RISK MANAGEMENT IN BANKS

RISK MANAGEMENT

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 to share and hedge risks, provide risk advisory services and act as a counterparty by assuming the risk of others. Because of this role they must excel at measuring and pricing financial risks. Important for survival of the organisation especially in adverse market conditions Issues with overestimation/underestimation

GROWTH OF RISK MANAGEMENT INDUSTRY

Following global events contributed to the growth of risk management industry
Changing from fixed to flexible exchange rate system in 1971 Oil shock of 1973 US stock market collapse of 1983 Japanese stock market collapse of 1989 and further Asian currency crisis of 1997 Russian default and subsequent failure of LTCM in 1998

GROWTH OF RISK MANAGEMENT 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

TOOLS FOR RISK MANAGEMENT

Derivatives Stop-loss limit Notional Amount Exposure limit VAR Back testing Stress Testing

VAR
VAR is defined as the maximum loss over a defined period of time at a stated level of confidence given the normal market conditions.
Advantages of VAR VAR is comparable across different business units in a firm with different asset classes and 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.

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 to overcome the limitation include back testing and stress testing.

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

RISK MANAGEMENT AND VALUE CREATION

By handling bankruptcy costs Eg : A firms debt obligations is INR 300000, bankruptcy costs are INR 75000 Expected profit (after operational expenses before debt servicing) is the following

Profit (before Probabili hedging) ty 200000 0.1 300000 0.2 400000 0.3 500000 0.4

Profit (after Probabili hedging) ty 200000 0 300000 0.20 400000 0.35 500000 0.45

RISK MANAGEMENT AND VALUE CREATION

Debt value = probability * expected payment to debt i.e 0.1* 125000+0.9* 300000 = 282500 Equity value = probability * expected payment to equity i.e 0.3* 100000+0.4* 200000 = 110000 Total value = 392500 If Hedging costs is 10,000 then the values after hedging Debt value = probability * expected payment to debt i.e 1* 300000 = 300000 Equity value = probability * expected payment to equity i.e 0.35* 100000+0.45* 200000 = 125000 Total value = 425000-10000= 415000 Incremental benefit = 415000-392500= 22500

RELATIONSHIP BETWEEN RISK MANAGEMENT,

MANAGEMENT COMPENSATION AND INCENTIVES

Management should be motivated towards maximizing firms value by following sound risk management practices for the firm General tendency to align managements incentive with the stock price doesnt serve the complete purpose of creating long term value for the firm Increasing the managements shareholding in the firm is better option If management compensation is related towards creating firm value then they would be more willing to take effective risk hedging policies and thereby increase the firm value This would also ensure lesser risk premium demanded by the investors because there would be lesser volatility in the stock price of the firm

RISK MANAGEMENT FRAMEWORK

1. Organisation for Risk Management o The Board of Directors Overall responsibility, articulates the risk management policies, procedures, aggregate risk limits, review mechanisms and reporting and auditing systems o The Risk Management Committee of the Board Board sub level committee responsible for ensuring the 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 simultaneously o Risk Management support group analyses and reports to the committee. Also responsible for independent risk monitoring, measurement, analysis and reporting

RISK MANAGEMENT FRAMEWORK

2. Risk Identification

Risk Identification consists of identifying various risks associated with the risk taking at the transaction level and examining its impact on the portfolio and on capital requirement Example : Say Branch B of XYZ bank has extended a loan of INR 1 crore in accordance with the corporate policy and guidelines for a period of 5 years at a rate of interest 1 pct over BPLR of the bank, BPLR being 10 pct. The loan is to be repaid in equal quarterly instalments with one year moratorium. Funding of the loan is to be done from a deposit of 3 years of the same amount, interest rate on it being 6 pct. What are the risks associated with the transaction without taking into account CRR/SLR requirements

RISK MANAGEMENT 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.

RISK MANAGEMENT FRAMEWORK

3. Risk Measurement

Risk measures capture variation in earnings, market value, losses due to default etc arising out of the uncertainties associated with the various risk elements Quantitative measures can be classified into three categories Based on Sensitivity Based on Volatility Based on Downside Potential (two components potential loss and probability of occurrence)

RISK MANAGEMENT FRAMEWORK

4. Risk pricing

Pricing should take into account the following Cost of deployable funds Operating expenses Loss probability Capital charge

RISK MANAGEMENT FRAMEWORK

5. Risk Monitoring and Control
Strong Management Information System for reporting, monitoring and controlling risk Well laidout procedures, effective control and comprehensive risk reporting framework Separate risk management framework independent of operational requirements with clear delineation of responsibility 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 their impact on capital levels b. Assess banks risk profile on a continuous basis and make necessary adjustments to the banks strategic plan accordingly c. Identify the large exposures and risk management concentrations

RISK MANAGEMENT FRAMEWORK

6. Risk Mitigation Refers to the reduction in risk achieved by adopting strategies that eliminate or reduce uncertainties associated with the risk elements Credit risk can be mitigated by collateralisations and by buying credit derivatives. It is also mitigated by having a robust credit appraisal and review process. Interest rate risk can be mitigated by using interest rate swaps or forward rate agreements Forex risk can be mitigated by using forex forward contracts, forex options 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

RISK MANAGEMENT FRAMEWORK

7. Risk Mitigation through diversification INR 000
Cash flow from Year 1 Year 2 Year 3 Year 4

Year 5 Total

Mean

Standard deviation

Standard deviation /Mean

Business A Business B Business C Business D Business E

10 3 12 6 7

3 8 8 9 12

4 1 9 2 5

8 6 2 3 8

11 4 4 5 6

36 22 35 25 38

7.2 4.4 7 5 7.6

3.56 2.70 4.00 2.74 2.70

0.49 0.61 0.57 0.55 0.36

Total Portfolio

38

40

21

27

30

156

31.2

7.85

0.25

TYPES OF RISK MANAGEMENT FAILURES

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

LINKAGES AMONG RISK, CAPITAL AND

RETURN

Higher risk means higher variability of returns, higher profit potential and loss possibilities, therefore capital requirement will be higher. Expected return would also factor in the risks associated with it. Higher the risks in a business model, higher would be the return expectations Example : Following returns from investment of INR 50,000
INR 000 Total 30 30

Cash flow from Investment-1 Investment-2

Year 1 6 3

Year 2 6 9

Year 3 6 5

Year 4 6 -2

Year 5 6 15

CASE STUDIES BARINGS BANK

Nick Leeson, trader at Baring PLC in Singapore, took concentrated positions on Nikkei 225 derivatives for bank in Singapore International Monetary Exchange (SIMEX). He took arbitrage positions on Nikkei derivatives 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 abandoned the hedge strategy and initiated a speculative longlong futures position in both exchanges in hope of profiting from an increase in Nikkei 225. He also engaged in unauthorised option writing to collect premium to keep himself ready for margin calls

CASE STUDIES BARINGS BANK

Leeson was solely responsible for back and front office operations of Singapore. He used an error account to hide his losses by fraudulently transferring funds to and from his error accounts He kept on building his positions even after Nikkei kept on falling, however after Jan 95 earthquake, the Nikkei plunged and he could not sustain his positions and failed to honor the margin calls It eventually led to the collapse of Barings bank (due to losses of USD 1.3 B), when it was sold to ING for mere USD 1.60 only It had various risk exposures such as Market, Event, Legal , Employee

CASE 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 or unwind 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 put options was not risky for him Though he never imagined that he could be susceptible to steep decline of copper prices

CASE STUDIES SUMITOMO

Commodity Futures Trading Commission (CFTC) began an investigation of market manipulation in Dec 95 Fall in Copper prices in June 96 after revelation of Hamanakas unfair dealings led to USD 2.6Bn loss for Sumitomo and USD 150 M fine from CFTC Positions were so large that company could liquidate them completely Sumitomos lack of Supervision created a high degree of operational risk, which could have been reduced with proper internal controls In Sumitomos case no approvals were required from senior management for large transactions and senior management was unequipped to understand the complex transactions It had various risk exposures such as Market, Liquidity, Legal , Employee

BANKING RISKS
Liquidity Risk Inability to obtain funds to meet cash flow obligations at a reasonable rate Funding risk due to unanticipated withdrawal/nonrenewal of deposits Time risk- due to non-receipt of expected inflows of funds Call risk Crystallization of contingent liabilities

BANKING RISKS
Interest Rate Risk Adverse impact on NIM due to changes in interest rates Gap or mismatch risk Due to mismatch in amount and tenor 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
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
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 counterpartys 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

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.
Mood y's S&P Investment Grade AAA Aaa Highest Rating

S&P Non-Investment Grade BB

Moody's

Ba

Speculative

AA

Aa

BBB

Baa

Very Strong Slightly more susceptible to adverse economic conditions Adequate capacity to repay principal and interest. Slightly speculative

Missed one or more interest or principal payments

CCC-C

Caa-C

No interest is being paid

Default

BANKING RISKS
Operational risk Risk of loss resulting from inadequate or failed internal processes, 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, wrongful discharge, misleading information, conflict of interests, vendor non-performance, poor financial performance, unethical behaviour, lack of transparency etc External events risk- Economic shocks, natural disasters

BANKING RISKS
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.

RELATION BETWEEN OPERATIONAL, MARKET 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 the credit rating for the firm and reduction in the market price for its securities.

INTEGRATED RISK MANAGEMENT

Integrated risk management is managing all risks that are associated with all the activities undertaken across the entire organisation. The sum total of all risk impacts is a critical factor for all organisations. Integrated risk management implies a coordinated approach across various risks by improving the understanding and interrelationships between various risks. An integrated approach to risk management centralizes the process of supervising risk exposure so that the organisation can determine how best to absorb, limit or transfer risk. It is an ongoing process that calls for standard definations and methods to identify measure and manage risk across all business units