Introduction to Risk Management in Banks1933

8/3/2019 Introduction to Risk Management in Banks1933

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Risk Management in Banks and Financial

Institutions

By A V Vedpuriswar

February 14, 2009


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1971 : Breakdown of Bretton Woods1973 : Oil shock1987 : US Stock market crash1989 : Crash of the Nikkei Index1994 : Mexican Peso crisis1997 : Asian currency crisis1998 : Russian rouble crisis/collapse of LTCM2000 : Dotcom bust2001 : WTC terrorist attack2007 : Sub Prime Crisis2008 : Collapse of Bear Stearns, Lehman, AIG,

Major upheavals in recent years


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Evolution of Analytical Risk Management tools

1938 Bond duration1952 Markowitz mean variance framework

1963 Beta

1966 Multiple factor models

1973 Black Scholes, Greeks

1983 Risk adjusted return on capital

1986 Limits on exposure by duration

1988 Limits on Greeks

1992 Stress testing

1993 Value-at-Risk1994 Risk Metrics

1997 Credit Metrics

1998 Integration of credit & market risk

2000 Enterprise wide risk management


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j Risks can be broadly classified into two groups.

j Business risks: Risks assumed willingly to create acompetitive advantage and to add value for shareholders.

j Financial risks: Relate to possible losses owing tofinancial market activities.

j What is the linkage?

Types of risk


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Risk Categories

Reputation risk

j Business environment

j Economic cycles

j Industry cycles

j Industry trends

j Technology changej Vision/strategy

Business risks

Primary Operational

Credit risk Liquidity riskMarket Risk

Transactionprocessing

Legal

Compliance Liability

Security Tax

Inherent risk


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Exposure to movements in risk factors

On positions which we can choose to close out

Risk factors in trading positions (and issuer risk)

redit Risk

Exposure to failure to perform

Cannot choose to close out underlying transaction

Although we may be able to distribute risk

Market, Credit and Operational Risk

Operational Risk

Market Risk

Exposure to failure of people, processes and systemsboth internal and external do not choose to take on

Harder to measure

Concentration on identifying / mitigating


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Examples of Risk

1. There is a general downturn in the marketsand clients reduce their trading volumes,reducing the commissions that we earn.

2. We enter into a new business area, but therevenues do not meet expectations, andwill not cover the costs of the investment

made.

3. A client we have lent money to goesbankrupt and we lose the funds.

4. Share prices fall 10% globally and we losemoney on our own positions.

5. Due to a credit market dislocation, we find

ourselves unable to borrow funds at anacceptable price to fund our actual orproposed commitments

6. A former employee sues the bank fordiscrimination.

7. A CD containing confidential WealthManagement client data is lost

8. A trader executes transactions, but doesnot enter them into the trading system untillater, and only inputs the ones that havenot lost money.

9. A regulator suspends our licence toconduct business in their country due tofailures in internal controls.

10.Wealth management clients move theirmoney away from us, due to publicrevelation of problems.

11.A counterparty who owes us money underan OTC derivative transaction defaults dueto financial difficulty

12.A counterparty who owes us money underan OTC derivative transaction refuses topay and claims they were not authorised toenter the trade

In which category does each of these risks fall?


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Valuation & Risk Management approaches

Derivatives Valuation Risk Management

PrincipleExpected discounted

value

Distribution of future

value

Focus Centre of distribution Tails of distribution

HorizonCurrent value,

discountingFuture value

Precision High precision needed Less precision needed

Distribution Risk neutral Actual


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jRisk of loss owing to movements in the level or volatility of market prices of stocks, interest rates,currencies, commodities.

Market risk


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jThis refers to the possibility that the transaction cannot beconducted at the prevailing market prices owing to the size ofthe position relative to normal trading lots.

jLiquidity risk may also arise because of the inability tomeet payment obligations.

jThis is especially a risk for portfolios that are leveraged andsubject to margin calls from the lender.

jIf cash reserves are insufficient, losses in market value maycreate a need for cash payments

jLeading to involuntary liquidation at depressed prices.

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Liquidity Risk


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Liquidity, model and market risks

jLiquidity, market and model risks are interrelated.

jBreakdown of markets leads to liquidity problems.

jWhen markets are not in place, models become necessary.

jModels pose various risks.


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j This risk arises because the counterparties may beunwilling or unable to meet contractual obligations.

j Pre settlement riskarises over the life of the contract.

j Settlement risk occurs when a counterparty defaults

after the institution has already made its payment.

j Settlement risk is very real for foreign exchangetransactions which involve exchange of payments indifferent currencies at different times.

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Credit risk


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The Nature of Credit Risk

jLess liquid positions

jLonger time horizons

e.g. 1 year

jNegatively skewed distributions

jPotential for longer tails

jCorrelations and concentrations


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Concentration risk

jMore concentration leads to greater tail risk

F

requency

Loss

Source: stylised dataset for illustration only

Less diversified

More diversified


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Credit Risk in banks

Traditional banking products, e.g.

Loans

commitments to lend

letters of credit

Traded products e.g.

OTC derivatives

Repos (and reverse repos)

Securities borrowing and lending

Plus settlement risk on e.g.

Foreign exchange


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Statistical view of Credit Risk

Probability of default x Loss given default x Exposure at defaultCounterparty/Group level

Cost of credit riskTheoretical expected

loss

Statistical loss Stress loss

Portfolio levelFrequency

Loss

Q W

Building block for

redit

portfolio


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j This is the risk arising out of inadequate or internalprocesses, people and systems from external events.

j The best protection against operational risks consists

of- redundancies of systems

- clear separation of responsibilities with stronginternal controls

- regular contingency planning.

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Operational Risk


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Barings ( 1995)

j233 year old bank collapses under $1.24 Billion loss

jLack of Internal Controls

jNo segregation of duties (Front and back office)

jPoor authorisation procedures

jLack of management awareness of inherent risk

jFraud

jMarket risk


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Operational Risk Definitions

Transaction Processing Risk(TPR) is the risk of financial loss due to

deficiencies in transaction processingsystems or internal controls front toback.

Legal Risk is the risk of financial loss

resulting from the non-enforceability ofrights arising under a contract or fromproperty or under the general law.

Liability Riskis the risk of loss

arising from potential or actual liabilityresulting from a legal or equitable claim,including contractual and legal claims,debt, and actions based on breach ordefault of contract, commitment of tort,violation of criminal law, infringement oftrademark or anti-trust action.

Security Risk is the risk of loss ordamage to our reputation arising from aloss of confidentiality, integrity oravailability of our information or assets.

Compliance Risk is the risk of lossincurred by the Bank by not adhering to

the applicable laws, rules andregulations, local and international bestpractice (including ethical standards)

and our own internal standards.

Tax Risk is the risk of loss due to taxauthorities successfully opposing theBanks position in tax returns.

What? Who? How? Why? You


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Operational Risk Drivers

jHigh Profile Losses

jReputational damage

jRegulatory Pressure

SOX (Sarbanes Oxley Act)

Basle II

MiFID (Markets in Financial Instruments Directive)

jCompetitive Advantage

Outsourcing / Offshoring

Technology Advancement

Business Growth (Trade volume and human capital)

Product Complexity and Evolution

Emerging Market Opportunity


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Sarbanes Oxley (SOX)

Enacted in response to a number of high-profile corporate and accountingscandals that resulted in a loss of public trust in corporate accounting andreporting practices (Enron).

Establishes new or enhanced standards for corporate accountability andpenalties for corporate wrongdoing.

Section 404 - CEO and CFO attest that the firm's financial accounts andthe controls over the processes used to produce them are sound.

Operations measures our controls semi-annually using OCD. This containsapproximately 105 individual standards.


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Credit, market, settlement and Operational Risk - Illustration

jA trader purchases 1 million spot from Bank A. The currentrate is $1.5/.

jThis means two days from now, the trader will have to give$1.5 million and receive 1 million.

jHe will then do a matching transaction with B.


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jMarket Risk: If the spot rate changes to $1.4/, loss for thetrader = 1.5 1.4 = $100,000, assuming the deal withcounterparty B is now stuck at 1.4.

j Credit Risk: Say the next day, B goes bankrupt and the ratechanges to $ 1.35/. Instead of selling to B at 1.4, A will have tooffload in the market to another bank, say at 1.35.

Loss = $50,000 (loss per unit = 1.4 1.35).

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jSettlement risk: If $1.5 million is delivered but 1 million isnot received, this is settlement risk.

j Operational risk: $1.5 million is wired to the wrong bank.

After two days, the money is received and remitted to theright bank with compensatory interest. The loss is theamount due.

Introduction to Risk Management in Banks1933

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