Risk Management in Banking

Risk Management in BankingPage #An Introduction to RiskRisk Management is the process of measuring or assessing the actual or potential dangers of a particular situation.

Page #Risk Has Two ComponentsUncertainty.Exposure.Page #Risk Management FunctionRisk Management should Create valueBe an integral part of the organizational processBe a part of decision makingBe systematic & structuredBe dynamic iterative & responsive to changeBe transparent and inclusiveBe based on best available informationPage #Risk Identification ProcessIdentificationPlanning & mapping the process in terms ofThe scope of risk managementIdentity & objectives of stakeholdersRisk evaluation criteriaDefining the framework for the risk management activityAnalyzing risks involved in the processMitigation or solution of risks using available technological, human and organizational resources.Page #Risk Identification MethodsObjective based: Identify risks which are in the way of achievement of objectivesScenario based: Develop/Identify all possible scenarios which will hamper meeting of objectivesIndustry based: Get a list and details of all known risks that a particular industry is exposed to. Check the relevance of each risk to your particular industry.Page #Risk in Pharma IndustryResearch & Development Typical risksProduct not effective or toxic in animal modelsProduct less effective than desired or Problematic side effectsDenial of regulatory approval or delayDifficulties in formulating product, scaling manufacturing processPricing or reimbursement issuesPage #After risk identification .. Then whatAvoid (eliminate, withdraw from or not be involved)Reduce (optimize, mitigate)Share (diversify, transfer, outsource or insure)Retain (accept & contain)Page #Types of RiskOperational.Credit.Market RiskReputational.Page #

Page #Operational RiskThe risk of loss resulting from inadequate or failed internal processes, people and systems, or from external events.

Page #Operational Risks IncludeInternal Fraud.External Fraud.Employment Practices and Workplace Safety.Clients, Products and Business Practices.Damage to Physical Assets.Business Disruption and System Failures.Execution, Delivery and Process Management.

Page #Internal FraudUnauthorized Activity.Transactions not reported.Transaction type unauthorized.Mismarking of position.Theft and Fraud.Fraud/credit fraud/worthless deposits.Theft/extortion/embezzlement/robbery.Misappropriation of assets.Forgery.Account take-over/impersonation.Bribes/kickbacks.Insider trading.Money laundering.Willful blindness.

Page #External FraudTheft and Fraud.Theft/robbery.Forgery.Check kiting.Identity theft.Elder financial abuse.Systems Security.Hacking damage.Theft of information (with monetary loss).

Page #Employment Practices and Workplace SafetyEmployee Relations.Compensation, benefit, termination issues.Organized labor issues.Safe Environment.General liability (slips and falls).Employee health and safety rules. Workers compensation.Diversity and Discrimination.All discrimination types.Harassment.Equal Employment Opportunity (EEO).

Page #Clients, Products and Business PracticesSuitability, Disclosure and Fiduciary.Fiduciary breaches/guideline violations.Suitability/disclosure issues.Retail consumer disclosure violations.Breach of privacy.Aggressive sales.Inadequate product offerings.Account churning.Misuse of confidential information.Lender liability.

Page #Clients, Products and Business Practices (CONTINUED)Improper Business or Market Practices .Antitrust.Improper trade/market practice.Market manipulation.Insider trading (on firms account).Unlicensed activity.Money laundering.

Page #Clients, Products and Business Practices (CONTINUED)Selection, Sponsorship and Exposure.Failure to investigate client per guidelines.Exceeding client exposure limits.Advisory Activities.Disputes over performance or advisory activities.

Page #Damage to Physical AssetsDisasters and Other Events.Natural disaster losses.Human losses from external sources (terrorism, vandalism).

Page #Business Disruption and System FailuresSystems.Hardware.Software.Telecommunications.Utility outage/disruptions.

Page #Execution, Delivery and Process ManagementTransaction Capture, Execution and Maintenance.Miscommunication.Data entry, maintenance or loading errors.Missed deadline or responsibility.Model/system misoperation.Accounting error/entity attribution error.Other task misperformance.Record retention.Documentation maintenance.Delivery failure.Collateral management failure.Reference data maintenance.

Page #Execution, Delivery and Process Management (CONTINUED)Monitoring and Reporting. Failed mandatory reporting obligations.Inaccurate external loss (loss incurred).Customer Intake and Documentation.Unapproved access given to accounts.Incorrect client records (loss incurred).Negligent loss or damage of client assets.

Page #Execution, Delivery and Process Management (CONTINUED)Customer/Client Account Management.Unapproved access given to accounts.Incorrect client records (loss incurred).Negligent loss or damage of client assets.Trade Counterparties.Non-client counterparty misperformance.Vendors and Suppliers.Outsourcing.Vendor disputes.

Page #Operational Risk ChecklistEmployee training.Close management oversight.Segregation of duties.Employee background checks.Procedures and process.Purchase of insurance.Exiting certain businesses.Capitalization of risks.

Page #Credit RiskRisk due to an uncertainty in a counterpartys ability to meet its obligations in accordance with agreed upon terms.

Page #Credit Risks Include:Loans.Acceptances.Interbank transactions.Trade financing.FX transactions.Futures.Swaps.Equities.Letters of credit.Options.Page #Sound Practices for Managing Credit RiskEstablish an appropriate credit risk environment.Operate under a sound credit-granting process.Maintain an appropriate credit administration, measurement and monitoring process.Ensure adequate controls over credit risk.Page #Establish an Appropriate Credit Risk EnvironmentBoard of Directors should review credit risk strategy periodically.Senior management should implement credit risk strategy approved by the Board.

Page #Operate Under a Sound Credit Granting ProcessCriteria should include thorough understanding of the borrower, purpose/structure of credit and its source of repayment.Establish overall credit limits at the level of individual borrowers/connected counterparties.Have a clearly established process for approving new credits/extension of existing credits.Extension of credit must be made on an arms length basis.Page #Maintain a Credit Administration, Measurement and Monitoring ProcessHave in place a system for ongoing administration of various risk-bearing portfolios.Develop an internal risk rating system for managing credit risk.Have an information system and analytical techniques that enable management to measure credit risk of on/off balance sheet activities.Page #Maintain a Credit Administration, Measurement and Monitoring Process (CONTINUED)System for monitoring overall composition and quality of the credit portfolio.Consider future changes in economic conditions when assessing individual credits.

Page #Ensure Adequate Controls Over Credit RiskSystem of independent, ongoing credit review.Credit granting function is properly handled and credit exposures are within limits.System for managing problem credits.

Page # Credit Risk ChecklistStringent credit standards for borrowers and counterparties.Strict portfolio risk management.Constant focus on changes in economic or other circumstances that can lead to a deterioration in the credit standing of a banks counterparties.

Page #Market RiskThe possibility for an investor to experience losses due to factors that affect the overall performance of the financial markets. Market risk, also called "systematic risk," cannot be eliminated through diversification, though it can be hedged against. The risk that a major natural disaster will cause a decline in the market as a whole is an example of market risk. Other sources of market risk include recessions, political turmoil, changes in interest rates and terrorist attacks.Page #Reputational RiskReputational risk is the potential that negative publicity, whether true or not, will result in loss of customers, severing of corporate affiliations, decrease in revenues and increase in costs.Page #Benefits of Effective Reputation ManagementImproving relations with shareholders.Creating a more favorable environment for investment.Recruiting/retaining the best employees.Reducing barriers to development in new markets.Securing premium prices for products.Minimizing threats of litigation.

Page #The key to managing reputational risk is sound risk management, coupled with straightforward communication about the problem the bank is facing.Page #Re-establishing a firms reputation takes a long time.

Page #Reputational Risk CasesPerrier Toluene traces.Exxon Valdez spill.Union Carbide Bhopal, India.Arthur Andersen Enron shredding.Firestone Tires.

Page #Reputational Risk ChecklistProcesses for crisis management are planned and documented.External perceptions of the bank are regularly measured.Reputational threats are systematically tracked.Employees are trained to identify and manage reputational risks.Standards on environmental, human rights and labor practices are set publically.Relationships and trust with pressure groups and other potential critics are established.

Page #Inter-relationship of risksIt is important to recognize that there is interdependency among the various kinds of risks.Example: If there is significant market risk, companies affected by this market risk could default leading to credit risk.

Example: If there are errors during data entry, this could result in incorrect numbers received by the public which brings the who market down. This is an example of an operational risk which leads to a market risk.

Page #Risk ManagementRisk management is the process of monitoring and addressing the potential for loss.Page #Risk ManagementBanks face several types of risk. All the following are examplesof the various risks banks encounter:

Borrowers may submit payments late or fail altogether tomake payments.Depositors may demand the return of their money at afaster rate than the bank has reserved for.Market interest rates may change and hurt the value of abanks loans.Investments made by the bank in securities or privatecompanies may lose value.Human input errors or fraud in computer systems canlead to losses.Page #Evolution of Risk ManagementEmerged as a discipline during the early 1990s.Used long before (1960s).Typically used to describe techniques for addressing insurable risks.

Page #Old Risk ManagementRisk reduction through safety, quality control and hazard education.Alternative risk financing, including self-insurance and captive insurance.The purchase of traditional insurance products.Use of derivatives to hedge or customize market risk exposures.

Page #New Risk ManagementTreats derivatives as a problem as much as a solution.Focuses on reporting, oversight and segregation of duties within the organization.

Page #Enrons Experience with Risk ManagementMaintained a risk management function.Lines of reporting were reasonably independent.Mark-to-market valuations were subject to adjustments by management.Few career risk managers.Fluid workforce.Employees constantly looking for next transfer.

Page #Regulatory Responses from the Financial Services CommunityBasel II.Sarbanes-Oxley Act of 2002.Graam-Leach-Bliley Act.Bank Secrecy Act/Anti-Money Laundering.Insider Trading Rules.Bank Bribery Act.Fair and Accurate Credit Transactions Act (FACTA)Fair LendingFederal Conflicts of Interest Statutes.Various record retention and reporting requirements.Page #Credit RiskCredit risk is the potential loss a bank would suffer if a bank borrower, also known as the counterparty, fails to meet its obligationspay interest on the loan and repay the amount borrowedin accordance with agreed terms. Credit risk is the single largest risk most banks face and arises from the possibility that loans or bonds held by a bank will not be repaid either partially or fully. Credit risk is often synonymous with default risk.

EXAMPLEIn December 2007, the large Swiss bank UBS announced a loss of USD 10 billion due to the significant loss in value of loans made to high-risk borrowers (subprime mortgage borrowers). Many high-risk borrowers could not repay their loans, and the complex models used to predict the likelihood of credit losses turned out to be incorrect. Other major banks all over the globe suffered similar losses due to incorrectly assessing the likelihood of default on mortgage payments. This inability to assess or respond correctly to this risk resulted in many billions of U.S. dollars in losses to companies and individuals around the world.

Page #Market RiskMarket risk is the risk of losses to the bank arising from movements in market prices as a result of changes in interest rates, foreign exchange rates, and equity and commodity prices.Interest rate risk is the potential loss due to movements in interest rates. This risk arises because bank assets (loans and bonds) usually have a significantly longer maturity than bank liabilities (deposits). This risk can be conceptualized in two ways. First, if interest rates rise, the value of the longer-term assets will tend to fall more than the value of the shorter-term liabilities, reducing the banks equity. Second, if interest rates rise, the bank will be forced to pay higher interest rates on its deposits well before its longer-term loans mature and it is able to replace those loans with loans that earn higher interest rates.

Page #Market Risk (contd.)Example of Interest rate risk: Many failed S&L thrifts had underwritten longer-term(up to 30-year) fixed-rate mortgages that were funded by variable-rate deposits. These deposits paid interest rates that would reset, higher or lower, based on the market level of interest rates.As market interest rates increased, the deposit rates reset higher and the interest payments the thrifts had to make began to exceed the interest payments they were receiving on their portfolios of fixed-rate mortgages. This led to increasingly large losses and eventually wiped out the equity of thousands of S&Ls and led to their failure.

Page #Market Risk (contd.)Equity risk is the potential loss due to an adverse change in the price of stock. Stock, also referred to as shares or equity, represent an ownership interest in a company. Banks can purchase ownership stakes in other companies, exposing them to the risk of the changing value of these shares.

EXAMPLE of Equity RiskAs the functionality and use of the Internet expanded in the late 1990s, stock prices in technology and Internet sector companies (known as dot-coms) increased rapidly. Interest in these companies grew and pushed stock prices higher and higher, in part driven by speculation of future increases. Unfortunately, from March 2000 to October 2002, this dot-com bubble burst, and the stock price of many of these companies including Amazon, Dell, AOL (America Online) and Yahoo! fell markedly, resulting in shareholder losses of 50% or more.

Page #Market Risk (contd.)Foreign exchange risk is the risk that the value of the banks assets or liabilities changes due to currency exchange rate fluctuations. Banks buy and sell foreign exchange on behalf of their customers (who need foreign currency to pay for their international transactions or receive foreign currency and want to exchange it to their own currency) or for the banks own accounts.

Page #Market Risk (contd.)EXAMPLE of Foreign Exchange RiskEarly in 1992, Swedish companies found it increasingly difficult to obtain credit. Because interest rates were high and the banking system was strained, banks that could lend funds charged high interest rates. Many SMEs turned to the Swedish banks for foreign currency loans; at the time, foreign interest rates were lower than domestic interest rates. Both the banks and the borrowers were willing to assume the currency exchange risk in order to obtain the foreign loans and their lower interest rates. At that time, the Swedish krona (SEK) had a stable exchange rate, linked to the ECU, a basket of European currencies, and there was no expectation that it would change. But later that yearNovember 19, 1992the Swedish government, after a lengthy and expensive struggle to maintain the strength of its currency, effectively devalued the currency, and allowed the SEK to float freely against other currencies by removing the linkage between the SEK and the ECU. The value of the SEK fell significantly, approximately 10% against the major currencies.On November 19, 1992, therefore, it took 10% more SEK for Swedish companies to make the interest payments on their foreign currency loans than it did the day before. While the interest rates on these loans did not change, the amount of SEK the borrower had to have to repay them increased by 10% because the value of the currency was 10% lower. (For example, a SEK 10 interest payment became a SEK interest payment.) While a 10% change may not seem like much, it presented a significant hardship to some borrowersparticularly for those companies that did not generate foreign currency revenue. As a result, many small and medium-sized companies in Sweden failed, making an already weak banking system and economy even more unstable.

Page #Market Risk (contd.)Commodity risk is the potential loss due to an adverse change in commodity prices. There are different types of commodities, including agricultural commodities (e.g., wheat, corn, soybeans), industrial commodities (e.g., metals), and energy commodities (e.g., natural gas, crude oil). The value of commodities fluctuates a great deal due to changes in demand and supply.

EXAMPLE of Commodity Risk: During the 1970s, two American businessmen, the Hunt brothers, accumulated 280 million ounces of silver, a substantial position in the commodity. As they were accumulating this large positionapproximately 1/3 of the worlds supplythe price of silver rose. For a short period of time at the end of 1979, the Hunt brothers had cornered the silver market and effectively controlled its price. Between September 1979 and January 1980, the price of silver increased from USD 11 to USD 50 per ounce, during which time the two brothers earned an estimated USD 2 to 4 billion as a result of their silver speculation. At its peak, the position held by the brothers was worth USD14 billion. Two months later, however, the price of silver collapsed to USD 11 per ounce, and the brothers were forced to sell their substantial silver holdings at a loss.

Page #Operational RiskOperational risk is the risk of loss resulting from inadequate or failed internal processes, people and systems or from external events.This definition includes legal risk, but excludes strategic and reputational risk Example of Operational Risk. In 1995, Baring Brothers and Co. Ltd. (Barings) collapsed after incurring losses of GBP 827 million following the failure of its internal control processes and procedures. One of Barings traders in Singapore hid trading losses for more than two years. Because of insufficient internal control measures, the trader was able to authorize his own trades and book them into the banks systems without any supervision. The traders supervisors were alerted after the trades started to lose significant amounts of money and it was no longer possible for the trader to keep the trades and the losses secret.

Page #Liquidity RiskLiquidity risk relates to the banks ability to meet its continuing obligations, including financing its assetsEXAMPLE In August 2007, Northern Rock, a bank focused on financing real estate in the United Kingdom, announced that it needed emergency funding from the Bank of England. Northern Rock was a relatively small bank that did not have a sufficient depositor base to fund new loans from deposits. It financed new mortgages by selling the mortgages it originated to other banks and investors and by taking out short-term loans, making it increasingly vulnerable to changes in the financial markets. How much financing Northern Rock could raise depended on two factors. The first was the demand for mortgages it originated to sell to other banks. The second was the availability of credit in the credit market to finance these mortgages. Both of these depended on how the overall banking marketplace, particularly the availability of funding to finance lending, was performing. When the credit markets came under pressure in 2007, the bank found it increasingly difficult to sell the mortgages it had originated. At the same time, Northern Rock could not secure the required shortterm financing it required. Effectively Northern Rock could not finance its assets, was unable to raise new funds, ran out of money, and, notwithstanding the emergency financing from the Bank of England, was ultimately taken over by the government.

Page #Business RiskBusiness risk is the potential loss due to a decrease in the competitive position of the bank and the prospect of the bank prospering in changing markets. EXAMPLE In the mid-1990s, BestBank of Boulder, Colorado (USA), attempted to build its credit card loan portfolios quickly by issuing cards to many low-quality, subprime, borrowers. Unfortunately, too many low-quality borrowers failed to pay their BestBank credit card debts. In July 1998, BestBank was closed after incurring losses of about USD 232 million. This serves as a classic example of a bank seeking to grow its business by lending money to high-risk customers: Although the bank was apparently generating high returns for a period of time, it failed to adequately provide for and guard against bad debts in its business strategy.

Page #Reputational RiskReputational risk is the potential loss resulting from a decrease in a banks standing in public opinion. Recovering from a reputation problem, real or perceived, is not easy. Organizations have lost considerable business for no other reason than loss of customer confidence over a public relations problem, even with relatively solid systems, processes, and finances in place.

EXAMPLE In early 1991, Salomon Brothers, then the fifth largest investment bank in the United States, was caught submitting far larger purchase orders for U.S. government debt than it was allowed. When the U.S. government borrows funds, it sells the debt at an auction and invites selected banks to purchase these securities, called Treasuries. To ensure that Treasuries are correctly priced and all investors willing to lend money to the U.S. government receive a fair price and interest rate, each bank invited to bid at this auction can only purchase a limited amount of the securities. By falsifying names and records, Salomon Brothers amassed a large position in the Treasuries, ultimately controlling the price investors paid for these securities. When its illegal activities became known, the price of Salomon shares dropped significantly, and there were concerns in the financial markets about Salomons ability to continue doing business. Salomon Brothers suffered considerable loss of reputation that was only partially restored by Warren Buffett, a well respected U.S. investor, who injected equity in the firm and took a leadership role in the firm. The U.S. government subsequently fined Salomon Brothers USD 290 million, the largest fine ever levied on an investment bank at the time.

Page #Success Depends UponA positive corporate culture.Actively observed policies and procedures.Effective use of technology.Independence of risk management professionals.Page #When risk management is done correctly you CAN sleep at night!Page #