MANAGEMENT OF FINANCIAL

INSTITUTIONS

RISK MANAGEMENT OF
COMMERCIAL BANK

Professor: Amira Guermazi

JUNIOR FINANCE
• The fundamental objective of bank management is to
maximize shareholders’ wealth = maximize the market value
of a bank’s common stock

• Profit maximization appears to suggest that the bank manager

simply invest in assets that generate the highest gross yields
and keep costs down

• To obtain higher yields, a bank must either take on increased

risk or lower operating costs.

• A bank’s profitability will generally vary directly with the

riskiness of its portfolio and operations
• Risk management is the process by which managers identify,
assess, monitor, and control risks associated with a financial
institution’s activities

• The complexity and range of financial products have made

risk management more difficult to accomplish and evaluate

• In larger financial institutions, risk management is used to

identify all risks associated with particular business activities
and to aggregate information such that exposures can be
evaluated on a common basis
RISK MANAGEMENT
• 6 types of risks are identified:

– Liquidity Risk
– Operational Risk
– Credit Risk
– Market Risk
– Off Balance Sheet Activities Risk
– Capital or Solvency Risk (the summary of all listed risks)
• Each of these risks is fundamental to the likelihood that
current events or potential events will negatively affect an
institution’s

– profitability
– the market value of its assets, liabilities, and stock holders’
equity

• The impact of adverse risk events can be absorbed by

sufficient bank capital such that the institution will remain
solvent

• As a result, capital or solvency risk is addressed separately and

represents a summary of the 5 risks listed above
• Using historical accounting data, it is possible to examine
potential sources of risk.

• However, historical data only tell the analyst what has

happened, not what is going to happen. Risk is about the
future, not the past.

• We use historical data as a measure of the business policies

and practices of the bank.

• If events change, such as an economic recession, or

management changes its business model, such as moving into
subprime lending, historical data may not be representative of
the bank’s risk profile.
CREDIT RISK
• Credit risk is associated with the quality of individual assets
and the likelihood of default

• It is extremely difficult to assess individual asset quality

because limited published information is available

• Whenever a bank acquires an earning asset, it assumes the

risk that the borrower will default, that is, not repay the
principal and interest on a timely basis
• Credit risk is the potential variation in net income and market
value of equity resulting from this nonpayment or delayed
payment

• Different types of assets and off-balance sheet activities have

different default probabilities

• Loans typically exhibit the greatest credit risk

• Changes in general economic conditions and a firm’s

operating environment alter the cash flow available for debt
service. These conditions are difficult to predict
• Similarly, an individual’s ability to repay debts varies with
changes in employment and personal net worth.

• For this reason, banks perform a credit analysis on each loan

request to assess a borrower’s capacity to repay

• Unfortunately, loans tend to deteriorate long before

accounting information reveals any problems. In addition,
many banks enter into off-balance sheet activities, such as
loan commitments, guaranty offers, and derivative contracts
• The prospective borrowers and counterparties must perform
or the bank may take a loss.

• These risks can be substantial, but are difficult to measure

from published data

• Bank investment securities generally exhibit less credit risk

because the borrowers are predominantly federal, state, and
local governmental units
• Banks are also generally restricted to investment-grade
securities, those rated Baa (BBB) or higher, which exhibit less
default risk

• Banks evaluate their general credit risk by asking three basic

questions and their credit risk measures focus predominantly
on these same general areas:

– What is the historical loss rate on loans and investments?

– What are expected losses in the future?
– How is the bank prepared to weather the losses?
HISTORICAL LOSS RATE
• Managers typically focus their attention initially on a bank’s
historical loan loss experience because loans exhibit the
highest default rates

• Ratios that examine the historical loss experience are related

to gross losses, recoveries, and net losses

• Gross loan losses (charge-offs) equal the dollar value of loans

actually written off as uncollectible during a period
• Recoveries refer to the dollar amount of loans that were
previously charged-off but now collected

• Net losses (net charge-offs)equal the difference between

gross loan losses and recoveries

• Net losses = Gross Losses - Recoveries

• Net losses directly reduce loan loss reserves that a bank sets
aside for potential losses

• It is important to note that net losses are not directly reported

on the income statement

• Instead, a bank reports provisions for loan losses, which

represents a transfer of funds (deducted from income before
determining taxes) to build the allowance for loan losses (loan
loss reserve) up to its desired level
• a bank’s balance sheet lists the allowance for loan and lease
losses under gross loans as a contra-asset account

• Importantly, this allowance or loan loss reserve is only an

accounting entry and does not represent funds that a bank
can go to when it needs cash.

• The greater is a bank’s loss reserves, the more it has provided

for loan losses but not charged-off.
EXAMPLE
Assets Equity Capital and
Liabilities
Cash and Due 10 Deposits 50

Gross Loans 50 Borrowed Funds 20

Securities 40 Equity Capital 30

On December 31st, the net income before provisions to

loan losses is 10 (no taxes)
10% of the loans presents a high default risk, the bank
decides to buil allowance for loans loss up to their
principal value
 Cash and Due Provision for Loan Losses
Balance Sheet Item Income Report Item

10 5
Equity Capital Loan Losses Reserve
Balance Sheet Item Balance Sheet Item
10 5 5

Assets Equity Capital and Liabilities

Cash and Due 10+10 Deposits 50
Gross Loans 50 Borrowed Funds 20
Loan Losses Reserve - 5
Securities 40 Equity Capital 30+10-5
• Effectively, only 2% of the loans are considered uncollectible,
charged off

Loan Losses Reserve Gross Loans

Balance Sheet Item Balance Sheet Item
1 5 50 1

Assets Equity Capital and Liabilities

Cash and Due 20 Deposits 50
Gross Loans 49 Borrowed Funds 20
Loan Losses Reserve - 4
Securities 40 Equity Capital 35
• 50% of the charged off loans are recovered

Loan Losses Reserve Cash and Due

Balance Sheet Item Balance Sheet Item
1 5 10
0,5 0,5

Assets Equity Capital and Liabilities

Cash and Due 20,5 Deposits 50
Gross Loans 49 Borrowed Funds 20
Loan Losses Reserve - 4,5
Securities 40 Equity Capital 35
• Actually, 20% of the loans are considered uncollectible,
charged off

Loan Losses Gross Loans Equity Capital

Reserve
5 5 50 10 5 35

Assets Equity Capital and Liabilities

Cash and Due 20 Deposits 50
Gross Loans 40 Borrowed Funds 20
Loan Losses Reserve 0
Securities 40 Equity Capital 30
EXPECTED FUTURE LOSSES
• Ratios that examine expected future loss rates, as a fraction of
total loans, are based on :
– past-due loans
– nonaccrual loans
– total noncurrent loans
– classified loans
• Past-due loans represent loans for which contracted interest
and principal payments have not been made but are still
accruing interest
• Past-due loans are often separated into 30–89 days past due
and 90 days and over past due date. The formal designation of
nonperforming loans are loans that are more than 90 days
past due.

• Nonaccrual loans are those not currently accruing interest.

These loans are currently or past due, or have other
problems, which have placed then in nonaccrual status

• Total noncurrent loans are the sum of these two types of

loans.
• Restructured loans are loans for which the lender has
modified the required payments on principal or interest.

• The lender may have lengthened maturity and/or

renegotiated the interest rate

• Classified loans are a general category of loans in which

regulators have forced management to set aside reserves for
clearly recognized losses
• Because some loans, such as speculative construction loans,
are riskier than others, an analyst should examine the
composition of a bank’s loan portfolio and the magnitude of
past due, nonaccrual, noncurrent, restructured, and classified
loans relative to total loans.

• These include the bank’s provisions for loan losses to average

total assets, the loan and lease loss allowance (loan loss
reserve) as a percentage of total loans, earning coverage of
net losses, and loan and lease loss allowance to net losses
• When management expects to charge-off large amounts of
loans, it will build up the allowance for loan losses. It does this
by adding to provisions for loan losses.

• Thus, a large allowance may indicate both good and bad

performance

• If asset quality is poor, a bank needs a large allowance

because it will need to charge-off many loans. The allowance
should be large .

• Cash flows from loans will decline along with reported

interest income. In this case, a high-loss reserve signals bad
performance.
• With high-quality assets, banks charge-off fewer loans, so the
allowance can be proportionately less.

• A bank with a large allowance for loan losses and few past
due, nonaccrual, or nonperforming loans will not need all of
the reserve to cover charge-offs, which will be low.

• Such a bank has reported provisions for loan losses that are
higher than needed such that prior period net income is too
low. Future profit measures should benefit once provisions
are lowered.
PREPARED FOR LOSSES
• Ideally, management should relate the size of the loan loss
reserve to noncurrent loans, which represent potential
charge-offs

• With a reserve equal to noncurrent loans (100% coverage), a

bank should be well protected because it shouldn’t expect to
charge-off all nonperforming and nonaccrual loans
• Regulators require that a bank’s loan loss reserve be adequate
to cover the known and inherent risk in the loan portfolio

• Another ratio used to measure a bank’s ability to cover

current period losses is earnings coverage of net losses:

Net operating income/net loan and lease losses

• It indicates how many times current earnings can cover

current net charge-offs

• A higher ratio signals greater coverage and, thus, greater

protection
• However, for the ratio to be useful, a bank must
consistently report realistic figures for earnings
and net losses

• When banks have asset quality problems,

management often plays games by understating
reserves and overstating earnings.

• Thus, the ratio is less revealing than ratios that

directly incorporate the size of the loss reserve.
CREDIT RISK SOURCES
• Three other sources of credit risk should be identified:

1/ banks that lend in a narrow geographic area or

concentrate their loans to a certain industry

• This risk is not fully measured by balance sheet or historical

charge-off data

• This lack of diversification could dramatically affect a majority of

the bank’s portfolio if economic factors negatively affected the
geographic or industry concentration.

• This type of bank could be subject to risks that the rest of the
banking industry is not subject to in its operations.
2/ banks with high loan growth

• assume greater risk, as credit analysis and review procedures are

less rigorous

• may be achieving this growth by making loans they have not made
in the past. Hence, their historical data may not represent the risk
of the current portfolio

• In many instances, the loans perform for a while, but losses

eventually rise

• Thus, high loan growth rates, particularly when the loans are
generated externally through acquisitions or entering new trade
areas, often lead to future charge-offs
3/ banks that lend funds in foreign countries take
country risk

• Country risk refers to the potential loss of interest and principal on

international loans due to borrowers in a country refusing to make
timely payments, as per a loan agreement

• foreign governments and corporate borrowers may default on

their loans due to government controls over the actions of
businesses and individuals
• Ideally, it would be useful to examine the actual loan files of a
bank to assess the quality of specific loans.

• Although this information is only provided to regulators.

Regulators, in fact, assign each bank a rating for asset quality
(“A” for asset quality) as part of the CAMELS rating system.

• A policy that analysts desire but bankers fear.

LIQUIDITY RISK
• Bank’s inability to meet payment or clearing obligations in a
timely and cost-effective manner

• Liquidity risk is greatest when a bank cannot anticipate new

loan demand or deposit withdrawals, and does not have
access to new sources of cash

• This risk can be the result of either funding problems or

market liquidity risk
• Funding liquidity risk is the inability to liquidate assets or
obtain adequate funding from new borrowing

• Market liquidity risk is the inability of the bank to easily

unwind or offset specific exposures without significant losses
from inadequate market depth or market disturbances
• A firm can provide for its liquidity needs in one of two ways:
– by holding liquid assets
– by securing its ability to borrow (issuing new liabilities) at
reasonable costs.

• Thus, when banks need cash, they can either sell liquid assets
or increase borrowings.

• Liquidity risk measures, therefore, focus on the quantity and

quality of liquid assets near maturity or available-for-sale, at
reasonable prices, as well as the bank’s ability to cheaply and
easily borrow funds to meet cash outflows.
HOLDING LIQUID ASSETS
• Liquidity refers to an owner’s ability to convert the asset to
cash with minimal loss from price depreciation

• Most banks hold some assets that can be readily sold to meet
liquidity needs

• These liquid assets provide immediate access to cash but are

costly for the bank to hold.

• Liquid assets generally pay very low rates of interest, which

could be below a bank’s average cost of funds
• cash assets are held to satisfy customer withdrawal needs,
meet legal reserve requirements, or to purchase services from
other financial institutions but do not pay interest.

• Hence, banks attempt to minimize cash holdings due to the

cost of holding them. For this reason, cash assets do not
represent a source of long-term liquidity for the bank

• Liquid assets, therefore, consist of unpledged, marketable

short-term securities that are classified as available-for-sale
ABILITY TO BORROW
FOR LIQUIDITY
• If two banks hold similar assets, the one with the greater total
equity or lower financial leverage can take on more debt with
less chance of becoming insolvent

• The lower is the bank’s borrowing capacity and the higher are
its borrowing costs

• Core deposits are stable deposits that are not highly interest-
rate sensitive. These types of deposits are less sensitive to the
interest rate paid
• The greater are the core deposits in the funding mix, the
lower are the unexpected deposit withdrawals and potential
new funding requirements; hence, the greater is the bank’s
liquidity.

• loans can provide liquidity in two ways.

– cash inflows from periodic interest and principal payments
can be used to meet cash out-flows.
– some loans are highly marketable and can be sold to other
institutions.
MARKET RISK
• It is the current and potential risk to earnings and
stockholders’ equity resulting from adverse movements in
market rates or prices.

• The three areas of market risk are:

– interest rate or reinvestment rate risk,
– equity or security price risk,
– foreign exchange risk:
INTEREST RATE RISK
• Interest rate risk analysis compares the sensitivity of interest
income to changes in asset yields with the sensitivity of
interest expense to changes in the interest costs of liabilities

• The GAP analysis’ purpose is to determine how much net

interest income and the market value of stockholders’ equity
will vary with movements in market interest rates
• A more comprehensive portfolio analysis approach compares
the duration of assets with the duration of liabilities using
duration gap and market value of equity sensitivity analysis to
assess the impact of rate changes on net interest income and
the market value of stockholders’ equity.

• Both GAP and duration GAP focus on mismatched asset and

liability maturities and durations as well as potential changes
in interest rates
REPRICING MODEL
• The repricing model attempts to measure how a bank’s
interest income will change relative to interest expense over a
given time period if interest rates change

• The time periods (called maturity buckets) typically include

one day, 3 months, 6 months, 1 year, 5 years, and greater than
5 years.

• The model classifies assets and liabilities as “fixed rate” or

“rate sensitive” based on whether the earnings or costs will
change on these accounts during the planning period if
interest rates change
• Rate sensitive accounts are those where the cash inflows on
an asset or outflows on a liability will change at some point
within the planning period if interest rates change.

• Accounts are classified as fixed rate if the cash inflows on an

asset or outflows on a liability will not change within the
planning period even if interest rates change.

• Conceptually one can then compare the rate sensitivities of

the two sides of the balance sheet and estimate how Net
Interest Income(NII) is likely to change if interest rates change.
Sensitive Rate Assets Sensitive Rate
Liabilities
Zero GAP or
Fixed rate Assets Fixed Rate Liabilities
Matched
Book Position

Sensitive Rate Assets Sensitive Rate

Liabilities Positive GAP
Position: if
Fixed rate Assets Fixed Rate Liabilities interest
earning

Sensitive Rate Assets Sensitive Rate

Fixed rate Assets Liabilities
Negative GAP
Position: if
Fixed Rate Liabilities Interest
earning
• The repricing model measures this ‘GAP’ or the difference in
sensitivity of interest income and interest expense in the
given maturity bucket

• If R = the general level of interest rates then we can predict

the ∆NII resulting from a given ∆R as follows:

• ∆NII =GAP× ∆R = (RSA-RSL)x∆R

• ∆NII =GAP× ∆R = (RSA-RSL)x∆R

• The change in NII over a given time period is a function of the

size and sign of the gap and the size and sign of the interest
rate change.

• When comparing the interest sensitivities of two or more

banks of different size, is more useful to compute

• The percentage gap= dollar gap / Assets

 Assets Equity Liabilities
SRA 100 SRL 50
FRA 206 FRL 256
Non earning Assets 34 Equity 34

Very little profit risk from an interest rate change on the $34 of NEA financed by equity.

Little profit risk from the $206 FRAs financed by FRLs because the cash inflows and
outflows on these accounts do not change over the given maturity bucket

No excessive amount of risk for the amount of RSAs financed by RSLs, because both are
rates sensitive: interest rates rise, the earnings on RSAs and the costs on RSLs should
both rise and the spread should be roughly unchanged

There are $50 remaining RSAs financed by FSLs. This category is a major source of
interest rate risk because one side (the assets) is rate sensitive and the other side is not.
This category is called the repricing gap.
• If the interest change is 2%, the Net Interest Income change:

• ∆NII =GAP× ∆R = (RSA-RSL)x∆R

• ∆NII =50×2% = 1

• The percentage gap= dollar gap / Assets

• The percentage gap= 1/340 =
• For a positive GAP, rising interest rates over the maturity
period will normally increase profitability, all else equal, and
falling interest rates will decrease profitability.

• Interest rates and profitability move in the same direction if

GAP is positive.

• For a negative GAP, rising interest rates will decrease

profitability, all else equal, and falling interest rates will
increase profitability.

• Interest rates and profitability move in opposite directions if

the CGAP is negative.
EQUITY AND SECURITY
PRICE RISK
• Changes in market prices, interest rates, and foreign exchange
rates affect the market values of any equities, fixed-income
securities, foreign currency holdings, and associated
derivative and other off-balance sheet contracts
FOREIGN EXCHANGE RISK
• Changes in foreign exchange rates affect the values of assets,
liabilities, and off-balance sheet activities denominated in
foreign currencies

• This risk exists because some banks hold assets and issue
liabilities denominated in different currencies.

• When the amount of assets differs from the amount of

liabilities in a currency, any change in exchange rates produces
a gain or loss that affects the market value of the bank’s
stockholders’ equity
• This risk is also found in off-balance sheet loan commitments
and guaranties denominated in foreign currencies.

• This risk is also known as foreign currency translation risk.

Banks that do not conduct business in nondomestic
currencies do not directly assume this risk.
OPERATIONAL RISK
• It refers to the possibility that operating expenses might vary
significantly from what is expected, producing a decline in net
income and bank value

• 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.”
• Some banks are relatively inefficient in controlling direct costs
and employee processing errors.

• Banks must also absorb losses due to employee and customer

theft and fraud

• Operational risk is difficult to measure directly but is likely

greater the higher are the numbers of divisions or
subsidiaries, employees, and loans to insiders.
CAPITAL OR SOLVENCY
RISK
• Capital risk is not considered a separate risk because all of the
risks mentioned previously will, in one form or another, affect
a bank’s capital and hence solvency

• A bank is technically insolvent when it has negative net worth

or stockholders’ equity

• The economic net worth of a firm is the difference between

the market value of its assets and liabilities
• Thus, capital risk refers to the potential decrease in the
market value of assets below the market value of liabilities

• If such a bank were to liquidate its assets, it would not be able

to pay all creditors, and would be bankrupt

• The greater equity is to assets, the greater is the amount of

assets that can default without the bank becoming insolvent
OFF BALANCE SHEET RISK
• Off-balance sheet risk refers to the volatility in income and
market value of bank equity that may arise from
unanticipated losses due to these off-balance sheet liabilities.

• Banks earn fees when they engage in off-balance sheet

agreements. These agreements, in turn, entail some risk as
the bank must perform under the contract
BANK REGULATION
• Each area of strategic decisions is closely tied with a bank’s
profitability

• The primary responsibilities are to acquire assets through

appropriate financing and to control the burden while
maintaining an acceptable risk profile

• Bank regulators attempt to help managers keep their firm

operating by regulating allowable activities

• Bank regulation is largely designed to limit risk taking by

commercial banks
• Regulators also limit the size of a loan to any single borrower
to reduce the concentration of bank resources

• To assess bank risk, regulators routinely examine the quality

of assets, mismatched maturities of assets and liabilities, and
internal operating controls.

• If they determine that a bank has assumed too much risk,

they require additional equity capital.

• Regulators use a rating system called CAMELS to access the

quality of banks’ earnings and risk management.
CAMELS RATING
• Federal and state regulators regularly assess the financial
condition of each bank and specific risks faced via on-site
examinations and periodic reports.

• Federal regulators rate banks according to the Uniform

Financial Institutions Rating system, which now encompasses
six general categories of performance under the label
CAMELS.

• Each letter refers to a specific category, including:

CAMELS RATING
• C = Capital Adequacy
• A= Asset Quality
• M = Management of Quality
• E = Earnings
• L = Liquidity
• S = Sensitivity to Market Risk
• The capital component (C)signals the institution’s ability to
maintain capital commensurate with the nature and extent of
all types of risk, and the ability of management to identify,
measure, monitor, and control these risks.
• Asset quality (A) reflects the amount of existing credit risk
associated with the loan and investment portfolio as well as
off-balance sheet activities
• The management category (M) reflects the adequacy of the
board of directors and senior management systems and
procedures to identify, measure, monitor, and control risks.
Regulators emphasize the existence and use of policies and
processes to manage risks within targets.

• Earnings (E) reflects not only the quantity and trend in

earnings, but also the factors that may affect the sustainability
or quality or earnings
• Liquidity (L) reflects the adequacy of the institution’s current
and prospective sources of liquidity and funds management
practices.

• Finally, the last category, sensitivity to market risk (S),reflects

the degree to which changes in interest rates, foreign
exchange rates, commodity prices, and equity prices can
adversely affect earnings or economic capital.
• Regulators numerically rate each bank in each of the six
categories, ranging from the highest or best rating (1) to the
worst or lowest rating (5).

• Regulators also assign a composite rating for the bank’s

overall operation.

• A composite rating of 1 or 2 indicates a fundamentally sound

bank.

• A rating of 3 indicates that the bank shows some underlying

weakness that should be corrected.

• A rating of 4 or 5 indicates a problem bank with some near-

term potential for failure.