Key Concepts in Financial Risk Management

Finance Risk Management Involves gain and loss Positive/negative outcome = opportunity/threat Can be quantifiable (FX risk) or very hard - impossible to quantify (reputational risk) FX risk - transactions taken place n varying currencies outside of companies functional currency. Risk management process Identification - critical step. If not identified how can it be managed ? Analysis - likelihood of occurring ? How severe risk impact ? Consequences ? Control/treatment - select & implement measures to modify risk. Major elements = risk control/mitigation. Others = risk avoidance/transfer. (scroll down for more) Monitoring - monitor track & review. Provides reassurance. Attitude towards risk Risk averse - not sought out & willingness to pay to reduce/remove risk e.g. purchasing insurance. Risk neutral - uncertainty towards risk unless there's a 'fair' reward. Greater risk = greater return expected Risk preferring - pleasure taking risk Risk appetite Amount of risk willing to take Managing this & risk culture are critical components of a bank management strategy Sudden change = excessive risk that exceeds the banks tolerance & appetite Banks risk appetite is witnessed in: ● Risk limits for trading/non-trading activities ● Appetite for writing loans to diff categories of borrowers ● Capital structure & funding strategy ● Approach to mergers, acquisition & expansion ● Nature of investors ● How much bank is scrutinised by regulators ● Quantitative/qualitative statements in risk reports Risk tolerance Amount that a bank can tolerate Based on financial capacity to absorb risk Categorising risk Financial risk Credit risk Market risk Interest rate risk Liquidity risk Non-financial risk Operational risk Currency (fx) risk Credit risk: (most important) When the borrowers failure to meet its obligations in agreed terms. (failure to repay) Serval components; ● Default risk - failure to make full & timely payments (meet obligations) ● Migration risk - change in the credit standing of a borrower ● Exposure risk - total amount bank/lender expects ● 'Loss given default' - amount lost when borrower defaults on loan ● Counterparty risk - probability of one of the parties failing to meet contractual obligations Default = failure to meet legal obligations of loan Market risk: When financial investment loses caused by adverse price movements Liquidation period = assess adverse deviations Longer period = increased adverse deviations Trading portfolio earnings (money from investments, dividends, interests & capital gains) are the variations in market value Increase/decline market value = market gain/loss Longer portfolio holding period, larger the worst/best case loss/gain as market volatility increases over time Portfolio instruments can be liquidated or hedged to limit market risk Interest rate risk: Arises from fluctuation interest rates Declines of net interest income or interest revenue minus interest cost If interest rates are unstable so are earnings Both borrowers & lender at risk, be that variable or fixed participants Variable - risk obvious Fixed - lenders lend at higher rate / borrowers borrow for less if rate declines Implicit and explicit options = source of interest rate risk e.g. loan renegotiation Liquidity risk: Not able to raise funds bcz of increase in cost of funding / contraction in market(e.g. sub-prime crisis) Funding risk dependent on how risky they're perceived and banks funding policy Impacts cost of funds Extreme lack of liquidity = bank failure Foreign exchange/ currency(FX) risk: Loses bcz changes in exchange rate Revenues & charges indexed (adjusted) to exchange rates - results in variations Variations also bcz of change in value of assets or liabilities denominated in foreign currency Exposed to translation risk from conversion of foreign currency to 'home' currency Consider international finance - hedging practices manage Hedging = buying or selling investment to reduce risk Operational risk: Loss bcz of ineffective or failed internal processes, people, systems or external events Different levels; ● Human errors ● Processes ● Technical ● Information technology Process risk; ● Inadequate procedures and controls ● Management deficiencies in risk monitoring or not abiding procedures/policies ● Errors recording transactions ● Technical deficiencies of info systems or risk measures/models ● Risk surveillance & undetected excess limits Risk oversight - motivations Banks that actively manage risks have competitive advantage e.g. secure appropriate RAROC Risk management Committees - monitor performance, limits potentials issues & introduces products and processes ALM (Asset-liability management) unit in charge of models that aggregates risks Hedging manages risk of the borrower risk and management market risk in portfolio ALM (Asset-liability management) - central function Main goals = manage liquidity risk, interest rate risk and mismatch risk on bank-wide basis Main target variables are; ● Net interest margin or income (difference between interest revenues & costs) ● Economic value of balance sheet (mark-to-market model valuation of assets minus liabilities) ● Maintaining adequate liquidity and mismatch risk ● Managing interest rates (set up limits) ● Stress scenarios and contingency planning Simple risk management process - control/treatment (ARTA) Avoid - high probability of occurrences and high financial loses = avoid activity Reduction - high and low = management control to reduce risk of loss Transfer - low and high = transfer some/all of risk to 3rd party by purchasing insurance, hedging etc. Accept - low and low = accept and continually monitor risk