The banking industry contributes significantly to economic growth. Its problem causes sluggish economic growth. Even if a bank intends to maximize profits, inadequate liquidity management and credit risks are viewed as a disadvantage, affecting the lives of millions and endangering the banking system.
When a borrower or counterparty fails to meet a bank’s obligations, credit risk arises. The most serious issue in the banking industry is exposure to credit risk. The other is counterparty risk, which can expose a bank to credit risk.
Liquidity risk can occur in the same pillar when banks fail to satisfy their short-term debt obligations. It is part of the banking business that short-term deposits with different due dates are used to pay for long-term loans.
They both have an impact on the banking industry’s performance.
By selling pledged collateral, a contemporary banking system can transfer risk to borrowers. It refers to the assets used to secure a loan. Credit risk transfer improves risk diversification when it occurs between a bank and the insurance industry in traditional banking.
However, such transfers can affect the institutions where the transaction takes place. It raises the systematic risk for market players and has a knock-on effect on the entire economy.
Credit and liquidity risks that are properly managed serve to ensure the financial industry’s profitability and stability. The central bank’s primary concern continues to be managing banks’ liquidity and credit concerns. Despite advances in banking intermediation, it has remained difficult for banks to manage liquidity and credit risks, with a poorer management system compared to the developed financial market.
Credit risk is determined by both internal and external elements of the borrower; credit and liquidity risks are not totally controlled in conventional and Islamic banking systems. They are managed, however, by an interest rate commission agent banking system (AIRCABS).
This structure shifts the risks to entrepreneurs and investors, who are compensated with interest, commissions, and fees. An agent bank can share the risks by selling loans to investors, renting the project as collateral for the sale, and getting loan repayment and loan repayment insurance.
AIRCABS transfers credit risk and liquidity constraints to investors and entrepreneurs, enhancing agent banks’ profitability and sustainability.
When a company transfers its risks to parties outside the banking sector, it can create a more stable financial sector than when it transfers its risks within the banking sector. If the entrepreneur fails to repay the loan, an investor’s agent bank (AIRCABS) will search for another entrepreneur with the same project interest and rent the project until the loan is paid off, without transferring ownership.
The investor and the agent bank decide on the final choice.
As a result, the bank transfers the risks to the new entrepreneur. When an investor wants to withdraw funds before the loan matures, the agent bank sells the project to a new entrant investor who has the same project interest as the previous investor and returns the loan balance to the previous investor.
By transferring credit and liquidity risk to new entrants, the agent bank earns interest rate commissions and other service fees. Depending on the agreement, an insurance company may pay the amount of the original loan that was not paid back or take on the credit and liquidity risk.
When the investor and the entrepreneur are unfamiliar with one another, the entrepreneur must pledge collateral. And when no other investment options are available, the agent bank sells the pledged collateral. So, the bank’s credit and liquidity risks will be taken on by the pledged collateral.
By moving liquidity and credit risks to non-banking institutions, AIRCABS avoids them. This can serve as a lesson for both conventional and Islamic banking systems, which continue to carry credit and liquidity risks that lead to crises and lag behind the economic pace.
The Basel accord was made to create an international regulatory framework for the banking industry to handle credit, liquidity, and market risks, which have been big worries. It is made up of Basel I, Basel II, and Basel III.
The primary objective of the Basel accord is to ensure that banks do not exceed their liquidity and credit risks, as both conventional and Islamic banks retain credit and liquidity risks.
Basel I attempts to strengthen financial system stability by establishing a minimum reserve requirement for international banks and managing credit risk through the risk weighting of various loan portfolios. By using AIRCABS, the bank would be able to keep the minimum reserve requirement while improving the steady mobilization of deposits.
This can be done until the depositor moves to the investor position, at which point the bank switches to the agent position and the depositor’s money becomes a stable deposit. Unless the deposit is time-bound, the deposit can be withdrawn, and it is considered volatile and unstable, causing the bank to face credit and liquidity concerns.
However, it manages banks’ credit risk based on the amount of loan repayment lag encountered by borrowers. As a result, the regulatory body issued a regulation requiring banks to retain cash reserves equal to eight percent of their risk-weighted assets.
AIRCABS, on the other hand, solves this problem by transferring credit risk to investors and businesses. This is accomplished by not listing investor funds as an asset on the bank’s balance sheet.
The second Basel agreement, an expansion of Basel I, focuses on a more comprehensive risk management mechanism, emphasizing credit and liquidity issues faced by banks worldwide. It takes into account operational and market concerns that Basel I did not.
When analyzing the credit exposure of a performing asset to credit risk, this agreement considers the market value rather than the book value of the asset. AIRCABS addresses the Basel II issue by building cutting-edge market, operational, liquidity, and credit risk prediction methods to limit the types of risks that business owners and investors will face.
The third Basel accord, Basel III, was established in response to the 2008 global financial crisis, which highlighted the worldwide banking system’s inability to manage well-known banking risks.
It focuses on managing inadequate corporate governance, liquidity management, and an overleveraged capital structure as a result of Basel I and II’s lack of regulatory limits and mismatched incentives. AIRCABS solves Basel III issues by delivering highly efficient service as well as cutting-edge risk prediction and management expertise to help the target organization become more effective.
Though the agent bank received interest rate commissions from the investors’ credit price until loan settlement, it is expected that the agent bank will be efficient in loan administration after disbursement from investor to entrepreneur in order to get the loan settled within the time specified in the loan contract.
Non-interest income is more volatile than interest income in the typical banking system. Non-interest income from daily banking operations must be generated by improving service delivery and gaining a strategic edge. As the bank’s non-interest income-generating businesses increase, so does its service delivery efficiency.
In short, AIRCABS allows the investor or entrepreneur to manage transferred risks and is capable of resolving Basel I, II, and III issues.
Ameha Tefera Tessema (PhD) is a Commercial Bank of Ethiopia employee. He can be reached at [email protected].
Contributed by Ameha Tefera Tessema (PhD)