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University Of Zimbabwe






Imagine you are the chief risk officer of a major corporation that operates as a bank.
The CEO wants you to assess a major new venture and from your assessment you are
convinced that the new venture is a positive net present value. Do an analysis and come
up with ideas that you expect me the CEO to know about as far as financial risk
management is concerned.
1 Introduction

The financial environment has become more riskier today than in the past. Globalisation;
removal of exchange controls and deregulation of interest rates has resulted in increased
market volatility in foreign exchange rates; interest rates and commodity prices. The
environment has rapidly changed over the last 3 decades ; and its mainly characterised by
financial innovation; increased competition as well as increased complexities. (Li;2003). This
has ultimately led to more opportunities and challenges. Such an environment encouraged
excessive risk-taking by most banks during the housing market. However ;huge subprime
losses at major banks such as Lehman Brothers; Meryll Lynch; Citigroup gave impetus to the
need for better risk management techniques. The primary function of the Chief Risk Officer
is to understand the risks the company is currently and intend to take in future and decide
which ones are acceptable and what action to take. Identifying and managing risks in projects
is always critical for success.( Koppenberger;2000). According to Briner, et al( 1997) huge
ventures attracts attention from senior managers ;and hence are more prone to risk and
failure. Hence a project with a higher net present value could be very risky; the general
principle of risk –reward trade off.

Definition of key terms

Net present value

Simply refers to present values of all cash flows less the initial investment. A positive present
value imply that present values of all the cash flows is larger than the initial investment.
Managers should accept project with positive net present value ;as it increases shareholders

Financial risk

Risk simply refers to the probability that actual outcome differs from expected outcome.
Financial risk however ;is a generic term which refers to the type of risk to which a financial
institution such as commercial bank is exposed for instance ;market risk and its various
forms;(equity price risk; interest rate risk; foreign exchange) ; credit risk; operational risk;
liquidty risk; technology risk and systemic risk.

Enterprise risk management

Is a holistic risk management process effected by an entity’s board of directors ;management,
and other personnel , applied in strategy setting and across the enterprise; designed to
identify potential events that may affect the entity , and manage risk to be within its risk
appetite ;to provide reasonable assurance regarding achievement of entity of objectives.

Risks faced by banks

A bank’s operations give rise to many risks. One of the results of the financial crisis of 2008
is that banks are now being tightly being regulated . Capital and liquidity requirements are
higher in order for them to meet the risks they are bearing. The main types of financial risk
include ;market risk; credit risk; liquidity risk; operational risk; systemic risk; regulatory or
compliance risk.

Market risk

Risk which depends on future movements on a multitude of market variables. (Hull; 2015). It
pertains in particular to short term trading in assets, liabilities and derivative products and
relates to changes in interest rates; exchange rates; and other asset prices. Modern conditions
have led to an increase in market risk especially in developed economies mainly due a
decline in traditional sources of income and a greater reliance by banks on income from
trading securities due to the process of disintermediation and shadow banking(Casu;et
al;2006). Market risk takes many forms which may include:

interest rate risk

can b e defined as a price established by the interaction of the supply of and the demand for
,future claims on resources. Interest rates have a crucial role in the financial system; for they
influence financial flows within the economy , distribution of wealth ; capital investment and
the profitability of financial institutions. For banks the exposure to interest rate risk has
grown sharply in recent years as a result increased volatility in market interest rates.

Foreign exchange

Is the risk that exchange rate fluctuations affect the value of a bank’s assets ,liabilities and off
balance sheet activities denominated in foreign currency. Banks have been engaged in trading
currencies where they make profits if they are favourable price movements between buying
and selling intervals. However banks do expose themselves to market risk . The foreign
exchange market is very volatile and as such banks need to have strong risk management
techniques.( Horcher; 2005).

Credit risk

According to the Basle Committee on Banking Supervision(2000) credit risk is defined as the
potential that a bank borrower or counterparty will fail to meet its obligations in accordance
with agreed terms. It is generally associated with loans ;however credit risk can also derive
from holding bonds and other securities. Credit risk can also be reflected through changes in
value of shares and ratings by the credit rating agencies. Banks should minimise credit losses
by building aportfolio of assets that minimise degree of risk. Zimbabwe banking sector also
had an issue of credit risk ; with the 2014 statistics revealing 20 % non-perfoming loans.

Liquidity risk

Is generated in the balance sheet by amismatch between the size and mauturity of assets and
liabilities. It is the risk that the bank is holding insufficient liquid assets on its balance sheet
and thus is unable to meet requirements without impairment to its financial or reputational
capital. Banks have to manage their liquidity to ensure that both predictable and
unpredictable demands are met.

Operational risk

Arise from possibility of fraud ; error;system or procedural problems. (Horcher;2005). The

ability to manage operational risk requires knowledge of processes ,systems and personnel
and the ability to ensure thta duties and procedures have been clearly established
,documented and followed. The complexities of financial products ,volatility of financial
markets,combined with the operational intricacies of an organisation can produce risks that
need to be managed carefully. Operational risk is one of the main innovations proposed for
basle 2 requiring banks to hold capital for such risks along with credit and market risk.

Regulatory risk

Like most industries the banking industry operate in a legal and regulatory framework which
priveleges some activities and also constrains some(Mallz;2011). Regulatory risk is
essentially the risk associated with change in regulatory policy. For example banks may be
subject to new risks if deregulation takes place and barriers to lending or to entry of new
Systemic risk

The risk faced by a financial system resulting from a systemic crisis where the failure of one
institution has repercussions on others ,thereby threatening the stability of financial
markets.The recent crises highlighted two main sources of instability in the banking system
;excessive leverage and interconnectedness through the highly volatile wholesale
market.(Carmaso;2009).The more deeply banks are connected the more they are likely to pull
each other into crisis ;through contagion effect.

Managing financial risk

Management of risk is a virtual part of good corporate gorvenance(Briner; et al 1997). Risk

analysis follows risk identification(Sharpano and Tatman ;1998) There are virtually two
strategies used to mange risk; risk decomposition which entails identifying risks ;one by one
and dealing with each separately and risk aggregation which implies relying on power
diversification to manage risks. However it is more effective to use both approaches to
manage risk. In coping with growing financial risksvarious derivatives products have been
developed for example ;options;swaps ;foward and future contracts. Since the 1990s we have
seen emergence of an active market for credit derivatives. These enable banks to be able to
hedge against credit risk. Likewise;futures and forward contracts are used to hedge against
foreign exchange risk; while interest rate swaps and caps are also used to hedge against
interest rate risk.

However ;although derivatives were initially created to hedge against risk ;argue they could
have also precipitated the global economic meltdown of 2008. Some of the complex financial
innovations and products created during the period could have enabled some banks to find
loopholes in the regulatory system ;that is ;regulatory capital arbitrage. However ; although
derivatives have been around for at least 2 decades now; they still have not yet been fully
grasped in emerging and most developing countries like Zimbabwe. Although there is
potentially high returns on equity and currency risks ;associated derivatives such as
futures;swaps;and options are not available in most emerging economies.(Mazin;2008).
Financial institutions in most developing countries are heavily regulated; thus many risk
management products are not available. In Zimbabwe ;Barbican Bank was prohibited in 2004
by the central bank to trade in derivatives.

Having identified these risks; it is imperative for the bank’s management to come up with
risk management tools that will be able to mitigate these risks at the same time exploiting the
opportunities that has been presented by this promising new venture.


INSTITUTIONS;John Wiley & Sons Inc; New York


EDITION;John Wiley & Sons Incoporated ;New Jersey

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