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Risk Management in Banks

A bank has many risks that must be managed carefully, especially since a bank uses a large amount of leverage. Without effective management of its risks, it could very easily become insolvent. If a bank is perceived to be in a financially weak position, depositors will withdraw their funds, other banks won't lend to it nor will the bank be able to sell debt securities in the financial markets, which will exacerbate the bank's financial condition even more. The fear of bank failure was one of the major causes of the 2007 – 2009 credit crisis and of other financial panics in the past. Although banks share many of the same risks as other businesses, the major risks that especially affect banks are liquidity risk, interest rate risks, credit default risks, and trading risks.

Liquidity Risk
Liquidity is the ability to pay, whether it is to pay a bill, to give a depositor their money, or to lend money as part of a credit line. A basic expectation of any bank is to provide funds on demand, such as when a depositor withdraws money from a savings account, or a business presents a check for payment, or borrowers may want to draw on their credit lines. Another need for liquidity is simply to pay bills as they come due. The main problem in liquidity management for a bank is that, while bills are mostly predictable, both in timing and amount, customer demands for funds are highly unpredictable, especially demand deposits (checking accounts). Another major liquidity risk is off-balance sheet risks, such as loan commitments, letters of credit, and derivatives. A loan commitment is a line of credit that a bank provides on demand. Letters of credit include commercial letters of credit, where the bank guarantees that an importer will pay the exporter for imports and a standby letter of credit which guarantees that an issuer of commercial paper or bonds will pay back the principal. Derivatives are a significant off-balance sheet risk. Banks participate in 2 major types of derivatives: interest rate swaps and credit default swaps. Interest rate swaps are agreements where one party exchanges fixed interest rate payments for floating rates. Credit default swaps (CDSs) are agreements where one party guarantees the principal payment of a bond to the bondholder. Liquidity management is achieved by asset and liability management. Asset management requires keeping cash and keeping liquid assets that can be sold quickly at little cost. Liability management is borrowing.

Asset Management

liquid assets can be converted into a means of payment for little cost. A large CD is a time deposit of $100. and the amount of their reserves to hold them over financially stressful times. and by diversification. Checking and savings accounts can reveal how well the customer handles money. By not renewing the loan. credit card and auto loan receivables. Repos are usually made with institutional investors. Liquid assets can be sold quickly for what they are worth minus a transaction cost or bid/ask spread. However. and get credit reports and credit scores from credit reporting agencies. Banks are big users of a debt instrument known as a repurchase agreement (aka repo). By buying liquid assets. along with the payment of interest. It can also include cash that a bank has in an account at a correspondent bank. Credit Risks Credit default risk occurs when a borrower cannot repay the loan. a bank can earn money while maintaining liquidity. prompting them to take their business elsewhere. Although reserves provide liquidity. Banks can substantially reduce their credit risk by lending to their customers. Banks will also verify incomes and employment history. Banks can also borrow directly from the in the money markets. Most repos are overnight loans. the bank receives the principal. such as mortgages. who often have cash to invest. Banks can also sell loans. Eventually. A bank can also increase liquidity by not renewing loans. Hence.The primary key to using asset management to provide liquidity is to keep both cash and liquid assets. credit risk analysis. especially those that are regularly securitized. which are also required by law. Liability Management A bank can increase liquidity by borrowing. Banks predominantly borrow from each other in an interbank market where banks with excess reserves loan to banks with insufficient reserves. usually after a period of 90 days of nonpayment.000 Central Bank. Banks are required by law to maintain an account for loan loss reserves to cover these losses. most banks do not want to use this method because most short-term borrowers are business customers. such as investment and pension funds. they earn little or no money. their minimum income and monthly expenses. which helps to reduce adverse selection. The primary liquidity solution for banks is to have reserves. requiring collateral for a loan. since they have much more information on them than on others. and not renewing a loan could alienate the customer. the loan is written off. either by taking out a loan or by issuing securities. which is a short-term collateralized loan where the borrower exchanges collateral for the loan with the intent of reversing the transaction at a specified time. and the most common collateral is Treasury bills. Many loans are short-term loans that are constantly renewed. Reserves are the amount of money held either as vault cash or as cash held in the bank's account at the Central Bank. such as when a bank buys commercial paper from a business. . Banks reduce credit risk by screening loan applicants.

it sharply contrasts with the ongoing securitisation process which requires the bank to sell the bad debt/loan in the market. i. Credit derivatives : Credit derivatives provide payoff to the investor that depends upon the underlying credit risk associated with any financial instrument. Thus. When banks make loans to others who are not customers. Typically. banks can seek protection against credit risk yet retain the loans intact in their books. but also because the collateral can be sold to repay the debt in case of default. such as the borrower's income and history. In a credit default swap. a credit derivative instrument involves stripping the credit or default risk embodied with a bank loan or a corporate bond or a portfolio of such assets. thereby creating a separate financial instrument altogether. however. The potential risk of a borrower is quantified into a credit rating that depends on information about the borrower and well as statistical models of the business or individual applicant. is largely identified synonymously with 'Credit Default Products' and the most widely traded instrument in this category is 'Credit Default Swaps' (CDS). only the credit or default risk aspect of the loan (asset) is transformed into another hybrid and tradable instrument.e. A bank can also reduce credit risk by diversifying—making loans to businesses in different industries or to borrowers in different locations.Collateral for a loan greatly reduces credit risk not only because the borrower has greater motivation to repay the loan. Credit risk analysis is the determination of how much risk a potential borrower poses and what interest rate should be charged. There are credit rating agencies for businesses most of which assign a number or other code that signifies the potential risk of the borrower. Based on the type of risk being transferred. with the option to put the credit to the protection seller should there be a . This not only provides protection to banks against 'bad assets' but also makes the credit risk amenable for trading as a separate derivative instrument. credit derivatives may be broadly classed in • • • credit default swaps total rate of return swaps equity default swaps The market in credit derivative. the protection buyer continues to pay a certain premium to the protection seller. instead of having derivatives written on the asset itself (as in case of equity derivatives). This is probably the most noteworthy feature of credit derivatives. In banking parlance. then the bank has to rely more on credit risk analysis to determine the credit risk of the loan applicant. A bank will also look at other information.. especially bank loans.

mandates that only banks and financial institutions can securitise their financial assets. To raise funds. credit card payments. In the traditional lending process. In particular. In other words. the conversion of existing assets into marketable securities is known as asset-backed securitisation and the conversion of future cash flows into marketable securities is known as future-flows securitisation. Some of the assets that can be securitised are loans like car loans. This requires a bank to hold assets (loans given) till maturity. For the purpose of distinction. Securitisation is a way of unlocking these blocked funds. housing loans. Unless there is a credit event. This will benefit investors as they will have a claim over the future cash flows generated from the multiplex. Suppose Mr X wants to open a multiplex and is in need of funds for the same. The process and participants Section 5 of the Securitisation and Reconstruction of Financial Assets and Enforcement of Security Interest Act. Failed or delayed payments by sellers of protection could leave the buyers exposed to unexpected credit risk on loans and bonds. 2002. Securitization Securitisation is the process of conversion of existing assets or future cash flows into marketable securities. et cetera and future cash flows like ticket sales. Mr X will also benefit as loan obligations will be met from cash flows generated from the multiplex itself. The funds of the bank are blocked in these loans and to meet its growing fund requirement a bank has to raise additional funds from the market. . collecting principal and interest. Mr X can sell his future cash flows (cash flows arising from sale of movie tickets and food items in the future) in the form of securities to raise money. the market participants and legal experts have raised doubts upon the ability of a protection buyer to enforce payment following a defined default event. Credit derivative transactions are negotiated over the counter and thus involve high degree of counterparty risk. The most pronounced problem involves issues relating to legal and documentation risks. Globally the credit derivatives market has grown spectacularly in recent years but it has yet to reach matured derivative markets in terms of liquidity. transparency and standardisation. and monitoring whether there is any deterioration in borrower's creditworthiness. a bank makes a event. car rentals or any other form of future receivables. maintaining it as an asset on its balance sheet. there is no exchange of the actual asset or the cash flows arising out of the actual asset. securitisation deals with the conversion of assets which are not marketable into marketable ones. The same problem is also coupled with the issue of willingness to pay.

So particular transaction of securitisation can enjoy a credit rating which is much better than that of the originator. To free these blocked funds the assets are transferred by the originator (the person who holds the assets. The assets being transferred to the SPV need to be homogenous in terms of the underlying asset. The way the PTCs are structured the cash flows are unpredictable as there will always be a certain percentage of obligors who won't pay up and this cannot be known in advance. etc. financial institutions (FIs). This is carried on by rating the securitised instrument which will acquaint the investor with the degree of risk involved. The customers who have taken a loan from the ABC bank are known as obligors. What this means is that only one type of asset (eg: auto loans) of similar maturity (eg: 20 to 24 months) will be bundled together for creating the securitised instrument. guarantee. insurance companies. The rating agency rates the securitised instruments on the basis of asset quality. The difference between rate of interest payable by the obligor and return promised to the investor investing in PTCs is the servicing fee for the SPV. pension funds. other financial institutions. and not on the basis of rating of the originator. The bank gives loans to its customers. scheduled commercial banks.Consider a bank. state industrial development corporations. ABC Bank in this case) to a special purpose vehicle (SPV). interest and prepayments received ) received from the obligors are passed onto the investors (investors who have invested in the PTCs) on a pro rata basis once the service fees has been deducted. The SPV will act as an intermediary which divides the assets of the originator into marketable securities. government etc. provident funds. maturity and risk profile. In India only qualified institutional buyers (QIBs) who posses t he expertise and the financial muscle to invest in securities market are allowed to invest in PTCs. The reason for the same being that since PTCs are new to the Indian market only informed big players are capable of taking on the risk that comes with this type of investment. The low risk of securitised instruments is attributable to their backing by financial assets and some credit enhancement measures like insurance/underwriting. The loans given out by this bank are its assets.The cash flows (which will include principal repayment. mutual funds. ABC Bank. In order to facilitate a wide distribution of securitised instruments. These securities issued by the SPV to the investors and are known as pass-through-certificates (PTCs). Mutual funds. Thus. fall under the definition of being a QIB. High rated securitised instruments can offer low risk and higher yields to investors. The investors can be banks. etc used by the originator. evaluation of their quality is of utmost importance. . some amount of risk still remains. Though various steps are taken to take care of this. the bank has a pool of these assets on its balance sheet and so the funds of the bank are locked up in these loans. The SPV is a separate entity formed exclusively for the facilitation of the securitisation process and providing funds to the originator.

A lot of banks have been selling off their NPAs to ARCIL. So the risk from the balance sheet of banks and FIs is not being completely removed as their investments into PTCs issued by ARCIL will generate returns if and only if ARCIL is able to affect recovery from defaulters. Once assets are securitised. In other words. However. the originator can get funds from new investors and additional funds from existing investors at a lower cost than debt. the terms of its liabilities are usually shorter than the terms of its assets. . securitisation can transform banking in other ways as well. As the securitised instruments can have a better credit rating than the company. Asset Reconstruction Company of India Limited (ARCIL) was the first (till date remains the only ARC) to commence business in India. Interest Rate Risk A bank's main source of profit is converting the liabilities of deposits and borrowings into assets of loans and securities. ARCs. It profits by paying a lower interest on its liabilities than it earns on its assets—the difference in these rates is the net interest margin. the SPV can have a servicer to collect the loan repayment instalments from the people who have taken loan from the bank. On acquiring bad loans ARCs restructure them and sell them to other investors as PTCs. securitisation is an alternative to corporate debt or equity for meeting its funding requirements. The servicer follows up with the defaulters and uses legal remedies against them. For an originator (ABC bank in the example). act as debt aggregators and are engaged in acquiring bad loans from the banks at a discounted price. the interest rate paid on deposits and short-term borrowings are sensitive to short-term rates. which. Banks can securitise the loans they have given out and use the money brought in by this to give out more credit. is the risk that interest rates will rise. Normally the originator carries out this activity. securitisation also helps banks to sell off their bad loans (NPAs or non performing assets) to asset reconstruction companies (ARCs). reducing its profits. like for giving new loans. thereby freeing the banking system to focus on normal banking activities. and. thus. these assets are removed from the bank's books and the money generated through securitisation can be used for other profitable uses. What is happening right now is that banks and FIs have been selling their NPAs to ARCIL and the same banks and FIs are picking up the PTCs being issued by ARCIL and thus helping ARCIL to finance the purchase. This creates interest rate risk. thereby helping banks to focus on core activities. while the interest rate earned on long-term liabilities is fixed. In the case of ABC bank. which are typically publicly/government owned. in the case of banks.The administrator or the servicer is appointed to collect the payments from the obligors. Impact on banking Other than freeing up the blocked assets of banks. causing the bank to pay more for its liabilities. Not only this.

The gap is the difference between Rate Sensitive Assets (RSA) and Rate Sensitive Liabilities (RSL) in various time buckets. Reducing Interest Rate Risk Banks could reduce interest rate risk by matching the terms of its interest rate sensitive assets to it liabilities. The gaps on the assets and liabilities are to be identified on different time buckets from 1–28 days. The gap reports indicate whether the institution is in a position to benefit from rising interest rates by having a Positive Gap (RSA > RSL) or whether it is a position to benefit from declining interest rate by a negative Gap (RSL > RSA). it must determine how its income will change when interest rates change. assets and off balance sheet positions into time buckets according to residual maturity or next repricing period. This is best exemplified by the many homeowners who defaulted because of rising interest rates on their adjustable rate mortgages (ARMs) during the 2007 – 2009 credit crisis. Interest-rate sensitive assets include savings deposits and interest-paying checking accounts. In addition.All short-term and floating-rate assets and liabilities are interest-rate sensitive—the interest received on assets and paid on liabilities changes with market rates. So for a bank to determine its overall risk to changing interest rates. Foreign Exchange Risk . Long-term CDs are not interest-rate sensitive. The interest changes should be studied vis-a-vis the impact on profitability on different time buckets to assess the interest rate risk. but this would reduce profits. 29 days upto 3 months and so on. The positive gap indicates that it has more RSAS than RSLS whereas the negative gap indicates that it has more RSLS. and. Gap analysis and duration analysis are 2 common tools for measuring the interest rate risk of bank portfolios. may not be able to afford it. It could also make long-term loans based on a floating rate. whichever is earlier. thus. but many borrowers demand a fixed rate to lower their own risks. The gap report should be generated by grouping interest rate sensitive liabilities. Long-term and fixed-rate assets and liabilities are not interest-rate sensitive. floating-rate loans increase credit risk when rates rise because the borrowers have to pay more each month on their loans. Interest rates on term deposits are fixed during their currency while the loan interest rates are floating rates.

or currency derivatives which will guarantee an exchange rate at some future date or provide a payment to compensate for losses arising from an adverse move in currency exchange rates. with a foreign branch or subsidiary in the country. which will match their assets with their liabilities. which knocked out power and communications in the surrounding area. ___________________________________________________________________________ . which introduces foreign exchange risk. Many types of operational risk. 11. and other property required to run the business are damaged or destroyed. can also take deposits in the foreign currency. since such losses are not insurable. good management is required to prevent losses due to faulty business practices. banks in the vicinity of the World Trade Center suffered considerable losses as a result of the terrorist attacks on September. If the exchange rate of the foreign currency falls. For instance. Banks can hedge this risk with forward contracts. Operational Risk Operational risk arises from faulty business practices or when buildings. 2001. A bank may hold assets denominated in a foreign currency while holding liabilities in their own currency. A bank. equipment.International banks trade large amounts of currencies. are covered by insurance. such as the destruction of property. then both the interest payments and the principal repayment will be worth less than when the loan was given. However. futures. when the value of a currency falls with respect to another. which reduces a bank's profits.