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Certificate in Retail and Digital Banking (Cert RDB) > 22. The Management of Risk > Flashcards

22. The Management of Risk Flashcards

1
Q

What is the definition of risk?

A

The chance that an outcome/investment’s actual returns will differ from the expected outcome/return

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2
Q

Why do banks need to take risks?

A

Greater risks = greater return.

They need to take risks to achieve appropriate growth/profit

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3
Q

What 4 actions do banks need to take in general in relation to risk?

A
  1. IDENTIFY
  2. ASSESS
  3. EVALUATE
  4. MANAGE
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4
Q

Name the types of risk faced by banks. (6)

A
  1. Credit risk
  2. Reputational risk
  3. Regulatory risk
  4. Environmental risk
  5. Settlement risk
  6. Other types of risk

THINK:SORCER

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5
Q

What is credit risk?

What effect could this have on the firm? (2) What effect could this have on the customer? (1)

A

The risk of borrowers not being able to repay their loans as agreed

Firm effects:
1. Profitability
2. Reputation - firm could be seen as responsibly lending depositors money

Customer effects:
1. bad credit score

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6
Q

What is reputational risk?

A

Damage to the bank’s reputation, e.g. negative media coverage that could effect the bank’s ability to attract new customers or maintain the ones it’s got

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7
Q

What is regulatory risk?

A

Introduction of new regulations and the impact they may have on a bank’s operations/profitability (e.g. high compliance costs)

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8
Q

What is environmental risk?

A

The risk that activities could damage the environment & negatively impact the bank

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9
Q

What is settlement risk?

A

A type of counterparty risk where one or more of the parties involved in a transaction fails to meet their obligations within the terms of a contract within the agreed upon time.

This could be due to operational issues or liquidity restraints, for example.

e.g. foreign exchange

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10
Q

Reputational risk is difficult to assess because it relies on a number of factors, but there are 3 key areas which we can focus on. What are these? (3)

A
  1. Lending policies
    - e.g. you can restrict/ban lending to businesses in certain industries like defence equipment.
  2. Environmental & Societal considerations
    - with regards to operations/lending decisions
  3. Social Media
    - dissatisfied customers posting online
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11
Q

The tasks carried out by banks don’t tend to make them one of the most environmental polluters; however, they still need to consider the environmental risk their actions have on the environment.

What is the main way in which a bank’s operational/lending decisions can have on the environment?

A

Banks need to be mindful of the environmental risk of the BUSINESSES THEY LEND TO - these companies could be polluting the atmosphere/contributing to oil spills/depleting natural resources themselves.

This could trigger a REPUTATIONAL RISK by association

The bank CAN ACTUALLY BE PROSECUTED for the environmental harm alongside the business they lend to if the assets form part of their security.

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12
Q

What is a risk appetite criteria?

What might going into the risk appetite criteria in relation to environmental risk?

A

Where businesses decide who they want to lend to in the main and who they only want to lend to on a restricted basis.

Enviro = which industries they want to lend to based on which industries have the greatest environmental impact.

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13
Q

How can banks manage settlement risk? (2)

A
  1. Undertake appropriate CREDIT RISK PROCEDURES
  2. RESOLVE POTENTIAL OPERATIONAL PROBLEMS
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14
Q

What is Herstatt Risk?

A

Another name for SETTLEMENT RISK

Named after Bankhaus Herstatt - this small German bank went into liquidation in 1974. They had paid counterparties in New York for foreign currency in the morning and then closed for good in the afternoon. The New York counterparties never received the funds they had paid for in return.

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15
Q

What is interest rate risk? (2)

How is this managed?

A

The bank occurs loses due to having to pay MORE INTEREST ON DEPOSITS compared with INTEREST RECEIVED THRPOUGH LENDING.

or

In term lending, the Bank of England BASE RATE GOES ABOVE THE FIXED RATE of interest on a mortgage etc.

Managed by banks MONITORING THEIR BALANCE SHEET and having a “CUSHION” of money set aside specifically to specifically ABSORB EXPECTED LOSSES.

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16
Q

What is meant by “Provisions for Bad Debts”?

A

Another name for the “cushion” of funds which banks hold to absorb losses as a result of interest rate risk

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17
Q

What is market risk?

A

Risk of losses due to price changes in the financial markets within which a bank participates

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18
Q

What type of risk is the following scenario an example of?

a foreign exchange (FX) payment is returned & re-converted into the remitter’s original currency. The exchange rate used to re-covert for the return is worse than the original conversion and money is lost.

A

Market risk

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19
Q

What is operational risk?

A

Failings on the part of people, internal processes, systems & external forces

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20
Q

What are the main consequences of operational risk? (4)

A
  1. Financial loss
    - errors, staff need to be deployed to resolve these
    - fraud
  2. Customer dissatisfaction
  3. Regulatory intervention
  4. Reputational damage
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21
Q

What type of risk do the following sub-types of risk fall under?

  • Conduct risk
  • Legal risk
  • Cyber risk
A

All types of operational risk

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22
Q

What is conduct risk?

A

Financial loss resulting from a fine or sanction as a result of inappropriate staff behaviour

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23
Q

What is legal risk?

A

Risk due to defects in a legal document

e.g. in a lending contract, might not be able to get repayments if responsibilities were not clearly defined under the contract

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24
Q

What is cyber risk?

A

The threat of data breaches & theft of information using electronic devices

e.g. financial loss as a result of fraudulent payments being paid from a customer’s account using their stolen information

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25
Q

What is Political risk?

A

Risk due to political stability/change in the country’s political regime

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26
Q

What is economic risk?

A

Losses due to economic instability

e.g. capital controls placed on payments in Greece in 2015

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27
Q

What is systematic risk?

A

Risk of the collapse of a financial system, caused by market events or other factors

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28
Q

What is liquidity risk?

A

Risk that the bank cannot/may not meet their financial obligations when they fall due

e.g. depositors wanting to withdraw their cash all at once, above the level of liquid cash held by the bank

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29
Q

What is funding risk?

A

Risk that the bank does not have adequate short-term, medium-term & long-term funding to cover ongoing liabilities

eg. a credit scoring agency downgrades a bank’s credit rating and they then fund it difficult/expensive to find funding within the financial markets

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30
Q

What is capital risk?

What is the regulatory response to this type of risk?

A

Risk that the bank has insufficient capital in reserves to cover bad debt as a result of day-to-day activities

Basel III

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31
Q

What are the main components of a risk management framework? (4)

A
  1. IDENTIFICATION
    - what are the types of risk? how do they arise?
  2. ASSESSMENT
    - probability of risk happening
    - impact on the bank
  3. CONTROL
    - Reduce the likelihood of risk events occurring
    - mitigate effects if it does occur
  4. MONITORING & REPORTING
    - monitoring processes - are they effective?
    - report internally to senior managers
    - report to regulators if required
32
Q

What are the 4 T’s of risk control? (4)

A
  1. TRANSFERING RISK
    - through insurance or ‘hedging’
    - through outsourcing activities - paying third parties who take on the risk on behalf of the firm
  2. TOLERATING RISK
    - no action is taken because risk is too low or mitigation is not cost effective
  3. TREATING RISK
    - take actions to reduce likelihood & minimize impact
    - mitigation strategies
  4. TERMINATING RISK
    - remove the risky part of the process altogether where possible, so long as it does not affect the business
33
Q

What mitigation strategy can be used to mitigate credit risk in lending?

A

Only offer secured loans rather than unsecure.

Risk is mitigated because if borrower defaults then you can repossess the security.

34
Q

Out of the 4 T’s of Risk Control, which is the most favourable action to take?

A

Terminating the risk altogether

35
Q

When we decide that tolerating the risk is the best course of action, does this mean that we can now ignore that risk altogether as we have accepted it?

A

No, must be monitored as they could change in future to become less tolerable

36
Q

What is the ‘Three Lines of Defence’ model used for?

A

how risk management roles & responsibilities should be defined & how they collaborate with one another

37
Q

In the ‘Three Lines of Defence’ model, who makes up the 1st line of defence?

What are their responsibilities relating to risk? (2)

Who do they report to?

A

Who = Operational Managers
What =
1. effective internal controls
2. managing daily processes to minimise risk

Report to = Senior management

38
Q

In the ‘Three Lines of Defence’ model, who makes up the 2nd line of defence?

What are their responsibilities relating to risk? (4)

Who do they report to?

A

Who = committee of managers in charge of various functions (idea is that they get together to co-ordinate the management of risk across all areas)

What =
1. Monitor the first line of defence
2. Implement the governance framework
3. Oversee each of their own functions (could be from compliance, IT, Risk management, Finance)
4. Highly involved in managing the consequences of risk when they occur

Report to = Senior Management

39
Q

In the ‘Three Lines of Defence’ model, who makes up the 3rd line of defence?

What are their responsibilities relating to risk?

Who do they report to?

A

Who = Functions that provide independent assurance (E.g. Internal Auditors)

What =
1. Internal auditing of risk management
2. Internal auditing of governance framework
3. Monitor the effectiveness of both 1st & 2nd line of defence & suggest how improvements can be made

Reports to = both Senior Management AND the board/audit committee

40
Q

What is an impact risk assessment used for? (2)

What does it do?

What tool can be used to achieve this?

A

To assess both the probability of a risk occurring AND the what the impact would be if it did

What = ranks risk from most to least critical to identify which areas need more resources to mitigate risk

Tool = risk matrix, probability vs impact

41
Q

What is the difference between credit risk and credit culture?

A

Credit risk = threat of not being repaid

Credit culture = A bank’s attitude to managing credit risk

42
Q

What is a governance framework used for? Who is it used by?

A

Used by the committee of managers to identify, assess and manage risk

43
Q

What are the warning signs that a customer is experiencing redundancy? (2) Do customers need to tell their lending bank if they are made redundant?

A
  1. Income drying up
  2. Rise in debt levels without explanation

Yes, customers need to inform bank so that debt management plan can be agreed

44
Q

What are the differences in risk of employed customers suffering from ill health compared with self-employed customers suffering from ill health?

A

Employed = sick pay for a period of time, then nothing if period of illness is prolonged for an extended amount of time

Self-employed = income severely affected straight away unless they can get someone else to do their job

45
Q

What is the risk of someone suffering from poor mental health? What can banks suggest to minimise this risk?

A

Risk that they are vulnerable and unable to cope with managing their debts.

Can suggest that they put a power of attorney (LPA) in place so that someone can deal with this on their behalf

46
Q

What are the risks that can occur as a result of a relationship breakdown? (6)

A
  1. One party could remove all of the funds from a joint account
  2. One party could work up debt without the other knowing
  3. The stress of the breakdown could distract people from handling finances
  4. There could be disputes over the ownership of assets/debt
  5. Could be a reduction of household income
  6. Could be an additional mortgage needed if one party moves out
47
Q

What are the risks involved with regards to a death occurring? (3)

A
  1. Surviving relatively likely to be bereaved - bank needs to be sensitive when dealing
  2. If adequate life insurance was not taken out, relatives may find dealing with any debt left difficult/distressing
    3.Dealing with the estate takes time - representatives may not be able to access funds and interest will accrue.
48
Q

Banks view Bankruptcy as a last resort for their customers and don’t usually tend to encourage this. However, sometimes other creditors will begin bankruptcy procedures for the customer, which is outside of the bank’s control.

If this happens, what should the bank do? Consider the following:

  1. The loan is a secure loan and the security value is greater than the amount of the loan.
  2. The loan is a secure loan and the security value is lower than the amount of the loan.
  3. The loan is an unsecure loan
A
  1. Rely on security & sit tight. Surrendering the security would let others have it and worsen the situation.
  2. Assess the shortfall - bank could sell the security & then join the other creditors to claim for any shortfall in repayment BUT in practice, it is unlikely that the security property would be sold before the bankruptcy proceedings begin
  3. Lender has to join the other creditors and hope there will be some form of repayment so they can regain at least part of the debt
49
Q

Banks would like customers to contact them if they are struggling to meet repayments so that they can work out a plan together, but in reality this often doesn’t happen. Why?

What can banks do instead to identify the risk of bad debt?

A

why = customers see the bank as biased and would rather seek help from third parties such as citizens advice

What banks do instead = MONITOR ACCOUNTS. They get reports for “out of order accounts”

50
Q

What information might cause an account to be flagged up as being “out-of-order”? (8)

A
  1. Going over an agreed overdraft in excess
  2. Unarranged overdrafts
  3. Overdraft/credit card balances that don’t return to being in credit when wage is paid
  4. Loan arrears
  5. Monthly debit turnover of the current account - are they increasing or decreasing compared with credits paid in
  6. Monthly credits into account drying up
  7. Failure to adhere to T&Cs e.g. not repaying overdraft by agreed date
  8. Dormant overdrawn accounts with no contact from the customer
51
Q

Describe Step 1 of the debt and arrears process.

A

Contact the customer as soon as the issue becomes apparent
- request funds to correct the problem
- OR request that the customer makes contact so the problem can be discussed, giving a reasonable timeframe for the customer to respond

52
Q

Describe Step 2 of the debt and arrears process.

A

2nd contact attempt - strong letter or telephone call (phone call usually leads to better results)

53
Q

What should be done if a response cannot be obtained from a customer following Step 2 of the debt and arrears process? Provide examples in relation to a current account (4)

A

This should be taken as a warning signal. Consider taking tougher action.

Current account examples:
1. Returning payments
2. Cancel standing orders and direct debits
3. Cancel debit cards
4. Searches with credit reference agencies to check for problems elsewhere

54
Q

What should you take care to avoid during the arrears process? Why?

A

Avoid sending a steady stream of letter but then taking no action.

This can be perceived as harrassment.

55
Q

What should be done once contact has been successfully made with the customer following steps 1 & 2 of the debt and arrears process? (4)

A
  1. Establish an understanding of the problem
  2. Show empathy
  3. Provide support to help remedy the situation/establish a realistic repayment plan
    - eg helping customer to decide how to prioritise repayments & essential expenses
  4. Inform customer of the consequences of not making payments
56
Q

What is a delinquent account?

A

Account that is performing poorly, e.g. in arrears or excess (above the approved credit limit)

57
Q

Who tends to handle delinquent accounts within lender firms? What is the benefit of this?

A

Specialist support colleagues.

Admin teams usually flag up the delinquent account and notify one of the specialist support teams. The two teams are the COLLECTIONS team and the RECOVERIES team - which the case is referred to depends on the MAGNITUDE and TERM of the loan.

Benefit = difficult cases handled by experts & admin time freed up for normal servicing of accounts.

58
Q

Which types of arrears cases are dealt with by the Collections Team? What is the aim of the work carried out by this team?

In what ways can the team achieve this aim? (3)

A

Which = accounts not yet in serious arrears

Aim = return to acceptable account performance without things escalating further. They should collect the MAXIUM AMOUNT possible whilst helping the customer to RETURN TO NORMAL PAYMENT PATTERNS without souring relations.

How? =
1. RE-APPRAISE CREDITWORTHINESS
- their current ability to repay the loan
2. RE-ASSESS SECURITY
- check whether the security is defective/value has decreased
3. CREATE AN ACTION PLAN
- improve customers ability to service debt
- Can make changes to the existing loan, such as:
a) repricing the loan upwards - b/c of the increased risk
b) repricing outwards - term extension to lower payments
c) refinancing - for debt consolidation

59
Q

What should the lender do if it is not viable for them to provide arrears customers with refinancing options? (2)

A

The collections team might recommend that the loan should be removed from the lender’s portfolio. Then,

If the debt is not seriously delinquent - encourage borrower to take their debt to another lender

If debt cannot be taken elsewhere - start actions for recovery.

60
Q

Which types of arrears customers do the recoveries team deal with?

A

Those who have become insolvent. This means that they are either UNABLE TO PAY THEIR DEBT or have NEGATIVE EQUITY

61
Q

Insolvent customers usually seek advice from external agencies. How are these agencies able to assist insolvent customers? (4)

A
  1. Help the customers to make arrangements with creditors

If this is not possible, then consider one of the following options to help the customer start afresh:

  1. Debt Relief Orders (DRO)
  2. Individual Voluntary Agreements (IVA)
  3. Bankruptcy
62
Q

Who are Debt Relief Orders suitable for? What are the eligibility conditions for those wishing to proceed with this type of action? (6)

A

Who? = those who DO NOT OWN THEIR OWN HOME and have little surplus income/assets

Eligibility =
1. Unable to repay debt & not involved in a FORMAL insolvency procedure.
2. Owe <£30k
3. Have <£75 per month surplus income
4. Have <£2k in assets (including vehicles)
5. Live in/carried out business in ENGLAND/WALES within the last 3 years
6. Not have applied for a DRO within the last 6 years

63
Q

Which body is in charge of running the Debt Relief Order/ DRO process? What are the skilled advisors called within this body who help people to apply for DROs?

A

Process run by = the Insolvency Service

Debt advisors = Approved Intermediaries

64
Q

If a Debt Relief Order is successfully taken out, how long does it last for and what does this mean for creditors?

What happens after the time period that the DRO lasts for is up?

A

Lasts for 12 months. Within this time, creditors cannot take action to recover any money at all unless they seek permission from the courts.

After the 12 months is up, the customer’s circumstances are re-assessed. If their circumstances have not changed - they become freed from all debts involved in the DRO.

65
Q

Tue or False - a Debt Relief Order (DRO) can only be awarded by the courts.

A

False - DROs do not involve the courts. They are an informal, cost effective way of dealing with low level insolvency.

66
Q

Who should an insolvent debtor contact if they wish to begin the IVA (Individual Voluntary Agreement) process?

What are the steps of the process once contact has been made? (3)

A

Debtor must contact an INSOLVENCY PRACTITIONER

  1. They apply to the court with a formal proposal to creditors to pay off either all or part of the debt
  2. Creditors VOTE on whether to accept - need creditors owning at least 75% of the total debt to vote in favour for it to pass, but if passed is legally binding on ALL creditors.
  3. Insolvency practitioner pays creditors in line with the agreement
67
Q

What are the benefits of having an Individual Voluntary Agreement (IVA) as opposed to filing for bankruptcy? (4)

A
  1. More say in how your assets are dealt with - you may be able to persuade creditors to keep your house.
  2. More say over payments made
  3. Avoid restrictions placed upon bankrupts
  4. Cheaper - bankruptcy involves more fees/expenses
68
Q

Are the following formal or informal processed?

  1. Debt Relief Orders
  2. Individual Voluntary Agreements
  3. Bankruptcy
A
  1. Informal
  2. Formal
  3. Formal
69
Q

What are the steps involved in filing for Bankruptcy? (3) Make sure to include the name for the person who gets appointed to oversee the process.

A
  1. Present a valid bankruptcy petition to the court
  2. A TRUSTEE gets appointed to share out any available money
    - must pay for the cost of proceedings first
    - then tell creditors if they will receive anything
  3. Bankrupt loses control of all assets apart from a few exceptions. The assets get sold to repay the creditors.
70
Q

What assets are exempt from being seized when someone gets made bankrupt? (2)

A

Assets that are needed for:
1. Business
2. Basic family life

71
Q

Who can file for bankruptcy? (2)

A
  1. The debtor themselves
  2. 1 or more creditors who are owed at least £5,000 in UNSECURED DEBT.
72
Q

What three things is it a criminal offence for a bankrupt person to do? (3)

A
  1. Obtain more than £500 without disclosing their bankruptcy
  2. Manage a business under a different name to the one they were made bankrupt with without telling those involved in the business
  3. Be involved with/act as a director for a limited company without asking for court permission
73
Q

Can bankrupts open a new bank account?

A

Yes, but they must advise the bank of their bankruptcy first

74
Q

Can bankrupts obtain an overdraft?

A

No

75
Q

True of false - if a bankruptcy finds themselves with any excess money, they should inform their Trustee?

A

True - need to inform Trustee if they have money over what is needed to pay for reasonable living expenses

The Trustee will then take the money and use it to pay the creditors

76
Q

How long does it take for someone’s bankruptcy to get discharged?

A

Usually 12 months

but can be earlier if Trustee concludes their enquiries early or longer if the debtor refuses to co-operate. Shortening/Lengthening of this timeframe can only occur by filing a notice in court.

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