Week 8 - Bank Management Flashcards
Risks must be…
- Identified
- Measured
- Managed
What are the major risks for banks?
- Credit risk
- Market risk
- Interest rate risk
- Liquidity/funding risk
- FX risk
- Country & sovereign risk
- Operational risk
What interests must be balanced in risk management?
- Regulators want less risk
- Shareholders want more risk
How are losses covered?
- Expected loss covered by LLP
- Unexpected loss covered by capital
What is the banking book?
Assets expected to be held to maturity
What is the trading book?
Securities / loans held for sale
What are a bank’s two books?
- Banking book
- Trading book
What is PD?
Probability of default (for this year / 90 days – discretionary)
What is included in credit risk?
- Failure to pay
- Credit rating downgrades
- Any failure to meet obligations
What is LGD?
Loss given default (% of exposure lost in event of default – e.g. will we recoup some from selling the collateral?)
What terms are important in measuring credit risk?
- PD
- LGD
How is credit risk calculated?
- Historical data where possible
- Statistical models otherwise
What are some traditional measures of credit risk?
- Total loans/total assets
- NPL/total loans
- Loan losses/total loans
- Loan loss reserves/total assets
What are some additional measures of credit risk?
- Loan concentration
- Rapid loan growth
- High lending rates
- Loan loss reserves/NPLs
- Total loans/total deposits
- NPLs/deposits
What is loan concentration?
Lending to one region/industry
What is market risk?
Losses arising from movements in market price
Where is market risk most relevant?
- Universal banks
- Arises from trading book
What is interest rate risk?
Unexpected rate changes affect earnings or market value
What causes interest rate risk?
Mismatch between fixed-rate vs rate-sensitive assets & liabilities
What is the strategic variable for banks?
Interest rates – they compete by charging lower/paying higher
What are the types of interest rate risk?
- Refinancing risk
- Reinvestment risk
When is refinancing risk relevant?
When assets are more long-term than liabilities
When is reinvestment risk relevant?
When liabilities are more long-term than assets
What is the danger in refinancing risk?
Interest rates rise
What is the danger in reinvestment risk?
Interest rates fall
What is another name for liquidity risk?
Funding risk
What are the types of liquidity risk?
- Day-to-day (managed by interbank lending)
- Liquidity crisis
What can FX risk affect?
- Assets
- Liabilities
- Off-balance sheet activities
- Banking & trading books
How can FX risk manifest?
- Make a loan in a foreign currency
- That currency depreciates
- You lose value
What is country risk?
Economic / social / political conditions keep borrowers from paying
What is sovereign risk?
Risk of government default
What is an example of sovereign risk?
Greek sovereign debt crisis in 2011 / defaulting on €1.6b to the IMF in 2015
What causes operational risk?
- External events
- Internal process / people / systems
What are examples of operational risks?
- Internal / external fraud
- Workplace safety
- Damage to physical assets
- Natural disasters / business disruption
- Technology / cyber risk
What is the only type of risk that should be fully hedged, and why?
Operational risk cannot increase profit
Why is operational risk difficult to measure?
Events are rare but severe
What are examples of miscellaneous risks?
- Off-balance sheet risk
- Capital risk
- Counterparty risk
- Conduct risk
- Reputational risk
What happens when risks are aggregated?
The collective Value at Risk of all traders is greater than the sum of its parts
What are examples of risk interrelation?
- Any crisis comes with reputational risk
- Macro cycles affect both interest rates + default rates
What are some risk mitigation techniques?
- Guarantees to reduce LGD
- Derivatives to hedge & reduce volatility
- Insurance to reduce operational risk
What is one ongoing trend in risk management?
It’s getting more expensive to insure against climate risk
How can market-based funding increase liquidity risk?
Market liquidity can rapidly disappear
How can diversification be applied to loan portfolios?
e.g. 0.01% of funds per borrower
