Day Two

Day Two

Period 9:00 to 10:40 AM

22

Managing Market and Credit Risk

– Market Risk

– Credit Risk - General

– The Credit Risk Model in Modern Banking

– Lending to Small Business

Day 2

3

Market Risk

• Market risk is the potential for loss arising from changes in interest rates, foreign exchange rates, equities, commodity prices, or credit spreads in market risk sensitive instruments.

• In banks, market risk exists in trading form or in non-trading form (asset/liability risk arising from the balance sheet)

4

Market Risk – Balance Sheet

• The bank’s balance sheet contains market risk

• The bank will earn less revenue if a) interest rates decline, reducing the yield on assets, or b) interest rates rise, increasing the cost of liabilities, or c) some combination of the two

• Management of balance sheet risk is called ALM, Asset/Liability Management

• ALM is very sensitive to the different maturities of assets and liabilities; banks analyze the weighted average maturity of assets/liabilities

5

Market Risk - Trading

• Trading is the buying and selling of financial instruments carrying market risk, such as equities, commodities, foreign exchange, bonds, and derivatives

• Trading risk usually arises when the bank fills a customer’s buy or sell order for a financial instrument, but the bank can initiate trading risk for its own account as well

• Trading risk is managed through Value at Risk

6

Market Risk - Trading

U S D o lla r G i lts

In te re s t R a tes

E uro Y en S te r ling

F o re ign E xch an ge

P rec io usM eta ls

E ne rgy R awM ate ria ls

C o m m o dit ies C red itS pre ads

N Y S E N A S D A Q

E qu ities

T rad ab le M a rke ts

S p o t/O v ern ig h t

S ho rt T e rmU p to O n e Y e ar

L on g T e rmO v er O n e Y e ar

D e lta G a m m a V ola tili ty

O ption a li ty

M atu ri ty/O ption a li ty

Method 1 Grouping

Method 2 Grouping

7

Market Risk – Value at Risk

• Value at Risk (VAR) is a process to calculate the potential loss in a trading portfolio

• VAR requires:– An accurate list of the bank’s trading assets and

liabilities– Current market prices and valuations for these assets

and liabilities– A computer model to match up the trading portfolio with

current prices, and then generate a mathematical distribution of potential losses

– VAR is calculated daily and a limit is set on

the acceptable loss amount

8

Trading

Portfolio

and

Historical

Market

Data

Algorithm Probability

Distribution

Potential

Loss

VAR Limit

Financial

Theory

Time

Horizon

And

Base

Currency

Confidence

Level

And

Single

Measure

Overage

Procedures

And

Back

Testing

INPUT MODEL OUTPUT VAR CONTROL

Asset

Grouping

And

Portfolio

Values

MappingProcess

RangeOf Values

RiskMeasure

RiskMitigation

Functions

Support

Value at Risk Process

Market Risk - Value at Risk

9

μ- 1σ + 1σ

Normal Distributiondescribing potentialmarket values for aportfolio with linearrisk characteristics

Current Value = mean μ

Potential gainsPotential losses

Loss at 1 standard deviation

Value at Risk

10

μ

New Current Value = mean μ


Portfolio Distributionskewed by inclusion ofcall options purchased

Value at Risk

11

μ- 1σ + 1σ

Studies have shown thatfor many tradable productsthe Normal Distribution doesnot exactly hold – extrememarket events tend to makelosses more severe than wouldotherwise be expected

Current Value = mean μ


Loss at 1 standard deviation

“Fat tail” exposure

Value at Risk

12

μ- 2σ + 2σ

If the bank selects the95% confidence level(2σ) as its measure ofrisk tolerance, this will generate a singlenumber representingthe Value at Risk forthe portfolio


VAR is set here at the 95% confidence level

2.5% of all potentialvalues are found ineach of these areasunder the curve

Value at Risk

13

Credit Risk

• Credit risk is defined as the potential for loss if a customer fails to perform on their obligations

• Credit risk, and credit loss, occur both on the transaction and portfolio level

• The credit risk management model that follows shows how credit risk is handled

1414

23

Credit Risk Management ModelCredit Strategy for Line of Business

Target Market

Portfolio Limits:Concentration/Cross Border

Individual Credits

•Risk Acceptance Criteria•Risk Ratings•Documentation•Covenants•Due Diligence

Early Problem Detection Workout Loss

Annual Credit Review

Reporting

Credit Loss Assessment

Loan Review

Loan Loss Reserve

Line Management

Credit CommitteeApprovals

Risk Management Department

Risk Analysis

Portfolio Valuation

Risk Controls

Oversight/Monitoring

Color Code

Source: Durval C. Araujo

Effective Risk Management Process

1515

Risk Analysis

Set Credit Strategy:– By industrial sector (hydrocarbons, mining,

chemicals, agriculture, etc.)– By wholesale/retail (export/import firms,

grocers, tourist shops, hotels, etc.)– By individual (business owners, high net worth,

service industry)– Identify risk/return requirements


1616

Risk Analysis

Set Target Market:– Which companies will be selected for

marketing?– How are industries to be defined?– Which SMEs qualify for credit?– How does the Target Market match with the

bank’s traditional strengths?


1717

Risk Analysis

Assign roles, responsibilities, authorities:Assign Target Markets to the appropriate bank

department

Define who solicits clients, who assesses the credit risk, who books loans

Who is accountable if something goes wrong with the credit? What actions may they take?

Effective Risk Management ProcessEffective Risk Management Process

1818

Risk Controls

For the Portfolio:• Create portfolio limits and limits based on

risk ratings or credit quality• Ensure limits provide proper diversification• Determine how exposure against the limit is

measured• Define how exceptions to limits may be

approved

Effective Risk Management ProcessEffective Risk Management Process

1919

Risk Controls

Determine Committee Approval Process

CreditCommittee

Asset/LiabilityCommittee

ReserveCommittee

PolicyCommittee

PolicyCommittee

Risk Mgt.Committee

Highest LevelInternal Committee

Approves portfolio limits, large credits, credit policy

Approves loanloss reserves

Coordinatesrisk/return across bank

Manages marketrisk and bankliquidity


2020

Risk Controls

For the Portfolio:

The combination of credit risk strategy, target markets, portfolio/concentration limits, and committee approval process constitutes the bank’s…..

……Credit Risk Philosophy


2121

Risk Controls

Portfolio diversification is essential so that no one industry or individual credit becomes too large a part of the portfolio


2222

Risk Controls

Proper credit risk management is not gambling….

….Proper credit risk management strikes a judicious balance between risk and return


2323

Risk Controls

For individual credits establish:

• Risk Acceptance Criteria• Risk Ratings• Documentation and Covenant Standards• Due Diligence


2424

Risk Controls

Risk Acceptance Criteria …

…define the types of credit products to be sold to a client, maximum amounts of acceptable exposure, collateral requirements, etc.


2525

Risk Controls

Risk Ratings…

…are internal ratings (such as 1 to 10) used to assess the client’s credit-worthiness and loan loss potential…increasingly they mimic the rating system used by Standard & Poor’s or Moody’s…they determine the required loan loss reserves for the client’s exposure


2626

Risk Controls

Legal Documentation and Covenants…

…are the minimum legal standards required from the client (such as parent guarantees for subsidiary exposure)…Covenants such as a maximum debt/equity ratio, pari passu clauses, etc. are important protections for the bank


2727

Risk Controls

Due Diligence…

…defines what is expected of the loan officers who monitor the credit…this will include routine review of financial information, industry analysis, and checks on collateral


2828

Portfolio Valuation

• In a sophisticated credit risk management process, all credits are treated on a portfolio basis

• In a portfolio, some credit risks increase total exposure, and some provide offsets

• Proper portfolio review identifies unacceptable concentrations of risk (by industry, product, maturity, etc.)

Ideally, credit reserves are set for the portfolio, not for the sum of all individual credit exposures


2929

Portfolio Valuation

Probability of Default x Loss Given Default =

Expected Loss

Expected Loss Loan Loss Reserves


3030

Portfolio Valuation

• Accurate credit portfolio valuation requires sophisticated computer modeling, and an excellent statistical history on credit losses by industry

• This will not be possible for Libyan banks; portfolio valuation for the time being will continue to be the sum of individual credit risks


3131

Portfolio Oversight and Monitoring

• All loans require on-going review to detect any problems as soon as they occur

• If the problems get worse, the loan turns into a Workout credit, and may eventually require increased credit reserves or a charge against earnings for credit loss


3232


• Workout loans are often defined as those credits whose Risk Rating has deteriorated beyond a certain point

• Workout loans can require tough negotiations with the customer

• The Workout loan is transferred from the loan officer who originated the credit, to a Workout loan unit specializing in problem credits


3333


An independent unit is required to review the loan portfolio

This unit is Loan Review

Loan Review has the power to checkany aspect of a loan, change the riskrating, require additional reserves,and force a change in RiskAcceptance Criteria

Loan Review confirms underwritingand analysis comply with the bank’scredit policies


3434


Many external players also provide oversight for the bank’s credit risk

• Bank auditors ensure that the loss reserve process follows acceptable accounting standards

• Central credit reporting bureaus such as Standard & Poor’s can downgrade the bank’s debt if problem loans increase


3535


Many external players also provide oversight for the bank’s credit risk

• Regulators and supervisors frequently inspect the loan portfolio, and may require a change in Risk Ratings or in reserves

• The legal and judicial system enforces contracts and covenants, and provides for an orderly insolvency process


3636

Small and Medium Enterprise

Lending

3737

The Secret of Lending to SMEs…

…Modernize Your Credit Process

Small and Medium Enterprise Lending

3838

Business Growth Patterns

Seed Start-Up Growth Stable Large Enterprise

SME Stage

Source: Bank Negara Malaysia


3939

SME Credit Providers

Seed Start-Up Growth Stable Large Enterprise

Development Finance, Government

Venture Capital

Commercial Banks (Loans, Trade Finance)

Leasing and Factoring

Bond and Equity Markets


4040

Challenges in Lending to SMEs

• Multiple financial books, usually unaudited

• Collateral difficult to value and secure

• Limited access to other forms of capital

• Often family owned and operated, and they are usually not familiar with banking forms, application process


4141

Advantages of a Modern Credit Process

• The SME market can be carefully targeted, and credit guidelines properly arranged

• Many SME loans can be bundled together and treated as a portfolio

• Risk can be better matched against return


4242

Using Risk Management skills when lending to an SME

– Set the target market carefully• Where does the bank have expertise – tourism

industry, agriculture, manufacturing?• Hire loan officers and risk managers who know these

industries well• Set Risk Acceptance Criteria – minimum size of

customer, basic financial condition, availability of collateral


4343


– Keep the loan product simple• Use a basic loan credit structure or trade

finance approach• Legal documentation should be easy to

understand for the borrower• Maturities should be short term


4444

Using Risk Management skills when lending to an SME– Understand the risks

• Quantify the default probabilities for the industry involved, even if you must estimate

• Price the loans based on these probabilities• Determine the value of collateral and your

ability to sell collateral if necessary• Keep the loan amounts small


4545


– Manage the risks• How often does your banker need to meet

with the customer to assess financial condition?

• How expensive will any extra effort be?• Have a plan in place in case something

goes wrong


4646

Using Risk Management skills when lending to an SME– Find a government partner

• Government has a strong policy interest in supporting SME lending

• Government can set up programs to educate entrepreneurs in applying for credit, making payments on time, preparing financial records, and keeping assets pledged as collateral in good condition

• Government may offer your bank insurance against SME losses


4747


– Manage the risks• Risk managers should monitor the portfolio

regularly• Is the rate of default in the portfolio higher

or lower than anticipated?• How much can be recovered after default?• Build up a data base of default history


4848


– Seek out opportunities• A few SMEs will grow to become

large corporations• Learn to spot these opportunities and

help them along with additional financing and new products


4949

Measuring Your Success

– Did the portfolio behave as anticipated?

– Were defaults no greater over time than

expected?

– Were your returns sufficient to cover all

your costs plus generate the expected

return?


5050

Measuring Your Success

– Did the risk managers work well with the business managers?

– Were your risk controls appropriate and useful?

– Did you develop a competitive advantage using Risk Management in a new market sector?


5151

• Building on Your Success

– Expand your new Risk Management skills to other parts of the bank, and to other types of risks

– The result….

Better risk/return balance

Greater profitability

Stronger market position!


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Day Two

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