Things That Ought To Be Remembered Flashcards
What are the main types of risk for a bank?
-credit risk
-interest rate risk
-liquidity risk
-market risk
-sovereign risk
-operational risk
-foreign exchange risk
Why’s it important for banks to manage risk?
Risks increase the uncertainty of an FI’s capital and could lead to financial distress.
Also the costs are bourne by customers (deposit holders) not investors.
What is credit risk?
The probability that a bank borrower or counterparty will fail to meet its obligations i.e. not pay in full
Counterparties are also important because you could have bought CDSs from other banks as insurance
How do banks manage credit risk?
They choose a combination of assets with sufficient risk and they exploit their ability to monitor and screen borrowers
How can credit risk actually be measured?
Qualitatively evaluate borrower specific factors
Credit scoring models
What is interest rate risk?
Risk that arises when an FI has different asset and liability maturities and sensitivities to interest rates
What are the two possible interest rate risk scenarios?
Refinancing risk (liabilities mature before asset)
Reinvestment risk (asset matures before liability)
How can interest rate risk be measured?
Gap analysis
Duration model
What is liquidity risk?
Arises when an FIs liability holders demand cash
Or when customers on asset size exercise their right to borrow through credit lines
What regulation helps with liquidity risk?
BIS requires banks to have a liquidity coverage ratio (LCR) > 100% at all times.
LCR = liquid assets/exp.outflows next 30 days
What can banks use to measure liquidity risk?
Liquidity index
This measures the potential losses an FI would suffer from the fire sale of assets
I = sum weighting(firesale/fair price)
What is market risk and how do we measure it?
Arises when assets and liabilities are exposed to market risk.
VaR
What is foreign exchange risk?
Changes to exchange rates can adversely affect the value of an FI’s assets and liabilities denominated in a foreign currency
What is operational risk?
The risk of loss resulting from inadequate or failed internal processes. Includes technology risk
What is gap analysis.
Looking at book value changes in assets and liabilities. We only look at rate sensitive assets and liabilities (floating rate)
If you have more rate sensitive assets than liabilities, what happens if interest rates increase?
Your profits increase
How can gap analysis be extended?
You can split assets and liabilities up according to maturity and compute a weighted gap
What are the criticisms of GAP analysis?
-Fails to consider market value effect. Values change according to IR
-Suffers from over-aggregation even within buckets
-Fails to deal with run-offs
-Doesn’t deal with pre-payment risk
What is duration analysis?
Looks at the sensitivity of bonds to changes in interest rate.
Change in asset value/change in IR
What is the formula for duration?
D=1/V(1C1/1+r + 2C2+P/1+r^2)
What are the flaws of the duration measure?
Convexity. The formula implies a linear relationship but it’s actually convex. This gets worse for bigger changes in IR
Data intensive
How is market risk measured?
Value at risk (VaR)
This is the sensitivity of your asset to price changes. The maximum you could lose in a certain time period.
What is the var formula?
Value of investment * z-score * sigma rt(days)
