BWBB 3193

SEMINAR IN BANKING

MANAGEMENT OF RISKS IN
BANKING
 Risk Definition
• The famous economist, Frank Knight, has differentiated between
risk and uncertainty as:

 Risks are unknown outcomes whose odds of happening can be

measured.
 Uncertainty occurs when possible outcomes and probabilities are
not known in advance.

• It is important to note that risk management is not about eliminating

uncertainties, but rather, it is about making decisions under
uncertainties.

• Uncertainties exist and pervasive in all aspects of banking where

inadequate risk management may threaten the solvency of a bank,
where insolvency is defined as a negative net worth or liabilities in
excess of assets.

• A risk manager should accept this fact early on and approach the
study of risk management as an enterprise for making decisions
under uncertainties.
 Type of Banking Risks

Market Risks

Credit Risks
Financial Risks

Operational Risks

ALM Risks

Banking Risks

Legal & Compliance Risks

Strategic Risks
Non-Financial Risks
Reputational Risks

Model Risks
 Financial Risks
1) Market Risk
 Defined as the risk of losses in on- and off-balance sheet
positions arising from movements in market prices.
 2 different components of market risk:
 General market risk – referred to as systematic market risk,
arising from movements in the general level of market rates
and prices. This risk cannot be diversified away. Example:
Global financial crisis and Covid-19 pandemic.
 Specific market risk – known as unsystematic market risk,
the risk arising from adverse movements in market prices that
are tied directly to the performance of a particular security.
This risk can be eliminated by adequate diversification.
 Financial Risks
1) Market Risk
 There are 4 types of market risks: Interest rate risk in the
trading book, foreign exchange risk, equity price risk, and
commodity price risk.

i. Interest rate risk in the trading book

- is the exposure of the bank’s earnings and financial condition
to adverse movements in interest rates.
- 2 types of interest rate risks:
 Traded interest rate risk (associated with the bank’s trading
book) – associated with market risk
 Structured interest rate risk (associated with the bank
balance sheet) – classified as an ALM risk
 Financial Risks
ii. Foreign exchange risk
- Is the exposure of bank’s earnings and financial condition to
adverse movements in foreign exchange rates.
- 2 important sources of foreign exchange risk:
 Traded foreign exchange risk – arising from the bank’s
market-making and proprietary trading activities that generate
foreign exchange exposures. Example: servicing a client’s
foreign exchange hedging requirements.
 Structured foreign exchange risk – arising from the structural
foreign exchange position imbalance between bank’s assets and
liabilities. Structural mismatch arises from:
 mismatch in currency denomination of the bank’s asset and
liabilities and accounting differences.
 Accounting differences (historical vs closing exchange rates).
 Financial Risks
iii. Equity price risk
- Is the exposure of bank’s earnings and financial condition to
adverse movements in the benchmark equity indices (systematic
risk) and individual equity prices (non-systematic risk).
- 2 components of equity price risk:
 Systematic risk or beta risk is the risk with the general market
and cannot be diversified away. The general market referred to
equity benchmark index such as KLCI, S&P 500, Stock
Exchange of Thailand.
 Unsystematic or specific risk is the risk associated with firm-
specific risks that can be eliminated by diversification. Example:
negative news on specific company, labor problems.
 Financial Risks
iv. Commodity price risk
- Is the exposure of bank’s earnings and financial condition to
fluctuations in commodity prices.

2) Credit Risk
 Defined as the potential that a borrower or counterparty will fail
to meet its obligations in accordance with the agreed terms.
 2 levels of credit risk: Transactional credit risk and portfolio
credit risk.
 Transactional credit risk – primarily determined by the
borrower or counterparty’s ability & willingness to pay its
obligation as they come due.
 Can be further subdivided according to 5 different types of
exposures:
 Financial Risks
 Retail credit risk – consumer’s default on a consumer credit
product
 Corporate credit risk – risk of loss due to a default of an
institutional/corporate client. Usually, it becomes the largest risk
faced by commercial banks.
 Counterparty credit risk – the risk that a counterparty to a
financial contract, such as derivatives, will default prior to the
expiration of the contract and fails to meet its obligations under the
contract.
 Sovereign risk – the risk of loss due to a default of a government
on its financial obligations.
 Country risk – the risk of loss due to events in a particular country
which are to some extent, under the control of government.
Example, borrower unable to fulfil his obligation because of
restrictions imposed on the ability to source foreign exchange to
repay foreign exchange obligations.
 Financial Risks
 Portfolio credit risk – the credit risk exposure of the bank on an
aggregated level. An important source of portfolio credit risk is
concentration risk.
 Concentration risk arises from the excessive exposure to:
 Single counterparty or group of connected counterparties
 Specific instrument
 Specific market segment.
 Financial Risks
3) Operational Risk
 The risk of loss resulting from inadequate of failed internal
processes, people and systems or from external events.
 This includes legal risk but excludes strategic and reputational
risk.
 4 main causes of operational risk:
 Process risk – the risk from faulty overall design and application
of internal business process
 People risk – the risk that employees do not follow the
organization’s procedures, practice and/or rules or deviate from
expected behaviour.
 Systems risk – the risk of failure arising from deficiencies in the
bank’s infrastructure and IT systems.
 External events risk – the risk associated with events outside the
bank’s control.
 Financial Risks
4) Asset and Liability Management (ALM) Risk
 Risks that are associated with structural mismatches in a bank’s
balance sheet.
 2 common source of ALM risk:
 Balance sheet interest rate risk
 Liquidity risk – the risk arising from the bank’s inability to
fund increases in assets and meet obligation as they come due.
 Non-Financial Risks
1) Legal and compliance risk
 Legal risk is defined as the possibility that lawsuits, adverse
judgements or faulty contracts can disrupt or adversely affect the
operations or condition of the bank. Example: fines, penalties.
 Compliance risk is the risk arising from violations of, or non-
conformance with laws, rules, regulations or internal policies.

2) Strategic risk
 The risk of loss in earnings, capital or reputation arising from
changes in the business environment, adverse strategic
decisions, and improper implementation of decisions or lack of
responsiveness to industry, economic or technological changes.
 Non-Financial Risks
3) Reputational risk
 The risk that may arise from negative publicity regarding an
institution’s business practices.

4) Model risk
 Banks rely heavily on models for assessing and quantifying risks.
 Model refers to a quantitative method, system or approach that
applies statistical, economic, financial or mathematical theories,
techniques and assumptions to process input data into
quantitative estimates.
 During the height of the 2008 global financial crisis many banks
relied of faulty model assumptions in measuring their risk
exposures from complex derivatives, which left many banks
stuck with highly illiquid assets.
 Risk Management in the Banking Context
 Coordinated – risk management is a coordinated effort from all
units in the banking organization.
 The three lines of defence model is an example of a coordinated
approach to risk management.

1st Line
2nd Line 3rd Line
Business Line or
Risk Management Internal Audit
Front Office
Function
 Risk Management in the Banking Context
 The first line of defence is the risk-originating units, which is
business line.
 This unit originates products and services – the sources of risks
to the bank.
 Business line is expected to embed the risk management
framework and sound risk management practices into their
standard operating procedures.
 Business line must adhere to all applicable policies, procedures
and processes established by the risk management function.
 Risk Management in the Banking Context
 The second line of defence is the risk management function.
 This unit is responsible for developing and implementing the
risk management framework.
 The third line of defence is internal audit, which reviews the
effectiveness of risk management practices.
 Internal audit confirms the level of compliance, recommends
improvements and enforces corrective actions where necessary.
 Risk Management in the Banking Context
 Activities – risk management is a structured and formal process.
 It entails the execution of different activities such as
communication, consultation, establishing the context,
identifying, analyzing, evaluating, treating, monitoring and
reviewing of risk.

 Direct and control – risk management aims to direct and

control risks that bank face.
 Risk management aims to make risks more manageable and
ensure that the banking organization will continue to operate as
a going concern, and to meet the complex requirements of the
bank’s internal and external stakeholders.
 Objective of Risk Management
1) Increase the likelihood of achieving business objectives
2) Encourage proactive management of risks
3) Compliance with laws and regulations.
4) Lower cost of funds
5) Efficient allocation of capital and resources
6) Enhance competitive advantage
 Risk Management Framework
 The effectiveness of risk management depends on the
effectiveness of the risk management framework.
 Elements of a sound risk management framework:

Effective Risk Governance

Risk Appetite

Risk Culture

Risk Management Policy

Risk Management Organization

 Overview of Risk Management Process
 Key activities of risk management process:

Communicating and Consulting

Establishing Context

Risk Assessment

Risk Treatment

Risk Monitoring and Review

 Approaches to the Management of Risk

Traditionally banks have focused on the management of interest

rate risk and liquidity risk, while credit risk is handled by a
separate department.

The modern asset-liability management (ALM) emphasises on the

management of interest rate and liquidity risks.

The modern approach not only looks on the banking book (on-
balance sheet assets and liabilities) but also the trading book, which
comprises off-balance sheet financial instruments.
 Credit Risk Management
Any increase in credit risk will raise the marginal cost
of debt and equity, which in turn will increase the cost
of funds for the bank.

There are four ways a bank can minimize its credit risk:
through accurate loan pricing, credit rationing, use of
collateral, and loan diversification.
 Loan pricing
Price of a loan (interest rate on lending) should exceed a risk
adjusted rate plus any administration costs associated with the
processing of the loans.

Thus, the loan rate should consist of a market rate, usually

interbank offer rate such as KLIBOR or set by the banks through
base rate, a risk premium, and administration costs.

The riskier the borrower, the higher the premium. If the risk
profile changes, the rate must be amended.
 Credit rationing
Due to adverse selection (the problem that those who desire to
issue financial instruments are most likely to use the funds for
unworthy, high-risk projects). Banks would be more selective in
providing loans.

The availability of a certain type of loan may be restricted to a

selected class of borrowers.
 Collateral or security
Banks use collateral to reduce credit risk.

If the price of the collateral (such as houses, shares or

equities) becomes more volatile, banks will demand more
collateral, for an unchanged loan rate, to offset any potential
losses arising from the change in value.
 Diversification
• If the number of risky loans increases and so is the
additional volatility, this can be offset by diversification.
• Banks can diversify its lending portfolio and thus reduces
its overall riskiness. As such banks are able to diversify
away all non-systematic risk.
• Banks normally conduct qualitative and quantitative
analysis to evaluate credit risk.
• If a bank cannot access information on a certain borrower,
it will use a qualitative approach to evaluate credit risk.
• Quantitative method requires the use of financial data to
measure and predict the probability of default by the
borrower.
 Interest Rate Risk and Asset-Liability
Management (ALM) Technique
The ALM approach is concerned with control on balance sheet
interest rate risk. For example, in a deposit product, once the
bank decides on the maturity of the deposit, it incurs interest rate
risk.

There are various ALM techniques that are used to manage

interest risk. These are the gap analysis, duration analysis and
duration gap analysis.
 Gap Analysis
The gap is the difference between interest-sensitive assets and
liabilities for a given time interval.

A negative gap means sensitive liabilities are greater than sensitive

assets.

A positive gap means sensitive assets are greater than sensitive

liabilities.
 Duration Analysis

Duration analysis allows for the possibility that the average life
(duration) of an asset or liability differs from their respective
maturities.

Suppose the maturity of a loan is six months and the bank opts
to match this asset with a six-month CD, if part of the CD is
repaid each month, then the duration of the loan will differ from
its maturity.

For the CD, duration will equal maturity if depositors are paid a
lump sum at the end of the six months. A duration gap is
created, exposing the bank to interest rate risk.
Duration is the present value weighted average term to
repricing, and was originally applied to bonds with coupons,
correcting for the impurity of a bond: true duration is less than
the bond’s term to maturity.
 Duration Gap Analysis
This type of analysis mixes both gap and duration analysis.
The duration of the assets and liabilities are matched.

The on and off-balance sheet interest sensitive positions of

the bank are placed in time bands, based on the maturity of
the instrument.

The position in each time band is netted, and the net position
is weighted by an estimate of its duration, where duration
measures the price sensitivity of fixed rate instruments with
different maturities to changes in interest rates.
If the duration of designated deposit and liabilities are
matched, then the duration gap on that part of the balance
sheet is zero.

This part of the balance sheet is then “immunized”

against unexpected changes in the interest rate.

Immunisation is used to obtain a fixed yield for a certain

period of time because both sides of the balance sheet are
protected from interest rate risk.
The protection, however is less than 100% and other risks, such as
credit risks, are still present.

The duration measure assumes a linear relationship between

interest rates and asset value. The relationship is normally convex
and thus, the greater the convexity of the interest rate –asset value
relationship, the less useful is the simple duration measure.

The use of duration to measure interest rate sensitivity is limited

to small changes in the interest rate.
 Liquidity Risk Management
Liquidity risk is the risk that a bank is unable to meet its
liabilities when they fall due.

This problem usually arises when there is a run on the

bank as depositors withdraw their cash.

A bank liquidity crisis is normally triggered either by loss

of confidence in the bank or because of poor management
practices, or the bank is a victim of a loss of confidence
in the financial system, caused by the failure of another
bank (contagion effect).
The objective of liquidity risk management is to avoid a situation
where the net liquid assets are negative.

To manage this type of risk, gap analysis is used. The gap is defined
(in terms of net liquid assets) as the difference between net liquid
assets and volatile liabilities.

Liquidity gap analysis is similar to interest rate risk but items from
the balance sheet are grouped according to the expected time the
cash flow (outflow or inflow) is generated. Net mismatched
positions are accumulated to produce a cumulative net mismatch
position.
 Currency Risk Management
FX risk arises from exposure in foreign currencies.

In the forex markets, duration analysis is used to

compute the change in the value of a foreign currency
bond in relation to foreign currency interest rates or
domestic currency interest rates or the spot exchange
rate.

A bank can also use gap analysis in the foreign exchange

markets where gaps that exist in individual currencies
are identified.
Some banks reduce currency risk by multicurrency-based
share capital, that is, denominating share capital in
multiple currencies.

If share capital is denominated in a mixture of currencies

to match the volume of business assets and liabilities,
then capital ratios will not change by much during
exchange rate fluctuations and currency risk is reduced
without using hedging instruments.