Mrs.Shefa El Sagga F&BMP110/2/2010. Chapter 3 Mrs.Shefa El Sagga F&BMP2 Management of Risks in...

Mrs.Shefa El Sagga F&BMPMrs.Shefa El Sagga F&BMP 1110/2/201010/2/2010

Chapter 3

Mrs.Shefa El Sagga F&BMPMrs.Shefa El Sagga F&BMP 22

Management of Risks in Banking

Key Financial Risks in the 21st Century

Approaches to the Management of Financial Risks

Financial Derivatives and Risk Management

Management of Market Risk

Risk Management by Major Global Bank 10/2/201010/2/2010

Management of Credit Risk

3.13.1 . .IntroductionIntroduction In Any profit-maximizing business, including banks, must

deal with macroeconomic risks, such as the effects of inflation or recession and microeconomic risks like new competitive threats. Breakdowns in technology, commercial failure of a supplier or customer, political interference or a natural disaster are additional potential risks all firms face. However, banks also confront a number of risks atypical of non-financial firms, and it is these risks which are the subject of this chapter.

The purpose of this chapter is to outline the key financial risks modern banks are exposed to, and to consider how these risks should be managed.


ContinueContinue:: Suppose an investor purchases equity in a bank and expects

a minimum return of 15%. If, when the shares are sold, the return is 20%, then an extra 5% is added to the value of the investment, and shareholder value-added is positive. If the return is less than 15%, the outcome for the investor is a negative shareholder value-added.

There is a link between shareholder value-added and other performance measures, such as return on assets or return on equity (ROA, ROE).


3.23.2 . .Key Financial Risks in the 21st CenturyKey Financial Risks in the 21st Century Risk management involves identification of the key financial risks, where

risk exposure should be increased or reduced, and finding methods for monitoring and managing the bank’s risk position in real time. where ALM is the key activity to the complex financial conglomerate offering a range of bank and non-bank financial services, the objective is to maximize profits and shareholder value-added, and risk management is central to the achievement of this goal. Shareholder value-added is defined as earnings in excess of an ‘‘expected minimum return’’ on economic capital.

The average risk premium ranges from 7% to 10% for banks in most OECD countries. The nominal rate of return on government bonds is normally treated as a risk-free rate, provided there is a low probability of the government defaulting on its obligation.

3.2.1. Formal Definitions. 3.2.2 Interaction among risks


3.2.1. Formal Definitions3.2.1. Formal Definitions Concept of risk: The possibility of exposure to loss, damage, it include

the possibility for undesirable events.

Risk is defined as the volatility or standard deviation (the square root of the variance) of net cash flows of the firm.

The risk may also be measured in terms of different financial products. But the objective of the bank as a whole will be to add value to the bank’s equity to shareholders. And to depend on the management of risks.

Large universal banks will focus on the management of risk on the banking book (the traditional asset–liability management), the trading book (where banks are buying and selling bonds, equity, etc.), and in the risk management advice they give to corporate customers.


Continue:Continue: Corporate treasurers of non-financial firms can incur large losses

as a result of poor financial risk management. But it rarely leads leads to insolvencyto insolvency, if the core business operations are sound. The risks specific to the business of banking are:

1. Credit & Counterparty.

2. Liquidity or funding risk.

3. Settlements or payments risk.

4. Market or price risk, which includes: currency risk. interest rate risk.

5. Capital or gearing risk.

6. Operational risk.

7. Sovereign and political risk.Mrs.Shefa El Sagga F&BMPMrs.Shefa El Sagga F&BMP 7710/2/201010/2/2010

1.1. Credit risk and counterparty riskCredit risk and counterparty risk If two parties enter into a financial contract, counterparty

risk is the risk that one of the parties will renege on the terms of a contract.

Credit risk is the risk that an asset or a loan becomes irrecoverable in the case of outright default, or the risk of an unexpected delay in the servicing of a loan.

If a borrower defaults on a loan or unexpectedly stops repayments, the present value of the asset declines. Losses from loan default should be kept to a minimum.

Good credit risk management has always been a key component to the success of the bank, the cause of the majority of bank failures can be traced back to weak loan books.


2.2. Liquidity or funding riskLiquidity or funding riskThe risk of insufficient liquidity for normal operating

requirements, and the ability of the bank to meet its liabilities when they fall due.

A shortage of liquid assets is often the source of the problems, because the bank is unable to raise funds in the retail or wholesale markets. Funding risk usually refers to a bank’s inability to fund its day-to-day operations.

The liquidity of an asset is the ease with which it can be converted to cash. A bank can reduce its liquidity risk by keeping its assets liquid (i.e. investing in short-term assets).

All banks make money by having a gap between their maturities, that is, more short-term deposits and more long-term loans: ‘‘funding short and lending long’’. Mrs.Shefa El Sagga F&BMPMrs.Shefa El Sagga F&BMP 9910/2/201010/2/2010

3.3. Settlement/payments riskSettlement/payments riskSettlement or payments risk is created if one party

delivers assets before receiving its own cash or assets, thereby exposing, it to potential loss.

Settlement risk can include credit risk if one party fails to settle liquidity risk – a bank may not be able to settle a transaction if it becomes illiquid.

Settlement risk is still present because If one bank fails to meet its obligations, other banks along the line are affected, even though they have an indirect connection with the failing bank, the counterparty to the exchange.


4.4. Market or price riskMarket or price risk Market (or price) risk is normally associated with instruments

traded though increasingly, where the market is not very liquid. General or systematic market risk is caused by a movement in

the prices of all market instruments because: a change in economic policy. where the price of one instrument moves out of line with other similar instruments, A bank can be exposed to market risk (general and specific) in relation to:

Equity. Commodities . Currencies. Debt securities. Debt derivatives. Equity derivatives.

Mrs. Shefa El Sagga F&BMPMrs. Shefa El Sagga F&BMP 111110/2/201010/2/2010

Continue:Continue:Thus, market risk includes a very large subset of other

risks. Two major types of market risks are 1. Currency and 2. Interest rate risk.

Interest rate risk are another form of price risk, because the interest rate is the ‘‘price’’ of money, or the opportunity cost. It arises due to interest rate mismatches.

The traditional focus of an asset–liability management group within a bank is the management of interest rate risk, but this has expanded to include off-balance sheet items. 10/2/201010/2/2010 Mrs. Shefa El Sagga F&BMPMrs. Shefa El Sagga F&BMP 1212

5.5. Capital or gearing riskCapital or gearing risk Banks are more highly geared (leveraged) than other businesses –

individuals feel safe placing their deposits at a bank with a reputation for soundness.

The banking system as a whole tends to be stable, unless depositors are given reason to believe the system is becoming unsound.

Banks which take on more risk should set aside more capital, and this is the principle behind the Basel risk assets ratio, consider the equation below:

ROE = ROA × (gearing multiplier) where: ROE: return on equity or net income/equity. ROA: return on assets or net income/assets. Gearing/leverage multiplier: assets/equity.


Continue:Continue: Basel requires a bank’s risk assets ratio to be 8% (= 0.08). If a bank

satisfies this requirement, it means its equity is about 8%, its debt must be 92%, giving a gearing/leverage ratio of 92/8, or 11.5.

Contrast this with a typical debt to equity ratio for non-financial firms, of, for example, 60/40 = 1.5.

Capital risk is the outcome of other risks incurred by the bank, such as credit, market or liquidity risk. Poor earnings, caused by high loan losses, or inappropriate risk puts the bank’s capital at risk. Two ratios will be monitored by agents funding or considering funding the bank:

The bank’s capital ratio or its Basel risk assets ratio. The bank’s leverage ratio – debt/equity.


6.6. Operational riskOperational risk The Bank for International Settlements defines operational

risk as: ‘‘The risk of direct or indirect loss resulting from inadequate or failed internal processes, people, and systems, or from external events.

Definition of operational risk varies considerably, and more important, measuring it can be even more difficult. the key types of operational risk are identified as follows.

A. Physical Capital.

B. Human Capital.

C. Legal.

D. Fraud.

Classification issues alone make quantification of operational risk difficult, so it should come as no surprise that the ‘‘Basel 2’’ proposals for the treatment of the operational risk.


7.7. Sovereign and political risksSovereign and political risksSovereign Risk normally refers to the risk that a government

will default on debt owed to a bank or government agency.

However, if the default is by a sovereign government, the bank is unlikely to be able to recover some of the debt by taking over some of the country’s assets. This creates problems with the loan contract.

Political Risk is broadly defined as state interference in the operations of a domestic and/or foreign firm. Banks can be subjected to sudden tax hikes, interest rate or exchange control regulations, or be nationalized.


Mrs.Shefa El Sagga F&BMP110/2/2010. Chapter 3 Mrs.Shefa El Sagga F&BMP2 Management of Risks in...

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