Risk Management Practices Of Rural Banks

Published Date: 02 Nov 2017

MASTER OF BUSINESS ADMINISTRATION (FINANCE)

LONG ESSAY TOPIC

ASSESSING RISK MANAGEMENT PRACTICES OF RURAL BANKS:

A STUDY OF GHANA

NAME: AMOFA-SARPONG KWABENA

STUDENT I.D: 10362680

SUPERVISOR: MRS. SARAH SERWAH BOATENG

CHAPTER ONE

1.0 INTRODUCTION

BACKGROUND OF THE STUDY

Risk management is the foundation or basis of prudent banking practice. Indeed, all banks in the present-day volatile environment are facing a large number of risks such as credit risk, liquidity risk, market risk, interest rate risk, etc. Thus, risks which may threaten a bank’s survival, growth and success. Thus, banking is a business of risk. For this reason, efficient risk management practices are absolutely required or needed in order to be successful and competitive in the business environment. Risk management is the process by which managers satisfy their needs by identifying key risks, obtaining consistently understandable, operational risk measures, choosing which risks to reduce and which to increase and by what means, and establishing procedures to monitor the resulting risk position (Akindele, 2012).

The misallocation of funds and imprudent risk taking have become some of the leading source of problems facing the Ghanaian banking industry, which has stifled the operations of some banks in Ghana especially rural banks. There is therefore the need for banks to be aware of the need to identify measure, monitor and control all inherent risks in their day to day business transactions and also hold adequate capital against these risks.

Carey (2001) indicates in this regard that risk management is more important in the financial and banking sector than in other parts of the economy. Most banks’ business philosophy is premised on the fact that their success as an ongoing concern depends on whether the risks they take are sufficiently calculated, reasonable and within their financial resources and competence. The purpose of financial institutions such as rural banks is to maximize revenues and offer the most value to shareholders by offering a variety of attractive financial products and services, and especially by administering risks. This has recently prompted many banks including rural banks to appoint senior managers to oversee the formal risk management functions to be performed in their daily operations.

Rural and Community Banks (RCBs) are the largest providers of formal financial services in rural areas and represent about half of the total banking outlets in Ghana (IFAD 2008).

By the 1970s, however, it had become evident that the Agricultural Development Bank (ADB) which was designed by the Government during that period to provide a vehicle for reaching small-scale farmers lacked the capacity to provide adequate rural Coverage (Mensah, 1997). This realization led to the emphasis on the development of a rural banking system, modelled on the rural banking system in the Philippines. In 1976, the Ghanaian government, through the Bank of Ghana, established Rural Banks to channel credit to productive rural ventures and promote rural development. Rural development is a strategy intended to improve the economic and social life of the rural poor (World Bank, 1975).

As a result, the first rural bank was set up on 5th July, 1976 at Agona Nyakrom in the Central Region and by December, 1987, the number of rural banks in Ghana had risen to 117. Currently, there are about 135 rural banks currently in Ghana with a total of about 564 agencies across the country. (ARB Apex Bank, 2012).

The financial Industry or sector has become a battle zone whereby every company or institution is trying to do something to be competitive, to succeed and to remain in business. It is of this view that the need has arisen to critically analyse and assess the risk management practices adopted by rural banks in their daily business operations or activities in order to achieve or gain competitive edge within the industry it operates.

The basic characteristics of rural banks are that they are communally owned and designed to operate within defined geographical areas and maintain concessionary prescribed minimum paid-up capital. The directors are elected from among the shareholders with some co-option based on relevant specialities. However, the desire of the rural banks to ensure profitable operations through financing trade and commerce, have seen the upsurge of their proliferation in the urban centres, which rather exposes them to undue credit risk from customers with high appetite for substantial credit facilities such as contractors in the construction sector and Businessmen (Owusu, 2008).

Although many studies have been done for risk management practices all over the world (Hallman & Forrest, 1991; Santomero, 1997; Santomero & Oldfield, 1997; Frosdick, 1997; Tchankova, 2002; Kallman & Maric, 2004; Fatemi & Fooladi, 2006; Laurentis & Mattei, 2009; Sensarma & Jayadev, 2009), very few studies have been conducted in relation to the area of rural banking especially in developing countries such as Ghana.

Rural banks in Ghana have now assumed important and strategic role in the economy and hence the need for proper application or assessment of effective risk management practices, techniques and principles adopted by them in their activities or operations.

1.2 STATEMENT OF THE PROBLEM

Rural and Community Banks (RCB) survival in an urban environment will depend largely on their ability to brace themselves to minimize risks. Rural and Community Banks operations in urban environments are likely to take on board more and bigger risks that require effective risk management through effective internal control mechanisms and prudent financial management to be competitive.

Rural banks in Ghana are grappling with huge challenges in managing their loan loss reserves due to bad loans and poor management systems applied by the banks and as a result, some of these Rural and Community Banks (RCBs) have been rendered insolvent and could soon fold up if austerity measures are not taken to reverse the trend.

Interestingly, with the rapid growth and current development of the rural banking sector and the expansion of their operations from the rural to the urban areas have seen the rural banks facing huge or tremendous challenges in analysing and managing their exposure to risks. This has therefore made risk management such a difficult issue or challenge for banks in Ghana especially for rural banks to deal with or control.

Despite the regulatory and supervisory role performed by the Bank of Ghana and the ARB Apex Bank, rural and community banks (RCBs) continue to experience more loan loss or loan default. Improper and ineffective form of appraisals, monitoring, evaluating and recovery and lack of adequate training for credit officers are vital or essential factors contributing to the collapse of some rural banks who fail to use effective risk management practices.

Due to the tremendous increase in the demand for credit by both rural and urban sectors over the past few years and the intense competition in the banking market, Rural and Community Banks (RCB’s) in the Koforidua Municipality of the Eastern Region, have gone beyond their core mandates or responsibilities by extending credit facilities to the urban population as well.

The Bank of Ghana have therefore charged the Board of Directors (BoD) and top management of all banking and financial institutions operating in the economy including rural banks to supervise the bank’s risk management practices and to ensure that effective controls and monitoring systems are in place to deal with its exposure to risks such as liquidity risk, credit risk, operational risk, interest rate risk, capital risk etc.

What practices, then, have Rural and Community Banks in the Koforidua Municipality adopted to manage its risks?

OBJECTIVE OF THE STUDY

The main purpose or objective of this study is to examine or assess the degree to which the rural banks in Koforidua use effective risk management practices and techniques in dealing with different types of risk. Specifically, the study seeks to:

Identify some of the effective risk management practices followed or adopted by some selected rural banks in Koforidua.

To compare risk management practices between the selected rural banks.

To identify the most important type or types of risk facing the rural banks in Koforidua.

To assess the role of the Board of Directors and Management of the selected rural Banks in managing their various banks’ exposure to risk.

RESEARCH QUESTIONS

The study intends to answer several key questions regarding the risk management practices of rural banks in Koforidua. These, inter alia, include the following:

Do the Rural banks’ staffs in Koforidua understand risk and risk management?

Have the Rural banks in Koforidua clearly identified the potential risks relating to each of their declared aims and objectives?

Do the rural banks in Koforidua examine and analyze risk in general?

Do the rural banks in Koforidua have a risk monitoring and controlling system?

What are the methods used in risk management in general by rural banks in Koforidua?

Do the rural banks in Koforidua manage their risks?

Hypothesis

Based on the stated objective in the introduction and the research questions mentioned above, the following hypothesis is formulated and tested in the study:

H1. There is a positive relationship between risk management Practices (RMPs) and understanding risk and risk management (URM), Risk Assessment and analysis (RAA), Risk Identification (RI), Risk Monitoring (RM), and credit risk analysis (CRA).

RMP=f (URM, RAA, RI, RM, CRA)

METHODOLOGY

Questionnaire

In order to address the research questions of this study, a survey questionnaire will be developed and modified by adopting or following the methodology of Al-Tamimi and Al-Mazrooei (2007) on their investigations on the degree to which banks (including Islamic banks) of UAE use RMPs and techniques in dealing with different types of risk and also comparing RMPs between national and foreign banks.

The questionnaire will be divided into two parts. Part-1 of the questionnaire will cover six aspects: URM, RI, RAA, RM, RMPs, and CRA. This part will include 36 close-ended questions based on an interval scale where six questions will correspond to the URM aspect, five questions will correspond to RI, ten questions will correspond to RAA, eight questions will correspond to RM, ten questions will correspond to RMPs, and seven questions will correspond to CRA. All the respondents will be asked to indicate their degree of agreement with each of the questions on a seven-point "Likert scale."

The Part-2 of the questionnaire will consist of two closed-ended questions based on an

"Ordinal scale" dealing with two topics: methods of Risk Identification (RI), and the type of risk facing the sampled rural banks.

The questionnaire survey will be conducted during the month of December, 2012-January, 2013.

Population Sample or Size.

Out of about 22 rural banks in the eastern region, there are currently about 10 rural banks operating in Koforidua. About five of these banks will be selected for the survey. The target population of this survey will include at least twenty members of staff (including senior level management staff) of each selected bank.

Data collection instrument.

Both primary and secondary data will be used for the study. Primary data for the study will be collected using questionnaire and interview. The questionnaire will be administered to some selected members of staff (including senior managers) of the selected Rural Banks whose schedule involves the granting and administration of various forms of risks encountered in their daily activities. This will allow respondents who are considerably knowledgeable in risk management to answer the questionnaire.

Data from the secondary sources will involve the gathering of information on credit operations from BoG reports, ARB Apex reports, journals, financial and management reports of the selected Rural Banks. These secondary sources will provide some useful statistics and information used in supporting the literature review which will be appropriately acknowledged.

SIGNIFICANCE OF THE STUDY

The study would be of assistance to the academic and research institutions, policy makers and the banking and financial industry for reasons as follows;

To the academic and research institutions, students pursuing programmes in finance and other related fields of study or those who are interested in researching in the area of risk management could use the study as a reference material for further studies into other sectors of the industry such as savings and loans companies, microfinance institutions etc.

To the government/policy makers, the findings or outcomes of this study will provide a guide especially for the bank of Ghana and the ARB Apex Bank who are the regulatory and supervisory bodies to make relevant or issue appropriate policy directives and supervisory guidelines to address this challenge facing the sector and for the ultimate improvement of risk management practices of banks in general especially rural banks.

It will also enable Rural and Community Banks to identify clearly the peculiar nature of their operations and come out with measures to control the menace of credit failure and the effect of various policies targeted at managing the risk facing the banking sector.

LIMITATIONS OF THE STUDY

The findings of this research or study will be limited to Risk Management Practices of some selected Rural Banks in the Koforidua Municipality. Therefore any analysis from the findings should also be limited to this study area in order to prevent any inconsistent findings and misleading conclusions.

An extremely detailed study of the above subject will not be possible because of the time constraint which is due to the fact that the study was conducted in one academic year.

ORGANISATION OF THE STUDY/CHAPTER DISPOSITION

The entire research work will be divided into four main chapters.

Chapter one (1) serves as an introduction to the chosen topic, it deals with statement of the problem, the research questions, and objectives of the study, Methodology of the study, Significance of the study and Limitations of the study.

Chapter two (2) will present a comprehensive review of relevant literature.

Chapter three (3) will deal with data collection and analysis.

Chapter three (4) will present the findings and discussions of the study.

Chapter four (5) will present the conclusion as well recommendations of the study.

CHAPTER TWO

LITERATURE REVIEW

2.0 INTRODUCTION

The positive impact and contribution of the Ghanaian Banking and financial system is a vital element to ensure economic stability, growth and development of the Country. Rural and Community Banks, like any other financial Institution therefore plays an essential part in developing the financial sector of any economy by providing valuable services and activities such as facilitating the flow of funds by lending to users of funds and also providing liquidity to savers on demand. They also provide financial assistance to new industries and businesses especially small scale enterprises, thereby increasing employment and growth opportunities. The varied nature of functions performed by these financial institutions exposes them to risk, negatively affecting their profitability, liquidity, growth and solvency.

This chapter discusses the concept of risk and risk management, operations of Rural and Community Banks in Ghana and some types of risk faced by them. The discussion is followed by a review of various related works that have been carried out various authors and writers.

The Concept and Definition of Risk

2.1.1 Definition

According to Skipper (2009), risk has no universal definition and one way to express it as the variability of outcomes. Shimpi (2001) has defined risk as the lifeblood of every organization and functional managers do manage risk head-on wherever it appears. Gupta (2004a, b) says "Risk refers to the possibility of deviation from the standard path. These deviations reduce the value and imply unhappy situations".

Risks are uncertain future events which could manipulate the success of the bank’s aims and objectives, including strategic, transactional, and economic objectives.

Risk can be classified into systematic and unsystematic risk. Systematic risk is associated with the overall market or the economy, whereas unsystematic risk is related to a specific asset or firm. Some of the systematic risk can be reduced through the use of risk mitigation and transmission techniques. In this regard Oldfield and Santomero (1997) refer to three generic risk mitigation strategies:

eliminate or avoid risks by simple business practices;

transfer risks to other participants; and

Actively manage risks at the bank level (acceptance of risk).

According to Machiraju (2004) risk could take the form of pure or speculative, diversifiable and non-diversifiable risk.

2.1.2 Pure versus speculative risk

Conventionally, writers on risk management have distinguished between pure and speculative risks. Pure risk exists when there is a probability of a loss but no probability of a gain and speculative risk exists when there is a likelihood of gain as well as a likelihood of loss (Mowbray, 2001).

According to Calomirus & Engel (2004), banks, like any other business organization, have the object of maximizing return on shareholders’ investments, after meeting all its obligations to other stakeholders. The main product of banks is credit; they then receive interest in return for the use of their credit. Banks, therefore, face speculative risk since they may gain by receiving both interest and principal or lose either/both principal and interest.

2.1.3 Diversifiable versus non-diversifiable risks

Some risks affect nearly all humans and firms at the same time, other risks are faced almost in isolation. Unless the manifestation of a risk affects individuals and organizations in the same way and at the same time, it is possible for the affected entities to reduce their exposure to risks through pooling or sharing arrangements (Mowbray, 2001). A risk is diversifiable if it is possible to reduce it through pooling or sharing arrangements. A risk is non-diversifiable if pooling arrangements are ineffective in reducing it for the participants in the pool.

In finance literature these distinction are often used – "systematic and non-systematic" or "market and unique" risk – and is very important in risk management because it affects the effectiveness of pooling or risk sharing arrangements.

Such constraints as risk could hinder a financial institution’s ability to conduct its ongoing or to take benefit of opportunities to enhance its business. Risk will exist as long as the business of financial institutions continues to operate.

2.2 Methods of Managing risk

Rejda (2008) identified five major methods of handling risk. These include:

Avoidance: It refers to a situation where certain loss exposure is never acquired or an existing loss exposure is abandoned. For example, a business firm can avoid the risk of being sued for a defective product by not producing the product.

Loss Control: It consists of certain activities that reduce both the frequency and severity of losses. This aims at reducing the probability of loss so that the frequency of losses is reduced and has to do with reduction in the severity of a loss after it occurs.

Retention: It means that a business firm retains all or part of a given risk. This can be active or passive. Active retention means that an individual is consciously aware of the risk and deliberately plans to retain all or part of it. Passive retention on the other hand, means certain risk may be unknowingly retained because of ignorance, indifference or laziness. Risk retention however is appropriate primary for high- frequency, low severity where potential losses are relatively small.

Non- Insurance transfer: It is a technique where the risk is transferred to a party other than insurance company. It can take the form of transfer of risk by contract, hedging price risk, and incorporation of the business.

Insurance – the risk is transferred to the insurer. This is important because the pooling technique is used to spread the losses of the few over the entire group so that average loss is substituted for actual loss. Again the risk may be reduced by application of the law of large numbers by which an insurer can predict future loss experience with greater accuracy.

2.3 Risk Management

Risk management is the process of controlling the likelihood and potential severity of an adverse event. It is about systematically identifying, measuring, limiting, and monitoring risks faced by an institution (Von-Pischke, 1989). Risk management is the process by which managers satisfy their needs by identifying key risks, obtaining consistently understandable, operational risk measures, choosing which risks to reduce and which to increase and by what means, and establishing procedures to monitor the resulting risk position (Akindele, 2012).

The objectives of risk management include: to minimize foreign exchange losses, to reduce the volatility of cash flows, to protect earnings fluctuations, to increase profitability and to ensure survival of the firm (Fatemi, 2000).

Risk management according to Ulrich (2004) is a discipline at the core of every financial institution and encompasses all the activities that affect it risk profile. Thus it involves the identification, measurement, monitoring and controlling risk to ensure that the individuals who take or manage risk clearly understand it, the organization risk exposure is within the limit established by Board of Directors, risk taking decisions are in line with the business strategy and objective set by the Board of Directors, the expected payoffs compensate for the risk taken, risk taking decisions are explicit and clear and sufficient capital as a buffer is available to take risk.

2.4 Risk Management Framework

Rosman (2009) have proposed a research framework on risk management practices and the aspects of risk management processes. This framework observes the relationship between risk management practices and the four aspects of risk management process i.e. (1) understanding risk and risk management; (2) risk identification; (3) risk analysis and assessment; and (4) risk monitoring.

An effective risk management framework should therefore include the following:

Clearly defined risk management policies and procedures covering risk identification, acceptance, measurement, monitoring, reporting and control

A well constituted organizational structure defining clearly roles and responsibilities of individuals involved in risk taking as well as managing. Financial institution in addition to risk management functions for various categories may institute a set-up that supervises overall risk management at the bank. The structure should be such that ensures effective monitoring and control over risk being taken. The individuals responsibility for review function such as internal audit, compliance etc, should be independent from risk taking units and report directly to board or senior management who are also not involved in risk taking.

There should be an effective Management Information System (MIS) that ensures flow of information from operational level to top management and a system to address any exception observed. There should be an explicit procedure regarding measures to be taken to address such deviations.

The framework should have a mechanism to ensure an ongoing review of systems, policies and procedures for risk management and procedure for adopt changes.

2.5 BRIEF HISTORY OF RURAL AND COMMUNITY BANKS IN GHANA

The concept of rural banking was conceived in the 1960s with the search for a system to tackle the financial problems of the rural dweller using the socialist development ideology. During this period the need for a veritable rural financial system in Ghana to tackle the needs of small-scale farmers, fishermen, craftsmen, market women, traders and all other micro-enterprises was felt. The need for such a system was necessary because the bigger commercial banks could not accommodate the financial intermediation problems of the rural poor as they did not show any interest in dealing with these small-scale operators.

Attempts in the past to encourage commercial banks especially the establishment of Agricultural Development Bank (ADB) to spread their rural network and provide credit to the agricultural sector failed to achieve the desired impact. The banks were rather interested in the finance of international trade, urban commerce and industry. There was therefore a gap in the provision of institutional finance to the rural agricultural sector.

More important still, the branch network of many banks covers mainly the commercial areas and does not reach down to the rural areas. Therefore not only are rural dwellers denied access to credit from organized institutions, but also cannot avail themselves of the opportunity of safeguarding their money and other valuable property which a bank provides.

The first rural bank, Nyakrom Rural Bank Limited, was opened in Agona Nyakrom in the Central Region in 1976 modelled around the rural banking system in the Philippines. As a result of the invaluable financial services rendered in the rural areas, the rural banking concept suddenly became popular with a number of rural communities applying to Bank of Ghana to establish rural banks.

By December 1987, there were about 117 rural banks before gradually growing to about 135 rural banks as at the end of 2011.

2.5.1 LICENSED RURAL & COMMUNITY BANKS IN GHANA

Rural and Community Banks in Ghana are increasingly becoming more visible on the financial landscape of the country. Their numbers have grown gradually since 1976 to about 135 as at January, 2012. The table below shows the number of rural and community Banks in each region of Ghana indicating the number of branches in each region.

REGIONS

NUMBER OF BANKS

NUMBER OF BRANCHES

GREATER ACCRA

6

13

EASTERN REGION

22

85

ASHANTI REGION

24

111

CENTRAL REGION

21

68

UPPER EAST

5

10

UPPER WEST

4

3

BRONG AHAFO

20

69

VOLTA

12

22

NORTHERN

6

3

WESTERN

13

55

TOTAL

135

439

Source: ARB APEX BANK OFFICIAL WEBSITE

2.5.2 ROLE OF RURAL AND COMMUNITY BANKS IN GHANA

In performing their functions as financial intermediaries (F.I’s), Rural and Community Banks engage in the following activities.

Facilitation of credit services: In the course of financial transactions, it is quite possible that the concerned parties may not be familiar with each other. Therefore, suppliers of goods and funds often expect the FI’s to help in evaluating or enhancing credit worthiness of a customer.

Fund deployment: the funds that are mobilized are first subject to regulatory requirements i.e. deposit taking institutions have specified proportion of their funds in instrument like government securities. The surplus funds are available as loans for various segments of businesses and individuals.

Funds transfer: financial institutions like savings and loans companies are key vehicle for moving fund in behalf of their customers. The core competence of financial institutions is to act as agent of corporation in supporting their liquidity needs across various geographical locations. They also act as settlement agent for their corporate client in realization and payment of funds. With growth in size, geographic expansion, and increase in complexity of corporation, savings and loans companies had involved in payment systems to ensure rapid turnaround of money.

Risk transfer: manufacturing and other companies (FI’s clients) are exposed to a number of risks. Some of the risks are central to their business, and they relate to product obsolescence, business model, distribution channel etc. the bulk of these risks have to be handled by these companies themselves. However, for risks that arise from financial markets, they look for their financial institutions to take them over since it is the latter’s core competence to handle them. FI’s are thus saddled with risk passed on by their customers in addition to the risk that are integral part of their business.

Funds mobilization: Mobilizing funds by accepting term deposits as well as allowing customers to operate their checking accounts by leaving balance in them

2.5.3 PRODUCTS & SERVICES OFFERED BY RURAL AND COMMUNITY BANKS.

Like any other depository financial institution, Rural and Community Banks offer the following products and services to its customers.

Bank Liability Products such as; Savings Accounts, Current Accounts, Fixed Deposit Accounts, Call Accounts etc.

Consumer Asset Products such as, Loans to individuals, small scale, medium scale and microfinance enterprises. E.g. Business Loans, Mortgage Loans, Business Loans, Car Loans, Personal Overdraft Plans etc.

Trust Services; Include Safe custody services, Purchase of treasury bills, Treasury management for individuals/firms

Transactional Products; Include Remittances, Drafts, Traveler's cheques, Standing orders etc.

Other Services Include ATM Services.

2.5.4 CURRENT STATE OF RURAL BANKING IN GHANA

The number of Rural and Community banks (RCB’s) as at 31st December, 2011 stood at 135 (Table I) and the total assets of RCB’s went up by 30.4 per cent (GH¢266.8 million) to GH¢ 1142.6 million. The growth in Total assets was funded by shareholders’ funds, deposits and borrowings which went up 23.8 percent, 32 percent and 13.9 percent respectively. The increase in assets reflected mainly in loans and advances (GH¢ 130.60 million), Investment (GH¢57.9 million) and cash and bank balances (GH¢ 32.7 million). Total assets in RCB’s constitute about 4.6 percent of the total assets of banks and NBFI’s compared with 4.5 percent in the previous year (Bank of Ghana Annual Report, 2011).

Rural and Community Banks (RCB) are incorporated under the Companies Code, 1963 (Act 179) and also operates under the Banking Act, 2004 (Act 673) as amended and other directives issued by the Bank of Ghana periodically.

They are fully owned and governed by local communities with individual shareholders who are residents of the communities in which they operate and elects from among themselves, a board of directors that exercises the ordinary corporate powers of the bank such as responsible for its strategic governance. The tenure of office of the directors is in accordance with section 289 of the Companies Code, 1963 (Act 179) which requires the longest served one-third of the membership to retire by rotation but becomes eligible to seek for re-election.

Key responsibilities of Board of Directors include (1) appraising and approving loan applications as well as ensuring repayment of loans; (2) monitoring the financial performance of the bank; (3) providing strategic guidance to management; and (4) supervising the management.

2.5.5 ADMINISTRATIVE & GOVERNANCE SYSTEM OF RURAL BANKS

The core management staffs of a typical RCB is composed of a chief executive officer who is in charge of the daily management of the bank; an internal auditor, responsible for internal control measures, who reports to the Board of Directors; a finance officer; and credit and project officers (in charge of microfinance operations). Many of the personnel are recruited from local communities. Almost all RCBs have one or more branches, each of which is staffed with a branch manager, an accountant, credit officers, clerks, and cashiers.

2.5.6 OVERSIGHT RESPONSIBILITY OF RURAL BANKS

The ARB Apex Bank was granted a banking license in 2001 and commenced commercial operations in 2002 with significant financial support from the Rural Financial Service Project, which was funded by the World Bank, the International Fund for Agricultural Development, and the African Development Bank. The Apex Bank provides specialized services essential to improving the quality and scope of products offered by RCBs and also performs important supervisory functions delegated by the Central Bank (i.e. Bank of Ghana). Check clearing, specie supply, treasury management, loan fund mobilization, domestic and international money transfers, information and communication technology, training, and inspection and audit are among the main services offered by the Apex Bank. The Apex Bank provides most of the services on a fee basis.

The ARB Apex Bank since its inception has instilled new lease of life into the activities of rural banks in Ghana. Despite constraints by funds, personnel and logistics, ARB Apex Bank is still on course in the other areas of its mandate.

2.6 RISKS FACING RURAL & COMMUNITY BANKS IN GHANA

Rural and Community Banks (RCB’s) like other financial Institutions are faced with different types of risk. The following are some of the risks they face in their daily operations;

2.6.1 Liquidity Risk

Liquidity risk can be defined as a risk arising from a bank’s inability to meet its obligations when they become due without incurring unacceptable losses (Comptroller of the Currency, 2001). Thus, liquidity risk arises when depositors demand immediate cash in respect of their financial claims with the Financial Institution. Therefore, it has become imperative on the part of financial institution’s management to ensure that there are sufficient funds available to meet future demands of providers and borrowers, at reasonable costs.

There has been an imminent feeling that liquidity risk has not been sufficiently covered with the prevailing risk management practices (Crowe, 2009).This claim finds support from the failure of many financial institutions including some rural banks in the recent past.

Liquidity risk not only affects the performance of a financial institution but also its reputation (Jenkinson, 2008). A financial institution such as rural banks may lose the confidence of its depositors or customers if funds are not provided for them on time.

According to Crowe (2009), financial institutions having good asset quality, strong earnings and sufficient capital may fail if it is not maintaining adequate liquidity. Muranaga and Ohsawa (2002) identified two key dimensions of liquidity risk as (a) liquidating the assets as and when required, and (b) at a fair market value.

According to Goodhart (2008), there are two basic facets of liquidity risk:

maturity transformation (the maturity of a bank’s liabilities and assets); and

The inherent liquidity of a bank’s asset (the extent to which an asset can be sold without incurring a significant loss of value under any market condition).

Financial institutions do not need to be worried about the maturity transformation if they have the assets that can be sold without bearing any loss. Whereas, financial institutions having assets that are going to be matured in a shorter period may have a less need to keep the liquid assets.

Apart from the above, liquidity risk may also arise due to recessionary economic conditions, causing less resource generation, breakdown or delays in cash flows from the borrowers or early termination of the projects. A severe liquidity crisis may cause massive drowning in form of bankruptcies and financial institutions runs (Goodhart, 2008), leading to a drastic financial crisis (Mishkin et al., 2006).

Liquidity problems may affect a financial institution’s earnings and capital and in extreme circumstances may result in the collapse of an otherwise solvent bank. These FI’s may have to borrow from the market even at an exceptionally high rate during a liquidity crisis. Thus, debt to equity ratio will rise, affecting the financial institution’s effort to maintain an optimal capital structure.

It is essential for financial institutions to be aware of its liquidity position from a marketing and financial perspective since it helps to expand its customer loans in case of attractive market opportunities (Falconer, 2001). A financial institution with liquidity problems losses a number of business opportunities and places them at a competitive disadvantage, as a contrast to those of the competitors.

2.6.2 Credit Risk

Credit risk is most simply defined as the potential that a bank borrower or counter party will fail to meet his obligations in accordance with agreed terms (Adams & Mehran, 2004).

Thus, it refers to the risk that the promised cash flows from loans and securities held by FIs may not be paid in full.

Credit risk arises from unexpected changes in borrower’s ability to repay loans. Although financial Institutions fail for many reasons, the single most important reason is bad loans. At the time the loans are made, the decisions seem correct, however the unforeseen changes in economic conditions and other factors such as interest rate shocks, changes in tax on loans and so on result in credit problem. Credit risk is the most visible risk facing banks (Aguais & Rosen, 2001). Credit risk management has now become one of the dominant factors considered in the risk management activities carried out by financial Institutions such as RCB’s in the financial services industry due to the increasing variety in the types of counterparties (from individuals to governments) and the ever-expanding variety in the forms of obligations (from personal loans to transactions using complex derivatives).

In the event of default, however, the FI earns zero interest on the asset and may lose all or part of the principal lent, depending on its ability to lay claim to some of the borrower’s assets through legal bankruptcy and insolvency proceedings. Accordingly, a key role of FIs involves screening and monitoring loan applicants to ensure that FI managers fund the most creditworthy loans.

Credit risk can be broadly classified in to two (2) forms namely;

Firm-specific credit risk

The risk of default of the borrowing firm associated with the specific types of project risk taken by that firm.

Systematic credit risk

The risk of default associated with general economy wide or macro conditions affecting all borrowers.

Loans constitute a large proportion of credit risk as they normally account for 10-15 times the equity of a bank (Kitua, 1996). Thus, operations and other activities of financial institution normally face challenges when there is a slight deterioration in the quality of loans. Poor loan quality has its roots in the information processing mechanism and often begins right at the loan application stage (Liuksila, 1996) and increases further at the loan approval, monitoring and controlling stages, especially when credit risk management guidelines in terms of policy and strategies/procedures for credit processing do not exist or weak or incomplete.

There is therefore the need to adopt sound credit management practices in order to achieve the ultimate goal of good recovery and to maintain good loan asset quality. This places a bank on a pedestal to achieve a sustainable growth and development by deepening financial intermediation as well as maximising shareholders’ wealth.

Sound credit management entails critical assessment of credit risk and control, structured credit delivery process, effective monitoring/supervision regime, institution of oversight mechanism by the Board of Directors in terms of policy measures and supervisory control by the regulator in respect of credit limits, insider dealings, classification and provisioning of credits.

2.4.3 Operational risk

Operational risk is closely related to technology risk and this has raised great concern among financial institutions including Rural and Community Banks’ managers and regulators alike. The Bank for International Settlement (BIS) defines operational risk as "the risk of direct or indirect loss resulting from inadequate or failed internal processes, people, and systems or from external event. Operational risk can also be defined as the entire process of policies procedures, expertise and system that an institution needs in order to manage all the risk resulting from it financial transaction (Hussain, 2000).

Exponential growth through technological innovation and global financial inter-linkages have contributed to the main growth areas of financial institutions including Rural and Community Banks in recent years and have all sought to improve efficiency in their operations with huge investments in internal and external communications, computers, and an expanded technological infrastructure. The major objective of technological expansion are lower operating cost, increase revenue, capture new markets, and exploit to the fullest extent possible better potential economies of scale and economies of scope in selling their product and services. Failure to achieve the anticipated cost savings in the form of economies of scale or scope , technological malfunctions or back- office break down expose the FI’s to operational risk. Marshall (2001) states operational risk; from wider view is the variance in net earning not explained by financial risk. Thus, he advocates that operational risk can be defined as residual risk, i.e. everything that is not market or credit risk.

Hussain (2000) further specifies that operational risk includes portfolio risk, country risk, and shift in credit rating, reputation risk, taxation risk and regulatory risk.

On the other hand, Saunders and Cornett (2003) advocate five sources of operational risk as follows:

Technology (e.g., technological failure and deteriorating systems).

Employees (e.g., human error, internal fraud, rogue trading, money laundering and confidential breach).

Capital assets (e.g., destruction by fire or other catastrophes).

Customer relationship (e.g., contractual disputes, default, dissatisfaction).

External (e.g., external fraud. war, collapse of market, taxation).

Operational risk can also be classified into two (2) areas namely; operational leverage failure and operational failure risk. Operational leverage risk is the risk when the firm changes in tax regime, in political, regulatory or the legal environment or in the nature or behaviour of competition. Operational failure risk is the risk that loses will be sustained; operations will not generate the expected returns of external factors such as or earnings foregone, as a result of the failure in processes, information systems or people. In contrast to leverage risk, the risk factors in failure risk are primarily internal (Finance Wise, 1999).

Bassis (1998) looks at operational risk in another way. According to him operational risk can be divided into different levels; the first level consist of technical issues such as when information systems or the measure are deficient, the second level has more organizational characteristics involving reporting and monitoring of risk and all related rules and procedures. Inadequate controls, policies, procedures also create operational risk. In addition, the bank faces the risk of technological obsolescence. Finally, customer misuse, either intentional or unintentional, also impacts operational risk as well.

These sources of operational risk can result in direct cost (e.g., loss of income), indirect costs (e.g. client withdrawals and legal cost), and opportunity cost which will reduce financial institutions’ profitability and value.

2.4.4 Interest rate risk

Asset transformation is a key special function of FIs and it involves an FI buying primary securities or assets and issuing secondary securities or liabilities to fund asset purchase. In mismatching the maturities of assets and liabilities as part of their assets transformation function, financial institutions potentially expose themselves to interest rate risk. Saunders and Cornett (2003) defined interest rate risk as the risk incurred by financial institutions when the maturities of its assets and liabilities are mismatched. A change in interest rate exposes the Rural and Community Banks to:

Refinancing risk: the risk that the cost of rolling over or borrowing funds will rise above the returns being earned on asset invested.

Reinvestment risk: It refers to the risk or uncertainty with regards to interest rate at which the future cash flows could be reinvested. Thus, it is the risk that the return or funds to be reinvested will fall below the cost of funds. Financial institutions are therefore faced with reinvestment risk by holding short-term assets relative to liabilities.

Price risk: The component of interest rate risk due to the uncertainty of the market price of a bond caused by possible changes in market interest rates.

Interest rate risk according to Thornhill (1990) arises when there is a mismatch between positions which are subject to interest rate adjustment within a specified period which are caused by financial institutions lending, funding, and interest rate activities.

Sauder and Cornett (2003) posit the following methods of measuring interest rate risk:

The repricing model/ funding gap: this model concentrates on the impact of interest rate changes on financial institution’s net interest income (NII) which is the difference between an FI’s interest income and interest expense.

The maturity model: this concentrates on the impact on interest rate change on the overall market of an assets and liabilities and ultimately net worth of financial institutions.

Duration gap analysis: it is a more comprehensive measure of financial institution’s interest rate risk. It is the weighted-average time to maturity on the loan using the relative present values of the cash flows as weight.

Reputation risk

Reputation risk refers to the risk to earnings or capital arising from negative public opinion, which may affect an FI's ability to sell products and services or its access to capital or cash funds. (Padma K., Suresh A.M & Vijayashree, 2012)

Reputations are much easier to lose than to rebuild and should be valued as an intangible asset for any organization. Most successful FIs cultivate their reputations carefully with specific audiences, such as with customers (their market), their funders and investors (sources of capital) and regulators or officials.

Reputation risk can range from problem of customer dissatisfaction with online services to severity breaches and fraud. Any problem with either severity or legal issues can significantly impact the reputation of the financial institution. For instance identify misrepresentation or "spoofing" where a financial institutions customers are directed toward a false site, can lead to an irreparable loss to trust between customers and the financial institution. For financial institutions that provide aggregate services, any breach can cause considerable risk.

The 1998 Basel report on electronic banking suggest that the reputation risk is serious enough that if a globally active bank experiences a blow to its reputation of other financial institutions offering similar service leading to systematic disruptions in the financial system as a whole.

A good information and comprehensive risk management approach, reporting helps an FI speak the 'language' of financial institutions and can strengthen an FI's reputation with regulators or sources of funding.

Managing the Specific Risk

2.5.1 Liquidity risk

Liquidity risk management is an essential component of the overall risk management framework of the financial services industry, concerning all financial institutions (Majid, 2003). A well-established system helps the financial institutions in timely recognition of the sources of liquidity risk to avoid losses and develop the mechanism required for proper risk measurement and management. A severe liquidity crisis may develop into a complete capitalization crisis within a short period and this situation may evolve due to fire sale risk that may arise because of taking large positions in illiquid assets. Financial institutions can avoid this crisis by:

Improving the maturity transformation by holding highly liquid assets as these assets can be sold or pledged to meet the funding risks in a short time (Goodhart, 2008).

Upholding a liquidity buffer, comprising of cash and liquid assets. This buffer provides a cushion to withstand the liquidity stress in a "survival period".

Increasing its cash reserves to mitigate the liquidity risk, but it might be costly in practice.

Focusing on some Liquidity ratios like liquid assets to total assets and liquid liabilities to total liabilities (Goddard et al., 2009).

Meeting the cash reserve requirement condition imposed by the Central Bank (a least amount that a bank is required to maintain at all times of its operations) to overcome the liquidity problems. Therefore, banks hold minimum cash balance to avoid liquidity problems (Jenkinson, 2008).

Acting on the assets side of the balance sheet if it is facing restrictions on raising liquidity. It will be forced to minimize the advancement of loans to its customers to reduce funding requirements.

Reducing liquidity pressure by transforming illiquid assets into cash. In times of immense funding pressure, securitization techniques are usually employed by the banking system for liquidation of assets like mortgages (Jenkinson, 2008).

The use deposits to hedge the liquidity risk. According to Gatev and Strahan (2003), the deposits provide a natural hedge to banks against the liquidity risk. The inflows of funds give a natural hedge to banks for outflows due to loan advancements.

Credit risk

Loans that constitute a large proportion of the assets in most financial institutions’ portfolios are relatively illiquid and exhibit the highest credit risk (Koch & MacDonald, 2000). The theory of asymmetric information argues that it may be impossible to distinguish good borrowers from bad borrowers (Auronen, 2003), which may result in adverse selection and moral hazards problems and these have led to substantial accumulation of non-performing accounts in financial institution.

The management of credit risk in the financial industry is as follows:

Policy and strategies (guidelines) that clearly outline the scope and allocation of a financial institution credit facilities and the manner in which a credit portfolio is managed, i.e. how loans are originated, appraised, supervised and collected.

The process of risk identification, measurement, assessment, monitoring and control. It involves identification of potential risk factors, estimate their consequences, monitor activities exposed to the identified risk factors and put in place control measures to prevent or reduce the undesirable effects.

A rapid pace of product innovations, further diversification by financial institutions into new geographical and product market areas, and a stepped up rate of credit intermediation (both in scope and pace).

Monitoring of borrowers over a period of time through regular contacts, establishing an appropriate credit environment that the bank can be seen as a solver of problems and trusted adviser, developing the culture of being supportive to borrowers whenever they are faced with challenges, monitoring the progress of borrower’s business through the bank’s account, regular review of the borrower’s reports as well as an on-site visit, updating borrowers credit files and periodically reviewing the borrowers rating assigned at the time the credit was granted.

Establish a clear process for approving new credits and extending the existing credits.

Operational Risk

Operational risk is measured through tracking of the loss data to suggest suitable remedial measures to mitigate this risk. The general approach to managing operational risk in contemporary times takes into account the proposed new Basel II Capital Accord, issued in 2001. Importantly, operational risk management approach must involve managing operational risk according to the principles of good corporate governance as they relate to overall responsibilities of management and appropriate disclosures. These principles according to Ulrich (2004) demand that the highest levels of management are fully aware of the potential operational exposure across the financial institutions and take appropriate action like establishing control mechanisms at various levels within the different business divisions to manage operational risk.

Nicholl (2004) also cite instances where individual heads of business units manage their own operational risk and ensure that appropriate controls are in place. Located in different markets, they are best equipped to use their experience and insight to manage the risks in an appropriate and timely manner. The most important policy measure is the organization’s determinant to instil in all employees a culture of risk awareness. Other important issues in the management of operational risks include the following:

Proactive risk management: The various decentralized risk management functions regularly identify measure, monitor, evaluate and report on operational risk in order to propose solution to the business units. They also review internal audit recommendations on operational risk and ensure implementation. Early warning operational risk indicators are important factors for effective identification of possible losses because they form the platform for effective operational risk management and will enhance the introduction of a more advanced capital measurement technique.

Crime: Financial institutions are constantly the target of crime syndicates and money launders. With white-collar or commercial crime on the upsurge, better co-operation must be created between the financial industry and other role players with regard to fraud and related crime. Financial Institutions must therefore be supportive and play leading parts in initiatives by governments and external agencies in this direction.

Business continuity management: Considerable effort must be made to ensure that critical systems and functions will continue following an incident of business disruption. In this regard, Ericsson (1997) recommends that significant attention should be given to t he continual improvement in policies and plans including the testing of such plans by individual business units.

Money laundering: Financial institutions are being encouraged to establish money laundering offices to assist management in complying with existing legal obligations and administering anti-money laundering legislation duties. Though the focus has been on detection and prevention measures, core obligations of reporting, internal rules, awareness and training "know your customer", record keeping and monitoring are also being addressed.

Interest Rate Risk

The management of interest rate risk in the financial industry is as follows as advocated by Madura (2009):

Floating–Rate Loans: In this method financial institutions use floating rate loans which allow them to support long term assets with short term deposit without overly exposing themselves to interest rate risk. It enables the Savings and Loans to maintain more spread between interest revenue and interest expenses.

Interest rate future contracts: An interest future rate futures contract allows for the purchase of a specific amount of a particular debt security for a specified price at a future point in time. Savings and Loans companies that sell futures contract on these securities can effectively hedge their fixed rate loans. They will benefit from the differences between the market value at which they can purchase these securities in the future and the future prices at which they will sell the securities.

Interest rate swaps: This strategy allows Savings and Loans Companies to swap fixed interest payment (on outflows) for variable payments (on inflow). The fixed rate outflow can be matched against the fixed rate loan held so that a certain spread can be achieved. In addition, the variable- rate inflow due to the swap can be matched against the variable cost of funds.

Maturity matching: One obvious method of reducing interest rate risk is to match each deposit’s maturity with an asset of the same maturity.

2.6 EMPIRICAL EVIDENCE/ STUDIES

There have been a large number of studies published about risk management in general. However, the number of the empirical studies on risk management practices in Rural and Community Banks (RCB’s) was found to be relatively small.

The following is an attempt to summarize the main conclusions of some selected studies.

Linbo Fan (2004) examined efficiency versus risk in large domestic USA banks. He found that profit efficiency is sensitive to credit risk and insolvency risk but not to liquidity risk or to the mix of loan products.

Ho Hahm (2004) conducted an empirical study on interest rate and exchange rate exposures of banking institutions in pre-crisis Korea. Results indicated that Korean commercial banks and merchant banking corporations had been significantly exposed to both interest rate and exchange rate risks, and that the subsequent profitability of commercial banks was significantly associated with the degree of pre-crisis exposure. The results also indicated that the Korean case highlights the importance of upgrading financial supervision and risk management practices as a precondition for successful financial liberalization.

Niinimaki (2004) in his paper entitled "The effects of competition on banks’ risk taking" found that the magnitude of risk taking depends on the structure and side of the market in which competition takes place. He also concluded that if the bank is a monopoly or banks are competing only in the loan market, deposit insurance has no effect on risk taking. Banks in this situation tend to take risks, although extreme risk taking is avoided. In contrast, introducing deposit insurance increases risk taking if banks are competing for deposits. In this case, deposit rates become excessively high, thereby forcing banks to take extreme risks.

Wetmore (2004) examined the relationship between liquidity risk and loans-to-core deposits ratio of large commercial bank holding companies. He concluded that the average loan-to-core deposit ratio had increased over the period studied, which reflects a change in the asset/liability management practices of banks. He also concluded that there is a positive relationship occurring between market risk and the change in loan-to-core deposits ratio after 1994, with a negative relationship occurring before 1994.

Wang and Sheng-Yung (2004) studied foreign exchange risk, world diversifications and

Taiwanese American depository receipts (ADRs). In this study they tried to answer the following question: Should USA investors purchase American depository receipts issued by Taiwanese multinationals? Empirical results indicated that foreign exchange risk is priced in Taiwanese ADRs. Moreover, Taiwanese ADRs were shown to help USA investors diversify their portfolios globally. These findings suggest that Taiwanese ADRs are valid investment tools for USA investors who seek international diversifications.

Khambata and Bagdi (2003) examined off-balance-sheet (OBS) credit risk across the top 20 Japanese banks. The main results of this study indicated that financial derivatives are heavily used by the top four banks and that loan commitments are the largest source of credit risk among traditional OBS instruments. The results also indicated that there is a wide difference across the banks in the use of derivative leverage. As compared to USA and European banks, Japanese banks use fewer OBS instruments as a percentage of their assets. This implies that Japanese banks are more conservative and risk-averse in general than their USA or European counterparts, especially given the bad financial condition of Japanese banks.

Al-Tamimi (2002) investigated the degree to which the UAE commercial banks use risks management techniques in dealing with different types of risk. The study found that the UAE commercial banks were mainly facing credit risk. The study also found that inspection by branch managers and financial statement analysis were the main methods used in risk identification. The main techniques used in risk management according to this study were establishing standards, credit score, credit worthiness analysis, risk rating and collateral; the study also highlighted the willingness of the UAE commercial banks to use the most sophisticated risk management techniques, and recommended the adoption of a conservative credit policy.

Salas and Saurina (2002) examined credit risk in Spanish commercial and savings banks; they used panel data to compare the determinants of problem loans of Spanish commercial and savings banks in the period 1985-1997, taking into account both macroeconomic and individual bank-level variables. The GDP growth rate, firms, family indebtedness, rapid past credit or branch expansion, inefficiency, portfolio composition, size, net interest margin, capital ratio and market power are variables that explain credit risk. Their findings raise important bank supervisory policy issues: the use of bank-level variables as early warning indicators, the advantages of mergers of banks from different regions, and the role of banking competition and ownership in determining credit risk.

Oldfield and Santomero (1997) investigated risk management in financial institutions.

In this study, they suggested four steps for active risk management techniques:

(1) The establishment of standards and reports;

(2) The imposition of position limits and rules (i.e. contemporary exposures, credit limits and position concentration);

(3) The creation of self investment guidelines and strategies; and

(4) The alignment of incentive contracts and compensation (performance-based compensation contracts).