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Introduction to Risk Management The Nature of Risk A Person walks across the street and a car spins

out of control and accidentally runs into the person.

A person sits down in first-class sleeper seat 1A to cross the ocean on Air, a flight delay could cause her to be late to a crucial meeting that prompted her to spend kshs 250,000 on her ticket, or the plane could end up in the ocean and she could miss the meeting permanently.

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Nature of Risk-Cont.The above is risk and therefore it is everywhere. You do not have to look very hard to find risk. This is an indication that the world is inherently full of risks; risk is in the food you eat, the air you breathe and even in sleep. The man crossing the street is at risk and might want to manage the risk by never crossing the street and the person flying by not flying.

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Nature of Risk-Cont.

However it is seemingly uneasy and impossible to replicate the same rationale in eating, breathing and sleeping. This calls for intermediate solutions designed to reduce risk without completely eliminating it; in crossing the road look both ways and in flying checking the frequency of on-time arrivals of the carrier and generally avoiding airlines whose accident rates are high.

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Nature of Risk-Cont.

Underpinning the above is that the world is an unpredictable place as long as there is some uncertainty about the future that could result in an adverse outcome. In fact the world is becoming a riskier place. In our desire to exist risk must be managed because any effort to experience progress without risk is both paradoxical and futile.

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Nature of Risk-Cont.

Change often creates risks and paradoxically innovation creates risk and also lends opportunities to reduce risk. Therefore playing it safe may be a risk itself.

We must recognize that risky changes can be beneficial and must not choose to sit idly by while the risky world revolves and evolves. The solution is to adopt a healthy and responsible risk management framework that neither lends itself to over-caution or to carelessness.

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Nature of Risk-Cont.

In managing risks we must avoid three basic fallacies;

Risk is always bad Some risks are so bad that they must be

eliminated at all costs Playing it safe is the safest thing to do

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Risk management as a process for individuals and Organizations Risk management is the process by which an individual

tries to ensure that the risks to which she is exposed are those risks to which she thinks she is willing to be exposed in order to lead the life she wants.

On the other hand an organization is a collection of individuals and each organization has stakeholders. A stakeholder in an organization is any individual whose personal welfare is affected by the success of the organization. Accordingly, organizations inherit many risks to which individual stakeholders are subject.

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Risk management as a process –cont. Unlike individuals whose risk management objectives are

clearly defined with respect to personal well being, organizations have a more complex risk management mandate. One factor that blurs the clarity of the mandate is whose risks an organization is managing considering all the stakeholders. If the interests of all the stakeholders in the organization were perfectly aligned, the risk management objective of an organization would not matter so much. However the interests of various stakeholders are not aligned and are often in conflict.

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Risk management as a process –cont.Therefore risk management in organizations gets tricky and the following

questions come to mind. Risk management by organizations seeks solutions to the following questions;

What are the risks to which the organization is exposed to? Should individual stakeholders of the organization themselves manage

risks? What risks should the organization manage? Is risk management always about risk control and loss avoidance, or can

risk be turned into opportunity? If some risks are to be managed by the company, what are the right tools it

needs to engage in risk management most effectively? How does a company choose a method of changing the risks to which it is

exposed? How does a company implement its strategic risk management objectives

tactically?

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Definition of risk management

Risk designates any uncertainty that might trigger losses. Risk management in banking designates the entire set of risk management processes and models allowing banks to implement risk based policies and practices. They cover all techniques and management tools required for identifying, measuring, monitoring and controlling risks.

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Goal of risk-based policies and practices;

Enhancing the risk-return profile of the bank portfolio; Banks take risks, they transform them, and they embed them in the banking products and services.

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Banking Business Lines

The Banking industry has a wide array of business lines. Risk management practices and techniques vary significantly between the main poles, such as retail banking, investment banking and trading, and within the main poles, and between business lines. It is important to note that risk management tools, borrowing from the same core techniques, apply across the entire spectrum of banking activities generating financial risks. However, risks and risk management differ across business lines.

Figure 1.1

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Commercial Banking

-Retail banking-has large number of transactions because it tends to be mass oriented and industrial. Lending relies more on statistical techniques. In terms of reporting, management focuses on large subsets of transactions which may include date of origination, type of customer, product family (consumer loans, credit cards, leasing). Here risk decisions focuses on the subsets.

-for medium and large corporate borrowers, individual decisions require more judgments because mechanical rules are not sufficient to assess the actual credit standing of a corporation.

-for the middle market segment to large corporate businesses, relationship banking is dominant. For the above two, risk decisions necessitate individual evaluation of transactions.

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Investment Banking

Deals with large transactions in exports/imports and commodities financing, project finance, acquisitions and structured financing customized to the needs of large corporate to make large and risky transactions feasible (Structuring means the assembling of products and derivatives, plus contractual clauses (covenants) for monitoring risk).

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Trading

Traders interact with customers and other banking business units to bundle customized products for large borrowers who include finance industry professionals, banks, insurance, brokers and funds.

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Private Banking

This is asset management and advisory services. They do not generate traditional banking risks. They mainly generate operational risks.

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Summary-business Lines

All main business lines share the common goals of risk-expected return enhancement. And it is imperative to note that banking business lines differ depending on the specific organizations of the banks, on their core businesses and geographical subdivisions. Nevertheless basic foundations for differentiating risk management practices and designing risk models relies on organizational dimensions of the banks.

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Bank Business Accounting

Accounting rules differ for the banking portfolio and the trading portfolio. Accounting rules use accrual accounting of revenues and costs, and rely on book values for assets and liabilities.

Trading relies on market values (mark-to-market) of transactions and profit and loss, which are variations of the mark-to market value of transactions between two dates.

The above distinction in valuation makes a case in separating portfolios into the banking book and trading book.

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Banking Book This groups and records all commercial banking

activities. It includes all the lending and borrowing, usually both traditional commercial activities, and overlaps with investment banking operations. The ‘buy and hold’ philosophy prevails for the banking book, which is different from the capital markets.

This portfolio generates liquidity and interest rate risks. All assets and liabilities generate accrued revenues and costs, of which a large fraction is interest driven. Maturity mismatch of assets and liabilities results in excesses or deficits of funds. Mismatch would also exist between interest references i.e. fixed or variable, as a result of customers demand and bank’s business policy.

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Trading book Groups all market transactions tradable in the market;

‘buy and hold’ does not apply. The market portfolio generates market risk, defined broadly as the risk of adverse changes in market values over a liquidation period. It also generates market liquidity risk, the risk that the volume of transactions narrows so much that trades trigger price movements.

The trading portfolio extends across geographical borders, like capital markets do, whereas traditional commercial banking is more local. Transactions use non-tradable instruments, or derivatives such as swaps and options which may trigger credit risk, the risk of loss if the counterparty fails. Derivatives are off-balance sheet market transactions. Derivatives also include futures contracts and foreign exchange contracts.

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Bank’s Financial Statements Bank’s Balance Sheet Report on treasury and banking, intermediation (lending

and deposits), financial assets (trading portfolio) and long-term assets and liabilities. The relative weights depend on the core business of the bank.

Income Statement It summarizes the main revenues and costs of an

organization. International accounting standards are progressing towards fair value accounting for the banking book. This is similar to mark-to-market or economic value. The major driving force for looking at fair values is the need to use risk-adjusted values in modeling risks.

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The Need for Risk Management Systems The banking system has experienced many significant

structural changes over the last four decades. We have witnessed mergers and alliances with insurance companies, institutions have grown substantially, regulators have relaxed their rules and allowed banks to offer new products and to enter new markets and business activities.

The expansion of the activities of the banks will attract new market, credit and operational risks. This will require revision of banks capital adequacy requirements which are currently tailored to the traditional bank activities.

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Risk Management Systems-cont. Customers are demanding more sophisticated

and complicated ways to finance their activities, to hedge their financial risks, and to invest their liquid assets. Banks are therefore getting engaged in risk shifting activities which demand better and better expertise and know-how in controlling and pricing risks that they face in the market.

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Risk Management Systems-cont. There is a change in emphasis from simplistic profit

oriented management to risk/return management. The consideration is no longer profit and maturity intermediation only, but also risks intermediation. Risks intermediation implies a consideration of both the profits and risks associated with banking activities. It is no longer gratifying to charge a high interest rate on a loan; the relevant question is whether the interest charged compensates the bank prices appropriately for the risk that it has assumed. The real problem is how to quantify risk and thus price it appropriately.

Risk Management Systems-cont.

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•In the banking industry, the classic risk is credit risk and this has been the main preoccupation of the banks risk management. However, it was not until 1988 that a formalized universal approach to credit risk in banks was set out.•A major impetus behind the implementation of risk management systems has been the Basle Committee on Banking Supervision, which is an international extension of the regulatory bodies of the major developed countries. Banks have begun to realize that sophisticated risk control tools make for sounder economic management.•Various well-publicized financial disasters during the 1990s, such as the collapse of Barings Bank in 1995 due to inadequate operational controls led to a re-look at risk management systems.

Academic Background of Risk Management and Technological Changes A common deficiency in risk management systems and

policy proposals is the lack of a firm theoretical foundation. Academic research published on risk management techniques and derivative valuation has evolved since the early 1950s.

The word risk has many meanings and connotations. It is widely used by professional traders, risk managers, and the public. Many articles in the newspapers and magazines talk about risky and choppy markets. A proliferation of names has emerged to describe the various risks; business risk, financial risk, residual risk, liquidity risk, default risk, systematic risk, specific risk, settlement risk, country risk, portfolio risk, systemic risk, legal risk, reputation risk, and more.

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Markowitz’s (1952) Markowitz showed that a rational investor should analyze

alternative portfolios based on their mean and on the variance of their rates of return. Markowitz makes two assumptions, first, that capital markets are perfect and second, that the rates of return are normally distributed.

Markowitz’s portfolio analysis suggests that the specific or idiosyncratic risk of a single security should not be measured in terms of its volatility as measured by the variance of the rates of return. The variance measures the potential dispersion of future rates of return, but this is not a relevant risk measure for a single security. This is because most of the specific risk due to volatile returns can easily be diversified away and eliminated at virtually no cost. It follows that the specific or idiosyncratic risk, of a security, should not be priced in the market place if it can easily be off-set against the returns of other securities.

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Sharpe (1964) and Lintner (1965) They took the portfolio approach one step

further by adding the assumption that a risk-free asset exists. They show that financial markets are in equilibrium when all investors hold a combination of a riskless asset and the market portfolio of all risky assets in the economy. They show that in order to be in the market portfolio, a risky asset must be priced according to its relative contribution to the total risk of the market portfolio, as measured by the variance of its rate of return distribution.

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Black and Myron Scholes, and Robert Merton, 1973 The next important development in the analysis of risk

occurred in 1973, with the publication of two seminal papers by Fischer Black and Myron Scholes, and Robert Merton, on the pricing of options. The papers make use of a framework similar to that used by Markowitz, Sharpe, and Lintner; namely, they assume the existence of perfect capital markets and assume that security prices are normally distributed or equivalently, that returns are normally distributed. To these they add the new assumptions that trading in all securities is continuous and that the distribution of the rates of return is stationary.

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Modigliani and Merton Miller 1958. In order to complete this introduction to the theoretical

basis of modern risk management, we must turn to the work Franco Modigliani and Merton Miller published in 1958. These academics showed that in a perfect capital market, with no corporate and taxes; the capital structure of a firm has no effect on the value of the firm. A corporation cannot increase its value by issuing more debt, despite the fact that the expected cost of debt is lower than the expected cost of equity. Instead, the greater the leverage in the capital structure in the firm, brought about by the increased level of indebtedness, means that the equity holders immediately face a greater level of financial risk.

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Summary- In order to understand the BIS recommendations

concerning capital adequacy in the banking industry, one has to understand Markowitz’s approach to risk and reward; the importance of measuring the correlation coefficients among different bank assets and liabilities is directly linked to the portfolio diversification effects of the fundamental model.

Developing fundamental theories on risk management and implementing them within a business are two different challenges. There are two prerequisites for any risk management system; first, reliable, broad, and up-to-date databases concerning both the bank’s transactional positions and the financial rates available in the wider marketplace; and second, statistical tools and procedures that allow the bank to analyze the data.

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Classifying the risks that face businesses (Banks)

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