Done by:

Mariam Zahid Ghulam

Esraa Al Awadhi

Lulwa Al Naoimi

Najlaa Al Khalifa

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Table of Contents

Title Page

Abstract 3

Risk Management Intro 4

Venture Capital Bank 5

Managing Risk at VCBank 6

VCBank and Industry Ratios 9

Capital Adequacy Ratio

Return on Equity

Return on Investments

10

11

12

Analysis 13

Conclusion 14

References 15

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Abstract

Risk management is an important part of any company, but especially when it comes to financial

intermediaries. But why is it so important?

In order for any firm to gain high returns, they must face high risk – in other words, “no pain, no gain.”

Because of this, banks must establish and execute an effective risk management plan to ensure optimal

performance.

This report is divided into 2 main parts: a personal interview with a risk executive at a bank and

analyzing that bank’s risk management performance on the basis of various financial ratios. The

theoretical information was gathered through various secondary resources including business websites

and risk management books, while the financial information on the banks was obtained through

BankScope.

The aim is to understand how efficient any risk team is in implementing their risk management plan to

be easily portrayed in their financial results.

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Risk Management

Risk management is a practice of identifying, assessing and prioritizing varieties of risks associated. The

first step is to define the risk, and then the risk manager will set up a plan in order to diminish or

eliminate the potential results of the negative event. There are varieties of risks that may be associated,

and the chosen strategy depends on the nature of the business. The risk management is a vital

component in the business planning. The role of the business management is set to dispose of risk that

may pose a threat to the business. Applying it on a broader view, RM plays an essential role in the

financial system as a whole, the results obtained from this activity has a great impact on society. An

example of an inadequate risk management is the recession that occurred in the 2008, which was a

result of loose credit risk management of financial institutions. In order to assure a sound system, and

avoid another chaotic event, there are several risk management standards to be applied, such as the

International Organization for Standardization (ISO).

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Venture Capital Bank

Venture Capital Bank is the oldest Islamic investment bank in the GCC, Middle East and North Africa that

specializes in venture capital investments opportunities and offers risk adjusted returns on investments.

In October 2005, VCBank was established in the kingdom of Bahrain, with the license of Islamic

investment banking from the Central Bank of Bahrain. VCBanks offers exclusive services and distinctive

opportunities to its clients across the GCC and MENA Markets. The bank is segregated into 4 areas,

which are venture capital and business development, private equity, financial advisory and real estate.

Venture Capital Bank has been distinctively set in order to support the fundamentally strong, high

potential and undervalued small to medium enterprises(SMEs) substantially, who lack the necessities for

growth and expansion, and in order to lead this emerging venture capital industry. The bank ensures

that all their performance, activities, rules and principles are all Shari’ah compliance, and use the

Shari’ah as a guide for their behavior and profession.

Venture Capital’s vision is to continue growing, and “to be the leading regional Islamic venture capital

based investment bank, helping to drive business growth, and supporting the social and economic

development of the MENA region. “

Venture Capital has been the chosen bank to conduct our assignment on, and have interviewed the Risk

Management Executive, to address certain information we seek.

Head of Risk Management

Tat Thong Tan (FRM, CFP) is an executive director at Venture Capital Bank. Malaysian by nationality,

Mr.Tan grew up in Singapore and England. He came to the region in 2007, after spending 17 years in

Malaysia, Singapore and Hong Kong. What had interested him to join the bank was the fact that it was a

venture capital, which in this region, is still in its infancy.

His job as a risk manager is attempting to manage the bank’s risk.

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Managing Risk at VCBank

The bank became operational in late 2005 with the aim of being a top Islamic investment bank focusing

on venture capital/private equity. It was established with a paid up capital of 66 million dinars which

increased to 150 million over a year.

In terms of their risk profile, they have implemented the “originate to distribute” model where an asset

is sourced for which they must find investors. They are also performing asset management business that

functions on a much smaller scale.

Venture Capital’s risk management process is set up of three broad functions:

1. Identify

2. Quantify (measure)

3. Mitigate

The identifying part of risk management starts out with a clear understanding of the various risks the

banks will be faced with. The financial statements of the bank are studied for any of the bank’s risks. It is

then the manager’s job to get involved with his employees, review the bank’s policy and the entire set

up.

The various risks faced by the bank derive the acronym CMOLOGIC which stands for credit, market,

operational, liquidity, others, governance, interest rate, and capital risk.

There are 2 types of liquidity risks: the bank’s cash position and fluctuations in asset prices. As an Islamic

bank, they face risks when they are unable to find investors for their assets – these assets for which they

themselves are sponsors and they inject their cash.

Despite of the different kinds of risks, Venture Capital’s main concerns are credit and liquidity risk. In

order to manage credit risks, VC has assigned certain limits such as concentration risk (need to know

geographic and sectorial spread of assets), single exposure limits (where the carried value exceeds 10%),

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connected counter parties (whether investments have been extended to a subsidiary/shareholder), and

interbank limits.

The bank carries out scenario analyses and sensitivity analyses to test how they would react to various

situations.

Quantifying risk involves applying numeric figures to each of the bank’s risks. VC bank has implemented

different methods to measuring each type of risk. For credit risk, they are following one of Basel II’s

prescriptions of 3 approaches: the standardized rating approach. In the case of market risk they use

value at risk (VAR) and the risk matrix system, among others. Self assessment and loss registering are

applied to measuring operational risks (basic indicator approach). Liquidity risks are managed by the

bank’s own cash injections and, at the same time, they provide a certain level of capital for their other

types of risks.

VC also carries out risk governance where the board of directors delegates the risk committee

overseeing the risk management framework. The risk manager, Mr.Tan, reports to (and gets instructions

from) the risk committee functionally and, on an administrative basis, reports to the CEO.

As a part of mitigating risks, the manager keeps an eye on controls via limits and then makes reports.

Being a venture capitalist, they are not using any tools (web-based or software) in their risk

management process. This is because of the fact that typically systems are associated with market risks

and to give an overview or macro view of their bank’s risk position.

The risk manager strongly believes that Venture Capital has incorporated Basel II fully, though they are

facing challenges (ICAAP – Internal Capital Adequacy Assessment Plan).

In order to calculate their Capital Adequacy Ratio, they are using the following formula:

CAR=T1+T 2−Large ExposureRisk weighted Assets

Single exposure limit those investments whose value exceeds 10% of capital, hence if capital is 100 and

investments is $20 then the investment is a large exposure of 20%. The risk weighted assets is divided

into credit, operational, and market risks.

If the bank faces any risk problems, their risk option is to share – not transfer – risk.

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Regardless of the application of Basel II, it is found to be ineffective for an investment bank even though

it is a good framework to monitor risks. The central bank requires banks to keep their capital at 12%, but

the company has kept this value in the region of high 30s - indicating they are a fairly well capitalized

bank. The risk manager finds this level of ratio as ideal and even wishes to strengthen it further.

Both Basel II and Basel III frameworks are efficient when applied to commercial banks, irrespective of

whether they are conventional or Islamic, but need to be reassessed in terms of investment banks.

According to the risk executive, “risk management is both an art and a science.” The science involves

implementing the correct systems, while art requires creative thinking.

Essential for risk management: know the types of risk, know the process, and risk management is a

science and an art.

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VCBank and Industry Ratios

To obtain a macro view of the bank’s performance, several financial figures were gathered and

compared to that of the industry. Venture Capital is a relatively small bank, in comparison to many

banks in the sector, including those which were chosen to conduct the analysis.

The banks chosen along with VCBank were Arcapita, another Islamic bank that also deals in venture

capital along with many other activities, and Investcorp Bank BSC, a conventional investment bank.

The following table gives a brief description on the position of the three banks:

Venture Capital Bank Arcapita Investcorp

Total Assets* 199 mil USD 3718 mil USD 2859 mil USD

Net Income* -59 mil USD 50 mil USD 140 mil USD

Country Ranking 28 9 10

World Ranking 10007 2323 2644

*latest figures available

As can be seen, VCBank possesses a weak position in the industry, both country- and worldwide. Even

with its narrow performance (dealing mostly with SMEs), the bank has been incurring a loss in the past

year.

Despite its size, the bank should be able to perform on positive results, if not at the same level. This

analysis studies how VCBank is able to control the risks it is subject to and stop it from affecting its

performance.

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Capital Adequacy Ratio (CAR)

Total Capital Ratio VC n.a. 45.44 50.74 46.52Total Capital Ratio Arcapita 15.80 12.70 17.10 18.59Total Capital Ratio Investcorp 25.70 22.90 20.04 18.37

Banks throughout Bahrain are required to keep a minimum capital adequacy ratio of 12% as per

enforced by the Central Bank of Bahrain. A CAR ratio at 12% is essential while one that is only slightly

higher is considered favorable by most banks.

Comparing the three banks, Arcapita is the only bank that has maintained its ratio at and around the

required percentage (fluctuating without a clear pattern). Investcorp, on the other hand, has had its CAR

ratio increase over the years and is currently at 25.70 – projecting the banks sound position. Venture

Capital is the only bank to go beyond the necessary percentage, with a CAR ratio of over 50% in 2009. It

is approximately double that of Investcorp and almost tripling over Arcapita.

Though maintaining a CAR above the requirement is acceptable, and, at times, preferable, this level may

be a side effect to VCBank. This means that a large amount of the money belonging to the bank is tied

up in provisions/risk management and therefore, less than half that amount is made available for

investment and continuation of other business activities.

Risk Weighted Assets

Venture Capital Bank Arcapita Investcorp

2011 n.a. 0.79 3.51

2010 -7.82 -7.87 2.44

2009 1.70 -1.25 -17.67

2008 10.16 6.10 2.24

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Return on Equity (ROE)

Comparison: Return on Average Equity (ROAE)2011/2010/2009 - 3 banks

Peer group:

1.Investcorp Bank BSC 2.Arcapita Bank B.S.C.

3.Venture Capital Bank BSC (c)-VCBank

-80.00

-70.00

-60.00

-50.00

-40.00

-30.00

-20.00

-10.00

0.00

10.00

20.00

%

1 2 3

1110

0911

10 09 11 1009

All investors would like to gain the highest possible return without dealing with any of the risks involved.

A high equity ratio is good for the economy as it protects banks against future crises. Overall, the higher

a bank’s ROE in comparison to the rest of the industry, the better. While, banks like Arcapita and

Investcorp are striving to increase their return on equity, VCBank’s ROE ratio faces a drop.

Although, this ratio has its drawbacks. It encourages banks to select risky, high leverage investments in

order to increase its performance.

It may also be argued that in the finance industry, there is generally no reason why banks ROE stays high

for an extended time period because of high competition. Hence, high returns as compared to industry

norms may be a sign of future problems. It could possibly mean the business is unaware of its risk,

taking too much risk, or barely meeting regulations. Despite this, rare a case exists where high-return

banks have failed.

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Return on Investments (ROI)

Comparison: Return on Average Assets (ROAA)2011/2010/2009 - 3 banks

Peer group:

1.Investcorp Bank BSC 2.Arcapita Bank B.S.C.

3.Venture Capital Bank BSC (c)-VCBank

-30.00

-25.00

-20.00

-15.00

-10.00

-5.00

0.00

5.00

%

1 2 3

1110

0911

10 09 11 10

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Return on investments seeks to measure the profitability on an investment and can be modified to

accommodate the type of investments made (in this case, assets). It must be remembered that banks

are constantly highly leveraged when calculating this ratio and therefore, a percentage as small as 1

indicates large profits.

By a look at the chart, it seems that there is some correlation between a bank’s ROE and ROI – as one

ratio increased or decreased, so did the other. As a result, when the return on equity for VCBank

dropped in 2010-2011, return on the assets of the bank plummeted to an even greater degree. This

value is again inconsistent with those that are a norm in the industry at the current period.

The issue with this ratio is that it can be manipulated in favor of the bank’s purposes.

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Analysis

Just by looking at the financial performance of Venture Capital Bank, Mr.Tan may be right about the fact

that the Basel Accord is ineffective when dealing with investment banks. But in comparison to two highly

ranked banks that function within the same industry, it shows that investment activities have little to do

with Basel, regardless of whether it is a conventional or an Islamic bank.

VCBank is spending too much capital to protect against risks, when they are barely taking any risks in the

first place. Based on the CAR ratio results, the bank is either too wary of the risks of activities or it is

heavily investing in risky businesses. The latter may be true as the bank deals largely with SMEs, but

then the remaining two ratios, ROE and ROI, should be showing positive results much higher than those

of its rivals.

In relation to the argument against high ROE, where the bank is unaware of its risk, taking too much risk,

or barely meeting regulations, it is understandable as to why a bank may wish to simply maintain its

current positive ratio. Though, despite the fact that VCBank has exceeded financial regulations and

working hard to mitigate risks, the bank has been showing increasingly dropping return on equity. This is

another factor that indicates the company is actually not taking enough risks.

Finally, ROI has been falling in the same manner as ROE, which is a vivid statement of the bank’s

negative income and poor performance. Experts say that a minimum of 10% is required for future

growth, so the bank is clearly making the wrong investments that are bringing losses.

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Conclusion

The bank is following a highly conservative approach and there is definitely poor management

performance. They may not be up to proper risk management standards as Mr.Tan states it to be.

Strong adherence to the financial regulations is useless if the bank is not willing to take the necessary

risks to become successful.

VCBank must reestablish their risk management plan in such a way that will allow them to take the risks

that will grant them a profitable position. It is logical as to why the bank would want to maintain a high

CAR ratio, especially when Islamic banks are not allowed to take excessive risks, but it also unacceptable,

in finance and in Islam, for the money to remain idle or be invested without a gaining purpose.

If other banks can perform profitably while following CBB standards, then there is no reason for Basel to

not be effective when applied to investment banks.

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References:

http://www.vc-bank.com/vision.html

http://www.investopedia.com/terms/r/riskmanagement.asp#ixzz1wqdE6D7y

http://www.whatisriskmanagement.net/

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