William Chittenden edited and updated the PowerPoint slides for this edition.

RISK IN FINANCIAL INTERMEDIATION

Session 6

Bank ManagementBank Management

Fundamental risks :

Credit risk

Liquidity risk

Market risk

Operational risk

Capital or solvency risk

Off-Balance Sheet Activities

Foreign Exchange Risk

Sovereign Risk

Legal risk

Reputational risk

Credit risk�the potential variation in net income and market value of equity resulting from nonpayment or delayed payment on loans and securities

Three Question need to be addressed:

1. What has been the loss experience?

2. What amount of losses do we expect?

3. How prepared is the bank?

Credit ratios to consider

What has been the loss experience? Net loss to average total LN&LS Gross losses to average total LN&LS Recoveries to avg. total LN&LS Recoveries to prior period losses Net losses by type of LN&LS

What amount of losses do we expect? Non-current LN&LS to total loans Total Past/Due LN&LS - including nonaccrual Non-current & restruc LN&LS / Gross LN&LS Current - Non-current & restruc/ Gr LN&LS Past due loans by loan type

Credit ratios to consider (continued)

How prepared are we? Provision for loan loss to: average

assets and average total LN&LS LN&LS Allowance to: net losses and

total LN&LS Earnings coverage of net loss

Liquidity risk�the variation in net income and market value of equity caused by a bank's difficulty in obtaining cash at a reasonable cost from either the sale of assets or new borrowings

Banks can acquire liquidity in two distinct ways:

1. By liquidation of assets Composition of loans & investments Maturity of loans & investments Percent of loans and investments pledged

as collateral2. By borrowing

Core deposits Volatile deposits Asset quality & stockholders� equity

Market risk�the risk to a financial institution�s condition resulting from adverse movements in market rates or prices

Market risk arises from changes in: Interest rates Foreign exchange rates Equity, commodity and security prices

Interest rate risk �the potential variability in a bank's net interest income and market value of equity due to changes in the level of market interest rates

Example: Rs.100,000 Car loan4 year fixed-rate car loan at 8.5%1 year FD at 4.5%

Spread 4.0%But for How long? Funding GAP

GAP = RSA - RSL, where RSA = amount of assets expected to reprice in a give period of time.

In this example:GAP1yr = Rs. 0 � Rs.100,000 = - Rs.100,000

This is a negative GAP.

Foreign exchange risk� the risk to a financial institution�s condition resulting from adverse movements in foreign exchange rates

Foreign exchange risk arises from changes in foreign exchange rates that affect the values of assets, liabilities, and off-balance sheet activities denominated in currencies different from the bank�s domestic (home) currency.

This risk is also often found in off-balance sheet loan commitments and guarantees denominated in foreign currencies; foreign currency translation risk

Foreign exchange risk

Foreign currency trading dominates direct portfolio investments. Trading volume may look very large but overall net exposure positions can be relatively small.

Net exposure i = (FX asset i - FX liabilities i) + (FX bought i -FX sold i )

= Net foreign assets i + Net FX bought i where i = I th currency

Foreign exchange risk

An FI can match its foreign currency assets to its liabilities in a given currency and match buys and sells in its trading book in that foreign currency to avoid FX risk.

Or it can offset its imbalance in its foreign asset-liability portfolio by an opposing imbalance in its trading book so that its net exposure position in that currency would be zero.

Foreign exchange risk

A positive net exposure position implies a FI is net long in a currency and faces the risk that foreign currency falls in value against the domestic currency. Failure to maintain a fully balanced position in any given currency exposes a FI to fluctuations in the FX rate of that currency against the dollar.

The greater the FI's exposure in a foreign currency and greater that currency's exchange rate volatility, greater the loss or gain potential to an FI's earnings.

Foreign exchange risk

Spot market for FX: The market in which foreign currency is traded for immediate delivery.

Forward market for FX: The market in which foreign currency is traded for future delivery.

Net exposure: The degree to which a bank is net long or net short in a given currency.

Foreign exchange risk

Net long in a currency: Holding more assets than liabilities in a currency.

Open position: An unhedged position in a particular currency. FX risks arise through mismatching foreign currency or foreign

asset-liability positions in individual currencies. These mismatches can be profitable if FX forecasts prove to be correct.

Unexpected outcomes and volatility can impose significant losses on an FI.

These risks can be minimised by hedging through matched foreign asset-liability books, through forward contracts and hedging through foreign asset and liability portfolio diversification.

Equity and security price risk�change in market prices, interest rates and foreign exchange rates affect the market values of equities, fixed income securities, foreign currency holdings, and associated derivative and other off-balance sheet contracts.

Large banks must conduct value-at-risk analysis to assess the risk of loss with their trading account portfolios.

Operational risk �measures the cost efficiency of the bank's activities; i.e., expense control or productivity; also measures whether the bank has the proper procedures and systems in place .

Typical ratios focus on: total assets per employee total personnel expense per employee Non-interest expense ratio

There is no meaningful way to estimate the likelihood of fraud or other contingencies from published data.

A bank�s operating risk is closely related to its operating policies and processes and whether it has adequate controls.

Operational & Technology Risk

OPERATING COST AND TECHNOLOGY RISK Financial risk is only one part of the risk profile of a

modern FI. They also have regular operations that result in additional costs and revenues. They also have to use various factors of production like labour, capital and other inputs optimally. Cost of these production factors has a direct bearing on the profitability and solvency of an FI.

Operational & Technology Risk

An efficient technological base for an FI can result in:

1. Lower costs by combining labour and capital in a more efficient mix

2. Increased revenues by allowing a broader array of financial services to be produced or innovated and sold to customers.

Technology has the potential to increase FI's net interest margin i.e. the difference between interest income and interest expense and other net income.

Operational & Technology Risk

Impact of technology on Banking: * Faster reconciliation of accounts * Electronic fund transfer * Electronic initiation and transmission of letters of credit * Portfolio insurance * Faster clearance of cheques * Note counting machines * Automatic Teller Machines * Home banking * Treasury management software * Payment of telephone and electricity bills

Operational & Technology Risk

Technological advances allow an FI to offer such products to its customers which have potential to earn higher profits.

The investment in many of these products is risky. Innovations may fail to attract sufficient business in relation

to initial cash outlay. Innovations in financial sectors get imitated fast. One benefit of technology is that it allows FI to cross-market

both new and existing products to customers. Technology increases the rate of innovation of new products. It improves the quality of service and lowers its cost. This is

possible due to economies of scale and economies of scope.

Operational & Technology Risk

Improvement in technology has contributed more risk to financial system

Daylight Overdraft Risk: Bank's reserve account becomes negative within the banking day. Risk of bank failure during the transaction time is a major risk.

International Technology Transfer Risk: Between 1974 and 1994 there has been a dramatic change in the position of American Banks. Not one American bank figured in top twenty in 1994 while top 20 positions were occupied by American banks in 1974 inspite of heavy investment in technology and financial services innovations in U S.

OFF-BALANCE-SHEET ACTIVITIES

Off-balance-sheet activities have both risk increasing and risk reducing attributes.

They are an important source of fee income for many FIs. They are less obvious and invisible to all but the very informed investor or

regulator. In economic terms they are contingent assets and liabilities that affect the

future rather than current shape of an FI's balance sheet. They have a direct impact on the future profitability and solvency

performance of the FI. Their efficient management is central to controlling overall exposure in a

modern FI. An activity is an off-balance-sheet asset if, when a contingent event occurs,

the off-balance-sheet item moves onto the asset side of the balance-sheet. Similarly, when an item moves to liability side of balance-sheet on a contingent event it is called an off-balance-sheet liability.

OFF-BALANCE-SHEET ACTIVITIES

The major types of off-balance-sheet activities for banks are:

* Loan Commitments * Letter of Credits * Bank Guarantees including DPGs * Futures, Forward contracts, Swaps and Options * Underwriting Commitments Although off-balance-sheet activities can be risk

increasing, they can also be used to hedge on-balance-sheet exposures resulting in lower risk as well as generating fee income to the FI.

Sovereign Risk

Mexican crisis and Asian meltdown confirms the importance of assessing the country or sovereign risk of a borrowing country in making lending or other investment decision like buying foreign bonds or equity.

If a borrower refuses or is unable to repay its loans the lender would probably seek to reschedule the promised interest and principal payments on the loan into the future. Continued inability to paywould result in liquidation of the firm's assets.

Consider lending to a first class borrower in a foreign country.

Sovereign Risk

The corporation may be doing well and repaying its debt as per repayment schedule.

However, the foreign exchange reserves of the country are precarious and in order to conserve the foreign exchange reserves, the government of that country refuses to allow any further debt repayment in hard currency to outside creditors.

This puts the foreign borrower automatically into default even though the company is a good credit risk.

These types of government action pose sovereign risk which is independent of the credit standing of the individual loan to the borrower.

Sovereign Risk

Unlike legal remedy in case of domestic bankrupcy courts, there is no international bankruptcy court to which the lender can take the foreign government. Lender's legal remedies to offset a sovereign country's default or moratoria decisions are very limited.

This means that making a lending decision to a party residing in a foreign country is a two step decision.

First, lender must assess the underlying credit quality of the borrower and set an appropriate credit risk premium.

Second, lenders must assess the sovereign risk quality of the country in which the borrower resides. Even if the credit risk is assessed as good but the sovereign risk is bad, the loan should not be made.

Sovereign Risk

A sovereign's negative decisions to its debt obligations or the obligations of its public and private organisation may take two forms:

Repudiation: an outright cancellation of all current and future debt obligations by a borrower. They were very common before the second world war.

Rescheduling: A country declares a moratorium or delay on its current and future debt obligations and then seeks to ease credit terms by rescheduling debt maturity and renegotiation of interest rates.

Capital risk� closely tied to asset quality and a bank's overall risk profile

The more risk taken, the greater is the amount of capital required.

Appropriate risk measures include all the risk measures discussed earlier as well as ratios measuring the ratio of: Tier 1 capital and total risk based capital to

risk weighted assets Equity capital to total assets Dividend payout, and growth rate in tier 1

capital

Definitions of capital

Tier 1 capital is: Total common equity capital plus

noncumulative preferred stock, plus minority interest in unconsolidated subsidiaries, less ineligible intangibles.

Risk-weighted assets are: The total of risk-adjusted assets where the

risk weights are based on four risk classes of assets.

Importantly, a bank's dividend policy affects its capital risk by influencing retained earnings.

Legal risk�the potential that unenforceable contracts, lawsuits, or adverse judgments can disrupt or otherwise negatively affect the operations or condition of the banking organization

Legal risk includes: Compliance risks Strategic risks General liability issues

Reputational risk

Reputational risk is the potential that negative publicity regarding an institution�s business practices, whether true or not, will cause a decline in the customer base, costly litigation, or revenue reductions.

Strategies for Maximizing Shareholder Wealth

Asset Management Composition and Volume

Liability Management Composition and Volume

Management of off-balance sheet activities Net interest margin management Credit risk management Liquidity management Management of non-interest expense Securities gains/losses management Tax management

CAMELS

Capital Adequacy Measures bank�s ability to maintain

capital commensurate with the bank�s risk

Asset Quality Reflects the amount of credit risk with

the loan and investment portfoliosManagement Quality

Reflects management�s ability to identify, measure, monitor, and control risks

CAMELS (continued)

Earnings Reflects the quantity, trend, and quality

of earnings

Liquidity Reflects the sources of liquidity and

funds management practices

Sensitivity to market risk Reflects the degree to which changes

in market prices and rates adversely affect earnings and capital

CAMELS Ratings

Regulators assign a rating of 1 (best) to 5 (worst) in each of the six categories and an overall composite rating 1 or 2 indicates a fundamentally sound

bank 3 indicates that a bank shows some

underlying weakness that should be corrected

4 or 5 indicates a problem bank

Performance Characteristics of Banks by Business Concentration and Size

Wholesale Banks Focus on loans for the largest

commercial customers and purchase substantial funds from corporate and government depositors

Retail Banks Focus on consumer, small business,

mortgage, and agriculture loans and obtain deposits form individuals and small businesses

Financial Statement Manipulation

Off-balance sheet activities Enron and �Special-Purpose Vehicles�

Window dressing Eliminate Fed borrowing prior to

financial statement reporting date Increase asset size prior to year-end

Preferred stock Meets capital requirements but causes

NIM, NI, ROE, and ROA to be overstated

Financial Statement Manipulation (continued)

Non-performing loans Banks may lend borrower funds to

make payments on past due loans, understating non-performance status

Allowance for loan losses Management discretion and IRS

regulations may be in conflict

Securities gains and losses Banks often classify all investment

securities as �available for sale,� overstating any true �gains or losses�

Non-recurring sales of assets This type of transaction is not part of

the bank�s daily activities and typically cannot be repeated; thus it overstates earnings

Financial Statement Manipulation(continued)