Banking Week 2

Question 1

Objectives of risk management

Answer 1

Maintaining solidarity (strong capital position )

To ensure sufficient liquidity

Duty of care for clients (behavioural and advice)

Achieving efficiency (sound business )

Question 2

Capital and liquidity

Answer 2

Capital (own funds)- can be used as a buffer for losses

Risks
credit risk,market, operational, interest rate

Other capital risks : business, reputational, strategic , compliance

Liquidity risk - bank run, market stress

Amounts are too large to mitigate with capital

Question 3

Credit risk

Answer 3

The potential that a banks borrower or counterpart will fail to meet its obligations in accordance with agreed terms

Days past due (eg 90 days suggested by EBA) can be a indicator for default

Risk with high impact (most important ?)

Mitigated with collateral (eg house)
Credit products require a lot of capital

Different borrowers (eg retail v commercial) have tailor made products :

• Maturity (liquidity or interest)
• Repayment method (interest only / bullet / linear annuity)
• Collateral

Credit approval process (analysis if borrower will pay back the money )

• Loan value
• Loan to income
• Other collateral
• behaviour of the borrower (payment behaviour, social media )

5Cs of credit management (Character, capacity, capital, collateral, conditions )

Question 4

Calculating credit risk (required capital )

Answer 4

-Exposure at default (EAD): expected exposure to a particular obligor at time of default
Amount may be more by drawing rights

• probability of default (PD)- likelihood that a borrower will default within a certain timeframe
• Probability within 1 year
• Designated as default by special credits department
• 90 days overdue with interest payments

Loss given default (LGD)- percentage loss over the total exposure when banks counterparty falls into default
Loss at time of the default, taking into account enforcement of collateral

-Expected loss (EL,€) = expected loss at time of default -EL= PDLGDEAD

Question 5

Calculating required capital credit risk

Answer 5

Expected loss - normal cost of doing business covered by provisioning and pricing policies

Unexpected loss -potential unexpected loss which capital should be held

Stress loss - potential unexpected loss which is too expensive to hold capital against- leads to insolvency

Standardised approach - banks must use a set of prescribed risk weights to determine their capital requirements for credit risk ; risk weight is determined by external credit rating of counterparty (eg AAA, or is unrated then a risk weight of 100% is assigned )

-Internal rating based approach (AIRB): 85% of RWA has to be calculated by the AIRB approach

Banks are allowed to use internal models to determine the PD,LGD and EAD

If the models show that risks in a portfolio are limited, the RWA will be lower resulting in lower capital requirements

RWA = EAD*f(PD,LGD,Maturity)

Question 6

Market risk

Answer 6

Market risk is the risk that the value of an investment will decrease due to movements in market factors such as:

Interest rates
Foreign exchange rates
Equity prices
Commodity prices

Banks can use internal models or the standardised approach to calculate RWA for market risk

Common method to monitor market risk is value at risk (VaR)

Loss taken :
Direct P&L (fair value)
In reserves, comprehensive income (after sale through P&L)
Hold to maturity

Question 7

Market risk VaR historical method

Answer 7

Example

95% confidence level we expect our worse daily loss will not exceed 4%

If we invest $100, we are 95% confident that our worst daily loss will not exceed 4$ ($100 x -4%)

Question 8

Operational risk

Answer 8

Risk of a loss resulting from inadequate or failed internal processes and systems or from external events

Examples: internal fraud, external fraud, system failure

Calculation - basic indicator approach, standardised approach and advanced measurement approach to calculate risk and RWA.

Under advanced measurement approach banks can use internal models based on the frequency and impact of the risk

Eg model in a bank shows fraud happens ten times a year

Average loses due to external fraud is 50,000 therefore expected loss from external fraud is 10*50,000 = 500,000

Question 9

Measuring operational risk

Answer 9

Basel III mínimum capital requirements for main risk types

• credit risk
• market risk
• operational risk

Operational risk - basic indicator approach , standardised approach, advanced measurement approach

Question 10

What are some other risks

Answer 10

Business risk

Reputational risk

Concentration risk

Strategic risk

Legal risk

Compliance risk