Lec Bank Risks

7/28/2019 Lec Bank Risks

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Risk Management,Swaps &VAR


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The potential loss an asset

or a portfolio is likely tosuffer due to a variety of reasons.


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Risk Categories

Reputation risk

Business environment

Economic cycles

Industry cycles

Industry trends

Technology change

Vision/strategy

Business risks

Primary/Financial

Non Financial/Operating

Credit r isk Liquidity risk Market Risk

Transactionprocessing Legal

Compliance Liability

Security Tax

Inherent risk


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NON-FINANCIAL RISKSOperational Risk arises as a result of failure of operating system in the bank due to certain reasonslike fraudulent activities, natural disaster, humanerror, omission or sabotage etc.Systemic Risk is seen when the failure of onefinancial institution spreads as chain reaction to

threaten the financial stability of the financial systemas a whole.Political Risk arises due to introduction of Service taxor increase in income tax, freezing the assets of thebank by the legal authority etc.Human Risk Labour unrest, lack of motivation,inadequate skills, problems faced by the bank after implementation of VRS lead to Human Risk.Technology Risk Obsolescence, mismatches,breakdowns, adoption of latest technology bycompetitors, etc, come under technology risk


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Credit Risk in banks

Traditional banking products, e.g.Loanscommitments to lend

letters of creditTraded products e.g.

OTC derivativesRepos (and reverse repos)Securities borrowing and lending

Plus settlement risk on e.g.Foreign exchange


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MANAGEMENT OF CREDITRISK

Measurement through Credit Rating /scoring

Quantification through estimate of expected loan lossesPricing on a scientific basis

Controlling through Effective loanreview mechanism and portfoliomanagement


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TOOLS OF CREDIT RISKMANAGEMENT

EXPOSURE C EIL INGS :Setting of prudential normsrelated to the Banks exposure to a single borrower / groupborrowers / sectorial borrowers

REVIEW / RENEWA L : This involves multi-tier creditapproving authority, constitution wise delegation of powers,higher delegated powers for better rated borrowers,discriminatory time for credit review / renewal, hurdle rates /

benchmarks for fresh exposures & periodicity for renewal basedon risk rating.


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COMPREHENSIVE RISK RATING MODELS

RISK B A SED SCIENTIFIC PRICING: Linking loanpricing to expected loss

PORTFOLIO MA NA GEMENT : Stipulate quantitativeceiling on specific rating categories, distribution of borrowers invarious industries / business groups , rapid portfolio reviews, on-going system for identification of credit weaknesses well inadvance, initiate steps to preserve the desired portfolio quality andintegrate portfolio reviews with credit decision making process.


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TOOLS OF CREDIT RISKMANAGEMENTL OA N REVIEW MECHA NISM : This shouldbe done independent of credit operations &administration and cover all the loans abovecertain cut-off limit ensuring that at least 30

40% of the portfolio is subjected to LRM in ayear.


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This is the risk arising out of inadequate or internal

processes, people and systems from externalevents.

The best protection against operational risksconsists of

- redundancies of systems- clear separation of responsibilities with stronginternal controls- regular contingency planning.

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Operational Risk


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Barings ( 1995)233 year old bank collapses under $1.24 Billion lossLack of Internal ControlsNo segregation of duties (Front and back office)Poor authorisation procedures

Lack of management awareness of inherent riskFraudMarket risk


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Operational Risk Definitions

Transaction Processing Risk(TPR) is the risk of financial loss dueto deficiencies in transactionprocessing systems or internal controlsfront to back.

Legal Risk is the risk of financial lossresulting from the non-enforceability of rights arising under a contract or fromproperty or under the general law.

Liability Risk is the risk of lossarising from potential or actual liabilityresulting from a legal or equitableclaim, including contractual and legalclaims, debt, and actions based onbreach or default of contract,commitment of tort, violation of criminallaw, infringement of trademark or anti-trust action.

Security Risk is the risk of loss or damage to our reputation arising from aloss of confidentiality, integrity or

availability of our information or assets.

Compliance Risk is the risk of lossincurred by the Bank by not adhering tothe applicable laws, rules andregulations, local and international bestpractice (including ethical standards)and our own internal standards .

Tax Risk is the risk of loss due to taxauthorities successfully opposing theBanks position in tax returns.

What? Who? How? Why? You


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Operational Risk Drivers

High Profile LossesReputational damage Regulatory Pressure

SOX (Sarbanes Oxley Act)Basle IIMiFID (Markets in Financial Instruments Directive)

Competitive AdvantageOutsourcing / OffshoringTechnology Advancement

Business Growth (Trade volume and human capital)Product Complexity and EvolutionEmerging Market Opportunity


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Structuring RM functionsSet firm-wide policies

Develop methodology

Set RM structure

Risk communication


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Identify and avoidMonitor

Limit Management

StressMarket, Credit VaR

Risk Analysis

Allocate capital RAROC

Active Risk Management


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RAROC

Risk Adjusted Rate of Return

Performance measurement

Marginal impact of any new

transaction

Consistent pricing


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Organizational structure

Front office

Middle office

Back office


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Middle office

risk management

pricing

economic forecasts


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ALCO

Assets Liability management committeeresponsible for

establishingdocumentingenforcing all policies involving market risk

FX

liquidityinterest rate


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Interdependence of RM

Senior Management

Risk Management Operations

Trading Room

Finance


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Senior management

Approves business plan and targets

Sets risk tolerance

Establishes policy

Ensures performance


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Trading Room Management

Establishes and manages risk exposure

Ensures timely and accurate deal capture

Signs off on official P&L


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Operations

Books and settles the trades

Reconciles front and back office

positions

Prepares and decomposes daily P&L

Provides independent MTMSupports business needs


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Risk ManagementDevelops risk policies

Monitors compliance to limits

Manages ALCO processVets models and spreadsheets

Provides independent view on risk

Supports business needs


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Risk LimitsGlobal risk limit

Risk limits for trading desks/units

Dynamic monitoring and adjustment


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Risk Approaches

Accounting - reported P&L

Economic - value

Liquidity needs


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Liquidity Rank

Based on forecasts and potential availability

of funds.

Hot funds - can be withdrawn quickly.

Stable funds - typically to maturity.


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Qualitative Requirements

An independent risk management unit Board of directors involvement Internal model as an integral partInternal controller and risk modelBacktestingStress test


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Quantitative Requirements

99% confidence interval10 business days horizonAt least one year of historic dataData base revised at least every quarter All types of risk exposureDerivatives


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Types of Assets and Risks

Real projects - cashflow versusfinancing

Fixed IncomeOptions

Credit exposure

Legal, operational, authorities


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Risk FactorsThere are many bonds, stocks and currencies.

The idea is to choose a small set of relevant economicfactors and to map everything on these factors.

Exchange rates

Interest rates (for each maturity and indexation)

Spreads

Stock indices


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Swapcurrency or interest rate

two loans with swapped payments

low credit riskchanges exposure:

currency

duration


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Description

A swap is an agreement between two parties toexchange (swap) payments at certain dates in thefuture.

Counterparty A Counterparty B

As payments to B

Bs payments to A


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Plain vanilla swap

Counterparty A is called the fixed rate payer or swap buyer Counterparty B is called the floating rate payer or swapseller

Counterparty A Counterparty B

Fixed rate payments

Floating rate payments


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Example

In this five-year swap, 12-month LIBOR isswapped for 2.67% fixed, on $100 million.

At initiation, the planned payments are:

Floating Leg Fixed LegYear 1-yr LIBOR Payment Fixed rate Payment

0 1.52% 2.67%

1 2.00% 1,520,000$ 2.67% 2,670,000$2 2.60% 2,000,000$ 2.67% 2,670,000$3 3.30% 2,600,000$ 2.67% 2,670,000$4 4.12% 3,300,000$ 2.67% 2,670,000$5 4,120,000$ 2,670,000$

Hypothetical 5-year Swap


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Value at Risk


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The Question Being Asked inVaR

What loss level is such that we are X %confident it will not be exceeded in N

business days?


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5% 95%

Choice of confidence level 95%

Normal market conditions the returns that account for 95% of the distribution of possible outcomes.Abnormal market conditions the returns that account for the other 5% of the possible outcomes.

Investment returns


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If a 95% confidence level is used to estimateValue at Risk for a monthly horizon;

losses greater than the Value at Risk estimateare expected to occur one in twenty months(5%).


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Common Interpretations of Value atRisk:

an attempt to provide a single number for senior management summarizing the total riskin a portfolio of assets

Hull an estimate, with a given degree of

confidence, of how much one can lose fromone s portfolio over a given time horizon

Wilmott


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Value at Risk:

r*0ValueAtRisk V (1 e )

r* 1.645 *

s m


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Conclusions:

Value at Risk can be used as a stand alone risk measure or be appliedto a portfolio of assets.

Value at Risk is a dollar value risk measure, as opposed to the other measurements of risk in the financial industry such as: beta andstandard deviation.

We are X percent certain that we will not lose more than V dollars in

the next N days.

Hull


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Measures of Risk

Standard Deviation ( s)Beta ()

Value at Risk (VaR)


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Measured byVAR

Measured by

Stand-Alone RiskOr

Total Risk

SystematicRisk

UnsystematicRisk

Non-Diversifiable

Risk

DiversifiableRisk

Market Risk Company-Specific Risk


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Risk Measure - Beta ()

Beta () formula:

Beta measures the portfolios systematic risk,that is, the degree to which its return is correlatedwith the return on the market as a whole.Stock with high beta (>1) is more volatile thanthe market taken as a whole.

)(),(

m

mi

k Var

k k Cov


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Risk Measures Value at Risk (VaR)

VaR is a measure of risk based on aprobability of loss and a specific time horizon.VaR translates portfolio volatility into a dollar value.Measure of Total Risk) rather thanSystematic (or Non-Diversifiable Risk)measured by Beta.


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Advantages of VaR

It captures an important aspect of riskin a single number

It is easy to understandIt asks the simple question: How bad canthings get?


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Advantages of VaR

VaR can measure the risk of many types of financialsecurities (i.e., stocks, bonds, commodities, foreign

exchange, off-balance-sheet derivatives such asfutures, forwards, swaps, and options, and etc.) As a tool, VaR is very useful for comparing aportfolio with the market portfolio (S&P500).


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Documents

Lec Bank Risks