1. R I S K1 1

2. What is Risk?hazard, a chance of bad consequences, loss orexposure to mischanceany event or action that may adversely affectan organizations ability to achieve its objectivesand execute its strategiesthe quantifiable likelihood of loss or less-than-expected returns1 2 3. Risk is everywhere future cannot bepredictedThe intuitive commonsense of Risk- Rewardcoupling No risk; no reward Taking on more risk is sensible only if it results in greater likelihood of greater reward! Appetite for risk determines what reward one seeksAnd the good news is Risk can be Managed 1 3 4. Risk is CostlyGreater risk imposes costs (reduces value)Example:Identical properties subject to damage. Greaterexpected property loss lowers value ofproperty, all else equalGreater uncertainty about property loss oftenlowers value of property, all else equal 1 4 5. Importance of Indirect LossesDirect Losses often cause indirect lossesExample: What are the direct and indirect lossesif a manufacturing plant experiences a majorfire?.Cost of Risk ExampleFirm value in ideal world of no risk = Rs.1,000,000.Issues to be examined:What is firm value with risk of worker injuries?What is relation between firm value and cost of risk?Business is faced with one source of risk: Probability of worker injury = 1/10 Losses from a worker injury: medical expenses Rs.100,000 lost payRs.500,000 total Rs.600,000Expected loss = Rs1/10 * 600,000 = Rs60,0001 5 6. Option 1: Do NothingCost of risk:Expected loss = Rs.60,000Cost of residual uncertainty= Rs.40,000(assumed)Cost of loss control= Rs.0Cost of loss financing= Rs.0Cost of internal risk reduction = Rs.0 Total cost of risk = Rs.100,000 Firm value = Rs.1,000,000 Rs.100,000= Rs.900,00016 7. Option 2: Loss controlSpend Rs.20,000 to reduce probability of loss to 1/20Cost of risk:Expected loss = Rs.30,000Cost of residual uncertainty= Rs.30,000(assumed)Cost of loss control= Rs.20,000Cost of loss financing= Rs.0Cost of internal risk reduction = Rs.0 Total cost of risk = Rs.80,000 Firm value = Rs.1,000,000 Rs.80,000= Rs.920,000 17 8. Option 3: Additional Loss controlSpend an additional Rs.20,000 to reduce probability ofloss to 1/40Cost of risk:Expected loss = Rs.15,000Cost of residual uncertainty= Rs.27,000(assumed)Cost of loss control= Rs.40,000Cost of loss financing= Rs.0Cost of internal risk reduction = Rs.0 Total cost of risk = Rs.82,000 Firm value = Rs.1,000,000 Rs.82,000= Rs918,000 1 8 9. Option 4: No loss control, but full insurancePremium = Rs.75,000Loading = premium - expected loss= Rs.75,000 Rs.60,000 = Rs15,000Cost of risk:Expected loss= Rs.60,000Cost of residual uncertainty = Rs.0Cost of loss control = Rs.0Cost of loss financing = Rs.15,000Cost of internal risk reduction =Rs.0 Total cost of risk= Rs.75,000 Firm value = Rs.1,000,000 Rs.75,000= Rs.925,000 1 9 10. Key points from example:Do NOT minimize risk, minimize cost of riskThere are cost tradeoffs:Increase insurance coverage ==>Increase loading paidDecrease residual uncertaintyAdditional loss control ==>Decrease expected lossesIncrease loss control costs110 11. Problem: If in an ideal world of no risk, the value of Building & Plant including Machinery& Equipment = Rs.120,000,000/-. Calculate the value of Building & Plant with risk ofdamage on all undermention options:Losses from a Building & Plant:Repair expenses= Rs.1,000,000/-lost accrue due to change damage Machinery & Equipment = Rs.4,500,000/-Total = Rs.5,500,000/-What will be the Building & Plant value with risk of damage and the relation betweenBuilding &Plant value and cost of risk?Option 1:Firm face one source of risk with cost of residual uncertainty of Rs.500,000/- &Probability of loss = 1/5.Option 2:Spend Rs.90,000 to reduce probability of loss to 1/10 with cost of residualuncertainty of Rs.250,000/- .Option 3:Spend an additional Rs.80,000 to reduce probability of loss to 1/20 with cost ofresidual uncertainty of Rs.125,000/- .Option 4:Spend Rs.550,000 Insurance Premium against full coverage with no losscontrol and no cost of residual uncertainty.1 11 12. Problem: If in an ideal world of no risk, the value of a Bank is Rs.765,906,169,000/-including all tangible & intangible assets. Calculate the value of Bank with risk of Cash& Valuable in lockers Burglary on all undermention options:Losses from Burglary :Damage expenses =Rs.056,000,000/-Loss accrue due to cash Burglary=Rs.474,500,000/-Loss accrue due to lockers Burglary =Rs.113,908,000/- Total = Rs.644,408,000/-Option 1:Firm face one source of risk with cost of residual uncertainty ofRs.13,000,000/- , Probability of cash Burglary = 1/20 & Probability of lockers Burglary =1/10.Option 2:Spend Rs.22,500,000 to reduce Probability of cash Burglary = 1/10 &Probability of lockers Burglary = 1/8 with cost of residual uncertainty of Rs.12,250,000/- .Option 3:Spend an additional Rs.5,780,000 to reduce Probability of cash Burglary = 1/5& Probability of lockers Burglary = 1/4 with cost of residual uncertainty of Rs.6,125,000/-Option 4:Spend Rs.52,000,000 Insurance Premium against full coverage with no losscontrol and no cost of residual uncertainty.112 13. Enterprise-wide Risk1-Internal RiskPeople RisksFraudHuman ErrorHealth & SafetyEmployment LawTraining & DevelopmentProcess RisksFinancial Process & ControlCustomer Relationship ManagementProject ManagementSupply Chain Management 113 14. Technology RisksData SecurityData IntegritySystem PerformanceCapacity PlanningChange Management2- External RiskFinancial RisksCredit RiskMarket RiskLiquidly Risk etc;Non-financial RisksPolitical RiskCompetitor Risk 1 14 15. Socio Economic Risk External FraudIdentifying Business Risk ExposuresPropertyBusiness incomeLiabilityHuman resourceExternal economic forcesEarningsPhysical assetsFinancial assetsMedical expensesLongevity (durability)1 15 16. Financial RiskWe are primarily concerned with the maincategories of financial risk: Market Risk- Pricing Risk Credit Risk- Default Risk Operational Risk- Failing Processes/SystemsLiquidity Risk FundsOther Relevant Risks 116 17. Market Risk the risk of a change in thevalue of a financial position due to changes inthe value of the underlying components onwhich that position depends, such as stock andbond prices, exchange rates, commodity prices,etc.Value of Financial Position Changes due to:1- Interest rate risk is the risk of negativeeffects on the financial result and capital of thebank caused by changes in interest rates.117 18. 2-Foreign exchange risk is the risk of negativeeffects on the financial result and capital of thebank caused by changes in exchange rates.Problem: To explore the new relation with thecustomer, during bank representative visit to thecustomer, who wish to have Forward cover against import ofgoods for 180days $600,000 Usance LC. If the Spot Rate isRs.87.98, profit on Foreign Currency is 5.85% andBorrowing Rate is 14.65%. Calculate the minimum rate with2% margin a bank can offer to its customer. Credit Risk the risk of not receivingpromisedrepayments on outstandinginvestments such as loans and bonds, because ofthe default of the borrower.1 18 19. Liquidity Risk - the risk that it will not bepossible to sell a holding of a particularinstrument at its theoretical price.Operational Risk the risk of lossesresulting from inadequate or failed internalprocesses, people and systems, or externalevents.Law, Compliance, Government Affairs-Legal Risk, Regulatory Risk, enforceability Risketc. 1 19 20. Energy Risk- Increasing globalization andinterdependence of energy products, deliverymechanisms, and risk management techniques.Exposure Risks include risks of banksexposure to a single entity or a group of relatedentities, and risks of banks exposure to a singleentity related with the bank.Investment Risks include risks of banksinvestments in entities that are not entities in thefinancial sector and in fixed assets.Stand-alone RiskPortfolio Risk1 21. Sovereign RiskProbability that the government of a country (oran agency backed by the government) will refuse tocomply with the terms of a loan agreement duringeconomically difficult or politically volatile times.Although sovereign nations dont "go broke," they canassert their independence in any manner they choose,and cannot be sued without their assent. Sovereign riskwas a significant factor during 1970s afterthe oil shock when Argentina and Mexico almostdefaulted on their loans which had to be rescheduled. 121 22. What do you Mean by Risk Management?An integrated framework for managing creditrisk, market risk, operational risk, economiccapital, and risk transfer in order to maximizefirm value. 122 23. Objective of Risk ManagementNeed for a RM ObjectiveRisk imposes costs on businesses and individuals.Risk Management (e.g., loss control and insurance)also is costly Tradeoffs must be madeNeed a criteria for making choices about how muchrisk management should be undertakenAppropriate CriteriaMinimize cost of risk - direct or overallCost distribution: one time, periodical, over a certaintime horizon. 1 23 24. The Risk Management Process1. Identification of risks2. Evaluation of frequency and severity of losses, including maximum probable loss = value at risk3. Choosing risk management methods4. Implementation of the chosen methods5. Monitoring the performance and suitability of the methods 1 24 25. Economic Capital - Capital is held to ensurethat a bank is likely to remain solvent, even if itsuffers unusually large losses.Available Economic Capital - The amount bywhich the value of all assets currently exceedsthe value of all liabilities.Required Economic Capital- The amount bywhich the value of all assets should exceed thevalue of all liabilities to ensure that there is avery high probability that the assets will still exceed 1 25 26. Function of Economic Capital1. To Address the unexpected loss at certain confidential level for certain time horizon2. Ensure solvency and stability of Financial Institutions in cases of market shocks3. May be aligned (associated) with the firms risk appetite 126 27. State Bank of PakistanAs per the revision of capital requirements fornew entrants, banks in different modes ofoperations are required a minimum paid upcapital of Rs 10 billion, instead of Rs 2 billionpreviously, depicting a surge of Rs 8 billion or400 percent. Minimum Paid up Dead line by which Capitalto be(Net of losses) increased Rs 5 billion - - Rs 6 billion - - Rs 10 billion- - Rs 15 billion- - Rs 19 billion- -1 Rs 23 billion- - 27 28. IMPORTANT RATIOS1. Debt to Service Coverage Ratio=Net Operative Income/ Debt Service - It is used to measure the ability of prospect tomeet the financial obligation. For example, if thenet income available to shareholder=Rs.55,234,098/- and its financial obligationagainst facility= Rs.24,777,980/-2. Loan to Value Ratio= Amount of Facility/ Value of Asset or Security - It is used to measure the security is to facilityamount in order to recover the facility in case ofdefault.1 28 29. Bank Regulation and BaselImportant State Objective Bank-Stable Economic Environment for PrivateIndividuals and Businesses.-Providing Reliable Banking System & ProtectDepositors even in the event of Bank Failure.-Deposit insurance introduced to build thedepositors confidence.-Bank Regulators prescribe minimum level ofcapital to cover the worst case loss over sometime horizon (possibility). 1 29 30. The worst case loss is the loss that is notexpected to exceed with some high degree ofconfidence. The high degree of confidencemight be 99% or 99.9%.The expected losses are covered as productprice.For example: the interest charged by the bank isdesigned to recover expected loan losses.Capital is a cushion to protect the bank fromextremely un-favourable outcome. 30 31. Reason For Regulating Bank Capital Bank regulation is unnecessary. Even if therewere no regulations, banks would manage theirrisks prudently and would strive to keep a levelof capital that is commensurate (matching) withthe risks they are taking.Without state interventions, banks that tookrisks by keeping low levels of capital equity.Deposit insurance may encourage banks forlow equity.Due to cost of insurance, regulations on thecapital banks must hold. 1 31 32. The capital a financial institution requiresshould cover the difference between expectedlosses over some time horizon and worst-caselosses over the same time horizon. The idea isthat expected losses are usually covered by theway a financial institution prices its products.For example, the interest charged by a bank isdesigned to recover expected loan losses.Capital is a cushion to protect the bank from anextremely unfavorable outcome 1 32 33. Risk Based Assets = Total Asset - Cash and Equivalents -Fixed Assets ORRisk Based Assets = Other Earning Assets excluding Loans +Net LoansBaselBasel Accord: The Basel Committee onBanking Supervisons regulatory framework ofcapital standards for banks, established in 1988to protect bank owners, depositors, creditors,and deposit insurers (e.g., governments) againstfinancial distress. 33 34. The Road to BaselRisk management: one of the most importantinnovations of the 20thcentury.[Steinherr, 1998] The late 20th century saw a revolution onfinancial markets. It was an era of innovation in academic theory, product development(derivatives) and information technology andof spectacular market growth. 1 34 35. Large derivatives losses and other financialincidents raised banks consciousness of risk. Banks became subject to regulatory capitalrequirements, internationally coordinated by theBasle Committee of the Bank of InternationalSettlements. 1 35 36. Some Dates 1950s. Foundations of modern risk analysis arelaid by work of Markowitz and others onportfolio theory. 1970. Oil crises and abolition of Bretton-Woods turn energy prices and exchange ratesinto volatile risk factors. 1973. CBOE, Chicago Board OptionsExchange starts operating. Fisher Black andMyron Scholes, publish an article on the rationalpricing of options. [Black and Scholes, 1973]1 36 37. 1980s. Deregulation; globalization - mergerson unprecedented scale; advances in IT. The Regulatory Process 1988. First Basel Accord takes first stepstoward international minimum capital standard.Approach fairly crude and insufficientlydifferentiated. 1 37 38. The BIS Accord defined two minimum capitaladequacy requirements:1. The first standard was similar to thatexisting prior to 1988 and required banks tohave assets-to-capital multiple of at most 20. Assets-to-capital