day two period 9:00 to 10:40 am. 22 managing market and credit risk –market risk –credit risk -...
TRANSCRIPT
Day Two
Period 9:00 to 10:40 AM
22
Managing Market and Credit Risk
– Market Risk
– Credit Risk - General
– The Credit Risk Model in Modern Banking
– Lending to Small Business
Day 2
3
Market Risk
• Market risk is the potential for loss arising from changes in interest rates, foreign exchange rates, equities, commodity prices, or credit spreads in market risk sensitive instruments.
• In banks, market risk exists in trading form or in non-trading form (asset/liability risk arising from the balance sheet)
4
Market Risk – Balance Sheet
• The bank’s balance sheet contains market risk
• The bank will earn less revenue if a) interest rates decline, reducing the yield on assets, or b) interest rates rise, increasing the cost of liabilities, or c) some combination of the two
• Management of balance sheet risk is called ALM, Asset/Liability Management
• ALM is very sensitive to the different maturities of assets and liabilities; banks analyze the weighted average maturity of assets/liabilities
5
Market Risk - Trading
• Trading is the buying and selling of financial instruments carrying market risk, such as equities, commodities, foreign exchange, bonds, and derivatives
• Trading risk usually arises when the bank fills a customer’s buy or sell order for a financial instrument, but the bank can initiate trading risk for its own account as well
• Trading risk is managed through Value at Risk
6
Market Risk - Trading
U S D o lla r G i lts
In te re s t R a tes
E uro Y en S te r ling
F o re ign E xch an ge
P rec io usM eta ls
E ne rgy R awM ate ria ls
C o m m o dit ies C red itS pre ads
N Y S E N A S D A Q
E qu ities
T rad ab le M a rke ts
S p o t/O v ern ig h t
S ho rt T e rmU p to O n e Y e ar
L on g T e rmO v er O n e Y e ar
D e lta G a m m a V ola tili ty
O ption a li ty
M atu ri ty/O ption a li ty
Method 1 Grouping
Method 2 Grouping
7
Market Risk – Value at Risk
• Value at Risk (VAR) is a process to calculate the potential loss in a trading portfolio
• VAR requires:– An accurate list of the bank’s trading assets and
liabilities– Current market prices and valuations for these assets
and liabilities– A computer model to match up the trading portfolio with
current prices, and then generate a mathematical distribution of potential losses
– VAR is calculated daily and a limit is set on
the acceptable loss amount
8
Trading
Portfolio
and
Historical
Market
Data
Algorithm Probability
Distribution
Potential
Loss
VAR Limit
Financial
Theory
Time
Horizon
And
Base
Currency
Confidence
Level
And
Single
Measure
Overage
Procedures
And
Back
Testing
INPUT MODEL OUTPUT VAR CONTROL
Asset
Grouping
And
Portfolio
Values
MappingProcess
RangeOf Values
RiskMeasure
RiskMitigation
Functions
Support
Value at Risk Process
Market Risk - Value at Risk
9
μ- 1σ + 1σ
Normal Distributiondescribing potentialmarket values for aportfolio with linearrisk characteristics
Current Value = mean μ
Potential gainsPotential losses
Loss at 1 standard deviation
Value at Risk
10
μ
New Current Value = mean μ
Potential gainsPotential losses
Portfolio Distributionskewed by inclusion ofcall options purchased
Value at Risk
11
μ- 1σ + 1σ
Studies have shown thatfor many tradable productsthe Normal Distribution doesnot exactly hold – extrememarket events tend to makelosses more severe than wouldotherwise be expected
Current Value = mean μ
Potential gainsPotential losses
Loss at 1 standard deviation
“Fat tail” exposure
Value at Risk
12
μ- 2σ + 2σ
If the bank selects the95% confidence level(2σ) as its measure ofrisk tolerance, this will generate a singlenumber representingthe Value at Risk forthe portfolio
Potential gainsPotential losses
VAR is set here at the 95% confidence level
2.5% of all potentialvalues are found ineach of these areasunder the curve
Value at Risk
13
Credit Risk
• Credit risk is defined as the potential for loss if a customer fails to perform on their obligations
• Credit risk, and credit loss, occur both on the transaction and portfolio level
• The credit risk management model that follows shows how credit risk is handled
1414
23
Credit Risk Management ModelCredit Strategy for Line of Business
Target Market
Portfolio Limits:Concentration/Cross Border
Individual Credits
•Risk Acceptance Criteria•Risk Ratings•Documentation•Covenants•Due Diligence
Early Problem Detection Workout Loss
Annual Credit Review
Reporting
Credit Loss Assessment
Loan Review
Loan Loss Reserve
Line Management
Credit CommitteeApprovals
Risk Management Department
Risk Analysis
Portfolio Valuation
Risk Controls
Oversight/Monitoring
Color Code
Source: Durval C. Araujo
Effective Risk Management Process
1515
Risk Analysis
Set Credit Strategy:– By industrial sector (hydrocarbons, mining,
chemicals, agriculture, etc.)– By wholesale/retail (export/import firms,
grocers, tourist shops, hotels, etc.)– By individual (business owners, high net worth,
service industry)– Identify risk/return requirements
Effective Risk Management Process
1616
Risk Analysis
Set Target Market:– Which companies will be selected for
marketing?– How are industries to be defined?– Which SMEs qualify for credit?– How does the Target Market match with the
bank’s traditional strengths?
Effective Risk Management Process
1717
Risk Analysis
Assign roles, responsibilities, authorities:Assign Target Markets to the appropriate bank
department
Define who solicits clients, who assesses the credit risk, who books loans
Who is accountable if something goes wrong with the credit? What actions may they take?
Effective Risk Management ProcessEffective Risk Management Process
1818
Risk Controls
For the Portfolio:• Create portfolio limits and limits based on
risk ratings or credit quality• Ensure limits provide proper diversification• Determine how exposure against the limit is
measured• Define how exceptions to limits may be
approved
Effective Risk Management ProcessEffective Risk Management Process
1919
Risk Controls
Determine Committee Approval Process
CreditCommittee
Asset/LiabilityCommittee
ReserveCommittee
PolicyCommittee
PolicyCommittee
Risk Mgt.Committee
Highest LevelInternal Committee
Approves portfolio limits, large credits, credit policy
Approves loanloss reserves
Coordinatesrisk/return across bank
Manages marketrisk and bankliquidity
Effective Risk Management Process
2020
Risk Controls
For the Portfolio:
The combination of credit risk strategy, target markets, portfolio/concentration limits, and committee approval process constitutes the bank’s…..
……Credit Risk Philosophy
Effective Risk Management Process
2121
Risk Controls
Portfolio diversification is essential so that no one industry or individual credit becomes too large a part of the portfolio
Effective Risk Management Process
2222
Risk Controls
Proper credit risk management is not gambling….
….Proper credit risk management strikes a judicious balance between risk and return
Effective Risk Management Process
2323
Risk Controls
For individual credits establish:
• Risk Acceptance Criteria• Risk Ratings• Documentation and Covenant Standards• Due Diligence
Effective Risk Management Process
2424
Risk Controls
Risk Acceptance Criteria …
…define the types of credit products to be sold to a client, maximum amounts of acceptable exposure, collateral requirements, etc.
Effective Risk Management Process
2525
Risk Controls
Risk Ratings…
…are internal ratings (such as 1 to 10) used to assess the client’s credit-worthiness and loan loss potential…increasingly they mimic the rating system used by Standard & Poor’s or Moody’s…they determine the required loan loss reserves for the client’s exposure
Effective Risk Management Process
2626
Risk Controls
Legal Documentation and Covenants…
…are the minimum legal standards required from the client (such as parent guarantees for subsidiary exposure)…Covenants such as a maximum debt/equity ratio, pari passu clauses, etc. are important protections for the bank
Effective Risk Management Process
2727
Risk Controls
Due Diligence…
…defines what is expected of the loan officers who monitor the credit…this will include routine review of financial information, industry analysis, and checks on collateral
Effective Risk Management Process
2828
Portfolio Valuation
• In a sophisticated credit risk management process, all credits are treated on a portfolio basis
• In a portfolio, some credit risks increase total exposure, and some provide offsets
• Proper portfolio review identifies unacceptable concentrations of risk (by industry, product, maturity, etc.)
Ideally, credit reserves are set for the portfolio, not for the sum of all individual credit exposures
Effective Risk Management Process
2929
Portfolio Valuation
Probability of Default x Loss Given Default =
Expected Loss
Expected Loss Loan Loss Reserves
Effective Risk Management Process
3030
Portfolio Valuation
• Accurate credit portfolio valuation requires sophisticated computer modeling, and an excellent statistical history on credit losses by industry
• This will not be possible for Libyan banks; portfolio valuation for the time being will continue to be the sum of individual credit risks
Effective Risk Management Process
3131
Portfolio Oversight and Monitoring
• All loans require on-going review to detect any problems as soon as they occur
• If the problems get worse, the loan turns into a Workout credit, and may eventually require increased credit reserves or a charge against earnings for credit loss
Effective Risk Management Process
3232
Portfolio Oversight and Monitoring
• Workout loans are often defined as those credits whose Risk Rating has deteriorated beyond a certain point
• Workout loans can require tough negotiations with the customer
• The Workout loan is transferred from the loan officer who originated the credit, to a Workout loan unit specializing in problem credits
Effective Risk Management Process
3333
Portfolio Oversight and Monitoring
An independent unit is required to review the loan portfolio
This unit is Loan Review
Loan Review has the power to checkany aspect of a loan, change the riskrating, require additional reserves,and force a change in RiskAcceptance Criteria
Loan Review confirms underwritingand analysis comply with the bank’scredit policies
Effective Risk Management Process
3434
Portfolio Oversight and Monitoring
Many external players also provide oversight for the bank’s credit risk
• Bank auditors ensure that the loss reserve process follows acceptable accounting standards
• Central credit reporting bureaus such as Standard & Poor’s can downgrade the bank’s debt if problem loans increase
Effective Risk Management Process
3535
Portfolio Oversight and Monitoring
Many external players also provide oversight for the bank’s credit risk
• Regulators and supervisors frequently inspect the loan portfolio, and may require a change in Risk Ratings or in reserves
• The legal and judicial system enforces contracts and covenants, and provides for an orderly insolvency process
Effective Risk Management Process
3636
Small and Medium Enterprise
Lending
3737
The Secret of Lending to SMEs…
…Modernize Your Credit Process
Small and Medium Enterprise Lending
3838
Business Growth Patterns
Seed Start-Up Growth Stable Large Enterprise
SME Stage
Source: Bank Negara Malaysia
Small and Medium Enterprise Lending
3939
SME Credit Providers
Seed Start-Up Growth Stable Large Enterprise
Development Finance, Government
Venture Capital
Commercial Banks (Loans, Trade Finance)
Leasing and Factoring
Bond and Equity Markets
Small and Medium Enterprise Lending
4040
Challenges in Lending to SMEs
• Multiple financial books, usually unaudited
• Collateral difficult to value and secure
• Limited access to other forms of capital
• Often family owned and operated, and they are usually not familiar with banking forms, application process
Small and Medium Enterprise Lending
4141
Advantages of a Modern Credit Process
• The SME market can be carefully targeted, and credit guidelines properly arranged
• Many SME loans can be bundled together and treated as a portfolio
• Risk can be better matched against return
Small and Medium Enterprise Lending
4242
Using Risk Management skills when lending to an SME
– Set the target market carefully• Where does the bank have expertise – tourism
industry, agriculture, manufacturing?• Hire loan officers and risk managers who know these
industries well• Set Risk Acceptance Criteria – minimum size of
customer, basic financial condition, availability of collateral
Small and Medium Enterprise Lending
4343
Using Risk Management skills when lending to an SME
– Keep the loan product simple• Use a basic loan credit structure or trade
finance approach• Legal documentation should be easy to
understand for the borrower• Maturities should be short term
Small and Medium Enterprise Lending
4444
Using Risk Management skills when lending to an SME– Understand the risks
• Quantify the default probabilities for the industry involved, even if you must estimate
• Price the loans based on these probabilities• Determine the value of collateral and your
ability to sell collateral if necessary• Keep the loan amounts small
Small and Medium Enterprise Lending
4545
Using Risk Management skills when lending to an SME
– Manage the risks• How often does your banker need to meet
with the customer to assess financial condition?
• How expensive will any extra effort be?• Have a plan in place in case something
goes wrong
Small and Medium Enterprise Lending
4646
Using Risk Management skills when lending to an SME– Find a government partner
• Government has a strong policy interest in supporting SME lending
• Government can set up programs to educate entrepreneurs in applying for credit, making payments on time, preparing financial records, and keeping assets pledged as collateral in good condition
• Government may offer your bank insurance against SME losses
Small and Medium Enterprise Lending
4747
Using Risk Management skills when lending to an SME
– Manage the risks• Risk managers should monitor the portfolio
regularly• Is the rate of default in the portfolio higher
or lower than anticipated?• How much can be recovered after default?• Build up a data base of default history
Small and Medium Enterprise Lending
4848
Using Risk Management skills when lending to an SME
– Seek out opportunities• A few SMEs will grow to become
large corporations• Learn to spot these opportunities and
help them along with additional financing and new products
Small and Medium Enterprise Lending
4949
Measuring Your Success
– Did the portfolio behave as anticipated?
– Were defaults no greater over time than
expected?
– Were your returns sufficient to cover all
your costs plus generate the expected
return?
Small and Medium Enterprise Lending
5050
Measuring Your Success
– Did the risk managers work well with the business managers?
– Were your risk controls appropriate and useful?
– Did you develop a competitive advantage using Risk Management in a new market sector?
Small and Medium Enterprise Lending
5151
• Building on Your Success
– Expand your new Risk Management skills to other parts of the bank, and to other types of risks
– The result….
Better risk/return balance
Greater profitability
Stronger market position!
Small and Medium Enterprise Lending