L7 Flashcards
what is risk?
chance of something undesirable happening
-loss from an unexpected event
-not uncertainty
Credit risk?
potential that a bank borrower will fail to meet its obligations
standalone: default risk, migration risk, exposure risk
portfolios credit risk: spread risk and country risk
-Swiss bank announced 10b due to lending money to high risk borrowers in 2007.
Credit exposures 2 problems
-many credit exposures are recorded at historical values
- majority of credit exposure consists of illiquid assets, so mv can only be estimated
degree of risk aversion varies across institutions
why?
because of:
-aggressive loan growth based on flexible underwriting standards
-conservative management to achieve consistent performance of a high-quality portfolio (choosy)
types of credit risk
-default risk
-migration risk
-recovery risk
-resettlement or substitution risk
-spread risk
-country risk
default risk:
counterpart declares bankruptcy or otherwise defaults on loan
migration risk:
deterioration in the counterpart’s creditworthiness
bank gives out loan to someone with good credit worthiness for good project, bank increase interest as theirs a risk of it maybe being downgraded
recovery risk:
actual recovery rate after liquidation of the counterparty’s assets will be less than the amount estimated
spread risk:
rise in spread required by the market
country risk:
non-resident counterpart will be unable to meet its obligation due to political or legislative event (foreign exchange constraints)
how banks manage credit risk?
Credit Risk Management models:
Credit-scoring models
Capital Market models
Credit-Scoring models:
forecasts a company’s default using accounting data:
Regression Models
Linear discriminant analysis
uses many models that use financial indicators of a company as an input, attributing a weight to each of them that reflects its relevant importance
Capital Market Models:
using price, return and volatility data obtained from the stock and bond markets: based on corporate bond spread or stock prices
-limitations= only apply to those listed on the stock price.
what is market risk
risk of changes in the mv of an instrument or portfolio of financial instruments, connected with unexpected changes in the market conditions (stock price, interest rates, ex rate)
-focus on the bank’s trading book- contains the portfolio of financial assets
Market Risk categories:
interest rate risk: when the MV of a position is sensitive to interest rates
foreign exchange risk: when mv is sensitive to ex rate
equity: mv sensitive to equity performance
commodity: mv sensitive to changes in the commodity prices
Market risk: interest rate
potential loss due to movements in interest rates
-affects profitability and econ value of a bank by:
Still depending on interest paid loans
banks assets usually have longer maturity than their liabilities
American S&L crisis in 1980s and 90s, Americana savings and loans. they were underwriting longer-term mortgage that were funded by the short term deposit:
short term deposit means the interest rate can go up, whereas their loans are still charging low interest rates
Market risk: interest rate
who is vunerable
lenders and borrowers are exposed to it
fixed rate reduces the uncertainty on cost/revenue, but doesn’t eliminate it
-if fixed rate goes up, opportunity cost for lender
-if it goes down, borrower can get money at a lower rate
forecasted future exposures, whether its fixed or variable are identical to the floating rate’s because the future interest is uncertain
what is equity risk?
potential loss due to an adverse change in stocks.
e.g., late 90’s share price in dot-coms companies increased rapidly, driven in part by speculation. from march 2000 to oct 2002, bubble burst, stock price fell (e.g. dell). resulted in shareholder losses of 50% or more
what is foreign exchange risk?
risk that the value of the bank’s assets or liabilities change due to fluctuations in the exchange rate
e.g. 1992, Swedish SMEs turned to foreign currency loans at low interest- at this time Swedish currency had stable exchange rate
in Nov, gover devalued and floated currency, value fell by 10%, borrower needed to pay 10% more for interest
what is Commodity Risk?
potential loss due to an adverse change in commodity prices: change because of supply and demand
-e.g., 70s hunt brothers, accumulated 280 million ounces of sliver (1/3 worlds supply) and they effectively had control of the price at 79
from sep 1979 to jan 1980, sliver price increased from $11 to 50 per ounce, they earned 2-4b. 2 months later, price collapsed and they had to sell their sliver at a loss
how to manage market risk?
many models such as VAR (Value at risk)
what does Var attempt to answer?
how much money could the bank lose from its portfolios of securities over the next periods with a given probability.
e.g., if period is 1 month, the prob is 1% and VAR =100M , bank could lose 100m with prob of 1% in next month
-calculated for different financial instruments and portfolios, allowing comparison between the risk
-usefulness depends on accuracy of calculations
-considers the prob distribution profit/loss
what is operational risk?
potential loss resulting from failed internal system, includes legal risk, but excludes strategic and reputational risk
e.g., 1995, Barings, oldest uk merchant bank collapsed after incurring losses of £827m following failure of its internal control and processes
-one trader in singapore hid trading losses for >2 years. becuase of insufficient internal control measures, trader was able to authorize his own trades and book them into bank’s systems without any supervision
what can operational risk damage and how it happens
-the orgs physical, financial, legal risk and relationships
happens through failed systems and controls and human error or management failure
-all risk which arent banking
how does operational risk differ from financial risk?
Operational
-unavoidable
-pure risk, losses only
-no relationship between risk and expected return
-difficult to see, understand and measure
-lack of effective hedging instruments
-difficult to price and transfer
financial risk
-consciously and willingly faced
-speculative risk, losses and profits
-increasing relationship between risk and expected return
-large availability of hedging instruments
-comparatively easy to price and transfer
what does liquidity risk relate to?
bank’s ability to meet its continuing obligations including financing its assets
e.g., aug 2007, northern rock approached BoE asking for liquidity help
-gover injected 1.4b, early 2012 sold to virgin money for 747m and the potential for the treasury to receive 280m over next few years- a “paper” loss between 400m and 650m
-BOE acted as LOLR (lender of last resort) to prevent potential contagion of crisis
-may lead to capital risk
business risk:
potential loss due to decrease in competitive postion of bank and prospect of bank prospering in market
e.g., mid 90s, BestBank of Boulder, attempted to build up its credit card loan portfolio quickly and issued cards to “subprime” borrowers. in july 1998, it was closed after incurring 232m losses
Reputation risk
e.g., 1991, salomon brothers was caught for purchasing US debt more than it was allowed, controlling the price. when known share price dropped
how banks manage risk?
world leading banking supervisors develped regulations on a number of “good practice”
-introduces linkage between level of equity capital and risk
-requires banks to adopt more formal procedures to measure and manage risk
risk management- complex + comprehensive process of bearing risk that banks want to bear, while having minimum risk:
-objective: maximize shareholders wealth through managing the trade of between risk and returns
good banks are able to manage their risk:
banks should be able to identify, measure, control and monitor all its risk
-inability to do so may result in lower profits, solvency and survival
