R

What is Risk? hazard, a chance of bad consequences, loss or exposure to mischance any event or action that may adversely affect an organizations ability to achieve its objectives and execute its strategies

the quantifiable likelihood of loss or lessthan-expected returns

1 2

Risk is everywhere future cannot be predicted The intuitive commonsense of Risk- Reward coupling No risk; no reward Taking on more risk is sensible only if it results in greater likelihood of greater reward! Appetite for risk determines what reward one seeks And the good news is Risk can be Managed
1 3

Risk is Costly Greater risk imposes costs (reduces value) Example: Identical properties subject to damage. Greater expected property loss lowers value of property, all else equal Greater uncertainty about property loss often lowers value of property, all else equal
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Importance of Indirect Losses Direct Losses often cause indirect losses

Example: What are the direct and indirect losses if a manufacturing plant experiences a major fire?.
Cost of Risk Example Firm value in ideal world of no risk = Rs.1,000,000. Issues to be examined: What is firm value with risk of worker injuries? What is relation between firm value and cost of risk? Business is faced with one source of risk: Probability of worker injury = 1/10 Losses from a worker injury: medical expenses Rs.100,000 lost pay Rs.500,000 total Rs.600,000 Expected loss = Rs1/10 * 600,000 = Rs60,000 1

Option 1: Do Nothing Cost of risk: Expected loss = Rs.60,000 Cost of residual uncertainty = Rs.40,000 (assumed) Cost of loss control = Rs.0 Cost of loss financing = Rs.0 Cost of internal risk reduction = Rs.0 Total cost of risk = Rs.100,000 Firm value = Rs.1,000,000 Rs.100,000 = Rs.900,000

Option 2: Loss control Spend Rs.20,000 to reduce probability of loss to 1/20 Cost of risk: Expected loss = Rs.30,000 Cost of residual uncertainty = Rs.30,000 (assumed) Cost of loss control = Rs.20,000 Cost of loss financing = Rs.0 Cost of internal risk reduction = Rs.0 Total cost of risk = Rs.80,000 Firm value = Rs.1,000,000 Rs.80,000 = Rs.920,000
1 7

Option 3: Additional Loss control Spend an additional Rs.20,000 to reduce probability of loss to 1/40 Cost of risk: Expected loss = Rs.15,000 Cost of residual uncertainty = Rs.27,000 (assumed) Cost of loss control = Rs.40,000 Cost of loss financing = Rs.0 Cost of internal risk reduction = Rs.0 Total cost of risk = Rs.82,000 Firm value = Rs.1,000,000 Rs.82,000 = Rs918,000
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Option 4: No loss control, but full insurance Premium = Rs.75,000 Loading = premium - expected loss = Rs.75,000 Rs.60,000 = Rs15,000 Cost of risk: Expected loss = Rs.60,000 Cost of residual uncertainty = Rs.0 Cost of loss control = Rs.0 Cost of loss financing = Rs.15,000 Cost of internal risk reduction =Rs.0 Total cost of risk = Rs.75,000 Firm value = Rs.1,000,000 Rs.75,000 = Rs.925,000
1 9

Key points from example: Do NOT minimize risk, minimize cost of risk There are cost tradeoffs: Increase insurance coverage ==> Increase loading paid Decrease residual uncertainty Additional loss control ==> Decrease expected losses Increase loss control costs
1 10

Problem: If in an ideal world of no risk, the value of Building & Plant including Machinery & Equipment = Rs.120,000,000/-. Calculate the value of Building & Plant with risk of damage on all undermention options: Losses from a Building & Plant: Repair expenses = Rs.1,000,000/lost accrue due to change damage Machinery & Equipment = Rs.4,500,000/Total = Rs.5,500,000/What will be the Building & Plant value with risk of damage and the relation between Building &Plant value and cost of risk? Option 1:Firm face one source of risk with cost of residual uncertainty of Rs.500,000/- & Probability of loss = 1/5. Option 2:Spend Rs.90,000 to reduce probability of loss to 1/10 with cost of residual uncertainty of Rs.250,000/- . Option 3:Spend an additional Rs.80,000 to reduce probability of loss to 1/20 with cost of residual uncertainty of Rs.125,000/- . Option 4:Spend Rs.550,000 Insurance Premium against full coverage with no loss control and no cost of residual uncertainty.

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Problem: If in an ideal world of no risk, the value of a Bank is Rs.765,906,169,000/including all tangible & intangible assets. Calculate the value of Bank with risk of Cash & Valuable in lockers Burglary on all undermention options: Losses from Burglary : Damage expenses =Rs.056,000,000/Loss accrue due to cash Burglary =Rs.474,500,000/Loss accrue due to lockers Burglary =Rs.113,908,000/Total = Rs.644,408,000/Option 1:Firm face one source of risk with cost of residual uncertainty of Rs.13,000,000/- , Probability of cash Burglary = 1/5 & Probability of lockers Burglary = 1/5. Option 2:Spend Rs.22,500,000 to reduce Probability of cash Burglary = 1/10 & Probability of lockers Burglary = 1/8 with cost of residual uncertainty of Rs.12,250,000/- . Option 3:Spend an additional Rs.5,780,000 to reduce Probability of cash Burglary = 1/15 & Probability of lockers Burglary = 1/15 with cost of residual uncertainty of Rs.6,125,000/- Option 4:Spend Rs.52,000,000 Insurance Premium against full coverage with no loss control and no cost of residual uncertainty.

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Enterprise-wide Risk 1-Internal Risk People Risk Fraud Human Error Health & Safety Employment Law Training & Development Process Risk Financial Process & Control Customer Relationship Management Project Management Supply Chain Management
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Technology Risks Data Security Data Integrity System Performance Capacity Planning Change Management 2- External Risk Financial Risks Credit Risk Market Risk Liquidly Risk etc; Non-financial Risks Political Risk Competitor Risk
1

14

Socio Economic Risk External Fraud Identifying Business Risk Exposures Property Business income Liability Human resource External economic forces Earnings Physical assets Financial assets Medical expenses Longevity (durability)
1 15

Financial Risk We are primarily concerned with the main categories of financial risk: Market Risk- Pricing Risk Credit Risk- Default Risk Operational Risk- Failing Processes/Systems Liquidity Risk Funds Other Relevant Risks
1 16

Market Risk the risk of a change in the value of a financial position due to changes in the value of the underlying components on which that position depends, such as stock and bond prices, exchange rates, commodity prices, etc. Value of Financial Position Changes due to:

1- Interest rate risk is the risk of negative effects on the financial result and capital of the bank caused by changes in interest rates.
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2-Foreign exchange risk is the risk of negative effects on the financial result and capital of the bank caused by changes in exchange rates.
Problem: To explore the new relation with the customer, during bank representative visit to the customer, who wish to have Forward cover against import of goods for 180days $600,000 Usance LC. If the Spot Rate is Rs.87.98, profit on Foreign Currency is 5.85% and Borrowing Rate is 14.65%. Calculate the minimum rate with 2% margin a bank can offer to it's customer.

Credit Risk the risk of not receiving promised repayments on outstanding investments such as loans and bonds, because of the default of the borrower.
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Liquidity Risk - the risk that it will not be possible to sell a holding of a particular instrument at its theoretical price. Operational Risk the risk of losses resulting from inadequate or failed internal processes, people and systems, or external events.

Law, Compliance, Government AffairsLegal Risk, Regulatory Risk, enforceability Risk etc.
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Energy Risk- Increasing globalization and interdependence of energy products, delivery mechanisms, and risk management techniques. Exposure Risks include risks of banks exposure to a single entity or a group of related entities, and risks of banks exposure to a single entity related with the bank. Investment Risks include risks of banks investments in entities that are not entities in the financial sector and in fixed assets.
Stand-alone Risk Portfolio Risk
1

Sovereign Risk Probability that the government of a country (or an agency backed by the government) will refuse to comply with the terms of a loan agreement during economically difficult or politically volatile times.

Although sovereign nations don't "go broke," they can assert their independence in any manner they choose, and cannot be sued without their assent. Sovereign risk was a significant factor during 1970s after the oil shock when Argentina and Mexico almost defaulted on their loans which had to be rescheduled.
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What do you Mean by Risk Management? An integrated framework for managing credit risk, market risk, operational risk, economic capital, and risk transfer in order to maximize firm value.

22

Objective of Risk Management Need for a RM Objective Risk imposes costs on businesses and individuals. Risk Management (e.g., loss control and insurance) also is costly Tradeoffs must be made Need a criteria for making choices about how much risk management should be undertaken

Appropriate Criteria Minimize cost of risk - direct or overall Cost distribution: one time, periodical, over a certain time horizon.
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The Risk Management Process 1. Identification of risks 2. Evaluation of frequency and severity of losses, including maximum probable loss = value at risk 3. Choosing risk management methods 4. Implementation of the chosen methods 5. Monitoring the performance and suitability of the methods
1 24

Economic Capital - Capital is held to ensure that a bank is likely to remain solvent, even if it suffers unusually large losses. Available Economic Capital - The amount by which the value of all assets currently exceeds the value of all liabilities. Required Economic Capital- The amount by which the value of all assets should exceed the value of all liabilities to ensure that there is a very high probability that the assets will still exceed
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Function of Economic Capital 1. To Address the unexpected loss at certain confidential level for certain time horizon 2. nsure solvency and stability of Financial E Institutions in cases of market shocks 3. ay be aligned (associated) with the firms M risk appetite
1 26

State Bank of Pakistan As per the revision of capital requirements for new entrants, banks in different modes of operations are required a minimum paid up capital of Rs 10 billion, instead of Rs 2 billion previously, depicting a surge of Rs 8 billion or 400 percent. Minimum Paid up Dead line by which
Capital (Net of losses) Rs 5 billion Rs 6 billion Rs 10 billion Rs 15 billion Rs 19 billion Rs 23 billion to be increased 2008-12-31 2009-12-31 2010-12-31 2011-12-31 2012-12-31 2013-12-31

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IMPORTANT RATIOS 1. Debt to Service Coverage Ratio=Net Operative Income/ Debt Service - It is used to measure the ability of prospect to meet the financial obligation. For example, if the net income available to shareholder= Rs.55,234,098/- and its financial obligation against facility= Rs.24,777,980/2. Loan to Value Ratio= Amount of Facility/ Value of Asset or Security - It is used to measure the security is to facility amount in order to recover the facility in case of default.
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Bank Regulation and Basel

Important State Objective Bank -Stable Economic Environment for Private Individuals and Businesses. -Providing Reliable Banking System & Protect Depositors even in the event of Bank Failure. -Deposit insurance introduced to build the depositors confidence. -Bank Regulators prescribe minimum level of capital to cover the worst case loss over some time horizon (possibility).
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The worst case loss is the loss that is not expected to exceed with some high degree of confidence. The high degree of confidence might be 99% or 99.9%. The expected losses are covered as product price. For example: the interest charged by the bank is designed to recover expected loan losses. Capital is a cushion to protect the bank from extremely un-favourable outcome.
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Reason For Regulating Bank Capital Bank regulation is unnecessary. Even if there were no regulations, banks would manage their risks prudently and would strive to keep a level of capital that is commensurate (matching) with the risks they are taking. Without state interventions, banks that took risks by keeping low levels of capital equity. Deposit insurance may encourage banks for low equity. Due to cost of insurance, regulations on the capital banks must hold.
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The capital a financial institution requires should cover the difference between expected losses over some time horizon and worst-case losses over the same time horizon. The idea is that expected losses are usually covered by the way a financial institution prices its products. For example, the interest charged by a bank is designed to recover expected loan losses. Capital is a cushion to protect the bank from an extremely unfavorable outcome
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Risk Based Assets = Total Asset - Cash and Equivalents Fixed Assets OR Risk Based Assets = Other Earning Assets excluding Loans + Net Loans

Basel
Basel Accord: The Basel Committee on Banking Supervisons regulatory framework of capital standards for banks, established in 1988 to protect bank owners, depositors, creditors, and deposit insurers (e.g., governments) against financial distress.
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The Road to Basel Risk management: one of the most important innovations of the 20th century. [Steinherr, 1998] The late 20th century saw a revolution on financial markets. It was an era of innovation in academic theory, product development (derivatives) and information technology and of spectacular market growth.
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 Large derivatives losses and other financial incidents raised banks consciousness of risk.

Banks became subject to regulatory capital requirements, internationally coordinated by the Basle Committee of the Bank of International Settlements.

35

Some Dates 1950s. Foundations of modern risk analysis are laid by work of Markowitz and others on portfolio theory. 1970. Oil crises and abolition of BrettonWoods turn energy prices and exchange rates into volatile risk factors. 1973. CBOE, Chicago Board Options Exchange starts operating. Fisher Black and Myron Scholes, publish an article on the rational pricing of options. [Black and Scholes, 1973]
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 1980s. Deregulation; globalization - mergers on unprecedented scale; advances in IT.

The Regulatory Process

1988. First Basel Accord takes first steps toward international minimum capital standard. Approach fairly crude and insufficiently differentiated.

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The BIS Accord defined two minimum capital adequacy requirements: 1. The first standard was similar to that existing prior to 1988 and required banks to have assets-to-capital multiple of at most 20. Assets-to-capital <+20 2. The second standard introduced what became known as the Cooke ratio. 3. The Cooke Ratio Used to calculate what is known as the banks total risk-weighted assets (also sometimes referred to as the risk-weighted amount).
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Cooke ratio calculated both on-balance sheet and off-balance sheet. Risk weight for on balance sheet items
Risk Weight % Asset Category
Cash, gold bullion, claims on OECD governments such as T. Bonds or insured residential mortgage Claims on OECD Banks and OECD public sector entities such as securities issued by government agencies or claims on municipalities

0 20

50
100

Uninsured residential mortgage loans

All other claims, such as corporate bonds and lessdeveloped country debt, claims on non-OECD Banks, real estate, premises, plant & equipment. 1 39

Calculate risk weighted assets (RWA), if the assets of the banks consist of $100 million of corporate loans, $10 million of OECD government bonds, and $50 million of residential mortgages. RWA= 1.0*100 + 0.0*10 + 0.5*50 = $125 Million
Problem: Calculate the risk weighted assets, if the assets of bank consist of Rs. 579.59 million of retail loan with the risk weight of 35.67%, Rs. 299.98 million of mortgages with the risk weight of 21.45%, Rs.987.09 million of corporate loans with risk weight of 16.79% and Rs.887.89 million of state loans with risk weight of 0%. Problem: Calculate the risk weighted assets, if the assets of bank consist of Rs. 799.09 million of corporate loan with the risk weight of 19.75%, Rs. 199.98 million of T.B with the risk weight of 0%, Rs.337.95 million of SME loans with risk weight of 36.79% and Rs.233.56 million of agriloans with risk weight of 37.08%.
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Off balance sheet items are expressed as Credit Equvilent Amount.

Credit Equvilent Amount is the loan principal that is considered to have the same credit risk. Credit perspective are considered to be similar to loan, such as bankers acceptance, have a conversion factor of 100%.

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1993. The birth of VaR. Seminal G-30 report addressing for first time off-balance-sheet products (derivatives) in systematic way. At same time JPMorgan introduces the *Weatherstone 4.15 daily market risk report, leading to emergence of RiskMetrics. 1996. Amendment to Basel I allowing internal VaR models for market risk in larger banks. Also referred as BIS 98.
The Amendment requires financial Institutions to hold capital to cover their exposure to market risks as well as 1 42 credit risks.

*Weatherstone Capital Management is a money management firm that utilizes active money management strategies that are designed to generate strong returns while reducing the level of risk that is found in most stock and bond market investments. Goal is to provide investment programs that generate strong returns relative to the amount of risk that is taken. Allows conservative and risk conscious investors the ability to comfortably allocate a higher portion of their investment portfolios to the segments of the financial markets that have historically generated the highest returns.
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Credit Risk Capital charged in 1988 Amendment also apply to all on-balance sheet and off-balance sheet in the trading and banking books, except positions in the trading books that consist of: Debt and equity trade securities and Positions in commodities and foreign exchange.

The market risk capital requirement for banks by using internal model-based approach k*VaR + SRC
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Where k=multiplicative factor, VaR= value at risk & SRC= specific risk charge

RWA for market risk capital is defined as 12.5 *k*VaR + SRC

The total capital required for Credit and Market Risk is given by
Total Capital= 0.8 x (Credit risk RWA + Market risk RWA)

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2001 onwards. Second Basel Accord, focusing on credit risk but also putting operational risk on agenda. Banks may opt for a more advanced, so-called internal-ratings-based approach to credit. July 2009 onwards, Second Basel Accord, focusing on Revised Securitisation and Trading Book Rules & implemented by Dec 2011. Nov 2010 Third Basel (G 20 endorsement of Basel III) will be implemented by Jan 2013Jan2019.
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Basel II: What is New? Rationale for the New Accord: More flexibility and risk sensitivity Structure of the New Accord: Three-pillar framework: Pillar 1: minimal capital requirements (risk measurement) Pillar 2: supervisory review of capital adequacy

Pillar 3: public disclosure

1

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Two options for the measurement of credit risk: Standard approach Internal rating based approach (IRB) For an on-balance-sheet item a risk weight is applied to the principal to calculate riskweighted assets reflecting the creditworthiness of the counterparty. For off-balance-sheet items the risk weight is applied to a credit equivalent amount. This is calculated using either credit conversion factors or add-on amount.
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-Standardized approach (for small banks. In USA, Basel II will apply only to the largest banks and these banks must use the foundation internal ratings based (IRB) approach). risk weights for exposures to country, banks, and corporations as a function of their ratings. Pillar 1 sets out the minimum capital requirements (Cooke Ratio): total amount of capital 8% risk-weighted assets Total capital = 0.08*(credit risk RWA + Market risk RWA + Operational risk RWA).
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 MRC (minimum regulatory capital) def = 8% of risk-weighted assets Explicit treatment of operational risk The Market Risk Capital Requirement: k * VaR + SRC, where SRC is a specific risk charge. The VaR is the greater of the pervious days VaR and the average VaR over the last 60 days. The minimum value for k is 3.
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Operational Risk: Banks have to keep capital for operational risk. Three approaches. - Basic indicator approach: operational risk capital = the banks average annual gross income (=net interest income + noninterest income) over the last three years multiplied by 0.15. - Standardized approach: similar to basic approach, except that a different factor is applied to the gross income from different business lines.
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-Advanced measurement approach: the bank uses its own internal models to calculate the operational risk loss that it is 99.9% certain will not be exceeded in one year. Tier 1 - Capital- Equity and similar sources of capital Tier 2 - Subordinated debt (life greater than five years) and similar sources of capital. Tier 3 - Short term subordinated debt (life between two and five years).
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Calculation of total risk weighted assets under the Basel II standardized approach, if the assets of the bank consist of $100 million of loans of corporation rated A (weighted risk=50%).$10 million of government bonds rated AAA(weighted risk=0%), and $50 million residential mortgages(weighted risk=35%).

Total Risk Weighted Assets = 0.5 *100 + 0.0*10 +0.35*50= $67.50 Million
Problem: Calculate the risk weighted assets under the Basel II standardized approach, if the assets of bank consist of Rs. 579.59 million of retail loan average rating of A+ Rs. 299.98 million of mortgages , Rs.987.09 million of corporate loans average rating of AA- and Rs.887.89 million of state loans average rating of AAA.
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Problem: Calculate the risk weighted assets under the Basel II standardized approach, if the assets of bank consist of Rs. 799.09 million of corporate loan with average rating of A-, Rs. 199.98 million of T.B with average rating of AAA, Rs.337.95 million of SME loans with average rating of A+ and Rs.233.56 million of agri-loans with average rating of BBB+. AAA To AACountry A+ To ABBB+ To BBBBB+ To BBB+ To BBelow B Unrated

20

50

100

100

150

100

Banks
Corporations

20
20

50
50

50
100

100
100

100
100

150
150

50
100

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Adjustment for Collateral There are two ways banks can adjust risk weights for collateral.

1- Simple Approach- the risk weight of the counterparty is replaced by the risk weight of the collateral for the part of the exposure covered by the collateral.
2- Comprehensive Approach- banks adjust the size of their exposure upward to allow for possible increases and adjust the value of the collateral downward to allow for possible decreases in the value of the collateral.
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Example: Suppose that an $80 million exposure to a particular counterparty is secured by collateral worth $70 million. The collateral consist of bonds issued by an A-rated company. The counterparty has a rating of B+. The risk weight for the counterparty is 150% and the risk rate for the collateral is 50%. The risk weighted assets applicable to the exposure using the simple approach is therefore 0.5 x 70 + 1.50 x (80 -70) = 50 Consider next the comprehensive approach. Assume that the adjustment to exposure to allow for possible future increases in the exposure is +10% and the adjustment to the collateral to allow for possible future decreases in its value is -15% (1.0 + 0.10) x 80 (1.0 0.15) x 70 = 1.10 x 80 0.85 x70 =88 59.5= 28.50 If the risk weight of 150% is applied to the exposure, the risk adjusted assets equal to 42.75 million (1.50 + .10) x 80 (1.50 -.15)x70 =128 94.5 1?????? 56

Expected losses are those that the bank knows with reasonable certainty will occur (e.g., the expected default rate of corporate loan portfolio or credit card portfolio) and are typically reserved for in some manner. Unexpected losses are those associated with unforeseen events (e.g. losses experienced by banks in the aftermath of nuclear tests, Losses due to a sudden down turn in economy or falling interest rates). Banks rely on their capital as a buffer to absorb such losses. Risks are usually defined by the adverse impact on profitability of several distinct sources of uncertainty.
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SBP Guidelines on Internal Credit Risk Rating Systems The banks are required to establish criteria to map their internal obligor & facility ratings according to the broad regulatory definitions of rating grades 1 to12. Facility grades should be assigned according to the severity of the expected losses in case of default, keeping in view the factors from A to F.
OBLIGOR/ FACILITY

1 A1 B1 C1

2 A2 B2 C2

3 A3 B3 C3

4 A4 B4 C4

5 A5 B5 C5

6 A6 B6 C6

7 A7 B7 C7

8 A8 B8 C8

9 A9 B9 C9

10 A10 B10 C10

11

12

A B C

A11 A12 B11 B12

C11 C12

D
E F

D1
E1 F1

D2
E2 F2
1

D3
E3 E3

D4
E4 F4

D5
E5 F5

D6
E6 F6

D7
E7 F7

D8
E8 F8

D9
E9 F9

D10
E10 F10

D11 D12
E11 F11 E12
58

F12

IRB (Internal rating based) approach onefactor Gaussian copula model of time to default. WCDR: the worst-case default rate during the next year that we are 99.9% certain will not be exceeded PD: the probability of default for each loan in one year EAD: The exposure at default on each loan (in dollars) LGD: the loss given default. This is the proportion of the exposure that is lost in the event of a default.
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Expected Loss (EL) Calculation Lending institutions need to understand the loss that can be incurred as a result of lending to a company that may default; this is known as expected loss (EL). EL can be expressed as a simple formula:

EL = PD * LGD * EAD
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The total exposure to credit risk is the amount that the borrower owes to the lending institution at the time of default; the exposure at default (EAD). Generally, EAD will not be larger than the borrowing facility.

PD & LGD are risk metrics employed in the measurement and management of credit risk. The metrics are used to calculate EL.

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The probability of default (PD) is the likelihood that a loan will not be repaid and will fall into default. It must be calculated for each borrower. The credit history of the borrower and the nature of the investment must be taken into consideration when calculating PD. External ratings agencies such as Standard and Poors or Moodys may be used to get a PD; however, banks can also use internal rating methods. PD can range from 0% to 100%. If a borrower has 50% PD it is considered a less risky company vs. a company with an 80% PD.
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For Example: A borrower (Company X) takes out a loan from Bank ABC for $10 million (EAD). Company X pledges $3 million collateral against this loan (for simplicity, lets say the collateral is cash). The Companys PD is determined by analyzing their credit risk aspects (evaluate the financial health of the borrower, taking into account economic trends, borrower relationship with the bank, etc.) For Company X, lets say the PD is 0.99. This means that the Company is extremely risky; the probability of them defaulting on the loan is 99%.

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Loss given default (LGD) is the fractional loss due to default. Continuing from the previous example: If Company X defaults (is unable to pay back the $10 million to Bank ABC), the Bank will be able to recover $3 million (this is the cash-secured collateral). So, how do we calculate the actual loss given default (LGD)? LGD = 1 Recovery Rate (RR) The Recovery Rate (RR) is defined as the proportion of a bad debt that can be recovered. It is calculated as: RR = Value of Collateral/Value of the Loan
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Back to our example, the recovery rate for Bank ABC = $3 million/ $10 million = 30% So % LGD= 1- 0.30 = 0.70 or 70%. $ LGD= 70% of a $10 million (EAD) loan is equal to $7 million. $ LGD = $7 million

Expected Loss (EL) is what a bank can expect to lose in the case that their borrower defaults. It is calculated below: EL = PD * LGD * EAD EL= 0.99* 70% * $10 million EL = $6.93 million Bank ABC can expect to lose $6.93 million
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Problems: Kamran & Sons is a company rated as A+ takes out a loan from Bank ABC for Rs.150 million against the mortgage of residential property having market value for Rs.160 Million & forced sale value for Rs.110 million(for simplicity, lets say the collateral is cash). Calculate the PD, LGD, EAD and EL . Problems: If the loan wise credit exposure of a bank alongwith other data PD is given below:

Type of Loan Corporate Loans Retail Loans Agri- Loans State Loans

Exposure Security Cash Value 241,673,000,000 229.885,000,000 329,881,000,000 299,887,000,000 098,875,000,000 034,888,000,000 167,988,000,000 000

Rating
AA+ ABB+ AAA

On the bases of above data calculate the EAD, LGD , EL & EL %. Problem: If the credit exposure against the medium term loans of a financial institution as per loan rating is given below: Exposure Rating 241,673,000,000 AAA 329,881,000,000 AA098,875,000,000 AA+ 167,988,000,000 B 196,778,000,000 BBOn the bases of above data 1calculate the EAD, LGD ,EL & EL %. 66

The VaR Measure Value at Risk (VaR) is an attempt to provide a single number that summarizes the total risk in a portfolio of financial assets.

VaR measure is used by the Basel Committee in setting capital requirements for banks throughout the world.

67

Value at Risk: A loss that will not be exceeded at some specified confidence level.
We are X% certain that we will not lose more than $V in the next N days. The Variable V is the VaR of the portfolio. It is a function of two parameters the time horizon (N days) and the confidence level (X%). E.g; In 5 days (N=5), VaR is the loss corresponding to the (100- 97)%=3 % (X=97%) of the distribution of the change in the value of the portfolio over 5 days.
1 Portfolio gain is +ve & Loss is ve. 68

Using the VaR measure with N=10 and X=99. This means that it focuses on the revaluation loss over a 10 day period that is expected to be exceeded only 1% of the time. VaR vs Expected Shortfall VaR is used in an attempt to limit the risks taken by a trader. Suppose that a bank tells a trader that the oneday 99% VaR of the traders portfolio must be kept at less than $10 million. Trader can construct a portfolio with 99% chance that the the daily loss is less than $10 million but 1% chance of loss of $500 million.
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Expected Shortfall, like VaR, is a function of two parameters: -N(the time horizon in days) and -X (the percentage confidence level) Expected loss during an N-day period conditional on the loss being greater than the Xth % of the loss distribution. E.g; X=99 and N=10, the expected short-fall is the average amount lost over ten day period assuming that the loss is greater than 99th % of the loss distribution.
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Properties of Risk Measures A risk measure used for specifying capital requirements can be thought of as the amount of cash 9or capital) that must be added to a position to make its risk acceptable to regulators. Proposed Properties that such a Risk Measure should have: Monotonicity: If a portfolio has lower returns than another portfolio for every state of the world, its risk measure should be greater. Translation invariance: If we add an amount of cash K to a portfolio, its risk measure should go down by K.
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Homogeneity: Changing the size of a portfolio by a factor while keeping the relative amounts of different items in the portfolio the same should result in the risk measure being multiplied by . Subadditivity: The risk measure for two portfolios after they have been merged should be no greater than the sum of their risk measure before they were merged. First three conditions are risk acceptable by adding cash needed to the portfolio. Forth condition states that diversification helps reduce risks.
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Example: Consider two $10 million one-year loans each of which has a 1.25% chance of defaulting. If a default occurs on one of the loans, the recovery of the loan principal is uncertain, with all recoveries between 0% and 100% being equally likely. If the loan does not default , a profit of $0.2 million is made. To simplify matters, we suppose that if one loan defaults then it is certain that the other loan will not default. For a single loan, the one-year 99% VaR is $2 million. This is because there is a 1.25% chance of a loss occurring, and conditional on a loss there is an 80% chance that the loss is greater than $2 million. The unconditional probability that the loss is greater than $2 million is therefore 80% of 1.25% or 1%. Consider next the portfolio of two loans. Each loan defaults 1.25% of the time and they never default together. There is therefore a 2.5% probability that a default will occur. The VaR in this case turns out to be $5.8 million. This is because there is a 2.5% chance of one of the loans defaulting, and conditional on this event there is an 40% chance that the loss on the loan that defaults is greater than $6 million. The unconditional probability that the loss on the defaulting loan is greater than $6 million is therefore 40% of 2.5%, or 1%. A profit of $0.2 million is made on the other loan showing that the one-year 99% VaR is $5.8% million. The total VaR of the loans considered separately is 2 + 2 = 4 million. The total VaR after they have been combined in the portfolio is $1.8 million greater at $5.8 million. This is in spite of the fact that there are very attractive diversification benefits from combining the loans in a single portfolio.
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Pure Risk Characteristics and Management Generalizations: Pure risk usually involves large potential losses relative to the expected loss and relative to available resources. Pure risk involves events that are firm-specific Price risk affects many firms Pure risk is managed by insurance Price risk is managed by derivatives (forward & option contracts, hedging) Pure risk involves wealth losses to society Price risk often involves wealth redistributions in society
Nevertheless, we use the same framework for management of pure risk and price risk 1
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What Is Credit Persons confidence in person. Credit Risk: A Performance Risk: specifically, the risk of loss due to a Borrowers/Debtor's non-payment of a loan or other obligation (i.e., the possibility that borrowers will not repay their loans on time or at all). Borrowers: Lenders distinguish between retail and commercial borrowers. Banks customize products to meet each groups unique financial needs.
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The Principles of Good Lending The Credit Analysis Process: Information sources/data-gathering Complete a comprehensive analysis The Five Cs of Credit The structured framework of analysis Rating agencies and other analytical tools

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The principles of lending ensure that the Borrower is able to make payments as and when due: To identify a clear purpose with defined terms To understand the Borrower and Borrower needs To understand the collateral/security To understand repayment risk (liquidity or solvency) To understand the future deterioration factors that may impact cash flow and thus, repayment of the obligation(s)

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Steps of the Credit Process (how banks lend money) Several sequential steps Management Profile Company Profile Industrial Review Credit History Facility Structure etc Identify the credit opportunity Evaluate credits Monitor credits on an ongoing basis

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Steps and considerations when evaluating credits Credit analysis process evaluates the borrowers ability to repay Assess the borrowers financial position using several different methods and sources of information Banking Book Management Banks use various tools to reduce the overall risk of their loan portfolios

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The 5 Cs (or 7 Cs) of Credit: 1.Character 2.Conditions 3.Capital 4.Capacity 5.Collateral 6.Common sense 7.Control 1- Character: Character is a lenders way to summarize a borrowers determination to manage its cash position and more importantly, honor its obligations (financial or otherwise).
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2- Conditions: Conditions focus on the economic and environments influences that may impact a companys financial position and its ability to honor its obligations. 3- Capital: The financing structure and level of capitalization (leverage) of a company. 4- Capacity: The predictability and sustainability of the cash flows of a company to service debt.
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5- Collateral: Collateral protects the lender when all else fails. In lending, collateral represents a borrowers asset pledge to secure a loan (collateral is a lenders protection in the event of a borrowers default). Structured Framework of Analysis*: Banks must have credit risk management systems that: Produce accurate and timely risk ratings Accurate classification of the ratings Well-managed credit risk rating systems promote bank safety and soundness by facilitating informed decision making.
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The Principles of Credit Risk through a review of a Structured Framework of Analysis -Business Risk -Financial Risk -Structural Risk Business Risk Influenced by: Macro economic trends Industrial Status Micro economic trends
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Include: Economic environment Business cycles Industry and regulatory trends Political risks Other social issues Changes to these factors have implications to business and credit wide ranging

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Financial Risk

Affected by:
Quality of management Company operation Financial position

Include:
Management strategy and skills Management integrity Company systems The borrowers operating and financial performance
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Structural Risk Reflect how the loan is structured:

Terms Payments Collateral Other credit features

The borrowers support of repayment: Collateral The ability (willingness) to pay
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Loss Distributions To model risk we use language of probability theory. Risks are represented by random variables mapping unforeseen future states of the world into values representing profits and losses.
The risks which interest us are aggregate risks. In general we consider a portfolio which might be a collection of stocks and bonds; a book of derivatives; a collection of risky loans; a financial institutions overall position in risky assets.
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Portfolio Values and Losses Consider a portfolio and let Vt denote its value at time t; we assume this random variable is observable at time t.

Suppose we look at risk from perspective of time t and we consider the time period [t, t + 1]. The value Vt+1 at the end of the time period is unknown to us.
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The distribution of (Vt+1 Vt) is known as the profit-and-loss or P&L distribution.

We denote the loss by Lt+1 = (Vt+1 Vt).

By this convention, losses will be positive numbers and profits negative. We refer to the distribution of Lt+1 as the loss distribution.
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Risk Factors Generally the loss Lt+1 for the period [t, t + 1] will depend on changes in a number of fundamental risk factors in the time period, such as stock prices and index values, yields and exchange rates. Writing Xt+1 for the vector of changes in underlying risk factors, the loss will be given by a formula of the form Lt+1 = l[t](Xt+1).
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where l[t] : Rd ! R is a known function which we call the loss operator.

The book contains examples showing how the loss operator is derived for different kinds of portfolio. This is a process known as mapping.
Loss Distribution The loss distribution is the distribution of Lt+1 = l[t](Xt+1)? But which distribution exactly?
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The Conditional distribution of Lt+1 given given Ft = ({Xs : s t}), the history up to and including time t? The unconditional distribution under assumption that (Xt) form stationary time series?

Conditional problem forces us to model the dynamics of the risk factors and is most suitable for market risk. Unconditional approach is used for longer time intervals and is also typical in credit portfolio management.
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Value at Risk: A loss that will not be exceeded at some specified confidence level.

Risk Measures Risk measures attempt to quantify the riskiness of a portfolio. The most popular risk measures like VaR describe the right tail of the loss distribution of Lt+1 (or the left tail of the P&L). To address this question we put aside the question of whether to look at conditional or unconditional loss distribution and assume that this has been decided.
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Denote the distribution function of the loss L := Lt+1 by FL so that P(L x) = FL(x).

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KEY FINANCIAL RATIOS 1. TOTAL ASSETS 2. TOTAL EQUITY 3. PRETAX PROFIT 4. POST TAX PROFIT 5. PRETAX PROFIT/ TOTAL ASSETS (av) 6. PRETAX PROFIT/ TOTAL EQUIT(av) 7. TIER 1 CAPITAL RATIO 8. TOTAL CAPITAL RATIO 9. TOTAL EQUITY/ NET LOANS 10. NET LOANS/ TOTAL DEPOSITS 11. LOAN LOSS RESERVES/ GROSS LOAN (av) 12. LOAN LOSS RESERVES/ NET LOANS 13. LOAN LOSS RESERVES/ NET LOANS (av) 14. TOTAL DEPOSIT/ NET LOAN RATIO
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1. TOTAL ASSETS Total assets represent resources with economic value that a corporation owns or controls with the expectation that it will provide future benefit. Total assets are calculated from year end figures gained from bank balance sheets. Formula = Cash and Equivalents + Other Earning Assets excluding Loans + Net Loans + Fixed Assets 2. TOTAL EQUITY Stockholders' equity represents the equity stake currently held on the books by a firm's equity investors or shareholders. Formula = Equity Reserves + Total Share Capital
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3. PRETAX PROFIT A measurement of financial profitability, pre-tax profit combines all profits before tax, including operating, non-operating, continuing operations and noncontinuing operations. Formula = Total income - Total expenses (before taxes) 4. POST TAX PROFIT Post-tax profit is a measure of profitability and represents net income for the group as a whole. This is calculated before deducting minority interests and preference dividends. Formula = Pre-Tax Profit (PBT) Taxes
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5. PRETAX PROFIT/ TOTAL ASSETS (av) The return on assets (ROA) percentage shows how profitable a company's assets are in generating revenue. The ratio is considered an indicator of how effectively a company is using its assets to generate earnings before payment of taxes and dividends.

Formula = Pre-tax profits / Total Assets average

The ratio is part of Profitability ratios of the bank, where: Pre-tax profits = Total income - Total expenses (before taxes) Total income includes interest income, commission, fees, other operating income, non operating income, exceptional and extraordinary income. Total Expenses includes interest expense, commission, fees, other operating expenses, non operating expenses, exceptional and 1 99 extraordinary expenses.

6. Pre-Tax Profit / Total Equity (Av) Return on equity (ROE) measures a corporation's profitability by revealing how much profit a company generates with the money shareholders have invested. Formula = Pre-tax profit / Total Equity average
The ratio is part of Profitability ratios of the bank, where: Pre-tax profits = Total income - Total expenses (before taxes) Total equity = Equity Reserves + Total Share Capital Equity Reserves includes retained earnings, current year earnings, other equity reserves, revaluation reserves and minority interests in reserves.
Total share capital is sum of common shares/stock, preferred stock/shares, minority interest less treasury stock. 1 100

7. Tier 1 Capital Ratio Tier 1 capital is the core measure of a bank's financial strength from a regulator's point of view. It absorbs losses without a bank being required to cease trading. Formula = (Total Equity - Revaluation Reserves) / Risk Based Assets Tier 1 Capital Ratio is part of 'Capital Adequacy' ratios of the bank, where: 1-Total equity = Equity Reserves + Total Share Capital
Equity Reserves includes retained earnings, current year earnings, other equity reserves, revaluation reserves and minority interests in reserves. Total share capital is sum of common shares/stock, preferred stock/shares, minority interest less treasury stock.
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2 Risk Based Assets = Total Asset - Cash and Equivalents - Fixed Assets OR Risk Based Assets = Other Earning Assets excluding Loans + Net Loans 3 Total Assets = Cash and Equivalents + Other Earning Assets excluding Loans + Net Loans + Fixed Assets Other earning assets includes treasury and other bills, government securities, deposits with banks, trading, financial and other listed securities including bonds, other equity investments such as equity share, non-listed securities, other assets and intangible assets such as software, patents etc.

Net loans include loans to banks or credit institutions; customer net loans; HP, lease or other loans; mortgages; loans to group companies and associates and trust account lending. Fixed assets include land and buildings and other tangible assets such as plant and machinery, 1furniture, fixtures and vehicles etc. 102

8. Total Capital Ratio Total capital Ratio or Capital Adequacy Ratio (CAR) measures a bank's capital position and is expressed as a ratio of its capital to its assets. It determines the capacity of the bank in terms of meeting the time liabilities and other risks such as credit risk, operational risk, etc. CAR below the minimum statutory level indicates that the bank is not adequately capitalized to expand its operations. The ratio ensures that the banks do not expand their business without having adequate capital. Formula = (Tier 1 Capital + Tier 2 Capital) / Risk Based Assets
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Total Capital Ratio is part of 'Capital Adequacy' ratios of the Bank . Where, 1 Tier 1 Capital = Total Equity - Revaluation Reserves 2 Tier 2 Capital = Revaluation Reserves + Subordinated Debt + Hybrid Capital + Provisions including Deferred Tax+ Total Loan Loss & Other Reserves 3 Total equity = Equity Reserves + Total Share Capital

9- Total Equity / Net Loans This ratio forms part of the Capital and Funding ratios of a bank, and measures a company's financial leverage by calculating the proportion of equity and debt the company is using to finance its assets. Formula = Total Equity / Net Loans
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Total equity covers total equity reserves, total share capital and treasury stock. Net loans include loans to Banks or Credit Institutions, Customer net Loans and loans to group companies.

10- Net Loans / Total Deposits Forming part of the Liquidity ratios of a bank, this ratio is often used by policy makers to determine the lending practices of financial institutions. The higher the Loan-to-deposit ratio, the more the bank is relying on borrowed funds. Formula = Net Loans / Total Deposits
Net loans include: loans to banks or credit institutions; customer net loans; HP, lease or other loans; mortgages; loans to group companies and associates and trust account lending. Total deposits cover customer deposits, central bank deposits, banks and other credit 1 105 institution deposits and other deposits.

11- Loan Loss Reserves / Gross Loans (Av) This ratio is part of 'Asset Quality' ratios of the bank and determines the quality of loans of a bank. The higher the ratio, the more problematic the loans are and vice versa. Formula = Loan Loss Reserves / Gross Loans average
Gross loans average comes from the average of the gross loans of prior year and the gross loans of the current year.

12- Loan Loss Reserves / Net Loans This financial ratio is a part of 'Asset Quality' ratios of the bank and is calculated by loan loss reserves by net loans.
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The ratio determines the quality of loans of a bank. The higher the ratio, the more problematic the loans are and vice versa. Formula = Loan Loss Reserves / Net Loans 13- Loan Loss Reserves / Net Loans (Av) This ratio forms part of the 'Asset Quality' ratios of the bank and determines the quality of loans of a bank. The higher the ratio, the more problematic the loans are and vice versa. Formula = Loan loss reserves / net loans average Net loan average is defined as the average of net loans of the prior year and the net loans of the current year.
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14- Total Deposits / Net Loans Ratio Total deposits / net loans ratio is a measure of 'Funding Base Analysis' of the bank and calculates the deposit drains. If the ratio is less than 1:1, it indicates that the bank is in danger of becoming insolvent. Formula = Total Deposits / Net Loans

Total deposits include customer deposits, central bank deposits, bank and other credit institution deposits and other deposits.
Net loans cover loans to banks or credit institutions; customer net loans; NP, lease or other loans; mortgages and loans to group companies.
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