The Bank as a commercial organization aims to make a profit, which ensures the stability and reliability of operation and can be used to expand its activities. However, the focus on the profitability of operation is always associated with various types of risks, which in the absence of limitation may result in losses. Therefore, any bank in determining the strategy of its activities creates a system of measures, which on the one hand, aims at making a profit, and on the other hand, takes into account the maximum possible prevention of losses in banking activities (Madura, 2012).
The banking system is weakly protected from many risks and, therefore, has low functional capacity. Thus, the banking activities in a market economy are subject to a significant number of risks, which may not only degrade the performance of the bank, but also bring it to bankruptcy. Risk management is the main process of banking performance (Brigham and Houston, 2011).
Consequently, the purpose of the paper is to explore risk management practice in the UK banking industry, because the UK banking sector is one of the oldest in the world and its peculiarities have been being formed since the creation of the Bank of England in 1694 (Gola and Roselli, 2009). It is necessary to describe the history of the UK banking system and to specify its main features and current trends, to define the main objective and the process of risk management, to clarify risk management principles in the UK banking sector, to consider peculiarities of the UK risk management practice, to provide with the popular methods of risks’ assessment and to conclude with the ways to improve the UK banking sector’s operation.
History of the UK Banking System: Main Features and Current Trends
The banking system of the United Kingdom is one of the oldest in the world, ceding only to Switzerland. It is characterized by a high degree of concentration and specialization, well developed banking infrastructure and a close relationship with the international loan market. In a global financial center, in London, more foreign banks than English ones operate. They are primarily American and Japanese banks (Gola and Roselli, 2009).
The Central Bank of England appeared in the late 17th century (in 1694), as a result of the so-called agreement between the nearly bankrupt government and a group of financiers. In order to wage war with France, government needed a large loan, for the issuance of which several of the London merchants united in one private joint-stock bank. As a thank you for the service they have received the right to get deposits, discounting bills, and issue tickets for a single bearer of value, corresponding to a certain weight of metal (Gola and Roselli, 2009).
The modern UK banking system is a three-tier: first level – the Bank of England, the second level – commercial banks, and the third level – building societies and credit unions. The Bank of England is responsible for monetary policy, financial stability and payment systems. Commercial banks are classified into four groups, namely deposit and commercial banks, savings banks, companies accounting for securities, and domestic and foreign banks. Organizations of the third level are numerous; their distinguishing feature is the involvement of shareholders as potential borrowers. Unions generally offer mortgage and consumer lending, but in recent years they have started to provide with a variety of other financial services. Country’s banking sector is widely represented by foreign capital (Lipsey and Chrystal, 2015).
A feature of the banking system of England is the availability of discount (accounting) houses – bill-brokers. Through them, the Bank of England lends to other commercial banks, although in recent years their role has been reduced. The second feature is that in England, there are enough licensed deposit-taking organizations. In practice, any organization before getting the status of the bank should undergo a trial period as such organization (Davies, Richardson, Katinaite and Manning, 2011).
Currently, HSBC Holdings is a British leading bank with total assets of almost USD2.7 trillion. It has over 6.5 thousand offices in 80 states all over the world. Other major players of the UK banking market are presented below, where it is clear how their financial positions changed within 2012-2015 (STATISTA, 2015).
Figure 1. The UK Top-Banks by Total Assets, 2012-2015 (in trillion GBP and USD)
Thus, the main drivers in the development of the UK banking system were technological progresses, financial modernization and the globalization of industries. One more aspect functioning on economies of scale is the cost of expert knowledge and personal data. In general, computerization in retail banking and improvement in both risk management procedures and the project of financial offers have all caused modifications in the delivery of the main financial services (Davies, Richardson, Katinaite and Manning, 2011).
Main Elements of the Risk Management and Its Practice in the United Kingdom
The Objective and the Process of Risk Management
The main objective of risk management at the bank is to maintain acceptable profitability ratios with indicators of safety and liquidity in the management of assets and liabilities of the bank, i.e., minimization of bank losses. Effective management of risk in the bank must address a number of issues – from monitoring of the risk to its valuation. The level of risk associated with a particular event is constantly changing due to the dynamic nature of the external environment of banks. This makes the bank to regularly clarify its position on the market, assess the risk of certain events, review the relationship with customers and assess the quality of its assets and liabilities, therefore, to adjust its policy of risk management (Hull, 2012).
The process of risk management of the bank includes prediction of risks, the determination of their likely size and impacts, and the development and implementation of measures to prevent or minimize related losses. Banking transactions are very diverse; each of them has its own characteristics and, consequently, a certain level of risk, or a fixed probability of losses. All variety of banking transactions is complemented by a variety of clients and changing market conditions, which greatly complicate the development of some of the criteria for assessing the risk (Ghosh, 2012).
Principles of the UK Risk Management Policy
The UK risk management policy is based on the following principles:
Forecasting possible sources of losses or situations that could cause damage to their quantitative measurement;
Financing risks, economic incentives to reduce them;
Responsibility and duty of managers and employees, clear policies and mechanisms for risk management;
Coordinated control of risks in all departments and services of the bank, monitoring of the effectiveness of risk management procedures.
Peculiarities of the UK Risk Management Practice
First of all, Bank of England has the Financial Policy Committee (FPC), which is a subcommittee of the Board of Directors. It consists of a manager, three deputy managing directors, executive director of the Financial Conduct Authority, the executive director responsible for financial stability, and four external members appointed by the Chancellor. FPC contributes to achieving by the bank its goal of financial stability by identifying, monitoring and taking measures to reduce the risks to the financial system. Also, FPC is responsible for the implementation of actions to eliminate or reduce systemic risks, to protect and strengthen the resilience of the whole UK financial system. The Committee has a secondary objective to support the government’s economic policy.
Secondly, stress testing has grown into a crucial technique for managers all over the world, and in the UK as well, to measure the power of banks by implication of the financial crisis, and the approach they are carried out has been renovated. The Bank of England has stated that banks should meet at least 3% leverage ratio to pass stress test in 2015 (Arnold and Binham, 2015). During stress testing a number of factors are taken into account by the bank, which change causes the implementation of the credit, exchange rate, interest rate, operational risk, and liquidity risk, which can cause extraordinary losses on the portfolio of assets or significantly complicate the management of these risks. Stress-testing policy of the bank is developed in order to comply with recommendations of the Bank of England as regards stress-testing, as well as with banking industry’s best practices set out by Basel Committee on Banking Supervision (BCBS). The goal of stress testing is to evaluate risk and capital adequacy in order to assess the Bank’s ability to survive in worse financial market conditions and to perform an anti-crisis action plan (Hull, 2012). In result of the stress test the bank receives (Bessis, 2015):
Quantification of the impact caused by changes in risk factors for assets, liabilities, income and capital to assess the financial stability of the Bank, is due to the ability of equity to compensate for possible large losses ;
Definition of actions that should be developed and applied by the Bank to reduce risk;
Development of methods to reduce the likelihood of data scenarios and / or reduce the negative impact (loss) for the financial stability of the Bank.
Thirdly, the UK banking industry pays huge attention to the risk of loss of business reputation by the financial institution (reputation risk). It is the risk that the financial institution losses by reducing the number of customers (counterparties) because of negative public understanding of the financial stability of a financial institution, its services or the nature of the activity as a whole (Gai, 2013).
Nevertheless, risk management in the UK banking sector also focuses on the evaluation of legal, strategic, information security, operational, liquidity, FX, interest rate and credit risks.
Methods to Assess Risks
Risk assessment is carried out based on the analytical data, prepared at the stage of identification by known methods and measurement tools. The initial information of the measurement stage is submission of proposals regarding measures on risk minimization. Risk management includes final approval of the risk management methods. The following approaches and tools are applied with the purpose of risk management in the UK banks (Ghosh, 2012; Bessis, 2015):
Risk management is the main in banking segment. Banking is in the process of change. In an effort to increase economic efficiency and improve resource allocation mechanism, the government is taking steps towards the establishment of an atmosphere of openness in the economy, competition and market discipline. The purpose of risk management is to maximize the value of a particular institution, which is determined by profitability and risk (Brigham and Daves, 2007).
In the process of the completion of the paper it was found that the UK banking system is one of the oldest in the world, which consists of three levels, namely the Central Bank, commercial banks and building societies and credit unions. The most important trend in the development of the banking system of Great Britain is a blurring of the boundaries between different types of credit institutions (Gola and Roselli, 2009; Davies, Richardson, Katinaite and Manning, 2011).
One of the methods of optimization of banking risks is to facilitate the interpretation of banking information in a graphical model of financial condition of the bank, which allows visualizing the proportions of the main characteristics of the bank, and given the scale – assessing their absolute relationship.
Arnold, M. and Binham, C. (2015). Banking sector stress tests lambasted as ‘fatally flawed’. Financial Times. [online] Available at: <http://www.ft.com/cms/s/0/9785ba8a-150b-11e5-a587-00144feabdc0.html> [Accessed: 21 January 2015]
Bessis, J. (2015). Risk Management in Banking, 4th ed. Hoboken, NJ: Wiley.
Brigham, E. F. and Daves, Ph. R. (2007). Intermediate Financial Management, 9th ed. Mason: Thompson South-Western.
Brigham, E. F. and Houston, J. F. (2011). Fundamentals of Financial Management. Concise 7th ed. Cengage Learning.
Davies, R., Richardson, P., Katinaite, V. and Manning, M. (2011). Evolution of the UK banking system. [online] Available at: <http://www.bankofengland.co.uk/publications/Documents/quarterlybulletin/qb100407.pd> [Accessed: 21 January 2015]
Gai, P. (2013). Systemic Risk: The Dynamics of Modern Financial Systems. Oxford: OUP Oxford.
Ghosh, A. (2012). Managing Risks in Commercial and Retail Banking. Hoboken, NJ: Wiley.
Gola, C. and Roselli, A. (2009). The UK Banking System and its Regulatory and Supervisory Framework. London: Palgrave Macmillan UK.
Hull, J. C. (2012). Risk Management and Financial Institutions, 3rd ed. Hoboken, NJ: Wiley.
Lipsey, R. G. and Chrystal, A. (2015). Economics. Oxford: Oxford University Press.
Madura, J. (2012). International financial management, 11th ed. Mason, OH: South-Western/Cengage Learning.
STATISTA (2015). Leading banks ranked by total assets in the United Kingdom (UK) from 2012 to 2015 (in trillion GBP and USD). [online] Available at: <http://www.statista.com/statistics/300792/uk-banking-sector-leading-banks-by-total-assets/> [Accessed: 21 January 2015]