Group 131

Bucharest, May
2008
 Banking Risk Management

Table of content
1. Introduction…………………………………………………………………3
2. Banking risk definition……………………………………………………..3
3. Classification of banking risk according to the banking characteristics..4
3.1 The operational risk or the task risk…………………………………..4
3.2 The technological risk………………………………………………...4
3.3 The risk of the new product…………………………………………..4
3.4 The strategic risk……………………………………………………...4
3.5 The group of the environment risk……………………………………4
3.6 The fraud risk is an internal risk……………………………………....4
3.7 The economic risk……………………………………………………..4
3.8 The legal risk………………………………………………………….5
4. The representative risks for the banking activity…………………………5
4.1 The Crediting Risk……………………………………………………5
4.2 Liquidity risk………………………………………………………….6
4.3 Risk of capital…………………………………………………………6
4.4 Market risk…………………………………………………………….7
4.4.1 Interest rate variation risk………………………………………7
4.4.2 Exchange rate risk……………………………………………...9
5. How to manage risks…………………………………………………………10
5.1 Standards and reports………………………………………………...11
5.2 Limitations and rules…………………………………………………11
5.3 Guidelines and investment strategies………………………………...11
5.4 Stimulating tactics……………………………………………………12
6. Procedures of managing risks……………………………………………….12
6.1 Procedures of managing the credit risks……………………………..12
6.2 Procedures of managing the interest rate…………………………….13
6.3 Management procedures of external exchange risk………………….14
6.4 Management procedures of liquidity risk……………………………15
7. Conclusion…………………………………………………………………...16

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 Banking Risk Management

1. Introduction

In this paper we will try to introduce the complex universe of banking risks. Banks
play a central role in the economy due to the fact that they guard the savings of the
population, they offer means of payment for goods and services and they finance
businesses.
For fulfilling all these functions in a safe and efficient way, banks have to benefit of
the entire confidence of the population. The stability of the banking system represents a
problem of general public interest but it can be done without an adequate management of
the risks that banks confront themselves.

2. Banking risk definition

Banks and other lending institutions must constantly balance risks and rewards. Too
high a price on loan products, and you lose the customer; too low, and you starve the
profit margin or take a loss. Too much capital on reserve, and you miss investment
revenue; too little, and you risk regulatory noncompliance and financial instability.
When every department, line of business and region measures and reports risks
differently – with disparate risk management systems – it can be difficult to exactly
measure overall risk exposure and strike the right balance.
Between all the groups of risk exists a permanent interaction because they express
different aspects of the same potential risk- current banking operations. So, for example,
a real excessive exposition at the crediting risk may generate the liquidity risk if the bank
does not have sufficient liquid assets needed to fulfil its falling due obligations without
the help of the sums resulted from the reimbursement of the credit received by the client.
The risk of liquidity, at its turn, can generate the bankruptcy risk if the bank is not able to
procure fast its adverse resources. More than that, in the banking system, the problems
that a bank confronts itself can affect negatively other partner banks (that are creditors to
her) so that it there is a permanent danger of contagiousness. This risk is called
systematic risk and is administration is done by the central bank. This does not mean that
each bank should not follow in permanence the solvency of its partners by using all the
information that it has.

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3. Classification of banking risk according to

the banking characteristics

The carrying out risks is associated to the operation from the sphere of financial
services. The following types are comprised here:

3.1 The operational risk or the task risk, expresses the probability that the
bank can become incapable of assuring services for the clients in a profitable way. In this
context are important not only the offer of services but also the capacity of the top
management to evaluate and control the expenses generated by the carrying out of these
services;

3.2 The technological risk that is associated to the quality and structure of the
financial products offer which have an own cycle of life and tend to be replaced by better
services. The incorrect decision of launching on the market a product or of introducing a
new one can generate significant losses and there exists the risk that the moment chosen
is not the most adequate from the point of view of maximizing the banking profit;

3.3 The risk of the new product is associated to the innovations from the
sphere of the financial products. It expresses the cumulated probability that more adverse
events taking place, as : the demand is under the level anticipated, exceeding the planed
level of specific costs, the lack of professionalism of the managerial team, etc ;

3.4 The strategic risk expresses the probability of not choosing the proper
strategy in the given conditions. It is inherent to any selection of markets, products and
geographical zones that are implied in defining the strategy of the bank in a complex
environment.

3.5 The group of the environment risk comprises a class of risks with powerful
possible impact over the banking performance, but over which the bank has, in the best
scenario, a limited control. These risks express the probability that an adverse change of
the environment to affect negatively the profit of the bank:

3.6 The fraud risk is an internal risk that we have still included in this group due
to the fact that for a bank, seen as an entity, documents and especially the employee’s
intentions represent an external variable hard to control. The fraud risk is an internal risk
that expresses, actually, the probability of committing thefts or other acts contrary to the
interests of the bank by the banks employees. Frauds can affect the profitableness of the
bank when they can not be detected or recuperated;

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3.7 The economic risk is associated to the evolution of the economic environment
in which the bank and its employees act. It can be manifested at the local, regional,
national or international level. It expresses the probability of diminishing the performance
of the bank as a consequence of an adverse evolution of the environment conditions.
These influence the quality of the placements, the volatility of the resources and the
potential of risk;

3.8 The legal risk reflects the fact that the banks have to operate in the context
established by the legal rules even if these create a competitive disadvantage to other
competitive financial institutions. Other aspect of this risk is that there exists a permanent
incertitude regarding the future evolution of the normative environment in which the
bank performs its activity but also concerning the moment of implementation of new
legal rules.
As incidence and amplitude of the losses they generate, the above mentioned risks are
far the most significant for banks and due to that, their administration can bring a plus of
solvency to the bank.

4. The representative risks for the banking activity

4.1 The Crediting Risk

The most important function of managing a bank is controlling the quality of the
credit portfolio as the weak quality of credits is the main cause of bankruptcy for banks.
The banks’ bankruptcy, related to credit management, could mainly be the reason of:
- lack of attention in formulating the norms of crediting;
- the existence of too generous crediting conditions;
- disregard of the internal crediting norms by the bank’s staff;
- the risky concentration of credits on certain debtors;
- the weak control exercised upon the staff (upon the inspectors);
- the excessive growth of the crediting portfolio, beyond the reasonable possibilities
of the bank to cover the risks;
- the inefficient or inexistent systems of detecting the problematic credits;
- the lack of knowledge regarding the client’s treasury flow;
The portfolio of credits must be established taking into account the following
conditions:
- it must increase the productive action of the capital, so that every entrepreneur
with a limited capital, can enhance the working capacity of its business with the
help of the credit;

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- it helps at the capital concentration, as there are the credits that contribute to
capital creation, that would later on result in powerful enterprises;
- the credit saves the currency circulation, because almost all of the credit
instruments can, at a certain time, replace the cash;
- it helps to stabilizing prices, due to the fact that it causes production to gradually
enter and situate itself on the market;
- it must ease and finance the consumption, because it makes possible the selling in
installments;
- the credit contracted to be paid as periodic insurance fee, becomes in this way a
source of income to the insurance companies;
- a great amount of credits leads to credit inflation, causing economic instability
and even collapse;
- the use for speculation, when the capital which could be used for production is
blocked in speculative games on the market;
A thorough examination of the debtor, and of his credit needs, from different
perspectives, could prevent the creditor from making fatal mistakes.
The examination regarding the credit capacity is made, taking into consideration: the
demand, the exploitation conditions, the credit conditions. This assessment has to be
made carefully, following a specific procedure, for not causing disastrous effects for both
the creditor and debtor.
4.2 Liquidity risk

Liquidity represents the assets’ capacity to be turned quickly and with minimum costs
into cash or cash equivalents (liquid money).Banking liquidity represents a bank’s
capacity to finance its current operations. For a bank, liquidity risk emerges when it
cannot cope with its finance capacity, not having the possibility to make total payments.
Preventing a bank from making its payments also consists in the daily analysis by the
management of the bank and a correct estimation of the coverage of liquidity needs,
firstly taking into consideration the amount of financial assets in its portfolios: too many
liquid financial assets compared to its needs or the existing liquidities do not cover
payment needs. Liquidity insufficiency can create severe financial problems, especially
for small banks, even leading to the bank’s bankruptcy.

4.3 Risk of capital

The capital is the main element of the banking activity, financing the engaging of
human and material resources and in the same time leading to the protection of the bank
from immediate risks.

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Its size and structure are essential elements in setting the banking society risk. The
main factors that initiated and fuelled the diversification of banking capital are the
liberalization of the normative frame and the innovations on the capital market.
The liberalization must be looked upon as being in tight correlation with recognizing
(accepting) the new banking instruments by the authorities, as well as the increase of
competition on the financial markets and the relative decrease of interest, manifested for
placements in banking capital. The innovations on the capital market were the ones that
allowed the banks to use financial instruments related to their needs.
The risk of capital or bankruptcy is specific to all economic agents. Nevertheless, the
risk is over dimensioned in the banking sector due to their intermediating function.
As banks place primarily borrowed money, are more interested in attracting deposits,
increase their assets volume and reach a dividend’s rate as high as possible. This way the
leverage effect increases, the ratio of capital to total banking liabilities decreases, the risk
of bankruptcy becomes unavoidable, because the bank can afore only smaller losses at an
assets volume larger and larger.
To avoid such phenomenon, the banking authority has to regulate in many ways level
of minimum banking capital, like the following:
• minimum absolute value;
• deposit method;
• its structure.
The norms referring to the minimum capital for the banking agents are periodic
updated. According to the conditions of international markets competition it was reached
an international agreement regarding capitalization norms. The norms are named
COOKE and express a percentage of total capital from total assets, according to the level
of risk.

4.4 Market risk

Beside capital risk, market risk is becoming the main element of the financial risk
management system. Market risk expresses the probability that a variation in financial
markets negatively affects the profit of the bank.
The modifications of financial markets conditions can affect the bank through tree
independent transmission channels:
1. through the variation of the evolution trend of the level of interest rate;
2. through exchange rate variation;
3. through financial assets variation.
Market risk refers to the possibility to positively or negatively influence the market
value and/or profit of a financial institution as a consequence of an unexpected price
variation.
Market risk management can be made through:
• the transfer of risk through insurance;
• the management of assets and liabilities;
• the usage of derived instruments.
The factors determining the focus on market risk are:
• the increase of the competition level on financial markets;

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• the liberalization of the legislative framework for the development of banking

activities;
• the increase in market volatility;
• the development of new technologies and products.

4.4.1 Interest rate variation risk

The reduction of a bank’s global exposure to interest rate variation risk supposes both
margin maximization and interest rate volatility minimization. When the margins are
decreasing, establishing the level of interest rates becomes the main objective.
The margin management becomes primordial in risk analysis, through its nature, being an
indicator of efficiency for financial intermediaries.
This indicator expresses the ratio between incomes obtained through interest rates and
expenses with interest rates.
The factors affecting the sensitivity of banks to interest rate variation risk on the
market are both internal and external.

The main internal factors are:

• The structure of the bank’s assets and liabilities;
• The quality and the lagging of credits due dates;
• The due date of received funds.
The external factors are determined by the evolution of the economic, general
conditions, which reflect in the level of interest rate on the market. These can not be
controlled or influenced by the bank, but they can be anticipated, especially when
determining short-term rates according to economic cycle stage.
The indicators of banking sensitivity to interest rate variation are based on the
grouping of assets and liabilities according to the sensitivity of income and expenses
involved in the variation. The sensitive assets include credit instruments with variable
interest rates like commercial portfolio titles, exchange rate risk and credits.
The sensitive liabilities involve deposits with variable interest rates and loans, both
the ones on the market as well as the ones from the central bank.
The main risk indicators for the variation of interest rate are:
• the gap;
• sensitivity index
The gap represents the difference between assets and liabilities at a given moments.
The sensitivity index of the bank to the interest rate fluctuations is computed as the ratio
between sensitive assets and sensitive liabilities at a given moment.
For a bank’s strategy for interest rate variation risk, at any moment in time, the gap
should be zero and the sensitivity index 1.
According to the size of these elements, it can be determined the bank’s position and
the effects of market interest rates modifications on the banking interest rates margin.
Against the interest rate variation risk the bank’s position at a given moments in time
can be long, short or neutral.
The bank’s position is computed as the difference between assets and liabilities with
fix rates.
A bank is in a short position if it holds fewer assets with fix rates than liabilities of the
same kind. The short position is favorable when the rates have an increasing trend. The

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bank is in a long position when the assets with fix rates are more than the liabilities of the
same kind.
From the profitability point of view the long position is favorable during periods of
interest rate decline.
The risk of interest rate variation is present in both positions: at appears at the short
position if the rates decrease and at the long position if the rated decrease. The variations
of the interest rate level have consequences over the variation of the value of liabilities or
fix interest rate debts because:
• if the dept or liability is negotiable on a market then its trend will reflect the
interest rate variation, and the relation exchange rate/ interest rate is a negative
one: if interest rate increases, the exchange rate decreases. The gain/loss appears
at each patrimonial evaluation;
• if the dept or liability is not negotiable the gain/loss id reflected upon the bank’s
result till the due date.
Significant modifications of the equilibrium conditions on the market, of liquidity and
monetary policy can influence the interest rate curve in different ways. As the real
interest rates are relatively stable, the main factor seems to be the monetary policy of
banking authority, which influences agents’ anticipations concerning the level of inflation
rate and nominal interest rates.
As measures to reduce the structural exposure of banks to interest rates decrease are
used the followings:
• the usage of operations outside the balance sheet;
• the coverage of anticipated reimbursement risk or rate renegotiation for fix
interest rate portfolios;
• tariff policy for new banking products.
The usage of operations outside the balance sheet involves the coverage of due date
differences between placements/assets and resources/liabilities.
The coverage of anticipated reimbursement risk or rate renegotiation for fix interest
rate portfolios depends on:
• contractual penalties;
• medium rate differences;
• competition aggressiveness.
The third measure of reduction of decreasing interest rate risk is easier to apply and
involves the margin rise due to the general reduction of liabilities’ costs. In such situation
credits for investments will obviously be with variable rates whose pivot should be a
long-term rate.
Treasury credits are evaluated according to the basic rate which depends on the
financing costs of the specific bank.
The tariffs on new products have to influence the reduction of banking operations
costs in rates renegotiation. The easiest instrument is the credit with renegotiable rate and
minimum buffer rate.
Interest rate risk is expressed in the following formula:
Interest Rate Risk (IRR) = [Sensitive assets/Sensitive liabilities]x100

4.4.2 Exchange rate risk

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It expresses the probability that a variation of the exchange rate on the market
influences negatively the interest rate margin.
Exchange rate risk depends on the size of the difference between external assets and
liabilities, based on the following elements:
• the exposure generated by international assets by balance sheet consolidation;
• transactional exposure;
• economic exposure.
The translation exposure appears in the case of banks with international activity.
Subsidiaries have to report data and consolidate financial results in the respective
country’s currency.
The transactional exposure results from the fact that a series of operations are done in
foreign currency and the exchange rate can vary
The economic exposure reflects the influence of exchange rate fluctuations on the
bank’s value. It is relevant if it is expressed in the country of reference currency.
The basic indicators for the appreciation of exchange rate risk are:
• individual foreign currency position;
• global foreign currency position.
The individual foreign currency position is computed for each currency used, the bank
treating separately the operations in foreign currency of the other assets and liabilities.
For each foreign currency they compare assets and liabilities and from the computation
they can get two distinctive positions:
1. the short foreign currency position, when assets>liabilities;
2. the long foreign currency position, when assets<liabilities.
According to the variation of exchange rate, the foreign currency position can be
favorable or not. When the exchange rate increases, the short position is unfavorable and
when it decreases it becomes favorable.
The long position is favorable when the rate increases and unfavorable when the rate
decreases.
The exchange rate risk appears when the bank does some operations with foreign
currency for their clients or for their own.
The bank can compute easily at the end of each day the exposure to exchange rate risk
for each currency. This can be limited according to the size of banking funds, usually at
8% from their value according to the solvency rate standards. Exchange rate risk can be
managed in 2 ways:
• by the bank’s immunity
• by covering exchange rate risk
The bank’s immunity involves the periodic adjustment of the bank’s foreign currency
positions in order to suppress long and short positions. This is a very costly operation due
to management cost relatively high and it also present an opportunity cost, not permitting
to speculate a certain position according to the exchange rate trend.
The coverage of exchange rate risk is used more frequently. Although it also involves
high transactional expenses, in the case of this measure the risks to be taken are more
reasonable, easily anticipated. The organization of the exchange rate risk management
should take into consideration the following:
• exposure definition;
• risk evaluation;

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• risk minimization;
• transaction procedure

5. How to manage risks

If we take into consideration what we have said earlier, what are the necessary
procedures that have to be executed in order to have a good management of risks? What
are the basic techniques that are used to limit and manage the different types of risks, and
how are these techniques implemented in each risk control area? We now look to these
questions. After a classification of procedures that managers use, one view will emerge
from the examination of big risk management systems. These systems contain the
following parts:
1. standards and reports
2. limitations and rules
3. guide lines and investment strategies
4. contracts and stimulating rewards

In general, these tools are used to measure exposure, to define management

procedures, to limit individual positions to acceptable levels and to encourage decision
making persons to manage risks in a way that is consistent with the purposes and
objectives of the company. In order to see how these four parts of the basic techniques of
risks management reach their targets, we will detail each of them.

5.1 Standards and reports

The first of the management risks technique implies two conceptually different
activities, and they are: establishing the standards and the financial reports. They are put
side by side as they are the “sine qua non” conditions of any risks system. Enrolment to
standards, risks categorization and evaluation standards are all the traditional tools of risk
management and control. The evaluation and consistent measurement of different types
of exposure, is essential to understand the different types of risks from the portfolio, and
to measure where the risks have to be either reduced or absorbed.
The standardization of financial reports is the next ingredient. Obviously external
consultation, regulating reports and evaluation done by specialized agencies are essential
for investors to understand the quality of the goods and the risk level of the company.
These reports were standardized a long time ago, even if it was considered to be a bad or
a good thing. Anyway the need goes beyond public reports. Such internal reports need
similar standardizing and smaller intervals, daily or weekly not quarterly.

5.2 Limits and rules

The second tool use to control internal management of active administration is the use
of limits and participation standards. The second idea refers to the fact that assuming
risks is only limited to that goods that have certain quality standards. Then even for those
investments that are feasible, some limitations are imposed in order to cover the exposure

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to counterparties, credits and total concentrations on relative positions to different types

of risks. Although these types of limitations are expansive and hard to establish, their
enforcement restricts the risks that are taken by a certain person, and thus by the whole
entity. In general, any person that has capital, will have a well defined limit. This applies
to negotiators, “lenders”, and portfolio administrators. The summary reports show the
limitations and the current exposure for every business unit, periodically. In large
organizations, with thousands of positions, precise and on time reporting is difficult, but
even more important.

5.3 Guidelines and investment strategies.

Guide lines and proposed positions for the near future are the third technique currently
in use. Thus, the strategies are showed through the use of concentration terms and
employment in certain areas of the market, through the exposure size and asset-debt
equivalence.
The limitations described in the last paragraph lead to passive avoidance of risks
and/or diversification, because the administrators work in general between some written
limits and rules. But also, the guide lines give strict advices in regards to the right level of
asset administration, in the conditions of the current market and the superior management
desire to absorb the risks that involved in the aggregate portfolio. Plus, security and even
the derived activity are fast evolving techniques, available to anyone willing to reduce
their own exposure, and to be in accordance with the management guide lines.

5.4 Stimulating tactics.

Assuming that the management can conclude stimulating contracts with the executive
managers, and to relate compensations with the risk each one brings into this relationship,
then the need for expansive complex control is reduced. Anyway, these types of
stimulating contracts ask for precise evaluation of the adequate positions and internal
control systems. Such tools include position show, risk analysis, cost allocation, and
establishing the giving back to different parts of the organization, not being trivial.
Ignoring the difficulty well thought systems satisfy both the needs of the management
and of the demand in a very harmonious way. Actually, the majority of financial failures
can be considered a lack of stimulation, as in the case of deposit insurance and of traders
that think they are to smart.
The banking industry has took into consideration for a long time the problem of risks
management in order to control four of the risks that mentioned above, which constitute
the most important part of their exposure to risk, more precisely, credit risks, interest rate,
exchange rate and liquidity.

6. Procedures of managing risks

6.1 Procedures of managing the credit risks

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Each bank has to apply a consistent evaluation and pointing scheme of investment
opportunities, in order to make consistent decisions and for the aggregate result report of
exposure to risks to have a clear meaning. In order to facilitate this, a high degree of
standardization is needed for the process and documentation. This lead to pointed
standardization between borrowers and a portfolio report to present important
information about the general quality of the portfolio.
This report is a singular pointing system where a single value is given to each loan, in
relation with the quality of the give credit given to the borrower. In some institutions a
dual pointing system is used, in which they point both the loan and the credit. In this
system the attention is focused on guaranties, in the first system the focus is on trust that
can be given to the borrower. Some banks prefer a dual system, whilst others think that
this kind of system shadows over the return of the loan.
According to these standards the bank can report its credit portfolio quality at any
moment. The main idea is that what the bank has to receive its reported in a single
format, be it loans, rates or derivatives. Assuming the adhesion to these standards, the
total credit quality of the company is reported monthly to the management through this
system. Changes that appear in time to this report happen because of two reasons, the
appearance or disappearance of some credits, or the pointing changes of a certain credit.
The first reason is normal, the credits are returned and new credits appear. The second
one is more important, because it shows the possible losses in a credit portfolio. Actually,
the pointing system should show the changes of loss estimations, if it is a good system.
Moody’s studies over their own pointing system showed the relationship between the
points give to the credits and the previous results. A similar result is expected from every
system of this type, but general data scarcity from the industry does not permit the same
trust in forecasts.
In order for this type of credit quality report to have sense, all credits must be followed
and revised periodically. It is actually a standard to meet for all credits that are over a
certain amount to be revised quarterly or annually, in order to ensure the link between the
points give to the credit and the offered guarantees. Plus, a change in material conditions
associated either with the borrower or with the guarantees will result in a reevaluation.
This process has as a result a periodic report on the quality of the portfolio and the
change of this quality from month to month.
The general accepted accounting principles (GAAP) ask for this monitoring. The credit
portfolio is the subject of reasonable standards of values, which were made even harsher
by the financial accounting standards board (FASB). Commercial banks are asked to
have a reserve for loss cases, in order to precisely represent the diminishing of the market
value out of known o forecasted losses. As an industry, the banks have usually searched
for loss forecasting using a two step process, including ordinary probability, and an
estimate of the ordinary loss. These approaches are similar to those of Moody. At least
quarterly, the reserve level is renewed, taking into consideration the risk evidence of
direct losses retrieved from the quality report and from the migration of the loans study
through different quality markings.

6.2 Procedures of managing the interest rate

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The interest rate risk area is the second risk type being monitored and managed. But
here banks have traditionally taken a different path from the practices of other parts of the
financial sector. Most of the banks make a clear distinction from their commercial
activity and the exposure of their interest rate exposure in the balance sheet.
Investment banks have always considered interest rate risk as a classical part of
market risk and have developed complex management systems for this risk, in order to
monitor and measure the exposure. For the large commercial banks and universal
European banks, that do business with assets, these types of systems has become a
necessary infrastructure part. But actually these systems vary very much from bank to
bank, and are less realistic than they seem. In many companies there are luxurious value-
at-risk (VaR) systems, but even more companies are only at the incipient stage, in which
the older systems are replaced by simple systems, ad-hoc limitations and close
monitoring. These measures can be enough for the institutions that have a reduced
commercial activity, working in their clients’ name, but only there.
For the institutions that have a commercial activity, the VaR systems are a must, and
have become a standard. This procedure was discovered in Risk Metrics by J.P. Morgan,
but other companies have the same type of systems. There are enough documents about
these facts thus we will skip this part. We will only say that the daily, monthly or weekly
volatility of the market value of goods with fix interest rate are included in the risk
measure of the whole portfolio together with the stock market risk and the risk of
financial assets in foreign currency.
For the balance sheet exposure to interest rate risk, banks use a different method.
Considering the GAAP standards, established for bank property, and the close
relationship between property and debts, the commercial banks prefer not to use the
reports, guides and limitations of the market. But they rely mostly on cash-flows and
registers, with market value. This system is known as the “reporting system with gaps”,
because the asymmetry between goods reevaluation and debts form a gap. This is
measured in unmatched percentages over a standard period of 30 days and a year.
Most banks went a step forward, by trying to understand that this types of reports and
the duration ones as well are only static and do not reflect well the dynamic nature of the
banking market, where values change over night. The profit percentage variation is
responsible for the good performance of the industry from the last 2 years. Thus the
industry has added another analysis level balance sheet rate risk administration
procedures.
Now the banks use simulating models of balance sheets, in order to investigate the
effect of interest rate variation over a period of 1, 3 or 5 years. These simulations are of
course part science and part art. They demand informed reevaluating programs, and up
front payment and money course estimations. In what concerns the first problem, this
type of analysis asks for response function to the change of the interest rate known from
the banks point of view, in which the banks price decisions are stimulated for every
interest. The second problem, simulations ask for precise up front payment models for
property products, like middle market loans, but also standard products like residential
mortgages or consumer market loans. Plus, these simulations demand production curve
simulation in a relevant area of interest movements and the changes of this curve.
Once done, thee simulations report the final deviations from gains associated with the
considered scenarios. If these deviations are accepted or not it all depends on the

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management imposed limits, which are in general give as deviations of the most probable
income. This notion of Earnings at Risk (EaR) becomes a standard comparison for
interest rate risk. Its usefulness is actually limited, because it assumes that the interest
area is correct and that the banks answers are precise and feasible. Still, the results are
considered as reflecting the unmatched effect of the interest rate from the balance sheet.

6.3 Management procedures of external exchange risk

The most active banks from the field have big commercial accounts and multiple
locations and their reporting is simple. Currencies are held in real time, with spot and
forward options evaluated on the market. But to report options is easier than to measure
and limit the risks. Here the second one is more often seen, than the first one. Limitations
are established by the office and by the individual negotiator, with live monitoring by
some banks and at the end of the day by other banks.
Limitations are the key elements in external commerce risk administration, as well as
in all the other related to commerce. It is a standard that currency establishes the
limitations for spot and forward options in the use values set.

6.4 Management procedures of liquidity risk

There are two different types of liquidity risks that have evolved inside the banking
sector and each one of them has its own validity. The first and easiest from of all the
points of view is the continuum need of funds. Corresponding to the standard
management of money, the need of liquidity is easy to foresee and analyze, but the result
is not so useful. In the today capital market, the banks that we are talking about have
large growth resources and use debts only in the case of very large growths of assets.
Thus the tries to analyze liquidity risk as a necessity of growth resources or as means of
payment of credits are not important for this study.
Liquidity risk which is a real challenge is the need of funds when and if there is a
sudden crisis. In this situation, the things are different. Standard reports of current assets
and open credit lines are not o useful in this situation. We need to analyze the necessary
funds in case of the worst cases. These cases include needed liquidity for a specific shock
of the bank, after a very big loss and a crisis that comprises all the banks system. In each
case, the banks examines the mean through which it can help itself, in case of a crisis, and
it tries the speed of the shock that will eventually become this fund crisis. The reports are
based on both aspects of the crisis. Other institutions compute the speed with which
assets can become liquid to respond to the situation by using a report that indicates the
speed with which a bank can acquire liquidities in case of a crisis. The means of response
that we considered take into account the measure in which the bank can considerably
reduce the balance sheet and they make estimations of fund sources that will be available
to the bank during the crisis. The results are usually expressed in exposure days.
These types of studies by their nature are imprecise but essential for the efficiency of
the operations of substantial changes in their financial status. As a result, the authorities
in the field have begun to implement some plans for cases that are related to lack of
liquidity. There is though a clear distinction between the attitudes of the institutions
towards these rules. Some institutions find them useful; they make plans and invest in

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 Banking Risk Management

secondary lines, whilst others don’t do these things because they do not trust that they
will work under real conditions.

Other risks taken into account but not modeled:

Except the four basic financial risks, credit, interest, external exchange and liquidity,
banks have other interest areas as well. Some of this, like operational risk and the fall of
the system, are not part of the field of activity of the bank, and they try to avoid them by
using standard procedures. The costs and benefits of these activities are evaluated the
same as in any other field. Although they are called administrating risks, they are very
different from the financial risks, that we cover in this paper.
There are other risks that are harder to manage: legal, regulating, judicial, reputation
and environmental. In each of these fields, important resources are used to keep the
company undercover. But given the fact that these risks are harder to measure from the
financial point of view, they are only formally and structured studied. But they are not
ignored by management.

7. Conclusion

The banking industry is clearly evolving to a higher level of risk management

techniques and approaches than had been in place in the past. Yet, as this review
indicates, there is significant room for improvement. Before the areas of potential value
added are enumerated, however, it is worthwhile to reiterate an earlier point. The risk
management techniques reviewed here are not the average, but the techniques used by
firms at the higher end of the market. The risk management approaches at smaller
institutions, as well as larger but relatively less sophisticated ones, are less precise and
significantly less analytic. In some cases they would need substantial upgrading to reach
the level of those reported here. Accordingly, our review should be viewed as a glimpse
at best practice, not average practices. Nonetheless, the techniques employed by those
that define the industry standard could use some improvement.

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