Chapter 4: Risk Management Flashcards
Define the two main types of risk - pure and speculative
Pure Risk - Risks which only offer the potential of an adverse outcome. Either a desired outcome occurs or if it does loss or harm results
Speculative Risk - The form of risk offers the potential for the outcome to be either better or worse than that which is expected (a two-way risk)
What’s the difference between uncertainty and risk
Uncertainty is the result of a lack of knowledge regarding a future
Risk is the possibility of an outcome being different to that which we expect
The uncertainty can be reduced whilst the risk remains.
In brief, what should a bank’s risk management system do?
- Identify the risk
- Assess the risk to reduce uncertainty and establish the level of risk
- Determine appropriate response to risk
What are the four Ts (responses to risk)
Tolerate
Treat
Transfer
Terminate
Define Tolerating a risk
Where the risk is deemed acceptable and there is no need to take any action.
Banks must tolerate some level or risk in order to generate profits
Define Treating a risk
This is treating the risk to reduce it to an acceptable level e.g. internal controls, or hedging activities by using derivatives
Define Transferring a risk
This is where a risk is considered unacceptably high but there’s no desire to terminate it. Therefore, you may transfer the risk to other 3rd parties i.e. an insurance company, or a credit default swap
This can create other risks
Define Terminating a risk
This involves ending the situation that gives rise to the risk cause the risk is unacceptable high.
It may be very expensive to terminate the risk
Define financial and non-financial risk
Financial risks are those which can cause a direct financial loss e.g. failing to repay a loan
Non-financial risks cause financial loss indirectly e.g. failing to meet regulatory responsibilities causing a financial loss
What are the types of financial risks?
- Operational Risk - risk inherent in an organisation’s activities and operations
- Market Risk - risk of losses from adverse movements in market prices
- Credit Risk - risk of losses from a creditor failing to pay
- Liquidity Risk
- Capital Risk
- Systemic Risk
Define Operational Risk and its features
Definition: The risk of loss resulting from inadequate or failed internal processes, people and systems or from external events
All forms of business activity are exposed to risk. Operational risk can fall into two main categories:
- Internal - events connected to a bank’s staff and systems e.g. errors, fraud
- External - events outside the business’ operations which could have a direct financial impact
Define Market Risk and its features
Definition: The risk of losses arising as a result of changes in market rates or prices
Banks hold assets which have a variable market value which actively quoted in a market and there is a potential for these prices to vary/fluctuate.
These assets are also exposed to market rates e.g. exchange or interest
Define Credit Risk and its features
Definition: The risk of losses as a debtor of a creditor failing to meet debt obligations in full and on time
Many banks have an agreement whereby another party is obliged to repay finance extended to them and if not repaid, the bank suffers a loss.
Also banks enter into financial contracts with other counterparties (capital market participants such as banks).
Define Counterparty Risk and how it relates to credit risk
Banks enter into financial contracts with other counterparties (capital market participants such as banks).
Counterparty risk describes the risk of contractual counterparties failing to meet their financial obligations
This is a significant component of credit risk as these transactions are typically large
Define Liquidity Risk
And why might payment obligations arise?
Definition: The risk of a bank having insufficient liquid funds (cash and securities) to meet its payment obligations
a) The result of the need to meet the withdrawal requests of depositors
b) The need to make margin/collateral payments
How can banks manage liquidity risk?
Banks need to forecast their liquidity needs
Ensure the banks have sufficient buffer of liquid assets to cope with unexpected events with an impact on liquidity
Define Capital Risk
The risk that the bank has insufficient capital to meet the regulatory requirements imposed by its prudential regulator
The risk that a company’s capital is eroded to the point that the company becomes insolvent
Define Systemic Risk
The risk of losses from the failure of an entire system or severe damage
Participants in the financial markets are inextricably linked e.g. the Global Financial Crisis
What are the six types of non-financial risk
- Strategic - risk to the success of a bank strategy from changes in the business environment
- Reputational - risk that the public perception of the bank will be damaged
- Technology - risk of technology failures and vulnerability to cybercrime
- Legal - risk of adverse law or court decisions against the bank
- Control - risk of failure in a bank’s system of internal controls
- Regulatory - risk of a bank failing to comply with its regulatory responsibilities
Define risk appetite
The amount of risk exposure, or potential adverse impact from an event, that the organisation is willing to undertake
What are one of the issues relating to risk appetite?
The quantification of a threshold of acceptable risk. Hard to translate certain risks into monetary terms
What are the main features of risk appetite?
A total risk appetite for the bank needs to be established that involves all risks.
Needs to be established by management, approved by the board
Needs to consider the views of all bank stakeholders
What are the things management consider when formulating a risk appetite?
Ability of management Management's competence to manage risk Management's limited resources Level of exposure that necessitates immediate action The point a formal strategy is needed to respond Past risk events Bank's culture and philosophy Past experience of gains/losses Stakeholder's needs/objectives Potential impact on financial statements Impact on the bank's operations
What are the steps taken when establishing risk appetite?
- Decide upon key risk metrics - financial measures e.g. largest loan approved; qualitative measures e.g. customer complaints; key performance indicators; broad measures of risk
- Discuss with relevant staff
- Attempt to establish a consensus
- Communicate the risk appetite
What are the main uses for risk appetite
1) Which risks to avoid and which ones to accept
2) When to obtain insurance to limit risk exposure
3) Establishing limits and thresholds
4) Setting the quality criteria for processing systems
What are the main rules to consider when deciding if a risk falls within the risk appetite
- What is the potential impact of the risk event
2. What is the likelihood of the event occurring
What did the Walter Report say about bank governance
Serious deficiencies in prudential oversight and financial regulation were accompanied by major governance failures within banks
What were the main findings of the Walker Report
1) The risk committee should have a non-exec and have the power to oversee large transactions
2) A remuneration committee should examine the pay across the whole organisation
3) Non-exec directors should be scrutinised more and required to spend up to 50% more time in the role
4) Chairman should be subject to annual re-election
What does a good corporate governance framework ensure?
Effective strategic guidance of the company
Monitoring of management by its board
Board accountability to the company and its shareholders
How does the board structure differ in UK/US and other jurisdictions?
UK/US:
Usually have a unitary board structure - A single body with exec and non-exec directors
Other:
Adopt a two-tier board structure comprising an executive board and a supervisory board (non-exec and employee representatives)
What are the main board responsibilities?
Monitoring managerial performance
Ensure an adequate return for shareholders
Prevent conflicts of interest
Balancing shareholder interests (trade-offs)
Oversee the risk management system
Who are the board accountable to?
Company
Shareholders
Take regard of other stakeholder interests
What are the five underlying principles the UK Corporate Governance Code are based on?
Leadership Effectiveness Accountability Remuneration Relationship with shareholders
Explain the ‘Leadership’ principle of the UK Corporate Governance Code. Its features.
Every company should be headed by an effective board so:
Clear division of responsibilities (exec and non-exec)
Chairman is responsible for leading the board
Non-execs should constructively challenge
Explain the ‘Effectiveness’ principle of the UK Corporate Governance Code
The board and its committees should have appropriate skills, experience and knowledge in order to effectively carry out their responsibilities
To be able to be effective:
a) Need a nomination committee - independent non-exec directors
b) Directors should allocate sufficient time
c) Need an induction
d) Regularly refresh their skills and knowledge
e) Board supplied with timely quality information
f) Needs a formal evaluation of its performance
Explain the ‘Accountability’ principle of the UK Corporate Governance Code
Board needs to determine the nature and extent of the principal risks its willing to take and should maintain sound risk management and internal control systems
Explain the ‘Relations with shareholders’ principle of the UK Corporate Governance Code
The board has a responsibility for ensuring that a satisfactory dialogue occurs with shareholders e.g. general meetings
What should the board/directors do in regard to risk and risk management?
- Confirm a robust assessment of the principal risks the company are facing
- Describe how these risks are being managed or mitigated
- Board should monitor the company’s risk management and internal control and carry out a review
Who should the audit committee be comprised of?
At least three independent non-executive directors
At least one member of the audit committee with recent and relevant financial experience
What are the main role and responsibilities of the audit committee
Monitor the integrity of the financial statements
Do any announcements relating to financial performance
Reviewing the company’s internal financial controls and risk management systems
Monitor and reviewing internal audit function
Make recommendations to the board in regards to the external auditor’s appointment, independence and objectivity
Developing and implementing policy of the external auditor
Define enterprise risk
Can be defined as the aggregate sum of all categories of risks affecting an organisation and its business
Define enterprise risk management
An integrated framework for the management of risk throughout an organisation.
It includes the processes of planning, organising, leading and controlling the activities to minimise the effects of risk on its capital and earnings
What is the objective ERM framework
To consider the potential impact of all categories of risk on its processes and activities in order to manage overall enterprise risk
What is the objective ERM framework
To consider the potential impact of all categories of risk on its processes and activities in order to manage overall enterprise risk
What are the four stages in the risk management framework
- Identification of risk –> often classified by source and different types are managed in different way
- Assessment of risk –> evaluate each risk. For financial risk = quantification. Non-financial risks = ranking/qualitative assessment
- Determination of appropriate response –> the 4 T’s. Tolerate, treat, transfer or terminate
- Reporting and review –> needs a mechanism for reporting risk performance and a review of effectiveness to senior management and the board
What does the risk management framework typically include
Number of board-level and executive committees reporting to the board
What is the role of a board risk committee?
What is the board risk committee responsible for?
Provide oversight over the bank’s overall risk management framework and report to the main board
Review and report to the board on:
a) current and future risk appetite
b) risk management framework e.g. principles, policies, methodologies, systems, processes, procedures
c) risk culture to ensure it supports the risk appetite
What is the asset and liability committee and what is its role?
A risk management committee made up of senior management from major business divisions and reporting to the main board
Role is to manage the risks that arise from the mismatches between assets and liabilities in the bank’s statement of financial position
What are the typical functions of the ALCO?
1) Liquidity and Funding Policies
2) Contingency plans for liquidity and funding
3) Assessing the impact and probability of liquidity shocks and interest rate changes
4) Determining the pricing of assets and liabilities
5) Ensuring the bank has sufficient capital and liquidity to meet regulatory requirements
6) Ensuring risks meet risk appetite
What is the credit committee responsible for?
What are their specific functions?
Determining a bank’s credit policy and making decisions regards to the use of bank funds for lending
Functions:
1) Setting and approving lending policies e.g. lending limits
2) a
What is the credit committee responsible for?
What are their specific functions?
Determining a bank’s credit policy and making decisions regards to the use of bank funds for lending
Functions:
1) Setting and approving lending policies e.g. lending limits
2) Approval of granting or extension of loans
3) Oversight of the bank’s framework
