Ch Modern Banking part

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                     Chapter 3


Management of Risks in Banking
         Key Financial Risks in the 21st Century
  Approaches to the Management of Financial Risks

     Financial Derivatives and Risk Management
                Management of Market Risk
                Management of Credit Risk
        Risk Management by Major Global Bank
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3.1. Introduction
 In Any profit-maximizing business, including banks, must
  deal with macroeconomic risks, such as the effects of
  inflation or recession and microeconomic risks like new
  competitive threats. Breakdowns in technology, commercial
  failure of a supplier or customer, political interference or a
  natural disaster are additional potential risks all firms face.
  However, banks also confront a number of risks atypical of
  non-financial firms, and it is these risks which are the subject
  of this chapter.

 The purpose of this chapter is to outline the key financial
  risks modern banks are exposed to, and to consider how
  these risks should be managed.
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 Suppose an investor purchases equity in a bank and expects
  a minimum return of 15%. If, when the shares are sold, the
  return is 20%, then an extra 5% is added to the value of the
  investment, and shareholder value-added is positive. If the
  return is less than 15%, the outcome for the investor is a
  negative shareholder value-added.
 There is a link between shareholder value-added and other
  performance measures, such as return on assets or return on
  equity (ROA, ROE).


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3.2. Key Financial Risks in the 21st Century
 Risk management involves identification of the key financial risks, where
  risk exposure should be increased or reduced, and finding methods for
  monitoring and managing the bank’s risk position in real time. where
  ALM is the key activity to the complex financial conglomerate offering a
  range of bank and non-bank financial services, the objective is to
  maximize profits and shareholder value-added, and risk management is
  central to the achievement of this goal. Shareholder value-added is
  defined as earnings in excess of an ‘‘expected minimum return’’ on
  economic capital.
 The average risk premium ranges from 7% to 10% for banks in most
  OECD countries. The nominal rate of return on government bonds is
  normally treated as a risk-free rate, provided there is a low probability of
  the government defaulting on its obligation.
       3.2.1. Formal Definitions.
       3.2.2 Interaction among risks

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3.2.1. Formal Definitions
 Concept of risk: The possibility of exposure to loss, damage, it include
  the possibility for undesirable events.
 Risk is defined as the volatility or standard deviation (the square root
  of the variance) of net cash flows of the firm.
 The risk may also be measured in terms of different financial products.
  But the objective of the bank as a whole will be to add value to the
  bank’s equity to shareholders. And to depend on the management of
  risks.
 Large universal banks will focus on the management of risk on the
  banking book (the traditional asset–liability management), the trading
  book (where banks are buying and selling bonds, equity, etc.), and in the
  risk management advice they give to corporate customers.

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 Corporate treasurers of non-financial firms can incur large losses
  as a result of poor financial risk management. But it rarely leads
  to insolvency, if the core business operations are sound. The
  risks specific to the business of banking are:
1.   Credit & Counterparty.
2.   Liquidity or funding risk.
3.   Settlements or payments risk.
4.   Market or price risk, which includes:
        currency risk.
        interest rate risk.
5.   Capital or gearing risk.
6.   Operational risk.
7.   Sovereign and political risk.
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1. Credit risk and counterparty risk
   If two parties enter into a financial contract, counterparty
    risk is the risk that one of the parties will renege on the
    terms of a contract.
   Credit risk is the risk that an asset or a loan becomes
    irrecoverable in the case of outright default, or the risk of
    an unexpected delay in the servicing of a loan.
   If a borrower defaults on a loan or unexpectedly stops
    repayments, the present value of the asset declines. Losses
    from loan default should be kept to a minimum.
   Good credit risk management has always been a key
    component to the success of the bank, the cause of the
    majority of bank failures can be traced back to weak loan
    books.
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2. Liquidity or funding risk
 The risk of insufficient liquidity for normal operating
  requirements, and the ability of the bank to meet its
  liabilities when they fall due.
 A shortage of liquid assets is often the source of the
  problems, because the bank is unable to raise funds in the
  retail or wholesale markets. Funding risk usually refers to a
  bank’s inability to fund its day-to-day operations.
 The liquidity of an asset is the ease with which it can be
  converted to cash. A bank can reduce its liquidity risk by
  keeping its assets liquid (i.e. investing in short-term assets).
 All banks make money by having a gap between their
  maturities, that is, more short-term deposits and more long-
  term loans: ‘‘funding short and lending long’’.
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3. Settlement/payments risk
Settlement or payments risk is created if one party
 delivers assets before receiving its own cash or
 assets, thereby exposing, it to potential loss.
Settlement risk can include credit risk if one party
 fails to settle liquidity risk – a bank may not be able
 to settle a transaction if it becomes illiquid.
Settlement risk is still present because If one bank
 fails to meet its obligations, other banks along the
 line are affected, even though they have an indirect
 connection with the failing bank, the counterparty
 to the exchange.
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4. Market or price risk
 Market (or price) risk is normally associated with instruments
  traded though increasingly, where the market is not very liquid.
 General or systematic market risk is caused by a movement in
  the prices of all market instruments because: a change in
  economic policy. where the price of one instrument moves out of
  line with other similar instruments, A bank can be exposed to
  market risk (general and specific) in relation to:
      Equity.
      Commodities .
      Currencies.
      Debt securities.
      Debt derivatives.
      Equity derivatives.
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 Thus, market risk includes a very large subset of other
  risks. Two major types of market risks are 1. Currency
  and 2. Interest rate risk.
 Interest rate risk are another form of price risk, because
  the interest rate is the ‘‘price’’ of money, or the
  opportunity cost. It arises due to interest rate
  mismatches.
 The traditional focus of an asset–liability management
  group within a bank is the management of interest rate
  risk, but this has expanded to include off-balance sheet
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5. Capital or gearing risk
 Banks are more highly geared (leveraged) than other businesses –
  individuals feel safe placing their deposits at a bank with a
  reputation for soundness.
 The banking system as a whole tends to be stable, unless
  depositors are given reason to believe the system is becoming
  unsound.
 Banks which take on more risk should set aside more capital,
  and this is the principle behind the Basel risk assets ratio,
  consider the equation below:
 ROE = ROA × (gearing multiplier) where:
    ROE: return on equity or net income/equity.

    ROA: return on assets or net income/assets.

    Gearing/leverage multiplier: assets/equity.
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 Basel requires a bank’s risk assets ratio to be 8% (= 0.08). If a bank
  satisfies this requirement, it means its equity is about 8%, its debt
  must be 92%, giving a gearing/leverage ratio of 92/8, or 11.5.
 Contrast this with a typical debt to equity ratio for non-financial
  firms, of, for example, 60/40 = 1.5.
 Capital risk is the outcome of other risks incurred by the bank, such
  as credit, market or liquidity risk. Poor earnings, caused by high
  loan losses, or inappropriate risk puts the bank’s capital at risk.
  Two ratios will be monitored by agents funding or considering
  funding the bank:
       The bank’s capital ratio or its Basel risk assets ratio.
       The bank’s leverage ratio – debt/equity.

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6. Operational risk
 The Bank for International Settlements defines operational
  risk as: ‘‘The risk of direct or indirect loss resulting from
  inadequate or failed internal processes, people, and systems, or
  from external events.
 Definition of operational risk varies considerably, and more
  important, measuring it can be even more difficult. the key
  types of operational risk are identified as follows.
       A.   Physical Capital.
       B.   Human Capital.
       C.   Legal.
       D.   Fraud.
 Classification issues alone make quantification of operational
  risk difficult, so it should come as no surprise that the
  ‘‘Basel 2’’ proposals for the treatment of the operational risk.
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7. Sovereign and political risks
 Sovereign Risk normally refers to the risk that a government
  will default on debt owed to a bank or government agency.
 However, if the default is by a sovereign government, the
  bank is unlikely to be able to recover some of the debt by
  taking over some of the country’s assets. This creates
  problems with the loan contract.
 Political Risk is broadly defined as state interference in the
  operations of a domestic and/or foreign firm. Banks can be
  subjected to sudden tax hikes, interest rate or exchange
  control regulations, or be nationalized.

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