banking presentation final- 4

8/12/2019 Banking Presentation Final- 4

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RISK MANAGEMENT IN BANKS



RISK M ANAGEMENT

Financial risk management is the process of detecting,assessing and managing financial risks

Why Risk Management is important for Banks Banks serve as financial intermediaries for managing

financial risk. They create markets and instruments toshare and hedge risks, provide risk advisory servicesand act as a counterparty by assuming the risk of

others. Because of this role they must excel atmeasuring and pricing financial risks.

Important for survival of the organisation especially inadverse market conditions

Issues with overestimation/underestimation



GROWTH OF RISK M ANAGEMENT INDUSTRY

Following global events contributed to thegrowth of risk management industry

Changing from fixed to flexible exchangerate system in 1971

Oil shock of 1973

US stock market collapse of 1983

Japanese stock market collapse of 1989and further

Asian currency crisis of 1997

Russian default and subsequent failure ofLTCM in 1998



GROWTH OF RISK M ANAGEMENT INDUSTRY

(CONTD)

2001 attack on WTC

Subprime crisis and subsequent failure of Bear

Stern, Lehman and other financial institutions in

2008-2009

Deregulation and Globalization – lesser entry

barriers, increasing competition, firms are more

competitive, exposure to global macroeconomic

factors, linked systemically, increased risk



TOOLS FOR RISK M ANAGEMENT

Derivatives Stop-loss limit Notional Amount

Exposure limit VAR Back testing Stress Testing



VAR

VAR is defined as the maximum loss over adefined period of time at a stated level ofconfidence given the normal marketconditions.

Advantages of VAR• VAR is comparable across different business

units in a firm with different asset classesand risk characteristics

• It is used for risk budgeting• Embraced by practioners, regulators and

academicians• Aggregates and reports multi product, multi

market exposures into one number.



VAR

Limitations of VAR• VAR requires accurate inputs

which becomes more daunting

as the number of assets increase• Subject to Model risk and

Implementation risk• VAR alone is not sufficient for

risk measurement. Measures toovercome the limitation includeback testing and stress testing.



RISK MANAGEMENT AND VALUE CREATION

1. By handling bankruptcy costs 2. By moving income across time and reducing

taxes 3. By benefiting a large shareholder 4. By reducing the probability of debt overhang




Profit (before

hedging) Probabili

ty Profit (after

hedging) Probabili

ty 200000 0.1 200000 0 300000 0.2 300000 0.20 400000 0.3 400000 0.35 500000 0.4 500000 0.45

By handling bankruptcy costsEg : A firm’s debt obligations is INR 300000, bankruptcy costsare INR 75000Expected profit (after operational expenses before debtservicing) is the following




Debt value = probability * expected payment to debti.e 0.1* 125000+0.9* 300000 = 282500Equity value = probability * expected payment to equity

i.e 0.3* 100000+0.4* 200000 = 110000Total value = 392500

If Hedging costs is 10,000 then the values after hedgingDebt value = probability * expected payment to debti.e 1* 300000 = 300000Equity value = probability * expected payment to equityi.e 0.35* 100000+0.45* 200000 = 125000Total value = 425000-10000= 415000

Incremental benefit = 415000-392500= 22500



RELATIONSHIP BETWEEN RISK MANAGEMENT,

MANAGEMENT COMPENSATION AND INCENTIVES

• Management should be motivated towardsmaximizing firm’s value by following sound riskmanagement practices for the firm

• General tendency to align management’s incentive

with the stock price doesn’t serve the completepurpose of creating long term value for the firm

• Increasing the management’s shareholding in thefirm is better option

• If management compensation is related towardscreating firm value then they would be more willingto take effective risk hedging policies and therebyincrease the firm value

• This would also ensure lesser risk premiumdemanded by the investors because there would belesser volatility in the stock price of the firm



RISK M ANAGEMENT FRAMEWORK

1. Organisation for Risk Managemento The Board of Directors – Overall responsibility,

articulates the risk management policies,procedures, aggregate risk limits, reviewmechanisms and reporting and auditing systems

o The Risk Management Committee of the Board – Board sub level committee – responsible for ensuringthe risk management processes confirm to policy,robustness of risk measurement models

o The Committee of senior-level executives – responsible for implementation of risk and business

policies simultaneouslyo Risk Management support group – analyses and

reports to the committee. Also responsible forindependent risk monitoring, measurement, analysisand reporting




2. Risk Identification

Risk Identification consists of identifying various risksassociated with the risk taking at the transaction level andexamining its impact on the portfolio and on capitalrequirement

Example : Say Branch B of XYZ bank has extended a loan ofINR 1 crore in accordance with the corporate policy andguidelines for a period of 5 years at a rate of interest 1 pctover BPLR of the bank, BPLR being 10 pct. The loan is to berepaid in equal quarterly instalments with one year

moratorium. Funding of the loan is to be done from a depositof 3 years of the same amount, interest rate on it being 6 pct.What are the risks associated with the transaction withouttaking into account CRR/SLR requirements




2. Risk Identification

Funding risk

Default risk

Basis risk Gap or Mismatch risk

Embedded Option risk

Reinvestment risk

Operational risk This transaction would also impact risks at the

aggregate level, also it may be noted that incremental

risk in the portfolio may also be less than the risks

taken at the transaction level.




3. Risk Measurement

Risk measures capture variation in earnings,

market value, losses due to default etc arisingout of the uncertainties associated with thevarious risk elements

Quantitative measures can be classified intothree categories

Based on Sensitivity

Based on Volatility Based on Downside Potential (two components -

potential loss and probability of occurrence)




4. Risk pricing

Pricing should take into account the following Cost of deployable funds

Operating expenses

Loss probability

Capital charge




5. Risk Monitoring and Control

• Strong Management Information System for reporting,monitoring and controlling risk

• Well laidout procedures, effective control and comprehensiverisk reporting framework

• Separate risk management framework independent ofoperational requirements with clear delineation ofresponsibility for management of risk

• Periodical review and evaluation (both internal and external)

Various reports should allow senior management to

a. Evaluate the level and trend of material risks and theirimpact on capital levelsb. Assess bank’s risk profile on a continuous basis and make

necessary adjustments to the bank’s strategic planaccordingly

c. Identify the large exposures and risk management

concentrations




6. Risk Mitigation

• Refers to the reduction in risk achieved by adopting strategies thateliminate or reduce uncertainties associated with the risk elements

• Credit risk can be mitigated by collateralisations and by buyingcredit derivatives. It is also mitigated by having a robust creditappraisal and review process.

• Interest rate risk can be mitigated by using interest rate swaps orforward rate agreements

• Forex risk can be mitigated by using forex forward contracts, forexoptions or futures

• Equity price risk can be mitigated by using equity options• Operational risk can be mitigated by strengthening the operational

processes, periodic reviews of process adherence• Counterparty risk can be mitigated by establishing exchanges as

counterparty• Risk mitigation measures aim to reduce downside variability in net

cash flow but it also reduces upside potential simultaneously




INR

000 Cash flowfrom

Year1 Year

2 Year3 Year

4 Year 5 Total Mean Standarddeviation

Standard

deviation/Mean

Business A 10 3 4 8 11 36 7.2 3.56 0.49

Business B 3 8 1 6 4 22 4.4 2.70 0.61

Business C 12 8 9 2 4 35 7 4.00 0.57

Business D 6 9 2 3 5 25 5 2.74 0.55

Business E 7 12 5 8 6 38 7.6 2.70 0.36

Total Portfolio 38 40 21 27 30 156 31.2 7.85 0.25

7. Risk Mitigation through diversification



TYPES OF RISK M ANAGEMENT F AILURES

• Risk Metrics Failure• Incorrect Measurement of known risks• Ineffective risk monitoring

• Ineffective risk communication• Ignorance of significant known risks• Unknown risk

Large financial loss is not necessarily a failure

of risk management



LINKAGES AMONG RISK, CAPITAL AND

RETURN

Higher risk means higher variability of returns, higherprofit potential and loss possibilities, thereforecapital requirement will be higher.Expected return would also factor in the risksassociated with it. Higher the risks in a businessmodel, higher would be the return expectations

Example : Following returns from investment of INR50,000

Cash flow from Year 1 Year 2 Year 3 Year 4 Year 5 INR

000

Total Investment-1 6 6 6 6 6 30 Investment-2 3 9 5 -2 15 30



C ASE STUDIES – B ARINGS B ANK

• Nick Leeson, trader at Baring PLC in Singapore, tookconcentrated positions on Nikkei 225 derivatives forbank in Singapore International Monetary Exchange(SIMEX). He took arbitrage positions on Nikkeiderivatives on different exchanges viz. Osaka, Tokyo

and SIMEX.• In 1994, Leeson lost USD 296 M, but reported a

profit of USD 46 M to management. He abandonedthe hedge strategy and initiated a speculative long-long futures position in both exchanges in hope of

profiting from an increase in Nikkei 225.• He also engaged in unauthorised option writing tocollect premium to keep himself ready for margincalls



C ASE STUDIES – B ARINGS B ANK

• Leeson was solely responsible for back andfront office operations of Singapore. He used anerror account to hide his losses by fraudulentlytransferring funds to and from his erroraccounts

• He kept on building his positions even afterNikkei kept on falling, however after Jan 95earthquake, the Nikkei plunged and he couldnot sustain his positions and failed to honor themargin calls

• It eventually led to the collapse of Barings bank(due to losses of USD 1.3 B), when it was sold toING for mere USD 1.60 only

• It had various risk exposures such as Market,Event, Legal , Employee



C ASE STUDIES – SUMITOMO

• Yasuo Hamanaka – Chief Copper Trader at Sumitomo

manipulated copper prices on London Metal Exchange

• Long position in futures contract and simultaneously

purchased large quantities of physical Copper

• Due to shortage of physical copper the other party was

forced to pay higher premium for physical copper orunwind its short position by an offsetting long position

resulting in handsome profits for Hamanka and

Sumitomo

• He sold put options to collect the premiums as he

thought he can push the prices up and thus writing putoptions was not risky for him

• Though he never imagined that he could be susceptible

to steep decline of copper prices



C ASE STUDIES – SUMITOMO

• Commodity Futures Trading Commission (CFTC) began aninvestigation of market manipulation in Dec 95

• Fall in Copper prices in June 96 after revelation ofHamanaka’s unfair dealings led to USD 2.6Bn loss forSumitomo and USD 150 M fine from CFTC

• Positions were so large that company could liquidate themcompletely

• Sumitomo’s lack of Supervision created a high degree ofoperational risk, which could have been reduced with properinternal controls

• In Sumitomo’s case no approvals were required from seniormanagement for large transactions and senior managementwas unequipped to understand the complex transactions

• It had various risk exposures such as Market, Liquidity, Legal ,Employee



BANKING RISKS

Liquidity Risk

Inability to obtain funds to meet cash flow

obligations at a reasonable rate

Funding risk – due to unanticipated withdrawal/non-

renewal of deposits

Time risk- due to non-receipt of expected inflows of

funds

Call risk – Crystallization of contingent liabilities



Interest Rate Risk

Adverse impact on NIM due to changes in interest rates

Gap or mismatch risk – Due to mismatch in amount andtenor of assets and liabilities

Basis risk – Interest rate of different assets, liabilities

may change in different magnitude Yield Curve risk – Due to non-parallel movements in

interest rates

Embedded Option risk – Due to prepayment of loans,premature withdrawal of deposits, exercise of put/call

option on bonds/debentures Reinvestment risk – Uncertainty with regard to interest

rate at which the future cash flows could be reinvested

BANKING RISKS



Market risk

Risk that the value of a portfolio, either an

investment portfolio or a trading portfolio, will

decrease due to the change in value of the market

risk factors.

Forex risk – Risk of loss due to adverse exchange

rate movements during the period in which the bank

has an open position

Market Liquidity risk- Inability to conclude a large

transaction near the current market price

BANKING RISKS



Credit risk

Risk of loss arising from a borrower who fails to

meet its obligations in accordance with the agreed

terms.

Counterparty risk – Due to counterparty’s refusal or

inability to perform

Concentration risk – Risk due to higher weight in

respect of a borrower or geography or industry

Country risk – Due to restrictions imposed by a

country

BANKING RISKS



CREDIT RATING

Credit rating is done with primary objective to determine whether

the account, after the expiry of a given period, would remain a

performing asset.

S&P Mood

y's S&P Moody's Investment

Grade Non-Investment

Grade AAA Aaa Highest Rating BB Ba Speculative

AA Aa Very Strong B B Missed one or more interest or principal

payments

A A

Slightly more

susceptible to

adverse economic

conditions CCC-C Caa-C No interest is being paid

BBB Baa

Adequate capacity to

repay principal and

interest. Slightly

speculative D Default



Operational risk

Risk of loss resulting from inadequate or failed internalprocesses, people and systems or from external events.

People – Fraud / Error

Process – Failed business processes

Compliance – Failure to comply with applicable laws,regulations, codes of conduct and standards of Good practice

System – Risk of loss due to system failure

Legal – Litigations arise due to lack of faith, wrongfuldischarge, misleading information, conflict of interests, vendornon-performance, poor financial performance, unethicalbehaviour, lack of transparency etc

External events risk- Economic shocks, natural disasters

BANKING RISKS



Other risks

Business Environment risk - Risk that a firm is

subjected to during daily operations

Strategic risk – Risk due to incorrect business

decisions of the management

Reputation risk – Risk arising from negative public

opinion

Environmental risk- It is the likelihood or probability

of injury, disease or death resulting from exposure

to a potential environment hazard.

BANKING RISKS



RELATION BETWEEN OPERATIONAL, M ARKET AND CREDIT

RISK

An operational failure may increase market and credit

risks. A bank that engages in buying and selling

derivatives without an adequate understanding of the

derivatives market could suffer significant losses.

Those losses could then result in a change in thecredit rating for the firm and reduction in the market

price for its securities.



INTEGRATED RISK M ANAGEMENT

Integrated risk management is managing all risks thatare associated with all the activities undertaken acrossthe entire organisation. The sum total of all risk impactsis a critical factor for all organisations. Integrated riskmanagement implies a coordinated approach across

various risks by improving the understanding andinterrelationships between various risks.

An integrated approach to risk management centralizesthe process of supervising risk exposure so that theorganisation can determine how best to absorb, limit or

transfer risk. It is an ongoing process that calls forstandard definations and methods to identify measureand manage risk across all business units

banking presentation final- 4

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