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Tutarial: Banks & Bank Risks

Tapie: Banking Risks

By the time you reach the end ofthis topic, you will be able to list and describe the
main risks that banks face.

In order to make a profit, every bank must take risks. The main risks facing banks are:

risk

Categories of Risk

The term 'risk' is generally associated with financiallosses, but is more accurately
described as an uncertainty that could result in losses or adverse fluctuations in
profitability. It is part of a bank's business to bear selected risks in order to generate
returns for the shareholders.

The banking industry faces a significant number of

risks which can be categorized as follows:

1. Credit risk
2. Operational risk
3. Market risk
4. Liquidity risk

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A bank's precise definitions of these risks are

important as they serve as the basis for both the qualitative and quantitative
assessment of the risks. As a result, the definitions have been continually refined
over the years, helped in no small part by supervisory requirements such as the
imposition of capital charges against these risks.

Credit Risk

Credit risk is the potential that a

bank's borrower or counterparty will
fail to meet its obligations in
accordance with agreed terms. It is
the single largest factor
threatening the soundness of
financial institutions and the financial
system as a whole.

Credit risk arises any time bank

funds are extended, committed, Los:s $everity
invested, or otherwise exposed,
whether reflected on or off the balance sheet. It can result from a variety of factors,
including:

• weak or non-existent credit standards for borrowers

• lax loan portfolio management
• poor economic conditions

It is important to note that credit risk incorporates not only the possibility that an
obligor will default, but also the risk that the credit standing or rating of the obligor
will decline (credit downgrade or migration). Such downgrades increase the
probability of default in the future and therefore negatively affect the current market
value of a contract with the obligor.

Credit risk is found in all banking activities where the profitability of that activity
(lending to individuals, for example) depends on whether or not the counterparty or
borrower repays the debt. For most banks, loans are the largest and most obvious
source of credit risk.

Credit Risk: Loans

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Best Bank has a loan portfolio of USD 10,000, consisting often loans with a principal
arnount of USD 1,000 each and a rnaturity of one year. The annual interest rate on each
loan is 10%. Calculate the total interest revenue on the loan portfolio.

Total interest revenue on the loan portfolio =

Credit Risk

True or False?

Short-term lending gene rally involves a greater degree of risk than long-term
lending.

Credit Risk: Sources

Apart from traditional types of loans, credit risk can be found in a bank's:

• investment portfolio
• overdrafts
• letters of credit

Credit risk also exists in a variety of bank products, activities, and services, such as:

• derivatives
• foreign exchange
• cash management services
• trade financing

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Credit Risk

In which of the following situations is a bank exposed to credit risk?

The bank purchases GBP 100 million gilts (UK government securities).
The bank buys GBP 5 million worth of shares in a beverages company
that is listed on the London Stock Exchange.
The bank has a contingent liability of GBP 5 million due to a legal suit filed
by a customer.

Operational Risk

The awareness of operational risk

has dramatically increased in recent
years due to a number of well-
publicized operational risk failures
(Barings and AIB/Allfirst, for
example) and the decision by the
Basel Committee on Banking
Supervision to introduce a capital
charge to protect against this form
of risk in the new capital adequacy
framework (Baselll).

Although operational risk can be difficult to define exactly, the Basel Committee's
definition has gained some credence in the banking industry. The Basel Committee
defines operational risk as "the risk of loss resulting from inadequate or failed
internal processes, people and systems, or from external events". This definition
includes legal risk, but excludes reputational and strategic risk.

Operational risk therefore includes losses that arise from events such as:

• internal fraud
• external fraud
• employment practices and workplace safety
• clients, products and business practices
• damage to physical assets
• business disruption and system failures
• execution, delivery and process management

Market Risk

Market risk is the risk

that movements in
market prices will
adversely affect the
value of on- or off-
balance sheet
positions. These
movements can occur
in:

• Interest rate_s

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• Foreign
exchange (FX) rates
• Equityprices
• Commodityprices

Cilck on oaci1 ol t!leso sources ol niarket risK lor niore inforrnatlon. \Nilon you are finished, ciick the
FQrvvard arrovv to continue

Market Risk Types: Interest Rate Risk

Interest rate risk, the exposure of a bank's

financial condition to adverse movements in
interest rates, is a particularly important form of
market risk. This is because many on- and off-
balance sheet items generate cashflows that are
interest rate-driven (for example, loans and
deposits, interest rate derivatives, certificates of
deposit and other money market instruments).

Interest rate risk incorporates both general

market risk and specific risk:

• General market risk refers to a change in

the value of an instrument that is linked with the behavior of the market as a
whole, for example, yield curve changes.
• Specific risk refers to the risk that an individual instrument's price moves
more or less than the general market, for example, risk related to the
creditworthiness of an issuer.

Interest Rate Risk

Managing interest rate risk is an essential role for a bank's treasury function and can
be an important source of profitability and shareholder value. However, excessive
interest rate risk can pose a significant threat to a bank's earnings and capital base:

• Changes in interest rates affect a bank's earnings by changing its net interest
income and the level of other interest-sensitive income and operating
expenses.
• Changes in interest rates also affect the underlying value of the bank's
assets, liabilities and off-balance sheet instruments because the present
value of future cashflows (and in so me cases, the cashflows themselves)
changes when interest rates change.

Interest Rate Risk Sources

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Sourees of intere,,~ rate risk in elude those described below.

Repricing risk

Yield curve risk

Basis risk

Optionalitv

Cilck un lhe but!ons for a cJescription or exarnpíe 01 eacr'¡ cf these nsks, '¡¡"\W¡enyou're f'iníshed,
clíck tl18 Forvvanj "r(C\v to contínu8,

Interest Rate Risk

True or False?

A bank can manage interest rate risk by taking an equal but opposite position
in the same instrument.

Market Risk Types: Foreign Exchange (FX) Risk

FX or currency risk refers to the risk that

unanticipated exchange rate fluctuations will
adversely impact the value of a bank's positions.
It can occur in both trading and lending activities.

FX risk aríses from spot FX positions, forward FX

positions, future income/expenses or any other
item representing a profit or loss in foreign
currencies. For example, FX risk can also arise
when a bank makes a cross-border loa n
.J. .t.,
r
denominated in the foreign currency.

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FX Risk

Best Bank ~-Iasa long s;pot position of EUR 10m against USD 12m (EURfUSD rate 1.20). =
The bank is rnaintaining a long position in euro because it expects the euro to appreciate
against U,e dollar

TrIe t)an~; intends to close out its position once U-le EURfUSD rate reaches 1.22.

re,sean

Market Risk Types: Equity Risk

Equity risk can consist of general

market risk or specific risk.

General market risk exists when

you invest in any stock. Having said
that, some stocks can be more
vulnerable to general market risk
than others. For example, the
technology crash in 2000 caused
global stock markets to decline, but
obviously had a particularly
significant impact on the share
prices of technology firms.

Specific risk is associated with investing in a particular company. Some companies

will underperform relative to others: when they do, it is for company-specific
reasons. Remember that the return on any stock can come in two forms - the
payment of dividends and capital appreciation in the form of a rising share price.

Dividend payment is optional and depends on the performance of the company,

while a rising share price depends on the market's assessment of the company's
performance. Therefore, the price of any stock represents the market's expectation
of the company's future earnings based on the market's recognition of its
performance. The risk of any stock is therefore directly related to the possible
changes in its price.

Unlike general market risk, specific risk can be reduced by diversification. The
effectiveness of diversification in reducing portfolio risk very much depends on the

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degree of correlation between the assets in a portfolio.

Equity Risk

Take a look at Ule following chart depicting share price rnovernents for two different stocks.

In tM key below the ctlart, click the stock that has Ule greatest equity risk.

Market Risk Types: Commodities Risk

A commodity is a physical product

that is traded on a secondary
market. Commodities are raw or
partly refined materials that can be
classified under some general
headings:

• grains (for example, wheat,

corn and soybean)
• softs (for example, coffee,
sugar and cocoa)
• meats (for example, cattle
and pork bellies)
• metals (for example, gold, silver and copper)
• power and energy (for example, natural gas and crude oil)

Components of Commodities Risk

For spot or physical trading of commodities, directional risk is the main

consideration - the risk that a commodity's spot price will increase or decrease.
Banks that use forward or derivative contracts are exposed to a number of
additional risks, including:

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• Basis risk - the possibility of losses as a result of adverse changes in the

relationship between prices of similar commodities.
• Interest rate risk - in this context, increases in the cost of financing forward
commodity positions.
• Forward gap risk - the risk that the forward price of a commodity may
change for reasons other than a change in interest rates.

In addition, banks may face counterparty credit risk on over-the-counter derivatives

and the funding of commodities positions may well open a bank to interest rate or
foreign exchange exposure.

Market Risk

A bank has extended to a customer a variable rate, 5-year loa n of USO 1m

linked to 6-month L1BOR. The bank funds the loan with a 6-month fixed
deposit. Given this scenario, what do you think will happen to the profit margin
made by the bank if interest rates rise?

The profit margin will increase.

The profit margin will decrease.

, The profit margin will not change.

Liquidity Risk

Liquidity is the ability to fund increases in assets and meet obligations as they
become due. It is crucial to the ongoing viability of any banking organization.

Ideally, a bank would like to invest at the highest yields and fund this investment at
the lowest possible cost. This might mean borrowing very short-term (for example,
by taking deposits) and lending at a higher yield for a longer term (for example,
mortgages) Borrowing short and lending long, however, can create a funding
mismatch, which might mean that a bank does not have sufficient liquidity to meet
commitments as they become due.

Types of Liquidity Risk

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There are a nurnber of different dirnensions to liquidity risk.

and

Funding (cash) liquidity risk

Asset (market) liquidity risk

The two dirnensions of liquidity risk can often be closely related. For exarnple, a bank that
cannot obtain the necessary funds in the market to meet its payrnent obligations may have to
resort to selling its assets (possibly at depressed prices) or pledging them as collateral for
loans.

Liquidity Risk

Rank these assets in arder from the most liquid to the least liquid.

Government (treasury) bilis

Cash

Personalloans

Risk Categories

Match the foliowing examples to the appropriate risk category.

The risk of being unable to seli or unwind asset

positions in the market.

The risk that a bank's borrower or counterparty will fail

to meet its obligations in accordance with agreed terms.

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The risk of loss resulting from inadequate or failed

internal processes, people and systems or from
external events.

The risk that the value of on- or off-balance sheet

positions will be adversely affected by movements in
market prices.

A tisk is an uncertainty U1at could result in losses or adverse fluctuations in proTitability.

8ank risks can ~)e divided into four categories:

• uedit risk
• operational risk
• rnarket risk
• li qui dity ti s k

Tl1ese risks are U-le basis ofqualitative and quantitative risk assessrnents.

back

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