L7

Question 1

what is risk?

Answer 1

chance of something undesirable happening

-loss from an unexpected event

-not uncertainty

Question 2

Credit risk?

Answer 2

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.

Question 3

Credit exposures 2 problems

Answer 3

-many credit exposures are recorded at historical values

• majority of credit exposure consists of illiquid assets, so mv can only be estimated

Question 4

degree of risk aversion varies across institutions

why?

Answer 4

because of:

-aggressive loan growth based on flexible underwriting standards

-conservative management to achieve consistent performance of a high-quality portfolio (choosy)

Question 5

types of credit risk

Answer 5

-default risk
-migration risk
-recovery risk
-resettlement or substitution risk
-spread risk
-country risk

Question 6

default risk:

Answer 6

counterpart declares bankruptcy or otherwise defaults on loan

Question 7

migration risk:

Answer 7

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

Question 8

recovery risk:

Answer 8

actual recovery rate after liquidation of the counterparty’s assets will be less than the amount estimated

Question 9

spread risk:

Answer 9

rise in spread required by the market

Question 10

country risk:

Answer 10

non-resident counterpart will be unable to meet its obligation due to political or legislative event (foreign exchange constraints)

Question 11

how banks manage credit risk?

Answer 11

Credit Risk Management models:

Credit-scoring models
Capital Market models

Question 12

Credit-Scoring models:

Answer 12

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

Question 13

Capital Market Models:

Answer 13

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.

Question 14

what is market risk

Answer 14

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

Question 15

Market Risk categories:

Answer 15

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

Question 16

Market risk: interest rate

Answer 16

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

Question 17

Market risk: interest rate

who is vunerable

Answer 17

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

Question 18

what is equity risk?

Answer 18

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

Question 19

what is foreign exchange risk?

Answer 19

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

Question 20

what is Commodity Risk?

Answer 20

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

Question 21

how to manage market risk?

Answer 21

many models such as VAR (Value at risk)

Question 22

what does Var attempt to answer?

Answer 22

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

Question 23

what is operational risk?

Answer 23

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

Question 24

what can operational risk damage and how it happens

Answer 24

-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

Question 25

how does operational risk differ from financial risk?

Answer 25

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

Question 26

what does liquidity risk relate to?

Answer 26

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

Question 27

business risk:

Answer 27

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

Question 28

Reputation risk

Answer 28

e.g., 1991, salomon brothers was caught for purchasing US debt more than it was allowed, controlling the price. when known share price dropped

Question 29

how banks manage risk?

Answer 29

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

Question 30

good banks are able to manage their risk:

Answer 30

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