Risk Management in Banks : An Introduction

By A V Vedpuriswar

June 14, 2014

The Rise of Risk Management

Year Event

1971 Breakdown of Bretton Woods

1973 Oil Shock

1987 Dow Jones crash

1989 Nikkei crash

1980s Latin American debt crisis

1994 Mexican Peso crisis

1997 Asian currency crisis

1998 Rouble /LTCM crisis

2000 Dotcom bust

2001 WTC terrorist strikes

2007 Sub Prime crisis

2008 Collapse of Bear Stearns, Lehman

2009 Sovereign debt crisis

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Evolution of Analytical Risk Management tools

1938 Bond duration1952 Markowitz mean variance framework1963 Beta1966 Multiple factor models1973 Black Scholes, Greeks1983 Risk adjusted return on capital1986 Limits on exposure by duration1988 Limits on Greeks1992 Stress testing1993 Value-at-Risk1994 Risk Metrics1997 Credit Metrics1998 Integration of credit & market risk2000 Enterprise wide risk management

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Interest rate trends

The Real Crisis

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The Ruble Crisis

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The Asian currency Crisis

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The Mexican Peso Crisis

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Rupee Dollar rate : 1993-2013

Risk Categories

Reputation risk

Business environment

Economic cycles

Industry cycles

Industry trends

Technology change

Vision/strategy

Business risks

Primary Operational

Credit riskLiquidity

riskMarket Risk

Transaction processing

Legal

Compliance Liability

Security Tax

Financial risks

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Examples of Risk

1. There is a general downturn in the markets and clients reduce their trading volumes, reducing the commissions that we earn.

2. A bank enters into a new business area, but the revenues do not meet expectations, and will not cover the costs of the investment made.

3. A client a bank has lent money to goes bankrupt and the bank loses the funds.

4. Share prices fall 10% globally and the bank loses money on our own positions.

5. Due to a credit market dislocation, a bank is unable to borrow funds at an acceptable price to fund actual or proposed commitments

6. A former employee sues the bank for discrimination.

7. A CD containing confidential Wealth Management client data is lost

8. A trader executes transactions, but does not enter them into the trading system until later, and only inputs the ones that have not lost money.

9. A regulator suspends the bank’s licence to conduct business in their country due to failures in internal controls.

10.Wealth management clients move their money away from the bank, due to public revelation of problems.

11.A counterparty who owes the bank money under an OTC derivative transaction defaults due to financial difficulty

12.A counterparty who owes the bank money under an OTC derivative transaction refuses to pay and claims they were not authorised to enter the trade

Which category?

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¨ Risk of loss owing to movements in the level or volatility of market prices of stocks, interest rates, currencies, commodities.

Market risk

¨ This refers to the possibility that the transaction cannot be conducted at the prevailing market prices owing to the size of the position relative to normal trading lots.

¨ Liquidity risk may also arise because of the inability to meet payment obligations.

¨ This is especially a risk for portfolios that are leveraged and subject to margin calls from the lender.

¨ If cash reserves are insufficient, losses in market value may create a need for cash payments, leading

to an involuntary liquidation of the portfolio at depressed prices.

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Liquidity Risk

Liquidity, model and market risks

¨ Liquidity, market and model risks are interrelated.

¨ Breakdown of markets leads to liquidity problems.

¨ When markets are not in place, models become necessary.

¨ Models pose various risks.

¨ This risk arises because the counterparties may be unwilling or unable to meet contractual obligations.

¨ Pre settlement risk arises over the life of the contract.

¨ Settlement risk occurs when a counterparty defaults after the institution has already made its payment.

¨ Settlement risk is very real for foreign exchange transactions which involve exchange of payments in different currencies at different times.

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Credit risk

The Nature of Credit Risk

¨ Less liquid positions

¨ Longer time horizons

– e.g. 1 year

¨ Negatively skewed distributions

¨ Potential for longer tails

¨ Correlations and concentrations

¨ This is the risk arising out of inadequate or internal processes, people and systems from external events.

¨ The best protection against operational risks consists of • redundancies of systems

• clear separation of responsibilities with strong internal controls

• regular contingency planning.

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Operational Risk

Barings ( 1995)

¨ 233 year old bank collapses under $1.24 Billion loss

¨ Lack of Internal Controls

¨ No segregation of duties (Front and back office)

¨ Poor authorisation procedures

¨ Lack of management awareness of inherent risk

¨ Fraud

¨ Market risk

Impact of Operational Risk¨ Operational risk is inherent in every banking

activity.

¨ Impact of Operational Risk – direct financial losses– indirect (revenue foregone as a result of business suspension)– damage to our reputation and franchise

¨ Objective is not to eliminate risk but reduce the risk as far as practical – avoid high frequency, high impact– mitigate or transfer high impact, low frequency– manage high frequency, low impact events for which the cost

of further risk reduction would exceed the reduction in losses– accept low frequency, low impact but monitor them

Operational Risk Drivers

¨ High Profile Losses

¨ Reputational damage

¨ Regulatory Pressure

– SOX (Sarbanes – Oxley Act)

– Basle II

– MiFID (Markets in Financial Instruments Directive)

¨ Competitive Advantage

– Outsourcing / Offshoring

– Technology Advancement

– Business Growth (Trade volume and human capital)

– Product Complexity and Evolution

– Emerging Market Opportunity

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Credit, Market, Settlement and Operational Risk - IllustrationA trader purchases £1 million spot from Bank A. The current rate

is $1.5/£. This means two days from now, the trader will have to give $1.5 million and receive £1 million. The trader will then offload position in the market with another counterparty B.

Market Risk: If the spot rate changes to $1.4/£, loss for the trader = 1.5 – 1.4 = $100,000, assuming the deal with counterparty B is now stuck at 1.4.

Credit Risk: Say the next day, B goes bankrupt and the rate changes to $ 1.35/£. Instead of selling to B at 1.4, A will have to offload in the market to another bank, say at 1.35.

Loss = $50,000 (loss per unit = 1.4 – 1.35).

Settlement risk: If $1.5 million is delivered but £ 1 million is not received, this is settlement risk.

Operational risk: $1.5 million is wired to the wrong bank. After two days, the money is received and remitted to the right bank with compensatory interest. The loss is the amount due.