Risk management for banks Flashcards
What is the major objective of a financial institution?
It is to increase return to shareholders
What is the effect of an increase in return?
It often leads to increased risk
What are the 2 types of risk ?
1) Financial risk
2) on financial risk
List the 8 financial risks
1) Credit risk
2) Interest rate risk
3) Market risk
4) Currency risk
5) Portfolio risk
6) Liquidity risk
7) Hedging risk
8) Industry risk
List the 5 non financial risks
1) Funding risk
2) Political risk
3) Legal risk
4) Operational risk
5) Strategic risk
What does interest rate risk mean ?
It means the mismatch between maturities of assets and liabilities
Is there a significant difference between Interest rate risk of financial institutions and other institutions?
No
When does a movement in interest rate have a serious effect on Financial institution profits?
When interest expense increase more rapidly than interest revenues
What is the most important measure of interest rate risk ?
The ratio of interest-sensitive assets to interest-sensitive liabilities
When do we want interest rates to decline?
When interest-sensitive liabilities are greater than interest-sensitive assets. Because expenses from the liabilities will decline, potentially improving profits.
When do we want interest rates to rise?
When interest-sensitive assets are greater than interest-sensitive liabilities. Because income from the assets will rise potentially improving profits.
What is the limitation of the ratio?
The ratio doesn’t take into account the extent of the risk
Provide an example of an interest-sensitive asset
A government bond
How is a government bond interest rate sensitive?
If interest rates change, the value of a bond changes
If interest rates rise, the value of the bond declines because newly issued bonds are worth more
How does it remain an asset if interest rates go in the wrong direction?
Because regardless of the direction interest rates go the investor still gets coupons and the Face value. The coupons aren’t related to the interest rates ; (e.g bonds with fixed coupon pmts)
Provide an example of an interest-sensitive liability
benefit pension fund or plan
How is it interest rate sensitive?
The money is taken and invested therefore, it becomes interest sensitive
How does it remain a liability if interest rates go in the right direction?
Because Even if interest rates go the wrong direction; still have the obligation to pay employees
What are the 2 risks Interest rate risk comprises of?
1) Mismatch risk
2) disintermediation risk
What is a liability cash flow?
net expected cash outflow for benefits, expenses, and premiums
What is an example of a liability cash flow?
deposits
money markets, etc
What is an asset cash flow
It is a net expected cash inflow for assets supporting the FI
What two things does the Cash flow stream for equity assets reflect ?
1)expected dividends while asset is held
2) expected proceeds for future sale
What are the Consequences if assets (Cashflows) are greater than liabilities (cashflows)?
This looks at the decisions the bank would make
Banks could reinvest the cash (assets) (e.g in the stock market )to get higher than the repo rate they’d receive in the central bank
With Regards to interest rate risk, What are the Consequences if assets (Cashflows?) are less than liabilities (cashflows?)
This looks at the decisions the banks would have to make
Bank could disinvest (in what they are currently investing in) and start investing in something else
What is Disintermediation risk?
It arises when options are available to expose FI to financial anti selection
What is financial anti selection?
It is also known as adverse selection. It refers to a situation in financial markets where one party in a transaction has more information about the asset or risk than the other, leading to an imbalance.
What is the option for borrowers when interest rates decline?
borrowers have the option (and incentive) to prepay loans and
refinance at different, more favorable rates
What is the option policyholders have when interest rates rise?
policyholders in insurance companies will surrender polices or borrow on their security if guaranteed terms exist
What is the effect of exercising these options on financial institutions?
A&L clients contribute to financial disadvantage of FI by the exercise of both options
How can the risk (of borrowers prepaying their loans and refinancing when interest rates are low and policyholders surrendering their policies when interest rates are high) be limited? i.e how can the financial disadvantage be controlled?
Adjust the terms of the policy (i.e make them stricter)
What is required to protect a bank against insolvency ?
Capital
What does credit risk mean?
It is the risk that promised cash flow from loans and securities held by Financial institutions may not be repaid in
full
What is capital made up of?
Capital is made up of equity and debt
What are the two types of losses banks identify?
1) Expected loss
2) Unexpected loss
List examples of expected losses
examples of expected losses include: loan default (e.g someone dying, losing their job and being unable to pay the loan)
List examples of unexpected losses
examples of unexpected losses include: Things like covid
What is the Fundamental problem with calculating these losses when using historical data?
It doesn’t take into account that history doesn’t always repeat itself
What 2 things do banks use to decide if a loan will be approved
1) economic conditions
2) borrower’s credit score
at what rate and how much?
The hope is to charge (borrowers) a rate high enough to compensate for the potential default
Which of the losses is bassel interested in?
Unexpected loss
How is unexpected loss calculated?
It is Calculated using CVaR
At what point is a bank in big trouble?
When losses exceed EL + UL
According to Basel what is capital set to maintain a fixed confidence level at?
99.9%
Which would be the biggest EL, UL or potential losses?
Potential Loss
What is the mathematical explanation for the 99.9% set by Basel?
The mathematical explanation is that 1 in a 1 000 years = a bank will default? (use formula; use numbers to figure out this formula)
What is the theoretical explanation for the 99.9% set by Basel?
theoretical explanation is that a bank must hold enough capital to cover its losses with 99.9% certainty over 1 year OR a bank will default ONLY once in a 1 000 years
Why is Basel only interested in UL?
UL can lead to a bank closing its doors if bank doesn’t make enough provision to cover its UL
What do you think is the best way (statistically) to calculate UL and why?
Logistic regression BUT the multi layered one BECAUSE it is easier to calculate and explain
What does liquidity risk mean?
It is the risk that a sudden surge in liability withdrawals may cause FI to liquidate assets
What do banks do when there is too little liquidity?
They borrow emergency funds at excessive cost
What is the solution for banks having too little liquidity?
Banks should Hold liquid assets; LCR ( requires banks to hold enough liquid assets to cover …)
What is the effect of mismatch risk on liquidity risk?
Limited mismatch risk will lead to lower liquidity risk. whereas high mismatch risk will lead to high liquidity risk.
Why might a FI face a sudden liquidity crisis?
If they Invest in assets that can’t be liquified easily
Is a bank run also a reason why they could face a sudden liquidity crisis?
No because a Bank run is not likely due to ease with which liquid funds can be borrowed
What circumstances might lead a FI to liquidate assets at fire-sale prices?
when a bank urgently needs money
What is market risk?
It is the risk incurred in trading of A&L due to changes in market variables
What do Market variables include?
Interest rates
exchange rates
AND commodity prices
List 2 examples of market risk
1) Interest rate risk
2) Liquidity risk
What does MR depend on?
It depends on the interest rates of an investor’s time horizon ; the shape of the yield curve (whether normal, inverted, , flat or teep): (solely for options): it depends on volatility
What is the effect of an increase in interest rates on the market value of assets?
An Increase in interest rates leads to a decrease in the market value of assets.
Why does the Increase in interest rates leads to a decrease in the market value of assets.
Because of the income from the assets (e.g incme from bond (FV and interest payments)
What is the Drawback of debt instruments (bonds) with longer maturity?
they are more sensitive to interest rate risk and they have more time to be more sensitive
How do we measure market risk?
Value at Risk (VaR)
What does VAR calculate when we measure market risk?
It calculates the likely loss that bank might face on the whole trading book
What do VAR models do?
(regarding market risk)
VaR models assess likely price changes of instruments within individual markets
What are the 2 main approaches for measuring market risk?
1) Variance/covariance
2) Simulation
How is the simulation approach (for measuring market risk) done?
base future price on what happened in the past
What does covariance measure?
how 2 assets move in relation to each other
what does it mean when covariance is high or low?
if it is high, that is bad because it means no diversification.
What is the drawback of simulation as an approach?
The past doesn’t always reflect the future
What does the variance measure?
It measures the volatility of return of a single asset/ portfolio
what does it mean when the variance is high or low?
if it is high, that means more risk
What does operational risk mean?
Risk of loss resulting from inadequate or failed internal processes, people, and systems or from external events.
What risk does operational risk include?
It includes legal risk
What risks does operational risk exclude?
It excludes strategic and reputational risk
What are the 3 main sources of operational risk?
1) People – deliberate and non-deliberate actions
2.) Systems – non-human physical (table) and non-human non-physical (software)
3) External – nature, legislation
What are potential problems with the definition of OR?
the “downside risk” aspect as it only makes a provision for this AND not upside risk
What are examples of OR that may have upside potential?
has to be someone or something doing something (legal) that happens on purpose or accidently that causes an
increase (in money? in returns?)
E.g Person that said he’d buy or sell a certain amount f shares @ a certain price BUT made a mistake and did the opposite (that is sold if they were supposed to buy) / could have accidentally added an extra 0
should be something
that didn’t exist but
exists now
What are the 4 ways a FI can hedge against operational risk?
To hedge against OR a FI must:
1. Hire qualified personnel
2. Have systems in place able to handle complex business activities
3. Market- and credit risk management should function separately
4. Regular internal audits
