Introduction

Question 1

What is the goal of risk management?

Answer 1

• Keep firms solvent. The capital is there for expected losses.
• Risk management is specifically important for financial institutions because of two factors:
  
  1. Their business model is taking risks (in contrast with non-financial institutions where they want to avoid risk).
  2. Contagion effects = externality. If one financial institution failes, many more can follow.

Question 2

What types of risks exist?

Answer 2

1. Credit risk
2. Market risk
3. Maturity transformation leads to liquidity risk & interest rate risk
4. Operational risk
5. Leverage: reinforces risk above: eg. Bank capital to assets ratio (%) = makes financial institutions vulnerable to shocks.

Question 3

What is the contagion effect and how can we protect against it?

Answer 3

• Contagion effect is the risk that if one financial institution failes, many more follow because of loss of confidence in the financial system.
• We want to internalize externalities bank failure through:
  
  1. Microprudential regulation:
     
     • Stability individual institution vs exogeneous shock
  2. Macroprudential regulation:
     
     • Stability financial system as a whole vs endogeneous shock

Question 4

What is the risk management process?

Answer 4

• Set internal boundaries for employees to ensure solvency, in line with external boundaries:
  
  • Capital adequacy requirements
  • Disclosure requirements
  • Governance requirements
• 3 consecutive steps:
  
  1. Identify risk
  2. Measure risk: quantify potential deviations from target or expected value
  3. Control risk: make sure that the risk exposure is in line with the risk appetite.

Question 5

Difference between managing and measuring risk?

Answer 5

• Managing risk: develop banking business
• Measuring risk: quantifying the nature and size of risk itself.

Question 6

What are the benefits of studying and listing recent financial scandals?

Answer 6

1. Likelihood of big losses
   
   • We suffer from disaster myopia: underestimate risks. So we need positive feedback to estimate the chance of big losses
2. Instruction manual for better risk management processes:
   
   • Categorize loss events to prevent them better in the future

Question 7

What are key elements of good risk management?

Answer 7

1. Learn from past failures: constant adaptation
2. Effective:
   
   • Set effective boundaries for employees: monitoring and evaluation.
   • Penalize employees for breaches, even if it results in profits.
   • Appropriate systems for detection: separation of tasks (front, middle and backoffice)
3. Main challenge: control risk without limiting business development: there is no such thing as risk-free banking. Balance needed between taking and controlling risk.

Question 8

What is Knight’s distinction?

Answer 8

1. Uncertainty: multiple possible outcomes, where you do not know the probabilities
2. Risk: assign probabilities to possible outcomes
   
   • Implies you can be harmed = most people are risk averse, which depends on preferences (are ignored because they are individual).

Question 9

What is a definition of risk?

Answer 9

• Likelihood of harmful consequences.
• Opportunity: likelihood of favorable outcome
  
  • By limiting risks, you limit opportunities
  • By exploiting risk = you exploit opportunities

Question 10

How can the risk appetite be defined?

Answer 10

1. Volatility, skewness and kurtosis
2. Value-at-Risk: amount that is at stake in a bad situation: you need the probability of profits and losses or returns
3. Expected shortfall: how much you stand to lose

Question 11

Typology of risk exposures?

Answer 11

1. Business risks: firm-wide, eg. product, business cycle, legal risks,…
2. Financial of non-business risk:
   
   1. Market risk: changes in market variables
   2. Credit risk: reduced credit quality, longer if products are more illiquid.
      
      1. PD = probability of default
      2. LGD = loss given default
      3. EAD = exposure at default
   3. Liquidity risk: not having necessary liquid means: combination of these two = liquidity black hole
      
      1. Funding: not finding funds to pay creditors
      2. Asset: inability to trade at market price
   4. Operational risk: inadequate systems, human performance, external events