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Transcript of Banking Presentation Final- 4
8/12/2019 Banking Presentation Final- 4
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RISK MANAGEMENT IN BANKS
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RISK M ANAGEMENT
Financial risk management is the process of detecting,assessing and managing financial risks
Why Risk Management is important for Banks Banks serve as financial intermediaries for managing
financial risk. They create markets and instruments toshare and hedge risks, provide risk advisory servicesand act as a counterparty by assuming the risk of
others. Because of this role they must excel atmeasuring and pricing financial risks.
Important for survival of the organisation especially inadverse market conditions
Issues with overestimation/underestimation
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GROWTH OF RISK M ANAGEMENT INDUSTRY
Following global events contributed to thegrowth of risk management industry
Changing from fixed to flexible exchangerate system in 1971
Oil shock of 1973
US stock market collapse of 1983
Japanese stock market collapse of 1989and further
Asian currency crisis of 1997
Russian default and subsequent failure ofLTCM in 1998
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GROWTH OF RISK M ANAGEMENT INDUSTRY
(CONTD)
2001 attack on WTC
Subprime crisis and subsequent failure of Bear
Stern, Lehman and other financial institutions in
2008-2009
Deregulation and Globalization – lesser entry
barriers, increasing competition, firms are more
competitive, exposure to global macroeconomic
factors, linked systemically, increased risk
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TOOLS FOR RISK M ANAGEMENT
Derivatives Stop-loss limit Notional Amount
Exposure limit VAR Back testing Stress Testing
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VAR
VAR is defined as the maximum loss over adefined period of time at a stated level ofconfidence given the normal marketconditions.
Advantages of VAR• VAR is comparable across different business
units in a firm with different asset classesand risk characteristics
• It is used for risk budgeting• Embraced by practioners, regulators and
academicians• Aggregates and reports multi product, multi
market exposures into one number.
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VAR
Limitations of VAR• VAR requires accurate inputs
which becomes more daunting
as the number of assets increase• Subject to Model risk and
Implementation risk• VAR alone is not sufficient for
risk measurement. Measures toovercome the limitation includeback testing and stress testing.
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RISK MANAGEMENT AND VALUE CREATION
1. By handling bankruptcy costs 2. By moving income across time and reducing
taxes 3. By benefiting a large shareholder 4. By reducing the probability of debt overhang
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RISK MANAGEMENT AND VALUE CREATION
Profit (before
hedging) Probabili
ty Profit (after
hedging) Probabili
ty 200000 0.1 200000 0 300000 0.2 300000 0.20 400000 0.3 400000 0.35 500000 0.4 500000 0.45
By handling bankruptcy costsEg : A firm’s debt obligations is INR 300000, bankruptcy costsare INR 75000Expected profit (after operational expenses before debtservicing) is the following
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RISK MANAGEMENT AND VALUE CREATION
Debt value = probability * expected payment to debti.e 0.1* 125000+0.9* 300000 = 282500Equity value = probability * expected payment to equity
i.e 0.3* 100000+0.4* 200000 = 110000Total value = 392500
If Hedging costs is 10,000 then the values after hedgingDebt value = probability * expected payment to debti.e 1* 300000 = 300000Equity value = probability * expected payment to equityi.e 0.35* 100000+0.45* 200000 = 125000Total value = 425000-10000= 415000
Incremental benefit = 415000-392500= 22500
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RELATIONSHIP BETWEEN RISK MANAGEMENT,
MANAGEMENT COMPENSATION AND INCENTIVES
• Management should be motivated towardsmaximizing firm’s value by following sound riskmanagement practices for the firm
• General tendency to align management’s incentive
with the stock price doesn’t serve the completepurpose of creating long term value for the firm
• Increasing the management’s shareholding in thefirm is better option
• If management compensation is related towardscreating firm value then they would be more willingto take effective risk hedging policies and therebyincrease the firm value
• This would also ensure lesser risk premiumdemanded by the investors because there would belesser volatility in the stock price of the firm
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RISK M ANAGEMENT FRAMEWORK
1. Organisation for Risk Managemento The Board of Directors – Overall responsibility,
articulates the risk management policies,procedures, aggregate risk limits, reviewmechanisms and reporting and auditing systems
o The Risk Management Committee of the Board – Board sub level committee – responsible for ensuringthe risk management processes confirm to policy,robustness of risk measurement models
o The Committee of senior-level executives – responsible for implementation of risk and business
policies simultaneouslyo Risk Management support group – analyses and
reports to the committee. Also responsible forindependent risk monitoring, measurement, analysisand reporting
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RISK M ANAGEMENT FRAMEWORK
2. Risk Identification
Risk Identification consists of identifying various risksassociated with the risk taking at the transaction level andexamining its impact on the portfolio and on capitalrequirement
Example : Say Branch B of XYZ bank has extended a loan ofINR 1 crore in accordance with the corporate policy andguidelines for a period of 5 years at a rate of interest 1 pctover BPLR of the bank, BPLR being 10 pct. The loan is to berepaid in equal quarterly instalments with one year
moratorium. Funding of the loan is to be done from a depositof 3 years of the same amount, interest rate on it being 6 pct.What are the risks associated with the transaction withouttaking into account CRR/SLR requirements
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RISK M ANAGEMENT FRAMEWORK
2. Risk Identification
Funding risk
Default risk
Basis risk Gap or Mismatch risk
Embedded Option risk
Reinvestment risk
Operational risk This transaction would also impact risks at the
aggregate level, also it may be noted that incremental
risk in the portfolio may also be less than the risks
taken at the transaction level.
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RISK M ANAGEMENT FRAMEWORK
3. Risk Measurement
Risk measures capture variation in earnings,
market value, losses due to default etc arisingout of the uncertainties associated with thevarious risk elements
Quantitative measures can be classified intothree categories
Based on Sensitivity
Based on Volatility Based on Downside Potential (two components -
potential loss and probability of occurrence)
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RISK M ANAGEMENT FRAMEWORK
4. Risk pricing
Pricing should take into account the following Cost of deployable funds
Operating expenses
Loss probability
Capital charge
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RISK M ANAGEMENT FRAMEWORK
5. Risk Monitoring and Control
• Strong Management Information System for reporting,monitoring and controlling risk
• Well laidout procedures, effective control and comprehensiverisk reporting framework
• Separate risk management framework independent ofoperational requirements with clear delineation ofresponsibility for management of risk
• Periodical review and evaluation (both internal and external)
Various reports should allow senior management to
a. Evaluate the level and trend of material risks and theirimpact on capital levelsb. Assess bank’s risk profile on a continuous basis and make
necessary adjustments to the bank’s strategic planaccordingly
c. Identify the large exposures and risk management
concentrations
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RISK M ANAGEMENT FRAMEWORK
6. Risk Mitigation
• Refers to the reduction in risk achieved by adopting strategies thateliminate or reduce uncertainties associated with the risk elements
• Credit risk can be mitigated by collateralisations and by buyingcredit derivatives. It is also mitigated by having a robust creditappraisal and review process.
• Interest rate risk can be mitigated by using interest rate swaps orforward rate agreements
• Forex risk can be mitigated by using forex forward contracts, forexoptions or futures
• Equity price risk can be mitigated by using equity options• Operational risk can be mitigated by strengthening the operational
processes, periodic reviews of process adherence• Counterparty risk can be mitigated by establishing exchanges as
counterparty• Risk mitigation measures aim to reduce downside variability in net
cash flow but it also reduces upside potential simultaneously
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RISK M ANAGEMENT FRAMEWORK
INR
000 Cash flowfrom
Year1 Year
2 Year3 Year
4 Year 5 Total Mean Standarddeviation
Standard
deviation/Mean
Business A 10 3 4 8 11 36 7.2 3.56 0.49
Business B 3 8 1 6 4 22 4.4 2.70 0.61
Business C 12 8 9 2 4 35 7 4.00 0.57
Business D 6 9 2 3 5 25 5 2.74 0.55
Business E 7 12 5 8 6 38 7.6 2.70 0.36
Total Portfolio 38 40 21 27 30 156 31.2 7.85 0.25
7. Risk Mitigation through diversification
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TYPES OF RISK M ANAGEMENT F AILURES
• Risk Metrics Failure• Incorrect Measurement of known risks• Ineffective risk monitoring
• Ineffective risk communication• Ignorance of significant known risks• Unknown risk
Large financial loss is not necessarily a failure
of risk management
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LINKAGES AMONG RISK, CAPITAL AND
RETURN
Higher risk means higher variability of returns, higherprofit potential and loss possibilities, thereforecapital requirement will be higher.Expected return would also factor in the risksassociated with it. Higher the risks in a businessmodel, higher would be the return expectations
Example : Following returns from investment of INR50,000
Cash flow from Year 1 Year 2 Year 3 Year 4 Year 5 INR
000
Total Investment-1 6 6 6 6 6 30 Investment-2 3 9 5 -2 15 30
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C ASE STUDIES – B ARINGS B ANK
• Nick Leeson, trader at Baring PLC in Singapore, tookconcentrated positions on Nikkei 225 derivatives forbank in Singapore International Monetary Exchange(SIMEX). He took arbitrage positions on Nikkeiderivatives on different exchanges viz. Osaka, Tokyo
and SIMEX.• In 1994, Leeson lost USD 296 M, but reported a
profit of USD 46 M to management. He abandonedthe hedge strategy and initiated a speculative long-long futures position in both exchanges in hope of
profiting from an increase in Nikkei 225.• He also engaged in unauthorised option writing tocollect premium to keep himself ready for margincalls
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C ASE STUDIES – B ARINGS B ANK
• Leeson was solely responsible for back andfront office operations of Singapore. He used anerror account to hide his losses by fraudulentlytransferring funds to and from his erroraccounts
• He kept on building his positions even afterNikkei kept on falling, however after Jan 95earthquake, the Nikkei plunged and he couldnot sustain his positions and failed to honor themargin calls
• It eventually led to the collapse of Barings bank(due to losses of USD 1.3 B), when it was sold toING for mere USD 1.60 only
• It had various risk exposures such as Market,Event, Legal , Employee
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C ASE STUDIES – SUMITOMO
• Yasuo Hamanaka – Chief Copper Trader at Sumitomo
manipulated copper prices on London Metal Exchange
• Long position in futures contract and simultaneously
purchased large quantities of physical Copper
• Due to shortage of physical copper the other party was
forced to pay higher premium for physical copper orunwind its short position by an offsetting long position
resulting in handsome profits for Hamanka and
Sumitomo
• He sold put options to collect the premiums as he
thought he can push the prices up and thus writing putoptions was not risky for him
• Though he never imagined that he could be susceptible
to steep decline of copper prices
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C ASE STUDIES – SUMITOMO
• Commodity Futures Trading Commission (CFTC) began aninvestigation of market manipulation in Dec 95
• Fall in Copper prices in June 96 after revelation ofHamanaka’s unfair dealings led to USD 2.6Bn loss forSumitomo and USD 150 M fine from CFTC
• Positions were so large that company could liquidate themcompletely
• Sumitomo’s lack of Supervision created a high degree ofoperational risk, which could have been reduced with properinternal controls
• In Sumitomo’s case no approvals were required from seniormanagement for large transactions and senior managementwas unequipped to understand the complex transactions
• It had various risk exposures such as Market, Liquidity, Legal ,Employee
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BANKING RISKS
Liquidity Risk
Inability to obtain funds to meet cash flow
obligations at a reasonable rate
Funding risk – due to unanticipated withdrawal/non-
renewal of deposits
Time risk- due to non-receipt of expected inflows of
funds
Call risk – Crystallization of contingent liabilities
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Interest Rate Risk
Adverse impact on NIM due to changes in interest rates
Gap or mismatch risk – Due to mismatch in amount andtenor of assets and liabilities
Basis risk – Interest rate of different assets, liabilities
may change in different magnitude Yield Curve risk – Due to non-parallel movements in
interest rates
Embedded Option risk – Due to prepayment of loans,premature withdrawal of deposits, exercise of put/call
option on bonds/debentures Reinvestment risk – Uncertainty with regard to interest
rate at which the future cash flows could be reinvested
BANKING RISKS
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Market risk
Risk that the value of a portfolio, either an
investment portfolio or a trading portfolio, will
decrease due to the change in value of the market
risk factors.
Forex risk – Risk of loss due to adverse exchange
rate movements during the period in which the bank
has an open position
Market Liquidity risk- Inability to conclude a large
transaction near the current market price
BANKING RISKS
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Credit risk
Risk of loss arising from a borrower who fails to
meet its obligations in accordance with the agreed
terms.
Counterparty risk – Due to counterparty’s refusal or
inability to perform
Concentration risk – Risk due to higher weight in
respect of a borrower or geography or industry
Country risk – Due to restrictions imposed by a
country
BANKING RISKS
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CREDIT RATING
Credit rating is done with primary objective to determine whether
the account, after the expiry of a given period, would remain a
performing asset.
S&P Mood
y's S&P Moody's Investment
Grade Non-Investment
Grade AAA Aaa Highest Rating BB Ba Speculative
AA Aa Very Strong B B Missed one or more interest or principal
payments
A A
Slightly more
susceptible to
adverse economic
conditions CCC-C Caa-C No interest is being paid
BBB Baa
Adequate capacity to
repay principal and
interest. Slightly
speculative D Default
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Operational risk
Risk of loss resulting from inadequate or failed internalprocesses, people and systems or from external events.
People – Fraud / Error
Process – Failed business processes
Compliance – Failure to comply with applicable laws,regulations, codes of conduct and standards of Good practice
System – Risk of loss due to system failure
Legal – Litigations arise due to lack of faith, wrongfuldischarge, misleading information, conflict of interests, vendornon-performance, poor financial performance, unethicalbehaviour, lack of transparency etc
External events risk- Economic shocks, natural disasters
BANKING RISKS
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Other risks
Business Environment risk - Risk that a firm is
subjected to during daily operations
Strategic risk – Risk due to incorrect business
decisions of the management
Reputation risk – Risk arising from negative public
opinion
Environmental risk- It is the likelihood or probability
of injury, disease or death resulting from exposure
to a potential environment hazard.
BANKING RISKS
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RELATION BETWEEN OPERATIONAL, M ARKET AND CREDIT
RISK
An operational failure may increase market and credit
risks. A bank that engages in buying and selling
derivatives without an adequate understanding of the
derivatives market could suffer significant losses.
Those losses could then result in a change in thecredit rating for the firm and reduction in the market
price for its securities.
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INTEGRATED RISK M ANAGEMENT
Integrated risk management is managing all risks thatare associated with all the activities undertaken acrossthe entire organisation. The sum total of all risk impactsis a critical factor for all organisations. Integrated riskmanagement implies a coordinated approach across
various risks by improving the understanding andinterrelationships between various risks.
An integrated approach to risk management centralizesthe process of supervising risk exposure so that theorganisation can determine how best to absorb, limit or
transfer risk. It is an ongoing process that calls forstandard definations and methods to identify measureand manage risk across all business units