Introduction to Banking and Finance

Guy HargreavesACE-102

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Recap of yesterdayHow banks generate financial returnsThe key metrics used in bank financial

management The advantages of economies of scale and

diversificationThe problems of asymmetric information,

adverse selection and moral hazard

Bank balance sheet risk management

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Today’s goalsAppreciate the key risks managed by banksUnderstand the tools used to manage the

various bank balance sheet risks Discuss pros and cons of existing and new

regulations around balance sheet risk management

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Banks and riskBanks are in the risk businessRisk is everywhere in banking

Market risk Liquidity risk Credit risk Operational risk Country risk Reputational risk Systemic risk

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Banks and riskThe profitability of banks is driven by how

well they manage risk “flows”: Customers transfer their risk to banks Banks take on risk for principal trading=> Managing all these risk flows as an ongoing

viable business has risk

Some risk is unmanageable and banks need to avoid this.

All risk needs to be properly priced and managed

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Major market risk typesInterest rate risk:

Exposure through a financial instrument to movements in interest rates

Fixed rate bonds, interest rate swaps, bond futures – anything with a long dated fixed cashflow

“Delta” – the change in the $ value of that instrument for a 0.01% change in interest rates

VAR – “Value at Risk” how much the bank would lose if a significant move in interest rates occurred

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Major market risk typesFX risk:

Exposure through a financial instrument to movements in foreign exchange rates

Spot FX, foreign exchange swaps, FX futures “Delta” – the change in the $ value of that

instrument for a certain change in FX rates Included in firmwide VAR

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Major market risk typesCredit trading risk:

Exposure through a financial instrument to movements in credit margins

Corporate bonds, credit swaps, credit indices “Delta” – the change in the $ value of that

instrument for a 0.01% change in credit margins Included in firmwide VAR Not to be confused with credit default risk

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Major market risk typesCommodity risk:

Exposure through a financial instrument to movements in commodity proves

Gold swaps, commodity futures “Delta” – the change in the $ value of that

instrument for a certain change in commodity prices

Included in firmwide VAR

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Trading versus banking booksBanks use two broad accounting regimes:

Banking book – holds corporate and retail loans on an “accruals” basis; uses a “loan provision” model for potential impairments or losses from defaults; no market risk

Trading book – holds securities and marketable instruments on a “mark-to-market” basis; gains and losses in market value brought to P&L daily; all market risk

Whether a financial instrument is held in a banking book or a trading book is critical to the way it is risk managed

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Liquidity (gap) riskThe ongoing ability of a bank to fund itself

Banks tend to “lend long” and “borrow short” – borrowers want the certainty of funding for long periods whereas savers don’t ant to lock up their funds for long periods

Liquidity or gap risk is the risk savers will not redeposit their funds when they come due, leaving the bank repaying deposits whilst the funds remain tied up in longer term assets

Reinvestment or refinancing risk is the risk that when a bank comes to refinance a deposit interest rates will be higher – it’s not liquidity risk but actually interest rate risk

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Credit (default) riskLoans in the banking book and bonds in the trading

book both have credit default risk The issuer will fail to repay a coupon or principal, or will go

into bankruptcy Banks have Special Asset Management units which do

nothing but manage defaulted customers Once in default, banks will often take control of the company

as “senior creditors”, sell all remaining company assets and use the proceeds to repay “creditors” in order of seniority

If a bank receives less than it is owed following liquidation it has suffered a recovery rate of < 100%

Banks may make “provisions” in their balance sheets for loans which they expect have a high chance of defaulting

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Operational riskOperational risk is defined as “the risk of loss

resulting from inadequate or failed internal processes, people and systems or from external events”

Regulators and banks are working towards a consistent and standardised way of measuring and holding capital against this risk

Causes of operational risk include internal and external fraud, employment practices and work safety, illegal business practices (eg money laundering) and physical or system failures

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Country riskInternational banks invest significant capital

into countries around the world to support their local operations

Some of these countries are risky emerging markets (eg Argentina) where the risk that the local government introduces foreign exchange controls or other measures that might be harmful

Sovereign risk is not country risk – it is the risk a sovereign will default on its debt

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Reputational riskBanks have suffered scandals and bad media

headlines since the 2007-9 GFC Most of the criticism has been fully justified!As a result many banks have seen their

reputations with customers, governments and other important stakeholders suffer badly

When a bank earns a poor reputation its WACC increases as savers become reluctant to deposit, and borrowers are less willing to do business with banks that have behaved badly

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Systemic riskThe 2007-9 GFC showed up serious flaws in

the banking system and the way banks were regulated

At a number of times the governments around the world were forced to step in and “bail out” the banking system

Even good banks came under stress as the system crashed – banks can not individually manage systemic risk but together they must all employ good management practices to ensure the system is sound

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Correlation risk“Correlation” is the relationship between two

independent variables. These variables might be financial asset prices, default rates of FX rates for example

Many financial market products have correlation assumptions built into them. Banks also assume their loan and securities portfolios will not be highly correlated

Correlation of 1 between assets A and B means if A increases in price by 10% then B will increase in price by 10% also

In financial crises often many assets become highly correlated. This is a major problem even for diversified loan books because default rates can increase across the portfolio and wipe out bank capital

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Bank risk management toolsValue at Risk (VAR) – banks look at 2-3 years

of price history and use probability models to determine to a high degree of confidence how far a market can move over say 1 or 5 days

Traders are then given $ amounts they can potentially gain or lose based on VAR – this sets the total amount of a financial instrument a trader can have exposure to in his/her trading book

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Bank risk management toolsVAR example:

Joe is an interest rate swaps trader and is given a $1m daily VAR limit he can trade for the bank

Joe trades 3-year bonds which have a delta of $250 ie if Joe owns $1m bonds and interest rates rise by 1 basis point or o.o1% Joe will lose ~$250 on a MTM valuation

Joe’s Risk Management team tell him based on their VAR models the 3-year bond is assumed to move 20 basis points or 0.2% maximum in a day

Joe is offered $30m of 3-year bonds by an investor – can he buy them?

if Joe bought the bonds he would have a delta of $250 * 30 = $7,500 ; at worst the bond yield will increase by 20 basis points in a day and if so Joe would lose $7,500 * 20 = $150,000 => Joe can buy the bonds as he has a daily VAR limit of $1m

Joe could buy a maximum of $200m bonds under that limit

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Bank risk management toolsWeaknesses in the VAR method have been

shown up since the 2007-9 GFC Markets have a capacity to move in much more

extreme ways than VAR models predict – especially highly correlated markets or assets

VAR models may underestimate “tail risks” – so-called “black swans” championed by Nassim Taleb

Regulators and bankers become too comfortable with VAR – belief that it is worst case makes risk managers overly comfortable

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Bank risk management toolsCredit default risk management is a critical

element of banking book management“Credit Committees” (CC) establish maximum

exposure limits to individual, group and related party borrowers

Limits are set for loans, derivatives, settlement, FX and many other financial products

CC monitors total exposure to the borrower or group Bankers are forbidden to lend or trade in more volume

with the borrower or group than the limit set by CC This prevents the bank from becoming overexposed to

any one borrower or group

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Bank risk management toolsCritical to bank credit default risk management

is to lend to a broad diversified set of borrowersDiversification means investing in a broad range

of uncorrelated borrowers such that “systematic risk” can be reduced in the portfolio

“Don’t put all your eggs in one basket”! Investing in $1 in each of 50 borrowers is far less risky

than investing $50 in just one If all the borrowers are perfectly correlated with each

other (ie correlation of 1) then the diversification will not be effective

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Bank risk management toolsAlso critical to bank credit default risk

management is for banks to accurately analyse and a borrower’s credit risk profile

Highly specialised bank credit analysts review a borrowers financial statements and estimate Probability of Default (PD) and Loss Given Default (LGD)

PD estimates are usually quite accurate but LGD is much harder to calculate

Expected Loss (EL) = PD * LGD * EAD EAD is Exposure at Default and can often be larger

than the facilities granted if interest is unpaid

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Bank risk management toolsCredit provisioning varies widely across the

banking system Large banks routinely take generic provisions

against their more diversified portfolios Smaller banks make less provisions – more eggs in

one basket!

Since the late 1990’s credit swaps have been used to manage loan, counterparty and other credit risks

Limited to the larger borrowers that have a higher profile borrowing base