RISK MANAGEMENT

Question 1

Why is risk management relevant?

Answer 1

1) To ensure the profitability and soundness of entity being managed.
2) Enhance banks intermediation roles
-Promote profitability,
-better diversify bank risk.
3)Rapid changes in finanacial market.

Question 2

Risk

Answer 2

• Defined as the potential of gaining or losing something of value.
  -probability that an actual return on an investment will be lower than expected.
  -risk and return are directly proportional.
  -more risk implies more returns(probability of incurring risk also goes up.)

Question 3

Risk in banking

Answer 3

1.Banks are highly leveraged and in control of very large volume of public funds.
2. Loss of confidence in banks = bank run= failure of economy.
3. New challenges for banks due to deregulation and globalization.
4.Deregulation = more autonomy= more complex lending =more risk.
5.Globalisation = less margins, more volatile= more competition= more cushion against losses required.

Question 4

Steps in risk management

Answer 4

A. risk analysis - defining the risk, understanding the nature of risk, quantify impact.
B. Risk identification - identify the risk to which a bank is exposed.
C. Risk measurement -Quantifying the risks in terms of financial impact.
D. Risk control- contol mechanisms to identify risk before hand. credit appraisal, pricing, credit approval authority, documentation, reporting.
E. Risk monitoring - Evaluation of banks risk management strategies.

Question 5

Risk management structure

Answer 5

A. Risk management committee - overall risk management, holds line management accountable, identify, monitor and measure the risk profile of the bank.
B. Committee approach to risk management - asset- liability management committee- market risk
- credit policy committee- credit risk and country risk.
C. management information system - design of risk management functions should be bank specific.
- Is a prerequisite for establishment of an effective risk management system.

Question 6

systematic vs unsystematic risk

Answer 6

A) systematic risk - Caused by factors beyond the control of the company
- factors that are external to the orgzn.
- includes market risk, interest rate risk, inflation risk, exchange rate risk.
B) Unsystematic - Risks that are not shared with a wider market.
- specific to an individual company.
-reduced by diversifying ones investments.

C) Systemic -company level failure creating economic havoc
- instability
- collapse.

Question 7

Types of risk in banking

Answer 7

1) systemic
2)credit risk- inability of customer/ counterparty to meet commitments.
3)market risk- unfavorable movement in market prices.
4)operational risk- inadequate internal processes.
5)liquidity risk- banks inability to meet both expected and unexpected cash and collateral obligation.
6) strategic risk - potential failures in strategic planning.
7)interest rate risk - potential impact on net interest income or margin caused by unexpected changes in market interest rates.
8)legal risk- imperfect legal system/ non performance.
9)reputation risk- negative public opinion leads to loss of clients.
10)foreign exchange risk - adverse movement in currency exchange rates, increased capital flows across globe coupled with volatility has made banks balance sheets vulnerable to exchange rate movements.
11) documentation risk
12) technological risk.

Question 8

types of interest rate risk

Answer 8

1. gap or mismatch risk - Holding assets and liabilities and off b.s items with different principal amounts maturity dates or repricing dates - unexpected changes in level of market interest rates
2. Basis risk - risk that the interest rate of different assets liabilities off b.s items may change in different magnitude.
3. Embedded option risk - changes in market interest rates may encourage prepayment of cash credit/ demand loans or premature withdrawal of term deposits before their stated maturities.
   4.yield curve risk - movement in yield curves and the impact of that on the portfolio values and income.
   5.price risk - occurs when assets are sold before their stated maturities. due to inverse relation between bond prices and yields.
   6.Reinvestment risk - uncertainty with regard to interest rate at which the future cash flows could be reinvested.

Question 9

risk management tools

Answer 9

credit risk management
market risk
liquidity
operational
interest rate
forex
stress testi