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