Unit 1

Risk Management in Banking

Unit 1

READ: Bessis 3rd edition, Sections 2, 5, 6Home Review Questions:• Discuss the various types of banking business lines.• Explain the difference between the banking book and the trading

book.• Describe types of banking risks.• Discuss banking regulations in place and its purpose.• Conduct a research in the area of the Basel Accord to explore how the capital adequacy requirement has evolved since its inception until today and evaluate its effectiveness.• Explain the types of risk measures in banking.

Additional reading (Study pack notes are taken from this book)

Anthony Saunders:Financial Institutions Management- A risk management approach, 6th edition.

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Risk Management in BankingUnit 1

BANKING RISKS AND RISK REGULATIONS

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Learning Objectives

By the end of this unit, you should be able to:

• Discuss the various types of banking business lines.

• Explain the difference between the banking book and the trading book.

• Describe types of banking risks.

• Discuss banking regulations including the Basel Accord.

• Explain the types of risk measures in banking.

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Banking Business Lines

1. Commercial banking which comprise of:– retail banking– corporate banking

2. Investment banking

3. Trading – which comprise of: – The bank’s proprietary trading – trading for third parties

4. Private banking

5. Custody – asset management and advisory services.

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Banking Book vs Trading BookThe Banking Book

• The banking book records all commercial banking transactions including all lending and borrowing activities. It is based on the buy and hold principle and accounting rules rely on book values of assets and liabilities.

• Liquidity and interest risk arise due to maturity mismatch and mismatch due to fixed and variable interest rates differences of loans and deposits. Loans in the asset of the banking portfolio are also exposed to credit risk. However, there is no market risk in the banking portfolio.

• Asset-Liability Management (ALM) is used to manage the liquidity and interest rate risk.

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Banking Book vs Trading Book

The Trading Book• The trading book records all market transactions tradable in

the market. It is accounted for based on the Profit and Loss (P&L) resulting from changes in the mark-to-market values of instruments held.

• The market portfolio gives rise to market risk – risk of adverse change to the market value of the instrument held, and market liquidity risk – risk that low volumes of trade that result in downward price movement.

• For non-tradable instruments including derivatives such as swaps and over-the-counter options, credit risk exposure should be considered – risk of loss if the counterparty fails.

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Basel I and II

Capital = Exposure x Risk Weight x 8%•Cooke ratio and Credit Risk (1988)•Inclusion of Market Risk component (1996)•Basel II (2007)

– Min. Capital requirements: credit, market, operation risks– Supervisory review– Market discipline

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Basel II

Credit Risk Components•PD•EAD•LGD•Credit conversion factor (for off-balance sheet exposures)

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Basel II

Risk weights vary by Asset classes:•Corporate•Banks•Sovereign•Retail customers and SMEs•Equity

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Basel II

THREE approaches to RISK WEIGHTS:•Standardised•Foundation (IRB) – banks own assessment of PD but Basel Standardised rules for LGD and EAD•Advanced (IRB) – both PD and LGD inputs are internal•In all cases, capital is calculated using IRB formulas

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Function of risk (economic) capital

• Protection against UNEXPECTED losses

Bank’s Product Lines

1. Retail financial services

2. Corporate Lending

3. Off-balance sheet transactions

4. Specialized finance

5. Market transactions

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Review or Tutorial Questions•Discuss the various types of banking business lines.•Explain the difference between the banking book and the trading book.•Describe types of banking risks.•Discuss banking regulations in place and its purpose.•Conduct a research in the area of the Basel Accord to explore how the capital adequacy requirement has evolved since its inception until today and evaluate its effectiveness.•Explain the types of risk measures in banking.

Supp. Reading: Anthony Saunders:Financial Institutions Management- A risk management approach, 6th edition.\

Off-balance Sheet Transactions

• Off-balance sheet transactions are contingencies given and obtained. They include: – guarantees provided, – committed credit lines not yet drawn down or stand-by

lines of credit.

• Derivative such as swaps, futures and options are off-balance sheet market transactions where obligation to make agreed payments are contingent on the occurrence of a specified event.

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Bank’s Financial Statements

1. The balance comprise of four levels:– Treasury and banking transactions– Intermediation– Financial assets– Long-term assets and liabilities

2. Income Statement– Fair value accounting requires the banking book to be

mark-to-market.

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Banking Risks• Credit Risk

• Interest rate risk

• Market risk

• Liquidity risk

• Operational risk

• Foreign exchange risk

• Country risk

• Performance risk

• Settlement risk

• Solvency risk

• Model risk

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Banking Regulations

• The regulators goals are:– Manage systemic risk– Promote a level playing field– Promote sound practices that contribute to financial

system safety.

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Capital Adequacy

Oversight body of the Basel Committee on Banking Supervision.

• Cooke Ratio (Basel I)• Second Basel Accord (Basel II) • Basel III

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Risk Measures

• Quantitative measures of risks comprise of three categories:– Sensitivity: Sensitivity measures the variation of a

variable due to the unit movement of a single market factor.

– Volatility: Dispersion around the average, including both the upside and downside.

– Downside measures of risk: focuses on the adverse deviation only

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Financial Services Industry

• Depository Institutions- commercial banks, savings institutions, credit unions(non-profit)

i. sources and uses of funds, assets, liabilities, equity, off-balance sheet activities,other fee-generating activities

• Non-depository Institutions:Insurance Companies-Life and property

i. Assets, liabilities, balance sheet, underwriting risks, loss risks, reinsurance

• Securities Firms and Investment Banksi. investing, investment banking, market making, trading, cash management,

mergers & acquisitions.ii. Assets,liabilities, balance sheet, regulation (unethical activities by Bear

Stearns, Lehman Brothers, Merrill lynch)

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Non-depository Institutions

• Mutual Fundsi. Long term-Bond funds, equity funds, hybrid funds, Short-term-

money market mutual funds.

ii. Mutual funds- open-end and closed-end

• Hedge Fundsi. More risky, moderate risk, risk-avoidance

ii. Regulation of hedge funds-mostly unregulated

• Finance Companiesi. Sales finance institutions, personal credit institutions, business

credit institutions

ii. Assets, liabilities and equity

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Credit risk

Leve

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ceCommercial bank: HSBC

Amount of risk

Market risk

Operational risk

Market risk

Leve

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ceInvestment bank: UBS

Amount of risk

Operational risk

Credit risk

Market risk

Leve

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ceTrading house: Goldman

Sachs

Amount of risk

Credit risk

Operational risk

Operational risk

Leve

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ceAsset manager: L & G

Amount of risk

Market risk

Credit risk