Risk Management

• Access and aggregate credit data across disparate systems and sources.
• Seamlessly integrate credit scoring/internal rating with credit portfolio risk assessment.
• Accurately forecast, monitor, measure, and report potential credit risk exposures across the entire organization, both on the counterparty level and portfolio level.
• Evaluate alternative strategies for pricing, hedging or transferring credit risk.
• Optimize allocation of regulatory capital and economic capital.
• Facilitate regulatory compliance and risk disclosure requirements for a wide variety of regulations such as Basel II.

Every bank must determine a credit risk policy: How much credit to supply, for what duration, for which type of client, etc. Apparent profitability is only one consideration, the second being the risk of loan. Hence, bank policy should specify the extent of diversification, limits on size, etc. Banks need to tie their tolerance for risk associated economic capital into their desired credit rating. A reporting system to track exposures to credit risk is required, coupled with a routine for updating information about creditors (Bessis, 2002).

For example, corporate bonds offer a high yield compared to some other investments, but the higher yield is not free. Most corporate bonds are debentures, meaning they are not secured by collateral. Investors of such bonds must assume not only interest rate risk but also credit risk, the chance that the corporate issuer will default on its debt obligations. Therefore, it is important that investors of corporate bonds know how to assess credit risk and its potential payoffs: while rising interest rate movements can reduce the value of your bond investment, a default can almost eliminate it (holders of defaulted bonds can recover some of their principal, but it is often pennies on the dollar).

Credit ratings published by various institutions are meant to capture and categorize credit risk. But institutional investors in corporate bonds often supplement these agency ratings with their own credit analysis. Many tools can be used to analyze and assess credit risk, but two traditional metrics are interest-coverage ratios and capitalization ratios (Harper, 2006).

Interest-coverage ratios answer the question, “How much money does the company generate each year in order to fund the annual interest on its debt?” A common interest-coverage ratio is EBIT (earnings before interest and taxes) divided by annual interest expense. Clearly, as a company should generate enough earnings to service its annual debt, this ratio should well exceed 1.0 – and the higher the ratio, the better (Harper, 2006).

Capitalization ratios answer the question, “How much interest-bearing debt does the company carry in relation to the value of its assets?” This ratio, calculated as long-term debt divided by total assets, assesses the company’s degree of financial leverage. This is analogous to dividing the balance on a home mortgage (long-term debt) by the appraised value of the house. A ratio of 1.0 would indicate there is no “equity in the house” and would reflect dangerously high financial leverage. So, the lower the capitalization ratio, the better the company’s financial leverage.

3.5.2.  Market Risk

It is the risk that the value of on and off balance sheet positions of a financial institutions will be adversely affected movements in market rates or prices, such as, interest rates, foreign exchange rates, equity prices, credit spreads and commodity prices resulting in a loss to earnings and capital.

Market risk is the possibility that the value of assets or liabilities will change because of the ups and downs in their prices. It is a standard measure of risk in the banking sector, in part because it is easier to quantify than are many other types of risk. An analyst can examine the past changes in prices and so calculate the variance of returns (Kolari and Gup, 2004). The greater the variance the greater the market risk, i.e. the greater the likely hood that returns may swing wildly in the future. The volatility of prices or returns has traditionally been used as a proxy for market risk.

The following figure depicts the categories of market risk:

(Shinasi, Lee and Drees, 1999)

3.5.2.1.     Equity Risk

Equity market risk arises from exposure to securities that represent an ownership interest in a corporation, in the form of common stock or other equity- linked instruments. The instruments held that would lead to this exposure include, but are not limited to, the following: common stock, listed equity options (buy and sell), over the counter (OTC) options, equity total return swaps, equity index futures and convertible bonds. The objective is to mitigate the risk associated with these securities via hedging on a portfolio or name basis that focuses on reducing volatility from changes in stock prices. Instruments used for risk mitigation include options, futures, swaps, and convertible bonds and cash positions (Bank of America, 2004).

3.5.2.2.     Interest rate Risk

The risk that an investment’s value will change due to a change in the absolute level of interest rates, in the spread between two rates, in the shape of the yield curve or in any other interest rate relationship. Such changes usually affect securities inversely and can be reduced by diversifying (investing in fixed-income securities with different durations) or hedging (e.g. through an interest rate swap).

Interest rate risk affects the value of bonds more directly than stocks, and it is a major risk to all bondholders. As interest rates rise, bond prices fall and vice versa. The rationale is that as interest rates increase, the opportunity cost of holding a bond decreases since investors are able to realize greater yields by switching to other investments that reflect the higher interest rate. For example, a 5% bond is worth more if interest rates decrease since the bondholder receives a fixed rate of return relative to the market, which is offering a lower rate of return as a result of the decrease in rates.

The movement of interest rates affects a bank’s reported earnings and book capital by changing

• Net interest income,
• The market value of trading accounts (and other instruments accounted for by market value), and
• Other interest sensitive income and expenses, such as mortgage servicing fees.

Changes in interest rates also affect a bank’s underlying economic value. The value of a bank’s assets, liabilities, and interest-rate-related, off-balance-sheet contracts is affected by a change in rates because the present value of future cash flows, and in some cases the cash flows themselves, is changed (Comptroller’s Handbook, 1998).

The assessment of interest rate risk should consider risk from both, an accounting perspective, i.e. the effect on the bank’s accrual earnings, and the economic perspective, i.e. the effect on the market value of the bank’s portfolio equity. In some banks, interest rate risk is captured under a broader category of market risk. In contrast to price risk, which focuses on the market to market portfolios, example trading accounts, interest rate risk focuses on the value implications for accrual portfolios held to maturity and available for sale accounts.

3.5.2.3.     Currency Risk

Currency Risk or foreign exchange is the risk to earnings or capital arising from movement of foreign exchange risks. This risk is found in cross border investing and operating activities. Market making and position taking in foreign currencies should be captured under price risk (Ludwig, 1996).

Foreign exchange risk is also known as translation risk and it is sometimes captured as a component of market risk. Foreign exchange risk arises from accrual accounts, denominated in foreign currency, including loans, deposits and equity investments, like, cross-border investing. Accounting conventions require quarterly revaluation of these accounts at current spot rates. This revaluation translates the foreign denominated accounts into US Dollar terms.

Transaction risk is the type of currency risk associated with the time delay between entering into a contract and settling it. The greater the time differential between the entrance and settlement of the contract, the greater the transaction risk, because there is more time for the two exchange rates to fluctuate.

Transaction risk creates difficulties for individuals and corporations dealing in different currencies, as exchange rates can fluctuate significantly over a short period of time. This volatility is usually reduced, or hedged, by entering into currency swaps and other similar securities.

Some examples of the way various corporations have dealt with foreign currency transaction risk would include, Lufthansa, the German airline, contracted with Boeing to purchase aircraft in the mid-1980’s when the value of the dollar was increasing. The price was set in dollars and Lufthansa was afraid that the dollar would strengthen, increasing the Deutsche mark cost of the planes. In 1986 Lufthansa entered into forward contracts for the dollars required to pay for the planes. Although Lufthansa feared a strengthening of the dollar what actually happened is that the dollar weakened. The forward contracts cost Lufthansa $140 to $160 million more for the planes than if it had simply waited and purchased the dollars on the spot market (Millman, 1995). Similarly, After sustaining a $953 million loss over the 1982-84 Caterpillar was acutely conscious of its exposure to foreign exchange fluctuations, particularly the yen, and foreign currency risk management a major focus of its corporate strategy. As a consequence in 1985 about 45 percent of its $198 million profit ($89 million) was from foreign exchange gains. And as mentioned before, in 1985 the $100 million foreign exchange gains more than offset its $24 million operating profit loss (Millman, 1990).

3.5.2.4.     Commodity Risk

Commodity risk represents exposures we have to products traded in the petroleum, natural gas, metals and power markets. Our principal exposure to these markets emanates from customer driven transactions. These transactions consist primarily of future, forwards, swaps and options. We seek to mitigate exposure to the commodity markets with instruments including, but not limited to, options, futures, and swaps in the same or similar commodity product as well as cash positions.

For example a company purchases certain raw materials such as Natural gas, propelene, acetone, and butanol under short and long-terms supply contracts. The purchase prices are generally determined based on prevailing market conditions (Bessis, 2002). Changing raw material prices historically have had material impacts on the company’s earnings and cash flows and will likely continue to have significant impacts on earnings and cash flow in future periods. The company uses commodity derivative instruments to modify some of the commodity price risks.

3.5.3.  Liquidity Risk

It is the current and prospective risk to earning s or capital arising from bank inability to meet its obligation when they come due without incurring unacceptable losses. Liquidity risk includes the inability to manage unplanned decreases or changes in funding sources. Liquidity risk also arises from the failure to recognize or address changes in market conditions that affect the ability to liquidate assets quickly and with minimal loss in value.

The  liquidity risk in banks manifest in different dimensions (Reserve Bank of India, 1999):

1. FUNDING RISK-need to replace net outflows due to unanticipated withdrawal / non renewal of deposits (Wholesale and Retail)
2. TIME RISK-need to compensate for non-receipt of expected inflows of funds, i.e. performing assets turning into non performing assets.
3. CALL RISK-due to crystallization of contingent liabilities and unable to undertake profitable business opportunities when desirable.

Liquidity risk policy includes a umber of policies according to the following liquidity risk management framework (Reserve Bank of India, 1999):

1. Excess Liquidity- Maintain substantial excess liquidity to meet a broad range of potential cash outflows in a stressed environment including financing obligations.
2. Asset Liability Management- ensure we fund our assets with the appropriate financing.
3. Inter Company funding- maintain parent company’s liquidity and manage the distribution of liquidity across the group structure.
4. Crisis planning- ensure all funding and liquidity management is based on stress scenario planning and feeds into our liquidity crisis plan.

Accordingly, liquidity risk has to be managed in addition to market, credit and other risks. Because of its tendency to compound other risks, it is difficult or impossible to isolate liquidity risk. In all but the most simple of circumstances, comprehensive metrics of liquidity risk do not exist. Certain techniques of asset-liability management can be applied to assessing liquidity risk. A simple test for liquidity risk is to look at future net cash flows on a day-by-day basis. Any day that has a sizeable negative net cash flow is of concern. Such an analysis can be supplemented with stress testing. Look at net cash flows on a day-to-day basis assuming that an important counterparty defaults (Shinasi, Lee and Drees, 1999).

Analyses such as these cannot easily take into account contingent cash flows, such as cash flows from derivatives or mortgage-backed securities. If an organization’s cash flows are largely contingent, liquidity risk may be assessed using some form of scenario analysis. A general approach using scenario analysis might entail the high-level steps, such as, construct multiple scenarios for market movements and defaults over a given period of time, assess day-to-day cash flows under each scenario.

3.5.4.  Operational Risk

Operational risk may be defined as the risk of loss resulting from inadequate or failed internal processes, people and system, or from external events (Macaulay, 2008).

It is the risk of loss resulting from inadequate or failed internal processes, people and systems or from external events. The definition includes legal risk, which is the task of loss resulting from failure to comply with laws as well as prudent ethical standards and contractual obligations (Macaulay, 2008). It also includes the exposure to litigation from all aspects of an institution’s activities. The definition does not include strategic or reputation risks.

The financial impact associated with an operational event that is recorded in the institution’s financial statements consistent with the Generally Accepted Accounting Principle (GAAP). Financial impact includes all out of pocket expenses associated with an operational event, but does not include opportunity costs, forgone revenue, or costs related to investment programs implemented to prevent subsequent operational risk losses. Operational risk losses are categorized by seven event factors. These include internal Fraud, which is an act of a type intended to defraud, misappropriate property or circumvent regulations, the law or company policy, excluding diversity/ discrimination events, which involve at least one internal party. External Fraud which comprises of the losses due to acts of a type intended to defraud, misappropriate property or circumvent the law, by a third party. These activities include theft, robbery, hacking or phishing attacks. Third comes the employment Practices and Workplace Safety losses arising from acts inconsistent with employment, health or safety laws or agreements, from payment of personal injury claims, or from diversity / discrimination. Next comes the clients, products & business practice, i.e. Losses arising from unintentional or negligent failure to meet a professional obligation to specific clients, or from the nature of design of a product. Another important event factor would be the damage to physical assets, which basically are losses arising from loss of, or damage to physical assets from natural disaster or other events. Another event factor is the business disruption & systems failures, which are the losses arising from disruption of business or system failures. This includes loss of due to failure of computer hardware, computer software, telecommunications failure or utility outage and disruptions. And last but not the least, execution, delivery and process management, which would include the losses from failed transaction processing or process management, from relations with trade suppliers and vendors.

3.5.4.1.     Categories of Operational Risk

(Shinasi, Lee and Drees, 1999)

1. People Risk or human resource risk, is the risk of loss caused intentionally or unintentionally by an employee (employee error) or involving employees such as in employment disputes. The reason for an employee to cause a loss to the firm, intentionally or unintentionally, may be multiple (Hoffman, 2002).
   1. Personal frustration, or deliberate action for personal gain (fraud)
   2. Improper or incomplete training
   3. Mismanagement
   4. Lack of competency
   5. Over work
2. Process risks stem from the design of the process and the extent of manual or human element in the steps of the process. Process risk control is best done at the stage of design of the process itself. The following factors increase the risks of processing errors but also open doors to frauds:
   1. Lack of procedures, guidelines or internal controls
   2. Poorly designed processes
   3. Absence of internal control

Process risk includes the three important types, i.e. transaction risk, operational control risk and model risk.

1. System risk includes the use of automated technology and has the potential to transform risks from manual operations to system failure risk, to induce internal and external fraud, and system security issues. The following factors increases the risk of processing errors, but also opens doors to frauds.
   1. System Failure
   2. Programming Error
   3. Information Risk
   4. Telecommunication Error
2. Other external risks involves the risk of loss caused by the actions of external parties, such as, in the perpetration of fraud, or in the case of regulators, the promulgation of change that would alter the firms ability to continue operating in certain markets. External human factors are more related to malicious acts and originated from hackers, crackers, crashers, spy, fraudsters, thiefs, but also political criminals. They can work alone or be part of an organization and their motivations depends on who they are: vengeance from and ex-employee, political reason, from an extremist, notoriety. There are also some other external factors that could be very disastrous for a company and they do not always relate to human factor:
   1. Natural Catastrophe
   2. Bankruptcy
   3. Change in regulations
   4. Litigations
   5. Act of terrorism or of criminality

4.     Conclusion

It is crucial for the banking industry to meet the increasingly complex savings and financing needs of the economy by offering a wider and flexible range of financial products tailored for all types of customers. With increasing levels of Globalization of banking industry, evolution of universal banks and bundling of financial services, competition in the banking industry will intensify further. The banking industry has the potential and the ability to rise to the occasion as demonstrated by the rapid pace automation which has already had a profound impact on raising the standard of banking services. The financial strength of individual banks which are major participants in the financial system is the first line of defense against financial risk. Strong capital positions and balance sheets place banks in a better position to deal with and absorb the economic shocks. Banks need to supplement this with sophisticated and robust risk management practices and the resolve to face competition without diluting the operating standards.

Looking ahead, the top challenges are expected to be allocating economic capital on a bank-wide proactive basis, with performance measures that motivate behavior aligned with capital objectives. The need to achieve comprehensive risk management will lead to the establishment of integrated risk frameworks, with the necessary systems and technology support. And as more time passes, banks globally will continue to find themselves operating in an increasingly dynamic environment, forcing them to execute their risk management strategies and adopt management systems that can quantify, major and monitor to meet tomorrow’s pace.

5.     BIBLIOGRAPHY

1.    Bank of America. (2004). Market Risk Management. Available: http://www.bankofamerica.com/annualreport/2004/backmatter/mda/mda_marketrisk.cfm. Last accessed 01 march 2008.

2.    Ben S. Bernanke. (2006). Modern Risk Management and Banking Supervision. Available: http://www.federalreserve.gov/newsevents/speech/Bernanke20060612a.htm. Last accessed 01 march 2008.

3.    Comptroller’s Handbook. (1998). Interest Rate Risk. Comptroller’s Handbook. 1 (3), 44-45.

4.      Donald R. van Deventer, Kenji Imai and Mark Mesler (2004). Advanced Financial Risk Management: Tools and Techniques for Integrated Credit Risk and Interest Rate Risk Management. John Wiley.

5.    Douglas G. Hoffman (2002). Managing Operational Risk: 20 Firmwide Best Practice Strategies. London: John Wiley and Sons. 196-200.

6.    Eugene A. Ludwig (1996). OCC. Washington D.C

7.    Garry J. Schinasi, Burkhard Drees, and William Lee. (1999). Managing Global Finance and Risk. Finance Development. 36 (4)

8.      Gregory J. Millman, The Vandals’ Crown: How Rebel Currency Traders Overthrew the World’s Central Banks (New York, The Free Press, 1995).

9.      Gregory J. Millman, The Floating Battlefield: Corporate Strategies in the Currency Wars (New York, AMACOM, 1990).

10. Jameel Ahmed. (2005). Implementation of Basel II in Pakistan. Available: http://www.sbp.org.pk/bsd/2005/C3.htm. Last accessed 01 march 2008.

11. Joël Bessis (2002). Risk Management in Banking. Kindle ed.56-150.

12. James W. Kolari and Benton E. Gup (2004). Commercial Banking: The Management of Risk. 3rd ed. Wiley. 300-303.

13.  Neil Crockford (1986). An Introduction to Risk Management (2nd ed.). Woodhead-Faulkner.

14. SAS. Credit Risk Management for Banking. Available: http://www.sas.com/industry/banking/credit/index.html. Last accessed 01 march 2008.

15. Panos Angelopoulos and Panos Mourdoukoutas (2001). Banking Risk Management in a Globalizing Economy Banking Risk Management in a Globalizing Economy. Kindle ed. Quorum Books. 24-26.

16. Reserve Bank of India. (1999). Risk Management Systems in Banks. Available: http://www.reservebank.com/scripts/NotificationUser.aspx?Id=85&Mode=0. Last accessed 01 march 2008.

17.  Tyson Macaulay. (2008). Operational Continuity: Convergence of Operational and Credit risks – Paper I.