprehensive results (Bryman and Bell, 2018). A research design is concerned with compiling and reviewing data to a direct study’s research topic. Qualitative studies like ours are associated with deductive approach wherein non-numerical data is sourced from authentic resources to inspect and scrutinize the research objectives. The population for this study consisted of the various types of banks operating in the United Kingdom (private, public, retail, and foreign banks). Additionally, the secondary form of data collection has been used to collect information from various legitimate sources like journals, articles, newspapers, and published reports to identify the categories of risk challenging the performance of the UK banking sector in recent times.

2. Literature Review

2.1 Banking Risks

Risk is expressed as a function of an event’s probability. Risks are unseen and intangible uncertainties in a company that manifest as sudden movements in profitability or consequential loss.

Financial risk, more explicitly, is the likelihood that an activity or event will have adverse effects on the price of a financial institution as an outcome of numerous sources of error. These implications can significantly affect a bank’s earnings/assets or its determination to reach its strategic goals. These sorts of errors increase the risk that the companies could not handle their daily operations or leverage on development opportunities.

Banks also classify banking risk-related losses as expected or typical versus unforeseen or non-traditional losses. Planned fatalities are those that a bank sees will ascend without a doubt as a result of the bank’s core functions. Unexpected/non-traditional losses are triggered by unanticipated incidents that occur due to domestic or global banking climate changes. Typically, banks will compensate for these forms of failures with their assets.

The types and sternness of risks to which a bank might be exposed vary according to a variety of factors such as the size of the bank, the sophistication of business operations, and capacity.

The kinds and degree of risks under which a bank might be susceptible varies depending on various factors, including the company’s size, maturity of business processes, and size.

Banks experience a series of risks, namely credit, market, profitability, administrative, conformance, and loss of reputation, which will be mentioned in greater detail below.

Systemic risk: The likelihood that a breakdown in a company, customer base, or settlement system will cause a ripple effect across capital markets, distressing each financial establishment after the other, or a lack of trust among stakeholders, leading to unusual market conditions, is known as systemic risk. The ripple effect represents the danger arising under the interdependence of many market segments. It happens when a business’s or business segment’s disorder has the potential to influence and trigger failure in other parts of the global financial system. Another element of systemic risk is the probability that such structural forces will affect investment valuation. This uncertainty can be minimized by the fact that it exists, and it can’t be diversified, so it comes under the heading of systematic and unsystematic risks. The prevailing rate of inflation and the perceived value of currencies, on the other hand, are two significant concerns for the banking sector.

Market risks are all those correlated with shifts in financial markets, which negatively influence the economy of financial goods and, therefore, the net income and net characteristics of financial corporations. In this situation, investment liquidation is vital, especially when examining such large deviations from current market value. Market risk refers to the possibility that economic factors may cause inflation or interest rates to push in the wrong direction. It considers stock and inflation rate market changes, some currency fluctuations, and commodity prices (all of which influence systemic risk). There are risks related to the cost of purchasing securities, dividends, divergence risk, and divestiture risk, in addition to customer risk (Fadus, 2013).

Interest rate risk is the risk of losing earnings due to volatile and unfavorable interest rate changes that can affect both the price and income produced by bank assets. Interest risk is essentially a product of interest rate volatility and mismatches in the period of assets and liabilities’ returns. Interest rate risk is measured by considering the divergence between financial assets and liabilities, the discrepancy between rate-sensitive revenues and expenses (net revenue risk), and the percentage changes in the market.  To conclude, the impact of unpredictable interest rates on a business’s earnings and net value is defined by its income statement composition, more precisely, the association between investment assets and liabilities and their repayment period (Buckle and Thompson, 2020).

Foreign exchange risk is classified as unpredictable and undesirable changes in foreign exchange rates that have a detrimental impact on the financial capital inflows and the net value of foreign exchange via banking institutions. For banks with global operations, foreign exchange risk is classified into two types: conversion or role risk, which is connected with unrestricted foreign currency assets or liability position, and payment or net revenue risk, which is connected with the transformation of such consolidated balance sheet products.

Liquidity risk refers to a bank’s failure to conduct regular currency transactions. Liquidity risk, more precisely, is the possibility that a bank would be unable to fulfill its responsibilities and obligations to its investors and insolvents. Additionally, this likelihood is dependent on additional variables, such as market- and economy-wide factors (systemic risk), as well as bank-specific risks. Liquidity risk operates on both sides of the transaction. Financial distress refers to a business’s failure to satisfy its depositors, especially in times of uncertainty and lack of faith in banks, which leads to significant deposit withdrawals. On the side of the financial assets, liquidity risk refers to a bank’s failure to negotiate new loans, deposits, as well as invest in new prospects. Thus, the optimal balance of viability and risk mitigation for a bank is for its financial assets to evolve simultaneously. Liquidity risk can manifest itself in a number of ways, including reluctance to raise funds at market value, currency value risk, and commodity liquidity risk. As a bank’s credit capability declines, the cost of funding rises, expanding the issue beyond pure liquidity issues at a period when funding costs are critical to a bank’s profitability.

Credit risk is considered to be the most severe of all risks. It corresponds to a customer’s unwillingness or inability to pay off their debt and is a dominant contributor of loss for both profitability of banks and the initial investment; the loss could be temporary or permanent, depending on the level extended to the counterparty. Failure to perform contractual obligations typically manifests itself in loans, swaps, options, and during settlement. Credit risk also corresponds to the likelihood of a debt or the credit status of an obligor of the stock issuer or the bond. This option does not always lead to default situations, but it increases the likelihood of insolvency, as an increase in the appropriate market value is essential to cover the additional risks involved with a value diminution.

Operational risk: The probability of enduring an explicit or implicit financial loss resulting from inadequate or failed internal management procedures, people, or arrangements, or as a due to external events, is referred to as an operational risk (de-Ramon, 2017). Operational risk is correlated with routine banking operations, which involve breakdowns of information or performance reports (record keeping), institutional risk-monitoring policies and practices, and inability to access the internal risk policy regulations in conditions requiring urgent remedial actions (settling). As a result, this risk pertains to individuals, procedures, technology, and information technology.

Legal risks are those that arise as a result of changes in the legal banking system. Even when both parties have formerly cooperated effectively and are totally capable of performing in the future, new law, new laws, tax legislation, and court decisions can transform previously successful transactions into struggles. Additionally, the legal risk may occur as a result of the management or employee activities of an organization. Fraud, regulatory or legal breaches, and other acts may result in significant and dangerous losses. Additionally, there is a chance of failure as a result of an unenforceable contract or counterparty’s absolute aversion. Finally, there is a risk that the contract is unconstitutional or that one of the parties to the contract lacks the necessary authority.

2.2 Risk Management in Banks

In the study conducted by Angelopoulos and Mourdoukoutas et al. (2001), risk management in banks specifically can be approached in two distinct ways: philosophically and operationally. The philosophical one examines the risk level or the connection between risk and reward. At the operational level, banking risks are identified and classified, as well as processes and techniques for measuring, measuring, and regulating them are developed. The institutional method to risk management entails recognizing essential risks, establishing appropriate, understandable operational risk controls, deciding which risks to reduce and which to increase, as well as procedures for tracking the resulting risk status (Benjamin et al., 2020). According to Rahim (2018), risk management consists of four steps: risk recognition, understand and analyze risk), risk evaluation and analysis (quantify and evaluate risk’s impact), risk control and mitigation (measure and reduce risk), and risk monitoring (examines and report the progress). According to Prajogo et al. (2018), risk management encompasses seven components: risk recognition, risk measurement, risk analysis and evaluation, risk tracking, risk regulation, risk prevention, and risk avoidance.

Numerous theoretical arguments exist to support the adoption of risk management in banks (Smith and Stulz, 1985; Fite and Pfleiderer, 1995).  The subsequent sub-sections address several critical theoretical issues in this regard:

  • Financial Economics Approach: Financial economics is established on the basis of the Modigliani-Miller model (Miller and Modigliani, 1958), which determines the conditions of meaninglessness. Stulz published a study on Optimal Risk management Policies in 1984 was the first to offer a reasonable economic justification for managers to manage both expected advantages and the volatility of their values (Santomero, 1995). He speculates on the reasons for risk management in businesses based on the irrelevance conditions, including obtaining internal financing; (ii) tax consequences (the non-linearity of the tax structure); (iii) the expense of financial distress; and (iv) stock market imperfections. Following this, several alternative propositions and justifications for risk management were created. 
  • Institutional Theory: Institutionalisation is described as “the process by which elements of the formal structure becomes widely accepted as both reasonable and relevant and contribute to the credibility of institutions” (Tolbert and Zucker, 1983). The institutional theory encompasses a range of subfields (Collier and Woods, 2011). Numerous research, however (Hudin and Hamid, 2014) are all the more strongly connected to business and organizational studies. Institutional theory is concerned with the laws and procedures imposed on organizations by external forces, most notably government monitoring bodies; and with all the customs and principles integrated into positions resulting from socialization processes or procedures (Meyer and Rowan, 1977).
  • Agency Theory: This theory is predicated on two fundamental premises (Jensen and Meckling 1976). To begin, both principal and agent seek to maximize their own interests. Second, the agent’s priorities will deviate from those of the principle, leading to speculation that the agent will act in the principal’s best interests. As a consequence, a breach of trust may occur between the principal and agent. Smith and Stulz (1985) examined organizational risk management and identified managers’ (agents’) perspectives toward risk-taking behavior and hedging. Fite and Pfleiderer (1995) then used agency theory to describe the effect of hedge policies on firm value. Tufano (1998) also made an agency-theory-based case for risk management. He claims that managers pursue hedging to the maximum extent possible without regard for their shareholders’ interests.
  • Stakeholder Theory: Stakeholder theory, as established by Freeman (1984) emphasizes the alignment of shareholders’ interests as that of the primary component of organizational policy. The principle of implied contracts has been extended from employment to other contracts, which has made the most significant contribution to managing risk (Cornell and Shapiro, 1987). Consumer trust in certain corporations, particularly in the services and high technology-based industries, is essential for them to continue delivering their products in the community and can make a significant contribution to their values. The value of such implied claims, on the other hand, is highly reliant on the expected costs of insolvency. The enterprise’s value rises as a result of risk management practices within a company that results in lower planned costs (Klimczak, 2007).

2.3 Previous Research on Risk Management Practices of Banks

Durrani (2013) conducted a study to evaluate how competition in the financial market has resulted in credit risks and has impacted the performance of banks in Australia. The results generated through empirical investigation showed that the cost of bank. The Australian banks’ interest income decreased as a result of the lower interest rates. Interest rate competition will result in increased pressure to provide more loans to compensate for credit quality and interest income declines. Gray (1998) conducted a study to provide an overview of current trends in the Australian banking sector with regards to credit risk measurement and management. The results declared that credit risk modeling would be a relatively easy activity for smaller regional banking institutions, as loss rates and residential housing defaults in Australia have remained relatively stable over a long period of time. Santomero (1997) analyzed the relative risk management systems in a variety of US institutions. He explored both the principles and methods of financial management at a sample of banks and concluded that the nature of risk management techniques differs significantly by bank size. He suggested that larger banks continued to use more advanced and scientific risk control methods. His study argued that credit risk management strategies in banks should be standardized for both borrowers and institutions.

Additionally, he indicated that credit losses should be closely monitored but that risk control programs were insufficient to do so. Bollen and colleagues (2015) conducted a study to examine the global financial crisis and its effect on Australia’s banking risk. The stock market correction resulted in an increase in systemic and systematic risks for central Australian banks, especially those with international connections. The risks were mitigated following the establishment of a guarantee scheme for all Australian banking institutions.

2.4 Research Gap

The existing studies have theoretically explained the kind of banking risks and strategies deployed for managing the same. However, very few or no studies have reviewed the need for risk management in the banking sector in the UK. Also, almost no research has drawn a comparison between the various drivers of banking risks in the UK in 2019 and 2020, nor has it studied the impact of the same on its overall performance. The current study aims to address this gap by exhaustively reviewing the information available and presenting it in the subsequent section according to its objectives.

3. Main Findings & Discussion

The following section presents the overall findings objective-wise:

3.1 The need for risk management in the banking sector in the UK

Over the past few years, several banking crises have deterred the performance of the financial stability of the banking sector. The banking industry has undergone a sea change due to fierce competition from FinTechs, shifting market strategies, increasing regulatory and enforcement restrictions, and innovative technologies. FinTech/non-bank startups are altering the competitive landscape for financial institutions, forcing them to reimagine their business models. When security breaches become more prominent and privacy issues become acute, regulation and oversight provisions become more stringent. Additionally, as if this weren’t enough, customer preferences change as customers demand personalized service 24 hours a day. The challenges posited by FinTechs are forcing the banking sector in the UK to either seek partnerships and acquisitions or require heavy investments to undertake the transition. Digital innovations are compelling players to foster an innovation culture to exploit technology to improve internal processes and performance.

Regulatory enforcement has risen to prominence as a significant obstacle for the banking sector due to the dramatic spike in money-making compared to earnings and losses caused due to random errors since the financial crisis of 2008. Regulatory enforcement has risen to prominence as a significant obstacle for the banking sector due to the dramatic spike in regulatory fees comparable to earnings and credit losses since the 2008 financial crisis. Banks and credit unions must comply with an increasing number of regulations, ranging from Basel’s risk-weighted accounting rules to the Dodd-Frank Act, as well as from the International Accounting Standard Panel’s Current Expected Credit Loss (CECL) to the Allowance for Loan and Lease Losses (ALLL). Compliance can impose a significant burden on taxpayers and is often contingent on the ability to correlate data. To overcome regulatory compliance obstacles, banks must cultivate an organizational culture of accountability and implement structured compliance processes and systems. The cost of compliance management is among other banking industry issues compelling financial institutions to alter their business models. The rising cost of equity, united with repeatedly low interest, a diminishing reappearance on capital, and reduced retail banking, all put downward pressure on profit margins in traditional banking. With several high-profile data breaches in recent years, privacy has emerged as a crucial problem for the banking industry, as well as a significant cause of anxiety for debit card union customers (TheDubs, 2021).

Furthermore, the crisis induced by COVID-19, Brexit uncertainty, and climate change has drastically impacted the performance of the banking sector in the UK. The British lenders are witnessing tremendous losses of up to £18 billion in the very beginning of 2020. Banks have reserved resources to cover anticipated losses due to the pandemic. The Bank of England reported that the pandemic had forced businesses to raise more than £70 billion of additional net financing through financial markets and government-based loan guarantee schemes to deal with the crisis induced by the pandemic (SPGlobal, 2020). Banks have started building significant capital buffers to be able to deal with the challenges imposed by COVID. The pandemic is expected to increase sternness via liquidity crunch, credit crush, increase in non-performing assets, and default rates, further decreasing the market interest rates. To be more precise, banks are expected to see upturns in several risks, such as liquidity risk, credit risk, interest rate risk, and market risk.

Pandemics, such as COVID-19, have complicated repercussions for banks and endanger the liquidity in the banking system (FSB 2020). The map in Figure 3.2 highlights the potential consequences of the COVID-19 disease outbreak for banks in the absence of structural reform. Due to economic fluctuations, bank debtors, both individuals and business owners, face significant credit risk (Vidovic and Tamminaina 2020). The banking industry could see a significant rise in credit risk and interest rates as a consequence of their creditors’ reduced incomes and economic downturn and compelled shutdown. Banks with a substantial lending portfolio, mainly to export-oriented businesses and local firms, could see a sharp increase in interest rates during or after the epidemic.

Additionally, the overall situation can convert many creditors into defaulters, worsening the banks’ credit risk (Baret et al. 2020).  Banks can encounter financial crises along with default risk as many borrowers withdraw funds to cover adequate living expenses (Baret et al. 2020). Due to the global epidemic, income prospects for individuals and businesses have dwindled, potentially forcing them to invest their savings. Individuals who lose their jobs will make futile attempts to live solely on their savings. If this pattern continues for an extended period of time, it will result in a liquidity shortage and constrain banks’ lending ability (Cheney et al. 2020).

Also, the UK decision to leave the EU is expected to fuel the repercussions of uncertainties for the UK financial services sector. Banks that operate in the UK will encounter the following risks: business losses due to market fluctuations or business displacement reduced import and export payments given the absence of single-market and currency conversion risks. A potential Brexit deal is also likely to modify banks’ relationships with their customers inside the EU, as they migrate from “inside the group” to “cross-border,” restructuring market structure based on the terms of the Brexit deal. The majority of the UK’s trade agreements with over 60 non-EU nations, including investment banking agreements, are concluded via the EU. Consequently, Brexit will necessarily entail the negotiation of new deals for the UK, slowing business until the contracts are finalized. According to the Bank of England, UK banks are well-positioned to deal with any liquidity problems that might arise as a result of changing operations or staying in the UK. Risk-weighted assets account for nearly 17% of their tier 1 capital (three times the amount during the 2018 global financial crisis), showing adequate cash reserves for contingencies (Deen, 2019).

Banking is one of the significant contributors to the UK economy. It becomes critical for the sector to identify and evaluate the impact of these unforeseen circumstances to prepare in advance for dealing with these emerging risks.

3.2 Risk map for a variety of risks in 2020

The Risk Map highlights the key factors that impact the euro area financial sector (see Figure 1) in the likelihood of occurrence and effect. Over the next three years, the banking system is expected to pose multiple significant risk drivers: fiscal, economic, and debt sustainability encounters in the European economy; business-model steadiness; and cyber-security and Information Technology vulnerabilities.

The critical risk drivers are as follows:

1. The euro-zone’s fiscal, institutional, and debt sustainability issues have gotten worse over the last year, posing significant risks to the euro-zone banking industry, namely credit risk and competitiveness prospects. The euro area’s fiscal, political, and debt sustainability challenges have intensified over the last year, posing additional threats to the Eurozone countries, including creditworthiness and profitability potential. Despite recent economic development, worries about the financial system persist, leaving euro-zone countries with high levels of debt vulnerable to sudden changes in financial sector expectations. As a result, consumer debt and, more specifically, government bonds remain elevated in Euro-zone countries, making these sectors vulnerable to potential shocks. The emergence of inward initiatives in several EU member states continues to trigger the Eurozone geopolitical difficulties.

2. Sustaining business models continue to be a priority, given the UK’s low profitability. The prospect of sustained lower tax rates and increased competition further impairs banks’ ability to benefit. Simultaneously, net costs remained constant, as cost-cutting measures were partially offset by factors such as increased salaries, need for IT expenditure, and risk analysis.  Additionally, while digital transformation has the ability to boost banks’ cost productivity by allowing them to provide innovative products in the coming years, it requires banks to reconsider their business strategies. Additionally, it will enable banks to render short-term investments in an attempt to transform their operations. 

3. Continued digital transformation of financial institutions renders banks more prone to cybercrime and institutional IT vulnerabilities. Cyber-attacks can have substantial economic effects or financial losses for banks and can sometimes have far-reaching ramifications due to the rapid spread of threats through industries.

4. The possibility of significant financial market mispricing persists. Following the sell-off in December 2018, global share prices recovered during the first half of 2019. Despite the slowdown, asset valuations in some target markets remain robust. Volatility in the financial markets moderated marginally in the first half of 2019 before accelerating in August, fueled by heightened trade tensions. Simultaneously, risk premia continue to be compressed. This would have a negative impact on the balance sheets, capital ratios, and funding costs of banks.

5. Central banks and regulatory bodies are centered mainly on climate threats and partnering with other international agencies through the Banking Sector Greening Network, with which the ECB is a member. Climate change-related risks are anticipated to have a significant impact on banks. Elevated severe weather and the move to a low-carbon economy could substantially affect eurozone countries’ banks, including their clinical condition and long-term risk appetite of their resources (i.e. over a period of more than two to three years). As a practice, banks’ risk management practices should mitigate these risks (ECB Banking Supervision, 2020).

3.3 Comparison between drivers of risks in 2019 and 2020

The below risk map Figure 3.5 of the banking sector explain the risks in 2019. The results highlight that the banking industry’s significant risks are attributed to geopolitical uncertainty, financial sector revaluation, political instability, Brexit, NPL tactics, Cyber-crime, and IT threats. Banks’ internal reporting procedures often play a significant role in managing different threats and opportunities, as proper risk assessment and risk appetite development and risk management rely primarily on risk assessment. The internal corporate governance team should emphasize different ratios such as the ROA, the cost-to-income ratio, etc. (SREP, 2020).

Table 3.1 Comparison between drivers of risk in 2019 and 2020

Drivers of Risk in 2019Drivers of Risk in 2020
1. Concerns with keeping pace with technological change Such as robotics and other workflow automation technologies, natural language processing and AI to dramatically increase productivity and reduce operational, risk management and enforcement costs.1. Concerns with increasing investments into emerging technologies to address customer concerns and escalating demand for online services due to the sudden outbreak of COVID-19.
2. Banking industry ability to hire and retain talented workforce competent enough to deal with technological transformations2. Banking industry capability to hire, train and retain workforce amidst enforced lockdown and rising trend of work from home
3. Deal with issues about cyber-breaches, changing regulatory compliances, market dynamics, intensifying competition. Sustaining the existing business model with rising competition from Fin-techs and other emerging digital innovators3. Compared to 2019, uncertainties linked to euro market economic conditions rose in 2020. The prospect of increasing market uncertainties such as Brexit, COVID-19, etc., has led directly to increasing protectionism and increased risk of low profitability. Moreover, declining interest rates in current times have further projected a fall in bank profitability. In addition, extreme scrutiny of money laundering cases is expected to increase in recent times, which is additionally scheduled to trigger loss risk due to misconduct and manipulation in the banking sector.

3.4 Risk management procedures and their effectiveness in UK banking sector

Roberts, (2015) further analyzed risk management in the UK banking sector, where the author argued that risk is a function of chance and prediction that can be quantified for successful financial management. The author has established that UK bank managers depend primarily on quantitative risk measurement and are responsible for managing various risks in the UK banking sector. England’s bank is responsible for developing multiple policies such as monetary, financial, macro-prudential supervision, etc. The two central UK banking committees are the Prudential Regulatory Authority and the Financial Policy Committee. The author provided that Prudential Regulatory Authority is responsible for reviewing bank safety standards, and the Financial Policy Committee is responsible for preventing credit risk and maintaining financial stability. In addition, the Economic Crime Agency helps in managing serious economic crime problems, and the Consumer Protection and Markets Authority ensures investor protection, market regulation, and business behavior.

3.4.1. ERM Model for the banking sector

The ERM model can be used in the banking industry to help track and report different threats and problems at regular intervals due to the controlled nature of the industry. Risk organization and management, risk analysis and planning, risk plan and assessments, legal and management environments, and risk evaluation and control are among the five major themes. The arrows at the base of these themes indicate that the elements of the ERM model are directly in contact. That is, ERM is just not a one-time exercise but rather a continuous method that banks can use to track threats, evaluate, and update counter-attack strategies as required (Soliman and Adam, 2017).

4. Conclusions & Recommendations

4.1 Conclusion

Risk management in banks has become a significant concern for both bank management and regulatory bodies due to the uncertainties and fluidity of the market environment (Lazarica, Bunea-Bontas, Petre, 2009). In a nutshell, this report’s findings indicated the significant risks impacting the performance of the banking sector in 2019 as well as 2020. A comprehensive distinguish between the various drivers of risk impacting the performance of the banking sector in 2019 and 2020 has been illustrated. Additionally, the report has elaborated on the need for having a proper risk management framework in place. Additionally, the findings of this study assisted in establishing that the primary risks confronting the banking sector in the United Kingdom at the moment including; Brexit uncertainty, the sudden outbreak of COVID-19, a weak business model, environmental tensions, political instability, the ongoing digital- evolution, the risk of fraud, and regulatory issues. The results have shown how pandemic has led to the emergence of several new pressures impacting the performance of the banking sector. For instance, economic contradiction, turbulent market forces, and the number of loan defaulters have considerably increased. All of these problems and concerns are likely to have an impact on how banks operate.

Further scrutiny of the information has revealed the two prime regulators in the UK; PRA that takes care of the financial safety and soundness of the banks, and FCA that manages how banks operate and deal with clients and other businesses in the financial market. The study has highlighted that prudential issues like liquidity risks are addressed and controlled by PRA while mis-selling and FCA handles market abuse. Besides these two bodies, the Bank of England oversees the financial market and payment systems. Moreover, for UK banks, the most considerable impact of Brexit has been the loss of clients present across the EU region. In such a scenario, an appropriate risk management system, i.e., an ERM framework, can be used to handle all risks and challenges effectively. Moreover, UK banks are expected to hold capital for dealing with the different types of threats, primarily; credit risk, market risk, and operational risks.

4.2 Recommendations

The banking authorities have a variety of options for dealing with current market threats. The following are the most critical steps that can be implemented:

  • Digitizing key processes:  Simplification, centralization, and automation is crucial to minimize operational and non-financial risk. To this end, the risk feature will help accelerate the digital transformation of core identified risks, such as card transactions and financing, by providing businesses with suggestions. Increased performance, consumer experience, and higher revenues are likely to be significant advantages.
  • Re-Adjust banks’ business models to changing market conditions
  • Banks should implement several cyber-security initiatives to reduce the risk of cyber-attacks
  • UK bank administrators should work to strengthen their flexibility to potential shocks and to improve investor protection
  • Bank managers should devise contingency plans to cope with several uncertainties, such as no COVID-19, no Bexit and so on.
  • United Kingdom bank executives should experiment with applied analytics to develop strategies for addressing governance-related risks and challenges: Risk management functions should conduct additional research into algorithms, especially artificial intelligence, to improve the precision of predictive models. These models can be used by risk managers for a variety of purposes, such as detecting major fraud, credit underwriting, emergency preparedness, and retail and small-business transactions.
  • The hiring of financial experts can bolster banks’ local risk management capacities: Institutions should strive to ensure that they have appropriate experts with experience in high-risk and complex activities and have suitable preparation to update skills continuously. At the same time, they need an active program to infuse an organization’s risk-conscious culture, promote their employees’ ethical actions, and track and manage conduct risk. Risk needs to shift from reactive to constructive. A change from a compliance-oriented risk mentality to a robust and constructive risk culture is needed.
  • Banks should integrate various risks into the risk management framework: Expanding regulation and adapting to business trends necessitates rapid, fact-based decision-making, which requires improved risk reporting. Although regulatory requirements have improved the quality of the information used in risk documents and their promptness, less attention was given to the word file and how the data could be used more effectively for decision-making. By substituting immersive tablet solutions that include real-time information and enable users to conduct root-cause analysis for paper-based reports, banks would be able to make informed decisions and recognize potential risks more quickly.
  • All bank employees, who are not in risk roles, must adapt participate in the activities involving risk analysis, measurement, and prevention into their day-to-day work. To enable appropriate ethical deployment of technology and integrated simulation and technological capabilities, human involvement is needed.

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