Risk Management in Banking

Risks Faced By Banks

Credit Risk
The risk that the promised cash flows from loans, advances and
securities held by banks may not be paid in full.

Interest Rate Risk

The risk incurred by a bank when the maturities of its assets and
liabilities are mismatched.

Refinancing Risk
The risk that the cost of rolling or reborrowing funds will rise above the
returns being earned on asset investments.

Reinvestment Risk
The risk that the returns on funds to be reinvested will fall below the
cost of funds.

Contd.
Market Risk
The risk incurred in the trading of assets and liabilities due to change in
interest rates, exchange rates and other asset prices.

Inflation Risk
The risk that an increasing price level for goods and services will
unexpectedly erode that purchasing power of bank earning and
dividends to shareholders.

Foreign Exchange Risk

The risk that exchange rate changes can affect the value of a banks
assets and liabilities at abroad.

Liquidity Risk
The risk that a sudden surge in liability withdrawals may leave a bank in
a position of having to liquidate assets in a very short notice and low
prices.

Contd.
Operational Risk
The risk that the existing technology or support systems may
malfunction or break down.

Earnings Risk
Earnings of a bank may decline after all expenses including taxes are
covered due to unexpected factors within or outside the bank like
change in law.

Country or Sovereign Risk

The risk that repayments from foreign borrowers may be interrupted
because of interference from foreign governments.

Insolvency Risk
The risk that a bank may not have enough capital to offset a sudden
decline in the value of its assets and liabilities.

Contd.
Off-balance Sheet Risk
The risk incurred by a bank due to activities related to contingent assets
and liabilities.

Technology Risk
The risk incurred by a bank when technological investments do not
produce the cost savings anticipated.

Product Risk
The risk that a new product or service will ne sell.

Fidelity Risk
The risk that employees will cause losses by theft ( white collar crime).

Event Risk
The risk for a bank arising out of war, revolution or natural catastrophe.

Need for Risk Management

Competition and deregulation
Asset price volatility
Hedging scope
Government protection of banks via the lender of
the last resort and moral hazard
Regulation risks
Business risks increased (such as fraud)

Why is Risk Management Important?

To avoid failure is a principal reason for managing risk.
To ensure the quality of assets.

To make sure that the assets and liabilities of a bank is

properly matched.
To safeguard the value of assets in response to interest rate

movement.
To protect banks from the crisis of liquidity.
To ensure that a bank has enough capital to offset a sudden

decline in the value of its assets.

To be sure to certain extent that banks are making profit.

Prerequisites for Risk Management

In order to measure risk, the country must have solid
accounting and disclosure standards that provide accurate,
relevant, comprehensive and timely information so that
banks can assess the condition and performance of
borrowers and counterparties.
To ensure accuracy, accounting systems need to be
supplemented by auditing systems and backed up by
enforceable legal penalties for providing fraudulent or
misleading information to government agencies and
outsiders.
Banks also need reliable information on the credit history of
potential borrowers and on macroeconomic and financial
variables that can affect credit and other risks.

Contd.
Additionally, banks need a staff with sufficient expertise in
risk management to identify and evaluate risk.

Thus, an adequate legal system and credit culture, in

which borrowers are expected to repay and are penalized if
they do not, are yet further prerequisites for sound and

accurate risk management.

The ability to seize the collateral of borrowers in default is
essential if banks are to have the incentives and ability to
mitigate risk.

Contd.
Without the legal infrastructure - the laws, courts and
impartial judges - necessary to enforce financial contracts in

a timely manner, much of risk management would be for

nothing, once the initial decision to extend credit was
made.
Finally, the potential for conflicts of interest in risk
management must be limited. In particular, regulations are
needed that restrict and require disclosure of connected
lending to bank owners, shareholders or management.

Risk Management
Risk analysis
The risk management analyzes the risks of transactions that
the bank takes because of its business: credit, market and
operational risks.
It surveys whether the risks are in line with the risk appetite
the bank wants to take.
It informs the front office on the risk it takes on
transactions and whether the bank is sufficiently rewarded
for it.

Contd.
Investment and pricing decisions
The risk management has a key role in the decision making on
investment and pricing decisions.
Risk is involved in the early stage of the investment process,
because it is better to avoid risks up front than to manage highrisk positions afterwards.
Risk management often acts as a decision aid. The better the risk
management, the better future losses are avoided and the better
the return.
On top of yes/no investment decisions, the risk management also
provides a decision aid on a correct pricing with information on
minimum margins for the assessed risk level.

Contd.
Risk quantification
Risk management has evolved from a rather qualitative risk ordering
towards a quantitative risk environment that assigns numbers to
categories of high and low risks.
Such a risk quantification requires a good definition of risk measures,
data with risk experience and quantitative analysts to model the risk.

Risk monitoring and reporting

The risk of existing positions is continuously monitored. Individual
transactions may become more risky, especially on longer maturities or
because of important changes in the financial, market, or
macroeconomic situation.

Contd.
Strategic advisor
The risk management is a strategic advisor to indicate to
the management of the bank which product types it should
take.
It surveys whether the investment strategy and global riskreturn position are in line with the banks strategy. Risk is
about uncertainty, losses may impact the banks earnings
and erode its capital.

Risk management is necessary to assess the possible

impact changing economic and/or market conditions on the
bank and how to mitigate risks that are too high.

Contd.
Solvency

Bank capital is required to absorb unexpected losses. When losses exceed

expectations, the capital buffer serves to absorb an unexpected loss amount.

When the capital buffer is insufficient, the bank becomes insolvent. Solvency
risk depends on the possibility of unexpected high losses and the capital level.

For a given portfolio, the capital level needs to be determined to obtain a

sufficiently low solvency risk for the bank, that is determined by the
management.

Regulation recently evolved to more risk-sensitive capital rules. The new Basel
III accord defines rules in which a higher regulatory capital buffer is required for
riskier positions.

Risk Management Process

The main steps in risk management are

Identification
Measurement
Treatment
- Risk avoidance
- Risk reduction
- Risk acceptance
- Risk transfer
Implementation
Evaluation

Why financial intermediaries like

commercial banks are important?
Transaction costs

Asymmetric information
- Adverse Selection
- Moral Hazard

Adverse Selection and Banks

a.
i)
ii)

Banks as lenders
Face adverse selection of potential borrowers
Mitigating factors
- Screening
- Require collateral

b. Banks as borrowers
i) Depositors face adverse selection of banks as they have less
information than the banks on the condition of the banks.
ii) Mitigating factors
- Screening
- Government requires information be publicized
- Require collateral
- Regulation and supervision by government

Moral Hazard at Banks

a. Banks as lenders
i)
Monitor customers - check out their business physically
ii) Require collateral
iii) Put restrictive covenants
iv) Government has laws to adhere to certain regulations
b. Banks as borrowers
i)
Depositors should monitor the bank
ii)
Banks hold a large amount of capital
iii) Government regulations on bank:
- Capital requirements
- Accounting requirements
- Exposure limitations size and sector
- Bank examinations
- Loan quality
- Management procedures

Credit Risk Management

The most important techniques to manage credit risk are
Selection
Limitation
Diversification
Credit enhancement

A strong credit risk management avoids important pitfalls like

Credit concentration
Lack of credit discipline
Aggressive underwriting to high-risk counterparts
Product at inadequate prices

Contd.
There are four types of credit culture important for credit
risk management strategy
1. Value driven
2. Immediate-performance driven
3. Production driven
4. Unfocused

Questions?