RISK MANAGEMENT &

FINANCIAL
INSTRUMENTS
Lecture 1 – Introduction; Fundamentals
OUTLINE
• Introduction
–Administration
–Course overview
• Fundamentals of Risk Management
–Overview of banking business
–Typology of bank risks
–Principles & Framework
INTRODUCTION
Admin - need two coordinators to help:
1. Class time and venue: Mon 12 - 3?
2. Main text: Te (2016), Module 1

Course overview:
1. Course synopsis:
• risk fundamentals overview,
• principles/practices of credit, market and operations risk
• Interrelatedness of risk categories
2. Learning outcomes:
• risk management fundamentals
• credit, market and operational risk – objectives, framework, strategy, monitoring and
control
• relationship between risk categories
• characteristics of derivatives used
INTRODUCTION (continued)
Course overview (continued):
3. Course information:
• References
• Teaching plan
• Assessment
FUNDAMENTALS OF RISK MANAGEMENT

A. Overview of banking business

B. Typology of bank risks
C. Principles & Framework
A. OVERVIEW
Banking activities:
• Commercial banking
 traditional: receive deposits => give out loans
• Investment banking
 non-traditional: fund-raising, corporate finance advisory,
securities trading, risk management solutions via derivatives
• Some blurring of activity lines
• Focus on traditional intermediation role
B. TYPOLOGY OF BANK RISKS
Risk vs Uncertainty (p20):
• Risks – unknown outcomes whose chances of
happening can be quantified
• Uncertainty – don’t know (in advance) the possible
outcomes and chances of happening
• Risk management:
 attempts to assess and quantify risks more comprehensively
 is not about removing uncertainties
 is about deciding in an environment which has uncertainties
 B. TYPOLOGY OF BANK RISKS
What are the key risks? Walk through FINANCIAL RISKS:
the diagram below. • Market
• Credit
• Operational
• Asset & Liability
Management

NON-FINANCIAL RISKS:
• Legal and compliance
• Strategic
• Reputational
• Model
B. TYPOLOGY OF BANK RISKS
MARKET RISK:
• Risk of losses in on- and off-balance sheet positions caused by changes in
market prices
• Two components: general/systematic & specific/unsystematic
• Four categories: i, fx, equity price, commodity price

CREDIT RISK:
• Risk of borrower/counterparty failing to pay its obligations

OPERATIONAL RISK:
Risk of losses caused by inadequate/failed processes, people, systems or
external events
C. PRINCIPLES & FRAMEWORK
Background:
• Managing risk is a core part of the banking business
• Past – accept risk as a result of doing banking business
• More recent - focus on managing risks independently and distinctly

Risk management:
• ISO31000 – coordinated activities to direct and control an organisation with
regard to risk
• Others:
• identifying, analysing and evaluating risks and thereby, taking actions to
manage risks so as to maintain or add value to the bank (Institut Bank-
Bank Malaysia - IBBM 2006)
• “measurement and ...mitigation of risk, with the ultimate goal of
maximising the value of a bank, while minimising the risk of bankruptcy”
(Schroeck 2002, p.28)
C. PRINCIPLES & FRAMEWORK
Risk Management definition (continued)
Coordinated effort bankwide
• Three lines of defence:
• Business (originator; address issues onset; embed risk management framework and
sound practices)
• Risk management function (develop, implement risk management framework)
• Internal audit (review effectiveness; recommend improvement)
Activities
• Structured and formal process
• Execute different activities
Direct and control
• Not to remove risks but to direct and control
• Make risk more manageable
C. PRINCIPLES & FRAMEWORK
Objectives:
• Increase chances of achieving business objectives
 Banks have various stakeholders
 Risk introduces uncertainty to achieving bank’s business objectives
 Aims to increase chances of bank achieving objectives via designing
and implementing strategies
• Provides framework and process to mitigate the impact of risks
• Encourage proactive management of risks
• Comply with laws and regulations
• Lower cost of funds
• Efficient allocation of capital and resources
• Enhance competitive advantage
C. PRINCIPLES & FRAMEWORK
Principles:
• Creates and protects value
• Integral part of all firm processes
• Part of decision making
• Explicitly address uncertainty
• Systematic, structured and timely
• Based on best available information
• Tailored
• Considers human and cultural factors
• Transparent and objective
• Dynamic, iterative, responsive to change
• Facilities eg DBKL
C. PRINCIPLES & FRAMEWORK
Framework:
• Definition – a set of components that provides the foundations and
organisational arrangements (p42)
 Elements – governance, culture, policy, organisation
 Risk appetite – characteristics; elements
• Characteristics of effective risk appetite framework:
 Process for communicating
 Top-down and bottom-up[
 Facilitate embedding risk appetite into risk culture
 Evaluate opportunities for appropriate risk-taking; act as defence against excessive
risk-taking
 Allow for statement to be used as tool to promote robust discussions
• Elements: statement, risk limits, roles & responsibilities
C. PRINCIPLES & FRAMEWORK
Risk culture:
• Norms and traditions of behaviour
• Elements – tone from top, accountability, effective communication and
challenge, incentives

Risk management policy:

• Statement of overall intentions and direction wrt risk management
• Important qualities: rationale, objectives-policies-risk link, dealing with
conflicts,

Risk management organisation:

• BOD, BOD RM committee, executive management risk committee,
management risk committee, lines of business risk committees
 RECAP
• Introduction
– Administration
– Course overview
• Fundamentals of Risk Management
– Overview of banking business
– Typology of bank risks
– Principles & Framework