FINA 6080: RISK
MANAGEMENT OF
FINANCIAL
INSTITUTIONS
Introduction to
Foundations of
Financial Risk
Management
TABLE OF CONTENTS
• Introduction to Financial Management
• Types of Risks
• Risk Management in Financial Institutions
• Regulatory Environment
• Course Expectations and Assessment Overview
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INTRODUCTION TO FINANCIAL
RISK MANAGEMENT
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WHAT IS FINANCIAL RISK MANAGEMENT?
Financial risk management refers to the practice of
identifying, measuring and managing the risks associated
with financial activities.
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THE PRACTICE OF RISK MANAGEMENT
1. Identify the risk which means recognizing all the potential challenges or threats that
could negatively impact the entity.
2. Measure the risk where you assess the magnitude and likelihood of these risks.
Think of it as evaluating how severe each risk is and how likely it is to occur.
3. Manage the risk is about developing strategies to either reduce the probability of
these risks happening or to mitigate their effects if they do occur.
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WHAT IS THE OBJECTIVE OF FRM?
The main objective of FRM is to maintain an acceptable
balance between risk and reward/return.
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RISK
RISK refers to the probability or likelihood
of an event occurring which could lead to a
negative impact or loss. Risks are generally
defined by their event triggers. For example,
credit risk is the risk that a customer
defaults, resulting in a loss to the lender.
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RISK VS RETURN
Risk vs Return is a concept that is based on
the trade-offs between the level of risk and
the amount of expected returned.
The higher the risk, the higher the expected
return.
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THE OBJECTIVE
OF FRM
For financial institutions,
the critical consideration is
determining the acceptable
level of return in relation
to the inherent risks
involved.
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RISK
MANAGEMENT
& FINANCIAL
INSTITUTIONS
A crucial principle in Financial Risk Management (FRM) for
Financial Institutions (FIs) is understanding that various risks affect
different types of FIs in distinct ways. The specific nature and
severity of a risk's impact on a FI are deeply intertwined with the
kind of activities and operations that the institution engages in.
For example, for a bank, liquidity risk is primarily about having
enough cash or liquid assets to meet the demands of depositors and
to fulfil loan commitments. In contrast, for an investment firm,
which deals more with investments and securities, liquidity risk is
more about the ability to quickly sell assets at a fair price.
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TYPES OF RISKS
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TYPES OF FINANCIAL RISKS
Financial Risks are associated directly with the financial
operations and transactions of a business or individual.
They are typically quantifiable and often linked to
financial loss.
▪ Credit Risk
▪ Market Risk
▪ Margin Risk
▪ Liquidity Risk
▪ Capital Risk
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CREDIT RISK
Credit risk is the risk of loss due to a customer being able to meet their contractual obligations.
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MARKET RISK
Market risk is the risk of loss due to changes in market values. The changes in the market value,
may be due to:
▪
“Pure” market risk – adverse changes to market value of securities i.e., changes in prices
▪
Interest rate risk – the risk of loss due to changes in the market interest rate
➢
Mismatch risk/gap risk is the risk that there is a mismatch in duration or currency
➢
Basis risk is the risk that the reference rates associated with assets and liabilities are
different
➢
Optionality risk is the risk of loss due to the customer having the right to and
exercising the option to repay a loan early (specific to lending institutions)
➢
Yield curve risk is the risk that interest rates may change across one part of the yield
curve
▪
Equity risk – the risk of loss due to changes in the price of stock investments/share prices
▪
Currency risk - the risk of loss due to changes in the price of one currency in relation to
another.
▪
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Commodity risk - the risk of loss due to changes in prices of commodities.
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LIQUIDITY RISK
Liquidity risk is the risk of loss due to the inability to meet financial obligations due to the inability to quickly convert assets into cash without significant loss in
value.
▪
Market Liquidity Risk or Liquidity Trading Risk is the risk which arises from the inability to quickly execute trades in the market at prevailing market prices.
Factors which influence liquidity trading risk include:
➢ Market Depth: How much the market can absorb in terms of trade volume without significantly moving the prices.
➢ Market Breadth: The presence of a wide range of active buyers and sellers in the market.
➢ Market Resiliency: How quickly prices return to normal after a large trade.
▪
Funding Liquidity Risk is the risk that an entity will not be able to meet its financial obligations as they come due because of an inability to obtain or renew
funding. Key considerations include:
➢ Availability of credit: Access to credit lines or the ability to issue debt.
➢ Cash Flow Management: Managing incoming and outgoing cash flows to ensure obligations can be met.
➢ Rollover Risk: The risk that an entity will not be able to renew or replace a loan or funding source upon its expiration.
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CAPITAL
RISK
Capital risk is the risk that changes in capital results in potential
losses i.e., the entity is unable to absorb its losses, which can be due
to:
1. Position risk, which is the risk of loss arising from a price change
in financial instruments.
2. Loss on investment of capital i.e., the return on investment
resulted in a loss.
3. Losses arising from other risks faced by the entity could result in
capital risk (losses larger than the capital available while
maintaining regulatory and/or board approved levels)
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TYPES OF NON-FINANCIAL RISKS
Non-Financial Risks are not directly related to financial
transactions or financial management but can have
significant impacts on an organization’s performance or
reputation. They are usually harder to quantify but can also
result in a financial impact or loss (usually indirectly).
▪ Operational Risk
▪ Strategic Risk
▪ Systemic Risk
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OPERATIONAL RISK
Operational risk is the risk of losses due to
➢ Conduct risk
➢ Reputational risk
system failures, people, and external events.
➢ Business disruption risk
Operational risk includes several additional
➢ Data & cyber risks
risks, such as:
➢ Fraud risk
➢ Legal risk
➢ Regulatory risk
➢ Political risk
➢ HR, Culture & Conduct risk
➢ IT risk
➢ Infrastructure risk
➢ Model risk
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SYSTEMIC RISK
Systemic risk is the risk of failure of the financial system/sector due
to failure of one or more entity.
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STRATEGIC RISK
Strategic risk is the risk of loss due to decisions made by directors and executive management.
➢ Competitive risk is the risk of loss due to falling behind competitors for various reasons
➢ Change risk is the risk of loss due changes made within a bank such as digital
transformation changes
➢ Governance risk is the risk of loss due to poor governance, risk, and compliance processes
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RISK MANAGEMENT IN FINANCIAL
INSTITUTIONS
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BANKS
Banks are a key player in the world of
finance. Banks are complex and
understanding the risks they face means we
need to first get a handle on the different
types of banks and what they do.
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THE BANK MODEL
The core business of banks revolves around something known as maturity
transformation.
Here’s the deal: banks tend to borrow money for shorter periods (like when they take
deposits or get wholesale lending) and then lend this money out for longer periods (think
mortgages). This is a fundamental aspect of how banks operate and it's crucial for
understanding the risks they manage.
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TYPES OF BANKS: DEPOSIT-TAKING BANKS
Type of Bank
Business Model
Products/Services
Deposit-taking bank
▪ Business Model: maturity transformation
via taking deposits and creating loans.
Operates from branches
▪ Clients: retail and corporate
▪ Banking License: Yes
▪ Owner: shareholders
▪
▪
▪
▪
▪
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Deposit services
Lending facilities
Trade finance
Payment services
Treasury and cash management
services
▪ Risk management services
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TYPES OF BANKS: WHOLESALE FUNDED BANKS
Type of Bank
Business Model
Products/Services
Wholesale funded
bank
▪ Business Model: maturity transformation
via wholesale funding and creating loans
▪ Clients: corporate
▪ Banking License: No
▪ Owner: shareholders
▪ Lending facilities
▪ Trade finance
▪ Payment services
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TYPES OF BANKS: INVESTMENT BANKS
Type of Bank
Business Model
Products/Services
Investment bank
▪ Business Model: providing a range of
services and own investing on secondary
markets (proprietary trading)
▪ Clients: retail and corporate
▪ Banking License: Yes
▪ Owner: shareholders
▪ Merger & acquisition services
▪ Debt capital issuance services
(documents needed, meetings
with potential investors,
underwriting new
shares/bonds, pricing,
distribution to investors)
▪ Equity capital issuance services
▪ Risk management services
▪ Sales
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TYPES OF BANKS: UNIVERSAL BANKS
Type of Bank
Business Model
Products/Services
Universal bank
▪ Business Model: maturity transformation
via taking deposits and creating loans
▪ Clients: retail and corporate
▪ Banking License: Yes
▪ Owner: shareholders
▪
▪
▪
▪
▪
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Deposit services
Lending facilities
Trade finance
Payment services
Treasury and cash management
services
▪ Risk management services
▪ Bancassurance
▪ Investment bank services Wealth management, Fund
management etc.
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TYPES OF BANKS: CHALLENGER BANKS
Type of Bank
Business Model
Products/Services
Challenger bank
▪ Business Model: maturity transformation
via taking deposits or wholesale funding
and creating loans. Operating solely online
▪ Clients: retail and corporate
▪ Banking License: Yes
▪ Owner: shareholders
▪
▪
▪
▪
▪
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Deposit services
Lending facilities
Trade finance
Payment services
Treasury and cash management
services
▪ Risk management services
▪ Investment bank services Wealth management, Fund
management etc.
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TYPES OF BANKS: SHADOW BANKS
Type of Bank
Business Model
Products/Services
Shadow bank
▪ Business Model: provide some banking
services via wholesale funding
▪ Clients: retail and corporate
▪ Banking License: No
▪ Owner: shareholders
▪ Asset managers services
▪ Hedge funds services
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TYPES OF BANKS: MUTUAL BANKS
Type of Bank
Business Model
Products/Services
Mutual bank
▪ Business Model: maturity transformation
via taking deposits and creating loans
▪ Clients: retail (mostly) and small business
▪ Banking License: Yes
▪ Owner: members
▪
▪
▪
▪
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Deposit services
Lending facilities
Trade finance
Payment services
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TYPES OF BANKS: DEVELOPMENT BANKS
Type of Bank
Business Model
Products/Services
Development bank
▪ Business Model: maturity transformation
via taking deposits and creating loans
▪ Clients: developing countries
▪ Banking License: Yes
▪ Owner: developed countries/member states
▪ Provide financing for
development projects in
developing and underprivileged countries and
communities
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TYPES OF BANKS: CENTRAL BANKS
Type of Bank
Business Model
Products/Services
Central bank
▪ Business Model: maturity transformation
via taking deposits (reserves for regulated
banks and other FIs) and creating loans
▪ Clients: government
▪ Banking License: No
▪ Owner: state
▪
▪
▪
▪
▪
▪
▪
▪
▪
▪
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Manages monetary policies
Manages inflation
May be the regulator for banks
Responsible for issuing coins and notes
Responsible for setting interest rates
Responsible for effective national
payment systems
Manages country’s foreign reserves
Hold reserves for banks (HQLAs)
Purchase or sell securities or make
temporary loans against securities as
collateral or vice versa to maintain
liquidity in the banking system
Stimulate demand using quantitative
easing (QE) i.e., increase money supply
and reduce yield on government bonds
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IDENTIFYING THE RISKS BANKS FACE
The risks faced by banks varies by the type of bank, however, most banks face credit risk, liquidity
risk, market risk and operational risk in some form.
Let’s look at a traditional bank – universal bank or deposit taking bank.
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IDENTIFYING THE RISKS BANKS FACE
A universal bank or a deposit-taking bank have similar business models, they both accept deposits
to fund their core business activity – loans.
Deposits
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Loans
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IDENTIFYING THE
RISKS BANKS FACE
The assets and liabilities of
a bank are a good-way to
split and understand their
risk exposure and
understanding how a bank
generates revenue.
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IDENTIFYING THE RISKS BANKS FACE
Interest
Earning
Assets
Loans (individuals) less provisions
Credit risk
Market risk – optionality, gap, basis risk
Loans (corporate) less provisions
Credit risk
Market risk – optionality, gap, basis risk
Investments – bonds from other companies and
other securities
Market risk – yield curve risk, gap risk, basis risk
High quality liquid assets (HQLAs)
Market risk – yield curve risk, gap risk, basis risk
Credit risk
Credit risk
Liabilities
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Deposits (individuals)
Liquidity risk – funding liquidity risk
Deposits (corporate)
Liquidity risk – funding liquidity risk
Wholesale funding
Liquidity risk – funding liquidity risk
Debt capital
Liquidity risk
Equity capital
Capital risk
Market risk
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IDENTIFYING THE RISKS BANKS FACE
Risks faced based on the business model
(maturity transformation):
▪ Liquidity risk
▪ Market risk – basis, gap, yield curve risk
Risks faced based on the products/services
(lending):
▪ Credit risk
▪ Market risk – optionality risk
▪ Capital risk
▪ Capital risk
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HOW DO BANKS MEASURE RISK?
Banks measure risk by the risk type.
▪ Credit risk is measured by modelling factors such as the probability of default (PD), loss given default (LGD) and
exposure at default (EAD).
▪ Market risk is measured by modelling the impact on market values based on changes in interest rates, using methods
such as Earnings at Risk/Value at Risk and Expected Shortfall.
▪ Operational risk is much more complicated to measure, however, for banks, the use methods such as the Poisson
distribution and negative binomial to model the frequency of OR events and pareto extreme value theory to model the
severity of the losses on OR events.
▪ Liquidity risk is measured by several ways such as loan to deposit ratio, liquidity coverage ratio, net stable funding ratio.
Short to longer term liquidity gap, concentration and funding source report, cumulative liquidity model, liquidity risk
factor, 1-week and 1-month liquidity ratios, inter-entity lending report, weekly qualitative report.
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HOW DO BANKS MANAGE RISK?
▪ Structure/Responsibility
➢ The Board
Risk Management Sub-Committee
▪ Inclusive of:
➢ Setting the strategy
➢ Setting the policy(ies) associated
➢ Setting the risk and other limits
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HOW DO BANKS MANAGE RISK?
▪ New business
➢ Freeze new business on specific product lines/territory etc
➢ Reduce the amount of new business
➢ Apply stricter standards (underwriting enhancements)
➢ Booking business which can act counter to the risk being mitigated
➢ Booking business which can act counter to the economic cycle (consumer staples during
recessions/downturns)
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HOW DO BANKS MANAGE RISK?
▪ Maturing business
➢ The ability to change rates/reduce rates on products such as term deposits
➢ If a specific block of business is funded by deposits, the bank could reduce exposure by
monitoring when the deposits are set to mature versus the block of business
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HOW DO BANKS MANAGE RISK?
▪ Sale of assets
➢ Sale of loan and bond positions
▪ Hedging
➢ Strong origination credit policy, i.e., underwriting
➢ Credit default swaps (CDS)
➢ Diversification of the portfolio
▪ Securitisation
➢ Creation of a security consisting of a portfolio of loans and sold to investors. Collateralized debt obligations
(CDOs) and asset-backed securities (ABS)
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THE ROLE OF THE BANK IN AN ECONOMY
Generate economic activity:
Stimulate economic growth:
▪
Promotes consumption in the economy
▪
Encourage saving
▪
Providing platforms for individuals to allow
▪
Providing loans to allow for business expansion
▪
Providing loans for individuals and businesses to allow
purchases/transactions to occur
▪
▪
Providing platforms for businesses to conduct merchant
idea creations/inventions – developing new
activities
products/services
Providing the ability for businesses to conduct trade
(domestic and international)
▪
Providing loans for individuals and businesses to access
large ticket items (houses – mortgage, plane – leasing
etc.)
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HOW ARE BANKS AFFECTED OVER ECONOMIC CYCLES
Good economic conditions (growth):
Bad economic conditions (recession):
Credit Risk
Credit Risk
▪
Unemployment is low, wages increase
▪
Unemployment is high, wages stagnates or decreases
▪
GDP is high, inflation is normal and rising (normal and
steep yield curves are possible)
▪
GDP is low, inflation is high and rising (humped, flat,
inverted yield curves are possible)
▪
Defaults are low, losses are low
▪
Defaults are high, losses are high
▪
Increased lending due to bank being comfortable
▪
Reduced lending as banks are hesitant to lend
▪
Loan rates are low (but still impacted by competition) to
encourage borrowing
▪
Loan rates are high to discourage lending
▪
Wholesale funding may dry up, and rate are high
▪
Wholesale funding is readily available, and rates are low
▪
Banks’ reluctance to lend can lead to further economic
contraction
▪
Increases in the value of assets, i.e., lower loses (collateral)
▪
Reduction in the value of assets, i.e., worsening losses
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HOW ARE BANKS AFFECTED OVER ECONOMIC CYCLES
Good economic conditions (growth):
Bad economic conditions (recession):
Capital Risk
Capital Risk
▪
Capital is not pressured, normal state
▪
Capital pressures are losses are higher
▪
Banks are more willing to take on risks and increase the
▪
Banks take fewer risks in times of recession due to capital
requirements
capital requirements as needed
▪
Increase in return on capital
▪
Reduction in return on capital
▪
Bank may need to absorb losses from T1 capital
▪
Bank may have to absorb losses using T2 capital and
become a gone concern and insolvent
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INSURANCE COMPANIES
Insurance companies are another major player in the financial
world. To grasp the risks they face, it's important to first get a
handle on the different types of insurance companies out there,
along with the variety of policies they offer.
Each type of insurance company has its unique set of risks, and
these are closely linked to the nature of the policies they sell and
their operational strategies. Understanding the specifics of their
business – from the kinds of risks they insure against to their
methods of operation – is crucial in identifying and managing the
risks inherent in the insurance industry.
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THE INSURANCE MODEL
The core business of insurance companies revolve around risk management.
They are the entity which provides protection from a wide range of risks – health,
life, general (car, home, contents), marine, cyber and credit to just name a few.
Here’s the deal: insurance companies provide coverage for risks faced by
someone/thing else (individual/company) but they themselves also face risks.
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TYPES OF INSURANCE POLICIES
Life insurance companies are one type of insurance company. They can offer a range of products such may include:
▪ Whole life insurance
▪ Term insurance
▪ Life paid-up insurance
▪ Endowment insurance
▪ Universal life insurance
▪ Variable life insurance
▪ Variable universal life insurance
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TYPES OF LIFE INSURANCE POLICIES
A life insurance is a contract between an insurance company and a policyholder
(you). In this contract, the policyholder (you) agree to pay a premium for a
specified period and the insurance company agrees to pay a sum insured (sum of
money) when the insurable event occurs (usually death).
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TYPES OF LIFE INSURANCE POLICIES – WHOLE LIFE
Whole life insurance is a contract between an insurance company and
policyholder. In the contract, the policyholder agrees to pay a premium until
death and the insurance company agrees to pay a death benefit to your
beneficiaries upon death at any age.
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TYPES OF LIFE INSURANCE POLICIES – LIFE PAID-UP
Life paid-up insurance is a contract between an insurance company and
policyholder. In the contract, the policyholder agrees to pay a premium until a
specified age, but they receive lifetime coverage; and the insurance company
agrees to pay a death benefit to your beneficiaries upon death at any age.
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TYPES OF INSURANCE POLICIES – TERM
Term insurance is a contract between an insurance company and policyholder. In
the contract, the policyholder agrees to pay a premium until a specified age or
period, and the insurance company agrees to pay a death benefit to your
beneficiaries only if death occurs in the specified period or age.
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TYPES OF LIFE INSURANCE POLICIES – UNIVERSAL
Universal life insurance is a contract between an insurance company and policyholder. In
the contract, the policyholder agrees to pay a premium until death and the insurance
company agrees to pay a death benefit to your beneficiaries upon death at any age. The
policyholder pays an excess of the premium which is invested by the company, fees are
deducted, and the investment account grows. The surplus premiums are invested based
on the company’s specification, i.e. they chose the funds the surplus premiums are
invested in.
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TYPES OF LIFE INSURANCE POLICIES – VARIABLE
Variable life insurance is a contract between an insurance company and policyholder. In
the contract, the policyholder agrees to pay a premium until death and the insurance
company agrees to pay a death benefit to your beneficiaries upon death at any age. The
policyholder pays an excess of the premium which is invested by the company, fees are
deducted, and the investment account grows. The surplus premiums are invested based
on the policyholder’s specification, i.e. they chose the funds the surplus premiums are
invested in.
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TYPES OF LIFE INSURANCE POLICIES – ENDOWMENT
Endowment insurance is a contract between an insurance company and
policyholder. In the contract, the policyholder agrees to pay a premium until a
specified age or period, and the insurance company agrees to pay a death
benefit to your beneficiaries only if death occurs in the specified period or age.
If you survive the period, the insurance pays you a sum insured amount.
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IDENTIFY THE RISKS LIFE INSURANCE COMPANIES FACE
Premium
Lapse risk
Liquidity risk
Death Benefit or
Mortality risk
Sum Insured
Other
Operational risk
Underwriting risk
Reinsurance risk
Market risk
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HOW DO LIFE INSURANCE COMPANIES MEASURE RISK?
• Lapse risk is measured first by using historical data and applying statistical and/or actuarial
predictive modelling.
• Liquidity risk
• Mortality risk
• Market risk
• Operational risk (underwriting risk)
• Reinsurance risk
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HOW DO LIFE INSURANCE COMPANIES MANAGE RISK?
• Reinsurance
• Improved underwriting
• Health lifestyle campaigns
• Hedging using a range of financial tools such as derivatives and swaps
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REGULATORY ENVIRONMENT
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WHAT IS THE ROLE OF THE REGULATOR?
The role of a regulator is to protect the public but regulating financial institutions and ensuring
they meet industry-specific standards such as Basel III.
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HOW ARE BANKS REGULATED
Banks are generally regulated by the central bank, however, in some countries like the UK and
South Africa, banks are regulated by two entities known as the twin peak regulation model. One
entity oversees financial conduct, while the other oversees the soundness of the financial sector. In
Barbados, banks are primarily regulated by the Central Bank of Barbados. In instances where a
bank offers investment services or products – trading, mutual funds etc., they are also regulated by
the Financial Services Commission under the Securities Act, Cap 318A and Mutual Fund Act,
Cap 320B.
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HOW ARE OTHER FINANCIAL INSTITUTIONS
REGULATED
Insurance, Pension, Securities, Mutual Funds and Co-operative Societies are regulated by the
Financial Services Commission of Barbados. These entities are regulated under the Insurance
Act, Cap 310, Occupational Pension Benefits Act, Cao 350B, the Securities Act, Cap 318A, the
Mutual Funds Act, Cao 320B and the Co-operative Societies Act, Cap 378A.
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EXPLORATORY QUESTIONS
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LET’S DISCUSS
What are the pros and cons of being a deposit-taking bank?
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LET’S DISCUSS - ANSWER
Pros
Cons
▪ Cost to income ratio is lower
▪ HQLAs are required which give a lower return
▪ Loan to deposit ratio (measures stability of
than other alternatives
funding) is higher and shows the bank has more
▪ Higher capital requirements
stable funding via deposit funding
▪ Has addl. Operating costs such as branches
compared to challenger and shadow banks
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LET’S DISCUSS
How do banks make revenue?
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LET’S DISCUSS - ANSWER
▪ Interest income
➢
Interest earned on loans (retail and corporate)
▪ Non-interest income (interest earned as fees – initial, ongoing, or closing/termination fees)
➢
Transaction fees
➢
Late fees
➢
Account fees
➢
Commitment fees
➢
Closing fees
➢
Insurance fees
➢
Asset management fees
▪ Trading income
➢
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Gains from price increases in markets for securities held by the bank
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LET’S DISCUSS
1. How do the core risks faced by banks differ from those encountered by life
insurance companies, and why do these differences exist?
2. Can you think of a recent financial event that impacted both banks and
life insurance companies differently? What were the key factors that
influenced their respective responses?
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COURSE EXPECTATIONS AND
ASSESSMENT OVERVIEW
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COURSE ASSESSMENT
This course is 50% coursework and 50% final exam.
Coursework will consist of two (2) assessments, each worth 25%.
▪ Assignment #1 – will be given on the 23rd February 2024 and discussed in class on the 1st
March 2024.
▪ Assignment #2 – will be given on the 5th April 2024 and discussed in class on the 12th April
2024.
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WHATSAPP GROUP FOR
PRODUCTIVE DISCOURSE
This group would allow you as students, the
opportunity to share ideas, articles and views on the
course, assignments, tests and any course-related topics
only.
If you would like to join the WhatsApp Group, scan the
QR code and fill out the form.
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CONTACT INFORMATION
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CONTACT
INFORMATION
Email Address:
nikita.gibson@cavehill.uwi.edu
Cell Number: (246) 836-7878
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