9 Bank risk management

Question 1

Four main functions of a bank

Answer 1

1) accepting deposits
2) granting loans
3) providing payments
4) providing maturity transformation

Question 2

What’s the aim of bank’s management?

Answer 2

▪ To manage a bank with the goal of maximising its value for shareholders under risk conditions
▪ Information asymmetry
▪ Appropriate risk management needed
▪ Corporate governance/principal-agent problem

Question 3

Definition of risk

Answer 3

▪ Risk is …the degree of uncertainty of future net returns.
▪ The basic measurement tool is the volatility (standard deviation of price associated with an underlying asset).

Risk NEVER disappears!
Derivatives help create the illusion that risk can disappear!

Question 4

Categorization of risks in banking

Answer 4

1. Financial risks
2. Non-financial risks

Question 5

Financial risks

Answer 5

▪ credit risk 60-80%
▪ market risk 5-15%
(interest rate risk, FX risk, equity risk, commodity risk)
▪ liquidity risk

Question 6

Non-financial risks

Answer 6

▪ operational
▪ legal
▪ taxes
▪ regulatory
▪ political
▪ reputational
▪ systemic

Question 7

risks that are more difficult to quatify

Answer 7

1. Market risk (the less difficult)
2. Credit risk
3. Liquidity risk
4. Operational risk
5. Political risk
6. Legal and regulation risk (the most difficult)

Question 8

Credit risk

Answer 8

▪ = risk to the bank of losses resulting from the failure of a counterparty to meet its obligations in accordance with the terms of a contract under which the bank has become a creditor of the counterparty,
▪ Credit risk represents 60-80% of all banking risks.

Question 9

Market risk

Answer 9

▪ = risk to the bank of losses resulting from changes in prices, exchange rates and interest rates on the financial markets. This is a summary term for interest rate risk, foreign exchange risk, equity risk and other risk associated with movements in market prices,
▪ Very roughly, 5–15% of all banking risks are accounted for as market risks.

Question 10

Operational risk

Answer 10

▪ = risk to the bank of loss resulting from inadequate or failed internal processes, people and systems, or the risk to the bank of loss resulting from external events, including the legal risk but it excludes strategic and reputational risk.
▪ Operational risk represents 5–20% of banking risks, depending also on the extent to which it overlaps with the definition of other risks (especially credit risk).

Question 11

Black swans

Answer 11

rare event with severe impact => tail events (challenging
for bank risk management)

Question 12

Liquidity risk

Answer 12

▪ Liquidity risk is the probability of a situation when a bank cannot meet its proper (both cash and payment) obligations as they become due or the bank will not be able to fund its assets,
▪ Potential loss due to insufficient market depth
▪ Liquidity risk arises from the different timing of the cash flows of assets and liabilities, i.e. liquidity risk arises from positive maturity transformation provided by banks
▪ No capital requirement on liquidity risk is needed since liquidity is measured differently (in Basel III: Long-term Coverage Ratio (LCR), Net Stable Funding Ratio (NSFR))
▪ Banks seek liquidity (quick assets) to cover the need to withdraw deposits and to grant the loans of clients.

Question 13

Systemic risk

Answer 13

▪ Systemic risk = the risk of widespread disruption to the provision of financial services that is caused by an impairment of all or parts of the financial system, which can cause serious negative consequences for the real economy
▪ = threat of market contagion
▪ DO NOT CONFUSE with systematic risk (undiversifiable risk, measured by beta in the CAPM model)

Question 14

Risks coveredunder Basell I & II & III regulations
(global banking standards)

Answer 14

1. Basel I (1988) - credit risk
2. Market risk (1996) - credit & market risk
3. Basel II (2007) - credit & market & operational risk
4. Basel II.5 (2009) - credit & market & operational risk
5. Basel III (2010) - credit & market & operational & liquidity risk

Question 15

Why is liquidity risk important in banking?

Answer 15

▪ Banks seek liquidity (quick assets) to cover the need to withdraw deposits and to grant the loans of clients.
▪ Unexpected changes in the interest income from credits can result in a rise of the liquidity problem for a bank.
▪ A bank’s need for liquidity can be satisfied by creating either liquid reserves of assets or by their purchase of money or deposits markets

Question 16

4 possible rescues to banks in trouble

Answer 16

1. guarantees on liabilities
2. asset purchase
3. liquidity transformation
4. recapitalization

Question 17

Assets and liabilities management (ALM)

Answer 17

▪ The basic goal of banking activities is to manage assets and liabilities (ALM) in a way that ensures the liquidity, solvency and profitability (efficiency) of the bank for:
I. capital management – capital structure,
II. asset management – liquidity, profitability and risk
III. asset and liability management and offbalance sheet management.

Question 18

Active banking operations

Answer 18

▪ Active banking operations are shown on the left-hand side of the balance sheet, reflecting the use of capital (credit operations, securities purchase), and reflecting operations in which a bank grants credits to third parties (the bank as a creditor) and this is also where income is generated (e.g. interest income).
▪ Loans and receivables form approx. 60 % of all assets

Question 19

Passive banking operations

Answer 19

Passive banking operations, depicted on the right-hand side of the balance sheet, is when a bank is in a debtor position, an operation linked to acquiring new liabilities (collection of deposits, issuing bonds’, CDs and inter-bank loans), issuing shares (equity) and setting up reserve funds and other funds from the profit.

Question 20

Off-balance sheet (OBS) activities of banks

Answer 20

1.Loan sales
2.Fee income from
A. Foreign exchange trades for customers
B. Servicing mortgage-backed securities
C. Guarantees of debt
D. Backup lines of credit
3.Trading Activities
A. Financial futures
B. Financial options
C. Foreign exchange
D. Swaps

Question 21

Four types of bank´s capital

Answer 21

1) equity (accounting capital)
equity = assets - liabilities
2) economic capital
a bank´s buffer against future unexpected losses brought about by credit, market, and operational risks
3) regulatory capital
used for the computation of capital adequacy (CAD)
4) market value of capital
market capitalization of a bank reflects bank’s value on a stock exchange and is calculated as the number of share multiplied by the bank’s share price (and therefore highly volatile!)

Question 22

Tier 1 capital

Answer 22

high-quality capital (retained earnings, profit of the current year)

Question 23

Tier 2 capital

Answer 23

supplementary capital (subordinated debt, loan loss reserves)

Question 24

is bank highly leveraged institution?

Answer 24

yes

Question 25

what is a small “skin in the game“

Answer 25

= Low share of equity on bank´s total liabilities, i.e. small “skin in the game“

Question 26

preferences of banks

Answer 26

banks prefer a low capital ratio and high
return on average equity (ROAE)

Question 27

Structural trends will transform bank risk management until 2025

Answer 27

1. Continued expansion of the breadth and depth of regulation
2. Changing customer expectations
3. Technology and analytics as a risk muscle
4. Additional (nonfinancial) risk types are emerging (contangion, model, cyber)
5. Better risk decisions through the elimination of biases
6. Need for strong cost savings

Question 28

Trend 3: Technology and analytics as a risk muscle

Answer 28

I. Big data
II. Machine learning
III. Crowdsourcing

Question 29

Big data

Answer 29

Today, a vast amount of customer data is available and accessible to banks. Faster, cheaper computing power enables banks to leverage new information—for instance, granular customer-payment and spending behavior, social-media presence, and onlinebrowsing activity—in risk decision making

Question 30

Machine learning

Answer 30

The rapid adoption of a new breed of models is offering much deeper insights into data. Machine learning identifies complex, nonlinear patterns in large data sets and makes more accurate risk models possible

Question 31

Crowdsourcing

Answer 31

The Internet enables the crowdsourcing of ideas, which many incumbent companies use to improve their effectiveness in certain areas (i.e. application of data science)

Question 32

Trend 4: Additional (nonfinancial) risk types are emerging

Answer 32

1. Contangion risk
2. Cyber risk
3. Model risk

Question 33

Contangion risk

Answer 33

Contangion risk is the risk that financial difficulties at one or more bank(s) spill over to a large number of other banks or the financial system as a whole (i.e. related to systemic risk).

Question 34

Cyber risk

Answer 34

Cyber risk means any risk of financial loss, disruption or damage to the reputation of an organisation from some sort of failure of its information technology systems (i.e. it is part of operational risk).