RISK ANALYSIS

AND
MANAGEMENT
LECTURE 2
TOPIC 3: Introduction to Risk
CONTENTS

ü Uncertainty, Risk and Exposure to Risk

ü Broad Classes of Financial Risk

ü Risk Management Process

ü Banking, A Universe of Risks

 UNCERTAINTY, RISK AND EXPOSURE TO RISK

WHAT IS RISK?
Risk in finance refers to the randomness of investment returns, including both positive and negative outcomes. In the financial
industry, risk is defined by the uncertainty that has adverse consequences on earnings or wealth, or the uncertainty associated
with negative outcomes only. Risk managers are responsible for Identifying, Assessing and Controlling the likelihood and
consequences of adverse events for the firm.
Uncertainty

You cannot remove uncertainty, however, the exposure of it can be changed. For example, a firm having revenues in foreign
currency can borrow in the same foreign currency to minimize any foreign exchange risk (the earning impact of foreign exchange
rate fluctuations).

Exposure
Exposure is the extent to which a business could be affected by certain factors that may have a negative impact on earnings. For
example, FX exposure depends on the extent of unexpected exchange rate changes, i.e. how volatile are exchange rates.
Unfavourable changes in FX can affect an entity borrowing in foreign currency.
UNCERTAINTY, RISK AND EXPOSURE TO RISK CONT’D

Exposure management techniques are useful for eliminating (or reducing) exposure by insuring against the possibility of
incurring a FX or interest rate loss.

Exposure management techniques can be internal (devices/measures used within the firm) or external (based on financial

markets).

ü External hedging indicates the use of derivatives (e.g., FX forward, swap, option, interest rate swap) to reduce the
exposure.

ü Internal hedging indicates reducing the exposure of the firm operationally.

 BROAD CLASSES OF FINANCIAL RISK

Financial risks are defined according to the uncertainty a firm may face. These broad classes include; credit risk, market risk,
liquidity risk and interest rate risk which can be divided into subclasses dependent on the events that trigger the losses.

Credit Risk

Credit risk can be defined as the risk, for the bank, to experience larger losses than expected losses because of a counterparty’s
default or credit deterioration.

Importance of distinguishing «expected losses» (EL) from «unexpected losses» (UL):

ü EL do not constitute a risk as they are in principle expected… and should be reflected in the pricing of the credits granted by
the bank. Banks set aside credit reserves.

ü UL are the risks that are unforeseen, and a bank should have enough capital to absorb such UL.
DEPOSITORY AND NON-DEPOSITORY INSTITUTIONS CONT’D

Three (3) major components in credit risk

ü Default risk Default Probability,(DP) – the probability that a borrower will default on contractual payments; expressed as a %.

ü Exposure risk Exposure at Default (EAD) – the loss exposure of a bank at the time of a loan’s default, expressed in monetary
terms. EAD is an amount that keeps on changing as the borrower continues to make payments.

ü Recovery risk Loss Given Default (LGD) – the percentage loss incurred if the borrower defaults. The LGD can be expressed as:

LGD = 1 – Recovery Rate (RR)

EL = EAD × 𝐷𝑃 × 𝐿𝐺𝐷= 𝐷𝑃 × 𝐸𝐴𝐷 × 1 − 𝑅𝑅 (expressed in monetary terms)

EL = DP × 𝐿𝐺𝐷 = DP × 1 − 𝑅𝑅 (Expressed in % of EAD)

Credit risk management is about mitigating/ reducing these three (3) components.
BROAD CLASSES OF FINANCIAL RISK

Market Risk

Market risk can be defined as the risk related to the uncertainty of a financial institution’s earnings caused by changes, and
particularly extreme changes, in market conditions such as the price of an asset, interest rates, market volatility, and market
liquidity. Thus, risks such as interest rate risk, credit risk, liquidity risk, and foreign exchange risk affect market risk.

For example:

ü Major financial institutions hold various financial products such as derivatives , stocks etc. Their values change on a day-to-
day basis based on movements in various market risk factors such as fluctuations in interest rate, foreign exchange rates , etc.

ü The Financial Crisis 06/07

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BROAD CLASSES OF FINANCIAL RISK

Liquidity Risk

The risk that an organization may be unable to meet their short-term financial obligations when they become due. Converting
assets into cash quickly. Funding liquidity refers to borrowing for raising cash. Asset liquidity refers to cash raised from the sale
of assets in the market (commodities, stocks etc) as an alternate source of funds, for example in market disruptions.

Example:

Company A who is a major corporation in a competitive industry, eventually there was a decline in demand, and a shortage of
cash due to some kind of economic downturn.

The impact; there was a decline of sales, surplus of products (using working capital for more products and not for their financial
obligations), inability to pay suppliers and employees (due to sales declining).

The consequences; increased borrowing costs to make short- term obligations (this may cause unfavourable loan terms), loss of
creditworthiness ( their credit standing will fall substantially which may cause investors to lose faith and withdraw), missed
business opportunities (unable to capitalize on other business investments)

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BROAD CLASSES OF FINANCIAL RISK

Interest Rate Risk

Unanticipated fluctuations in interest rates due to any monetary policy measures by the central bank. Interest rate risk can affect a FI
liquidity. When the economy faces high inflationary pressures, the central bank will increase interest rates to slow the economy
(contractionary monetary policy).

Interest rate risk affects all parties involved in lending and borrowing, including floating rate borrowers and lenders, as well as fixed-rate
loans and debts, due to market fluctuations and opportunity costs arising from market movements. Interest rate risk is primarily associated
with fixed income securities ie. Bonds.

Foreign Exchange Risk

Foreign exchange risk is the risk of incurring losses due to fluctuations of exchange rates. For example, A company doing business
internationally and earns revenue in foreign currency or pay for purchases in the foreign currency, exchange risk becomes a factor in these
interactions. The value of the foreign currency can change between the time of the transaction and the time the payment is made or
received and converted to the country’s home currency.

International institutions seek to manage these risks by hedging with derivatives (swaps, forward and futures contracts etc).

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BROAD CLASSES OF FINANCIAL RISK

Solvency Risk

The risk of being unable to absorb losses with the available capital. According to the principle of “capital adequacy” promoted by
regulators, a minimum capital base is required to absorb unexpected losses potentially arising from the current risks of the firm.
Solvency issues arise when the unexpected losses exceed the capital level, as it did during the 2008 financial crisis for several
firms.

Operational Risk

The risk of loss resulting from the inadequacy or failure of internal processes or deliberate external events, whether accidental
or natural. The regulators define operational risk as “the risk of direct or indirect loss resulting from inadequate or failed internal
processes, people and systems or from external events”.

Management of operational risk means and includes identification, assessment, monitoring and control/mitigation of this risk.

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RISK MANAGEMENT

ü Risk management requires that the risks of a financial institution be identified, assessed and controlled within an enterprise-
wide framework with risk limits and delegations.

ü Risk models measure and quantify risk, providing input for management processes.

ü All risk processes imply that risk policies be properly defined and that the risk appetite of the firm be well defined.

ü Limits aim at avoiding that adverse events, affecting a transaction or a portfolio of transactions, impair the credit standing of
the firm.

ü Banks need to segment their activities into meaningful portfolios ( for example by business unit, product or type of clients).

ü Delegations decentralize and simplify the risk process, allowing local managers to make decisions without referring to upper
levels (effective management of risks before the Board).

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BANKING, A UNIVERSE OF RISKS

Banks are by nature exposed to a very large number of risks

Banks should put a lot of efforts in properly:

ü Identifying all the risks they are exposed to – market risk, credit risk, operational risk

ü Measuring them properly – forecasting, stress testing

ü Assessment of overall risks – portfolio models ie. Creating risk profiles

ü Taking actions to reduce/ mitigate the risks to stay below risk appetite – limiting, derivatives, risk-adjusted prices

ü Create risk control/monitoring – align with risk-bearing capacity ie. Defining a risk appetite for each of these risks and tolerance to
the financial impact of risk

For the identification of credit risks that impact the capital, see, for example, CBB’s definitions and expectations of FIs:

https://www.centralbank.org.bb/news/general-press-release/the-central-bank-of-barbados-issues-credit-risk-management-guideline-to-
assist-financial-institutions-in-meeting-their-obligations-relating-to-this-key-risk-area

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BANKING, A UNIVERSE OF RISKS

Moreover, given the business model (borrowing short term and lending longer term), many banks are also naturally exposed to
the liquidity risk

ü The risks impacting the solvency and liquidity of banks should be properly measured ( We will review together a set of
indicators commonly used by banks)

ü When the risk level taken by the bank exceeds/ may exceed the level of risk tolerance(set by the Board), measures should be
taken to reduce the risks ( We will review together a few examples of instruments used to (partially) hedge these risks)

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BANKS NEED CAPITAL TO ABSORB UNEXPECTED LOSSES ARISING FROM
THEIR RISK EXPOSURES

• Banks are very leveraged

ü With just a little bit of capital, they borrow funds (e.g. deposits, bank bonds, etc) and make loans / invest in securities

• In case of losses on the asset side (loans, securities)

ü Losses are first absorbed by capital
ü If not enough capital, the banks’ creditors are at risk which can compromise financial stability

• Issue of conflicting interests between shareholders of a bank and supervisors or creditors

ü Capital is the most expensive funding source (investors may expect a share in profit) shareholders want to minimise it (to improve ROE)
ü Creditors would benefit from a larger capital buffer

ü Conflict of interests….necessity to regulate and impose «minimum capital requirements»

ü At international level, Basel Committee on Banking Supervision defines general guidelines (e.g. the famous Basel III rules following the 2008 crisis)

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INTRODUCTION OF BASEL REGULATIONS’ PILLARS: A SNAPSHOT OF
BASEL REGULATIONS

Regulation Issued Dec 2009 Proposed Nov 2010

Jul 2009 Basel II Basel II adjustments G20 endorses
May 2009 Basel adjustments for for enhanced capital BCBS Basel
Committee securitisation and adequacy rules,
publishes liquidity risk
III proposals
July 1988 trading book
Dec 1996 Basel I Jun 2004 management and Dec 2010
Basel I is Principles for instruments (also
amendment for Basel II is systemic risk Basel III is
published sound stress called Basel 2.5)
market risk published monitoring (also called published
testing practices
Basel III)

Jan 2013 Jan 2019

Jan 2011
Dec 1992 Current official Current
Dec 2006 Basel III
Official date for Basel official
Official observation
deadline for III deadline for
deadline for period
Basel I implementation Basel III
Basel II begins
compliance compliance
compliance

Regulation Implemented

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RISK-WEIGHTED ASSETS –A CENTRAL CONCEPT FOR REGULATORY
REQUIREMENTS…

Basel rules consider that different levels of capital should be assigned to different levels of risk

ü Indeed, a loan of 100 to a riskier customer is more likely to generate higher losses than a loan of 100 to a less risky
customer

ü Hence more capital should be put aside for the former.

In practice, «risk weights» are used to reflect this

ü The riskier the asset, the higher the risk weights

ü Risk-weighted assets(RWA) = Assets multiplied by risk weights

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BASEL I: A SIMPLE FRAMEWORK

ü The focus was to protect banks from credit risk.

ü Basel I was focused on banks holding more capital in the event of liquidation and capital should always be available to absorb
unexpected losses without triggering bankruptcy of the bank.

ü According to Basel I, assets were classified into four categories based on risk weights.

TYPE OF CREDIT WEIGHT WEIGHTED ASSETS

To sovereign 0% 0
(OECD)
To Banks 20% 20
Mortgage credit 50% 50
Others 100% 100
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THE COMPUTATION OF THE CAPITAL ADEQUACY RATIO: BASEL I

Capital Adequacy Ratio (CAR)

ü When a bank suffers large and unexpected losses, they rely on capital to absorb those losses before affecting their creditors.

ü The Reserve Bank/ Central Bank (regulators) requires banks to hold a minimum amount of capital against the riskiness of
their assets to make banks more resilient to losses.

ü The original credit risk Cooke ratio of the 1988 Accord stipulates that the capital base should be at least 8% of weighted
assets.

ü Risk-weighted assets (RWA) are calculated as the product of the size of loans with risk weights. The risk weights serve to
differentiate the capital load according to the credit quality of borrowers.

ü The regulators’ 8% capital adequacy ratio can be interpreted as a view that banks could not lose more than 8% of their total
risk-weighted portfolio of loans for credit risk.

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CAPITAL ADEQUACY RATIO (CAR)

𝑇𝑖𝑒𝑟 1 𝐶𝑎𝑝𝑖𝑡𝑎𝑙 + 𝑇𝑖𝑒𝑟 2 𝐶𝑎𝑝𝑖𝑡𝑎𝑙

𝑀𝑖𝑛 𝐶𝐴𝑅 = ≥ 8%
𝑅𝑊𝐴

Tier 1 capital is the main measure of a bank’s financial strength from a regulatory point of view. It consists of core capital
(common stock and disclosed reserves), but may also include non-redeemable, non-cumulative preferred stock.

Tier 2 capital is regarded as the second most reliable form of capital from a regulatory point of view. It consists in capital that is
redeemable at a given date in the future or that may be difficult to value. It includes undisclosed reserves, revaluation reserves,
general provisions, hybrid instruments and subordinated term debt (with a minimum maturity of five years).

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BASEL REGULATIONS’ PILLARS

ü Basel regulation has evolved to comprise three (3) pillars concerned with minimum capital requirements (Pillar 1),
supervisory review (Pillar 2), and market discipline (Pillar 3). Today, the regulation applies to credit risk, market risk,
operational risk and liquidity risk.

ü Due to the 06/07 financial crisis banks need to meet its obligations in a timely manner. Basel III has thus introduced liquidity
ratios (current ratio, quick ratio and cash ratio). With this enhancement, the BCBS’ objective is to ensure that banks hold
enough assets that can be easily and quickly converted to cash to meet liabilities over both short- and longer-term periods.

ü Basel regulations were not only focused on quantitative requirements. Under Pillar 2 and the stress-testing guidelines are
good examples of how the BCBS aims to achieve this objective. The global financial crisis has alerted supervisors of the need
to work together more closely and to facilitate the management of systemic risk.

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BASEL II –A MORE REFINED FRAMEWORK

Minimum Capital Supervisory review Market Discipline

Pillar 1

Pillar 2

Pillar 3
Requirements Evaluates activities and
Maintains minimum risk profiles by supervisors
regulatory capital to determine if the banks
calculated for credit risk, should hold higher levels
operational risk and of capital than the
market risk to align more minimum requirements in
closely to the bank’s actual Pillar I and if further
risk of economic loss actions are required
Solution Solution
Comply with local Establish appropriate risk
regulatory requirements management processes
Leverages the ability of
market discipline to
motivate prudent
management by enhancing
the degree of transparency
in the banks’ public
reporting to shareholders
and customers
Solution
Maintain transparency
through public disclosure

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BASEL III REGULATIONS

• It introduces a new regulatory regime for capital, liquidity and banking supervision.

• The BCBS noted from the financial crisis banks were too highly leveraged, held insufficient capital (specifically
insufficient high-quality capital) and had inadequate liquidity buffers. Individual banks had inadequate risk management
and corporate governance processes and regulatory supervision was not strong enough. It is important to note that Basel
II doesn’t go away. Basel III introduces enhancements to the Basel II framework.

• Key enhancements
ü Higher and better quality of capital
ü Tighter standards for liquidity risk measurement and monitoring
ü New rules to addresses forward-looking provisioning for credit losses
ü Additional measures to reduce systemic risk

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RISK ANALYSIS AND
MANAGEMENT

THE END

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