Format 260 x 190 mm / ext 328 / spine 13.3mm / 80 gsm matt art
Principles and Framework
This book offers a broad-based understanding of the types of risk faced by banks and how these risks may be
identified, assessed and managed. It aims to provide general banking practitioners with insights into key risk
management concepts and practices, as well as intelligently discuss developments in bank risk management.
The contents are organized and presented in an easily readable format to enable learners to understand
key qualitative risk factors and how they impact risk management. Each chapter contains numerous
illustrative examples and case studies of real life situations to enable students to relate theories to real world
events.
Key features of the book:
• Chapter overview complete with clear learning objectives
• Real world illustrations that relate theories to real world events
• Illustrative examples that contextualize and elaborate on new and complex concepts
The other title in this series:
Risk Management in Banking: Risk Models, Capital and Asset Liability Management
About the Author
Philip Te
Philip Te is the Programme Director for the Quantitative Finance and Risk Management Series at the Ateneo
Centre for Continuing Education—the largest continuing education institution in the Philippines. He has lectured
extensively on financial risk management, Basel II/III, derivatives, IAS 39/IFRS 9, option pricing, corporate treasury
management and hedging strategies. He is the author of Bank Risk Management Primer, published by the Bankers’
Association of the Philippines.
A Chartered Financial Analyst (CFA), Philip is also a certified Financial Risk Manager (FRM) and
Energy Risk Professional (ERP), both awarded by the Global Association of Risk Professionals (GARP).
He is also a Certified Public Accountant (CPA).
Philip is currently a vice president at the Client Solutions Group of a global commercial bank. Prior to this, he
was the head of the Structured Products and Financial Engineering Department of a local commercial bank and
a senior associate at the Ernst & Young Financial Services Risk Management (FSRM) and Quantitative Advisory
Services (QAS) group.
Risk Management in Banking Principles and Framework
Risk Management
in Banking
Risk Management
in Banking
Principles and Framework
Philip Te
Risk Management
in Banking
Principles and Framework
Philip Te
Published by Oxford Fajar Sdn. Bhd. (008974-T)
under licence from Oxford University Press,
4 Jalan Pemaju U1/15, Seksyen U1
Hicom-Glenmarie Industrial Park
40150 Shah Alam
Selangor Darul Ehsan
© Asian Institute of Chartered Bankers 2016
First published 2016
ISBN 978 983 47 1691 2
All rights reserved.
No part of this publication may be reproduced,
stored in a retrieval system, or transmitted in any form or
by any means, electronic, mechanical, photocopying, recording
or otherwise, without the prior permission of
Asian Institute of Chartered Bankers.
Impression: 9 8 7 6 5 4 3 2 1
Text set in 10.5 point ITC Legacy Serif Std Regular by
Chitra Computers, India
Printed by Percetakan Printpack Sdn. Bhd., Selangor Darul Ehsan
INTRODUCTION
This book is part of the Asian Institute of Chartered Bankers’ (AICB) Bank Risk Management
Qualification. This qualification is designed as a qualitative introduction to bank risks and
bank risk management. While primarily targeted at banking practitioners, this book also offers
the general audience a highly readable guide to the practices and procedures for managing
risks in banking.
The learning support for the BRMP Qualification is provided by AICB’s premier learning
partner, the Asian Banking School.
This intermediate level qualification on bank risk management comprises two modules:
ŸŸModule 1: Risk Management in Banking: Principles and Framework
ŸŸModule 2: Risk Management in Banking: Risk Models, Capital and Asset Liability
Management
The two modules were developed in collaboration with the Ateneo-Bankers Association of
the Philippines (BAP) Institute of Banking.
Asian Institute of Chartered Bankers
The Asian Institute of Chartered Bankers (AICB) is the professional body for the banking
and financial services industry. We are committed to raising the competency standards
of the banking profession by staying industry relevant and embracing innovations in the
development and delivery of our qualifications and learning.
Asian Banking School
The Asian Banking School (ABS) is AICB’s premier learning partner. ABS aims to raise the
calibre and dynamism of talent in the industry through the delivery of world-class professional
qualifications and learning programmes.
Ateneo-Bankers Association of the Philippines (BAP) Institute of
Banking
The Ateneo-Bankers Association of the Philippines (BAP) Institute of Banking is a non-stock,
non-profit organization, which comprises the country’s commercial banks as its institutional
members.
Unique to the BAP, its mandate acts as the unifying voice of the banking industry in an
environment where business interest and background both among domestic and foreign
banks, in particular, are profoundly diverse.
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ACKNOWLEDGEMENTS
The Asian Institute of Chartered Bankers wishes to thank members of the Bank Risk
Management Professional Curriculum Working Committee, who have generously contributed
their time and expertise in guiding the design and development of the curriculum for the
qualification.
Dr John Lee Hin Hock
(Chairman)
Malayan Banking Berhad
Mr Nigel Denby
Ambank Berhad
Mr Suresh V. Raman
Citibank Berhad
Eddie Cheong Wai Seong
Bank of China (Malaysia) Berhad
Dr Vijayan Paramsothy
Asian Banking School
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CONTENTS
Introductioniii
Acknowledgementsiv
CHAPTER
1
CONCEPTS OF BANK RISKS
1.1
BANKING BUSINESS ACTIVITIES, PRODUCTS AND BUSINESS LINES
1.1.1
Corporate Finance
1.1.2
Trading and Sales
1.1.3
Retail Banking
1.1.4
Commercial Banking
1.1.5
Payments and Settlements
1.1.6
Agency Services
1.1.7
Asset Management
1.1.8
Retail Brokerage
3
4
6
9
10
13
13
14
15
1.2
ROLES OF BANKS IN THE ECONOMY
1.2.1
Primary Role of Banks: Financial Intermediation
1.2.2
Functions of Financial Intermediation
1.2.3
Other Roles of Banks
15
15
17
19
1.3
TYPOLOGY OF BANK RISKS
1.3.1
Financial Risks
1.3.2
Non-financial Risks
20
22
28
CONCLUSION
CHAPTER
2.1
2.2
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2
30
RISK MANAGEMENT PRINCIPLES
AND FRAMEWORK
RISK MANAGEMENT IN THE
BANKING CONTEXT
2.1.1
Definition of Risk Management
2.1.2
Objectives of Risk Management
33
33
34
RISK MANAGEMENT PRINCIPLES
39
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vi
Contents
2.3
RISK MANAGEMENT FRAMEWORK
2.3.1
Definition of Risk Management Framework
2.3.2
Uses of the Risk Management Framework
2.3.3
Elements of a Sound Risk Management Framework
CONCLUSION
CHAPTER
3
63
RISK MANAGEMENT PROCESS
3.1
OVERVIEW OF RISK MANAGEMENT PROCESS
3.1.1
Qualities of a Sound Risk Management Process
3.1.2
Risk Management Activities
67
67
68
3.2
COMMUNICATION AND CONSULTATION
68
3.3
ESTABLISHING THE CONTEXT
3.3.1
Establishing the External Context
3.3.2
Establishing the Internal Context
3.3.3
Establishing the Risk Management Process Context
3.3.4
Risk Criteria
70
71
71
72
72
3.4
RISK ASSESSMENT
3.4.1
Risk Identification
3.4.2
Risk Analysis
3.4.3
Risk Evaluation
73
73
74
74
3.5
RISK TREATMENT
3.5.1
Avoid Risk
3.5.2
Take or Increase Risk
3.5.3
Remove the Risk Source
3.5.4
Change Likelihood
3.5.5
Change Consequences
3.5.6
Share the Risk
3.5.7
Risk Retention
75
76
77
77
78
78
79
79
3.6
RISK MONITORING AND REVIEW
80
CONCLUSION
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42
42
42
43
80
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Contents
CHAPTER
4
INTERNATIONAL RISK REGULATION
4.1
IMPORTANCE AND OBJECTIVES OF REGULATIONS FOR BANKS
4.1.1The Banking Industry and its Critical Role in the Economy
4.1.2
Financial Safety Nets
4.1.3
Special Nature of the Banking Business
83
83
84
86
4.2
ROLE OF BANKING SUPERVISION
87
4.3
TYPES AND SOURCES OF BANKING REGULATIONS
4.3.1
Sources of Banking Regulations
4.3.2
Types of Banking Regulations
91
91
94
4.4
INTRODUCTION TO RISK-BASED CAPITAL FRAMEWORK UNDER BASEL I 99
4.4.1
History of the Basel Committee on Banking Supervision
99
4.4.2
Basel I: The 1988 Basel Capital Accord
102
4.5
THE THREE PILLARS OF BASEL II
4.5.1
Pillar 1—Minimum Capital Requirements
4.5.2
Pillar 2—Supervisory Review and Evaluation Process
4.5.3
Pillar 3—Market Discipline
106
107
111
114
4.6
INTRODUCTION TO BASEL III REQUIREMENTS
4.6.1
2008 Global Financial Crisis and Basel II Weaknesses
4.6.2
Basel III—Capital Reforms
4.6.3
Basel III—Liquidity Reforms
116
116
120
123
CONCLUSION
CHAPTER
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5
vii
126
CREDIT RISK
5.1
DEFINITION OF CREDIT RISK
5.1.1
Credit Risk as Potential Losses
5.1.2
Credit Risk as an Exposure
5.1.3
Credit Risk as Failure to Meet Obligations
129
129
133
137
5.2
EXPECTED AND UNEXPECTED CREDIT LOSSES
5.2.1
Expected Loss
5.2.2
Unexpected Loss
141
141
146
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viii
Contents
5.3
CREDIT RISK MANAGEMENT FRAMEWORK
5.3.1
Credit Risk Environment
5.3.2
Credit-Granting Process
5.3.3
Credit Administration
5.3.4
Credit Monitoring
5.3.5
Credit Measurement
5.3.6
Credit Risk Control
CONCLUSION
CHAPTER
6
162
IDENTIFICATION OF CREDIT RISK
6.1
SOURCES OF CREDIT RISKS
6.1.1
Credit Risk from Loans and Advances
6.1.2
Credit Risk from Investment Securities
6.1.3
Credit Risk from Off-balance Sheet Exposures
6.1.4
Credit Risk from Derivatives
165
165
167
169
171
6.2
TYPOLOGY OF STANDALONE CREDIT RISK
6.2.1
Retail Credit Risk
6.2.2
Sovereign Credit Risk
6.2.3
Corporate Credit Risk
6.2.4
Counterparty Credit Risk
172
173
183
192
201
6.3
OVERVIEW OF PORTFOLIO CREDIT RISK
6.3.1
Sources of Portfolio Credit Risks
6.3.2
Credit Concentration Risk Management
203
203
207
CONCLUSION
CHAPTER
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147
147
155
159
160
160
161
7
208
OPERATIONAL RISK
7.1
DEFINITION OF OPERATIONAL RISK
7.1.1
Operational Risk—the Residual Definition
7.1.2 Operational Risk—the Causal Definition
211
211
211
7.2
OPERATIONAL RISK EVENTS
7.2.1
Internal Fraud
7.2.2
External Fraud
7.2.3
Employment Practices and Workplace Safety
216
216
218
218
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Contents
7.2.4
7.2.5
7.2.6
7.2.7
Clients, Products and Business Practices
Damage to Physical Assets
Business Disruption and Systems Failures
Execution, Delivery and Process Management
OPERATIONAL RISK CONSEQUENCES
223
7.4
OPERATIONAL RISK MANAGEMENT GOVERNANCE AND PROCESS
7.4.1
Operational Risk Governance
7.4.2
Operational Risk Framework
7.4.3
Operational Risk Management Process
7.4.4
Business Resiliency and Continuity
225
225
229
231
233
CHAPTER
8
233
IDENTIFICATION OF OPERATIONAL
RISK
8.1
SOURCES OF OPERATIONAL RISKS
236
8.2
OPERATIONAL RISK BUSINESS LINES
238
8.3
INTERNAL OPERATIONAL RISK LOSS DATA
8.3.1
Incident Reporting
8.3.2
The 8 × 7 Matrix
8.3.3
Basic Statistical Analysis
240
242
244
245
8.4
EXTERNAL OPERATIONAL RISK LOSS DATA
246
8.5
NEW PRODUCTS AND BUSINESS ACTIVITIES AND OUTSOURCING
ACTIVITIES
8.5.1
New Products and Business Activities
8.5.2
Outsourcing in Financial Services
248
249
249
CONCLUSION
CHAPTER
9.1
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219
221
222
222
7.3
CONCLUSION
9
ix
252
MARKET RISK
FINANCIAL MARKET ACTIVITIES
9.1.1
Functions and Roles of Financial Markets
9.1.2
Types of Financial Markets
255
255
255
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x
Contents
9.2
DEFINITION OF MARKET RISK
9.2.1
Trading Book versus Banking Book
9.2.2
Daily Valuation and Mark to Market
264
265
266
9.3
TYPES OF MARKET RISKS
9.3.1
Foreign Exchange Risk
9.3.2
Interest Rate Risk
9.3.3
Equity Price Risk
9.3.4
Commodity Price Risk
268
269
271
273
274
9.4
MARKET RISK MANAGEMENT PROCESS
9.4.1
Market Risk Identification
9.4.2
Market Risk Assessment
9.4.3
Market Risk Control
9.4.4
Market Risk Monitoring and Reporting
280
281
281
284
285
CONCLUSION
CHAPTER
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10
286
LIQUIDITY RISK
10.1 INTRODUCTION TO LIQUIDITY RISK
10.1.1 Definition of Liquidity Risk
10.1.2 Asset-based Liquidity Risk
10.1.3 Liability-based Liquidity Risk
289
290
291
291
10.2 SOURCES OF LIQUIDITY
10.2.1 Asset-based Sources of Liquidity
10.2.2 Liability-based Sources of Liquidity
292
292
299
10.3 LIQUIDITY RISK STRATEGY
10.3.1 Stored Liquidity Management
10.3.2 Purchased Liquidity Management
301
301
303
10.4 ELEMENTS OF SOUND LIQUIDITY RISK MANAGEMENT PRACTICES
10.4.1 Liquidity Risk Management Framework
10.4.2 Governance Structure
10.4.3 Measurement and Management of Liquidity Risk
10.4.4 Public Disclosure
304
304
305
309
311
CONCLUSION
312
BIBLIOGRAPHY
313
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C
1
P
HA
TE
R
CONCEPTS OF
BANK RISKS
Banking organizations face different types of risks. Generally, banking organizations are
in the business of taking and managing risks. One key lesson learned from the 2008
global financial crisis is the importance of having sound risk management practices.
Banks that had survived or had been relatively unscathed were found to have strong risk
management practices. On the other hand, banks that had either collapsed or were on
the brink of collapse were found to have weak risk management practices.
This book introduces entry-level risk management students (‘students’) to foundational
concepts in bank risk management. In order to understand risk management, students
must have a good knowledge of the different risks that banking organizations face. It is
also imperative that they understand the different banking business activities, products
and the roles that banks play in the economy.
This chapter begins with a review of the different banking business activities, products
and business lines. It then discusses the different roles that banks play in the economy.
The chapter ends with an overview of the different types of bank risks.
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2
Risk Management in Banking: Principles and Framework
Concepts of Bank Risks
Business Activities and
Business Lines
Roles of Banks in the
Economy
Typology of
Bank Risks
Corporate Finance
Financial Intermediation
Financial Risks
Trading and Sales
Functions of Financial
Intermediation
Non-Financial Risks
Retail Banking
Other Roles of Banks
Commercial Banking
Payments and Settlements
Agency Services
Asset Management
Retail Brokerage
Figure 1.1 Diagrammatic outline of this chapter’s topics
LEARNING OUTCOME
At the end of this chapter, you are expected to be able to:
DEMONSTRATE knowledge of the different business activities, products and business lines;
the important roles that banks play and the different types of risks that banks face
LEARNING OBJECTIVES
At the end of this chapter, you will be able to:
REVIEW the different business activities and business lines of banks
DISCUSS the important roles that banks play in the economy
DEFINE the different types of risks that banks face
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3
Chapter 1 Concepts of Bank Risks
1.1 BANKING BUSINESS ACTIVITIES,
PRODUCTS AND BUSINESS LINES
LEARNING OBJECTIVE
1.1
REVIEW the different business activities and business lines of banks
The business of banking has evolved over the years in response to the changing complexity of
the global business environment.
While banks are traditionally viewed as financial institutions that generate and accept
deposits from the public and extend those deposits as commercial loans to individuals and
households, the range of business activities and business lines that banks are engaged in are
actually more diverse and more complex.
This section reviews the different business activities, products and business lines of banks.
For a more comprehensive discussion of the different banking business activities and business
lines, the student is encouraged to review the materials in the Executive Banker programme.
Banking activities can be broadly classified into two broad categories:
ŸŸCommercial banking
ŸŸInvestment banking
Table 1.1 Broad categories of banking activities
Broad Categories
Commercial banking
Involves the traditional role of accepting deposits and extending consumer,
commercial and real estate loans.
Investment banking
Involves providing specialized and non-traditional services for institutional
investors, corporations and governments.
It generally involves:
ŸŸ Helping clients raise funds via the debt or equity securities market
ŸŸ Providing corporate finance advisory services in areas such as mergers and
acquisitions or restructuring
ŸŸ Assisting in the trading of securities in the secondary markets with the bank
providing brokerage or market-making services
ŸŸ Providing risk management solutions to clients via derivative transactions
To better understand the different business activities that banks engage in, the International
Convergence of Capital Measurement and Capital Standards (Basel II) issued by the Basel Committee
on Banking Supervision provides a helpful framework in classifying and understanding the
different underlying banking business lines. The Basel Committee divides banking business
activities into eight business lines:
1. Corporate finance
2. Trading and sales
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Risk Management in Banking: Principles and Framework
3. Retail banking
4. Commercial banking
5. Payments and settlements
6. Agency services
7. Asset management
8. Retail brokerage
Each of these business lines is further subdivided into activity groups.
1.1.1
Corporate Finance
Corporate finance business line involves two broad categories of services:
ŸŸFinancial advisory
ŸŸUnderwriting
The corporate finance business line involves banking services that help clients (usually
corporations, governments and institutional investors) raise funds via the capital markets.
Financial advisory
Financial advisory involves providing comprehensive advice on strategic initiatives such as
purchases and disposal of assets or companies, identifying potential acquisition targets,
evaluating strategic options and alternative risk management strategies. Examples of banking
business activities that fall under financial advisory are:
ŸŸMergers and acquisitions (M&A)—is a financial advisory service provided by a banking
organization to corporations to consolidate or integrate companies. This consolidation
may be executed either via a merger or acquisition. Merger refers to the combination of
two or more companies to form a new company. Acquisition refers to the purchase of one
company by another. In an acquisition, there is no new company formed.
Real World Illustration
Morgan Stanley Lands WhatsApp Sale
Facebook Inc.’s $19 billion acquisition of WhatsApp Inc. caps a roller coaster seven days for
Morgan Stanley. Morgan Stanley landed the sole advisory role for closely-held WhatsApp, which
could earn the bank $35 million to $45 million in fees.
Source: Bloomberg News, 20 February 2012
ŸŸPrivatization—is a financial advisory service provided by banking organizations to
governments to transfer ownership of publicly-owned assets or entities to private
investors or corporations.
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Chapter 1 Concepts of Bank Risks
Real World Illustration
Goldman Sachs and UBS to Lead Privatization of Royal Mail
The United Kingdom government appointed UBS and Goldman Sachs as lead advisors for the
sale of Royal Mail. Royal Mail is a state-owned postal service. The planned sale of Royal Mail
will be the largest privatization in Britain since former Prime Minister John Major broke up the
country’s railway more than a decade ago. The 360-year-old postal service company is one of the
biggest employers of the UK with about 159,000 employees.
Source: Bloomberg News, 29 May 2013
ŸŸInitial public offering (IPO) advisory—involves the initial sale of a private company’s
equity shares to the public. The process of going public through an IPO is complex. There
are many economic, legal and regulatory considerations as well as taxation, reporting
and timing considerations that private companies must address to ensure a successful
IPO. Banking organizations help such private companies navigate through the complex
IPO process.
Real World Illustration
JPMorgan, Citi and Barclays Appointed to Lead GoPro IPO
GoPro, the maker of wearable sports cameras and accessories used by Discovery Channel and
ESPN, appointed JPMorgan, Citi and Barclays to lead its initial public offering. GoPro plans to
use the proceeds from the offering for debt repayment and investment purposes.
Source: Reuters, 11 June 2014
ŸŸResearch—banking organizations provide value-adding research to their clients. These
researches provide insights into macroeconomic developments (global, regional and
local) that will impact the clients’ strategic decisions.
Real World Illustration
UBS Equities Research: Global Breadth, Predictive Insight
UBS offers thought-leading, award-winning research bringing a truly collaborative global
perspective to understanding regions, sectors and stocks:
•
Micro—Independent assessments of more than 3,300 companies—some 85% of the world
market capitalization.
•
Macro—Broad and deep economics, strategy and quantitative research coverage.
Source: UBS website
ŸŸDebt and equity advisory—involves advising companies on raising financing via debt
or equity issuance. Banking organizations typically link the financing requirements of
companies to the debt and equity capital markets.
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Risk Management in Banking: Principles and Framework
Real World Illustration
Barclays Global Finance and Risk Solutions
Equity Capital Markets
Barclays provide a full range of capabilities from IPOs to private equity transactions. Barclays
work with bankers to operate, structure and market equity and equity-linked securities.
Debt Capital Markets
Barclays offer tailored solutions to the client’s specific issues, and excel at guiding issuers and
investors through difficult markets.
Leveraged Finance
Barclays is a lead arranger and underwriter of debt capital in international and high yield markets
providing clients with all aspects of debt financing.
Loans
Barclays provide coverage of a wide variety of specialist industry sectors, spanning corporates,
project finance, structured trade, export finance and financial institutions.
Source: Barclays website
Underwriting
Underwriting involves assisting borrowers in the issuance of new securities. It usually involves
helping borrowers lower the risk of an unsuccessful issue by committing to sell a pre-agreed
volume of securities for a fee. Examples of such underwriting activities are:
ŸŸInitial public offering (IPO) underwriting—A company going through its initial
public offering sometimes takes huge risks, particularly if the IPO undertaking is not
as successful as projected. Banking organizations typically provide value by making a
firm commitment to purchase the company’s shares in case of an unsuccessful issue.
To compensate banking organizations for taking this risk, companies pay underwriting
fees.
ŸŸSyndications—A single bank may not have the capacity or appetite to undertake a large
transaction, e.g. lending. Syndications are sometimes formed to share risks among banks.
ŸŸSecuritization—This is the process in which certain types of assets are pooled or collected
to create or repackage as a new security. The newly-repackaged security is then sold to
investors.
ŸŸSecondary market private placements—Private placements are the sale of securities
to a small group of investors. Secondary market is the market where previously issued
securities are traded. Banking organizations provide value by acting as a ready market for
trading privately-placed securities.
1.1.2
Trading and Sales
Trading and sales business line helps clients buy and sell financial instruments such as equity
securities, debt securities, foreign exchange, commodities and derivatives. It involves the use of
a wide platform of products and services in the area of capital markets, fixed income, foreign
exchange, commodities and derivatives.
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Chapter 1 Concepts of Bank Risks
Market-Making
Proprietary Trading
Trading and Sales
Sales
Treasury
Figure 1.2 Areas of trading and sales business line
The following are the main areas of the trading and sales business line:
Market-making
Market-making involves creating a secondary market in an asset or security. There are two
types of market-making roles for banks:
ŸŸAgency transactions—Agency market-making transactions require banks to act on behalf
of their customers. A bank engaging in an agency market-making transaction typically
match the client’s buying and selling requirements. Banks in agency transactions earn a
fixed fee or commission.
Bid-ask spread typically represents the earning of market-makers in agency
transactions. The bid-ask spread is the difference between the price at which the dealer is
willing to sell the security and the price at which it is willing to buy the security.
ŸŸPrincipal transactions—Principal market-making transactions allow banks to profit on
the price movements of securities and may involve taking positions.
In contrast to agency transactions, principal market-makers may accumulate or short
sell inventory of securities and express a view on the market.
Illustrative Example
Agency Transactions versus Principal Transactions
Bank XYZ acts as a market-maker for an equity security issued by NGP Corporation. Assume
that a seller approached Bank XYZ and is willing to sell the security at $130. Another client, a
buyer, approached Bank XYZ and is willing to buy the security at $140.
Alternative 1: Agency Transactions
If Bank XYZ plays the role of an agency transaction market-maker, Bank XYZ simply acts as a
broker matching the buying and selling requirements of the buyer and the seller in the market.
Since the seller is willing to sell the security at $130, Bank XYZ pays the seller $130 in exchange
for the security.
Bank XYZ immediately sells the security to the buyer at $140. In this transaction, Bank XYZ
locks in a profit of $10—the difference between the buying and selling rate or more formally, the
bid-ask spread.
Alternative 2: Principal Transactions
If Bank XYZ instead plays the role of a principal transaction market-maker, it does not necessarily
have to match the buying and selling requirement of the seller in the market.
Following the example above, Bank XYZ may buy the NGP Corporation security from the seller at
$130. The bank does not necessarily need to sell the security immediately. Bank XYZ may express
a view that the value of NGP Corporation will rise beyond what the buyer in the market is willing to
pay for the security.
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Risk Management in Banking: Principles and Framework
If the value of the security rises to $200, Bank XYZ will be able to earn a profit of $70 (market value
of $200 minus the acquisition cost of $130). This is significantly higher than the bank’s locked-in
profit had it locked in at the bid-offer rate in an agency transaction. This, however, also entails a
higher risk. If the value of the security falls to $100, Bank XYZ will lose $30 (market value of $100
minus the acquisition cost of $130).
Proprietary trading
Proprietary trading involves the bank’s role of taking an active risk position in an underlying
instrument or asset. This involves the use of the bank’s capital or borrowed money to take
positions in any financial instruments or commodities for the sole purpose of making a profit
for its own account.
There is a thin line between proprietary trading and principal market-making transactions.
The main difference is that proprietary trading is not related to any actual or anticipated client
activity.
Proprietary trading is the subject of many criticisms during the aftermath of the 2008 Global
Financial Crisis due to the bulk of the losses of large banks being attributed to proprietary
trading positions. Global regulatory reforms have focused on addressing the issue of whether
banks should be allowed to risk their own capital in speculative trading.
Proposals were made either for outright prohibition of proprietary trading or for limiting
the ability of banks to engage in proprietary trading.
Real World Illustration
EU Unveils Plan to Ban Proprietary Trading
On 29 January 2014, the European Commission unveiled the final piece in Europe’s
comprehensive banking system reform measures.
The European Commission plans to impose an outright ban on proprietary trading by about 30
of Europe’s largest banks.
Proprietary trading declined dramatically at Europe’s biggest banks since the financial crisis,
from around 15% of banks’ trading revenues before the crisis to between 0% and 4% now. This
measure aims to ensure that lenders do not revert to old trading habits once markets recover.
National supervisors would be allowed to force banks to wall off certain investment banking
activities, including market-making and derivatives trading, from deposit-taking. But retail banks
would still be allowed to carry out various risky trading activities, within limits set by supervisors.
Source: Wall Street Journal, 29 January 2014
Sales
Financial market sales offer solutions to clients for their risk management and investment
requirements. Sales activities include marketing and distribution of the bank’s products and
services. Structuring units also support sales in creating or designing customized solutions to
clients.
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Treasury
Treasury activities involve managing the bank’s liquidity risk, long-term funding programmes,
and the level and composition of equity capital.
1.1.3
Retail Banking
Retail banking business line refers to products and services offered by banks to consumers and
small businesses through their branch networks and online infrastructure.
Consumer and SME Banking
Retail Banking
Private Banking
Card Services
Figure 1.3 Retail banking—products and services
The following are the key sub-business lines under retail banking:
(a) Consumer and SME banking
Retail banking can be further subdivided into consumer banking and small and medium enterprise
(SME) banking.
Consumer banking offers diverse services which cater to savings (e.g. current and savings
accounts), investment and borrowing (e.g. housing loans, personal loans, special purpose
loans, etc.) and other banking needs (e.g. trust services) of individuals and households.
Small and medium enterprise (SME) banking, on the other hand, offers diverse services targeted
to meet the unique needs of small businesses, such as merchant and payment services, cash
management, insurance brokerage and payroll management.
(b) Private banking
Private banking activities generally involve providing customized solutions to high net-worth
clients. Private banking clients typically reach the minimum threshold of the amount of assets
under management by the bank (e.g. $1 million and above). Examples of services offered to
private banking clients are:
ŸŸCash management
ŸŸFund transfers
ŸŸAsset management
ŸŸFacilitation of shell companies and offshore entities
ŸŸLending services
ŸŸFinancial planning services
ŸŸTrust services
ŸŸCustody services
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(c) Card services
Card services of retail banks are one of the most popular forms of accessing consumer credit
loans. Credit card services offer the holder access to credit as the holder can charge a purchase
on account represented by the card.
Real World Illustration
Navigating the New Era of Asian Retail Banking
McKinsey published Retail Banking in Asia: Actionable Insights for New Opportunities to tackle
the challenges of retail banking in Asia.
Based on McKinsey’s estimates, by 2015 more personal financial assets will reside in Asia than
in Europe. Retail banking revenue in Asia, growing at 9% per year since 2010, is expected to
reach more than $900 billion by 2020.
The key findings of the paper are:
•
Despite dramatic growth, banks in emerging Asia is expected to see an ROE decline by four
to five percentage points in the coming years.
Rapidly shifting consumer behaviour will force banks to revisit their business models. New
regulatory requirements and high-risk customer segments will add to the cost of doing
business, putting downward pressure on returns.
Non-traditional competitors will enter the market, vying with established ones for their revenue
pools.
Unlike the early days of digital banking, when consumers valued low prices above everything
else, today’s consumers want greater control over their finances, fair and transparent pricing,
and a single, consistent, engaging experience. Banks must make digital banking an integral
part of their new operational models.
Banks are seeing returns on investment in their multiple channels, but physical branches are
not necessarily a thing of the past. They will continue to play a role in emerging markets, but
in a new way.
Customer centricity is a much-discussed term in Asia but many banks have not been able to
turn this vague concept into specific business models.
To win in Asia, retail banks must understand their customers, their competitors, their own
business models and their regulatory environments.
•
•
•
•
•
•
Source: McKinsey Insights and Publications, July 2013
1.1.4
Commercial Banking
Commercial banking activities primarily involve granting of loans to households and
businesses from deposits or funds taken from depositors. The following are some of the
common activity groups associated with commercial banking:
(a) Lending
Granting credit to households and businesses is one of the primary functions of commercial
banking. Commercial banking lending allows businesses to access funding to support their
general business needs or growth objectives. There are two types of general lending that a
commercial bank offers:
ŸŸWorking capital financing facilities—Working capital financing are short-term
financing facilities offered by commercial banks. Examples of such facilities are overdraft
facilities, short-term advances and lines of contingencies.
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Lending
Project Finance
Real Estate
Export Finance
Commercial Banking
Trade Finance
Factoring
Leasing
Guarantees
Bills of Exchange
Figure 1.4 Business activities under commercial banking
ŸŸMedium- to long-term facilities—Medium- to long-term loans for acquisition,
investment or expansion purposes are granted to selected clients based on cash flow
projections, evaluation of business plans and acceptable security packages.
(b) Project finance
Project finance is a specialized type of lending where the repayment is based on a project’s
internally generated cash flow. Project finance is frequently applied to large capital-intensive
infrastructure projects. Typical clients of project financing are companies in the power,
transportation, oil and gas, leisure and property, telecommunications and mining industries.
Financing is secured by the project assets and repaid from the project cash flow with only
limited recourse.
Real World Illustration
Asian Banks Top Project Finance Deals in 2013
In a report published in January 2014, Thomson Reuters said that Japanese and other Asian
banks accounted for the bulk of the $204 billion project finance deals in 2013. This catapulted the
Asian banks as the top six arrangers, outperforming several big European banks which handled
$90 billion worth of deals alongside the Middle East and Africa. The six Asian banks included
Mitsubishi UFJ of Japan with a 5.7% market share at $11.5 billion deals followed by the State
Bank of India (4.9% market share) and China Development Bank (4.1% market share).
Thomson Reuters attributed the lower turn out by the European banks to changes in priorities
in terms of business dealings because of the latter’s shrinking balance sheets. However, in the
same report, Thomson Reuters noted that Europe, the Middle East and Africa remained to be
the most active regions. It also indicated that power projects constituted more than one-third of
the total value of project finance deals at $70.1 billion while oil and gas and transportation deals
accounted for a fifth in terms of volume. On the other hand, the Americas deal increased by 21%
to $51 billion while volume in Asia fell 29% to $63 billion.
Source: Thomson Reuters, 17 January 2014
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(c) Real estate
Commercial real estate (CRE) financing is a specialized type of lending for companies
involved in industrial and commercial real estate development and construction. Examples
of commercial real estate financing are term and bridge financing for launching a real
estate project and construction loans to support ground-up construction, renovations or
improvements.
(d) Export finance
Short-term export finance business activities involve providing financing options to address
working capital gaps in a trading cycle.
Export credit agency-supported finance is a specialized form of medium- to long-term
financing provided to corporations and governments to finance the import of capital goods
and services. An export credit agency (ECA) typically provides a guarantee or insurance policy to
a commercial bank for a loan provided to the importer of capital goods. ECAs are governmentbacked agencies created to support their country’s exports.
(e) Trade finance
Trade finance business activities typically refer to the financing of working capital needs for
trade transactions.
(f) Factoring
Factoring is a form of working capital financing that allows clients to generate cash flow. It
involves the assignment of receivables in favour of the bank. Clients sell the receivables to the
commercial bank in exchange for advance financing.
(g) Leasing
Lease financing is a specialized form of alternative financing that allows companies to acquire
equipment. In a lease financing agreement, the bank (acting as the lessor) owns the property
that allows the company (the lessee) to use the property in exchange for a consideration.
Leasing services of a commercial bank can be broadly divided as follows:
ŸŸFinance lease
ŸŸOperational lease
ŸŸSale and leaseback
ŸŸHire purchase
ŸŸVendor leasing
ŸŸBlock discounting
The common capital asset goods in lease agreements are aircrafts, capital assets in IT and
telecommunications, plants and equipment.
(h) Guarantees
Commercial banks issue bank guarantees ensuring that a client’s obligations will be met.
A bank guarantee represents an irrevocable obligation on the part of the commercial bank
issuing the guarantee should the client fail to fulfil its obligations.
Bank guarantees are issued to demonstrate a client’s performance capability and financial
integrity to their customers and suppliers. Examples of guarantees issued by commercial
banks:
ŸŸBid bonds or tender guarantees—are guarantees provided to suppliers to demonstrate
the client’s commitment to execute a contract that has been awarded. It ensures that the
client submits a serious offer in a bidding transaction.
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ŸŸCommercial guarantees—are guarantees provided to ensure that the client will fulfil its
obligations to pay for goods or services.
ŸŸFinancial guarantees—are guarantees provided to ensure that the client will repay the
borrowed money. This assures lenders of repayment.
ŸŸPerformance bonds or guarantees—In a bidding transaction, the successful bidder is
required to post performance a guarantee based on a percentage of the contract amount.
Banks issue performance bonds or guarantees for their bidding clients.
(i) Bills of exchange
A bill of exchange is a negotiable instrument containing an instruction to a third party to pay
a stated amount of money on a specified future date or on demand. Commercial banks may
purchase a bill of exchange in advance of its due date (discounting).
1.1.5
Payments and Settlements
Banks provide payments and settlements business line that facilitates payments of goods and
services on behalf of the clients. Bank branches, internet and mobile banking facilities, and
automated teller machines are some of the most popular channels of payments.
A payment system is an infrastructure that allows individuals and businesses to transfer
funds from one financial institution to another. Payment systems are categorized either as
retail payment system or large-value payment system.
A retail payment system is a fund transfer system that handles a large volume of relatively
low-value payments. Examples are credit card payment transactions, direct debits, cheques
and credit transfers.
A large-value payment system is a fund transfer system that handles large-value and high
priority payments.
A settlement system is an infrastructure that allows securities or financial instruments to be
settled and transferred by book-entries according to a set of predetermined multilateral rules.
1.1.6
Agency Services
Banks may act on behalf of their clients in managing and protecting their assets and properties
via the agency services business activities of banks.
Custody
Agency
Corporate Agency
Corporate Trust
Figure 1.5 Types of agency services offered by commercial banks
Examples of business activities under the agency services are:
(a) Custody
Banks provide custodial services for the settlement, safekeeping and reporting of clients’
marketable securities and cash.
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(b) Corporate agency
Corporate agency services provide transactional services for corporations and governments. Banks
performing corporate agency services act on behalf of the clients. Examples of such services are:
ŸŸCheque clearing
ŸŸPayment processing (interest and dividends)
ŸŸBills collection (as collection agency)
ŸŸTax management
(c) Corporate trust
Corporate trust services involve banks acting in a fiduciary capacity for financial transactions.
Examples of these services are:
ŸŸEscrow services—where the bank acts as a neutral third party for financial transactions
ŸŸDocumentary custodian services—where the bank safe keeps collateral loan files
1.1.7
Asset Management
Asset management activities involve managing or providing advice on a client’s individual
assets or investment portfolios for a fee. Banks are usually compensated based on a percentage
of the total assets under management. There are two primary types of accounts of asset
management services:
(a) Separately managed accounts
Separately managed accounts are created for the purpose of investing a client’s funds on a
standalone basis.
(b) Pooled investment accounts
Banks may serve as the investment manager for commingled or pooled investment accounts.
Some of the most common pooled investment accounts are:
ŸŸCollective investment funds (CIF)—These are bank-administered trust funds designed
to facilitate investment management by combining individual accounts into a single
investment fund with a specific investment strategy.
ŸŸMutual funds—These are open-ended investment companies registered with the Securities
and Exchange Commission. Mutual funds pool money from their shareholders and
invest in a portfolio of securities, and continuously offer to sell the shares to the public
or redeem them.
These funds can either be discretionary or non-discretionary.
ŸŸDiscretionary accounts—In a discretionary account, the bank has the sole authority to
purchase and sell assets, and execute transactions for the principal’s benefit. The bank’s
investment authority, however, is usually defined in the investment policy guidelines.
ŸŸNon-discretionary accounts—In non-discretionary accounts, the bank may provide
investment advisory services for a fee to the principal but must obtain the principal’s
consent prior to buying or selling of assets.
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1.1.8
Retail Brokerage
Retail brokerage services are brokering services that primarily serve the trading and investment
requirements of retail investors. There are two main types of services offered for retail brokerage
clients:
(a) Full service retail brokerage—provides comprehensive services to retail clients including
personal finance advisory, research and market intelligence, and estate and tax planning.
(b) Execution only brokerage—processes and executes client orders for independent retail
investors. This service does not provide any financial or investment advice.
1.2 ROLES OF BANKS IN THE ECONOMY
LEARNING OBJECTIVE
1.2
DISCUSS the important roles that banks play in the economy
This section reviews the various roles that banks play in the economy. Understanding these
key roles will provide a context on the rationale for the regulatory reforms that have been
approved or debated, particularly those that focused on risk management. This section also
aims to strengthen the case for a more focused approach for risk management in the banking
context.
1.2.1
Primary Role of Banks: Financial Intermediation
Financial intermediation is the primary role that banks play in the economy. Financial
intermediation is defined as a productive activity in which an institution incurs liabilities
on its own account for the purpose of acquiring financial assets by engaging in financial
transactions in the market. By playing the role of financial intermediaries, banks channel
funds from lenders of funds to borrowers of funds.
Lenders or providers of funds are usually households and corporations with excess savings.
Borrowers or users of funds are usually corporations with financing requirements to fund
their expansions or households with investment or liquidity requirements.
Figure 1.6 shows the role of banks as financial intermediaries. Banks channel excess deposit
funds from depositors and lend these funds to borrowers.
In a way, banks serve as ‘middlemen’ that match the investment/deposit requirements
of depositors and the borrowing requirements of borrowers. To better understand the
importance of financial intermediation, it will be helpful to visualize an environment where
financial intermediaries do not exist.
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SOURCE OF FUNDS
USE OF FUNDS
Deposit Funds
Lend Funds
BORROWERS
DEPOSITORS
Figure 1.6 Banks as financial intermediaries
Figure 1.7 depicts a world with no financial intermediaries. In such a scenario, depositors
with excess funds will directly place their funds with corporations or borrowers with financing
requirements. Conversely, corporations with borrowing requirements will directly issue
securities to depositors with investment/ savings requirements.
This arrangement, while possible in theory because of technological advancements, will
introduce some serious challenges for both the depositors and borrowers.
Cash Investment
BORROWERS
DEPOSITORS
Securities
Figure 1.7 World with no financial intermediaries
(a) From the depositors’ perspective
Individual depositors will find it difficult and extremely costly to continuously monitor in
a timely manner the financial health of the borrower, which ultimately will determine the
likelihood of repayment. These monitoring costs will significantly decrease the attractiveness
of investing in securities directly issued by the borrower.
An individual depositor may suddenly need cash prior to the date when the security issued
by the borrower becomes due and demandable. The individual depositor may find it difficult
to seek another buyer who will be willing to purchase the security. Individual investors may
incur liquidity costs and may be forced to sell the security at less than the initial investment
due to lack of liquidity.
(b) From the borrowers’ perspective
Borrowers may find it difficult and extremely costly (in terms of money and time) to access
individuals and households with excess investible fund. Marketing and distribution of their
securities may not be part of their own core competencies. They will, therefore, incur high
administrative and distribution costs just to seek and service depositors with excess funds.
Borrowers will typically prefer to issue securities with a longer time horizon as the investments
typically take time before returns and positive cash flows are generated. Depositors, on the
other hand, may suddenly require liquidity prior to the borrowers’ desired borrowing horizon.
This may limit the amount of securities that borrowers can tap directly.
Given that borrowing is not part of the borrower’s normal course of business operations,
they will incur additional processing and administrative costs to service the transactional
costs associated with borrowing, e.g. processing payments of interest and principal, handling
information requests by depositors, etc.
Banks address the serious challenges enumerated above by performing the important
functions of financial intermediation.
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1.2.2
Functions of Financial Intermediation
Ceccheti and Schoenholtz (2011) enumerated five main functions of financial intermediaries:
(a) Pooling resources of small savers
In a world with no financial intermediaries, borrowers are forced to deal directly with individual
depositors. To reach the targeted amount of financing, borrowers may be forced to deal with
many individual depositors. Dealing with many individual depositors increases the borrower’s
administrative and processing costs. The borrower would naturally prefer to deal with fewer
depositors with larger sums of excess funds. The borrower may impose a minimum investible
threshold, e.g. the borrower will only deal with an individual depositor with at least US$1 million
excess fund. By imposing a minimum investible threshold, the borrower has effectively limited
the market in which it could raise funds. In fact, there may only be a few depositors who are
willing to invest excess funds of US$1 million in a single company’s borrowing.
One of the important roles of banks is the ability to pool small resources together from
many individual depositors. The bank, as a financial intermediary, will then be able to collect
these funds and lend the pooled resources to a borrower. The borrower will then be able to
raise the required amount of financing and deal with only one entity, namely, the bank.
(b) Providing safekeeping, accounting and payment mechanisms for resources
Borrowers may incur high costs in safekeeping, accounting and processing payments. On
the other hand, banks are able to spread the costs associated with servicing the safekeeping,
accounting and processing requirements of these transactions by performing multiple
financial intermediation transactions. This reduces the cost per transaction as banks take
advantage of economies of scale.
(c) Providing liquidity
Liquidity refers to the ease of converting an asset into cash. One of the problems in a transaction
with no financial intermediaries is that an individual depositor will find it difficult to seek
buyers before the maturity of the security should it need liquidity.
Banks provide liquidity by allowing depositors to redeem their deposits prior to maturity.
By pooling funds from many depositors, a decision by some depositors to withdraw their
funds early would not be an issue under normal circumstances.
(d) Diversifying risk
In a world with no financial intermediary, if a borrower defaults on its obligation, the depositor
will shoulder all the losses. By pooling many individual deposits and by lending to as many
borrowers as prudence dictates, banks provide diversification to the individual depositors. A
default by one borrower will not necessarily result in a single depositor losing all its investment.
(e) Collecting and processing information
Individual depositors will find it extremely costly to monitor borrowers on a regular basis. It
will be more cost efficient if the task of monitoring the borrowers’ financial health is delegated
to financial intermediaries such as a bank. The bank monitors borrowers on behalf of the
depositors/investors. This reduces the costs of monitoring the borrowers.
As banks gain economies of scale in collecting and processing information, banks can
invest in more sophisticated tools to collect, process and understand information relating to
borrowers and gain more expertise in understanding the specific borrower risks as well as risks
associated with the portfolio as a whole.
In playing the role of financial intermediaries, banks perform three other important economic
functions—asset transformation, maturity transformation and liquidity transformation.
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Risk Management in Banking: Principles and Framework
ŸŸAsset transformation—By performing their financial intermediation role, banks
channel deposits from savers to borrowers as loans.
Deposits
Loans
Figure 1.8 Asset transformation
Without banks acting as financial intermediaries, the loans issued by borrowers
directly to depositors will be less attractive and more costly because of high monitoring
costs, low liquidity and higher risk.
With the bank generating proceeds from depositors and directly issuing a financial
liability (deposit liability) to the depositors, the asset becomes more attractive due to
lower costs (lower monitoring costs, higher liquidity) associated with dealing with the
bank directly. As the bank pools more deposits, all depositors share in the risk of a
borrower defaulting. This also lowers the risks of individual depositors.
With the bank investing directly in the borrower, a security that is initially viewed to be
of higher risks and higher costs from an individual depositor’s standpoint is transformed
into an instrument of relatively lower risks and costs from the bank’s perspective due to
economies of scale.
ŸŸMaturity transformation—Banks transform maturities of assets and liabilities by
taking short-term liabilities (deposits) and transform them into long-term assets, such
as corporate loans. Banks benefit from earning a spread between the earnings on longterm assets and costs on short-term liabilities. This addresses the differences in the time
horizon preferences of the depositor and the borrower.
Depositors generally want to invest excess funds in shorter-term securities to give
them the flexibility should there be a need for cash in the future. The ability to convert
these securities into cash is, therefore, an important consideration for the depositors.
Borrowers, on the other hand, prefer to borrow on a longer-term basis. This is to allow
sufficient flexibility and time for the investment to generate positive cash flows and returns.
Maturity Mismatch
DEPOSITORS
BORROWERS
Short Term
Long Term
Figure 1.9 Maturity transformation
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Banks perform the important function of transforming the maturity of financial
instruments by taking short-term sources of funds (deposits) and lending these funds on
a long-term basis (lending). This function of maturity transformation adds value by giving
both the depositors and borrowers the flexibility to meet their time horizon preferences.
The performance of this maturity transformation function, however, comes with a cost.
The difference in the tenor between the asset (long term) and liability (short term) exposes
the bank to maturity mismatch risk.
This is an important concern for the bank particularly when there is an extraordinary
volume of short-term depositors who demand repayment of their deposited funds. This
will force the bank to draw on its existing cash or liquidate its investments in longer-term
assets, such as receivables from borrowers at less favourable prices.
ŸŸLiquidity transformation—Banks perform the important function of creating liquidity
in the economy by accepting short-term liquid deposits (as liabilities) and channelling
them to long-term illiquid assets. This allows the conversion of funds from savings to
investment.
Banks enhance liquidity of financial instruments in the economy by fulfilling the
liquidity preference of two types of participants—the borrower and the depositor.
The borrower prefers to be liquid for a longer period of time as it needs time and
flexibility for investments to generate positive cash flows, which will enable the borrower
to repay the obligation. This is why borrowers generally prefer to borrow over a longer
period of time. Depositors, on the other hand, prefer to be liquid over a shorter period
of time.
Banks perform the important function of liquidity transformation by giving liquidity
to both depositors and borrowers. By accepting liquidity risks, banks are able to fulfil the
opposite liquidity preference of the borrowers and depositors.
LIQUID ASSETS FOR
DEPOSITORS
Liquidity Mismatch
LONG-TERM
BORROWERS
DEPOSITORS
May demand repayment of
deposits at any time
Banks cannot demand repayment
before maturity. Generally, banks
may find it difficult to sell these
loans at a high price.
Figure 1.10 Liquidity transformation
1.2.3
Other Roles of Banks
Other than financial intermediation, banks also perform other important roles.
(a) Payments role
Banks provide payment services that directly impact the economy. Two of these payment
services are cheque clearing and wire transfer services.
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Risk Management in Banking: Principles and Framework
(b) Risk management and investment advisor role
Banks perform risk management advisory services for individuals and businesses by offering
products that will allow them (customers) to hedge against possible adverse scenarios. Banks
also provide financial advice to individuals and corporate clients on how to better manage
their respective finances.
1.3 TYPOLOGY OF BANK RISKS
LEARNING OBJECTIVE
1.3
DEFINE the different types of risks that banks face
After discussing the important roles that banks play in the economy, we can now appreciate
why regulators and policymakers are focusing post-2008 global financial crisis reforms on
improving the risk management practices of banks.
Banks encounter risks in all their business activities. We have discussed generic banking
business activities in an earlier section. Before these risks are discussed in more detail, it is
important to first distinguish between risk and uncertainty.
The famous economist, Frank Knight, in his seminal dissertation Risk, Uncertainty and Profit,
made a helpful distinction between risk and uncertainty:
ŸŸRisks are unknown outcomes whose odds of happening can be measured.
ŸŸUncertainty, on the other hand, occurs when possible outcomes and probabilities are not
known in advance.
It is important to distinguish between the two as we begin our study on risk management.
Despite all the technological developments and progression of our ability to assess
and quantify risks in a more sophisticated manner, it is important to recognize that risk
management is not about eliminating uncertainties. Rather, it is about making decisions
under uncertainties.
As the famous (and much derided) saying of the U.S. Secretary of Defence Donald Rumsfeld
goes—“There are known knowns. These are things we know that we know. There are known unknowns.
That is to say, there are things that we know we don’t know. But there are also unknown unknowns. There
are things we don’t know we don’t know.”
The entire banking industry—the risk management profession included—was humbled
when an unprecedented global banking crisis unfolded despite all the sophisticated risk
management models that were being used in the years before the banking crisis.
Uncertainties exist and are pervasive in all aspects of banking. A new risk manager should
accept this fact early on and approach the study of risk management as an enterprise for
making decisions under uncertainties.
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In this section, the different types of risks that banks face are enumerated. This section
serves as the introductory background material for the succeeding chapters. Figure 1.11
depicts the generic definitions of the different types of risks, which the student should be
familiar with.
Market Risks
Credit Risks
Financial Risks
Operational Risks
Asset and Liability Management (ALM) Risks
Banking Risks
Legal and Compliance Risks
Strategic Risks
Non-Financial Risks
Reputational Risks
Model Risks
Figure 1.11 Types of bank risks
Bank risks can be broadly classified into financial risks and non-financial risks.
Financial risks are risks that are associated with transactions that are financial in nature.
Below are the major risks that are classified under financial risks:
ŸŸMarket risk
ŸŸCredit risk
ŸŸAsset and liability management risk
mm Balance sheet interest rate risk
mm Liquidity risk
ŸŸOperational risk (Note: For purposes of classification, this book classifies operational
risk as a financial risk. However, students should be aware that operational risk has both
financial and non-financial dimensions.)
Non-financial risks are risks that are associated with transactions that are non-financial
in nature. In the past, non-financial risks receive far less attention compared to financial risks.
This is because it is more challenging to measure non-financial risks compared to financial
risks. However, in recent years, non-financial risks have received closer scrutiny as many banks
realized they are as exposed to non-financial risks as to financial risks. The major risks that are
classified under non-financial risks are:
ŸŸCompliance risk
ŸŸStrategic risk
ŸŸReputational risk
ŸŸModel risk
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1.3.1
Financial Risks
Market risk
Market risk is defined as the risk of losses in on- and off-balance sheet positions arising from
movements in market prices. There are two different components of market risk:
ŸŸGeneral market risk—is the risk arising from movements in the general level of market
rates and prices. General market risk is also referred to as systematic market risk. In
modern portfolio theory, general market risks are risks that cannot be diversified away.
Events such as a global financial crisis and recessions are some examples of systematic risks.
ŸŸSpecific market risk—also known as unsystematic market risk—refers to the risk arising
from adverse movements in market prices that are tied directly to the performance of a
particular security. In modern portfolio theory, specific market risks are risks that can be
eliminated by adequate diversification.
Market risk can also be categorized into the following four types of risks:
ŸŸInterest rate risk in the trading book—is the exposure of the bank’s earnings and financial
condition to adverse movements in interest rates. Interest rate risk is commonly associated
with positions in fixed income securities. There are two types of interest rate risks:
mm Traded interest rate risk or the interest rate risk associated with the bank’s trading book—is the
interest rate risk associated with market risk.
mm Structural interest rate risk or the interest rate risk associated with the bank’s balance sheet—is
more appropriately classified as an asset and liability management (ALM) risk.
ŸŸForeign exchange risk—is the exposure of the bank’s earnings and financial condition to
adverse movements in foreign exchange rates. There are two important sources of foreign
exchange risk:
mm Traded foreign exchange risk—arises from the bank’s market-making and proprietary
trading activities that generate foreign exchange exposures, e.g. servicing a client’s
foreign exchange hedging requirements. Traded foreign exchange risk normally
resides in the bank’s trading book.
mm Structural foreign exchange risk—arises from the structural foreign exchange position
imbalance between the bank’s assets and liabilities. Structural mismatches arise from:
–– Mismatches in the currency denomination of the bank’s assets and liabilities; and
–– Accounting differences (e.g. investments in foreign currency denominated assets
are translated using historical exchange rates but financial assets and liabilities are
translated using the closing exchange rates).
Foreign exchange risk can also be classified into three types:
mm Transaction risk—arises from the impact of exchange rates on foreign currency
denominated receivables and payables. It arises from the difference between the price
at which the receivables are collected or payables are paid and the price at which they
are recognized in the bank’s financial statements.
mm Business risk—is the risk arising from the impact of exchange rates on a company’s
long-term competitive position.
mm Translation risk—or revaluation is the risk of changes in the reported domestic
accounting results of foreign operations or transactions due to changes in foreign
exchange rates.
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Chapter 1 Concepts of Bank Risks
ŸŸEquity price risk—is the exposure of the bank’s earnings and financial condition to
adverse movements in the benchmark equity indices (systematic or general equity market
risk) and individual equity prices (non-systematic or specific equity market risk). There
are two main components of equity price risk:
mm Systematic risk or beta risk is the risk that is associated with the general market and cannot
be diversified away. The general market is frequently the equity benchmark index of
the applicable individual stock. Below are some of the benchmark equity indices for
different countries.
Real World Illustration
Benchmark Equity Indices
Equity Benchmarks
mm
U.S. Stocks
S&P 500, Dow Jones Industrial Average (DJIA)
European Stocks
Stoxx Europe 600
China
Shanghai Stock Exchange Composite Index (SHCOMP)
Malaysia
Kuala Lumpur Composite Index (KLCI)
Singapore
Strait Times Index (STI)
Thailand
Stock Exchange of Thailand (SET)
Philippines
Philippine Stock Exchange Index (PSEI)
Indonesia
Jakarta Stock Exchange Composite Index (JCI)
Vietnam
Vietnam Ho Chi Minh Index (VN Index)
Unsystematic or specific risk is the risk associated with firm-specific risks that can be
eliminated by diversification. Examples are adverse industry developments, negative
news on a specific company, labour problems and weather disturbance in the primary
place of operation.
Illustrative Example
Systematic Risk versus Unsystematic Risk
Identify whether the following news refers to systematic or unsystematic risk.
Case 1: Death of a charismatic CEO
Steven P. Jobs, the visionary co-founder of Apple who helped usher in the era of personal
computers and then led a cultural transformation in the way music, movies and mobile
communications were experienced in the digital era, died at the age of 56.
Solution: Unsystematic risk
Case 2: Weakness in the global economy
More evidence of a weakening global economy emerged Thursday ahead of the Federal Reserve’s
decision to take aggressive new steps to stimulate growth in the United States. A report from the
Organization for Economic Cooperation and Development pointed to a slowdown in the coming
months in Italy, China, India and Russia with weak growth in France and Germany—the two
biggest economies of the struggling euro zone.
Solution: Systematic risk
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Risk Management in Banking: Principles and Framework
Case 3: Loss of market share
Consumer Intelligence Research Partners on Thursday came out with its latest numbers on
mobile market share in the United States and found that BlackBerry devices accounted for 0% of
all smartphone activations in the fourth quarter of 2013, which is not too surprising considering
that the company spent a good chunk of the quarter with a ‘For Sale’ sign hung around its neck.
In its last earnings report, BlackBerry said it only sold 1.9 million smartphones for the quarter and
most of those were BlackBerry 7 devices targeted toward emerging markets. Thus, BlackBerry
posting a 0% market share in the US over that period is well within the realm of possibility.
Solution: Unsystematic risk
ŸŸCommodity price risk—is the exposure of a bank’s earnings and financial condition to
fluctuations in commodity prices. Compared to other types of market risks, commodity
price risk requires special attention due to the following peculiarities of the commodities
market:
mm Concentration of supply—very few market players control supplies of many commodities.
This means that prices for the commodities do not necessarily move according to their
economic fundamentals. The action of a very few market players can have a significant
impact on the commodity prices.
Real World Illustration
The Potash Cartel
A turmoil broke out in the global potash industry after Russian-based potash producer Uralkali
announced it was terminating its sales partnership with Belarus, one of the two big groups holding
the alleged monopoly of potash with a market share of two-thirds of the total market valued at
$22 billion, according to a Wall Street Journal article entitled ‘The Potash Cartel’, published on
30 July 2013. The Uralkali announcement brought the prices of potash down, which would in
turn prompt potash miners to increase their production in the hope of increasing market share.
But such a move would push prices even lower as well as provide customers the leverage to
negotiate for lower prices.
Uralkali estimated a 25% drop in the price of potash—valued at $300 per metric ton—by the
end of 2013. There were also indications that stocks of potash-mining companies suffered a
rapid decline in terms of value. Furthermore, the article mentioned that the market for potash,
a potassium-based fertilizer ingredient, has been dominated by two big marketing groups,
Belarusian Potash Co. and North America’s Canpotex. Both companies dismissed reports that
they were operating as a cartel. They were thought to have pegged identical prices in India and
China, two of the major markets for potash.
Source: Wall Street Journal, 30 July 2013
Unique characteristics of commodities—Different commodities display different
characteristics and physical attributes that affect their prices. Features such as
storability could affect pricing of commodities. Gold, which is one of the most durable
commodities, would display a different pricing behaviour compared to electricity,
which cannot be stored, or even with an agricultural commodity.
mm Seasonal factors—Seasonal changes in demand and supply could also affect commodity
prices. Different commodities display different seasonal features.
mm
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Chapter 1 Concepts of Bank Risks
Credit risk
Credit risk is defined as the potential that a borrower or counterparty will fail to meet its
obligations in accordance with agreed terms. There are two levels in credit risk:
ŸŸTransactional credit risk—refers to credit risk exposures generated on a transactional
level. It is primarily determined by the borrower or counterparty’s ability and
willingness to pay its obligations as they come due. Transactional credit risk can be
further subdivided according to five different types of exposures:
mm
Retail credit risk—is the risk of loss due to a consumer’s default on a consumer
credit product arising from the bank’s retail business. The Basel Committee on
Banking Supervision defines retail credit exposures as homogenous portfolios
consisting of:
–– Large number of small, low-value loans
–– Consumer or small business focus
–– Incremental risk of any single exposure is small
mm Corporate credit risk—is the risk of loss due to a default of an institutional/corporate
client. Corporate credit risk is usually the largest risk faced by traditional commercial
banks.
mm Counterparty credit risk—is the risk that a counterparty to a financial contract, such
as derivatives, will default prior to the expiration of the contract and fails to meet
its obligations under the contract. While counterparty credit risk is classified under
credit risk, a large element that determines a bank’s counterparty credit risk exposure
is closely linked to market risk.
mm Sovereign risk—is the risk of loss due to a default of a government on its financial
obligations.
mm Country risk—is the risk of loss due to events in a particular country which are,
to some extent, under the control of the government. Country risk covers a wider
range of risks than sovereign credit risk. One example of a risk within the scope of
country risk is transfer risk. Transfer risk refers to the borrower’s inability to fulfil its
obligations because of government actions, such as restrictions imposed on the ability
of private sector borrowers to source foreign exchange to repay their foreign exchange
obligations.
ŸŸPortfolio credit risk—is the credit risk exposure of the bank on an aggregated level.
Portfolio credit risk considers the impact of consolidating individual transactional
credit risk exposure on a consolidated bank basis. This includes taking into account
the positive diversification effect of taking individual exposures on a portfolio level. An
important source of portfolio credit risk is concentration risk.
mm Concentration risk refers to an exposure with the potential to produce losses that are
substantial enough to threaten the financial condition of a banking institution.
Concentration risk arises from excessive exposures to:
–– Single counterparty or group of connected counterparties
–– Specific instrument
–– Specific market segment
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Risk Management in Banking: Principles and Framework
Real World Illustration
Concentration Risk: The Case of Continental Illinois
In the mid-1970s, Continental Illinois embarked on an aggressive strategy of growth to make it
among the largest commercial and industrial lender in five years. During this period, Continental
spurred loan growth by becoming particularly aggressive in the energy industry, a sector which
it felt it had special expertise. Not contented, Continental also developed special relationship
with Penn Square Bank, a relatively small bank that specialized in oil and gas sector loans.
Continental purchased a total of $1.1 billion worth of loans from Penn Square (size: $436 million).
These loans represented 17% of Continental’s total oil and gas loan portfolio.
After years of oil price rise, it began to drop in April 1981. Exploration and drilling companies
were among the first to bear the full brunt of the downturn. Compounded by other problems,
Continental filed for bankruptcy.
Source: The Collapse of Continental Illinois National Bank and Trust Company: The Implications
for Risk Management and Regulation, Wharton Financial Institutions Center
Asset and liability management (ALM) risk
Asset and liability management (ALM) risks are risks that are associated with structural
mismatches in a bank’s balance sheet. There are two common sources of ALM risks:
ŸŸBalance sheet interest rate risk—is the exposure of a bank’s balance sheet to adverse
movements in interest rates. Balance sheet interest rate risk is a normal part of the
business of banking. There are four important sources of balance sheet interest rate risk:
mm Repricing risk—arises from the differences in the maturity and repricing of bank assets,
liabilities and off-balance sheet positions. There are two main sources of repricing
risk:
–– Maturity differences
–– Repricing of cash flow (for variable rate assets or liabilities)
Illustrative Example
Repricing Risk
Assume that Bank DEF has the following asset and liability profile:
•
•
10-year loan receivable earning 5% interest
2-year deposit liability paying 3% interest
Assuming the bank can continue to fund the 10-year loan at 3% interest (deposit), it will earn a
positive spread of 2% (= 5% – 3%). Suppose after two years, depositors demand 5% interest
to continue to roll their deposits. Bank DEF will then face declining profitability prospects as the
spread now falls to 0%.
Yield curve risk—Yield curve is a linear graph depicting the relationship of interest rates
over the different maturities of a bond. Yield curve risk is the risk that arises when
unanticipated shifts of the yield curve have adverse effects on the bank’s income or
underlying economic value.
mm Basis risk—is the risk arising from an imperfect correlation in the adjustment of interest
rates earned and paid on different instruments with similar repricing characteristics.
mm
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Chapter 1 Concepts of Bank Risks
mm
Optionality risk—is the risk arising from cash flow altering options embedded in the
bank assets, liability and off-balance sheet positions.
ŸŸLiquidity risk—is the risk arising from the bank’s inability to fund increases in assets
and meet obligations as they come due. There are two main sources of liquidity risk:
mm
Asset-based liquidity risk
One of the ways a bank can fund growth in its assets or pay its obligations as they
come due is to sell its existing assets. Assets that can easily be converted into cash are
generally considered to be of higher quality (in liquidity terms) than those that are
not. This ensures that the bank can fund increases in assets and pay its obligations
without incurring unacceptable losses.
Long-term
Sell existing ASSETS to generate cash to:
(a) Fund increases in the bank’s other assets
(b) Pay obligations as they come due
LENDING
Figure 1.12 Funding bank’s growth via sales of assets
Another important source of asset-based liquidity risk is the off-balance sheet
commitments. Banks frequently allow a client to borrow funds over a commitment
period on demand. This is referred to as a loan commitment transaction. When the
client draws on its loan commitment, the bank must fund the obligation immediately—
creating a demand for liquidity.
mm
Liability or funding-based liquidity risk
The bank’s liquidity profile is also largely determined by the quality of its sources of
funding—the liability side of the bank’s balance sheet.
When liability holders demand cash by withdrawing their deposits (or lending), the
bank needs to borrow additional funds or sell assets to meet the withdrawals. Banks
use cash to satisfy the demands of the liability holders.
In times of liquidity stress, volatile sources of funds (liability) would force banks
to replace these liabilities in order to continue to operate as a going concern. In such
a situation, replacing these sources of funds will force banks to accept unacceptable
increases in funding costs.
Replace existing LIABILITIES to generate cash to:
(a) Fund increases in the bank’s other assets
(b) Pay obligations as they come due
DEPOSIT
Figure 1.13 Replacing bank’s liabilities during liquidity stress
On the other hand, having access to stable sources of funds will give banks the
flexibility not to replace/raise funding in times when it will not be optimal to do so.
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Risk Management in Banking: Principles and Framework
Operational risk
Basel II defines operational risk as 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. There are four main causes of operational risk:
ŸŸProcess risk—is the risk from faulty overall design and application of internal business
processes.
ŸŸPeople risk—is the risk that employees do not follow the organization’s procedures,
practice and/or rules or deviate from expected behaviour.
ŸŸSystems risk—is the risk of failure arising from deficiencies in the bank’s infrastructure
and information technology systems.
ŸŸExternal events risk—is the risk associated with events outside the bank’s control.
While operational risk is classified under financial risk in this book, it actually has both
financial and non-financial dimensions. Key man or person risk is the risk of loss arising from
losing one or more important member of the banking organization. Because of the knowledge
or skills that this key person possesses, it will be difficult to immediately replace this individual.
This is an example of an operational risk with a non-financial dimension. Rogue trading or the
unauthorized execution of trades by an authorized trader is an example of an operational risk
that has a financial consequence to the banking organization.
1.3.2
Non-financial Risks
Legal and compliance risk
ŸŸLegal risk is defined as the possibility that lawsuits, adverse judgments or faulty contracts can
disrupt or adversely affect the operations or condition of the bank. Legal risk is the exposure
to fines, penalties or punitive damages resulting from supervisory actions as well as private
settlements.
ŸŸCompliance risk, on the other hand, is the risk arising from violations of, or nonconformance with, laws, rules and regulations or internal policies. It is the risk of legal or
regulatory sanctions, material financial loss, or loss to reputation that a bank may suffer
as a result of its failure to comply with laws, regulations, rules, related self-regulatory
organization standards, and code of conduct applicable to its banking activities.
Real World Illustration
European Legal Tab Tops $77 Billion as Probe Widens
In November 2013, Bloomberg News reported that the legal costs incurred by Europe’s largest
banks had accumulated to $77 billion since the financial crisis—five times their combined profit
in 2012. Of the amount, $24.9 billion was spent on settling lawsuits and probes, $31.5 billion
on compensating clients for mis-selling of banking products and $ 20.9 billion was set aside as
reserve for potential further liabilities. The average gain in legal costs for the 17 listed banks
included in the study was 16% in 2013.
Source: Bloomberg News, 22 November 2013
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Chapter 1 Concepts of Bank Risks
Strategic risk
Strategic risk is the risk of loss in earnings, capital or reputation arising from changes in the
business environment, adverse strategic decisions, and improper implementation of decisions
or lack of responsiveness to industry, economic or technological changes.
Strategic risk arises from failure to properly formulate or implement strategies leading to
significant damage to a bank’s financial position, reputation, competitiveness or business
development prospects.
Reputational risk
Reputational risk is the risk that may arise from negative publicity regarding an institution’s
business practices. Whether true or not, such reputational risk can cause a decline in customer
base, costly litigations or revenue deductions.
In a 2013 global survey conducted by Deloitte on more than 300 companies around the
world, reputational risk was ranked as the biggest risk concern by the respondents. Reputation
is rated as the highest impact risk area for most individual sectors.
Real World Illustration
Debate Continues over Defining Reputational Risk
Reputational risk should be seen as an impact and not a risk, delegates at Risk USA were
told this week. Panelists argued that measuring the impact of reputational risk is difficult—often
because the link between a negative event and reputational damage is uncertain.
“I don’t believe it’s a risk and we struggle with this topic because we have to ask, is it a risk?”
Craig Spielmann, global head of operational risk systems and analytics at RBS, told delegates.
“I look at it more as an impact than a risk—an outcome of something that goes wrong to begin
with.” He said there is also wide debate in the industry over the extent to which reputation is
actually impacted by significant events. “Look at the financial crisis and all these things that
have happened. Look at JP Morgan in the papers this week. Will anyone not do business with
them?”
Stephan Schenk, head of operational risk at TD Bank, agreed. “The strange thing is that a
negative event can actually have a positive impact on your reputation because more folks know
about you and attempt to do more business with you.”
Panelists argued that the main reason that measuring reputational risk is extremely difficult is
because shareholder value in financial institutions has remained relatively steady, even in the
face of repeated crises.
“There is no proof that eroding shareholder value actually happens,” said Spielmann. “If you look
at companies like JP Morgan, the last six months have been really tough for them, but their stock
price is going up. We haven’t seen any evidence or any correlation that these things in the long
term hurt shareholder value.”
One area where panelists agreed financial institutions may be able to measure reputational risk is
in staff turnover. “I’m sure if you went back and looked at some of these companies, the amount
of turnover that there has been over the past eight or so years is significant,” said Ivan Pooran,
head of enterprise and operational risk at GE Capital Americas. “And you can make an argument
that is probably correlated to other things, but I’m pretty sure, having come from one of these
organizations, that the link to reputational risk is pretty high.”
Source: Risk.Net, 25 October 2013
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Risk Management in Banking: Principles and Framework
Model risk
Banks rely heavily on models for assessing and quantifying risks. Model refers to a quantitative
method, system or approach that applies statistical, economic, financial or mathematical
theories, techniques and assumptions to process input data into quantitative estimates.
Models provide a formal structure for banking organizations to assess, analyze and
quantify risks by simplifying the often complex, dynamic and interrelatedness nature of risk
exposures to enable efficient and effective decision-making. Banks often heavily rely on these
simplifications.
Model risk is defined as the risk of loss, incorrect business decisions, financial reporting
errors or reputational damage arising from possible errors and misapplication of inputs of
models.
Model risk has received considerable attention during the height of the 2008 global financial
crisis. Many banks relied on faulty model assumptions in measuring their risk exposures from
complex derivatives. The results of the model used to formally quantify the risk exposures led
to faulty decisions, which left many banks stuck with highly illiquid assets.
CONCLUSION
This chapter provides a review of the different business activities and business lines of the
banking organization. Since these business activities and business lines generate risk exposures
to the banking organization, it is important to have a firm foundation of the nature of the
latter. After reviewing the different banking business activities and business lines, the critical
roles of the banks in the economy were discussed. Understanding these critical roles of banks
as financial intermediaries serves as a useful context for understanding risk management. In
the previous section, the different types of bank risks were enumerated and briefly discussed.
In the next chapter, we will discuss in further detail the basic risk management principles
and framework.
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C
2
P
HA
TE
R
RISK MANAGEMENT
PRINCIPLES AND
FRAMEWORK
In the previous chapter, we briefly reviewed the different business activities that a typical
banking organization engages in. This provided an important context for discussing
the different types of risks that a banking organization faces as risks usually arise from
its business activities. After discussing the different types of risks that banks face, this
chapter provides an overview of risk management in the banking context.
This chapter begins with an introduction to risk management in the banking
context. It then proceeds with a broad overview of the different elements of a sound risk
management infrastructure—principles, framework and process—in accordance with
the principles laid out by the International Organization for Standardization (ISO) in
ISO 31000: Risk Management—Principles and Guidelines. ISO is the world’s largest developer
of voluntary international standards. ISO 31000 provides the principles and generic
guidelines on risk management that can be used by any entity from any specific industry
or sector. This chapter aims to apply these principles in the banking context. It then
discusses the risk management principles and risk management framework in detail.
Risk management process will be covered in the succeeding chapter.
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Risk Management in Banking: Principles and Framework
Risk Management Principles
and Framework
Risk Management in the
Banking Context
Risk Management
Principles
Risk Management
Framework
Definition of Risk
Management
Definition of Risk
Management Framework
Objectives of Risk
Management
Uses of a Risk
Management Framework
Elements of a Sound Risk
Management Framework
Figure 2.1 Diagrammatic outline of this chapter’s topics
LEARNING OUTCOME
At the end of this chapter, you are expected to be able to:
EXPLAIN the basic principles of risk management and the different elements of a sound risk
management framework
LEARNING OBJECTIVES
At the end of this chapter, you will be able to:
DISCUSS the objectives of risk management in the banking context
EXPLAIN the basic principles of risk management
DISCUSS the different components of a sound risk management framework—risk governance,
risk appetite, risk culture, risk policy and risk management organization
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Chapter 2 Risk Management Principles and Framework
2.1 RISK MANAGEMENT IN THE
BANKING CONTEXT
LEARNING OBJECTIVE
2.1
DISCUSS the objectives of risk management in the banking context
Banking organizations face risks as part of their business. Taking risk is part of the business
of banking. These risks, however, when not understood and managed properly, may lead to
huge losses and may even threaten the bank’s survival. This is a common theme in almost all
bank failures and crises.
Despite the pervasiveness of risks in banking activities, the focus on managing risks
independently and distinctly is a relatively new phenomenon. In the past, risks were simply
accepted as a consequence of doing business. There was relatively little or modest formal effort
to actively understand and manage risks.
As the business environment rapidly evolved and became more globalized, banks responded
by introducing innovative products. This made the banking business model more complex
and volatile. The banking failures in the 1970s and 1980s heightened concerns that the risks
of doing business must be actively understood and managed. The lessons learned from these
failures gradually resulted in the elevation of risk management as a critical and formal function
and activity that is equally important as the core banking business activities.
2.1.1
Definition of Risk Management
ISO 31000 defines risk management as:
‘Coordinated activities to direct and control an organization with regard to risk…’
The definition reveals some important features of risk management, which are discussed
below.
Coordinated
Risk management is a coordinated effort from all units in the banking organization. However,
the common misconception is that risk management should be the responsibility of a single
function in the banking organization, for example, the risk management function. Risk
management is too broad in scope and banking risks are too complex to be managed by a
single function. Everyone in the organization has a role to play in risk management.
The three lines of defence model used by many banking organizations is an example of a
coordinated approach to risk management.
The three lines of defence model puts risk ownership across the three levels in the bank: the
business lines, risk management function and internal audit.
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Risk Management in Banking: Principles and Framework
First Line
Second Line
Third Line
Business Line or
Front Office
Risk Management
Function
Internal Audit
Figure 2.2 The three lines of coordinated defence in risk management
The first line of defence are the risk-originating units, which are the business lines.
They originate products and activities, which are the sources of risks to the bank. They are,
therefore, in the best position to address risk issues at the onset. Business lines are expected
to embed the risk management framework and sound risk management practices into their
standard operating procedures. They are responsible for monitoring and accountable for risk
management performance in operation. Business lines must, therefore, adhere to all applicable
policies, procedures and processes established by the risk management function.
The second line of defence is the risk management function. This function is responsible
for developing and implementing the risk management framework. It ensures that the risk
management framework covers all risks to which the bank is exposed to.
The third line of defence is internal audit, which reviews the effectiveness of risk management
practices. Internal audit confirms the level of compliance, recommends improvements and
enforces corrective actions where necessary.
Activities
Risk management is a structured and formal process. It entails the execution of different
activities such as communication, consultation, establishing the context, and identifying,
analyzing, evaluating, treating, monitoring and reviewing of risk.
Direct and control
Risk management aims to direct and control risks that banks face. The objective is not to
eliminate risks but to direct and control them. Risk management aims to make risks more
manageable and ensure that the banking organization will continue to operate as a going
concern, and meet the complex requirements of the bank’s internal and external stakeholders.
Risk management plays a central and integral role in the banking business model. Given the
important role that banking organizations play in the economy, it is thus essential to have an
understanding of the main objectives of risk management.
2.1.2
Objectives of Risk Management
Increase the likelihood of achieving business objectives
In traditional finance, the typical business objective of corporations or other types of business
entities is to maximize shareholder value. This means that the overriding objective is to
maximize profitability and generate shareholder wealth over the long run.
The banks’ critical roles eventually heightened public interest and involvement in
the banking business. This means that banking organizations have to satisfy multiple
stakeholders and not only the stockholders. Other than the stockholders, the different
important stakeholders are discussed in Table 2.1.
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Chapter 2 Risk Management Principles and Framework
Table 2.1 Important stakeholders of a banking organization
Stakeholders of a Banking Organization
Depositors
ŸŸ Bank depositors are one of the most important stakeholders of a banking organization. The
deposit base usually forms the bulk of a typical bank’s sources of funds.
ŸŸ Many bank failures occurred due to the loss of trust and confidence of depositors in the
ability of the banking organization to continue as a going concern. This loss of confidence,
when not managed or mitigated properly, may result in a bank run as well as the cessation
of the bank’s ability to continue to operate as a going concern.
ŸŸ The importance of maintaining depositor trust and confidence is one of the key reasons why
banks must consider, as part of their business objectives, the prudent management of trust
and confidence of their deposit clients.
Customers
ŸŸ Bank customers are important stakeholders. As discussed in the previous chapter, banks
play a vital role in the economy. At a more fundamental level, banks play a role in the
development of a community. Failure of a banking organization may result in spillover
effects to the economy in general and the community in particular.
ŸŸ The importance of banks in the community in which it operates in makes it important for
banks to consider their customers in forming its business strategy.
ŸŸ Given the competitive landscape in the global financial landscape, banking organizations
that fail to deliver the expectations of customers will face loss of business, market share and
ultimately, profitability.
Regulators
ŸŸ The regulators of banking organizations are also an important stakeholder. They frequently
act as lenders of last resort.
ŸŸ Regulators exercise oversight over regulated banking entities. Failure by a banking
organization to comply with regulatory requirements may affect its ability to continue to
operate as a going concern.
ŸŸ The importance of regulatory compliance in the ability of banking organizations to continue
to operate as going concerns makes it imperative for banks to incorporate regulatory
concerns in the design and execution of their respective business objectives.
Employees
ŸŸ Employees are the most important assets of banking organizations. Banks rely on their
employees to execute the business objectives.
ŸŸ Employees are also important stakeholders of the bank. They are often some of the most
affected stakeholders in the event of a bank failure. The interest of employees should,
therefore, be considered in forming banking business objectives.
General public
ŸŸ During the 2008 global financial crisis, many governments throughout the world extended
sizeable financial assistance to failing banks to prevent their collapse as well as the banking
industry. This financial assistance is often called a bailout. In most cases, the financial
assistance given or lent came from taxes paid by the general public.
ŸŸ Given the burden on the public by a bank bailout, the interest of the general public must be
considered in the bank organization’s business objectives.
Risk introduces uncertainty to the attainment of the banking organization’s business
objectives. Risk management aims to increase the likelihood of the organization attaining its
business objectives by designing and executing strategies that will manage risks, which cause
uncertainty on the organization’s ability to achieve its stated business objectives.
Risk management provides the framework and process that will allow the banking
organization to mitigate the impact of those risks on the organization’s business objective.
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Risk Management in Banking: Principles and Framework
Encourage proactive management of risks
The absence of risk management frequently results in the banking organization taking on
risks in a passive and reactive manner. The lack of a formal process to assess and mitigate risks
makes the organization more vulnerable to unwanted risk exposures and frequently impairs
its ability to respond to the risks in a timely and cost effective manner.
Risk management provides a systematic and structured framework and process to assess
and mitigate risks. The systematic and structured framework encourages management to
proactively assess and mitigate the risk exposures that the organization faces. This allows the
bank to anticipate emerging risks and equips the organization with the necessary tools to
respond to the risks in a timely and cost effective manner.
Compliance with laws and regulations
The banking industry is one of the most heavily regulated industries in most jurisdictions.
Special laws and regulations apply to banks that are designed to ensure the safety and
soundness of the banking organizations. Failure to comply with the regulations may have
adverse consequences on the bank, which could range from monetary and non-monetary
penalties or sanctions to the extent of being forced to cease to exist as a going concern.
Risk management plays an important role in ensuring that the banking organization
complies with the relevant laws and regulations. Strong risk management practices strengthen
processes and controls that ensure compliance with relevant laws and regulations.
Regulation also plays an important role in risk management. After the 2008 global
financial crisis, regulators are increasingly placing stronger emphasis on strengthening the
banking organizations’ risk management practices. Failures in risk management practices
are consciously being met with substantial fines that not only monetarily affects the banking
organization but also results in significant damages to the bank’s reputation.
Real World Illustration
US Bank Legal Bills Exceed $100 Billion
On 28 August 2013, Bloomberg released a report claiming that the six biggest U.S. banks had
accumulated more than $100 billion worth of legal costs or $51 million a day since the financial
crisis. This amount is reported to be worth more than all dividends that had been paid out to
shareholders in the past five years. The costs may continue to rise as regulators, prosecutors
and investors file new claims against these banks, which initially saw a 40% increase in litigation
and legal costs since January 2012.
This scenario exemplifies how risk management adds value to banking organizations. Sound risk
management practices often entail establishing processes and controls in order to minimize the
chance of non-compliance of regulations.
Source: Bloomberg, 28 August 2013
Note: This article shows an example of risk management adding value to banking organizations.
Sound risk management practices often entail establishing processes and controls that will
minimize the chance of non-compliance of regulations.
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Lower cost of funds
Banks fund their assets through a combination of liability and equity sources of funding.
Liability sources of funding typically come from depositors and borrowings with other banks
and creditors. Equity sources of funding are typically sourced from shareholders.
A bank’s cost of funds from both liability and equity sources of funding are positively
related to the depositors and investors’ perception of the bank’s risk profile. This is consistent
with the standard finance theory that the higher the risk, the higher the return required.
Conversely, the lower the risk, the lower the return required.
The higher the perception of the bank’s risk profile, the higher will be the cost of its funds.
This is because investors, lenders and depositors will demand higher returns to compensate
them for taking higher risks. Conversely, the lower the perception of the bank’s risk profile, the
lower will be the cost of its funds. Investors, lenders and depositors may be willing to demand
a lower return due to the bank’s lower risk profile.
Risk management provides value by lowering a bank’s cost of funds. Strong risk management
practices allow for efficient and effective management of ‘surprises’ in achieving a bank’s
business objectives. Lowering these ‘surprises’ or uncertainties would lower the bank’s overall
risk profile. Depositors, investors and creditors of the bank would view the bank’s strong risk
management practices in a favourable manner. This favourable view may translate to lower
perception of risk and, therefore, lower cost of funds for investors and depositors.
The reverse is also true for banks with weak risk management practices. Depositors, investors
and creditors will penalize banks with weak risk management practices by demanding higher
returns on their investment to compensate for the higher risk they are taking. This, therefore,
will increase a bank’s cost of funds.
Credit rating agencies assess the risk management practices of banking organizations and
this is used as a factor in coming up with the credit rating assessment of banks. Rating agencies
assess the quality of a bank’s risk management approach and practices and its appropriateness
to the organization’s risk profile.
The stronger the risk management practices of a banking organization, the more stable the
organization’s credit rating will be. The more stable the credit rating, the lower the expected
cost of funds holding, other things remaining constant.
Efficient allocation of capital and resources
While a bank’s resources are limited and in most cases, scarce, business opportunities, on the
other hand, are many and unlimited.
Risk management provides a structured framework and process to assess the risk
implications of each business undertaking. This assessment can then be used to allocate scarce
resources to businesses that generate higher returns commensurate to the level of risk taken.
This is referred to as the risk-adjusted returns.
In contrast, without a sound risk management framework, banking organizations may
be tempted to focus on maximizing accounting earnings, e.g. net income. This focus on
maximizing accounting earnings overlooks the risk implications of a business undertaking.
Risk-adjusted return or performance measures the return on a transaction or business activity
after considering the risk associated with the latter. This allows management to have a fair
perspective on how to best allocate scarce capital.
Risk management provides relevant and timely information that management may use when
deciding which business activity or business line will receive more capital and strategic focus.
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Illustrative Example
Role of Risk Management in Providing Relevant and Timely Information
Bank XYZ engages in the following business lines:
Business Line
Net Income
Asset Invested
1
$10,000,000
$5,000,000
2
$2,000,000
$5,000,000
3
$1,000,000
$2,000,000
4
$500,000
$2,000,000
If Bank XYZ’s business objective is to maximize accounting earnings, it appears that business
line 1 is the most attractive option. It provides the highest accounting return per $1 of asset
invested. Bank XYZ may channel all or most of its scarce capital resources to business line 1.
Business Line
Net Income
Asset Invested
Return on Investment
(Accounting)
1
$10,000,000
$5,000,000
200%
2
$2,000,000
$5,000,000
40%
3
$1,000,000
$3,000,000
33%
4
$500,000
$3,000,000
17%
The problem with using maximizing accounting returns as the overriding objective is that it
totally ignores risk in the capital allocation decision. Risk management provides information to
management on the level of risk taken for each business line. This level of risk is then taken into
consideration when calculating the return and allocating capital. The table below shows how the
decision and allocation will change if the level of risk is considered.
Business
Line
Net Income
Return on
Investment
(Accounting)
Volatility
(or Other Risk
Measure)
Return Per
1 Unit of Risk
1
$10,000,000
200%
500%
40%
2
$2,000,000
40%
100%
40%
3
$1,000,000
33%
20%
165%
4
$500,000
17%
10%
170%
Enhance competitive advantage
Risk management has evolved from being a compliance function to one that is now increasingly
being viewed as a function that delivers competitive advantage to the organization.
Strong risk management practices have proven to be a source of competitive advantage
as evidenced by those banks that have performed well—even during the global financial
crisis—are those with superior risk management practices. Many banking organizations,
on account of their strong risk management practices, are given more flexibility to pursue
business opportunities that may not be available for those with weaker risk management
practices.
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Chapter 2 Risk Management Principles and Framework
2.2 RISK MANAGEMENT PRINCIPLES
LEARNING OBJECTIVE
2.2
EXPLAIN the basic principles of risk management
ISO 31000 Risk Management—Principles and Guidelines enumerates three different but interrelated
components of risk management.
Risk Management Principles
Risk Management Framework
Risk Management Process
Figure 2.3 Interrelated components of risk management
Risk management principles enumerate fundamental characteristics of effective risk
management. These foundational principles serve as bases for designing a risk management
framework, which is a set of components that provide the foundations and organizational
arrangements for designing, implementing, monitoring, reviewing and continually improving
risk management throughout the organization (ISO 31000). Risk management framework
integrates the risk management process into the organization’s overall corporate governance,
strategy and planning, management, reporting processes, policies, values and culture.
Risk management process is the systematic application of management policies, procedures
and practices to the activities of communicating, consulting, establishing the context, and
identifying, analyzing, evaluating, treating, monitoring and reviewing risk.
(Principles of risk management are discussed in this section, while the risk management framework is in the
next section. We will discuss the risk management process in more detail in the next chapter.)
Principles of risk management
In order for risk management to be effective, ISO 31000 enumerates 11 principles:
1. Risk management creates and protects value
2. Risk management is an integral part of all organizational processes
3. Risk management is part of decision making
4. Risk management explicitly addresses uncertainty
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Risk Management in Banking: Principles and Framework
5. Risk management is systematic, structured and timely
6. Risk management is based on best available information
7. Risk management is tailored
8. Risk management takes human and cultural factors into account
9. Risk management is transparent and objective
10. Risk management is dynamic, iterative and responsive to change
11. Risk management facilitates continual improvement of the organization
Principle 1: Risk management creates and protects value
Risk management creates and protects value by increasing the likelihood of achieving the
organization’s objectives. It also creates and protects value as it results in the improvement of
the banking organization’s governance and control processes, compliance with regulations
and effectiveness and efficiency in the allocation of scarce capital and resources.
Principle 2: Risk management is an integral part of all organizational processes
Risk management is not a standalone activity that is separate from the main activities and
processes of the organization. Aside from ensuring profitability and delivering shareholder
value, risk management should form part of the responsibilities of management.
Principle 3: Risk management is part of decision making
To be effective, risk management should be part of the decision-making process. Risk
management should help decision makers make informed choices, prioritize actions and
distinguish among alternative courses of action.
Principle 4: Risk management explicitly addresses uncertainty
Risk management does not view risk in a deterministic manner. Risk management should
explicitly take into account uncertainty, the nature of the uncertainty and how that
uncertainty can be addressed.
Principle 5: Risk management is systematic, structured and timely
Risk management is a systematic, structured and timely process that contributes to efficient,
consistent, comparable and reliable results. It is a rigorous process that encourages everyone
in an organization to assess uncertainty in a structured and systematic manner, and design
mitigation strategies methodically.
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41
Principle 6: Risk management is based on best available information
While risk management aims to assess and manage risk in a forward-looking manner, it
has to rely on the best available information as of a specified predetermined date. Below are
some examples of information sources that can be used as inputs to the risk management
process:
ŸŸHistorical data
ŸŸPast experience
ŸŸStakeholder feedback
ŸŸObservation
ŸŸForecasts
ŸŸExpert judgement
Principle 7: Risk management is tailored
Risk management is not a one size fits all exercise. Each banking organization has unique
circumstances that must be considered in designing the organization’s risk management
framework and process. Risk management should be aligned with the organization’s
external and internal context and risk profile.
Principle 8: Risk management takes human and cultural factors into account
The effectiveness of risk management processes, no matter how sophisticated the designs
are, still depends on the commitment and capabilities of everyone in the organization. Risk
management considers the capabilities, perceptions and intentions of external and internal
people that can facilitate or hinder achievement of the organization’s objectives.
Principle 9: Risk management is transparent and inclusive
To be effective, risk management should not be an isolated activity. Everyone in an
organization should be involved. Risk management is relevant and up-to-date if stakeholders
and decision makers at all levels are involved in an appropriate and timely manner.
Principle 10: Risk management is dynamic, iterative and responsive to change
Risk management should continually evolve and recognize the dynamic environment in
which banking organization operates in. As external and internal events occur, context and
knowledge changes, monitoring and review of risks take place. New risks emerge. Some
risks evolve. Some risks change. Some disappear. Risk management should be able to
capture and calibrate its responses to the changing nature of uncertainty.
Principle 11: Risk management facilitates continual improvement of the
organization
Risk management should develop and implement strategies to improve their risk
management maturity alongside all aspects of the organization.
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Risk Management in Banking: Principles and Framework
2.3 RISK MANAGEMENT FRAMEWORK
LEARNING OBJECTIVE
2.3
DISCUSS the different components of a sound risk management framework—risk governance,
risk appetite, risk culture, risk policy and risk management organization
2.3.1
Definition of Risk Management Framework
The effectiveness of risk management depends on the effectiveness of the risk management
framework. Risk management framework is a set of components that provide the foundations
and organizational arrangements for designing, implementing, monitoring, reviewing and
continually improving risk management throughout the organization.
Foundations of the risk management framework include policy, objectives, mandate and
commitment to manage risks. Organizational arrangements include plans, relationships,
accountabilities, resources, processes and activities. For risk management to be effective,
the risk management framework should be embedded in the organization within the bank’s
overall strategic and operational policies and procedures.
Risk Management
Framework
Operations
Strategy
Figure 2.4 Risk management, strategy and operations
Different banks apply different approaches in embedding their respective risk management
frameworks in their strategic and operational practices. The most popular approach is the
three lines of defence model. (We will extensively discuss the three lines of defence model in a later
section.)
2.3.2
Uses of the Risk Management Framework
Risk management framework assists in managing risks effectively through the application of
the risk management process at varying levels and within specific contexts of the organization.
The framework ensures that information about risk derived from the risk management
process is adequately reported and used as a basis for decision-making and accountability at
all relevant organizational means. The framework assists in integrating risk management into
the overall management system.
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Chapter 2 Risk Management Principles and Framework
2.3.3
Elements of a Sound Risk Management Framework
Figure 2.5 shows the various elements—at a minimum—of a sound risk management
framework.
Effective Risk Governance
Risk Appetite
Risk Culture
Risk Management Policy
Risk Management Organization
Figure 2.5 Elements of a risk management framework
Effective risk governance
The 2008 global financial crisis exposed a number of governance weaknesses that resulted in
the banks’ failure to understand the risks they were taking.
The Financial Stability Board (FSB) enumerated the weaknesses on risk governance that
were highlighted in the 2008 global financial crisis. FSB is an international body that monitors
and makes recommendations about the global financial system and promotes international
stability. FSB coordinates national financial authorities and international standard-setting
bodies as they work toward developing strong regulatory, supervisory and other financial
sector policies. The weaknesses are:
ŸŸMany members of the board of directors had little financial industry experience and have
limited understanding of the rapidly increasing complexity of the financial institutions
they were governing.
ŸŸMany boards did not pay sufficient attention to risk management or set up effective
structures, such as a dedicated risk committee.
ŸŸMany risk committees were often staffed by directors short on both experience and
independence from management.
ŸŸThe information provided to the board were voluminous and not easily understood.
ŸŸMany banks lacked a formal process to independently assess the propriety of their risk
governance frameworks.
ŸŸA culture of excessive risk-taking and leverage were allowed to permeate in the weaklygoverned banks.
The International Risk Governance Council (IRGC) defines governance as the actions,
processes, traditions and institutions by which authority is exercised and decisions are
taken and implemented. Risk governance applies the principles of good governance to the
identification, assessment, management and communication of risks. IRGC is a non-profit and
independent organization involved in helping improve the understanding and governance of
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Risk Management in Banking: Principles and Framework
systemic risks that have impacts on human health and safety, the environment, the economy
and on society at large.
Risk governance is concerned with:
ŸŸthe roles of board of directors in setting risk strategy, an effective risk management
framework and oversight of senior management actions;
ŸŸthe role of senior management in ensuring that day-to-day management of business
activities is consistent with the risk appetite, strategy and policies approved by the board;
ŸŸthe risk management process and internal control functions are working in a sound
manner;
ŸŸthe effects of incentives and organizational culture on risk-taking behaviours and
perceptions of risk in the institution;
ŸŸthe availability of comprehensive and integrated systems to support enterprise-wide or
consolidated view of risks for both the individual financial institution and for the group;
and
ŸŸthe capacity of institutions to respond swiftly to changes in the operating environment
and development in the institution’s business strategies.
A risk governance framework is the framework through which the board and management
establish the organization’s strategy, articulate and monitor adherence to risk appetite and
risk limits, and identify, measure and manage risks. The framework comprises three main
functions:
1. Board of directors
2. Risk management function
3. Functions charged with the independent assessment of risk governance
Board of Directors
Risk Management
Function
Independent
Assessment of Risk
Governance
Figure 2.6 Different functions in the risk management framework
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Chapter 2 Risk Management Principles and Framework
In the next section, we look at the interactions among these three different functions of a
risk governance framework proposed by the Financial Stability Board.
Table 2.2 Key roles in the risk governance framework
Summary of Key Roles in the Risk Governance Framework
Board of directors
ŸŸ The board is responsible for ensuring that the organization has the
appropriate risk governance framework given its business model,
complexity and size which is embedded in the organization’s risk culture.
Risk management function
ŸŸ The chief risk officer (CRO) and the risk management function are
responsible for the organization’s risk management across the entire
entity, ensuring that its profile remains within the risk appetite statement as
approved by the board.
ŸŸ The risk management function is responsible for identifying, measuring,
monitoring and recommending strategies to control or mitigate risks, and
reporting on risk exposures on an aggregated and disaggregated basis.
Independent assessment
of the risk governance
framework
ŸŸ The independent assessment of the organization’s risk governance
framework plays a critical role in the ongoing maintenance of its internal
controls, risk management and risk governance.
ŸŸ It helps the organization accomplish its objectives by bringing a disciplined
approach to evaluate and improve the effectiveness of risk management,
control and governance processes. This may involve internal parties (such
as internal audit) or external parties (such as third-party reviewers, e.g.
audit firms and consultants).
The Financial Stability Board, in its February 2013 thematic review of risk governance
practices of banks, came up with the following recommendations:
ŸŸSet requirements on the independence and composition of the boards, including
requirements on the relevant types of skills of the board, collectively, should have (e.g.
risk management, financial industry expertise) as well as the time commitment expected.
ŸŸHold the board accountable for its oversight of the bank’s risk governance.
ŸŸEnsure that the level and types of risk information provided to the board enable effective
discharge of board responsibilities. Boards should satisfy themselves that the information
they receive from management and the control functions is comprehensive, accurate,
complete and timely to enable effective decision-making on the organization’s strategy,
risk profile and emerging risks. This includes establishing communication procedures
between the risk committee and the board, and across other board committees, most
importantly, the audit and finance committees.
ŸŸSet requirements to elevate the chief risk officer’s (CRO’s) stature, authority and
independence in the organization. This includes requiring the risk committee to review
the performance and objectives of the CRO; ensuring that the CRO has unfettered access
to the board and risk committee, including a direct reporting line to the board and/or
risk committee; and expecting the CRO to meet periodically with the directors without
the executive directors and management present.
ŸŸThe CRO should have a direct reporting line to the chief executive officer (CEO) and
a distinct role from other executive functions and business line, e.g. no ‘dual-hatting’.
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ŸŸThe CRO should be involved in activities and decisions (from a risk perspective) that may
affect the organization’s prospective risk profile, e.g. strategic business plans, new products,
mergers and acquisitions, and the internal capital adequacy assessment process (ICAAP).
ŸŸRequire the board (or audit committee) to obtain an independent assessment of the
design and effectiveness of the risk governance framework on an annual basis.
An example of Bank Negara Malaysia on their principles of risk governance (1 March 2013):
Board Practices
ŸŸThe board must ensure that the financial institution’s corporate objectives are
supported by a sound risk strategy and an effective risk management framework that
is appropriate to the nature, scale and complexity of its activities.
ŸŸThe board must provide effective oversight of senior management’s actions to ensure
consistency with the risk strategy and policies approved by the board, including the
risk appetite framework.
Senior Management Oversight
ŸŸSenior management is responsible for ensuring that day-to-day management of the
financial institution’s activities is consistent with the risk strategy, including the risk
appetite and policies approved by the board.
Risk Management and Internal Controls
ŸŸThe risk management framework must enable the continuous identification,
measurement and continuous monitoring of all relevant and material risks on a groupand firm-wide basis, supported by robust management information systems that
facilitate the timely and reliable reporting of risks and the integration of information
across the institution. The sophistication of the financial institution’s risk management
framework must keep pace with any changes in the institution’s risk profile (including
its business growth and complexity) and the external risk environment.
ŸŸRisk management must be well-integrated throughout the organization and
embedded into the culture and business operations of the institution.
ŸŸFinancial institutions must establish an independent senior risk executive role (chief
risk officer or its equivalent) with distinct responsibility for the risk management
function and the institution’s risk management framework across the entire
organization. The executive must have sufficient stature, authority and seniority
within the organization to meaningfully participate in and be able to influence
decisions that affect the financial institution’s exposures to risk.
ŸŸFinancial institutions must establish and maintain an effective risk management
function with sufficient authority, stature, independence, resources and access to the
board.
ŸŸEffective implementation of the risk management framework must be reinforced with
an effective compliance function and subjected to an independent internal audit review.
ŸŸFinancial institutions must have appropriate mechanisms in place for communicating
risks across the organization and for reporting risk developments to the board and
senior management.
Remuneration
ŸŸExecutive remuneration must be aligned with prudent risk-taking and appropriately
adjusted for risks. The board must actively oversee the institution’s remuneration
structure and its implementation, and must monitor and review the remuneration
structure to ensure that it operates as intended.
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Complex and Opaque Corporate Structures
ŸŸThe board and senior management must be aware of and understand the institution’s
operational and organizational structure and the risks it poses and be satisfied that
it is not overly complex or opaque such that it hampers effective risk management by
the financial institution.
ŸŸWhere a financial institution operates through special-purpose structures, its board
and senior management must understand the purpose, structure and unique risks
of these operations. Appropriate measures must be undertaken to mitigate the risks
identified.
Role of Subsidiary and Parent Entities with Respect to Risk Governance
ŸŸThe board and senior management of subsidiary financial institutions will be held
responsible for effective risk management processes at the subsidiary level and must
have appropriate influence in the design and implementation of risk management in
the subsidiary. Conversely, the board and management of a parent financial institution
with local and overseas operations is responsible for the risk management of the group
and must exercise oversight over its subsidiaries with appropriate processes established
to monitor the subsidiaries’ compliance to the group’s risk management practices.
Source: Bank Negara Malaysia website
Risk appetite
Risk appetite is the aggregate level and types of risk a financial institution is willing to
assume within its risk capacity to achieve its strategic objectives and business plan (Financial
Stability Board). Risk appetite is a key and integral component of a bank’s risk management
framework.
In November 2013, the FSB released the final version of the Principles for an Effective Risk
Appetite Framework. The document sets out key elements for an effective risk appetite framework,
effective risk appetite statement, risk limits and defining the roles and responsibilities of
board of directors and senior management. It presents high-level principles to allow banks to
develop an effective risk appetite framework.
The risk appetite framework is the overall approach, including policies, processes, controls
and systems through which risk appetite is established, communicated and monitored.
ŸŸCharacteristics of an effective risk appetite framework
An effective risk appetite framework should:
mm Establish a process for communicating the risk appetite framework across and within
the financial institution as well as sharing non-confidential information to external
stakeholders.
mm Be driven by both top-down board leadership and bottom-up involvement of
management at all levels, and embedded and understood across the financial
institution.
mm Facilitate embedding risk appetite into the financial institution’s risk culture.
mm Evaluate opportunities for appropriate risk-taking and act as a defence against
excessive risk-taking.
mm Allow for the risk appetite statement to be used as a tool to promote robust
discussions on risk and as a basis upon which the board, risk management and
internal audit functions can effectively and credibly debate and challenge management
recommendations and decisions.
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Be adaptable to changing business and market conditions so that, subject to approval
by senior management and the board as appropriate, opportunities that require an
increase in limit of a business line or legal entity could be met while remaining within
the agreed institution-wide risk appetite.
mm Cover activities, operations, and systems of financial institutions that fall within its
risk landscape but are outside its direct control, including subsidiaries and third-party
outsourcing providers.
mm
ŸŸElements of the risk appetite framework
The risk appetite framework generally has three main components:
mm Risk appetite statement (RAS)
mm Risk limits
mm Roles and responsibilities of those overseeing the implementation and monitoring of
the risk appetite framework
Risk Appetite Statement (RAS)
Risk Limits
Roles and Responsibilities
Figure 2.7 Elements of the risk appetite framework
Risk appetite statement (RAS) is an articulation in written form of the aggregate
level and types of risk that a financial institution is willing to accept or to avoid, in order
to achieve its business objective. The RAS includes:
mm quantitative measures of loss or negative outcomes expressed relative to earnings,
capital, risk measures, liquidity and other relevant measures as appropriate, e.g.
volatility; and
mm qualitative statements.
The RAS should address more difficult to quantify risks, such as reputation and conduct
risks as well as money laundering and unethical practices. The statement should be
directly linked to the financial institution’s strategy, address its material risks under both
normal and stressed market and macroeconomic conditions, and set clear boundaries
and expectations by establishing quantitative limits and qualitative statements.
ŸŸKey characteristics of an effective RAS:
mm Includes key background information and assumptions that inform the financial
institution’s strategic and business plans at the time they were approved.
mm Be linked to the institution’s short- and long-term strategic, capital and financial
plans as well as compensation programmes.
mm Establish the amount of risk that the financial institution is prepared to accept in
pursuit of its strategic objectives and business plan, taking into account the interests
of its customers and its fiduciary duty to shareholders as well as capital and other
regulatory requirements.
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Chapter 2 Risk Management Principles and Framework
mm
mm
mm
mm
mm
Determine for each material risk the maximum level of risk that the financial
institution is willing to operate within, based on its overall risk appetite, risk capacity
and risk profile.
Includes quantitative measures that can be translated into risk limits applicable to
business lines and legal entities as relevant, and also at the group level, which in turn
can be aggregated and disaggregated to enable measurement of the risk profile against
the risk appetite and risk capacity.
Includes qualitative measures that articulate clearly the motivations for taking
on or avoiding certain types of risks, including for reputational and other conduct
risks across retail and wholesale markets, and establish some form of boundaries or
indicators to enable monitoring of these risks.
Ensure that the strategy and risk limits of each business line and legal entity are
aligned with the institution-wide risk appetite statement.
Be forward looking and, where applicable, subject to scenario and stress testing
to ensure that the financial institution understands what events might push the
organization outside its risk appetite and/or risk capacity.
Below are good examples of the RAS for both financial and non-financial risks:
Real World Illustration
ING Bank NV Risk Appetite Statement (Financial Risks)
Financial risks
For financial risks, ING Bank expresses its risk appetite as the tolerance to allow key ratios to
deviate from their target levels. Therefore the high-level risk ambition is translated into quantitative
targets on ING Bank level for solvency risk, liquidity and funding risk and for concentration and
event risk.
The solvency risk appetite is closely aligned to Capital Management activities and policies. ING
Bank has expressed tolerances for its risk-weighted solvency position (core tier 1 ratio), for nonrisk weighted solvency (leverage ratio) and for more value-based solvency (economic capital).
The solvency risk appetite statements are not only compared to the actual reported level, but also
include the potential impact of a standardised and pre-determined one in 10 years stress event
(i.e. at the 90% confidence level and a one-year horizon). Based on this mild stress scenario the
impact on ING Bank’s earnings, revaluation reserve and RWA is calculated (which are labelled as
earnings-at-risk, revaluation reserve-at-risk and RWA-at-risk). These stressed figures are used
as input for a two-year simulation which depicts the developments of ING Bank’s solvency level
versus its risk appetite.
Liquidity and funding risk have two dimensions—where liquidity focuses on having a sufficient
buffer to cope with the short-term situation, managing the funding profile ensures long-term
compliance to both internal and external targets. Managing liquidity and funding risk focuses on
both ‘business as usual’ (based on the run-off profile to show the stickiness of deposits combined
with the run-off of assets without new production) and a stressed situation. There we define
liquidity risk as the time to survive a specific scenario, while for funding risk, we focus on the
maximum funding gap allowed.
The concentration and event risk appetite set at ING Bank level are directly translated into
corresponding limits in the underlying credit, market and liquidity and funding risk appetite
statements.
Source: ING Bank Annual Report 2012
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Real World Illustration
ING Bank NV Risk Appetite Statement (Non-Financial Risks)
Non-financial risks
To ensure robust non-financial risk management, ING Bank monitors the implementation of
ING Bank’s Risk Policies and Minimum Standards. Business units have to demonstrate that
appropriate steps have been taken to control their operational, compliance and legal risks. ING
Bank applies Key Control testing scorecards to measure the quality of the internal controls within
a business unit, which are based on the ability to demonstrate that the required risk management
processes are in place and effective within the business units.
Key Control testing forms one of the inputs of the Non-Financial Risk Dashboard (NFRD) which is
a report that is a fixed item on the agenda for the meetings of the MBB and the Risk Committee.
NFRD provides management at all organisational levels with information on their key operational,
compliance and legal risks. NFRD is based on their risk tolerance within their business and a
clear description of the risks and responses enabling management to prioritize and to manage
operational, compliance and legal risks.
Source: ING Bank Annual Report 2012
Risk limits are quantitative measures based on forward-looking assumptions that
allocate the financial institution’s aggregate risk appetite statement to business lines,
legal entities as relevant, specific risk categories, concentrations and other levels as
deemed appropriate. Some of the considerations in setting risk limits are as follows:
mm Risk limits should be set at a level to constrain risk-taking within the approved risk
appetite, taking into account the interest of customers and shareholders as well as
capital and other regulatory requirements, in the event that a risk limit is breached
and the likelihood that each material risk is realized.
mm Risk limits should be established for business lines and legal entities, and generally
expressed relative to:
–– Earnings
–– Capital
–– Liquidity
–– Other relevant measures, e.g. growth and liquidity
mm Risk limits should include material concentrations at the institution or group-wide,
business line and legal entity levels. Examples of the breakdown of material risk
concentrations are:
–– By counterparty
–– By industry
–– By country/region
–– By collateral type
–– By product
mm Risk limits should not be strictly based on comparison to peers or default to regulatory
limits.
mm Risk limits should not be overly complicated, ambiguous or subjective.
mm Risk limits should be monitored regularly.
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Chapter 2 Risk Management Principles and Framework
The following is an example of how risk limits are cascaded into statements per risk
type and per business:
Real World Illustration
ING Bank NV Risk Limits
The Bank Risk Appetite is translated per risk type, which is further cascaded down through the
organization to the lowest level needed. The risk appetite statements are then translated into
dedicated underlying risk limits which are used for day-to-day monitoring and management of
ING Bank’s risks.
For financial risks a sequence of different risk appetite frameworks are implemented to address
the most significant risks. This implies that a whole framework of credit risk limits is in place that
monitors the overall quality of the ING Bank credit portfolio, but also of all the underlying portfolios.
In addition, specific concentration risk appetites are defined on product level, geographic level
and (single name) counterparty level which are cascaded down into the organization. For market
risk, the risk appetite for the trading book activities within Financial Markets is accompanied by a
risk appetite framework for market risks in the banking books. For both types of market risk, limits
at bank level are translated down into the organization. The liquidity and funding risk appetite
statements that are defined on ING Bank level are translated down into the organization, taking
the liquidity and funding specific situation of each (solo) unit into account.
The non-financial risk appetite framework that is described under the previous step is cascaded
down within the organization without any need to make specific adjustments for each of the
reporting solo entity.
Source: ING Bank Annual Report 2012
Table 2.3 Roles and Responsibilities in Risk Appetite Setting
Roles and Responsibilities in Setting the Risk Appetite Framework
Chapter-02.indd 51
Board of directors
ŸŸ The board of directors is primarily responsible for approving the banking
organization’s risk appetite framework. It is also responsible for holding senior
management accountable for the integrity of the risk appetite framework. The
board should conduct periodic high-level review of actual versus approved limits.
Any breaches should be dealt with accordingly.
Chief executive officer
ŸŸ The chief executive officer (CEO) is responsible for establishing the risk appetite
for the banking organization. He/She is also responsible for translating the risk
appetite into risk limits for business lines and legal entities.
ŸŸ The CEO is accountable, together with the rest of the senior management team,
for the integrity of the risk appetite framework and for ensuring that the risk
appetite framework is implemented throughout the organization.
Chief risk officer
ŸŸ The chief risk officer (CRO) provides relevant inputs to the CEO in developing
the organization’s risk appetite. He/She is responsible for actively monitoring
the organization’s risk profile relative to its risk appetite, strategy, business and
capital plans, risk capacity and compensating programme.
ŸŸ The CRO is responsible for independently monitoring the business line and
legal entity risk limits against the bank’s aggregate risk profile to ensure that it is
aligned with the bank’s risk appetite. He/She is also responsible for establishing
a process for reporting on risk and on alignment of risk appetite and risk profile
with the organization’s culture.
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Roles and Responsibilities in Setting the Risk Appetite Framework
Chief financial officer
ŸŸ The chief financial officer (CFO) provides relevant inputs to the CEO in
developing the risk appetite of the bank, particularly in the area of integrating risk
appetite into the organization’s compensation and decision-making processes.
The CFO works with the CRO and CEO to ensure that breaches in risk limits and
material risk exposures that could endanger the organization’s financial condition
are reported in a timely manner.
Business line leaders
and legal entity-level
management
ŸŸ Business line leaders and legal entity-level management cascade the risk
appetite statement and risk limits into their activities. They should establish
and ensure adherence to approved risk limits. They are also responsible for
implementing controls to effectively monitor and report risk limits adherence.
Internal audit
ŸŸ Internal audit is responsible for independently assessing the integrity, design and
effectiveness of the organization’s risk appetite framework.
Risk culture
The Institute of International Finance (IIF) defines risk culture broadly as ‘the norms and
traditions of behaviour of individuals and of groups in an organization that determine the
way they identify, understand, discuss and act on the risks the organization confronts and the
risk it takes’. This definition implies that risk culture influences decisions at all levels in the
organization.
The Institute of Risk Management (IRM) defines risk culture as ‘the values, beliefs,
knowledge and understanding about risk shared by a group of people with a common purpose,
in particular the employees of an organization or of teams or groups within an organization’.
Many considered the lack of a sound risk culture as one of the root causes of the global
financial crisis. Many banks encouraged excessive risk-taking behaviours that have impacted
the banks in various ways, from damaging their reputation to incurring huge legal fines to
exposing their banks to the threat of collapse. Some banks continued to build up risk before
the onset of the 2008 financial crisis without considering the implications of a potential
blowup.
The Financial Stability Board (FSB) issued a consultative document entitled Guidance on
Supervisory Interaction with Financial Institutions on Risk Culture to help understand and assess
an institution’s risk culture and whether it supports appropriate behaviours and judgements
within a risk governance framework.
ŸŸElements of a sound risk culture
There are four elements of a sound risk culture—tone from the top, accountability, effective
communication and challenge, and incentives.
mm Tone from the top
Key Points:
–– The board of directors and senior management are the starting point for setting
a bank’s risk culture and promoting appropriate risk-taking behaviours, which
must reflect the values being espoused.
–– It is a necessary but not a sufficient condition for promoting sound risk management.
–– Non-executive directors can play an important role in bringing experience from other
industries where behaviours and practices generally require a sound risk culture.
Examples of these industries are health-care, power and nuclear energy. These nonexecutive directors may offer a fresh perspective on the bank’s risk culture.
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Chapter 2 Risk Management Principles and Framework
Real World Illustration
Nuclear Safety Culture
Nuclear safety culture is the core values and behaviours resulting from a collective commitment
by leaders and individuals to emphasize safety over competing goals to ensure protection of
people and the environment. Below are the principles of a sound nuclear safety culture:
1. Everyone is personally responsible for nuclear safety.
2. Leaders demonstrate commitment to safety.
3. Trust permeates the organization.
4. Decision-making reflects safety first.
5. Nuclear technology is recognized as special and unique.
6. A questioning attitude is cultivated.
7. Organizational learning is embraced.
8. Nuclear safety undergoes constant examination.
Source: Institute of Nuclear Power Operations
–– The board of directors and senior management should clearly:
§§ articulate the underlying values that support the desired risk culture and
behaviours;
§§ recognize, promote and reward behaviour that reflects the stated risk culture
and its core values; and
§§ systematically monitor and assess the actual culture.
Table 2.4 Indicators of tone from the top
Indicators of Tone from the Top
(adapted from the General Supervisory Guidance section of the Guidance on Supervisory Interaction with
Financial Institutions on Risk Culture by the Financial Stability Board (FSB), 7 April 2014)
Chapter-02.indd 53
Leading by example
The board of directors and senior management should:
ŸŸ establish, monitor and adhere to an effective risk appetite statement
ŸŸ have a clear view of the risk culture
ŸŸ systematically monitor and assess the prevailing risk culture and proactively address
any identified areas of weakness or concern
ŸŸ promote through action and words a risk culture that expects integrity and a sound
approach to risk
ŸŸ promote an open exchange of views, challenge and debate
ŸŸ have mechanisms in place which help lessen the influence of dominant personalities
and behaviours.
Espoused values
The board of directors and senior management should:
ŸŸ systematically monitor and assess whether the espoused values are communicated
and adhered to by management and staff at all levels
ŸŸ ensure that the risk appetite statement, risk management strategy and overall
business strategy are clearly understood and embraced by management and staff
at all levels and effectively embedded in the decision-making and operations of the
business
ŸŸ establish a compensation structure that supports the institution’s espoused values
and promotes prudent risk-taking behaviour.
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Risk Management in Banking: Principles and Framework
Indicators of Tone from the Top
(adapted from the General Supervisory Guidance section of the Guidance on Supervisory Interaction with
Financial Institutions on Risk Culture by the Financial Stability Board (FSB), 7 April 2014)
Common
understanding and
awareness of risk
The board of directors and senior management should:
ŸŸ demonstrate a clear understanding of the quality and consistency of decisionmaking throughout the business, including how decision-making is consistent with
the bank’s risk appetite and risk strategy
ŸŸ have a clear view on the business lines considered to pose the greatest challenges
to risk management and these are subject to constructive and credible challenge
about the risk-return balance
ŸŸ systematically monitor how quickly issues raised by the board, supervisors, internal
audit, and other control functions are addressed by management.
Learning from risk
culture failures
The board of directors and senior management should:
ŸŸ establish processes to ensure that failures or near failures in risk culture are reviewed
at all levels of the bank and are seen as opportunities to strengthen the bank’s risk
culture and make it more robust.
mm
Accountability
Key Points:
–– The board of directors and senior management should establish a policy of risk
ownership where employees are held accountable for their actions and are aware of
the consequences of not adhering to the desired behaviour toward risk.
–– There should be a clear delineation of responsibilities with regard to monitoring,
identification, management and mitigation of risk.
–– Employees at all levels should understand the core values of the bank’s risk culture
and its approach to risk, be capable of performing their prescribed roles, and be
aware that they are held accountable for their actions in relation to the bank’s risktaking behaviour.
Table 2.5 Indicators of accountability
Indicators of Accountability
(adapted from the General Supervisory Guidance section of the Guidance on Supervisory Interaction with
Financial Institutions on Risk Culture by the Financial Stability Board (FSB), 7 April 2014)
Chapter-02.indd 54
Risk ownership
ŸŸ Clear expectations should be set with respect to monitoring, reporting and responding
to current and emerging risk information across the institution, including from the
lines of business and risk management to the board and senior management.
Mechanisms should be in place for the lines of business to share information on
emerging and unexpected risks.
ŸŸ Employees are held accountable for their actions and are aware of the consequences
for not adhering to the desired risk management behaviour.
Escalation process
ŸŸ Escalation processes should be established and used with clear consequence for
non-compliance with risk policies and escalation procedures.
ŸŸ Employees should be aware of the process and believe that the environment is
open to critical challenge and dissent. These mechanisms should be established for
employees to raise concerns when they feel discomfort about products or practices.
ŸŸ Whistleblowing should be proactively encouraged and supported by the board and
senior management.
Enforcement
ŸŸ Consequences should be clearly established, articulated and applied for the
business lines or individuals who engaged in excessive risk-taking relative to the risk
appetite statement. Breaches in internal policies, procedures and risk limits and nonadherence to internal code of conducts should impact an individual’s compensation
and responsibilities or affect career progression including termination.
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Chapter 2 Risk Management Principles and Framework
mm
Effective communication and challenge
Key Points:
–– A sound risk culture promotes an environment of effective communication and
challenge in which decision-making processes promote a range of views, allow
for testing of current practices and stimulate a positive, critical attitude among
employees and an environment of open and constructive engagement.
–– A sound risk culture must encourage transparency and open dialogue in order to
promote the identification and escalation of risk issues.
Board
Management
Staff
Figure 2.8 Open dialogue in effective communication and challenge
Table 2.6 Indicators of effective communication and challenge
Indicators of Effective Communication and Challenge
(adapted from the General Supervisory Guidance section of the Guidance on Supervisory Interaction with
Financial Institutions on Risk Culture by the Financial Stability Board (FSB), 7 April 2014)
Open to dissent
ŸŸ Alternate views or questions from individuals and groups are encouraged, valued and
respected and occur in practice. Senior management should have mechanisms in
place to ensure that alternate views can be expressed in practice, and should request
regular assessments of the openness to dissent at all layers of management involved
in the decision-making process.
Stature of risk
management
ŸŸ The chief risk officer and the risk management function share the same stature as
the lines of businesses, actively participating in senior management committees and
proactively involved in all the relevant risk decisions and activities. They should have
appropriate access to the board and senior management.
ŸŸ Compliance, legal and other control functions should have sufficient stature not only to
act as advisors but also to effectively exert control tasks with respect to the institution’s
risk culture.
mm
Incentives
Key Points:
–– Financial and non-financial incentives should support the core values and risk
culture at all levels of the financial institution.
–– Performance and talent management should encourage and reinforce maintenance
of the institution’s desired risk management behaviour.
–– Remuneration systems should reward servicing the greater, long-term interest of
the bank and its clients.
–– Risk management and compliance considerations should have sufficient status in
driving compensation, promotion, hiring and performance evaluation.
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Risk Management in Banking: Principles and Framework
Table 2.7 Indicators of incentives
Indicators of Incentives
(adapted from the General Supervisory Guidance section of the Guidance on Supervisory Interaction with
Financial Institutions on Risk Culture by the Financial Stability Board (FSB), 7 April 2014)
Remuneration
and
performance
ŸŸ Remuneration and performance metrics should consistently support and drive the
bank’s desired risk-taking behaviour, risk appetite and risk culture. Annual performance
reviews and objective-setting processes include steps taken by the individual to promote
the bank’s desired core values, compliance with policies and procedures, internal audit
results and supervisory findings.
ŸŸ Incentive compensation programmes systematically include individual and group
adherence to the bank’s core values and risk culture, including:
mm treatment of clients,
mm cooperation with internal control functions and regulators,
mm respect for risk exposure limits, and
mm alignment between performance and risk.
Talent
development
and succession
planning
Understanding key risks and essential elements of risk management and the culture of
the organization is a critical skill for senior employees. These should be reflected in the
development plans for employees. Succession planning processes for key management
positions include risk management experience and not only revenue-based accomplishments.
Training programmes are available for all staff to develop risk management competencies.
Risk management policy
A risk management policy is a statement of an organization’s overall intentions and direction
with respect to risk management. The risk management policy should clearly state the
objectives for, and commitment to, risk management.
ISO 31000 discusses the following issues that must be addressed in the risk management
policy:
ŸŸThe organization’s rationale for managing risk
ŸŸLinks between the organization’s objectives and policies and the risk management policy
ŸŸAccountabilities and responsibilities for managing risk
ŸŸThe way in which conflicts of interest are dealt with
ŸŸCommitment to make the necessary resources available to assist those accountable and
responsible for managing risk
ŸŸThe way in which risk management performance will be measured and reported
ŸŸCommitment to review and improve the risk management policy and framework
periodically and in response to an event or change in circumstances.
Risk management organization
While a unit is mandated to carry out the risk management function, risk management is the
responsibility of everyone in the organization. Everyone has a risk management role to play.
The International Finance Corporation (IFC) manual on Standards on Risk Governance for
Financial Institutions enumerates the different roles of those within the banking organization,
who are directly or indirectly involved in risk management. It proposes a vertical structure
descending from the board of directors to the board risk committee, the chief executive
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Chapter 2 Risk Management Principles and Framework
officer and the chief risk officer, the risk management committee up to the dedicated risk
management function.
Board of Directors
Executive Management Risk Committee
Management Risk Committee
(e.g. ALCO, Credit Committee, or Committee, etc.)
Information reporting
Oversight
BoD RM Committee
Lines of Business Risk Committees
Business Units—Risk Origination
Figure 2.9 Vertical risk management organizational structure by the IFC
ŸŸBoard of directors (BoD)
mm Sets policies, strategies and objectives and oversees the executive function.
mm Sets the risk appetite and ensure that it is reflected in the business strategy and
cascaded throughout the organization.
mm Establishes and oversees an effective risk governance and organizational structure.
ŸŸBoard risk committee
mm The board risk committee is a dedicated board-level committee mandated by the BoD
to perform a more focused risk oversight function. It is responsible for:
–– making recommendations on risk appetite;
–– reviewing periodically the bank’s risk profile;
–– reviewing strategic decisions from a risk perspective;
–– reviewing periodically the risk management and internal controls framework
relative to the bank’s risk profile;
–– approving risk policies, limits and delegations;
–– considering key risk issues brought up by management or requesting information
about risk issues; and
–– reviewing and recommending for BoD’s approval key policy statements required
by the regulators.
mm The board risk committee guides the process of risk appetite setting and ensures that
risk issues are given sufficient weight in deliberations by the BoD.
mm The committee ensures that reporting is adequate to properly inform board decisions,
and the decisions are properly communicated and understood at the executive level.
mm The committee ensures that key users of risk information are given a complete picture
and adequate interpretation of the bank’s risk profile.
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ŸŸChief risk officer
mm The chief risk officer (CRO) has the broad and exclusive responsibility for all risk issues.
The CRO performs the most critical executive function relating to risk management.
mm The CRO should have direct access to the board risk committee, both to present
information and risk issues.
mm The CRO should be a member of the bank’s executive/management board, reporting
to either the CEO or the BoD.
mm The CRO should be able to adequately communicate the risk assessment to the BoD
and facilitate sound board-level risk decisions.
mm The CRO should have sufficient technical expertise to understand the intricacies of
the bank’s risk exposures.
Real World Illustration
Board Risk Committees—Risk Governance Structure HSBC
Below is HSBC’s risk governance structure. Note the various board-level committees responsible
for risk or risk-related matters.
Authority
Board
Governance Risk
Committee (GRC)
Financial System
Vulnerabilities
Committee
Risk Management
Meeting of
the Global
Management
Board (GMB)
Chapter-02.indd 58
Governance Structure for the Management of Risk
Membership
Responsibilities
Executive and
• Approves risk appetite, strategy and
non-executive Directors
performance targets for the Group
• Approves appointment of senior risk officers
• Delegates authority for risk management
• Encourages a strong risk governance culture
which shapes the Group’s attitude to risk
Independent non-executive • Advises the Board on:
Directors
− risk appetite and alignment with strategy
− alignment of remuneration with risk appetite
(through advice to the Group Remuneration
Committee)
− risks associated with proposed strategic
acquisitions and disposals
• Reviews the effectiveness of the Group’s
systems of risk management and internal
controls (other than over financial reporting)
• Oversees the maintenance and development
of a supportive culture in relation to the
management of risk
Executive Directors and
• Oversees controls and procedures designed to
co-opted non-director
identify areas of exposure to financial crime or
members
system abuse
• Oversees matters relating to anti-money
laundering, sanctions, terrorist financing and
proliferation financing
• Reviews policies and procedures to ensure
continuing obligations to regulatory and law
enforcement agencies are met
Group Chief Risk Officer
• Formulates high-level global risk policy
Group Chief Legal Officer
• Exercises delegated risk management authority
Group Chief Executive
• Oversees implementation of risk appetite and
Group Finance Director
controls
All other Group Managing
• Monitors all categories of risk and determines
Directors
appropriate mitigating action
• Promotes a supportive Group culture in relation
to risk management
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Chapter 2 Risk Management Principles and Framework
Authority
Global Standards
Steering Meeting
of the GMB
Global Risk
Management
Board
Subsidiary board
committees
responsible
for risk-related
matters and global
business risk
committees
Membership
Group Chief Risk Officer
Group Chief Legal Officer
Group Chief Executive
Group Finance Director
All other Group Managing
Directors
Group Chief Risk Officer
Chief Risk Officers of
HSBC’s global businesses
and regions
Heads of risk areas within
the Global Risk Function
Responsibilities
• Develops and implements global standards
reflecting best practices which must be adopted
and adhered to throughout the Group
• Oversees initiatives to ensure our conduct
matches our values
• Supports the Risk Management Meeting and
the Group Chief Risk Officer in providing
strategic direction for the Global Risk function,
sets priorities and oversees their execution
• Oversees consistent approach to accountability
for, and mitigation of, risk across the Global
Risk function
Independent non-executive • Provides certification to the GRC or
Directors and/or other
intermediate risk committee on risk-related
independent members, as
matters and internal controls (other than over
appropriate
financial reporting) of relevant subsidiaries or
businesses, as appropriate
Source: HSBC Annual Report 2012
ŸŸRisk management function
mm
mm
mm
Chapter-02.indd 59
The risk management function is an independent function reporting directly to the
CRO with a comprehensive mandate covering all risk types and business lines.
It is a dedicated function with the primary responsibility, together with the
different business lines, for assessment and control of market, credit, liquidity and
operational risk. Further functional specialization is also done to create units for risk
methodology, model, reporting, policy and technology.
The responsibilities of the risk management function are:
–– Collects and analyzes information for risk assessment;
–– Researches and implements externally- or internally-developed risk measurement
methodologies, including rating systems;
–– Estimates risk levels with its available methodologies;
–– Estimates economic capital;
–– Prepares proposals and analysis to assist the risk committee in developing risk
policies and setting risk limits;
–– Monitors risk pricing, rate setting, provisioning and hedging activities;
–– Contributes to measuring profitabilty by developing, testing or approving riskadjusted return measures and methodologies;
–– Approves risk-taking activities of significant impact within the established
framework of risk limits;
–– Makes recommendations to various committees regarding approvals of new
products that fall outside the established framework of risk limits;
–– Supports the board risk committee with routine reports and other information
and analysis;
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Risk Management in Banking: Principles and Framework
–– Monitors compliance with limits and policies and reports on all exposures on a
regular basis;
–– Participates in identifying and managing problem exposures, including problem
loans;
–– Educates all departments, risk-related committees and management bodies about
risk;
–– Communicates risks to senior management and all relevant departments;
–– Contributes risk analysis required in strategy setting and determining risk appetite;
and
–– Organizes regular meetings to discuss reports and issues relating to exposures,
risks, profits and losses, past and planned activities.
ŸŸBusiness units—risk origination: ‘three lines of defence’ model
In structuring their risk governance organizational structure, banks often rely on the
‘three lines of defence’ model. This model recognizes that everyone in an organization
has a responsibility to play a risk management role.
The three lines of defence model puts risk ownership across the three levels in the
bank—the business lines, risk management function and internal audit.
1st Line
• Business Line
2nd Line
• Risk Management Function
3rd Line
• Internal Audit
Figure 2.10 Three lines of defence model in risk management
The first line of defence is the risk-originating units of the bank, which are the business
lines. They originate products and activities which are the sources of risks. They are, therefore,
in a best position to address risk issues at the onset. Business lines are expected to embed
the risk management framework and sound risk management practices into their respective
standard operating procedures. Business lines are accountable and responsible for monitoring
risk management performance in operation. They must, therefore, adhere to all applicable
policies, procedures and processes established by the risk management function.
The second line of defence is the risk management function. It is responsible for developing
and implementing the risk management framework. It ensures that the risk management
framework covers all risks to which the bank is exposed to. It exercises approval authority in
accordance with delegated authorities.
The third line of defence is internal audit. Internal audit reviews effectiveness of risk
management practices. It confirms the level of compliance, recommends improvements and
enforces corrective actions where necessary.
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Chapter 2 Risk Management Principles and Framework
The case study below is a sample risk management structure from a global commercial
bank.
Supervisory Board
Audit Committee
Risk Committee
Management Board Bank
CRO
Bank Finance and Risk Committee
Risk Committees
Internal Audit
SB Level
Executive Level
2-tier board structure
CASE STUDY: ING Bank Risk Governance Structure Walkthrough
GCC(P)
GCC(TA)
ALCO Bank
Regional and BU Level
Non-Financial Risk Committee
Local and Regional Risk Committees
BU Line Management
Regional and Local
Managers
1st line of defence
Bank Risk Management Function
Regional and BU Risk Managers
2nd line of defence
3rd line of defence
Figure 2.11 The three lines of defence structure in ING Bank
The framework in Figure 2.12 shows a comprehensive risk governance structure that follows
the ‘three lines of defence’ model. Business unit (BU) line management, regional and local
managers serve as the first line of defence, being the risk originating units. The second line of
defence is the risk management function which is headed by the chief risk officer. The CRO
steers a functional, independent risk organization both at the bank and regional/local levels. The
third line of defence is the internal audit function, which provides an on-going independent and
objective assessment of the effectiveness of internal controls of the first two lines.
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Risk Management in Banking: Principles and Framework
SB Level
2-tier board structure
ŸŸBoard level oversight
Supervisory Board
Audit Committee
Risk Committee
Management Board Bank
CRO
Figure 2.12 ING Bank’s two-tier board structure
ING Bank has a two-tiered board structure:
mm Supervisory Board is responsible for supervising the policy of the Management
Board Bank and the bank’s general course of affairs and its business. The Supervisory
Board is assisted by two committees:
–– Audit Committee assists in reviewing and assessing ING Bank’s major risk exposures
and the operation of internal risk management and control systems, as well as
policies and procedures on compliance with applicable laws and regulations.
–– Risk Committee advises on matters relating to risk governance, risk policies and risk
appetite setting.
mm Management Board Bank is responsible for managing risks associated with the
bank’s activities. Its responsibilities include ensuring internal risk management
and control systems are effective and that the bank complies with relevant laws and
regulations.
ŸŸRole of the chief risk officer
The chief risk officer (CRO) ensures that the board is well informed and understand ING
Bank’s risk position at all times. He/She regularly reports on the bank’s risk appetite levels
and actual risk profile. The CRO also briefs the committees on developments in internal
and external risk-related issues and ensures that board committees understand specific
risk concepts. In addition, the CRO is responsible for the management and control of
risk at the consolidated level to ensure that the bank’s risk profile is consistent with its
financial resources and risk appetite. Lastly, he/she is also repsonsible for maintaining a
robust organizational basis for risk management.
Executive Level
ŸŸExecutive level
Bank Finance and Risk Committee
Risk Committees
GCC(P)
GCC(TA)
ALCO Bank
Non-Financial Risk Committee
Figure 2.13 The executive-level risk committees at ING Bank
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Chapter 2 Risk Management Principles and Framework
The Executive Level Bank Finance and Risk Committee is a platform for the CRO and
CFO to discuss and decide on issues pertaining to finance and risk. It coordinates, at a
high level, the finance and risk decisions that impact internal and/or external reporting.
There are four executive-level risk committees:
mm Credit Committee—Policy
Responsible for discussing and approving policies, methodologies and procedures
relating to country, credit and reputation risks within the bank.
mm Credit Committee—Transaction Approval
Discusses and approves transactions, which entail taking credit risk.
mm Asset and Liability Committee
Responsible for approving the overall profile of the bank’s market risks. It defines
policies regarding funding, liquidity, interest rate mismatch and solvency.
mm Non-Financial Risk Committee (NFRC)
Responsible for the design and maintenance of the risk management framework,
including the operational risk management, compliance and legal policies, minimum
standards, policies and guidelines, the NFRC structure and development of tools,
methods and key parameters for risk identification, measurement and monitoring/
reporting.
ŸŸRisk management function
mm The CRO bears overall responsibility for the risk management function.
mm There are three risk departments—Market, Credit and Non-financial Risk—which bear
direct responsibility for risk decisions at the bank level.
mm In addition, there are two departments that report to the CRO:
–– Risk Integration and Analytics—Responsible for inter-risk aggregation processes and
for providing bank-wide risk information to the CRO and the Management Board
Bank.
–– Model Validation—Carries out periodic validation of all material risk models used
by the bank. This department reports directly to the CRO to ensure independence.
CONCLUSION
In this chapter, we have discussed the objectives of risk management. We have introduced
the three elements of a sound risk management infrastructure, namely principles, framework
and process. We discussed the 11 principles for effective risk management. We also covered in
detail, the different elements of a sound risk management framework—risk governance, risk
appetite, risk culture, risk management policy and the risk organization.
In the next chapter, we will discuss the third element of a sound risk management
infrastructure—the risk management process.
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C
3
P
HA
TE
R
RISK MANAGEMENT
PROCESS
In the previous chapter, the overall risk management infrastructure including the
principles, framework and process were briefly introduced. It began with a discussion
of the objectives of risk management and the principles that underlie effective risk
management practices. We also discussed the risk management framework, which
provides the foundations and organizational arrangements for designing, implementing,
monitoring, reviewing and continually improving risk management throughout the
organization.
This chapter discusses the third component of the overall risk management
infrastructure—the risk management process. It begins with a general overview of the
risk management process, followed by a detailed discussion on the risk management
process of establishing the context, risk assessment and risk mitigation. As with the
previous chapter, the materials in this chapter are substantially taken or adapted from
ISO 31000: Risk Management—Principles and Guidelines (2009).
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Risk Management in Banking: Principles and Framework
Risk Management Process
Overview of Risk
Management
Process
Communication
and Consultation
Establishing
the Context
Risk
Assessment
Risk
Treatment
Risk Monitoring
and Review
Qualities of Sound
Risk Management
Process
Establishing the
External Context
Risk Identification
Avoid Risk
Risk Management
Activities
Establishing the
Internal Context
Risk Analysis
Take or
Increase Risk
Establishing the
Risk Management
Process Context
Risk Evaluation
Remove the
Risk Source
Risk Criteria
Change
Likelihood
Change
Consequences
Share the Risk
Risk Retention
Figure 3.1 Diagrammatic outline of this chapter’s topics
LEARNING OUTCOME
At the end of this chapter, you are expected to be able to:
ENUMERATE the different activities in the risk management process
LEARNING OBJECTIVES
At the end of this chapter, you will be able to:
DISCUSS the general risk management process and the different activities in the process
DISCUSS the importance of the communication and consultation process
EXPLAIN the importance of establishing the context of the risk management process
DISCUSS the different activities under the risk assessment process
ENUMERATE the different risk treatment options
DESCRIBE the risk monitoring and review process
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Chapter 3 Risk Management Process
3.1 OVERVIEW OF RISK MANAGEMENT
PROCESS
LEARNING OBJECTIVE
3.1
DISCUSS the general risk management process and the different activities in the process
ISO 31000 defines the risk management process as the:
‘Systematic application of management policies, procedures and practices to the activities of
communicating, consulting, establishing the context and identifying, analyzing, evaluating,
treating, monitoring and reviewing risk.’
Risk Management
Communicating and Consulting
Establishing the Context
Risk Assessment
Risk Treatment
Risk Monitoring and Review
Figure 3.2 Key activities of the risk management process
3.1.1
Qualities of a Sound Risk Management Process
In order for the risk management process to be effective, it should contain the following
qualities:
ŸŸThe process should be an integral part of management
For the risk management process to be effective, it should form part of the management
decision-making process. A risk management process that is divorced and separated
from the management decision-making process will have limited ability to influence the
likelihood that the banking organization will be able to achieve its risk management
objectives.
ŸŸThe process should be embedded in the organizational culture and practices
Given the complexity of banking organizations, the risk management process can only
be effective if it is deeply embedded in all the underlying business activities of these
institutions. The risk management process, regardless of its sophisticated design, will
not be effective unless it forms part of an organization’s culture and practices. Risk
culture involves an organization’s collective behaviours and attitudes toward risks.
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The Financial Stability Board (FSB) emphasizes the important role that risk culture
plays in influencing the actions and decisions taken by individuals within the institution
and in shaping an institution’s attitude toward its stakeholders.
ŸŸThe process should be tailored to the organization’s business processes
There is no risk management process template that can be imposed on any one banking
organization. The process should fit the unique circumstances of the individual bank.
However, the process should meet the minimum standards required by regulations and
international standards.
3.1.2
Risk Management Activities
The risk management process comprises different and distinct activities. Each activity has a
specific objective and role. The following sections will focus on each of the risk management
activities in detail. These activities are:
ŸŸCommunication and consultation
ŸŸEstablishing the context
ŸŸRisk assessment
ŸŸRisk treatment
ŸŸMonitoring and review
3.2 COMMUNICATION AND CONSULTATION
LEARNING OBJECTIVE
3.2
DISCUSS the importance of the communication and consultation process
For risk management to be effective, communication and consultation with all key external
and internal stakeholders should take place during all stages of the risk management process.
Communication and consultation is a continuous and iterative dialogue between the banking
organization and its stakeholders regarding risk management.
Communication is a two-way process that involves sharing information about the risk
management process. It is a process that the banking organization conducts to provide, share or
obtain information and to engage in dialogues with its stakeholders regarding risk management.
Organization
Stakeholders
Figure 3.3 Two-way communication between the bank and its stakeholders
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Chapter 3 Risk Management Process
Consultation is a two-way process of informed communication between the organization
and its stakeholders on an issue prior to making a decision or determining a direction on that
issue.
Communication and consultation ensures that the interests of different stakeholders are
understood and considered. This process is important as stakeholders make judgements on
risk based on their perceptions of the risk. The different perceptions of risk can significantly
impact the decisions and choices made by the banking organization.
The different risk perceptions of different stakeholders can be illustrated by the story of the
six blind men and the elephant. As the story goes, there are six blind men who have never seen
an elephant all their lives. One day, they got a chance to touch and feel an elephant. After that,
they argued strongly over what the elephant looks like.
Blind man 1: The elephant looks like a rope—after touching the tail
Blind man 2: The elephant looks like a wall—after touching the body
Blind man 3: The elephant looks like a spear—after touching a tusk
Blind man 4: The elephant looks like a tree branch—after touching the trunk
Blind man 5: The elephant looks like a pillar—after touching a leg
Blind man 6: The elephant looks like a hand fan—after touching an ear
fan
wall
rope
spear
pillar
branch
Figure 3.4 The six blind men and the elephant
Who among the blind men is correct? Clearly, no single person is correct! In the same
manner, risks are viewed differently by different stakeholders. This is why it is important for
the banking organization to conduct an extensive communication and consultation process
to ensure that all the different perspectives of the stakeholders are adequately considered in
developing the risk management infrastructure.
Communication and consultation with different stakeholders also helps to bring different
expertise together for analyzing risks and designing risk treatment strategies. Communication
and consultation should be done continuously for all phases of risk management. This helps
ensure adequacy and appropriateness of each phase of the risk management activities.
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Establishing
the Context
Communication
and
Consultation
Monitoring
and Review
Risk
Assessment
Risk
Treatment
Figure 3.5 Continuous communication and consultation
3.3 ESTABLISHING THE CONTEXT
LEARNING OBJECTIVE
3.3
EXPLAIN the importance of establishing the context of the risk management process
In this phase, the banking organization articulates its risk management objectives in a more
detailed manner compared to the risk management framework design process.
Establishing the context is an important prerequisite before the banking organization can
perform the risk assessment in an adequate and effective manner. In other words, it allows the
organization to:
ŸŸconsider the internal and external factors that must be considered in the risk assessment
phase;
ŸŸestablish the scope of the risk management process; and
ŸŸdefine the risk criteria for analyzing and assessing risks.
(a) External context—is the external environment in which the organization seeks to achieve its
objectives.
(b) Internal context—is the internal environment in which the organization seeks to achieve its
objectives.
(c) Risk management process context—includes the objectives, strategies, scopes and parameters of
the organization’s activities or those parts of the organization where the risk management
process is being applied.
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(d) Risk criteria—refers to the terms of reference against which the significance of risk is
evaluated.
3.3.1
Establishing the External Context
External context is the external environment in which the organization seeks to achieve its
objectives. Establishing the external context helps to ensure that the objectives and concerns
of external stakeholders are considered when developing the risk criteria. The external context
includes:
ŸŸCultural, social, political, legal, regulatory, financial, technological, economic, natural
and competitive environment
ŸŸKey drivers and trends having impacts on the organization’s objectives
ŸŸRelationships with, and perceptions and values of, external stakeholders
The risks the banking organization faces are, to a certain extent, influenced by external
events. The bank should identify and examine these events to ensure that the risk management
process adequately and appropriately captures these external factors. An example, which is of
foremost relevance to ASEAN banks, is the planned regional integration. If it pushes through
as planned, the ASEAN Economic Community (AEC) will be an external factor that could
affect risk management decisions of many banking organizations. Towards this end, banking
organizations must be prepared to seize the opportunities and to manage the risks of this
event.
Technological development is another example with potential effects on the banking
industry. For example, crowdfunding—the raising of funds from a large number of people
via the internet and social media—can potentially disrupt the business of commercial and
investment banking. Another important technological development is the emergence and
rising popularity of digital currencies, such as the bitcoin.
Banks should, therefore, consider all crucial external developments or events in the risk
management process.
3.3.2
Establishing the Internal Context
Internal context is the internal environment in which the organization seeks to achieve its
objectives. Internal context is anything within the organization that can influence the way in
which an organization undertakes risk. The internal context can include:
ŸŸGovernance, organizational structure, roles and responsibilities
ŸŸPolicies, objectives and the strategies that are in place to achieve them
ŸŸThe capabilities of the banking organization as a whole, understood in terms of resources
of knowledge
ŸŸInformation systems, information flows and decision-making process—both formal and
informal
ŸŸRelationships with, and perceptions and values of, internal stakeholders
ŸŸOrganization’s culture
ŸŸStandards, guidelines and models adopted by the organization
ŸŸForm and extent of contractual relationships
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Establishing internal context is important as it helps to ensure that the risk management
parameters are appropriate given the unique circumstances of the banking organization.
There is no one-size-fits-all risk management infrastructure for the organization. For risk
management to be properly embedded in the risk culture and processes, the organization’s
unique circumstances and capacity must be considered.
3.3.3
Establishing the Risk Management Process Context
Establishing the risk management process context involves defining the objectives, strategies,
scope and parameters of the bank’s activities, particularly with respect to the risk management
process. Establishing the risk management process context typically involves:
ŸŸDefining the goals and objectives of risk management activities
ŸŸDefining responsibilities for and within the risk management process
ŸŸDefining the scope as well as the depth and breadth of the risk management activities to
be carried out
ŸŸDefining the activity, process, function, project, product, service or asset in terms of time
and location
ŸŸDefining the relationships between a particular project, process or activity and other
projects, processes or activities of the organization
ŸŸDefining the risk assessment methodologies
ŸŸDefining the way performance and effectiveness is evaluated in managing risk
ŸŸIdentifying and specifying the decisions that have to be made
ŸŸIdentifying, scoping or framing the studies needed, their extent and objectives, and the
resources required for such studies
3.3.4
Risk Criteria
Risk criteria are the terms of reference against which the significance of a risk is evaluated.
They allow a banking organization to clearly define the level of risk that the institution is
willing to accept. The risk criteria are used as a framework for the organization to assess
the significance of its risks. This will enable the bank to decide whether a certain risk level is
acceptable, tolerable or unacceptable.
Defining the risk criteria and the conditions, which will make risks acceptable, tolerable or
unacceptable, will be a critical input for the banking organization to assess whether taking on
the risk exposure is acceptable or not. The following should be considered when defining the
risk criteria:
ŸŸNature and types of causes and consequences that can occur, and how they will be
measured
ŸŸHow likelihood will be defined
ŸŸThe timeframes or likelihoods and/or consequences
ŸŸHow the level of risk is to be determined
ŸŸViews of stakeholders
ŸŸThe level at which risk becomes acceptable or tolerable
ŸŸWhether combinations of multiple risks should be taken into account and, if so, how
and which combinations should be considered
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3.4 RISK ASSESSMENT
LEARNING OBJECTIVE
3.4
DISCUSS the different activities under the risk assessment process
Risk assessment refers to the overall process of:
ŸŸRisk identification
ŸŸRisk analysis
ŸŸRisk evaluation
3.4.1
Risk Identification
Risk identification is the process of finding, recognizing and describing risks. It involves the
identification of the following:
ŸŸRisk sources
A risk source is an element which alone or in combination has the intrinsic potential to give
rise to risk (ISO 31000).
Example—Credit risk is one type of risk. A risk source is the banking organization’s lending
activities, which have the potential to give rise to credit risk.
ŸŸRisk events and their causes
A risk event is an occurrence or change of a particular set of circumstances. The event can
be one or more occurrences, and can have several causes. It can also consist of something
not happening. An event without consequences can also be referred to as a ‘near miss’,
‘incident’, ‘near hit’ or ‘close call’.
Example—With respect to credit risk, an example of a risk event could be the default of a
borrower or the deterioration of a counterparty’s creditworthiness.
ŸŸConsequences
Risk consequence is the outcome of an event affecting objectives. The event can lead to a
range of consequences, which can be certain or uncertain and can have positive or negative
impact on the objectives.
Example—One risk consequence of the deterioration of a counterparty’s creditworthiness
is the potential adverse impact on the banking organization’s earnings or capital.
The objective of risk identification is to generate a comprehensive list of risks that are based on
specific events that might create, enhance, prevent, degrade, accelerate or delay the achievement
of objectives. A comprehensive risk identification process is critical as any risk that is not
identified at this stage may not be included in the risk analysis stage. All significant causes and
consequences must be considered.
Risk identification should also include examing the knock-on effects of particular
consequences. These knock-on effects may include a large number of risk events and
consequences that happen quickly in a series.
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Real World Illustration
Financial Contagion
One of the examples of the importance of identifying knock-on effects of a risk event is financial
contagion. Financial contagion generally refers to a risk event which initially affects only a few
financial institutions or a particular geographic region, but eventually escalates into a crosscountry or cross-company transmission of monetary shocks. Some examples of knock-on effects
of events:
ŸŸ September 2008—The bankruptcy of Lehman Brothers sent shockwaves globally in equity
markets from Asia to the United States. The Lehman shock eventually spilled over to other
financial institutions, such as the US-based insurer American International Group (AIG). This
event eventually erupted into one of the greatest financial meltdowns in history.
ŸŸ July 1997—Thailand devalued its baht after the currency came under attack from speculators,
and she requested the International Monetary Fund (IMF) for technical assistance. The Thai
crisis sparked a chain of currency devaluation across other Southeast Asian economies, such
as Malaysia, Indonesia and the Philippines. It also spread to South Korea, Hong Kong and
China.
3.4.2
Risk Analysis
Risk analysis is the process of comprehending the nature of risk and determining the level of
risk. It involves developing an understanding of the risk.
Risk analysis provides the basis for risk evaluation and decisions about how risks should
be treated and on the most appropriate risk treatment strategies and methods. It also
involves quantifying the magnitude of risk or combination of risks, expressed in terms of the
combination of consequences and their likelihood.
Risk analysis involves consideration of the:
ŸŸCauses and sources of risk
ŸŸPositive and negative consequences of risk
ŸŸLikelihood that those consequences can occur
ŸŸFactors that affect the consequences and likelihood
Risk analysis should also consider the interdependence of different risks and their sources.
It can be done in a qualitative, quantitative or a combination of qualitative and quantitative
approaches.
Consequences and their likelihood can be determined by:
ŸŸModelling the possible outcomes of an event or set of events
ŸŸExtrapolating from experimental studies or from available data
3.4.3
Risk Evaluation
Risk evaluation is the process of comparing the results of risk analysis with risk criteria to
determine whether the risk and/or its magnitude are acceptable or tolerable.
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Risk Evaluation
Risk
Analysis
Risk
Criteria
Figure 3.6 Comparing the results of risk analysis and risk criteria
The purpose of risk evaluation is to assist in making decisions based on outcomes of
the risk analysis—about which risks need treatment and the priority for risk treatment
implementation. It involves comparing the level of risk quantified during the risk analysis
process with established risk criteria. Figure 3.7 shows the possible decisions based on the
outcomes of the risk analysis vis-à-vis the risk criteria.
Urgent
Do Something
Not Urgent
Do Nothing
Risk Evaluation
Do Further Analysis
Figure 3.7 Decision-making under the risk evaluation process
The decisions reached under the risk evaluation process should consider the following:
ŸŸRisk appetite and tolerance of the organization
ŸŸRisk criteria
ŸŸLegal, regulatory and other requirements
3.5 RISK TREATMENT
LEARNING OBJECTIVE
3.5
ENUMERATE the different risk treatment options
Risk treatment involves selecting one or more options for modifying risks, and implementing
those options. It entails a cyclical process of assessing the risk treatment and deciding whether
the residual risks—also referred to as retained risks—are tolerable or not. Residual risk is
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the risk remaining after a risk treatment. If the residual risks are not tolerable, the banking
organization may generate a new risk treatment, which will then be assessed for effectiveness.
Figure 3.8 illustrates the risk treatment process.
Risk treatment
assessment
Residual risk levels
are tolerable
Do nothing
Residual risks are
not tolerable
Generate a new risk
treatment
Assess the effectiveness
of the new treatment
Figure 3.8 Cyclical process of risk treatment assessment
Risk treatment varies widely. Figure 3.9 shows some of the common risk treatment options,
which are not necessarily mutually exclusive.
Share the Risk
Retain Risk by
Informed Decision
Avoid Risk
Risk Treatment
Options
Take or Increase
Risk
Remove the Risk
Source
Change the
Likelihood
Change the
Consequences
Figure 3.9 Risk treatment options
3.5.1
Avoid Risk
One of the risk treatment options is to avoid the risk by deciding not to pursue or continue with
the activity that generates the risk. In a highly innovative and globalized business environment,
banking organizations are often presented with numerous business opportunities. However,
the organization may find it prudent to forego those opportunities where the risks outweigh
the potential benefits.
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Chapter 3 Risk Management Process
Real World Illustration
Banks Exit Commodity Trading on Regulatory Pressures
Barclays, JPMorgan and Morgan Stanley announced measures to exit their physical commodity
trading business as higher capital requirements and increased political and regulatory scrutiny
have diminished profits and increased risk for the banks. Regulatory developments are expected
to make owning physical commodities less practical for banks.
Banks Avoid Virtual Currency Craze
According to the Wall Street Journal, banks are cautious of dealing with virtual currency
companies (e.g. bitcoin companies) on concerns that businesses could enter into difficulty with
anti-money laundering laws or be involved in illegal activities, including market-making and
derivatives trading, from deposit taking. But retail banks would still be allowed to carry out various
risky trading activities, within limits set by supervisors.
3.5.2
Take or Increase Risk
Another risk treatment option is to take or increase risk in order to pursue a business
opportunity. This option can only be taken if the banking organization is confident that it has
the ability, expertise and willingness to tolerate and manage the residual risk arising from the
business opportunity that generates the specific risk.
Real World Illustration
Goldman Sachs Stands Firm as Banks Exit Commodity Trading
Goldman Sachs, whose top three executives began their careers at the firm in the commodity
trading unit, is poised to gain market share as pressure from regulators drives competitors to
scale back. Its Chief Executive Officer, Lloyd C. Blankfein, said that the firm was committed to
the commodity trading division.
According to Paul Gulberg, an analyst at Portales Partners LLC, “keeping a complete ‘food
chain’ of these businesses could continue giving Goldman Sachs informational advantage
over competitors, which reduce their presence in certain aspects of the commodity business,
predominantly physical.”
Source: Bloomberg, 15 April 2014
3.5.3
Remove the Risk Source
An alternative risk treatment option is to remove the risk source. An example of this is a risk
treatment option called risk transfer—a strategy that involves the contractual shifting of risk
from one party to another. While this approach effectively removes this type of risk from the
banking organization, other types of risks may arise. An example is the purchase of insurance.
It may remove the risk from the insured events but it exposes the organization to counterparty
credit risk, i.e. the risk that the insurance provider will not be able to fulfil its commitments or
obligations under the contract.
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A popular risk transfer mechanism is the use of derivatives contract. Derivatives are financial
instruments whose value depends on the performance of one or more underlying variable.
Derivative contracts allow the efficient transfer of risk from one party to another.
Real World Illustration
Operational Risk Transfer Mechanisms
Fidelity bond coverage or financial institution blanket bond instrument is an example of a risk
transfer mechanism to transfer operational risk. This bond coverage protects the banking
organization against losses from events such as fraudulent acts committed by employees,
burglary, unexplained disappearances of property, counterfeiting and forgery.
Directors’ and officers’ liability coverage provides indemnity against losses incurred by directors
and officers. Property insurance protects the organization against losses from fire, theft, inclement
weather, etc.
Source: Operational Risk Transfer Across Financial Sectors, Basel Committee on Banking
Supervision Joint Forum, August 2003
3.5.4
Change Likelihood
Another risk treatment option is to reduce the chance of a risk event from happening. The
likelihood of a risk event occurring can be reduced if more rigorous controls are in place.
Preventive controls are designed to keep risk events from occurring. They decrease the
likelihood of a particular risk event from happening.
Table 3.1 Preventive controls to change the likelihood of risk events from happening
Examples of Preventive Controls
Impact on Likelihood of Risk Events
Training on policies and procedures
Lower likelihood of a risk event occurring as personnel are more
aware of the policies and procedures
Segregation of duties
Lower likelihood of a risk event occurring due to more effective
checks and balances
Strict access authorizations
Lower likelihood of a risk event occurring as unauthorized access
may be less likely to happen
Other examples of risk treatment options are standardization of business processes and
automation of manual processes to minimize risks due to human errors.
3.5.5
Change Consequences
Aside from reducing the likelihood of a risk event from happening, another approach is to
reduce the consequence if the risk event occurs. An example of this risk treatment option is the
requirement for the borrower to post securities or cash as collateral. If the risk event occurs,
the bank (creditor) may sell the securities or use the cash collateral to minimize the impact of
losses arising from the risk event (in this case, a credit risk event).
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3.5.6
Share the Risk
Risk sharing is a risk treatment option where the consequence of risk is distributed among
several participants.
Real World Illustration
Syndicated Loans
For a borrower requiring a very large loan, a group of bank lenders could work together (as
a syndicate) to provide a flexible and efficient source of funding under a syndicated loan. A
syndicated loan simplifies the borrowing process as the borrower uses one agreement covering
the group of banks and different types of facilities rather than entering into a series of bilateral
loan agreements. For banks, this is an efficient way to share credit risk exposures and at the
same time accommodate the borrower’s requirements.
Source: Loan Market Association
3.5.7
Risk Retention
Banks may also decide to retain risk using informed decision-making. Similar to the take or
increase risk option, the decision should be made after considering the bank’s ability and
willingness to retain the specific risk. The decision is made after carefully considering the
results of the risk analysis and the pre-set risk criteria.
The selection of the most appropriate risk treatment strategy involves balancing the costs
and efforts of implementing the particular strategy against the benefits derived. When selecting
the risk treatment options, the bank should consider the stakeholder values and perceptions
and the most appropriate way to communicate with them.
A risk treatment plan should also be produced to ensure that individual risk treatments are
clearly prioritized in terms of implementation.
Real World Illustration
Risk Treatment Plan—Minimum Content
ŸŸ Reasons for selection of treatment options
ŸŸ Person accountable for approving the plan
ŸŸ Person accountable for implementing the plan
ŸŸ Proposed actions
ŸŸ Resource requirements including contingencies
ŸŸ Performance measures and constraints
ŸŸ Reporting and monitoring requirements
ŸŸ Timing and schedule
The risk treatment plan should be integrated with the bank’s management processes and
discussed with the appropriate stakeholders.
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3.6 RISK MONITORING AND REVIEW
LEARNING OBJECTIVE
3.6
DESCRIBE the risk monitoring and review process
Risk monitoring is the process of checking, supervising, critically observing or determining the
status of the risk in order to enable change from the required or expected performance level.
Risk review, on the other hand, is the process of determining the suitability, adequacy and
effectiveness of the risk management process.
Risk monitoring and review involves a regular process of checking. It should be a planned
part of the risk management process. The responsibilities for risk monitoring and reviewing
should be clearly defined.
Risk reporting is an important part of the risk monitoring and review process. It involves
documenting and communicating the results of the bank’s risk assessment and treatment
measures to both the internal and external stakeholders. Risk reporting aims to inform the
stakeholders on how the organization manages its risk exposures. It plays a critical role in
ensuring that the different stakeholders impose market discipline on the organization,
particularly with respect to how it assesses and manages risks.
Some of the main objectives of the monitoring and reviewing process are:
ŸŸEnsure the controls are effective and efficient in both design and operation
ŸŸObtain further information to improve risk assessment
ŸŸAnalyze and learn lessons from events, changes, trends, successes and failures
ŸŸDetect changes in the external and internal context
ŸŸIdentify emerging risks
CONCLUSION
In this chapter, we discussed the third component of the risk management infrastructure—the
risk management process. We provided an overview of the overall risk management process
involving communication and consultation, establishing the context, risk assessment, risk
treatment, and risk monitoring and reviewing. In the next chapter, we will discuss the internal
risk regulatory environment, which influences the practice of risk management in the banking
industry context.
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C
4
P
HA
TE
R
INTERNATIONAL
RISK REGULATION
In chapter 1, we discussed some of the important roles that banking organizations play
in the economy. Given the critical functions that banks perform, the banking industry
operates in a heavily-regulated landscape.
The banking industry had undergone significant changes in the years following
the 2008 global financial crisis—arguably, the worst crisis that industry players had
encountered in decades. Regulatory reforms were crafted, designed and implemented
to address and incorporate many of the lessons learned from the crisis. The regulatory
reforms were expected to significantly impact banking business models in the years
following their implementation.
Given the far-reaching impact of banking regulations, it is essential for risk
management students to appreciate the role of regulations in the banking business,
understand how regulations mould the bank’s strategic business choices and be familiar
with the international standards that shape local and global banking regulations.
We begin this chapter by discussing the role, objectives and sources of banking
regulations. We then look at the work of the Basel Committee on Banking Supervision
(BCBS) to strengthen global capital requirements and liquidity standards.
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Risk Management in Banking: Principles and Framework
This chapter does not intend to provide a comprehensive survey of the different banking
regulations. Rather, it aims to provide students with basic information on the important roles
of banking regulations and risk management practices.
International Banking
Regulation
Types and
Sources
of Banking
Regulations
Introduction to
Risk-Based Capital
Framework under
Basel I
The Banking
Industry and its
Critical Role in
the Economy
Sources
of Banking
Regulations
History of the
Basel Committee
on Banking
Supervision
Financial Safety
Nets
Types of
Banking
Regulations
Importance and
Objectives of
Regulations
Role of
Banking
Supervision
Basel I: The 1988
Basel Capital
Accord
Special Nature
of the Banking
Business
The Three
Pillars
of Basel II
Introduction
to Basel III
Requirements
Pillar 1:
Minimum
Capital
Requirements
2008 Global
Financial Crisis
and Basel II
Weaknesses
Pillar 2:
Supervisory
Review
Process
Basel III:
Capital
Reforms
Pillar 3:
Market
Discipline
Basel III:
Liquidity
Reforms
Figure 4.1 Diagrammatic outline of this chapter’s topics
LEARNING OUTCOME
At the end of this chapter, you are expected to be able to:
DISCUSS the role of regulations in the business model of banking and in the practice of risk
management
LEARNING OBJECTIVES
At the end of this chapter, you will be able to:
EXPLAIN the importance and objectives of regulations for banks
EXPLAIN the role of banking supervision in ensuring safety and soundness of banking
organizations
ENUMERATE the different types and sources of banking regulations
EXPLAIN the objectives and basic features of Basel I—the first risk-based capital standard for
banks
DISCUSS the basic features of the ‘three pillars’ of Basel II
EXPLAIN the key capital and liquidity reforms under Basel III
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Chapter 4 International Risk Regulation
4.1 IMPORTANCE AND OBJECTIVES OF
REGULATIONS FOR BANKS
LEARNING OBJECTIVE
4.1
EXPLAIN the importance and objectives of regulations for banks
The banking industry is one of the most heavily regulated industries. There are many reasons
why regulations play a central role in this industry, which can be broadly summarized into
three main categories:
ŸŸCritical role in the economy
Banks play many critical roles in the economy. Disruptions in the banking industry
could adversely impact the economy.
ŸŸFinancial safety nets
The economic damages associated with banking crises provide the rationale for
governments to intervene and attempt to stem any contagion. The interventions—
collectively referred to as financial safety nets—result in direct costs to the governments
and taxpayers.
ŸŸSpecial nature of banking
The banking business is a business of trust and confidence. Lessons from previous
banking crises show that a loss of trust and confidence in a bank could immediately
threaten its ability to survive.
Financial
Safety Nets
Critical Role of
Banks in the
Economy
Special Nature
of the Banking
Business
Banking Risk
Regulation
Figure 4.2 Banking risk regulation
4.1.1The Banking Industry and its Critical Role
in the Economy
The banking industry performs the vital role of allocating resources from households or
depositors with excess funds to corporations or institutions with requirements for those
funds. Corporations and institutions use these funds to pursue investment opportunities,
which directly contribute to the economy’s growth and employment opportunities.
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In the closely-linked international economy, the banking industry provides critical payment
and settlement mechanisms, which facilitate both local and international trade transactions.
The absence of such payment and settlement mechanisms may impact the volume of trade
and business activities.
The banking industry also contributes directly to a country’s economic output through the
different services it performs for the economy and indirectly through the different investments
the banks make, which benefit other industries, e.g. information technology industry.
Disruptions in the banking industry through adverse events such as banking crises are
sometimes associated with profound declines in an economy’s output and significant increases
in unemployment. Banking crises frequently result in deep economic recessions.
Real World Illustration
The Aftermath of Financial Crises
In their influential study on defining elements that followed severe financial crises, Harvard
University professors, Reinhart Carmen and Kenneth Rogoff, conclude that banking crises are
associated with profound declines in output and employment. Other key findings are:
ŸŸ Unemployment rate rises an average of 7 percentage points during the down phase of the
cycle, which lasts on average over four years.
ŸŸ Output falls an average of over 9%.
ŸŸ The real value of government debt tends to explode, rising an average of 86% in the major
post—World War II. Government debt explodes due to a collapse in tax revenues in the wake
of deep and prolonged economic contractions.
Source: C
armen M. Reinhart and Kenneth S. Rogoff, ‘The Aftermath of Financial Crises’, American
Economic Review, American Economic Association, 99(2), pp 466−72, May 2009
Given the many adverse consequences associated with failures of the banking industry,
regulations are designed to minimize the likelihood of banking crises from occurring.
4.1.2
Financial Safety Nets
The economic damages associated with banking crises provide the rationale for governments
to intervene and attempt to stem any contagion. These interventions—collectively referred to
as financial safety nets—result in direct costs to the government and taxpayers.
The need for financial safety nets provides some of the strongest rationale for regulating
the banking industry. Regulations are designed to avoid the possibility that the government
and ultimately, the taxpayers, will bear the direct costs of providing the financial safety nets
associated to prevent bank failures.
Figure 4.3 depicts the three main types of financial safety nets.
Lender of
Last Resort
Deposit
Insurance
Government
Bailouts
Figure 4.3 Main types of financial safety nets
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Chapter 4 International Risk Regulation
Lender of last resort
Lender of last resort refers to the role of the central bank in constraining a banking crisis and
stemming a contagion arising from the failure of a financial institution. To ensure financial
stability, one of the central bank’s main roles is to prevent a banking crisis from occurring.
As the ultimate holder of liquidity reserves, the central bank has to provide liquidity to
banking institutions in times of a crisis. It may also make emergency loans of high-powered
money to temporary illiquid banks. High-powered money refers to bank reserves and currencies
held by the central bank. Another tool that is within the central bank’s control is to contain
public fears and panics through announcements of its commitment to provide liquidity to
temporary illiquid banks.
The central bank, in playing the lender of last resort role, operationalizes within a strict
framework. Otherwise, it may create unwanted incentives for banks to misbehave. The classical
Thornton-Begehot’s Model of Lender of Last Resort is the most popular framework to implement the
lender-of-last-resort role. The principal features of the framework are:
ŸŸWillingness to lend freely and to the public
The lender of last resort should provide liquidity to the banking system as a whole and
not to specific institutions.
ŸŸAccommodating sound institutions
The liquidity should only be extended to temporary illiquid institutions. Insolvent
institutions should be allowed to fail.
ŸŸCharging penalty rates
The liquidity extended should carry high penalty rates to encourage quick repayment of
the loans once the crisis ends.
ŸŸRequiring good collateral
In providing emergency credit, the lender of last resort should require high quality
collateral. This ensures that the central bank’s losses are minimized and encourages
prompt repayment of the credit facility. In recent years, however, many central banks
have started to forego this requirement.
Real World Illustration
The Federal Reserve as the Lender of Last Resort
In 2008, the Federal Reserve took on the role of the lender of last resort to contain the deepening
credit crisis. It allowed banks to access hundreds of billions of dollars in emergency loans to borrow
U.S. Treasury securities in exchange for their illiquid assets as collaterals. The Federal Reserve
was trying to ease the credit squeeze by agreeing to hold large volumes of illiquid assets that the
banks were struggling to sell by providing them with either cash or Treasury securities that they
could immediately convert to cash.
Source: New York Times, 12 March 2008
Deposit insurance
In the event that the lender of last resort fails to contain the insolvency of a financial institution
or contain a banking crisis, many jurisdictions attempt to provide some form of guarantee or
insurance in the event of bank insolvency.
The objective of deposit insurance is to avoid bank runs, which occur when depositors rush
to withdraw their deposits because they expect the bank to fail. The sudden withdrawals will
force the bank to sell its illiquid assets at a loss—a fire sale—and eventually lead to its failure.
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Risk Management in Banking: Principles and Framework
Deposit insurance is designed to provide explicit but limited guarantee on deposits in the
event of a bank failure. It has a different objective from the lender of last resort. While the
lender of last resort aims to provide liquidity to illiquid but solvent banks, deposit insurance
is triggered in the event of bank insolvency.
Regulations are imposed to limit the losses that these governments will incur from deposit
insurance claims. The regulations are designed to provide confidence on the banks’ safety and
soundness, such as requiring the banks to adhere to minimum capital and liquidity standards.
Real World Illustration
Deposit Insurance Schemes in ASEAN
The International Association of Deposit Insurers (IADI) was formed in May 2002 to enhance the
effectiveness of deposit insurance schemes by promoting guidance and international cooperation.
IADI currently represents 68 deposit insurers from 67 jurisdictions.
ŸŸ As of January 2014, 113 jurisdictions have instituted some form of an explicit deposit insurance
system; up from 12 in 1974.
ŸŸ The purpose of deposit insurance varies; it typically involves promoting financial stability and
protecting small depositors from losses in event of a bank failure.
ŸŸ Seven member states of ASEAN—Brunei, Indonesia, Malaysia, Philippines, Singapore,
Thailand and Vietnam—are members of IADI. The IADI members are entities that have a
deposit insurance system in place by law of agreements.
ŸŸ Deposit insurance was first introduced in East Asia by the Philippines in 1963, followed
by Japan in 1971, Taiwan in 1985 and Korea in 1996. The Asian financial crisis in 1997
spurred the rapid development of the deposit insurance system in the region with Hong Kong,
Indonesia, Malaysia, Singapore and Vietnam implementing their own systems.
ŸŸ In 2008, the Thailand Deposit Protection Agency (DPA) was established to provide protection
to depositors. Prior to this, since the 1997 Asian crisis, a blanket guarantee was issued by the
Financial Institutions Development Fund (FIDF).
ŸŸ In Malaysia, the deposit insurance system was introduced in September 2005 and is
administered by Perbadanan Insurans Deposit Malaysia (PIDM).
Sources: PDIC Occasional Paper No. 2, IADI website
Government bailouts
The third level of financial safety nets is a government bailout. This involves the government
stepping in to bailout insolvent banks to prevent a potential meltdown in the banking system,
which will impact the economy. This usually takes the form of giving capital support to
the insolvent banks. A bailout entails a huge cost on the government’s part and ultimately
the taxpayers bear the costs of these failures. A bailout is usually the last resort to avert the
potential damaging impact in the economy of a collapse in the banking system.
The three financial safety nets comprise the tools that are at the government’s disposal
to avert a banking crisis. Given the enormous costs to the government—and ultimately, to
taxpayers—associated with these financial safety nets, it is clear why the banking sector is
heavily regulated.
4.1.3
Special Nature of the Banking Business
Trust and confidence are of central importance to the banking business. A common theme
seen in previous bank failures is that the loss of public’s confidence in a bank’s ability to
survive could, at times, threaten the entity’s ability to continue as a going concern.
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Chapter 4 International Risk Regulation
A bank run occurs when depositors demand immediate withdrawal of their funds before
the bank actually fails. In such situations, banks may need to generate liquidity by selling
their assets at fire sale prices. When the sale proceeds are insufficient and the banks have
exhausted all sources of liquidity, they may cease to exist as going concerns. An individual
bank run may escalate into a contagion when the public loses confidence in the banking
system as a whole. The contagion could potentially emerge into a banking crisis if it is not
averted.
Therefore, regulations are designed to ensure that banks are managed in a safe and sound
manner as well as to avert bank failures by imposing minimum standards on their boards and
management.
4.2 ROLE OF BANKING SUPERVISION
LEARNING OBJECTIVE
4.2
EXPLAIN the role of banking supervision in ensuring safety and soundness of banking
organizations
Banking supervision is the comprehensive process of monitoring the performance, practices
and processes of banks to ensure that these banks are managed in a safe and sound manner in
accordance with applicable laws and regulations.
Banking supervisors are entities authorized by law to be primarily responsible for promoting
the safety and soundness of banks and the banking system. They execute this primary objective
through specific powers granted by the country’s legal framework.
Real World Illustration
Bank Negara Malaysia
One of the main responsibilities of Bank Negara Malaysia is to bring about financial system
stability and fostering a sound and progressive financial sector.
Bank Negara Malaysia discharges the responsibility of promoting a sound and efficient financial
system by preserving the soundness of financial institutions and preserving the robustness of the
financial infrastructure to withstand adverse economic cycles and shocks, thereby maintaining
confidence in the country’s financial system. This is achieved through the regulation and
supervision of the licensed financial institutions, by ensuring the continued reliability of major
payment and settlement systems and actively contributing to the development of efficient financial
markets.
Bank Negara Malaysia remains vigilant to new emerging trends and challenges to the Malaysian
financial system which could undermine financial stability by devoting significant resources
towards instituting robust surveillance processes, which aim to identify vulnerabilities and support
pre-emptive actions to prevent systemic disturbances.
Source: Bank Negara Malaysia website
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Figure 4.4 depicts the types of actions that bank supervisors may take in the event that they
conclude a bank is not acting in a safe and sound manner or is in violation of laws and regulations.
Supervisory Actions
Take and/or require the bank to take timely
(prompt) corrective action
Impose a range of sanctions
Revoke a bank's licence
Cooperate and collaborate with relevant
authorities to achieve an orderly resolution
of the bank
Figure 4.4 Bank Negara Malaysia—supervisory actions
Bank Negara Malaysia executes its mandate through its regulation and supervision
departments. Table 4.1 depicts the different sub-departments of the regulation and supervision
departments.
Table 4.1 Sub-departments of BNM regulation and supervision departments
Regulation Department
Chapter-04.indd 88
Functions
Financial Sector
Development
Progressive development of the financial sector including the promotion of
competitive and robust financial institutions and financial infrastructure enhancement
Financial Surveillance
Comprehensive and integrated macro-prudential surveillance and assessments of
emerging trends and vulnerabilities of the financial system
Prudential Financial Policy
Development of a sound and robust prudential framework for financial institutions
that promotes harmonization and alignment across sectors
Consumer and Market
Conduct
Formulates and enforces market conduct policies to ensure fair treatment of financial
consumers as well as undertakes initiatives to increase the financial literacy levels
of Malaysian consumers
Islamic Banking and
Takaful
Create an enabling environment through improvements in the regulatory regime and
develop relevant prudential policies to effectively support an Islamic financial system
Development Finance and
Enterprise
Promote the roles of development financial institutions in effectively and efficiently
delivering its mandated roles of promoting strategic sectors of the economy. Drive,
incentivize and influence financial services providers to provide financing to strategic
targeted sectors and underserved stakeholders
Malaysia Islamic Financial
Center (MIFC) Promotion
Unit
Develop and implement a comprehensive range of MIFC promotional strategies and
initiatives to position Malaysia as an international Islamic financial hub
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Chapter 4 International Risk Regulation
Supervision Department
Functions
Financial Conglomerates
Supervision
Supervision of domestic financial conglomerates and Islamic banks which are part of
the domestic banking groups
Banking Supervision
Supervision of foreign banks, stand-alone investment banks, stand-alone and
foreign licensed Islamic banks, and development financial institutions
Insurance and Takaful
Supervision
Supervision of insurance companies, reinsurance companies, takaful operators,
retakaful operators and international takaful operators
Payment Systems Policy
Development of policies and strategies to promote the safety, security and efficiency
of payment systems and payment instruments, and drive migration to e-payment
initiatives
Specialist Risk Unit
Provides prompt independent assessment and advice on emerging risks in specific
and across regulated financial institutions to facilitate pre-emptive actions
Source: Bank Negara Malaysia website
The Core Principles for Effective Banking Supervision (Basel Committee on Banking Supervision,
September 2012) discusses the supervisory approach and tools at the disposal of bank
supervisors. Bank supervisors typically adopt a risk-based approach to banking supervision.
This approach aims to efficiently target supervisory resources where they can be utilized for
the best effect, focusing on outcomes as well as processes, moving beyond passive assessment
of compliance with rules. It typically involves the following processes:
ŸŸForward-looking assessment of the risk profiles of individual banks and groups
ŸŸIdentify, assess and address risks emanating from banks and the banking system
ŸŸEstablish a framework for early intervention
ŸŸHave plans to take action to resolve banks in an orderly manner if they become
non-viable
Forward-looking
assessment of risk
profile of banks
Identify, assess and
address risks from banks
and banking system
Resolution mechanism
Framework for early
intervention
Figure 4.5 Processes in a risk-based approach to banking supervision
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Risk Management in Banking: Principles and Framework
Real World Illustration
SuRF Approach to Banking Supervision
Since 1997, Bank Negara Malaysia (BNM) has adopted a risk-based approach to banking
supervision through the Supervisory Risk-based Framework (SuRF). The framework strengthens
BNM’s risk- and impact-focused approach to supervision, which is underpinned by more
comprehensive and holistic risk assessments of individual financial institutions. The framework
facilitates the appropriate concentrations of supervisory attention on institutions that are of higher
risk.
The enhanced risk-based supervision approach includes a supervisory intervention framework to
promote greater granularity and clarity in terms of the appropriate level of intensity of supervisory
intervention actions to be taken on financial institutions.
Source: Bank Negara Malaysia website
Bank supervisors can avail of a wide range of techniques and tools to implement BNM’s
supervisory approach and deploy resources based on its risk-based examination strategy. They
employ an appropriate mix of on-site and off-site supervision to evaluate the condition of
banking organizations, their risk profiles, internal control environment and the corrective
measures necessary to address the supervisory concerns.
•
On-site examinations
Off-site examinations
•
Provide independent verification that adequate policies, procedures
and controls exist at banks
Determine that information reported by banks is reliable
Obtain additional information on the bank and its related companies
needed for the assessment of the condition of the bank
Monitor the bank’s follow-up on supervisory concerns
•
•
•
•
Regularly review and analyze the financial condition of banks
Follow up on matters requiring further attention
Identify and evaluate developing risks
Identify priorities and scope of further off-site and on-site work
•
•
Figure 4.6 On- and off-site examinations to assess a bank’s condition
The tools that bank supervisors use to regularly review and assess the safety and soundness
of banks include:
ŸŸFinancial statements and account analyses
ŸŸBusiness model analyses
ŸŸHorizontal peer reviews
ŸŸReview of stress test outcomes
ŸŸAnalysis of corporate governance, risk management and internal controls
The supervisors will communicate to the bank their findings of the analyses in a timely
manner by means of written reports or through discussions or meetings with the bank’s
management.
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Chapter 4 International Risk Regulation
4.3 TYPES AND SOURCES OF BANKING
REGULATIONS
LEARNING OBJECTIVE
4.3
ENUMERATE the different types and sources of banking regulations
Banking laws and regulations provide the frameworks for banking supervisors to set and
enforce minimum prudential standard for banks and banking groups.
4.3.1
Sources of Banking Regulations
The sources of banking regulations include domestic/national laws, international laws and
international standard of soft laws.
Domestic/National laws
Each country has its own laws, which are mostly derived from statutes enacted by the
legislative body. These statutes are written in broad terms and, thus, require interpretation
and implementation. Banking supervisors will issue their interpretation and implementation
through memorandums, guidelines and/or circulars.
Real World Illustration
Law, Policy and Guidelines—Bank Negara Malaysia
Administered legislations—vest comprehensive legal powers to Bank Negara Malaysia to
regulate and supervise the financial system. The relevant legislations are:
ŸŸ
ŸŸ
ŸŸ
ŸŸ
ŸŸ
ŸŸ
ŸŸ
ŸŸ
Central Bank of Malaysia Act 2009
Financial Services Act 2013
Islamic Financial Services Act 2013
Insurance Act 1996
Development Financial Institutions Act 2002 (Act 618)
Anti-Money Laundering and Anti-Terrorism Financing Act 2001 (Act 613)
Money Services Business Act 2011
Government Funding Act 1983
Guidelines and circulars—provide interpretation and implementation guidelines on the details
of the administered legislation. The guidelines and circulars are divided into the following:
ŸŸ Banking—capital adequacy, financial reporting, anti-money laundering and counter financing
of terrorism, prudential limits and standards
ŸŸ Insurance and takaful
ŸŸ Development financial institutions
ŸŸ Shariah
ŸŸ Money services business
ŸŸ Agent banking
ŸŸ Representative offices
ŸŸ Business conduct
ŸŸ Regulation intermediaries
ŸŸ Others
Source: Bank Negara Malaysia website
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International laws
In terms of banking regulation, there are only a few international agreements that directly
address the regulation of banks. There are, however, treaties that contain provisions that impact
banking regulations indirectly. An example is the Financial Sector Assessment Programme
(FSAP) of the International Monetary Fund (IMF). When a country joins the IMF, it agrees to
subject its economic and financial policies to the scrutiny of the international community. The
IMF’s regular monitoring of economies and associated provision of policy advice—referred to
as surveillance—is intended to identify weaknesses that are causing, or could lead to, economic
instability.
Country surveillance is an ongoing process that culminates in regular comprehensive
consultations with individual member countries. These are the ‘Article IV consultations’ as
required under Article IV of the IMF’s Articles Agreement.
The Financial Sector Assessment Programme (FSAP), established in 1999, is a comprehensive
and in-depth analysis of a country’s financial sector. It is a key IMF instrument for surveillance
and provides input to the Article IV consultations. The IMF 2007 Surveillance Decision
clarified that financial sector policies would always be a subject of IMF’s bilateral surveillance;
and the October 2008 ‘Statement of Surveillance Priorities for 2008–2011’ gave prominence
to financial sector issues.
Real World Illustration
Summary of Findings on Financial System Stability Assessment
ŸŸ Malaysia’s financial system has weathered the recent global financial crisis well, helped
by limited reliance on financial intermediaries on cross-border funding, a well-developed
supervisory and regulatory regime, and a well-capitalized banking system.
ŸŸ Stress tests suggest that banks are resilient to a range of economic and market shocks;
though the high level of reliance on demand deposits is a potential vulnerability. Other risks
faced by the financial system include those related to rapid loan growth, rising house prices
and high household leverage which call for enhanced monitoring of household leverage and
a review of the effectiveness of macroprudential measures.
ŸŸ The regulatory and supervisory regime for banks, insurance firms, securities markets and
market infrastructure exhibits a high degree of compliance with international standards. Areas
for improvement include enhancing the framework of consolidated supervision and addressing
legal provisions that could potentially compromise supervisory independence. In addition, in
the case of the Labuan International Business and Financial Centre (IBFC), more work needs
to be done to update the prudential framework to meet current international standards.
Source: Malaysia: Financial System Stability Assessment, 28 January 2013
International standards (Soft laws)
International standards or ‘soft laws’ refer to a set of rules that consists of law-like statements
or regulations that fall short of hard law.
ŸŸBasel Committee on Banking Supervision
The Basel Committee on Banking Supervision (BCBS) is the primary global standardsetter for the prudential regulation of banks and provides a forum for cooperation on
banking supervisory matters. Its mandate is to strengthen the regulation, supervision
and practices of banks worldwide with the purpose of enhancing financial stability.
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Chapter 4 International Risk Regulation
The BCBS does not possess any formal supranational authority. Its decisions do
not have legal force. Rather, the BCBS relies on members’ commitments to achieve its
mandate.
BCBS formulates supervisory standards and guidelines to promote global financial
stability. However, similar to its decisions, these supervisory standards and guidelines
have no legal force. They are developed and issued upon agreement of members, and in
the expectation that individual national authorities will implement them.
mm
mm
Minimum standards
BCBS establishes minimum standards for prudential regulation and supervision of
banks. These standards constitute minimum requirements and members may decide
to go beyond them. The key standards of the BCBS are its capital adequacy framework
(Basel III), the liquidity coverage ratio and the Core Principles for Banking Supervision.
Guidelines
Guidelines elaborate the standards. They generally supplement the minimum
standards by providing additional guidance for the purpose of their implementation.
BCBS has issued a wide array of guidelines on corporate governance, liquidity risk
management, operational risk and internal controls, foreign exchange settlement risk,
internal and external audit, stress testing and supervisory colleges.
Sound practices—BCBS also produces sound practice papers, which describe actual
observed practices. Recent sound practices papers have covered topics such as stress
testing, asset securitization, resolution and remuneration.
Implementation—BCBS has established a more active programme to monitor
members’ commitments to implement the Basel Committee standards. This is designed
to promote greater consistency in the implementation of global standards and improved
transparency of instances where national differences exist.
ŸŸInternational Organization of Securities Commissions
The International Organization of Securities Commissions (IOSCO) is the acknowledged
international body that brings together the world’s securities regulators and is recognized
as the global standard setter for the securities sector. IOSCO membership regulates more
than 95% of the world’s securities markets.
The IOSCO Objectives and Principles of Securities Regulation have been endorsed
by both the G20 countries and the Financial Stability Board as the relevant standards in
this area. They form the basis for the evaluation of the securities sector for the Financial
Sector Assessment Programmes (FSAPS) of the IMF and the World Bank.
ŸŸThe Joint Forum
The Joint Forum is a group of senior financial sector supervisors working under the
auspices of its parent committees—BCBS, IOSCO and the International Association
of Insurance Supervisors. Its objective is to support banking, insurance and securities
supervisors in meeting their regulatory and supervisory objectives and, more broadly, to
contribute to the international regulatory agenda.
ŸŸFinancial Action Task Force
The Financial Action Task Force (FATF) is an inter-governmental body established
in 1989 by the ministers of its member jurisdictions. The FATF objectives are to set
standards and promote effective implementation of legal, regulatory and operational
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measures for combating money laundering, terrorist financing and other related
threats to the integrity of the financial system.
The FATF has developed a series of Recommendations that are recognized as the
international standard for combating of money laundering and the financing of
terrorism and proliferation of weapons of mass destruction.
ŸŸFinancial Stability Board
The Financial Stability Board (FSB) was established to coordinate at the international
level the work of national financial authorities and international standard-setting bodies,
and to develop and promote the implementation of effective regulatory, supervisory and
other financial sector policies.
In April 2008, the FSB issued its Report of the Financial Stability Forum on Enhancing
Market and Institutional Resilience, wherein it proposed concrete actions in the following
areas:
Strengthening prudential oversight of capital, liquidity and risk management
Enhancing transparency and valuation
mm Changes in the role and uses of credit ratings
mm Strengthening the authorities’ responsiveness to risks
mm Robust arrangements for dealing with stress in the financial system
mm
mm
ŸŸInternational Accounting Standards Board
The International Accounting Standards Board (IASB) is the independent standardsetting body of the IFRS Foundation. Its members are responsible for developing and
publishing the International Financial Reporting Standards (IFRS).
The IFRS Foundation’s interpretative body—the IFRS Interpretations Committee
(IFRIC)—is mandated to review accounting issues that have arisen within the context of
the current IFRS and to provide authoritative guidance on those issues.
ŸŸInternational Swaps and Derivatives Association
The International Swaps and Derivatives Association (ISDA), established in 1985, is an
organization mandated to make over-the-counter (OTC) derivatives markets safe and
efficient, and to facilitate effective risk management for users of derivative products.
ISDA has over 800 member institutions in 64 countries which it represents in
promoting high standards of commercial conduct and leading industry action on
derivatives issues, which include:
Providing standardized documentation globally to ensure legal certainty and
maximum risk reduction through netting and collateralization.
mm Promoting infrastructure that supports an orderly and reliable marketplace as well as
transparency to regulators.
mm Enhancing counterparty and market risk practices, and advancing the effective use of
central clearing facilities and trade repositories.
mm Representing the derivatives industry through public policy, ISDA governance, ISDA
services, education and communication.
mm
4.3.2
Types of Banking Regulations
Banking regulations can be divided into four main types. Table 4.2 describes the types of
regulations that are designed to address specific policy objectives.
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Table 4.2 Main types of banking regulations
Regulation
Types
Competition
Description
ŸŸ Competition regulations address issues of non-competitive behaviour among banks. The
objective is to foster competition among banks to ensure that they provide consumers with
banking services and products at reasonable prices.
ŸŸ There is a complex relationship between competition and financial stability. Some studies
show that competition is favourable to bank stability. Other studies, however, conclude
that competition may endanger the stability of banks. This is because banks should have
sufficiently large capital and diversified exposures to withstand potential shocks in the
business environment. Hence, there may be conflicting objectives.
Examples:
ŸŸ Separation of commercial and investment banking, e.g. the Glass-Steagall Act during the
1930s Great Depression
ŸŸ Antitrust regulations in banks
ŸŸ Banking entry restrictions
ŸŸ Licensing criteria
ŸŸ Branching restrictions
Safety and
soundness
ŸŸ Regulations seek to promote a safe and sound banking system. The regulations are
not intended to dictate how banks should be managed. Rather, they prescribe minimum
standards on the management of banking organizations.
Examples:
ŸŸ Minimum capital and liquidity standards
ŸŸ Guideline and limits on large credit exposures
ŸŸ Corporate governance requirements
ŸŸ Regular reporting and disclosure standards
ŸŸ Internal control standards
ŸŸ Accounting standards
ŸŸ Anti-money laundering standards
Consumer
protection
ŸŸ Regulations also seek to protect consumers from irresponsible and unfair banking
business practices. It also aims to protect banks from potential legal liabilities and ensure
public confidence in the banking organizations.
ŸŸ Regulations aim to promote high ethical and professional standards in the banking sector.
Examples:
ŸŸ Consumer disclosures
ŸŸ Bank confidentiality requirements
ŸŸ The U.S. Truth in Lending Act
ŸŸ Client suitability requirements
Monetary policy
ŸŸ Regulations are designed to implement the monetary policy objectives of a country’s
central bank. Through regulations on reserve requirements and deposit rates, the central
bank can control monetary supply and implement its monetary policy objectives.
Examples:
ŸŸ Reserve requirements
ŸŸ Deposit rates regulations
Minimum prudential regulations and requirements standards
Prudential regulations and requirements standards provide minimum standards on risk
management and condition of banks. In the document Core Principles of Effective Banking
Supervision, the following minimum standards for sound prudential regulations and
requirements for banks are enumerated and discussed.
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Table 4.3 Objectives of prudential regulations
Prudential Regulations
Corporate governance
Risk management
process
Objectives
Reference Documents
ŸŸ Ensure banks have robust corporate
governance policies and processes.
ŸŸ Principles for Enhancing Corporate
Governance, October 2010
ŸŸ The policies and processes should
cover the strategic direction, group
and organizational structure, control
environment, responsibilities of the
bank’s boards and senior management
and compensation.
ŸŸ Compensation Principles and
Assessment Methodology, January
2010
ŸŸ Ensure banks have a comprehensive
risk management process to identify,
measure, evaluate, monitor, report and
control or mitigate all material risks
on a timely basis, and to assess the
adequacy of their capital and liquidity in
relation to their risk profiles as well as
market and macroeconomic conditions.
ŸŸ Principles for Enhancing Corporate
Governance, October 2010
ŸŸ Enhancements to the Basel II
Framework, July 2009
ŸŸ Principles for Sound Stress Testing
Practices and Supervision, May
2009
ŸŸ It also aims to develop and review
contingency arrangements, including
robust and credible recovery plans
that take into account the specific
circumstances of individual banks.
Capital adequacy
ŸŸ Ensure individual banks have prudent
and appropriate capital adequacy
requirements that reflect the risks
undertaken by, and presented by, the
bank in the context of the markets and
macroeconomic conditions in which it
operates.
ŸŸ Capitalization of Bank Exposures to
Central Counterparties, July 2012
ŸŸ Revisions to the Basel II Market
Risk Framework, February 2011
ŸŸ Minimum Requirements to Ensure
Loss Absorbency at the Point of
Non-Viability, January 2011
ŸŸ Sound Practices for Backtesting
Counterparty Credit Risk Models,
December 2010
ŸŸ Guidance for National Authorities
Operating the Countercyclical
Buffer, December 2010
ŸŸ Basel III: A Global Regulatory
Framework for More Resilient
Banks and Banking Systems,
December 2010
ŸŸ Guidelines for Computing Capital
for Incremental Risk in the Trading
Book, July 2009
ŸŸ Enhancements to the Basel II
Framework, July 2009
ŸŸ Range of Practices and Issues in
Economic Capital Frameworks,
March 2009
ŸŸ International Convergence of
Capital Measurement and Capital
Standards: A Revised Framework,
Comprehensive Version, June 2006
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Prudential Regulations
Credit risk
Objectives
Reference Documents
ŸŸ Ensure that banks have an adequate
credit risk management process
that takes into account their risk
appetites, risk profiles and market and
macroeconomic conditions.
ŸŸ Sound Practices for Backtesting
Counterparty Credit Risk Models,
December 2010
ŸŸ These include ensuring that a bank
has prudent policies and procedures
to identify, measure, evaluate, monitor,
report and control or mitigate credit risk
(including counterparty credit risk) on a
timely basis for the full credit lifecycle—
credit underwriting, credit evaluation
and ongoing management of the bank’s
loan and investment portfolios.
Problem assets,
provisions and reserves
Concentration risk and
large exposure limits
97
ŸŸ FSB Report on Principles for
Reducing Reliance on CRA Ratings,
October 2010
ŸŸ Enhancements to the Basel II
Framework, July 2009
ŸŸ Sound Credit Risk Assessment and
Valuation for Loans, June 2006
ŸŸ Principles for the Management of
Credit Risk, September 2000
ŸŸ Ensure that banks have adequate
policies and processes for early
identification and management of
problem assets, and the maintenance of
adequate provisions and reserves.
ŸŸ Sound Credit Risk Assessment and
Valuation for Loans, June 2006
ŸŸ Ensure that banks have adequate
policies and processes to identify,
evaluate, monitor, report and control or
mitigate c oncentrations of risks on a
timely basis.
ŸŸ Joint Forum Cross-Sectoral Review
of Group-wide Identification
and Management of Risk
Concentrations, April 2008
ŸŸ Principles for the Management of
Credit Risk, September 2000
ŸŸ Sound Credit Risk Assessment and
Valuation for Loans, June 2006
ŸŸ Principles for Managing Credit Risk,
September 2000
ŸŸ Measuring and Controlling Large
Credit Exposures, January 1991
Related parties
transactions
ŸŸ Ensure that abuses arising from
transactions with related parties are
prevented and address the risk of
conflict of interest.
ŸŸ Principles for Managing Credit Risk,
September 2000
Country and transfer
risks
ŸŸ Ensure that banks have adequate
policies and processes to identify,
measure, evaluate, monitor, report and
control or mitigate country and transfer
risks in their international lending and
investment activities on a timely basis.
ŸŸ Management of Banks’ International
Lending, March 1982
ŸŸ Country risk is the risk of exposure
to loss caused by events in a foreign
country.
ŸŸ Transfer risk is the risk that a borrower
will not be able to convert the local
currency into foreign exchange and,
thus, will be unable to make debt
service payments in a foreign currency.
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Prudential Regulations
Market risk
Objectives
ŸŸ Ensure that banks have an adequate
market risk management process
that takes into account their risk
appetites, risk profiles, market and
macroeconomic conditions, and the risk
of a significant deterioration in market
liquidity. This includes prudent policies
and processes to identify, measure,
evaluate, monitor, report and control or
mitigate market risks on a timely basis.
Reference Documents
ŸŸ Revisions to the Basel II Market
Risk Framework, February 2011
ŸŸ Interpretative Issues with Respect
to Revisions to the Market Risk
Framework, February 2011
ŸŸ Guidelines for Computing Capital
for Incremental Risk in the Trading
Book, July 2009
ŸŸ Supervisory Guidance for Assessing
Banks’ Financial Instrument Fair
Value Practices, April 2009
ŸŸ Amendment to the Capital Accord to
Incorporate Market Risks, January
2005
Interest rate risk in the
banking book
ŸŸ Ensure that banks have adequate
systems to identify, measure, evaluate,
monitor, report and control or mitigate
interest rate risk in the banking book on
a timely basis.
ŸŸ Principles for the Management and
Supervision of Interest Rate Risk,
July 2004
Liquidity risk
ŸŸ Ensure that banks have prudent and
appropriate liquidity requirements that
reflect their liquidity needs and that they
have a strategy that enables prudent
management of liquidity risk and
compliance with liquidity requirements.
ŸŸ Basel III: International Framework
for Liquidity Risk Measurement,
Standards and Monitoring,
December 2010
ŸŸ Ensure that banks have an adequate
operational risk management framework
that takes into account their risk
appetites, risk profiles, and market and
macroeconomic conditions.
ŸŸ Principles for the Sound
Management of Operational Risk,
June 2011
Operational risk
ŸŸ Principles for Sound Liquidity Risk
Management and Supervision,
September 2008
ŸŸ Recognizing the Risk-Mitigating
Impact of Insurance in Operational
Risk Modelling, October 2010
ŸŸ High-Level Principles for Business
Continuity, August 2006
ŸŸ Joint Forum Outsourcing in
Financial Services, February 2005
Internal control and audit
ŸŸ Ensure that banks have adequate
internal control frameworks to establish
and maintain a properly controlled
operating environment for the conduct
of their businesses, taking into account
their risk profiles.
ŸŸ The Internal Audit Function in
Banks, June 2012
ŸŸ Enhancements to the Basel II
Framework, July 2009
ŸŸ Compliance and the Compliance
Function in Banks, April 2005
ŸŸ Framework for Internal Control
Systems in Banking Organizations,
September 1998
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Prudential Regulations
Objectives
Reference Documents
Financial reporting and
external audit
ŸŸ Ensure that banks and banking
groups maintain adequate and reliable
records, prepare financial statements
in accordance with accounting policies
and practices that are widely accepted
internationally, and annually publish
information that fairly reflects their
financial condition and performances,
and bears an independent external
auditor’s opinion.
ŸŸ Supervisory Guidance for Assessing
Bank’ Financial Instruments Fair
Value Practices, April 2009
ŸŸ Ensure that banks and banking groups
regularly publish information that is
easily accessible and fairly represents
their financial condition, performances,
risk exposures, risk management
strategies, and corporate governance
policies and processes.
ŸŸ Pillar 3 Disclosure Requirements for
Remuneration, July 2011
Disclosure and
transparency
ŸŸ External Audit Quality and Banking
Supervision, December 2008
ŸŸ The Relationship Between Banking
Supervisors and Banks’ External
Auditors, January 2002
ŸŸ Enhancements to the Basel II
Framework, July 2009
ŸŸ Basel II: International Measurement
of Capital Measurement and Capital
Standards, June 2006
ŸŸ Enhancing Bank Transparency,
September 1998
Abuse of financial
services
ŸŸ Ensure that banks have adequate
policies and procedures, including strict
customer due diligence (CDD) rules to
promote high ethical and professional
standards in the financial sector and
prevent the bank from being used,
intentionally or unintentionally, for
criminal activities.
ŸŸ FATF Recommendations, February
2012
ŸŸ Consolidated KYC Risk
Management, October 2004
ŸŸ Shell Banks and Booking Offices,
January 2003
ŸŸ Customer Due Diligence for Banks,
October 2001
4.4 INTRODUCTION TO RISK-BASED CAPITAL
FRAMEWORK UNDER BASEL I
LEARNING OBJECTIVE
4.4
EXPLAIN the objectives and basic features of Basel I—the first risk-based capital standard
for banks
4.4.1
History of the Basel Committee on Banking Supervision
Prior to the Basel Committee on Banking Supervision, there was no international body or
forum imposing minimum standards on how banks should be regulated and supervised.
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Banking regulation was left to the discretion of their respective national regulators. The need
to coordinate the regulation of banks at an international level happened just after the collapse
of the Bretton Woods International Monetary System.
Bretton Woods International Monetary System
The Bretton Woods International Monetary System was the prevailing international monetary
arrangement from the end of World War II to 1974. It adopted a par value system for
international foreign exchange. The par value system is a fixed exchange rate system with the
following features:
ŸŸEach country (other than the United States) agreed to fix the par value of its currency in
terms of the U.S. Dollar. Each country would intervene in the foreign exchange market,
either by buying or selling dollars, to maintain its parity within the prescribed 1% margin.
ŸŸThe U.S.A., on the other hand, agreed to peg the price of its currency (U.S. Dollar) with
gold. For example, in 1958, the U.S. Treasury pegged the price of the dollar at $35 per
one ounce of gold.
ŸŸThe International Monetary Fund (IMF) was established to promote international
monetary cooperation and to administer the par value system. IMF exists to manage
temporary imbalances to maintain the par values such as if a country’s imports exceeded
its exports.
ŸŸThe exchange rates could be adjusted only to correct a fundamental disequilibrium in
the balance of payments.
In a nutshell, the currencies of all member countries other than the U.S.A. were directly
pegged to the U.S. Dollar which, on the other hand, was directly pegged to gold.
Currencies of countries
other than the U.S.
U.S. Dollar
Gold
Figure 4.7 Pegging of currencies
In the 1960s, many countries expressed concerns that the U.S. Dollar’s fixed value against
gold was overvalued. The sizeable deficits due to increased domestic and military spending
caused by the Vietnam War worsened the overvaluation of the U.S. Dollar. Many countries
then opted to convert their U.S. Dollar to gold. These conversions led to the gradual depletion
of the U.S. gold reserves.
In August 1971, U.S. President, Richard Nixon, announced the temporary suspension of
the Dollar’s convertibility into gold. This led to the end of the Bretton Woods System.
The collapse of the Bretton Woods System led countries to choose any form of foreign
exchange arrangement—allowing the currency to float freely, pegging it to another currency or
a basket of currencies, adopting the currency of another country, participating in a currency
bloc or a monetary union.
Failure of Bank Herstatt
In 1974, a relatively unknown bank in Cologne, Germany—Bank Herstatt—had a high
concentration of activities in the area of foreign trade payments. Under the Bretton Woods
System, this was not an issue as the par value system was relatively fixed. This means that the
bank’s foreign exchange activities carried little risk.
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The collapse of the Bretton Woods System led many countries to adopt a floating exchange
rate system. A floating exchange rate system is an exchange rate regime where a currency’s value
is allowed to fluctuate according to market demand and supply. This new regime exposed
Bank Herstatt to huge risks from its foreign exchange activities.
In March 1974, Germany’s Federal Banking Supervisory Office conducted a special audit on
the bank. Herstatt’s open exchange positions amounted to DM2 billion, which is three times
as large as its capital. At the close of business day on 26 June 1974, the regulator withdrew the
banking licence of Bank Herstatt as it was deemed to be insolvent with just DM1 billion in
assets against DM2.2 billion in liabilities.
The failure of Bank Herstatt developed into an international problem. When the banking
regulator closed Bank Herstatt at the close of business day, it was still morning in New York.
Herstatt’s counterparties had already delivered one leg of a foreign exchange transaction (e.g.
Deutsche Mark) not knowing Herstatt’s banking licence had been terminated. The bank’s
liquidators refused to deliver the other leg of the foreign exchange transaction, e.g. U.S. Dollar.
Due to the time difference, banks outside Germany took heavy losses on their unsettled
trades with Bank Herstatt. This is illustrated in Figure 4.8.
New York
Germany
Deutsche Mark
U.S. Dollar
Closed by German
Regulator
Figure 4.8 Settlement risk—failure of Bank Herstatt
Basel Committee on Banking Supervision
The failure of Bank Herstatt brought an international dimension to the banking crisis. It also
heightened the need to coordinate bank regulatory and supervisory efforts on an international
level.
In 1974, central bank governors of the G10 countries established a Committee on Banking
Regulations and Supervisory Practices. This committee was later renamed as the Basel
Committee on Banking Supervision (BCBS).
The Basel Committee was designed as a forum for regular cooperation among its member
countries on banking supervisory matters. It is the primary global standard-setter for the
prudential regulations of banks and provides a forum for cooperation on banking supervisory
matters. It aims to enhance financial stability by improving supervisory know-how and the
quality of banking supervision worldwide. The Basel Committee executes this mandate by:
ŸŸSetting minimum supervisory standards
ŸŸImproving the effectiveness of techniques for supervising international banking business
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ŸŸExchanging information on national supervisory arrangements
ŸŸEngaging with challenges presented by diversified financial conglomerates
ŸŸWorking with other standard-setting bodies
The BCBS issues standards, guidelines and sound practices to achieve its objectives.
Table 4.4 Role of the Basel Committee on Banking Supervision
Standards
The BCBS standards constitute minimum regulatory and supervisory requirements of banks.
These standards are expected to be incorporated into local legal frameworks of BCBS
member countries.
Guidelines
The BCBS guidelines elaborate the standards. They supplement the standard by providing
additional guidance for the purpose of their implementation.
Sound practices
The BCBS sound practices describe actual observed practices among banks with the goal
of promoting common understanding and improving supervisory or banking practices. Banks
can compare these sound practices with their current practices and identify potential areas for
improvement.
The standards, guidelines and sound practices have no legal force. The BCBS relies on
its members’ commitments to incorporate these standards and decisions in their own legal
framework.
4.4.2
Basel I: The 1988 Basel Capital Accord
In the 1980s, many Latin American countries defaulted on their foreign debt obligations. In
1970, their debt level was just US$29 billion but, by the end of 1982, the debt levels increased
by more than tenfold to US$327 billion.
1970
1978
29
159
1982
327
Figure 4.9 Debt levels of Latin American economies (in US$ billion)
Many U.S. commercial banks were heavily exposed to these Latin American economies. By
1982, the nine largest U.S. money-centre banks held Latin American Debt amounting to 176%
of their capital. This led the Basel Committee to focus their work on capital adequacy.
In 1988, the BCBS issued the International Convergence of Capital Measurement and Capital
Standards, commonly referred to as the 1988 Basel Capital Accord (or Basel I). This is the first
international framework for measuring capital adequacy and minimum standards, which each
member countries intend to implement in their respective countries. The two main objectives
of Basel I are:
ŸŸStrengthen the soundness and stability of the international banking system
ŸŸEstablish a level playing field among international banks
The 1988 Basel Capital Accord aims to establish minimum levels of capital for internationally
active banks relative to their respective risk-weighted assets or off-balance-sheet exposures.
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This system provides for the implementation of a framework with a minimum capital to riskweighted assets of 8% by end 1992.
Basel I Ratio =
Total Capital
≥ 8%
Risk-weighted Assets
The Basel I ratio is also called the Cooke Ratio—named after Peter Cooke, a former chairman
of the Basel Committee on Banking Supervision. The Cooke Ratio has two main components
in its calculation:
ŸŸTotal capital
ŸŸRisk-weighted assets or off-balance-sheet exposures
The objective of the Cooke Ratio is to encourage banks to maximize the level of capital that
they hold while at the same time, to minimize their risk-weighted assets or exposures.
Why focus on capital?
Banks hold assets such as loans and receivables in their books. Deterioration in the credit
quality of a bank’s book will result in write-downs and credit losses. They are directly recognized
in the bank’s profit and loss (P&L). These write-downs and credit losses directly impact the
bank’s retained earnings, which are part of the bank’s capital.
As long as losses do not exceed its capital, the bank will continue to exist as a going concern.
This is because the bank has no contractual obligation to pay its equity holders. If losses exceed
the bank’s capital, losses will accrue to the debtholders. The bank has a contractual duty to
make payments on its financial obligations to its debtholders.
Debtholders have a legal recourse to force the bank to file for bankruptcy and cease to exist
as a going concern. This is the reason why capital is considered as a buffer that allows the
banking organization to withstand losses in a stress scenario.
ŸŸTotal capital
For regulatory capital purposes, capital is stratified into two types:
mm Core capital or Tier 1 capital—comprises basic equity capital and disclosed reserves
(retained earnings). This includes permanent shareholders’ equity, i.e. issued and fullypaid ordinary shares/common stocks and perpetual non-cumulative shares.
Disclosed reserves are created or increased by appropriations of retained earnings
or other surplus, such as share premiums, retained profit, general reserves and legal
reserves.
mm Supplementary capital or Tier 2 capital—is a secondary source of capital for banks.
Tier 2 capital is composed of:
–– Undisclosed reserves—or hidden reserves are unpublished reserves that could be
freely and immediately used to meet unforeseen future losses.
–– Revaluation reserves—are reserves generated as a result of the positive revaluation
of fixed assets and equity investments relative to its historic cost of acquisition.
–– General provisions/general loan-loss reserves—are held against unidentified
losses that are freely available to meet losses, which subsequently materialize.
–– Hybrid debt capital instruments—are instruments that combine the characteristics
of equity capital and debt.
–– Subordinated term debts—are unsecured, long-term debt instruments that
rank lower than secured debt obligation of banks but rank higher than equity.
Subordinated term debts are limited to a maximum of 50% of the Tier 1 capital.
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For purposes of calculating the available capital, banks are required to deduct the
following items from their capital:
Goodwill
Investments in unconsolidated banking and financial subsidiary companies
mm Investments in the capital of other financial institutions
mm
mm
ŸŸRisk-weighted assets
The other feature of the Cooke Ratio is the risk weighting of assets or exposures.
These assets or exposures are weighted according to broad categories of relative
riskiness. The risk weighting is kept as simple as possible. In Basel I, there are five
risk weights, i.e. 0%, 10%, 20%, 50% and 100%. Riskier assets are assigned higher risk
weights.
Table 4.5 Risk weights under the Cooke Ratio
Risk Weights
0%
Category
ŸŸ Cash
ŸŸ Claims on central governments and central banks in their national currencies
ŸŸ Claims on the OECD central governments and central banks
10%
ŸŸ Claims on domestic public-sector entities (at national discretion)
20%
ŸŸ Claims on multilateral development banks
ŸŸ Claims on banks incorporated in the OECD*
ŸŸ Claims on banks incorporated outside the OECD with maturity of less than one year
50%
ŸŸ Loans secured by mortgage on residential properties
100%
ŸŸ Claims on private sectors
ŸŸ Claims on banks incorporated outside the OECD with maturity of greater than one year
ŸŸ Claims on central governments outside the OECD
ŸŸ Fixed assets
ŸŸ Real estates and other investments
* OECD countries are those which are full members of the Organization for Economic Cooperation and Development
Illustrative Example
Computing for Basel I Capital Ratio
A simplified balance sheet of Bank XYZ:
RM
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RM
Cash
100,000,000 Deposit
470,000,000
Real estate loans (unsecured)
50,000,000 Common shares
30,000,000
Loans from Company X
200,000,000
Real estate loans (secured)
150,000,000
Total Assets
500,000,000 Total Liabilities and Equity
500,000,000
(a)
Calculate the Basel I capital ratio for Bank XYZ.
(b)
Determine if Bank XYZ is within the minimum capital requirements under Basel I.
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Solution:
(a) Step 1: Calculate the risk-weighted assets
RM
Risk
Weights
Risk-Weighted Assets
(RM)
Cash
100,000,000
0%
0
Real estate loans (unsecured)
50,000,000
100%
50,000,000
Loans from Company X
200,000,000
100%
200,000,000
Real estate loans (secured)
150,000,000
50%
Risk-weighted assets
75,000,000
325,000,000
Step 2: Calculate the total capital
Total capital = RM30,000,000
Step 3: Calculate the Basel I ratio
Total capital
Risk-weighted assets
30,000,000
=
325,000,000
= 9.23%
Basel I ratio =
(b) The bank’s Basel I ratio is 9.23%. This is above the minimum Basel I capital requirement of 8%.
Basel I covers only credit risk. Risks arising from other sources, such as market risk, are left
to the discretion of the respective country’s national supervisor.
The 1996 market risk amendment
One of the criticisms against Basel I is that it covers only the bank’s credit risk exposures. In
the 1990s, many banks had substantial exposures to market risks. In 1995, Barings Bank—the
oldest bank in Britain— collapsed due to the speculative activities of a single British trader
based in Singapore. Trading losses peaked when a wrong bet on Japan equities led to the bank’s
recognition of US$1.3 billion in losses. The 233-year-old institution’s capital and reserves were
wiped out.
In January 1996, the Basel Committee issued an amendment to the 1988 Basel Capital
Accord which incorporated within the Basel I capital requirements, market risks arising from
banks’ open positions in foreign exchange, traded debt securities, equities, commodities and
options.
Market risk is defined as the risk of losses in on- and off-balance sheet positions arising
from movements in market prices. Market risk includes:
ŸŸGeneral and specific risk pertaining to interest rate risk and equity risk in the trading book
ŸŸForeign exchange risk and commodity risk throughout the bank
Banks have two alternative methodologies of measuring market risks:
ŸŸStandardized method—involves a rule-based ‘black box’ approach to measure:
mm Interest rate risk
mm Equity position risk
mm Foreign exchange risk
mm Commodities risk
The standardized methodology uses a building-block approach in which the specific risk
and the general market risk arising from debt and equity positions are calculated separately.
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ŸŸInternal models approach—allows banks to use risk measures derived from their own
internal risk management models, subject to the fulfillment of certain conditions and
upon the explicit approval of the central bank.
For purposes of calculating the regulatory capital requirement for market risk, banks are
required to calculate daily value-at-risk (VAR) at the 99th percentile, one-tailed confidence
interval with a 10-day holding period.
The amendment also introduced another type of capital, namely Tier 3 capital. At the
discretion of the respective country’s central bank, banks may employ a third tier of capital (Tier
3) consisting of short-term subordinated debt for the sole purpose of meeting a proportion of
the capital requirements for market risk. This means that banks may not use the Tier 3 capital
to satisfy credit/counterparty risk requirements under the Basel I Accord.
The Tier 3 capital is limited to 250% of a bank’s Tier 1 capital that is required to support
market risks. In addition, the combined total of Tier 2 and Tier 3 capital shall not exceed the
bank’s total Tier 1 capital.
4.5 THE THREE PILLARS OF BASEL II
LEARNING OBJECTIVE
4.5
DISCUSS the basic features of the three pillars of Basel II
In June 2004, the Basel Committee released the Revised Capital Framework. This revised capital
framework was designed to improve the way regulatory capital requirements reflect underlying
risks, and address the financial and risk management innovation that occurred in the years
following Basel I. Basel II consists of three pillars:
ŸŸMinimum capital requirements (Pillar 1)
ŸŸSupervisory review process (Pillar 2)
ŸŸMarket discipline (Pillar 3)
Pillar 1:
Minimum capital
requirements
Pillar 2:
Supervisory
review process
Pillar 3:
Market discipline
Figure 4.10 The three pillars of Basel II
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4.5.1
Pillar 1—Minimum Capital Requirements
Pillar 1 of Basel II sets out a revised minimum capital requirements for banks. While Basel II
retains the 8% minimum capital requirements for banks, it expands the mechanism of risk
weighting a bank’s assets. The formula for determining a bank’s Basel II ratio is:
Basel II Ratio =
Total Capital
Market Risk + Credit Risk + Operational Risk
≥ 8%
Basel II specifies the minimum capital calculations for three types of risks:
ŸŸMarket risk
ŸŸCredit risk
ŸŸOperational risk
Market risk
The Basel II capital framework consolidated the market risk amendment to the minimum
capital requirements. The minimum capital requirements for market risk is essentially the
same as discussed in section 4.4.2’s subtopic—The 1996 market risk amendment.
Real World Illustration
Fundamental Review of the Trading Book
In October 2013, the Basel Committee on Banking Supervision released the second consultative
paper on the fundamental review of capital requirements for the trading book. The key features
of the proposed revised framework include:
ŸŸ Revised boundary between trading book and banking book. The new approach aims to
introduce a more objective boundary between the two books that remains aligned with the
banks’ risk management practices and reduces incentives for regulatory arbitrage.
ŸŸ Revised risk measurement approach and calibration. The proposal involves a shift in market
risk measure from value-at-risk to expected shortfall.
ŸŸ Market illiquidity. The proposal involves the introduction of liquidity risk horizons in the market
risk metric and an additional risk assessment tool for trading desks with exposure to illiquid,
complex products.
ŸŸ Revised standardized approach. The proposal includes a new risk-sensitive approach that
can be used as an alternative to the internal models approach which is appropriate for banks
and do not require sophisticated measurement of market risk.
ŸŸ Revised internal models approach. The proposal includes provisions requiring a more
comprehensive model approval process and a more consistent identification and capitalization
of material risk factors.
ŸŸ Strengthened relationship between the standardized and model-based approaches. The
proposal requires mandatory calculation of the standardized approach by all banks and
mandatory public disclosures of standardized capital charges by all banks.
ŸŸ Closer alignment between trading and banking book in the regulatory treatment of credit risk.
ŸŸ The proposal considers using the standardized approach calculation as the floor or surcharge
to the model-based approach.
Source: Fundamental Review of the Trading Book–Second Consultative Document, October
2013, Basel Committee on Banking Supervision
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Operational risk
Operational risk is not explicitly covered in Basel I but it is formally defined in Basel II as the
risk of loss resulting from inadequate or failed processes, people, systems or from external
events. Figure 4.11 depicts the three measurement approaches for operational risk as outlined
in Basel II.
Basic Indicator Approach
Advanced Measurement
Approaches
Standardized Approach
Figure 4.11 Three measurement approaches for operational risk
ŸŸBasic Indicator Approach—is the simplest method and uses the average of the previous
three years of a fixed percentage of the bank’s positive annual gross income as the basis
for setting capital.
Internationally active banks and banks with significant operational risk exposures
are expected to use an approach that is more sophisticated than the Basic Indicator
Approach (BIA).
ŸŸStandardized Approach—In this approach, banks’ activities are divided into eight
business lines:
Corporate finance
Trading and sales
mm Retail banking
mm Commercial banking
mm Payment and settlement
mm Agency services
mm Asset management
mm Retail brokerage
mm
mm
Capital charges for each of the business lines are based on a percentage (beta) of that business
line’s gross income. The percentage (beta) was set according to the perceived riskiness of the
business line.
Table 4.6 Quantum for capital charges
Business Lines
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Beta Factors
Corporate finance (b1)
18%
Trading and sales (b2)
18%
Retail banking (b3)
12%
Commercial banking (b4)
15%
Payment and settlement (b5)
18%
Agency services (b6)
15%
Asset management (b7)
12%
Retail brokerage (b8)
12%
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The total capital charge is the three-year average of the sum of the charges across business
lines in each year.
ŸŸAdvanced Measurement Approach (AMA)—is the most complex method of calculating
operational risk regulatory capital. Under the AMA, the regulatory capital requirement
will be based on the risk measure generated by the bank’s internal risk measurement
system. The use of AMA is subject to supervisory approval.
Subject to getting prior supervisory approval, a bank will not be allowed to revert to
or choose a simpler approach once it has received approved to adopt a more advanced
approach.
Real World Illustration
Operational Risk—Revisions to Simpler Approaches—Consultative Document
In October 2014, the Basel Committee on Banking Supervision released a consultative paper
that sets out proposed revisions to the Standardized Approach for measuring operational risk
capital. Once finalized, the revised Standardized Approach will replace the current non-model
based approaches, i.e. Basic Indicator Approach, Standardized Approach and the Alternative
Standardized Approach.
A statistically superior measure of operational risk, which is referred to as the Business Indicator
(BI), will replace gross income as the key input for determining operational risk capital.
The proposal aims to remove the differentiation by a business line which is found not to be a
significant risk driver. Instead, size is found to be a significant risk-driver and is incorporated in
the new methodology.
Source: Operational Risk–Revisions to Simpler Approaches–Consultative Document, October
2014. Basel Committee on Banking Supervision
Credit risk
Basel II introduced significant changes to the minimum capital requirements for Basel I. Basel
II provides capital incentives for banks to move to more sophisticated credit risk management
approaches.
Standardized Approach
Internal Ratings-Based
(Foundations)
Internal Ratings-Based
(Advanced)
Figure 4.12 Three measurement approaches for credit risk
ŸŸStandardized approach—is similar to Basel I except that Basel II focuses on the credit
ratings assessment of External Credit Assessment Institutions (ECAIs) to define the
required risk weights. Higher-rated individual claims have lower risk weights compared
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Risk Management in Banking: Principles and Framework
to lower-rated claims. Further, under the standardized approach, credit risk exposures
are divided into the following exposure types:
mm
Sovereigns
Table 4.7 Risk weights—sovereigns
mm
Corporate Credit Ratings
Risk Weights
AAA to AA-
0%
A+ to A-
20%
BBB+ to BBB-
50%
BB+ to B-
100%
Below B-
150%
Unrated
100%
Public sector entities, banks and securities firms
Table 4.8 Risk weights—public entities, banks and securities firms
Corporate Credit Ratings
Risk Weights
(Option 1: 1 Rating below
Sovereign)
Risk Weights
(Option 2: External Credit
Assessment Institutions
Rating-Based)
AAA to AA-
20%
20%
A+ to A-
50%
50%
BBB+ to BBB-
100%
50%
BB+ to BB-
100%
100%
Below B-
150%
150%
Unrated
100%
50%
mm
Corporates
Table 4.9 Risk weights—corporates
Corporate Credit Ratings
Risk Weights
AAA to AA-
20%
A+ to A-
50%
BBB+ to BB-
100%
Below BB-
150%
Unrated
100%
ŸŸInternal ratings-based approach (IRB) approach—allows banks to rely on their own
internal estimates of risk components to determine the capital requirement for a given
exposure. This approach requires prior supervisory approval.
Under the IRB approach, banks must categorize banking book exposures into broad
classes of assets with different underlying risk characteristics. These classes of assets are:
mm
mm
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Corporate
Sovereign
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Bank
mm Retail
mm Equity
mm
The IRB approach will be covered in more detail in Book II.
4.5.2
Pillar 2—Supervisory Review and Evaluation Process
Pillar 2 of the Basel II Framework describes the mandatory processes for both banks and
supervisory authorities (regulators) to establish a link between a bank’s risk profile, its
risk management infrastructure and its capital. Pillar 2 goes beyond the minimum capital
requirements of Pillar 1; risks that are not addressed in Pillar 1 are addressed in Pillar 2.
The supervisory review process aims to:
ŸŸensure that banks have adequate capital to support all the risks in their business; and
ŸŸencourage banks to develop and use better risk management techniques in monitoring
and managing risks.
Pillar 2 has two major components:
ŸŸInternal Capital Adequacy Assessment Process
ŸŸSupervisory Review and Evaluation Process
Internal capital
adequacy assessment
process
Dialogue/
Discussion
Supervisory review
evaluation process
Figure 4.13 Major components of Pillar 2
Figure 4.13 illustrates the mandatory process for both the banks and supervisory authority
to engage in dialogues. It aims to establish a link between a bank’s risk profile, its risk
management infrastructure and its capital.
ŸŸInternal capital adequacy assessment process (ICAAP) is a process for banks to assess their
capital adequacy in relation to its risk profile.
ŸŸSupervisory review and evaluation process (SREP) is an evaluation process to ensure that
banks have adequate capital in relation to their risk profile and a forum to encourage
banks to develop and use better risk measurement and management techniques.
Internal capital adequacy assessment process
Banks are required to implement a process for assessing their capital adequacy in relation to
their risk profile as well as a strategy on capital management. This process is referred to as the
internal capital adequacy assessment process (ICAAP).
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ICAAP serves as the guideline for setting capital targets commensurate with the bank’s
risk profile and control environment. Figure 4.14 depicts the five main features of a rigorous
internal capital adequacy assessment process.
Elements of
Rigorous
ICAAP
Board and senior management oversight
Sound capital assessment
Comprehensive assessment of risks
Monitoring and reporting
Internal control review
Figure 4.14 Main features of ICAAP
ŸŸBoard and senior management oversight
The bank’s board of directors has a responsibility for setting the bank’s tolerance for
risks. It should also ensure that management:
mm establishes a framework for assessing the various risks;
mm develops a system to relate risk to the bank’s capital level; and
mm establishes a method for monitoring compliance with internal policies.
The bank management is responsible for understanding the nature and level of risk
being taken by the bank, and how the risk relates to adequate capital levels. It also has
to ensure that the formality and sophistication of the risk management processes are
appropriate in light of the risk profile and business plan.
ŸŸSound capital assessment
The bank should have the following elements of sound capital assessment:
mm Policies and procedures designed to ensure that the bank identifies, measures and
reports all material risks.
mm A process that relates capital to the level of risk.
mm A process that states the capital adequacy goals with respect to risk, taking account of
the bank’s strategic focus and business plan.
mm A process of internal controls, reviews and audits to ensure the integrity of the overall
management process.
ŸŸComprehensive assessment of risks
All material risks the bank faces should be assessed in the capital assessment process.
The assessment should cover the following broad categories of risks:
mm Credit risk
mm Market risk
mm Operational risk
mm Interest rate risk in the banking book
mm Liquidity risk
mm Other related risks
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ŸŸMonitoring and reporting
The bank should establish an adequate system for monitoring and reporting risk
exposures and for assessing the impact of the bank’s changing risk profile on the need
for capital.
ŸŸInternal control and review
The internal control structure is an essential component of the capital assessment
process. The bank should conduct periodic review of its process to ensure its integrity,
accuracy and reasonableness. The review should encompass the following areas:
mm Appropriateness of the bank’s capital assessment process
mm Identification of large exposures and risk concentrations
mm Accuracy and completeness of data inputs into the bank’s assessment process
mm Reasonableness and validity of scenarios used in the capital assessment process
mm Stress testing and analysis of assumptions and inputs
Supervisory review and evaluation process
The supervisory review process aims to:
ŸŸensure that banks have adequate capital to support all the risks in their business; and
ŸŸencourage banks to develop and use better risk management techniques in monitoring
and managing their risks.
Figure 4.15 shows the key focus areas of the supervisory review process.
Review of adequacy
of risk assessment
Supervisory
response
Supervisory review
of compliance with
minimum standards
Assessment of
capital adequacy
Assessment of the
control environment
Figure 4.15 Key areas in the supervisory review process
ŸŸAdequacy of risk assessment
Bank supervisors should assess the degree to which the bank’s internal targets and
processes incorporate the full range of material risks, the adequacy of risk measures used
in assessing the internal capital adequacy, and the extent to which the risk measures are
used operationally in setting limits, evaluating business line performance, and evaluating
and controlling risks.
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Risk Management in Banking: Principles and Framework
ŸŸAssessment of capital adequacy
Supervisors should review the bank’s business process to determine the following
elements:
mm Target levels of capital chosen are comprehensive and relevant to the current operating
environment
mm Target levels are properly monitored and reviewed by senior management
mm Composition of capital is appropriate for the nature and scale of the bank’s business
ŸŸAssessment of the control environment
Supervisors should consider the quality of the bank’s management information system
and reporting, the manner in which business risks and activities are aggregated and
management’s record in responding to emerging or changing risks.
ŸŸSupervisory review of compliance with minimum standards
Supervisors should ensure that banks meet the minimum requirements in capital, risk
management standards and disclosures.
ŸŸSupervisory response
Supervisors should take appropriate action if they are not satisfied with the results of the
bank’s own risk assessment and capital actions. The actions may include:
mm Intensifying the monitoring of the bank
mm Restricting the payment of dividends
mm Requiring the bank to prepare and implement a satisfactory capital adequacy
restoration plan
mm Requiring the bank to raise additional capital immediately
4.5.3
Pillar 3—Market Discipline
Pillar 3 of the Basel II Framework aims to encourage market discipline by developing a
set of disclosure requirements, which will allow market participants to assess key pieces
of information on the bank’s capital, risk exposures, risk assessment process and capital
adequacy.
The main objective of Pillar 3—Market Discipline is to allow the public to enforce
discipline on banks by requiring the institutions to provide key pieces of information to
help them (the public) make informed assessment of the banks’ risks and capital adequacy
profiles.
Pillar 3 enforces banks’ compliance with market discipline disclosures pertaining to
information on:
ŸŸScope of application
ŸŸBank’s capital
ŸŸCapital adequacy
Scope of application
This section establishes the scope of the Pillar 3 disclosures. The Basel Committee requires
banks to apply the Pillar 3 disclosures at the top consolidated level of the banking group.
This section also discusses the analysis of total capital and Tier 1 capital ratios of significant
banking subsidiaries within the group.
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Table 4.10 Pillar 3—scope of application
Qualitative disclosures
ŸŸ Name of the top corporate entity in the group
ŸŸ Outline of differences in the basis of consolidation for accounting and
regulatory purposes
ŸŸ Restrictions on transfer of funds or regulatory capital within the group
Quantitative disclosures
ŸŸ Aggregate amount of surplus capital of insurance subsidiaries
ŸŸ Aggregate amount of capital deficiencies in all subsidiaries not included in the
consolidation
ŸŸ Aggregate amounts of the bank’s total interests in insurance entities
Capital
Table 4.11 Tier 1—disclosures of bank’s capital
Qualitative disclosures
ŸŸ Summary information on the terms and conditions of the main features of all
capital instruments
Quantitative disclosures
ŸŸ Amount of Tier 1 capital with separate disclosures of:
mm Paid-up share capital / common stock
mm Reserves
mm Minority interests in the equity of subsidiaries
mm Innovative instruments
mm Other capital instruments
mm Surplus capital from insurance companies
mm Regulatory calculation differences deducted from the Tier 1 capital
mm Other amounts deducted from the Tier 1 capital including goodwill and
investments
ŸŸ Total amount of Tier 2 and Tier 3 capital
ŸŸ Other deductions from capital
ŸŸ Total eligible capital
Capital adequacy
Table 4.12 Tier 1—disclosure on bank’s capital adequacy
Qualitative disclosures
Summary discussion of the bank’s approach to assessing the adequacy of its
capital to support current and future activities
Quantitative disclosures
Capital requirements for credit risk
Capital requirements for equity exposures
Capital requirements for market risk
Capital requirements for operational risk
Total capital and Tier 1 capital ratio
Risk exposure and assessment
Banks are required to disclose all material risks which they face and the techniques they use to
identify, measure, monitor and control those risks. The detailed disclosures will include the
following key risks:
ŸŸCredit risk
ŸŸMarket risk
ŸŸInterest rate risk and equity risk in the banking book
ŸŸOperational risk
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4.6 INTRODUCTION TO BASEL III REQUIREMENTS
LEARNING OBJECTIVE
4.6
EXPLAIN the key capital and liquidity reforms under Basel III
The 2008 global financial crisis highlighted many weaknesses in the banking sector, which
were not adequately addressed by the Basel II capital framework. These weaknesses included
excessive leverage, inadequate and low-quality capital, and insufficient liquidity buffers.
These weaknesses were further amplified by a procyclical deleveraging process and the
interconnectedness of systemically important financial institutions.
Basel III was designed to address the lessons learned from the 2008 crisis. It does not replace
the Basel II capital framework. Instead, it supplements Basel II by addressing its weaknesses.
In order to understand the context in which Basel III was designed, it is important for the
students to appreciate the weaknesses of the banking sector and related issues arising from
the 2008 crisis.
4.6.1
2008 Global Financial Crisis and Basel II Weaknesses
Figure 4.16 depicts the key weaknesses of the Basel II regime—from the bank-level (micro-level)
and system-wide (macro-level) perspectives—that were highlighted by the 2008 financial crisis.
Inadequate and low
quality capital
Bank-level
weaknesses
Insufficient liquidity
buffers
Excessive leverage
2008 financial crisis
weaknesses
Procyclicality
System-wide
weaknesses
Interconnectedness
of systemically
important financial
institutions
Figure 4.16 Weaknesses of Basel II highlighted by the 2008 financial crisis
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Inadequate and low-quality capital
The global banking system entered the crisis with an insufficient level of high quality capital.
As the crisis unfolded, many banks were forced to rebuild their common equity capital bases,
at a time when it was expensive and difficult to do so.
Another issue involved the many innovative instruments that were considered to be capital
under the Basel II framework, but did not perform as an effective buffer for losses during the
crisis. Capital is considered to be effective if it is loss-absorbing. Capital is intended to serve as
an effective buffer for credit risk and to absorb losses during a financial crisis. This means that
banks must not be obligated to replace this capital when it is less optimal to do so.
Real World Illustration
Deutsche Bank Elects not to Exercise Call
Deutsche Bank AG, Europe’s biggest investment bank by revenue, passed up an opportunity to
redeem EUR 1 billion of subordinated bonds, saying it would be more expensive to refinance the
debt. The bank had the option to buy back the 3.875% notes on 16 January 2014 or pay a socalled step-up coupon of 88 basis points more than Euribor.
Deutsche Bank’s decision startled bondholders because borrowers are expected to repay
callable notes at the first opportunity and the securities are valued on that basis.
“Frankly I am surprised,” said Bill Blain, a broker at KNG Securities in London. “No doubt some
doomsters will say Deutsche Bank is skipping a call because it faces further losses.”
Source: Bloomberg News, 17 December 2008
Insufficient liquidity buffers
In the years running up to the 2008 financial crisis, liquidity did not receive adequate attention
as debates about bank regulation were focused on capital adequacy. While a strong capital
position was a necessary condition for banking sector stability, the crisis showed that it was
insufficient.
Prior to the crisis, liquidity was abundant and cost of funding was low. During the crisis,
funding dried up and remained in short supply for a very long period. One of the lessons
learned was that illiquid markets could last for a long period of time. For example, many
banks had assumed that the liquidity crunch would not last as long as it did from the time the
Federal Home Loan Mortgage Corporation (Freddie Mac) announced that it would no longer
purchase most of the risky subprimes and mortgage-related securities in February 2007 to the
Lehman Brothers collapse in 2008. Many banks had expressed confidence that liquidity in the
markets would be restored.
Excessive leverage
Excessive leverage in the banking system played a crucial role in creating vulnerabilities that
increased the depth and severity of the 2008 crisis.
According to the Turner Report, from 2003 onwards, there were significant increases in
the balance sheet leverage of many commercial and investment banks driven by dramatic
increases in gross assets and derivative positions. Further, the U.S. Financial Crisis Inquiry
Commission reported that, as of 2007, five major global investment banks were operating
with extraordinarily high leverage. By one measure, their leverage ratios were as high as 40:1—
meaning, for every $40 in asset, there was only $1 to cover for the losses. This implied that a
drop in asset value of less than 3% could wipe out the bank’s entire value.
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During the period leading up to the crisis, many banks reported strong Basel II Tier 1
risk-based ratio while still being able to build high levels of both on- and off-balance sheet
leverages.
Procyclicality
Procyclicality refers to the mutually reinforcing mechanisms through which the financial
system can amplify business fluctuations and possibly cause or amplify financial instability.
It is the tendency of financial variables to fluctuate around a trend during the economic cycle.
One of the unintended consequences of Basel II is encouraging behaviour that amplifies
the effects of business cycle fluctuations. During periods of economic expansions, risk
measurement models signal lower risk. Regulatory capital required, therefore, is lower. Banks
tend to take more risk during these favourable economic conditions. Further, they do not raise
capital when it is cheaper and more optimal to do so.
On the other hand, during periods of economic contractions, risk measurement models
signal higher risk. The regulatory capital required is higher. This forces banks to raise more
capital when it is more expensive to do so. Besides, banks are restricted from taking more
risks, which will further amplify the economic contraction. These reinforcing mechanisms
are disruptive and apparent during a downturn. For instance, financial institutions will incur
losses and capital buffers decline, which will force them to raise funding in an unfavourable
environment. This will also result in tightening of credit extension and selling of assets, which
will in turn weaken the economy.
There are two types of procyclicality:
ŸŸProcyclicality of capital
When conditions are good, financial institutions are profitable. Their strong capital
base allows them to take larger risk positions. This triggers additional demand for assets
and leads to further increase in their prices. On the other hand, when conditions are
unfavourable, they make losses and their capital base deteriorates. This triggers sellingoff of assets and leads to further decrease in their prices.
ŸŸProcyclicality of leverage
Procyclicality of leverage occurs when financial institutions’ balance sheets expand and
contract with economic cycles. The different mechanisms at work are:
mm
mm
mm
Risk measurement models. Risk measurement models are procyclical, especially
when constructed with short data series. Risk management practices hardwired to
valuations strongly amplify fluctuations in leverage and lead to fire sales and onesided markets.
Short-term money markets. When liquidity is perceived to be abundant, there is a
strong incentive or appetite to lengthen asset maturity and hold strongly-leveraged
positions.
Risk appetite. Valuation gains may encourage further risk-taking while valuation
losses may trigger sharp pull-backs.
Interconnectedness of systemically important financial institutions
During the financial crisis, excessive interconnectedness among systemically important banks
transmitted shocks across the financial system and economy. The collapse of Lehman Brothers
in 2008 sent global shockwaves across financial institutions.
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Corporate
issuers
Insurance
companies
Mortgage
banks
Other
banks/
dealers
Lehman Brothers
Over 7,000 legal
entities in more
than 40 countries
Money
market
funds
Hedge
funds
Sovereign
and municipal
debt
issuers
Source: Presentation by PricewaterhouseCoopers’ Financial Services Institute
Figure 4.17 The Lehman shockwaves
The 2008 financial crisis provided lessons on the costs to the economy in the absence
of effective powers/regulatory tools for dealing with the failure of systemically important
financial institutions.
Basel III reforms
During the period 2009−2010, the Basel Committee introduced various reform measures
to address the lessons learnt from the 2008 financial crisis. They focused on strengthening
global capital and liquidity rules towards promoting a more resilient banking sector. These
measures—collectively referred to as Basel III—are expected to be fully implemented by 2019.
The reforms aim to address the following bank-level and system-wide weaknesses that were
identified in the 2008 financial crisis:
ŸŸRaising the quality of capital to ensure banks are better able to absorb losses on both a
going-concern and gone-concern basis
ŸŸIncreasing the risk coverage of the capital framework
ŸŸRaising the level of the minimum capital requirements
ŸŸIntroducing an internationally harmonized leverage ratio to serve as a backstop to the
risk-based capital measure and to contain the build-up of excessive leverage in the system
ŸŸRaising standards for the supervisory review process (Pillar 2) and public disclosures
(Pillar 3)
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ŸŸIntroducing minimum global liquidity standards
ŸŸPromoting the build-up of capital buffers in good times that can be drawn down in
periods of stress
4.6.2
Basel III—Capital Reforms
The Basel III capital reforms focus on strengthening both the quality and level of capital. It
prescribes increasing the required amount of capital and at the same time limited the use of capital
that is not fully loss absorbing.
The two main purposes of capital are:
ŸŸGoing-concern capital
Going-concern capital is capital that absorbs losses without the bank being subjected
to excessive pressure to contain its liquidity. It allows the entity to continue as a going
concern and enhances its ability to stay solvent.
The objective of Tier 1 capital is to allow the entity to survive and continue as a going
concern. Hence, only capital that allows the bank to stay solvent and continue as a going
concern can be considered as Tier 1 capital. The predominant form of Tier 1 capital must
be common shares and retained earnings.
The common equity Tier 1 capital includes:
mm Common shares
mm Share premium
mm Retained earnings
mm Accumulated comprehensive income
mm Minority interest
mm Regulatory adjustments
Other than common equity shares, there are certain innovative capital structures
that can be considered as Additional Tier 1 capital—an alternative Tier 1 capital with no
maturity date. Additional Tier 1 capital is a hybrid debt instrument with principal loss
absorption features. A common example of these hybrid debt instruments are preferred
shares, which contain both debt and equity features.
The principal loss absorption feature generally allows the bank to convert common
shares at pre-specified trigger point or contain a write-down mechanism, which allocates
losses to the instrument at a specified trigger point.
ŸŸGone-concern capital
Gone-concern capital refers to capital that aims to protect senior creditors, depositors
and taxpayers in the event of a bank failure.
Tier 2 capital, which is ranked junior to senior creditors and depositors but more
senior compared to common equity holders, is considered to be a gone-concern capital.
The Basel Committee on Banking Supervision held the consensus that high-quality
capital means higher loss-absorbing capital to allow banks better withstand periods of
stress.
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Quantity of capital
Common Tier 1: 4.5%
Tier 1 Capital: 6.0%
Total Capital: 8.0%
Figure 4.18 Capital requirements under Basel III
Under Basel III, there is no change in the level of total capital required to support a bank’s
risk-weighted assets. As with Basel II, the minimum total capital required is 8%. (Note: The
additional 2.5% capital conservation buffer is not part of the regulatory capital minimum
requirement. Failure to meet this requirement will only restrict the bank’s ability to make
capital distributions, but will not result in constraints to the bank’s operations.)
There are, however, some changes to the level of high-quality capital required, namely:
ŸŸCommon Tier 1 capital requirement increased from 2% of risk-weighted assets to 4.5%
ŸŸTier 1 capital requirement increased from 4% of risk-weighted assets to 6%
Capital conservation buffer
Basel III introduced a framework to promote conservation of capital and the build-up of
adequate buffers above the minimum capital requirement that can be drawn upon during
periods of financial stress. The objective is to encourage banks to hold capital buffers above
the regulatory minimum.
At the onset of the 2008 financial crisis, a number of banks continued to make large
distributions of capital through dividend payments, share buy-backs and generous
compensation payments even though the financial condition and outlook the banking sector
was deteriorating.
Many of the activities were driven by a collective action problem where any reductions in
distributions were perceived as sending a signal of weakness. This made individual banks less
resilient as they did not do enough to rebuild their capital buffers, particularly during the
good times.
The capital conservation buffer aims to increase the resilience of the banking sector during
a downturn and provide a mechanism for rebuilding capital during an economic recovery. The
buffer will help to avoid breaches of the minimum capital requirement and to maintain the
capital buffer above the regulatory minimum outside periods of stress.
When the buffers are drawn down, banks may consider reducing their discretionary
distribution of earnings or raising new capital from the private sector.
Unlike the minimum capital requirement, failure to meet the capital conservation buffer
requirement will not result in constraints to the bank’s operation. Rather, it will result in
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Risk Management in Banking: Principles and Framework
restrictions to distributions of capital. Hence, this should not be viewed as establishing a new
capital requirement. The items subject to distribution restrictions include:
ŸŸDividends
ŸŸShare buybacks
ŸŸDiscretionary payments on other Tier 1 capital instruments
ŸŸDiscretionary bonus payments to staff
A capital conservation buffer of 2.5% of the risk-weighted assets should be established
above the regulatory minimum requirement. This buffer should fully comprise Common Tier
1 equity.
Countercyclical buffer
Losses in the banking sector can be extremely large when a downturn is preceded by excess credit
growth. These losses can destabilize the banking sector and spark a vicious cycle. Problems in
the financial system can contribute to a downturn in the real economy that feeds back to the
banking sector. These problems led to the Basel III reforms where banking organizations are
required to build up additional capital defences during periods when the risks of system-wide
stresses are growing markedly. This countercyclical capital buffer regime aims to ensure that
the banking sector capital requirements take account of the macro-financial environment in
which banks operate in.
The countercyclical buffer is a macro-prudential measure to protect the banking sector from
periods of excess credit growth that have been often associated with a build-up of systemic risk.
This capital buffer does not address the resilience of individual banks during periods of stress
as this is covered by the minimum capital requirements and the capital conservation buffer.
Banking supervisors will deploy the capital buffer regime when excess aggregate credit
growth is judged to be associated with a build-up of system-wide risk to ensure the banking
system has a buffer of capital to protect it against future potential losses. The objective is to
control the supply and demand of credit to moderate the excessive build-up of credit.
The countercyclical buffer between 0% to 2.5% of risk-weighted assets may be imposed by
the relevant national supervisors during periods of excess credit growth. This capital buffer
should fully comprise Common Tier 1 equity.
Leverage ratio
One of the underlying features of the 2008 global financial crisis was the build-up of excessive
leverage in the banking system. In some cases, banks built up excessive leverage while still
showing strong risk-based capital ratio. During the most severe part of the crisis, the market
forced the banking sector to reduce leverage in a manner that amplified the downward pressure
on asset prices.
To prevent an excessive build-up of leverage, the Basel III framework introduces a non-risk
based leverage ratio as an additional regulatory prudential tool to complement the minimum
capital adequacy requirements. The leverage ratio will serve as a backstop to the risk-based
capital requirement and helps contain system-wide build-up of leverage.
Basel III leverage ratio
The formula for calculating the Basel III leverage ratio, which is defined as the capital measure
(numerator) divided by the exposure measure (denominator), is:
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Chapter 4 International Risk Regulation
Basel III Leverage Ratio =
Tier 1 Capital
≥ 3%
Total Exposure
The capital measure is the bank’s Tier 1 capital as defined by Basel III. The exposure measure
for this ratio is the sum of the following exposures:
ŸŸOn-balance sheet exposures
ŸŸDerivative exposures
ŸŸSecurities financing transaction exposures
ŸŸOff-balance sheet items
The objectives of the leverage ratio requirement are:
ŸŸConstrain the leverage in the banking sector
ŸŸIntroduce additional safeguards against model risks and measurement errors by
supplementing the risk-based measure with a simple, transparent and independent
measure of risk
Implementation of the leverage ratio requirements has started with banks submitting
reports to their country’s banking regulator. This was followed public disclosures, which
commenced on 1 January 2015. The Basel Committee will monitor the impact of the disclosure
requirements and make final adjustments, if any, to the definition and calibration ratio by
2017.
4.6.3
Basel III—Liquidity Reforms
One of the most important lessons from the 2008 financial crisis is that while strong capital
requirements are a necessary condition for banking sector stability, strong liquidity is also
of equal importance. During the early liquidity phase of the crisis, many banks continued to
experience difficulties despite having adequate capital levels. The crisis revealed the importance
of liquidity for the proper functioning of the banking system.
Basel III introduces two minimum standards for liquidity, namely:
ŸŸLiquidity coverage ratio
ŸŸNet stable funding ratio
These two standards have been developed to achieve the following two separate but
complementary objectives:
ŸŸPromote short-term resilience of a bank’s liquidity profile by ensuring it has sufficient
high quality liquid resources to survive an acute stress scenario for one month (liquidity
coverage ratio).
ŸŸPromote longer-term resilience by creating additional incentives for a bank to fund its
activities with more stable sources of funding (net stable funding ratio).
Liquidity coverage ratio
Liquidity coverage ratio is intended to promote resilience to potential liquidity disruptions
over a 30-day horizon. It will help to ensure that banks have sufficient unencumbered,
high-quality liquid assets to offset the net cash outflows they could encounter under an
acute short-term stress scenario.
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Risk Management in Banking: Principles and Framework
Cushion of high-quality
liquid assets
30-day
liquidity stress
scenario
Figure 4.19 Liquidity coverage promotes resilience
The scenario is built upon circumstances experienced during the global financial crisis that
began in 2007 and entails both institution specific and systemic shocks. High-quality liquid
assets (e.g. cash and domestic government bonds) should be unencumbered and liquid in
markets during a time of stress.
Liquidity Coverage Ratio =
Stock of High-quality Liquid Assets
≥ 100%
Net Cash Outflows Over the Next 30 Days
Net stable funding ratio
Net stable funding ratio requires a minimum amount of stable sources of funding for a bank
relative to the liquidity profiles of its assets as well as the potential for contingent liquidity
needs arising from off-balance sheet commitments over a one-year horizon.
The ratio aims to limit over-reliance on short-term wholesale funding during times of
buoyant market liquidity and encourage better assessment of liquidity risk across all on- and
off-balance sheet items. It covers the entire balance sheets and provides incentives for banks to
use stable sources of funding.
Net Stable Funding Ratio =
Available Amount of Stable Funding
Amount of Required Stable Funding
Required stable funding
(function of liquidity characteristics
of assets/activities)
Available amount of
stable funding
Figure 4.20 Limiting over-reliance on short-term funding during buoyant market conditions
Stable funding is the portion of those types and amount of equity and liability financing
expected to be reliable sources of funds over a one-year horizon under conditions of extended
stress.
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125
Table 4.13 Highlights of Basel II and Basel III
Basel II
Basel III
Pillar 1—Minimum capital requirements
Total
capital
• Tier 1 + Tier 2 = 8%
risk-weighted assets
Core
Tier 1
• At least 2% of
risk-weighted assets
Basel III introduced certain reforms to the
provisions of Basel II.
Tier 1 must be at least These reforms are:
50% of the total capital ŸŸ Increasing the quantity and quality of capital
Market risk
ŸŸ Standardized approach
ŸŸ Internal models approach
Operational risk
ŸŸ Basic indicator approach
ŸŸ Standardized approach
ŸŸ Advanced measurement approach
Credit risk
ŸŸ Standardized approach
ŸŸ Internal ratings-based approach (foundation)
ŸŸ Internal ratings-based approach (advanced)
Pillar 2—Supervisory review
Pillar 2 provides for a mandatory process for both banks and
regulators to establish the link between a bank’s risk profile,
its risk management infrastructure and its capital.
Pillar 3—Market discipline
Aims to encourage market discipline by developing a
set of disclosure requirements which will allow market
participants to assess key pieces of information on the scope
of application, capital structure and adequacy, and risk
positions and assessment process.
Minimum capital
requirement
Capital
conservation
buffer
2.5%
Countercyclical
buffer
0% to
2.5%
Common Tier 1: 4.5%
Tier 1 Capital: 6.0%
Total Capital: 8.0%
ŸŸ Introduction of a liquidity risk framework
Liquidity coverage ratio
The liquidity coverage ratio aims to promote shortterm resilience of the liquidity risk profiles of banks.
Stock of HQLA
Ner cash outflows over next 30 days
≥ 100%
Net stable funding ratio
The net stable funding ratio is the amount of
available stable funding to the required amount
of funding. It aims to limit over-reliance on shortterm wholesale funding and encourage better
assessment of liquidity risk across all on- and offbalance sheet items.
Available amount of stable funding
Required amount of stable funding
> 100%
ŸŸ Other reforms
Introduction of a leverage ratio
Capital
Exposure
> 100%
The Basel III leverage ratio is a test minimum
requirement for the trial run period of January 2013
to January 2017. The basis of calculation is the
average of the three month-end leverage ratios
over a quarter.
Risk coverage
Counterparty credit risk charge to be introduced.
Credit valuation adjustment (CVA) to be introduced
as a price for counterparty credit risk.
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Risk Management in Banking: Principles and Framework
CONCLUSION
In this chapter, we discussed the international regulatory environment of risk management.
We enumerated the different reasons why banking organizations operate in one of the most
heavily-regulated industries. We also enumerated the different sources and types of banking
regulations. Thereafter, we talked about the most important international risk regulation—
Basel Capital Accords—as well as their evolution. It was emphasized that the Basel Accords are
an evolving international regulatory regime that addresses the weaknesses that were uncovered
during successive financial crises. The Basel Committee on Banking Supervision continues to
adjust these regulations as new concerns and issues emerge. At the end of the chapter, we
enumerated the different reforms that were instituted in response to the 2008 global financial
crisis.
After discussing the basic concepts of risk management in the previous chapters, we will
proceed with an overview of the most important and significant risks for many banking
organizations—credit risk—in the next chapter.
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C
5
P
HA
TE
R
CREDIT RISK
In the previous four chapters, students were given an overview of bank risks and risk
management principles and practices as well as the international regulatory context. This
chapter focuses on the largest and most important risk for many banking organizations—
credit risk. While credit risk is associated with bank lending activities, it is pervasive in
many banking business activities.
In this first chapter on credit risk, the risk management students are introduced to
the fundamental concepts. In the following Chapter 6, we will look at the important
processes and credit risk identification. These two chapters will provide the foundation
in understanding the more advanced discussions on credit risk management, and
measurement and credit reporting in Book II.
This chapter begins with a definition of credit risk. It then differentiates between
expected and unexpected losses. At the end of the chapter, the credit process is discussed.
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Risk Management in Banking: Principles and Framework
Credit Risk
Definition of Credit Risk
Expected and Unexpected
Credit Losses
Credit Risk as Potential
Losses
Credit Risk as an
Exposure
Credit Risk Management
Framework
Expected Loss
Credit Risk Environment
Unexpected Loss
Credit-Granting Process
Credit Administration
Credit Risk as Failure to
Meet Obligations
Credit Monitoring
Credit Measurement
Credit Risk Control
Figure 5.1 Diagrammatic outline of this chapter’s topics
LEARNING OUTCOME
At the end of this chapter, you are expected to be able to:
DISCUSS the basic principles of credit risk in the banking context
LEARNING OBJECTIVES
At the end of this chapter, you will be able to:
DEFINE credit risk
DISTINGUISH between expected and unexpected credit losses
ENUMERATE the different elements of the credit risk management framework
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Chapter 5 Credit Risk
5.1 DEFINITION OF CREDIT RISK
LEARNING OBJECTIVE
5.1
DEFINE credit risk
The Basel Committee on Banking Supervision defines credit risk as the:
Potential that a bank borrower or counterparty will fail to meet its obligations in accordance
with agreed terms.
This definition of credit risk—also called default risk—has three main elements, which will
be discussed in more detail in the succeeding sections:
ŸŸCredit risk as potential losses
ŸŸCredit risk as an exposure
ŸŸCredit risk as failure to meet obligations
5.1.1
Credit Risk as Potential Losses
It is important to emphasize that the concern of credit risk management is the potential losses
from a bank borrower or counterparty’s failure to meet its obligations. In short, credit risk
involves uncertainty.
During the various stages of the credit risk exposure, the bank faces uncertainty with respect
to credit risk on two dimensions:
ŸŸthe likelihood of occurrence or the chance that the borrower or the counterparty will fail
to meet its obligations, i.e. probability of default
ŸŸthe consequence of the borrower or the counterparty’s failure to meet its obligation, i.e.
loss given default
Probability of default
Dimensions of
credit risk
Loss given default
Figure 5.2 Two dimensions of uncertainty
Likelihood of occurrence—probability of default
The likelihood of occurrence can be described as qualitatively or quantitatively. Qualitatively—
This likelihood of occurrence can range from unlikely to certainty. Unlikely events indicate
that there is little or no chance that the borrower will fail to meet its obligations. Likely
events indicate that there is a high chance that the borrower will fail to meet its obligations
in accordance with the agreed terms. Figure 5.3 depicts the likelihood of occurrence using a
continuum that ranges from no likelihood to certainty of occurrence.
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Risk Management in Banking: Principles and Framework
No
likelihood
Medium
likelihood
High
likelihood
Certainty
Higher
likelihood of
occurrence
Figure 5.3 Likelihood of occurrence
Quantitatively—If described quantitatively, the likelihood of loss is frequently referred to in
practice as the probability of default (PD). It quantifies how likely the borrower or counterparty
will fail to meet its obligations under the agreed terms. The probability of default—usually
denoted as a percentage—is frequently expressed as a continuum between 0% to 100%.
A zero per cent (0%) probability of default indicates that as at the time of assessment, there
is virtually no likelihood that the borrower or counterparty will fail to meet its obligations in
accordance with agreed terms. A hundred per cent (100%) probability of default indicates virtual
certainty that the borrower or counterparty will not be able to meet its obligations as they
come due.
Probability
of default (PD)
0%
Probability
of default (PD)
100%
Higher
likelihood of
occurrence
Figure 5.4 Probability of default
Table 5.1 discusses the factors that impact the probability of default.
Table 5.1 Factors impacting the probability of default
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Factors
Probability of Default
Financial standing
and condition of the
borrower
ŸŸ The stronger the borrower or counterparty’s financial standing and condition, the
lower the likelihood that the borrower or counterparty will fail to meet its obligations.
Competitive position
in the industry
ŸŸ The borrower’s position in the industry could affect its likelihood of failing to fulfil its
obligations in the future. A borrower with a dominant position in the industry (i.e.
can command higher market share) is less likely to default than borrowers with less
dominant positions.
Developments in the
borrower’s industry
ŸŸ Developments in the borrower’s industry could also affect the probability of default.
Borrowers which operate in volatile industries (e.g. high technology firms) tend to
display a higher probability of default than borrowers which operate in more stable
industries (e.g. utility companies).
ŸŸ There are industries where the default rates are higher compared to other industries.
For example, in the February 2014 Annual Corporate Default Survey conducted by
Moody’s, media and publishing reported the highest default rate (4.8%) whereas
utilities and government-related issuers—highly regulated industries with stable
business models—reported 0% default rate.
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Chapter 5 Credit Risk
Factors
State of the
economy
Probability of Default
ŸŸ The state of the economic environment also influences the likelihood that a borrower
or counterparty will fail to meet its obligations. The borrower or counterparty will more
likely default during economic recessions than during economic expansions.
ŸŸ In the 2013 Annual Global Corporate Default Study and Rating Transitions by
S&P, default rates noticeably increased during periods of economic recessions
and slowdowns—early 1980s recession due to hyperinflation and oil price shocks,
early 1990s recession, early 2000s recession including the Dotcom crash and the
September 11 attacks, and the 2008−2009 global financial crisis. Default rates were
the lowest during periods of economic expansions.
Consequence of occurrence—loss given default
The consequence of occurrence describes the borrower’s impact or the counterparty’s failure
to meet its obligations. It quantifies the magnitude of loss that the banking organization will
incur in the event of the borrower or counterparty’s failure to meet its obligations.
The magnitude of loss can be described qualitatively. Like in the case of the likelihood of
occurrence, the magnitude of loss can range from no loss to medium loss to full loss.
No loss
Low
High
Full
Higher
consequence
of loss
Figure 5.5 Consequence of occurrence
If the consequence of occurrence is described in a quantitative manner, it is frequently
referred to in practice as the loss given default (LGD). It quantifies the dimension of
uncertainty that is associated with the amount of loss that the banking organization will
incur if the borrower or counterparty fails to meet its obligations. It is usually quantified as a
percentage of loss over the bank’s total exposure in the event of default.
Loss given
default (LGD)
0%
Loss given
default (LGD)
100%
Higher loss
given default
Figure 5.6 Loss given default
The LGD is closely related to the concept of recovery rates. The recovery rate (RR) is the
percentage of recovery of the bank’s total exposure in the event of default. The higher the
recovery rate, the lower the loss given default. Conversely, the lower the recovery rate, the
higher the loss given default.
The LGD is equal to 100% minus the recovery rate. As the recovery rate increases, the amount
of loss given default decreases.
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If the recovery rate is 0%, the amount of loss is equal to the full exposure, i.e. 100%. As the
recovery rate increases and approaches 100%, the amount of loss decreases to 0%.
LGD = 100% − RR
Table 5.2 describes the various factors that could influence the recovery rate.
Table 5.2 Factors influencing the recovery rate
Factors
Details / Explanation
Type of instruments
Unlike the probability of default which depends on issuer-specific characteristics, the
recovery rate of any exposure depends on the unique characteristics of the issue or
specific instrument.
Different credit instruments entail different rights over the borrower or counterparty’s
assets of the types of obligations according to the levels of priority are:
ŸŸ Secured obligations
Secured or collateralized obligations are obligations that are backed by collateral—an
asset pledged by the borrower to secure its obligations. In the event of default, the
non-defaulting party (the bank) may sell the collateral and minimize (or eliminate) its
losses due to the borrower or counterparty’s failure to fulfil its obligations.
The higher the quality of the collateral, the higher the recovery rate of the creditor. The
lower the quality of the collateral, the lower the recovery rate.
ŸŸ Unsecured obligations
Unsecured obligations are obligations that are not backed by any collateral and are
granted only based on the borrower’s creditworthiness.
Senior unsecured obligations
Senior unsecured obligations receive priority
claims on the borrower’s assets after fulfilling the
obligations to secured lenders.
Subordinated unsecured
obligations
Subordinated unsecured obligations receive lower
priority than senior unsecured obligations.
In the 2013 study by Standard & Poor’s on the U.S. recovery rates from 1987 to 2013, it
was noted that secured obligations tend to have higher recovery rates than unsecured
obligations. Within unsecured obligations, the study shows that senior unsecured
obligations tend to have higher recovery rates than subordinated unsecured obligations.
Quality of collateral
The quality of collateral has a strong influence on the recovery rate if the borrower
defaults. While obligations that are secured by collateral generally have higher recovery
rates than obligations that are not secured by any collateral, the recovery rate could differ
depending on the type of collateral posted.
Collateral assets can either be a physical collateral (e.g. inventories and real estates) or
intangible collateral (e.g. intellectual property rights). Recovery is generally the highest
for physical assets such as inventories and receivables. In the 2013 study by Standard &
Poor’s, mean recovery for inventories and receivables is at 87.7%. Recovery is lower for
financial assets such as loans. In the 2013 study on recovery rates, the mean recovery
for unsecured loans is only 36.3%.
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Chapter 5 Credit Risk
Factors
Industry or sector
Economic cycle
5.1.2
Details / Explanation
The concept of the quality of collateral is closely related to the industry which the
defaulting borrower belongs to. The recovery by the lender ultimately depends on the
asset quality of the borrower or counterparty. This means that industries with assets that
can be easily sold may have higher recovery rates compared to industries with assets
that are difficult to sell. This point is clearly illustrated in the 2013 S&P study on U.S.
recovery rates for each industry or sector:
Industry / Sector
Recovery Rates
Aerospace and defence / automotive / capital goods /
metals, mining and steel
52.3%
Consumer products / services
51.2%
Energy and natural resources
60.2%
Forest and building products / homebuilders
54.1%
Health care / chemicals
49.4%
High technology / computers / office equipment
48.0%
Leisure time / media and entertainment
51.6%
Telecommunications
37.1%
Transportation
49.0%
Utility
63.6%
The timing of the default can also influence the recovery rate. If the borrower defaults
during a recession, the recovery rate tends to be lower than that during a non-recession
year. In the same 2013 S&P study, the recovery rate in the U.S. was consistently higher
when the default occurred during non-recession years compared to that during recession
years.
Credit Risk as an Exposure
Credit risk can also be viewed as an exposure to a borrower or counterparty. The bank’s
exposure can be analyzed at two levels:
ŸŸIndividual or standalone level
ŸŸPortfolio level
Individual or standalone level
The generation of credit risks typically starts at the individual or transactional level. Individual
or transactional credit risk exposures are typically classified into retail, corporate, sovereign
and counterparty credit risk.
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Table 5.3 Standalone risks
Types of Standalone Risks
Retail credit risk*
A risk is classified as a retail credit risk exposure if it meets the following criteria:
ŸŸ Orientation criterion
The exposure should be to an individual person or persons or to a small business
ŸŸ Product criterion
The exposure should take the form of any of the following:
mm Revolving credits and lines of credit
mm Personal term loans and leases
mm Small business facilities and commitments
Securities such as bonds and equities are excluded from the retail category.
ŸŸ Granularity criterion
Retail credit portfolio should be sufficiently diversified such that no aggregate
exposure to one counterparty exceeds 0.2% of the total regulatory portfolio.
ŸŸ Value criterion
Individual exposures should be of low value. The maximum exposure to one
counterpart cannot exceed a certain absolute threshold.
Corporate credit risk*
Corporate credit risk refers to a bank’s credit risk exposure to:
ŸŸ Corporation
ŸŸ Partnership
ŸŸ Proprietorship
Sovereign credit risk
Refers to the bank’s exposure to debt obligations issued by sovereigns or other
quasi-sovereigns.
Counterparty credit risk
This is the risk that a counterparty to a transaction could default or deteriorate in
creditworthiness before the final settlement of a transaction’s cash flows.
* Exposures to small and medium enterprises (SMEs) can be classified as either retail or corporate credit risk depending on the
specific circumstance.
Portfolio level
Traditionally, credit risk is assessed and analyzed at an individual transactional level. In the
traditional credit-granting process, for example, credit was extended after considering the
merits from a transactional standpoint. Emphasis was made on ‘picking the superior credits’
or extending credit to ‘selected top industries’ or to ‘selected markets’.
The collapse of large corporate borrowers, such as Enron, WorldCom, Parmalat and Tyco,
has shown the limits of the strategy of ‘picking superior credits’. Exposures to a large single
borrower may be a risky strategy, particularly when the exposures have accumulated to a level
that may threaten the bank’s safety and soundness.
Real World Illustration
Faith in Parmalat
Parmalat is a multinational Italian dairy and food corporation. It collapsed in 2003 after revealing
one of the worst accounting scandals in corporate history—a EUR14 billion hole in its balance
sheet.
“But when you have a client like Parmalat, which is bringing in all that money and has industries
around the world, you don’t exactly ask them to show you their bank statements.”
Luca Sala, former Head of Corporate Finance Division, Bank of America
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Chapter 5 Credit Risk
‘Selecting top industries’ as a centerpiece credit risk strategy proved to be risky as well. During
the industrial boom, many banks tend to build excessive credit risk exposures to booming
industries. Industry trends, technological developments, macroeconomic or sectoral shifts could
sometimes quickly reverse the fortunes of these industries and put the banks at risk.
Continental Illinois National Bank and Trust Company (CINB) was one of the most notable
cases of bank failures in the 1980s; and is still one of the largest bank failures in history. Many
refer to Continental Illinois as the original and the first ‘too-big-to-fail’ institution. In the
1980s, CINB embarked on a lending strategy to focus on a specific sector—the energy sector—
an area which the bank felt it possessed strong expertise. CINB invested its lending resources
to this sector. In fact, CINB was one of the few banks that had energy sector engineering
experts on its lending team.
CINB also aggressively purchased speculative loans from the Oklahoma-based Penn
Square Bank, which had extended billions of dollars’ worth of loans to speculative activities
in the oil and gas exploration industry. In the 1980s, when oil prices dropped, many energy
companies started to default on their loans. Penn Square Bank, the relatively smaller bank
which specialized in oil and gas exploration loans, filed for bankruptcy. As a result, CINB faced
liquidity problems which eventually led to one of the most costly failures in banking history.
A credit strategy that focuses on ‘selected markets’ where the bank has expertise and
knowledge is clearly a sound strategy. However, there are instances when banks display
excessive optimism on certain growth markets or countries—leading to a build-up of excessive
credit risk exposures in those markets. An example would be the build-up of credit risk
exposures in emerging markets—where many banks held bullish sentiments throughout the
1980s and 1990s. At the height of the emerging markets turmoil during the 1980s and 1990s,
the exposures posed threats to the banks’ safety and soundness.
While it is important to assess and manage credit risk on a standalone level, i.e. on a per
transaction level, it is also vital to assess credit risk on a consolidated portfolio level. Good
credit decisions on a transactional level may turn out to be a poor credit portfolio when taken
as a whole. In the same way, bad credit decisions on a transaction level may be mitigated if the
banking institution has a well-constructed and diversified credit portfolio.
Portfolio credit risk analyzes credit risk from the consolidated level, i.e. from the level of
the institution as a whole. Portfolio credit risk considers the impact of diversification and
correlation of individual loans among each other from the portfolio’s consolidated level.
Figure 5.7 shows that portfolio credit risk is driven by three main factors.
Correlation
Standalone
credit risk
Concentration
risk
Portfolio
credit risk
Figure 5.7 Factors driving portfolio credit risk
ŸŸStandalone credit risk
Standalone credit risk is the credit standing of individual–specific borrowers. The bank’s
credit portfolio is composed of individual credit exposures to specific borrowers. A well-
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Risk Management in Banking: Principles and Framework
constructed credit portfolio should first start with good credit decisions on an individual,
transactional level. This means that individual transactions should be assessed on a
name-by-name basis.
Good credit decisions result in lower standalone credit risk for the bank. Bad credit
decisions result in higher credit risk.
(The standalone credit risk for each specific type of borrowers was discussed in the previous chapters.)
ŸŸCorrelation
Good credit decisions on a standalone level are a necessary step in constructing a
robust and sound credit portfolio. However, this is rarely sufficient. Additionally, banks
should consider how the individual credit risk exposures behave when aggregated on a
portfolio level. One of the important sources of risk in a portfolio risk is the correlation
of individual loans among each other. Correlation measures the interdependence of the
standalone credit risks. Examples of highly-correlated industries are:
mm Agricultural products industry and food processing industry
The processed food industry is highly correlated to the agricultural products industry,
given that agricultural food prices are likely a major portion of the input costs of
the processed food industry. Constraints on the supply side would likely impact the
bottom line of the processed food industry.
Likewise, adverse shocks on the demand side of processed food consumers could
affect the bottom line of agricultural products industry. The processed food industry
is a major customer of the agricultural products industry.
On the other hand, credit exposures that are negatively correlated tend to respond
differently to risk factors. Credit risk exposures that are negatively correlated tend to
provide diversification benefit to the portfolio.
mm Oil and gas industry and plastics
The oil and gas industry and plastics industry are another example of highly-correlated
industries.
A major component of the cost structure of the plastics industry is the price of oil
and gas. Plastics are made from liquid petroleum gases, natural gas liquids (NGL)
and natural gas. Liquid petroleum gases (LPG) are by-products of petroleum refining.
Based on the Energy Information Agency’s estimate, in 2010, about 191 million
barrels of LPG and NGL were used to make plastics products—about 2.7% of the total
U.S. petroleum consumption.
mm Alternative energy industry and agricultural products industry
Another group of industries that are seemingly uncorrelated but are actually correlated
are the agricultural products industry and alternative energy industry.
In recent years, the search for alternative sources of energy has led to the birth of
the biofuel industry. This industry is relatively new and is expected to be a significant
player in the alternative energy landscape. Biofuel industry produces fuel from living
organisms such as agricultural crops. Ethanol is made from crops such as corn and
sugar cane.
The agricultural products industry now serves not only the market for food
production but for energy production as well.
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Real World Illustration
Biofuel Demand in the U.S. Driving Higher Food Prices
In July 2011, The Guardian released a report published by Purdue University economists for the
Farm Foundation policy organization that revealed an increased demand for corn over the last
five years. This increase was attributed to the U.S. government’s support for ethanol production,
which included annual subsidies for ethanol refineries amounting to $6 billion.
Wallace Tyner, one of the authors mentioned in the report, claimed that in 2005 alone, the industry
used about 16 million acres or 6.4 million hectares to meet ethanol demands in the United States
and the Chinese soybean imports. In 2010, the usage rose to 18.6 million hectares or 46.5 million
acres to meet the demand. The U.S. Department of Agriculture took notice of this remarkable surge
in the demand for corn by U.S. ethanol refiners. The latter’s consumption was noted to be way
above the corn consumption by livestock and poultry farmers. In 2010, 27% of the corn production
was dedicated to meet the demand for corn ethanol in contrast with its 10% consumption in 2005.
The Guardian article likewise cited another report from the Centre for Agricultural and Rural
Development at the Iowa State University which estimates that 40% of the U.S. corn crop
production currently goes to corn ethanol production, while the cobs and the husks of the corn are
used as raw materials for animal feed. Ken Powell, the chief executive of General Mills, shared
in an interview with the Financial Times that the government’s ethanol subsidy was to be blamed
for driving up food prices in accordance with the natural law of demand and supply.
Source: The Guardian, 19 July 2011
ŸŸConcentration risk
Concentration risk refers to the risk that any single exposure or group of exposures
could potentially result in losses that are substantial enough to threaten the financial
condition of a banking organization. Concentration risk occurs when a bank’s portfolio
contains a high level of direct or indirect credits to:
mm A single counterparty
mm A group of connected counterparties
mm A particular industry or economic sector
mm A geographic region
mm An individual foreign country or a group of countries whose economies are strongly
interrelated
mm A type of credit facility
mm A type of collateral
Concentrations can also occur in credits with the same maturity.
5.1.3
Credit Risk as Failure to Meet Obligations
Credit risk is the failure of the borrower or counterparty to meet its obligations in the lending
contract. Many times, credit risk is associated with the borrower or counterparty’s inability
to pay its financial obligation—interest and debt—as it becomes due. This inability to pay is
formally recognized in a judicial process called bankruptcy.
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However, there are a wide range of events before bankruptcy happens. Credit risk covers all
those events, which include:
ŸŸAdministrative errors
ŸŸTechnical default
ŸŸDefault resolution
ŸŸBankruptcy
Technical default
ŸŸ Failure to pay due
to administrative
errors
ŸŸ Violation of debt
covenants
Administrative
errors
Bankruptcy
ŸŸ Restructuring
ŸŸ Insolvency
bankruptcy filing
Default resolution
Figure 5.8 Credit risk events
Administrative errors
This refers to the failure of a borrower or counterparty to pay its financial obligations under the
loan agreement in a timely manner due to an administrative error or mistake. Compared to other
events involving credit risk, this failure to pay is not due to the borrower or counterparty’s
inability to do so.
This type of failure to pay is frequently remedied during the grace period as agreed upon by
the parties. In such cases, the borrower is given a grace period—typically within five business
days after the due date—to make payment.
While failure to pay due to an administrative error is usually not linked to the borrower or
counterparty’s inability to meet its financial obligations, this sometimes indicate weaknesses
in the managerial processes of the borrower or counterparty.
Real World Illustration
Delinquent Debt Service due to Administrative Error
On 17 March 2014, the Town of Southeast, New York was delinquent in the payment of interest
and principal on its bonds. According to the town management, the town was notified by the
Depository Trust Company (DTC) after 4 p.m. on 17 March that a debt service payment had not
yet been received.
Upon realizing the error, the town attempted to make the payment before the end of the day, but
could not complete the wire transfer until the next morning.
Moody’s, a major credit rating agency, believes that the payment delay was due to an administrative
error, not an impairment of the town’s ability to pay. However, the delayed debt service payment
reveals a weakness in managerial processes that may threaten the town’s credit rating.
Source: Moody’s Global Credit Research, 1 April 2014
Technical default
This refers to the failure of the borrower or counterparty to meet its obligations under the
agreement other than failure to make payments. It includes violations or non-performance of
the borrower or counterparty of the loan covenant.
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Chapter 5 Credit Risk
Loan covenants are clauses in the loan agreement that require the borrower to adhere to
certain conditions about its conduct and financial situation. They are designed to satisfy the
lender that the borrower will be able to fulfil its financial obligations, and that the lender will
not be disadvantaged against the borrower’s other creditors in the event that the borrower can
no longer fulfil its obligations.
Loan covenants could either be affirmative or negative. Affirmative covenants are clauses
which require the borrower to perform certain actions. Examples of affirmative covenants are:
ŸŸCommitment to deliver financial statements to the lender in a timely manner
ŸŸPromise to pay taxes
ŸŸObtain insurance on the borrower’s property against fire, theft and other risks
ŸŸCompliance with laws and regulations
ŸŸMaintenance of certain financial ratios, e.g. maximum level of indebtedness to net worth
Negative covenants are clauses which require the borrower not to take certain actions that
could undermine its ability to repay the loan. Examples of negative covenants are:
ŸŸProhibition to incur additional indebtedness in excess of a certain level or amount
ŸŸNot to pledge the borrower’s assets to other creditors
ŸŸNot to declare dividends or other distributions
ŸŸProhibition to become a guarantor for the obligations of another person or organization
ŸŸNot to sell assets in excess of a certain percentage of the total assets except for inventories
ŸŸNot to make a capital expenditure in excess of a certain level for a predefined period of time
Violation of debt covenants typically allows the lender to demand the full repayment of
the principal and interest even before the agreed maturity date of the loan. Should the lender
decide not to require early repayment of the principal and interest, the lender may require the
borrower to take remedial actions to cure the violations or amend certain provisions of the
loan in the lender’s favour, e.g. increase the interest rate.
Real World Illustration
Conseco Inc. Debt Ratings and Violation of Debt Covenants
According to a Moody’s Global Credit Research report released in April 2014, Indiana-based
financial services company, Conseco Inc., was at the brink of violating the financial covenants
in its secured bank facility, particularly those related to statutory capital and risk-based capital
ratio, based on the review of its June 2009 financials. This resulted in Fitch Ratings assigning
Conseco a negative outlook, questioning its capacity to remain compliant with the covenants.
The company was granted a temporary covenant relief in order to restore the covenants to their
previous levels.
Source: Moody’s Global Credit Research, 1 April 2014
Restructuring
Restructuring is an agreement between a lender and borrower to modify the terms of the
loan agreement to avoid foreclosure or bankruptcy. It is also sometimes referred to as loan
workouts. Common examples of restructuring are:
ŸŸReduction in the interest payable
ŸŸReduction in the amount of principal payable at maturity or at scheduled principal
repayment dates
ŸŸPostponement or deferral for the payment of interest or principal
ŸŸChange in the ranking of the priority of payment of any obligation, e.g. a debt-for-equity
swap agreement—a restructuring agreement where the lender agrees to cancel the debt in
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exchange for an ownership stake in the borrower’s company. Equity holders rank lower
in terms of priority of payments compared to debt holders.
ŸŸChange in the currency or composition of any payment of interest or principal
Real World Illustration
Examples of Restructuring
Case 1: Write-down of Principal
In October 2011, Greek bondholders agreed to voluntarily write down the value of Greek bonds
by 50%, which translates into €100 billion and will reduce the nation’s debt load to 120% of the
economic output by 2020.
Case 2: Modification of Interest
In January 2012, Greece and its creditors disagreed over the interest rate that private investors
would be paid on new bonds they would receive in exchange for existing government debt. The
European Union stipulated that the interest rate on the new bonds must be below 4% in order for
Greece to reach its long-term debt reduction target.
Case 3: Change in the Ranking of Priority
SolarWorld, once Germany’s largest solar company, announced an agreement with its major
creditors to reduce its €1.2 billion debt load. Part of the agreement is to exchange its debt obligations
into equity holdings in a debt-to-equity swap agreement. The debt-to-swap agreement will wipe
out existing shareholders by reducing the capital stock by 95% and handing ownership over the
company to its creditors.
Source: Various news sources
Insolvency and bankruptcy
Insolvency is a condition where the borrower no longer has the capacity to pay its obligations
as they come due (i.e. cash flow insolvency) or when the borrower’s assets are less than its
liabilities (i.e. balance sheet insolvency).
Bankruptcy refers to the formal legal proceeding for borrowers who are already insolvent. While
in practice, the terms insolvency and bankruptcy are used interchangeably, there is a difference
between the two. An insolvent borrower may threaten its ability to continue as a going concern
and may eventually lead to bankruptcy. However, insolvency may not be a permanent condition
if the borrower or lender were able to resolve the state of insolvency, which then allows the
borrower to continue to operate as a going concern. On the other hand, a borrower who is in the
bankruptcy stage ceases to continue to operate as a going concern, and is in the liquidation stage.
It is, therefore, a more permanent condition. Bankruptcy is a legal status of insolvency. Hence, all
borrowers in the bankruptcy stage are insolvent. However, not all borrowers who are insolvent
are in the bankruptcy stage. It is important to note that bankruptcy is a legal status of insolvency.
Bankruptcy can be broadly classified as either voluntary or involuntary. Voluntary
bankruptcy is when the borrower initiates the bankruptcy proceeding to protect itself from
creditors and to ensure an equitable settlement of its obligations.
Real World Illustration
Lehman Files for Bankruptcy
Lehman Brothers, a 158-year-old investment bank, initiated one of the biggest bankruptcy filings
in U.S. history. Lehman filed for bankruptcy after Barclays and Bank of America abandoned talks
to acquire Lehman Brothers and after Lehman Brothers lost 94% of its market value for the period
ending September 2008.
Source: Bloomberg News, 15 September 2008
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Chapter 5 Credit Risk
Involuntary bankruptcy occurs when creditors force the borrower into bankruptcy.
Involuntary bankruptcy is requested by the creditors as a legal remedy to force the borrower
to pay its obligations.
Real World Illustration
NMI Involuntary Bankruptcy
National Medical Imaging was in the business of leasing radiology machines. The leases were
bundled and sold as investment packages serviced by Lyon Financial Services, a unit of U.S.
Bancorp. When the company’s business started to suffer from the economic downturn and new
regulations, NMI approached the bank for a restructuring of the loan terms.
NMI stopped the payments after U.S. Bancorp refused NMI’s request for restructuring. U.S.
Bancorp responded by filing an involuntary bankruptcy against NMI.
Source: Bloomberg News, 15 September 2008
5.2 EXPECTED AND UNEXPECTED CREDIT
LOSSES
LEARNING OBJECTIVE
5.2
DISTINGUISH between expected and unexpected credit losses
In order to understand how credit risk affects banking organizations, the concept of expected
and unexpected credit losses must be understood. Distinguishing between the two types of
credit losses is an important prerequisite in measuring and managing credit risk.
Credit loss is incurred by the banking organization from its lending activities. Credit loss
affects a bank’s profitability. The losses can fluctuate over time. During economic booms,
credit losses are generally low, and generally higher during economic recessions.
5.2.1
Expected Loss
Expected loss is the average level of credit losses that the bank can reasonably experience over
a specified risk horizon. The loss should be viewed as the cost of doing business. It forms part
of the cost components of the business of lending. Figure 5.9 on the next page illustrates the
three main components of expected credit loss.
Probability of default
Probability of default (PD) measures the degree of likelihood that the borrower or counterparty
will not be able to meet its obligations as they come due. It is expressed as a percentage between
0% (indicating virtually no likelihood of default) to 100% (indicating virtual certainty that the
borrower will default).
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Risk Management in Banking: Principles and Framework
Exposure
at default
Probability
of default
Loss given
default
Expected credit loss
Figure 5.9 Components of expected credit loss
Exposure at default
Exposure at default (EAD) is the estimate of the amount outstanding in the event that the
borrower defaults. The amount outstanding should include the drawn amounts plus likely
future drawdowns of yet undrawn lines.
The EADs for loans and advances to customers are normally expressed in terms of notional
amount, reflecting the values carried on the bank’s balance sheet. The EADs for financial
market transactions are expressed in terms of mark-to-market net of margin.
Credit exposures from loans or bonds represent the simplest and most straightforward type
of exposure at default. The EAD for loans or bonds is either (1) the principal amount plus
accrued interest, or (2) the market value or replacement cost of the loan or bond. It is common
to simply assume that, for many loans and bonds, the EAD is equal to the principal amount
plus accrued interest.
Determining the exposure at default for other contracts, such as derivative transactions,
is less straightforward. Derivatives are contracts whose values depend on the performance of
underlying variables. The future payoff profile of a derivative transaction is not known at the
start of the contract. It evolves, depending on the performance of the underlying variables. In
fact, for some derivatives that generate two-way credit exposures, such as swaps and forwards,
it is difficult to determine at the onset who is the exposed counterparty.
In a traditional lending exposure, the lending bank is the sole exposed party. Many
derivative transactions create a two-way or bilateral credit risk exposures. If the market value
of the derivative transaction is positive for the bank, the bank is the exposed party as the
counterparty may have an incentive to default from the transaction. On the other hand, if
the market value of the derivative transaction is negative for the bank, the counterparty is the
exposed party, and the bank may have an incentive to default from the transaction.
Loss given default
Loss given default (LGD) is the percentage of the exposure that the bank might lose in the
event the borrower defaults. The loss is expressed as a percentage. Alternatively, the LGD is
calculated as the difference between 100% and the recovery rate (RR).
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Chapter 5 Credit Risk
LGD = 100% − RR
Recovery rate (RR) is the proportion of the defaulted obligations that the bank can
reasonably expect to recover from bankruptcy or foreclosure in the event of a default. The RR
is frequently expressed as a percentage of the face value of exposure.
Illustrative Example
Computing Loss Given Default
Bank ABC entered into a loan transaction with Company XYZ. The loan was not collateralized. At
the end of the bankruptcy proceeding, it was determined that Bank ABC can only recover 30% of
the loan transaction. Calculate the loss given default of Bank ABC.
Solution:
LGD = 100% − RR
= 100% − 30%
= 70%
The formula for calculating the expected credit loss is:
EL
Expected Loss
=
PD
Probability of Default
×
LGD
Loss Given Default
×
EAD
Exposure at Default
Illustrative Example
Computing Expected Credit Loss
Bank XYZ has an outstanding loan commitment of MYR2,000,000 of which MYR1,500,000 is
currently outstanding.
It is expected that 75% of the remaining commitment would have been drawn down. It was also
assessed that the default rate is 1% over the next year. Recovery rate in case of a default is
expected to be only 60% of the exposure at default.
Calculate the expected credit loss over a one-year horizon.
Solution:
Step 1: Calculate the exposure at default
Outstanding loan
Add:
Expected drawdown on default (MYR500,000 × 75%)
Exposure at default
MYR1,500,000
375,000
MYR1,875,000
Step 2: Determine the probability of default
Probability of default: 1%
Step 3: Calculate the loss given default
Loss given default = 100% − Recovery rate
= 100% − 60%
= 40%
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Risk Management in Banking: Principles and Framework
=
EL
Expected loss
PD
=
7,500
×
Probability of Default
1%
Probability of Default
×
LGD
Loss Given Default
×
40%
EAD
Exposure at Default
×
Loss Given Default
1,875,000
Exposure at Default
Banking organizations are expected to incorporate the expected loss in pricing loans. The
pricing of loans is a key element in the credit risk management process. It ensures that the
bank is adequately compensated for taking the risks associated with its lending activities. This
means that the bank should earn sufficient income to cover not only the costs to fund the
loans and other overhead costs but also the expected credit loss.
Real World Illustration
Risk-Informed Pricing
On 16 December 2013, Bank Negara Malaysia (BNM) issued the policy guideline BNM/RH/STD
028-3 on Risk-Informed Pricing. The document sets out standards that define the responsibilities
of financial service providers to adopt a risk-informed approach in pricing retail loan/financing
products. The document sets out requirements on:
ŸŸ
ŸŸ
ŸŸ
ŸŸ
Governance of loan/financing pricing
Retail loan/financing policy
Estimation of pricing components
Profit cross-subsidization practices
Source: Frequently Asked Questions on CCRIS, Credit Bureau, BNM website
Banks are also required to set aside credit reserves if the revenue is not sufficient to cover for
expected credit loss. The process of setting aside a portion of its earnings to cover for expected
credit losses is known as loan loss provisioning. These loan loss provisions appear as operating
expenses in the bank’s income statement. They generate credit reserves that the bank can draw
upon. Table 5.4 discusses the manner in which the reserves are assigned on two levels.
Table 5.4 Provisioning of general loans and specific loans
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Type of Loan
Provisioning
Description
General loan provisioning
ŸŸ This provision is applied to the loan portfolio as a whole. The provisions are
established for losses that are known to exist but that cannot be directly
addressed or attributed to any individual loans.
ŸŸ Banking organizations are typically required to set aside a percentage of their
total loan portfolios as general loan provisions.
Specific loan provisioning
ŸŸ This is a provision established against a loss that is directly attributable to a
specific loan. The provision is assigned based on the loan classification under
an approved loan grading system.
ŸŸ Loan grading is a system of classifying a loan by assigning scores or grades
based on the characteristics of the individual loan.
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Chapter 5 Credit Risk
Type of Loan
Provisioning
145
Description
ŸŸ The following is an example of a loan classification system adopted from the
U.S. Federal Reserve classification system:
Standard loans
These loans are performing and have sound credit
fundamentals.
Specially mentioned
loans
These loans are still performing but have potential
weaknesses that may weaken the loans and the
bank’s asset quality.
Substandard loans
These loans have weaknesses where the borrower’s
payment capacity is already not assured.
Doubtful loans
These loans are substandard loans with full collection
already highly questionable and improbable.
Loss loans
These loans are uncollectible.
Real World Illustration
Loan Loss Provisioning Practices in Asia
In the aftermath of the 1997 Asian financial crisis, many jurisdictions in Asia adopted stronger
standards particularly in establishing reserves in the loan portfolio. Many of the moves converge
with internationally accepted accounting regimes (e.g. IAS 39) or improvements to loan grading
or provisioning schemes.
Malaysia
Bank Negara Malaysia increased its reserve requirements for various prudential loan grades.
Up to March 1998, no specific reserve level was required for loans graded substandard, while
stipulating 50% for doubtful loans and 100% for loss loans. In March 1998, a 20% requirement
for substandard loans—net of collateral—was introduced and the general reserve levels were
increased to 1.5% of total loans.
Philippines
The Philippines adopted the IAS 39 in 2005 including the loan impairment framework. For banks,
however, the Bangko Sentral ng Pilipinas (BSP) requires that the general reserve levels be
maintained in accordance with the IAS 39 or BSP guidelines, whichever is higher. The BSP
requirements include a general provision for loans without heightened credit risk characteristics
at 1% and previously restructured loans at 5%. Specific reserves are determined based on the
particular loan grade assigned.
Singapore
Singapore adopted the IAS 39 in 2005. The Monetary Authority of Singapore assigns a transitional
arrangement of general provisions of 1% of loans net of collateral values.
Thailand
In 1998, Thailand significantly increased the minimum loan loss reserves required for various
supervisory loan grades. In 2006 and 2007, the Bank of Thailand further tightened loan
provisioning standards for all loans graded substandard or below.
Indonesia
The definition for prudential loan classification scheme with five grades was adopted in December
1998 and a tighter definition for each grade was instituted in 2005. General loan loss reserves
should not be less than 1% net of collateral.
Source: Bank for International Settlements Working Paper No. 375
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5.2.2
Unexpected Loss
Loss rate
Unexpected loss refers to credit losses above the expected levels. These losses may occur at any
time but the timing, frequency and severity of losses are difficult to estimate.
Provisioning is expected to cover only for the expected value of losses from the loan portfolio.
There are instances when the unexpected losses can go beyond what the bank expects. In these
instances, the bank is expected to hold a buffer that would protect the entity against losses
beyond the expected levels. This buffer is in the form of bank capital. Sufficient capital is
necessary to cover the risks of peak losses.
It would be convenient to assume that banks hold capital to cover all unexpected losses by
assuming the worst-case scenario. The worst-case scenario is when the banks lose their entire
assets or loan portfolios in a given year. Holding enough buffer or capital to cover such losses
may not only be economically inefficient but also not economically feasible. This is the reason
why, in practice, a statistical or probabilistic approach is frequently used to determine the
amount of capital as provision for unexpected losses.
Some banks quantify the amount of capital required for unexpected losses by estimating
the amount of loss which will be exceeded in a small, pre-defined probability. The probability is
determined by assessing the probability of bank insolvency arising from credit losses that the bank
is willing to accept. This small-defined probability can therefore be considered as the probability
of bank insolvency. Setting this probability depends on the bank’s risk appetite framework and,
on a broader level, the bank’s insolvency that bank supervisors are willing to accept.
Unexpected loss is the worst-case loss (or peak loss) for a given time horizon and assuming a
given confidence level. Figure 5.10 illustrates the difference between expected and unexpected
loss. Expected loss is represented by the dashed line which is the average loss from credit risk
exposures over time.
Unexpected
Loss (UL)
Expected
Loss (EL)
Time
Frequency
Source: Basel Committee for Banking Supervision
Figure 5.10 Difference between expected and unexpected loss
There are instances when the losses occur beyond the dashed line, i.e. expected loss. These
may occur from time to time, but the timing and amount of loss is difficult to estimate. The
losses above the dashed line represent the unexpected credit losses.
In Figure 5.11, the curve shows that losses below the expected loss dashed line are expected
to occur more frequently. Unexpected losses—losses beyond the expected loss dash line—are
expected to occur with less frequency.
Buffers are set aside to cover for both expected and unexpected credit losses. This can be
quantified using different techniques but the most popular quantitative technique is the valueat-risk (VAR) model. This covers the unexpected loss determined at a certain confidence level.
Loan reserves or provisioning is used to cover expected credit losses. Capital, on the other
hand, is used to cover unexpected credit losses.
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Frequency
Chapter 5 Credit Risk
100% minus confidence level
Potential Losses
Expected Loss (EL)
Unexpected Loss (UL)
Value-at-Risk (VaR)
Source: Basel Committee on Banking Supervision
Figure 5.11 Capital setting for unexpected loss
The shaded region—100% confidence level—represents potential losses that are not covered
by the bank’s capital. This region is the small risk of bank insolvency that the bank is willing
to take. This ‘small-probability’ risk is usually set by the banking regulator.
5.3 CREDIT RISK MANAGEMENT FRAMEWORK
LEARNING OBJECTIVE
5.3
ENUMERATE the different elements of the credit risk management framework
The Basel Committee on Banking Supervision issued the document Principles for the Management
of Credit Risk to promote sound practices for managing credit risk. The sound practices address
the following areas of the credit and credit risk management process:
ŸŸCredit risk environment
ŸŸCredit-granting process
ŸŸCredit administration, monitoring and measurement process
ŸŸCredit risk control
5.3.1
Credit Risk Environment
The overall credit risk environment—comprising credit risk governance structure, credit risk
strategy and credit policies—sets the tone for the entire credit and credit risk process.
Credit risk governance structure
Credit risk governance applies the principles of good governance to the identification,
assessment, management and communication of credit risks to ensure that risk-taking
activities are aligned with the bank’s risk appetite and capacity. It defines the roles and
responsibilities of the board of directors and senior management with respect to credit risk
management.
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ŸŸ The board of directors has the overall responsibility for setting the tone for the organization’s credit risk environment through approving and
periodically reviewing the credit risk strategy and significant credit risk policies.
ŸŸ It is also primarily responsible for the oversight of the credit and credit risk management infrastructure and processes. It must ensure that
appropriate oversight is performed on the bank’s credit activities.
ŸŸ The role of the board of directors is supervisory in nature.
ŸŸ The board of directors is also responsible for:
mm Periodically reviewing the financial results of the bank and based on the results, determine whether changes need to be made to the bank’s
credit strategy.
mm Determining that the bank’s capital level is adequate for the risks assumed throughout the organization.
mm Ensuring that senior management is fully capable of managing the bank’s credit activities and that the activities are within the strategy,
policies and tolerances approved by the board.
mm Approving the overall credit-granting criteria including general terms and conditions.
mm Approving the manner in which the bank organizes its credit-granting functions.
mm Ensuring that the bank’s remuneration policies do not contradict its credit risk strategy.
ŸŸ Senior management has the responsibility for implementing the credit risk strategy approved by the board of directors, and developing policies
and procedures for identifying, monitoring, measuring and controlling credit risk.
ŸŸ Senior management is also responsible for:
mm Ensuring that the bank’s credit-granting activities conform to the established strategy, the written procedures are developed and
implemented, and that loan approvals and review responsibilities are clearly and properly assigned.
mm Ensuring that there is a periodic independent assessment of the bank’s credit-granting and management functions.
mm Determining that any staff involved in an activity where there is credit risk is capable of conducting the activity to the highest standards and
in accordance with the bank’s policies and procedures.
ŸŸ The lending unit under the corporate banking business line is primarily responsible for originating and building the bank’s credit portfolio.
ŸŸ The lending unit is responsible for managing lending relationships with new and existing clients. It is also responsible for developing new credit
businesses and products.
Senior management
Corporate banking
Roles and Responsibilities
Board of directors
Designated Groups
Table 5.5 Functions of credit risk governance
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Credit risk
management
Designated Groups
ŸŸ The credit risk management function is responsible for implementing the risk control framework with respect to credit risk. It can be classified
into three main functions:
mm Centralized credit function
mm Credit risk management planning and control
mm Credit risk portfolio management
ŸŸ The centralized credit function’s mandate is to develop, review and update credit risk identification, assessment, measurement, and
management methodology and processes. Some of the responsibilities of the centralized credit function are to:
mm Develop internal guidelines on credit risk
mm Review the credit decision-making structure
mm Enhance credit review processes
mm Develop, review and enhance credit portfolio risk models
mm Streamline internal credit risk reporting
ŸŸ Credit risk management planning and control can be subdivided into three sub-functions—strategic credit risk planning, operational credit risk
analysis and credit risk control.
ŸŸ Strategic credit risk planning involves planning and monitoring the credit risk portfolio and aligning actual credit risk with the bank’s capital
management strategy. Operational credit risk analysis involves identifying, measuring and aggregating credit risk at the portfolio level. Credit
risk control involves defining and monitoring credit risk limits, recommending courses of actions if limits are exceeded and setting credit riskadjusted prices.
ŸŸ Credit portfolio risk management is responsible for managing portfolio concentration risk, ensuring that the portfolio meets regulatory standards
and advising on strategies to maximize the bank’s risk-adjusted returns.
ŸŸ The credit risk management function should be adequately segregated and independent of the risk-taking functions within the organization.
Staffing levels within the credit risk management department should be adequate to support its mandate.
ŸŸ The credit risk management function bears the primary responsibility, together with the relevant risk-taking units, for the assessment and
control of credit risk.
ŸŸ The credit risk function should:
mm Independently collect and analyze information needed for credit risk assessment
mm Implement and review credit risk measurement methodologies
mm Estimate credit risk levels
mm Prepare independent analysis to assist the board risk committee, the asset and liability management committee, and other risk-related
committees in developing credit risk policies and setting credit risk limits
Roles and Responsibilities
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Real World Illustration
Specific Requirements by Bank Negara Malaysia
Board of Directors
Senior Management
The specific requirements for the board of The specific requirements for senior management
directors with respect to credit risk governance with respect to credit risk governance are:
are:
ŸŸ Ensure clear delineation of roles and
ŸŸ Review of credit policy—The board should
responsibilities for credit risk management.
endorse major credit policy and business plan ŸŸ Ensure that policies and limit structures clearly
annually to ensure that they are consistent
set the bank’s risk tolerance.
with each other and within the banking ŸŸ Implement proper channels of communication
organization’s credit risk tolerance.
to ensure that the board’s credit policies
ŸŸ New credit risk activity—The board should be
and credit risk tolerances are clearly
aware of any new credit products or significant
communicated and adhered to by all levels of
variations to existing credit products. It must
the organization.
ensure that the new activity is suitable from ŸŸ Ensure that adequate and effective operational
the business perspective and complies with
procedures, internal controls and credit risk
the business plan and regulations. The board
management systems.
must ensure that the new activity will be ŸŸ Put in place an effective and comprehensive
adequately incorporated within the credit risk
credit risk reporting process.
management process and standards of the ŸŸ Put in place an effective management
banking organization.
information system.
ŸŸ Reports—At least every year, the board ŸŸ Ensure sufficient resources and competent
should review the list of all existing credit
personnel are deployed to manage and
products and be briefed on the target markets
control the daily operations and credit risk
of the credit products, their performance and
management functions effectively.
credit quality.
ŸŸ Commission
periodic
independent
assessments of the banking institution’s
At least every quarter, the board should be
credit-granting functions.
briefed on the overall credit risk exposure and
should review, at a minimum, the following:
mm Amount of credit risk exposures—broken
down by categories such as types of
exposures, products and level of credit
grades
mm Large concentrations of credit
mm Problem loans list
mm Status
of significant credits under
rehabilitation programmes
mm Credit areas with high rapid growth
mm Significant credit exception reports
At least every year, the board should be
briefed on the potential amount of losses from
deteriorating credits that could incur due to
adverse changes in the economy and under
stressed situations.
Source: Best Practices for the Management of Credit Risk, Bank Negara Malaysia, September
2001
Credit risk strategy
Credit risk strategy establishes the objectives of guiding the bank’s credit-granting activities
and adopting the necessary policies and procedures. The strategy should reflect the bank’s risk
tolerance and profitability objectives.
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Chapter 5 Credit Risk
In addition, the credit risk strategy should also address the following areas:
ŸŸWillingness to grant credit based on type of exposure, economic sector, geographical
location, currency, maturity and anticipated profitability.
Real World Illustration
Standard Chartered—Sustainable Lending
At Standard Chartered, our Group Environmental and Social Risk Policy governs our approach to
integrating environmental considerations into all our lending decisions.
Since the policy was established in 1997, we have factored risks such as climate change, impacts
on biodiversity, deforestation, and air and water pollution into our lending decisions.
We have also adopted the Equator Principles, reinforcing our commitment to provide loans only
to those project sponsors who can demonstrate, to our satisfaction, the ability and willingness to
undergo comprehensive scrutiny to ensure they are working in a socially responsible way and
applying sound environmental management techniques.
We are currently developing position statements for sectors and issues perceived to be sensitive
in the context of sustainable development. These statements will set out the international
standards to which customers borrowing from Standard Chartered are encouraged to operate.
Source: Standard Chartered website
Real World Illustration
Citi Environmental Policy Framework—Prohibited Activities
Citi does not directly or indirectly finance the following types of projects or activities:
ŸŸ Production or activities involving harmful or exploitative forms of forced labour and child labour
ŸŸ Illegal logging
ŸŸ Production or trade in any product or activity deemed illegal under host country laws or
regulations
ŸŸ Production or trade in wildlife or products regulated under the Convention on International
Trade in Endangered Species of Wild Fauna and Flora (CITES)
ŸŸ Drift net fishing in the marine environment using nets in excess of 2.5 km in length
Source: Environmental Policy Framework, Citi, August 2014
ŸŸIdentification of target markets and the overall characteristics that the bank would
achieve in its credit portfolio, e.g. levels of diversification and concentration tolerances.
Real World Illustration
ING Bank
As part of the focus on core clients, ING Bank further reduced its relative exposure to central
governments and banks and the financial sector while growing the private individual and
corporate portfolios.
The category Central Banks reduced considerably as less excess liquidity was deposited at
central banks.
Source: 2013 Annual Report, ING
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ŸŸGoals of credit quality, earnings and growth including the bank’s credit pricing strategy.
The bank’s credit pricing strategy ensures that the bank is adequately compensated for
taking credit risks and an optimal risk-reward level is achieved. Risk-informed or riskbased pricing incorporates the bank’s actual costs (e.g. funding costs and overhead costs)
and expected costs (e.g. expected credit loss) in the pricing of loans.
ŸŸStrategy for selecting risks, maximizing profits and determining acceptable risk and
reward trade-off for its activities after factoring the bank’s cost of capital. The strategy
must ensure that the bank’s capital level is sufficient for the risks assumed throughout
the organization.
ŸŸStrategy to address the cyclical effect of any economy and resulting shifts in the
composition and quality of the overall credit portfolio. Credit strategy should be viable
in the long run through various economic cycles.
Credit policies
The design and implementation of written credit policies are the cornerstones of safe and
sound banking related to identifying, monitoring, measuring and controlling credit risk.
Credit policies are designed to guide the entire banking organization in implementing and
executing the bank’s overall credit risk strategy. These policies provide guidelines to ensure
compliance with the bank’s credit risk strategy.
Credit policies establish the framework for lending and guide the credit granting,
administration, measurement and management practices of the bank. The policies should be
clearly defined, aligned with prudent banking practices and relevant regulatory requirements,
and adequate for the nature and complexity of the bank’s activities.
Credit policies should ensure that the bank has prudent policies and procedures to
identify, measure, evaluate, monitor, report and mitigate credit risk on a timely basis for the
full credit lifecycle—credit underwriting, credit evaluation and ongoing management of the
organization’s loan and investment portfolios.
Credit policies typically focus on four key areas:
ŸŸSound credit-granting and underwriting standards—credit underwriting
ŸŸMonitoring and controlling credit risk—credit monitoring and control
ŸŸIdentification and administration of problem credits—credit administration and
management
ŸŸFramework to properly evaluate new business opportunities—credit evaluation
Real World Illustration
Global Standards and Regulations on Credit Risk
ŸŸ
ŸŸ
ŸŸ
ŸŸ
ŸŸ
ŸŸ
ŸŸ
ŸŸ
ŸŸ
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Management of Banks’ International Lending, March 1982
Measuring and Controlling Large Credit Exposures, January 1991
Principles for the Management of Credit Risk, September 2000
Sound Credit Risk Assessment and Valuation for Loans, June 2006
Joint Forum Cross-Sectoral Review of Group-Wide Identification and Management of Risk
Concentrations, April 2008
Enhancements to the Basel II Framework, July 2009
Financial Stability Board (FSB) Report on Principles for Reducing Reliance on Credit Rating
Agency Ratings, October 2010
Sound Practices for Backtesting Counterparty Credit Risk Models, December 2010
Supervisory Framework for Measuring and Controlling Large Exposures, April 2014
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Credit policies should address the following key areas:
ŸŸTarget markets
Credit policies should clearly specify the bank’s target markets. They should also clearly
specify which markets not to pursue due to various reasons, such as consistency with the
bank’s strategic priorities and risk capacity or alignment with the bank’s reputational
and sustainability policies.
Real World Illustration
Credit Suisse
Credit Suisse has issued a document summarizing sector policies and guidelines for its financing
and advisory activities. It articulates the industries or areas where the bank will not undertake
lending or advisory activities. For example, Credit Suisse has adopted policies not to:
ŸŸ directly finance the development, manufacture and acquisition of nuclear, biological and
chemical weapons, anti-personnel mines and cluster ammunitions.
ŸŸ finance any operations undertaken by oil and gas companies in UNESCO World Heritage
Sites, Wetlands on the Register of Wetlands of International Importance of the Ramsar
Convention on Wetlands, most protected areas, primary tropical moist forests and high
conservation value forests or critical natural habitats.
Source: Summary of Credit Suisse’s Sector Policies and Guidelines
ŸŸPortfolio mix
Credit policies should discuss high-level policies on the bank’s target portfolio mix and
its strategy of ensuring diversification.
ŸŸConcentration limits
Credit policies should also address issues on risk concentration which refers to the
bank’s exposure to a potential risk that can produce losses large enough to threaten
the organization’s health or ability to maintain its core operations. Examples of risk
concentration are:
Individual counterparties
A group of individual counterparties or related entities
mm Counterparties in specific geographical regions
mm Industry sectors
mm Specific products
mm Service providers
mm Natural disasters or catastrophes
mm
mm
ŸŸCountry risk
For internationally active banks, their credit policies should cover how the bank intends
to address the different country risks—which are associated with conditions in the home
country of a foreign borrower or counterparty. These encompass the entire spectrum of
risks arising from the economic, political and social environments of the foreign country
that may have potential consequences for the foreigners’ debt and equity investments in
that country.
Mitigating transfer risks should be a part of the country risk management framework.
Transfer risk is the risk arising from a borrower’s failure to obtain the foreign exchange
necessary to service its cross-border debt and other contractual obligations.
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Policies on country risk typically articulate the maximum risk appetite for each
country’s exposure to ensure that the exposure and potential future losses do not exceed
a certain agreed level.
Real World Illustration
Country Risk Framework of ING Bank
Country risk is the risk specifically attributable to events in a specific country (or group of countries).
Country risk is the risk of loss that ING Bank faces associated with lending, pre-settlement,
money market and investment transactions in any given country or group of countries, as a
result of country risk events. A country risk event can be described as any event or crisis, which
relates mostly to large domestic economic, financial and political shocks, as well as transfer or
exchange restrictions, affecting all counterparties in a specific country in an indiscriminate way.
The occurrence of a country risk event may cause all counterparties in a country to be unable to
ensure timely payments, despite their willingness to meet their contractual debt obligations. As
such, country risk is an additional factor to be taken into account in the credit approval process
of individual customers, as the country risk event probability may impact the default probability of
individual counterparties.
To manage country risk effectively, ING Bank uses two components, which together form the
country risk framework. The first component is to set a maximum economic capital consumption
and the second component is to assign country reference benchmarks, which define the
maximum appetite for credit risk, that ING Bank has per country to ensure that exposures and
potential future losses do not exceed a certain agreed level. The country reference benchmark
is based on the country’s GDP and the funds entrusted locally in that country. In countries where
ING Bank is active, the relevant country’s risk profile is regularly evaluated, resulting in a country
rating, which is used to set the country reference benchmark. Based on these two components,
country limits are set and exposures derived from lending, investment, pre-settlement and money
market activities are then measured and reported against these country limits on a daily basis.
Source: ING Bank
ŸŸRoles and responsibilities
Credit policies should clearly define specific roles and responsibilities of the personnel
involved in the whole credit process. In addition, policies on segregation of duties should
be in place to ensure that controls (e.g. checks and balances) are working as intended.
Examples of proper segregation of duties are:
The process of credit administration, credit approval, credit control and review should
be independent of the front-office unit responsible for originating the credit.
mm The problem loan management unit should be independent of all the units involved
in the credit process.
mm
ŸŸSpecific policies and procedures for the entire credit process
Credit policies should cover all the important activities in the credit process. These
activities include:
Credit origination
Credit appraisal and review
mm Credit approval
mm Credit documentation
mm Credit administration
mm Problem loan management
mm Credit portfolio management
mm Credit control
mm
mm
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Chapter 5 Credit Risk
mm
mm
Internal audit
Credit policy and process review
Real World Illustration
Specific Requirements by Bank Negara Malaysia
Lending Policy
Collateral Policy
Banks should develop and maintain policies and
procedures that will outline its risk management
policies for their lending activities. At a minimum,
the lending policy should set parameters for the
following:
Banks should develop standards and guidelines
on acceptable collateral arrangements. At
a minimum, the collateral policy should set
parameters for the following:
ŸŸ
ŸŸ
ŸŸ
ŸŸ
ŸŸ
ŸŸ
ŸŸ
ŸŸ
ŸŸ
Credit authority
Acceptable markets or lending areas
Credit concentration limits
Credits to related parties
Limit on credit growth
Acceptable credit maturity tenor
List of unacceptable credits
Risk rating of credits
Collections and charge-offs, i.e. criteria and
rating for delinquent credits, procedures for
reporting problem credits, and guidelines and
authority for charge-offs
ŸŸ Credit exceptions
ŸŸ Limit on concentration of collateral
ŸŸ Approach used for the valuation and frequency
of review of collateral
ŸŸ Approved panel of solicitors, property valuers
and insurance companies
ŸŸ For secured facilities, the maximum margin
of advance that may be granted against each
type of collateral
ŸŸ Collateral documentation requirements
Source: Best Practices for the Management of Credit Risk, Bank Negara Malaysia
5.3.2
Credit-Granting Process
Credit-granting process is the process by which the bank decides whether a prospective
borrower should receive financing or lending. This process is essential in approving the credit
in a safe and sound manner.
The credit-granting process involves setting a criteria by which the borrower would be
evaluated on its eligibility for credit based on the bank’s credit risk standards, the quantum of
the exposure the bank is willing to take on, the types of credits available to the borrower, and
the terms and conditions of the credit to be extended.
Is the borrower
eligible for credit?
For how much?
What types of credits
are available?
Under what terms
and conditions?
Figure 5.12 Criteria for the credit-granting process
The credit-granting process starts with credit origination where the lending business unit
has proposed a financing package to the prospective borrower. It then undergoes a credit
evaluation and assessment process where the borrower’s ability to repay the obligation and
other risk mitigants are assessed and evaluated. Thereafter, the loan application undergoes a
credit approval process where the financing is either granted or rejected.
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Credit origination
Credit origination is the process where the lending business unit proposes the financing/
lending to the prospective borrower. At this stage, the bank is expected to have a comprehensive
understanding of the applicant. This includes performing the appropriate customer due
diligence in accordance with its know-your-customer (KYC) standards. At a minimum, the
bank should be able to establish the borrower’s background details as outlined in Table 5.6.
Table 5.6 Know-your-customer process—validating the borrower’s details
Aspects of KYC
Description of the Due Diligence Process
Identity
The bank should, at a minimum, be able to establish and verify the borrower’s identity.
Before granting credit, the bank must ensure that all relevant information that will establish
the applicant’s identity is obtained. The bank should gain sufficient understanding and
appreciation of the purpose and intended nature of the relationship.
Integrity and
reputation
Before granting credit, banks should consider the borrower’s integrity and reputation. Its
integrity and reputation has a direct impact on its creditworthiness.
Legal capacity
The bank should perform the necessary due diligence to ensure that the borrower has
the legal capacity to assume liability. Failure to do so may expose the bank not only to
credit risks but also to legal risks (i.e. operational risks) arising from uncertainty on the
bank’s ability to demand repayment from the borrower or counterparty despite its ability
to do so.
Connected
interests
In granting credit, the bank should be able to assess the borrower’s financial interdependence
to other borrowers of the bank. The bank should have the ability to aggregate exposures
across different connected borrowers and counterparties in order to establish an appropriate
overall credit limit across all the connected exposures.
Exposure limits are needed in all areas of the bank’s activities that involve credit risk.
These are used to ensure that the bank’s credit-granting activities are adequately diversified
and do not exceed the bank’s capital constraints and risk appetite. For new credits, the bank
should have a clearly established process in place. For existing credits, there should be a
clearly established process for amendment, renewal and refinancing.
Credit evaluation and assessment process
There should be sufficient information to enable the evaluation and assessment of the
borrower or the counterparty’s credit risk profile. Table 5.7 details the factors that should be
considered and documented in approving credits.
Table 5.7 Factors for consideration during the credit assessment
Factors
Purpose of the credit
Areas for Assessment
Before granting any credit, the bank must first understand the intended usage of the
loan. While the borrower’s repayment capacity is essential, the bank cannot simply
approve the loan without establishing the actual purpose of its usage. Failing to
properly establish the exact purpose of the credit can expose the bank to different
risks, such as making the bank a conduit for violations of laws and regulations.
The common examples of purposes of credit usage are:
ŸŸ
ŸŸ
ŸŸ
ŸŸ
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Finance working capital requirements of the organization
Finance acquisitions or new business venture
Finance temporary liquidity requirements
Refinance existing obligations or equity
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Chapter 5 Credit Risk
Factors
Areas for Assessment
Sources of repayment
Before granting any credit, the bank must have a thorough understanding of the
borrower’s sources of repayment. Borrowers generally have two sources of
repayment:
157
ŸŸ Internal sources
Internal sources include cash flow that the borrower generates from its operations.
The strength of the borrower’s operating cash flow supports its ability to repay
its obligations. The more stable the operating cash flow, the more positive the
borrower’s historical track record of repaying its obligations.
The larger the operating cash flow, the lower the financing requirements of the
borrower are. This may indicate a higher future ability to repay its obligations. The
lower the operating cash flow, the higher the future financing requirements will
be. This may indicate a lower future ability to repay its obligations.
ŸŸ External sources
External sources include the borrower’s ability to raise future debt and equity from
outside parties. To repay its existing obligations in the future, the borrower can
raise funding from external sources.
The borrower can either refinance its existing obligations by borrowing from
banks or from the public. Alternatively, the borrower can repay existing obligations
by either issuing shares for the first time through an initial public offering (IPO) or
through issuing additional equity shares.
Internal cash flows
Sources of repayment
Debt
External sources
Equity
Current risk profile of the
borrower or counterparty
The borrower or counterparty’s current risk profile should be analyzed to understand
the nature of risks that could lead an increased risk of default. It can be analyzed in
two different aspects:
ŸŸ Business risk
Business risk or operating risk is the risk that the borrower will not be able to
achieve its profitability due to adverse external macroeconomic and political
developments, changes in the industry or developments in the company. The
borrower’s business expertise and the status of the economic sector and its
position within which it operates in, must also be considered when granting the
credit facility.
ŸŸ Financial risk
Financial risk is the risk that the borrower will not be able to pay its obligations as
they come due. The borrower’s repayment history and current capacity to repay,
based on historical financial trends and future cash flow projects, under various
scenarios must be taken into account before granting the credit.
Collateral arrangements
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Collateral arrangements are assets or securities taken by the bank to secure a credit
risk exposure. The bank can use these collateral arrangements as additional sources
of repayment should the borrower or counterparty fails to meet its obligations.
However, collateral arrangements cannot be a substitute for a comprehensive
assessment of the borrower or counterparty’s repayment capacity.
The bank should also analyze the dynamics of how market and economic
developments affect the market value of the collateral. The analysis should be used
in deciding the types of collateral arrangements that are acceptable to the bank.
The legal enforceability of collateral must also be considered. This refers to the
bank’s legal ability to sell the collateral in the event that the borrower or counterparty
fails to pay its obligations.
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Factors
Areas for Assessment
Proposed terms and
conditions
The proposed terms and conditions of the credit should consider the risks involved
against the expected return, factoring both price and non-price terms.
Price terms include arrangements such as the interest to compensate the bank
for assuming the credit risk. Non-price terms include collateral arrangements and
loan covenants that are intended to protect the bank.
The proposed terms and conditions should adequately address the following:
ŸŸ
ŸŸ
ŸŸ
ŸŸ
ŸŸ
ŸŸ
Purpose of the loan
Loan structure and maturity
Disbursement of loan proceeds
Repayment schedule
Minimum standards on financial ratios
Collateral requirements
Credit approval
Credit approval is the process of deciding whether the borrower is worthy of the credit being
granted. In making the decision, the process involves considering the factors detailed in Table 5.8—
the ‘5Cs of Credit’.
Table 5.8 The 5Cs of credit
The 5Cs
Factors for Consideration
Character
Does the borrower have the requisite integrity and reputation of honouring its obligations as they
come due?
Capital
Does the borrower have a sufficient stake in the success of the business?
Capacity
Does the borrower have the ability to meet its obligations as they come due, based on its internal
and external repayment capacity?
Conditions
Are the credit terms and conditions—both price and non-price—sufficiently strong to enable the
borrower to pay its obligations? Are the terms and conditions legally enforceable?
Collateral
Is the collateral arrangement of sufficient quality?
Credit approval should be made in accordance with the bank’s written guidelines and
granted by the appropriate management level. The credit approval process should establish
accountability for decisions taken and designate who has the absolute authority to approve
credits or changes in credit terms. There should be a clear audit trail documenting that
the approval process was complied with and identifying individual(s) and/or committee(s)
providing inputs in making the credit decision.
In approving credit, the bank should ensure the risk/reward relationship is appropriately
considered. Risk-informed pricing ensures that the bank is adequately compensated for the
level of risks it is incurring.
The bank should invest in adequate credit decision resources so that it is able to make
sound credit decisions consistent with its credit strategy and meet competitive time, pricing
and structuring pressures.
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Chapter 5 Credit Risk
Table 5.9 Designated specialists involved in credit approval
Persons Responsible
Duties / Responsibilities
Credit analysts
Each credit proposal should be subject to careful analysis by a qualified credit analyst
with experience commensurate with the size and complexity of the transaction.
Specialist credit groups
Banking organizations should establish specialist credit groups to analyze and
approve credits relating to significant product lines, types of credit facilities, and
industrial and geographic sectors.
Credit risk officers
Banking organizations must develop a pool of credit risk officers who have the
experience, knowledge and background to exercise prudent judgement in assessing,
approving and managing credit risk.
5.3.3
Credit Administration
Credit administration—a critical element in maintaining the bank’s safety and soundness—is a
support team within the organization that monitors the quality of credit transactions. The team
performs the following roles:
ŸŸReview on a periodic basis the credit quality of the borrower and obtain current financial
information
ŸŸEnsure that the borrower is compliant with the terms and conditions of the credit
ŸŸMonitor the quality of the collateral in the light of market and economic developments
ŸŸEnsure that the credit files are up-to-date. The credit files should include all the information
necessary to ascertain the borrower or counterparty’s current financial condition as well as
sufficient information to track the decisions made and the credit history.
ŸŸPrepare various documents, e.g. loan agreements
ŸŸSend out renewal notices
Real World Illustration
Minimum Contents of Credit Files
ŸŸ
ŸŸ
ŸŸ
ŸŸ
ŸŸ
ŸŸ
ŸŸ
Loan documentation
Current financial statements
Financial analyses
Internal rating documentation
Internal memoranda
Reference letters
Appraisals
To ensure the effectiveness of the credit administration function, the bank should ensure
the following:
ŸŸEfficiency and effectiveness of credit administration operations, including monitoring
the documentation, contractual requirements, legal covenants and collateral
ŸŸAccuracy and timelines of information provided to management information systems
ŸŸAdequacy of segregation of duties
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ŸŸAdequacy of controls over all back office procedures
ŸŸCompliance with prescribed management policies and procedures as well as applicable
laws and regulations
5.3.4
Credit Monitoring
The credit monitoring function monitors the condition of individual credits and single
obligors across the bank’s various portfolios. Among its functions are:
ŸŸIdentify and report potential problem credits
ŸŸEnsure that these potential problem credits are subject to more frequent monitoring,
possible corrective action, classification and/or provisioning
ŸŸEnsure that the bank understands the borrower or counterparty’s current financial
condition
ŸŸMonitor compliance with existing covenants
ŸŸAssess collateral coverage relative to the obligor’s current condition
ŸŸIdentify contractual payment delinquencies
An important tool in monitoring the quality of individual credits and the total portfolio
is the use of an internal risk rating system. The system is a means of differentiating the degree of
credit risk in the bank’s different credit exposures. Internal risk rating categorizes credits into
various classes that take into account different gradations of risk.
The internal risk rating system allows:
ŸŸMore accurate determination of the overall characteristics of the credit portfolio
ŸŸIdentify credit concentrations
ŸŸIdentify problem credits
ŸŸDetermine adequacy of loan loss reserves
ŸŸDetermine internal capital allocation
ŸŸEnsure accuracy of the pricing of credits
ŸŸDetermine profitability of transactions and relationships
Credit monitoring also involves ensuring that the actual exposures do not exceed established
limits. Exposures exceeding a specific exposure limit should be reported to senior management
for prompt action.
Other than monitoring the performance of the credit on an individual level, the bank
should also monitor the overall composition and quality of the credit at a portfolio level.
5.3.5
Credit Measurement
Measuring credit risk is an important prerequisite in properly managing the bank’s credit
risk exposure. One cannot manage what one cannot measure. The organization should have
methodologies that will enable it to quantify risk both on a standalone (i.e. individual) level
and at the product and portfolio level.
The measurement of credit risk should take into account the following:
ŸŸThe specific nature of the credit and its contractual and financial conditions
ŸŸThe exposure profile until maturity in relation to potential market movements
ŸŸThe existence of collateral or guarantee
ŸŸThe potential for default based on internal ratings
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Credit measurement models have evolved significantly for the past few years in response
to the changing regulatory environment, more complex credit risk exposures and improved
computing developments. Table 5.10 summarizes the different types of credit measurement
models.
Table 5.10 Credit measurement models
Model / System
Description
Expert systems
Credit risk measurement previously relied on expert systems or ‘rule of thumbs’ in assessing
credit risk exposure by focusing on borrowers’ characteristics. The 5Cs of credit is an example
of this expert system.
Financial
statement
analysis
Financial statement analysis involves analyzing the borrower’s financial statements—
balance sheet, income statement, cash flow statement and statement of changes in
equity—to come up with an understanding of the borrower’s overall ability to repay its
obligations. These ratios are compared with other companies within the same industry or
economic sector.
External ratings
services
External ratings agencies, such as Standard & Poor’s (S&P), Moody’s and Fitch Ratings,
provide a measure of the borrower’s relative creditworthiness. These external agencies
assign a specific rating to individual borrowers. These ratings can be used to infer relative
creditworthiness of the borrower.
Accounting
scoring-based
models
Accounting-based credit scoring models use different key accounting variables to produce
a credit risk score or a probability of default measure. If the credit score or the probability of
default breaches a certain benchmark, the loan application is rejected or subjected to further
analysis.
Quantitative
models
Quantitative models apply state-of-the art finance theories—such as portfolio theory and
option pricing theory—to model the different factors affecting credit risk measurement, such
as probability of default, loss given default and exposure.
5.3.6
Credit Risk Control
Banks must establish a system of independent, ongoing assessment of the bank’s credit risk
management processes. The results of such reviews should be communicated directly to the
board of directors and senior management.
The goal of credit risk management is to ensure that a bank’s credit risk exposure is within
the parameters set by the board and senior management. The establishment and enforcement
of internal controls, operating limits and other practices will help to ensure that credit risk
exposures do not exceed levels acceptable to the bank.
Internal credit reviews should be done by individuals who are independent of the business
function. The credit review function should report directly to the board of directors and
senior management. Limit systems should ensure that the granting of credit exceeding certain
predetermined levels receive prompt management attention.
Internal audits of credit risk processes should be conducted on a periodic basis. Credit risk
reviews should be able to identify weakened or problem credits. The bank should have an
objective and disciplined remedial management process. It should have policies in place to
ensure that problem credits are effectively identified and managed. The workout programme
should be independent of the bank’s credit origination process.
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CONCLUSION
This chapter provided the risk management students with an overview of credit risk, which
is defined as a potential, as an exposure and failure to meet contractual obligations. Expected
credit loss was also distinguished against unexpected credit loss. At the end of the chapter, an
overview of the credit process was provided—from the credit risk environment to the creditgranting process, credit administration and monitoring, and credit risk measurement and
control. In the next chapter, you will be introduced to the credit risk identification process.
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C
6
P
HA
TE
R
IDENTIFICATION
OF CREDIT RISK
In the previous chapter, the risk management students were introduced to the definition
of credit risk. The concepts of expected and unexpected credit loss were also distinguished.
The entire credit process was later discussed in detail.
This chapter focuses on the identification of credit risk. It aims to equip students with
the necessary tools to find, recognize and describe credit risk in a banking organization.
The different sources of credit risks are enumerated. We then discuss the different types
of standalone credit risk exposures—retail, sovereign, corporate and counterparty credit
risks. Before concluding, we look at the different issues relating to credit risk in the
portfolio context.
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Identification of Credit Risk
Sources of Credit Risks
Typology of Standalone
Credit Risk
Overview of Portfolio
Credit Risk
Credit Risk from Loans
and Advances
Retail Credit Risk
Sources of Portfolio
Credit Risks
Credit Risk From
Investment Securities
Sovereign Credit Risk
Credit Concentration
Risk Management
Credit Risk from OffBalance Sheet Exposures
Corporate Credit Risk
Credit Risk from
Derivatives
Counterparty Credit Risk
Figure 6.1 Diagramatic outline of this chapter’s topics
LEARNING OUTCOME
At the end of this chapter, you are expected to be able to:
IDENTIFY the different sources of credit risks in the banking context
LEARNING OBJECTIVES
At the end of this chapter, you will be able to:
DESCRIBE how banking activities generate credit risks
DISCUSS the different types of standalone credit risk exposures
DISCUSS credit risk in the portfolio context
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Chapter 6 Identification of Credit Risk
6.1 SOURCES OF CREDIT RISKS
LEARNING OBJECTIVE
6.1
DESCRIBE how banking activities generate credit risks
For many banking organizations, credit risk remains one of their largest and most significant
risk exposures. Credit risk exists in many banking activities and products. This section aims
to enumerate the different sources of credit risks. While credit risk is often associated with
the bank’s lending activities, it actually exists in many aspects of the banking business. This
section discusses the four major sources of credit risks for a typical banking organization:
ŸŸLoans and advances
ŸŸInvestment
ŸŸOff-balance sheet activities
ŸŸDerivatives
6.1.1
Credit Risk from Loans and Advances
Loans and advances are debt instruments—held by banking organizations—which represent
contractual claims to receive cash flows from other parties.
In performing the financial intermediation role, banks lend money to customers who have
short- to long-term funding requirements. This activity creates an asset that gives the bank the
right to demand repayment of the principal and interest at a predetermined future date. The
asset is commonly referred to as loans and advances to customers.
USD10 million at 3% interest
p.a. payable after 5 years
3% interest per annum
X
X
Interest payment
dates
USD10 million
Principal repayment
date
X If the borrower defaults, the bank will no longer receive both the interest and principal due.
Figure 6.2 Lending relationships between bank and customer
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At the start of the lending relationship with a customer, the bank lends funds (principal)
to the customer with the expectation that the bank will receive compensation—in the form of
interest on periodic payment dates—for the funds lent. On the principal repayment date, the
customer is expected to return the principal. Credit risk arises when the borrower fails to meet
its obligations to pay the interest and principal.
The bank may lose substantially all the amounts lent to the customer. The amount of
loss depends on the specific arrangements under the loan (e.g. whether the loan is secured or
unsecured) and the bank’s legal rights to claim on the assets of the defaulting customer (e.g.
whether the loan is senior or subordinated).
Loans and advances to customers are likely the single largest asset in the bank’s balance
sheet. This asset represents the largest source of credit risk exposure for many banks. Figure
6.3 gives a visual depiction of the balance sheet of one of Asia’s largest commercial banks as
of December 2013. It shows that loans and advances constitute the majority of the bank’s
balance sheet—62% of the total assets. This is the reason why loans and advances are the single
largest source of credit risk for many banks.
Cash
5%
Investment
securities
15%
Loans and advances
62%
Interbank
exposures
10%
Derivatives
4%
Other assets
2%
Goodwill
1%
Properties
1%
Investments in associates
0%
Figure 6.3 Balance sheet composition of a top Asian bank (2013)
Loans and advances can be classified according to the types of borrowers:
ŸŸRetail
ŸŸCorporate
ŸŸSovereign
ŸŸCounterparty
In drawing up a classification framework of the credit risk exposures, the various types of
borrowers entail different approaches in identifying and analyzing the credit risk exposures.
While the general principles of credit risk are essentially the same across different types of
exposures, the risk management practitioners/students will need to apply different sets of
approaches and tools in order to better understand and analyze credit risk exposures arising
from each distinctive type of borrowers.
For example, retail credit risk exposures, by their nature, are usually large in volume but
small in amounts on an individual level. It would, therefore, make sense for the bank to
analyze these risk exposures at the portfolio level. This, however, would not be the appropriate
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Chapter 6 Identification of Credit Risk
approach to analyze corporate credit risk exposures which are usually smaller in volume but
larger in amounts.
At times, differences also arise from the different information that is available for one type
of exposure versus another type. For example, the risk management practitioner frequently has
access to financial statements or reports issued by corporate borrowers. These data, however, are
not available for retail borrowers. It is, thus, important to understand both the general principles
underlying credit risk analysis and the specific peculiarities of the different types of exposures.
Loans and advances can also be classified according to the availability or unavailability of
collateral to protect the lender.
Table 6.1 Secured and unsecured loans
Loan Type
Secured loan
Description
Secured loan is a loan that is backed by collateral. In event the borrower fails to pay its obligations,
the lender may take possession or sell the collateral to mitigate its exposure to the borrower.
Examples of collateral are:
ŸŸ Real estates—mortgage loans secured by immovable properties which are either residential or
commercial
ŸŸ Personal properties or chattels, e.g. cars, jewellery, art pieces
ŸŸ Intangible assets, e.g. patents, trademarks, copyrights
ŸŸ Investment securities or deposits
The bank should assess both the borrower’s creditworthiness and the collateral in assessing its
exposure to the loan.
Unsecured loan
6.1.2
Unsecured loan is a loan that is not backed or secured by collateral. It is also called a clean loan.
In an unsecured loan, the bank relies solely on the borrower’s creditworthiness.
Credit Risk from Investment Securities
Investment securities, such as loans and advances, represent the bank’s contractual right to
receive cash flows—in the form of interest and principal—from the issuing entity. Failure of the
issuing entity to pay their contractual obligations exposes the bank to credit risk.
In comparison to loans and advances, investment securities are generally considered to
be more marketable and tradable. This means that the holder of the investment securities
generally has the right to transfer ownership of the securities without the explicit authorization
from the issuer. This is not usually true for loans and advances. While investment securities
are usually not as large as loans and advances, they still represent a significant portion of the
bank’s balance sheet.
Investment securities are more frequently associated with market risk—resulting from onand off-balance sheet positions arising from movements in market prices or variables such as
interest rates, foreign exchange, commodity prices and equity prices. However, it is important
to consider that investment securities also expose the bank to credit risk. More importantly,
the risk management students should be aware of the complex interrelationship between
market and credit risks.
In the past, market and credit risks have been treated as standalone risks that are unrelated
to each other. In the recent years, however, there has been an increasing attention on their
complex relationship. In many instances, market and credit risks reinforce each other, which
could expose the bank to huge losses.
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Table 6.2 summarizes key points from the working paper of the Basel Committee’s Research
Task Force on the Interaction of Market and Credit Risk (IMCR Group) on the interactions
between market and credit risks.
Table 6.2 Interactions between market and credit risks
Nature of Impact
Implication / Impact of Interactions
Impact of credit risk on
market risk
ŸŸ Credit risk can amplify the bank’s market risk exposure.
ŸŸ The market value of investment securities is determined by the fair value of the
expected cash flows to be received by the investor.
ŸŸ One significant driver of the market value of investment securities is the issuer’s
ability and willingness to fulfil its contractual obligations, i.e. credit risk.
ŸŸ As credit risk increases, the market value of the investment securities goes
down (i.e. higher market risk). As credit risk improves, the market value of the
investment securities goes up (i.e. lower market risk).This is because the market
value of any investment security is influenced by its intrinsic cash flow—future
dividends, interest and/or principal. Deterioration in the creditworthiness of the
issuing entity lowers the probability that the intrinsic cash flow will be received
in full and on schedule by the investor. This lowers the market value of the
investment security, which is evidenced by how fast the value of an investment
security deteriorates when there are concerns on the issuer’s credit standing.
ŸŸ On the other hand, improving credit prospects can have a positive influence
on the market value of the investment security. An improvement in the issuer’s
creditworthiness increases the probability that the intrinsic cash flow of the
investment security will be paid in full and on schedule. This is the reason why
the value of an investment security frequently improves when there is an actual
or anticipated credit rating upgrade on the issuer of the investment security.
Impact of market risk
on credit risk
ŸŸ Market risk can amplify the bank’s credit risk exposure.
ŸŸ Credit risk may be affected by fluctuations in asset prices. An example would
be how a company facing falling equity or stock prices would have difficulty in
refinancing or sourcing new funds as investors and lenders see falling stock
prices as a negative verdict on the company. This may increase the likelihood
that the company will fail to meet its obligations as they come due.
ŸŸ Investment securities are usually associated with market risk. This is because one
of their defining characteristics is their marketability or tradability. This exposes
the bank to fluctuations in market prices. However, if market developments
significantly restrict the marketability or tradability of the investment securities,
the bank is stuck with an exposure that may force it to hold to maturity, thus
exposing the bank to credit risk.
Similar economic
factors
ŸŸ Market and credit risks tend to be driven by the same macroeconomic factors.
For example, stock and bond prices are affected by changes in the overall
macroeconomic environment, development prospects of the industry and other
company specific developments.
Credit risk also exists in securities financing transactions. These transactions include a wide
range of secured transactions. The most common types of securities financing transactions are
securities lending and repurchase agreements.
A common feature of securities financing transactions is that the borrower typically posts
collateral—usually in the form of acceptable securities—and receives funding from the lender.
While lending is done in a secured manner, it does not fully eliminate the credit risk of the
lending entity. This is because when the borrower defaults in its obligation to repay after a
certain pre-agreed period, the lender is left with the security (as collateral for the securities
financing transaction). The value of the security may be lower than the value of the lender’s
exposure. This exposes the lender to credit risk losses if the borrower defaults.
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Chapter 6 Identification of Credit Risk
This is why in a securities financing transaction, both the borrower’s ability and the credit
and market risk characteristics of the security are assessed before approving and providing
the funds. Frequently, the lender would impose a reduction in the valuation of the collateral,
which serves as a buffer for the lender should the market value of the collateral fall. This
reduction is also known as a haircut.
6.1.3
Credit Risk from Off-balance Sheet Exposures
Off-balance sheet activities are banking business activities that generate potential exposures
for the bank upon the occurrence of a contingent event. These activities, unlike the previous
two exposures discussed—loans and advances, and investments—are not recognized in the
bank’s balance sheet.
Off-balance sheet assets are activities that trigger the recognition of assets in the balance sheet
when a contingent event occurs. On the other hand, off-balance sheet liabilities are activities that
trigger the recognition of liabilities in the balance sheet when a contingent event occurs.
Off-balance
sheet asset
Off-balance
sheet liability
Contingent
event
Asset
Contingent
event
Liability
Figure 6.4 Off-balance sheet activities
Table 6.3 describes some common examples of off-balance sheet activities that generate
credit risk exposures for banks.
Table 6.3 Off-balance sheet activities and credit risk
Type of Activities
Loan
commitments
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Details of Exposures
ŸŸ Loan commitments are contractual agreements to extend loans for a given period of
time and at a certain interest rate. Banks typically charge an upfront fee for making the
funds available to the borrower. They may also impose a back-end fee for the unused
portion of the loan commitment, which can be broadly divided into:
mm Irrevocable commitments
Irrevocable commitments are loan commitments that the bank is bound to honour
in all circumstances. A common example of irrevocable commitment is a standby
facility that provides an unconditional commitment to lend money when the borrower
makes a request under the facility.
mm Revocable commitments
Revocable commitments are loan commitments that the bank can revoke without
incurring any penalty in the event that the borrower’s credit standing deteriorates.
An example is the credit line extended to a borrower. A credit line is an uncommitted
facility line opened up by one bank in favour of another bank or customer.
mm A credit line is an arrangement where the borrower can draw funds from as long
as it does not exceed the maximum limit and as long as the bank does not revoke
the facility.
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Type of Activities
Guarantees
and similar
contingent
liabilities
Details of Exposures
ŸŸ Guarantees and acceptances are obligations by the bank to ‘stand behind’ a third
party. Guarantees and acceptances expose the bank in acting as the guarantor to the
guaranteed party. If the guaranteed party defaults on its obligations, the bank assumes
its obligations. This is why guarantees and acceptances are viewed as full credit risk
exposures on the borrower or guaranteed party.
ŸŸ The bank is also exposed to credit risk through warranties, indemnities and
performance bonds routinely issued by banks. These are akin to guarantees except
that the bank does not stand behind the financial obligations of an external party.
Rather, it supports the external party’s ability to meet its routine business obligations.
ŸŸ Banks sometimes sell assets to third parties to remove assets from their balance sheets.
In a normal sales transaction, all the risks and rewards of ownership are transferred to
the third party. However, there are times when the bank (the seller) retains the credit
risk by giving the third party (the buyer) recourse to the bank if the issuer or borrower
defaults. These are also known as transactions with recourse. Loans sold to a third
party may also generate credit risk exposure if the loans sold are with recourse to the
bank. Recourse is the ability of the third party to sell the loan back to the seller (the
bank) if the credit quality of the asset worsens. This means that credit risk on the loan
sold back may be restored.
ŸŸ Standby letter of credit is another example of a contingent liability that generates
credit risk exposure to the bank. A standby letter of credit is an obligation on the bank’s
part to a designated beneficiary to perform or provide compensation under the terms of
the underlying contracts to which they refer, should the bank’s customers fail to do so.
ŸŸ Commercial letters of credit or documentary letters of credit are guarantees sold
by the bank to exporters or importers that payments for goods shipped or sold will be
honoured even if the purchaser of the goods defaults.
Table 6.4 describes the credit risk exposures arising from off-balance sheet commitments,
which can be classified into relative degrees of credit risk.
Table 6.4 Classification of credit risks arising from off-balance sheet activities
Degrees of Risk
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Description
Examples
Full risk
The credit risk is akin to a direct credit
substitute. The credit risk is equivalent to
that of an on-balance sheet exposure to the
same borrower or counterparty.
Guarantees and acceptances where the
bank has the obligation to stand behind
the financial obligations of a third party are
comparable to a loan exposure to another
party. Guarantees and acceptances
are usually considered as full credit risk
exposures.
Medium risk
There is a significant credit risk but
mitigating circumstances suggest less than
a full credit risk.
Documentary letters of credit are examples
of transactions that generate medium credit
risk exposures. This is because while the
credit risk exposure is equivalent to a loan
exposure, the tenors of documentary letters
of credit are usually very short. Further,
documentary letters of credit are usually
partially protected by collateral.
Low risk
There is a small credit risk but not one which
can be ignored.
Commitments that are cancellable at
any time by the bank without prior notice
or that can be automatically cancelled
due to deterioration in the borrower’s
creditworthiness can be considered as of
low credit risk exposures.
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Chapter 6 Identification of Credit Risk
6.1.4
Credit Risk from Derivatives
The 2008 global financial crisis highlighted the importance of considering credit risk arising
from derivative transactions. Banks can either act as end-users (used for proprietary trading
or hedging purposes only) or dealers (used to service clients or counterparties’ requirements
for a fee).
Derivatives are financial instruments whose values depend on the performance of one
or more underlying variables. The underlying variables can be practically anything, such as
interest rates, foreign exchange, equity, commodities or credit. Derivatives can be broadly
classified into three types—forwards, swaps and options.
Table 6.5 Derivatives—forwards, swaps and options
Types of Derivatives
Forwards
Forward contracts are derivative contracts where one party has the obligation to buy (sell) and
another party has the obligation to sell (buy) an underlying asset at a fixed rate to be settled or
delivered at a future date.
Swaps
Swap contracts are derivative contracts between two parties to exchange cash flows on periodic
dates in the future.
Options
Option contracts are contracts where one party has the right to buy (sell) an underlying asset and
another party has the obligation to sell (buy) at a future date. The party who holds the right to buy
or right to sell is called the option holder. The party who has the obligation to sell or to buy is called
the option seller or writer. The option holder pays an option premium at the start of the contract in
exchange for the right to buy or sell.
Derivative contracts generate credit risk exposures to the bank when the counterparty or
client fails to meet its obligations to pay the cash flows stated in the contract. In the case of a
forward or a swap contract, the exposure generates a two-way exposure. This means that the
exposed party cannot be determined at the start. The exposure depends on the market value of
the contract on the date of default.
If the bank experiences a positive market value on its forward or swap contract, it becomes the
party with a credit risk exposure as the other party to the contract will have more incentive to
default in the contract. On the other hand, if the bank records a negative market value on its forward
or swap contract, the other party becomes the party with a credit risk exposure as the bank may
have more incentive to default in the contract. This is further illustrated in the example below:
Illustrative Example
Suppose we have two parties—a forward buyer and a forward seller. The forward buyer has an
obligation to buy an underlying asset after one year at 100. The forward seller has an obligation
to sell an underlying asset after one year at 100.
ŸŸ Scenario 1: After one year, the underlying asset trades at 105. Who is the exposed party?
ŸŸ Scenario 2: After one year, the underlying asset trades at 95. Who is the exposed party?
Obligation to
buy at 100
Forward buyer
Forward seller
Obligation to
sell at 100
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Solution:
Scenario 1: After 1 year, underlying asset trades at 105
In this scenario where the underlying asset trades at 105, the forward buyer is obliged to pay 100
and the forward seller is obliged to deliver the asset which is now worth 105. This means that
contract has a positive value for the forward buyer and a negative value for the forward seller. The
forward seller may default on this contract. Therefore, the exposed party is the forward buyer.
sed
Expo
party
100
Forward buyer
Forward seller
Asset worth 105
Scenario 2: After 1 year, underlying asset trades at 95
In this scenario where the underlying asset trades at 95, the forward buyer is obliged to pay 100
and the forward seller is obliged to deliver the asset which is now worth 95. This means that
contract has a positive value for the forward seller and a negative value for the forward buyer. The
forward buyer may default on this contract. Therefore, the exposed party is the forward seller.
Exposed party
100
Forward buyer
Forward seller
Asset worth 95
Option contracts, on the other hand, generate a one-way exposure. This means that the
exposed party can be ascertained at the start. In a plain vanilla option contract, the option
holder is always the exposed party. This is because the option holder pays the premium at the
start of the contract.
If the option has a positive value, the option holder will exercise its right to buy or sell
under the contract. The option seller or writer may default on its obligation. If the option has
a negative value, the option holder will not exercise its right to buy or sell under the contract.
The option contract will not trigger a payoff. Therefore, no credit risk exposure is generated.
6.2 TYPOLOGY OF STANDALONE CREDIT RISK
LEARNING OBJECTIVE
6.2
DISCUSS the different types of standalone credit risk exposures
Credit risk identification can be done on two levels:
ŸŸLevel 1—Standalone or transactional level
ŸŸLevel 2—Portfolio level
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Chapter 6 Identification of Credit Risk
Credit risk identification starts with understanding the bank’s exposure to the credit risk
on a standalone or transactional level. This involves understanding the credit standing of
specific types of borrowers to which the bank is exposed to. The focus of assessing credit risk
exposures on a standalone or transactional level is to ensure that adequate standards on credit
granting are in place for specific borrowers or transactions. The bank should be compensated
on the level of risk it is taking when granting credit to specific borrowers, taking into account
the nature of the transaction.
While analyzing credit risk on a standalone or transactional level is a necessary requisite
in evaluating credit risk, it is rarely sufficient. There are additional risks when viewed from
a consolidated, bank-wide perspective. Concentration risk or the risk that any risk exposure
type may result in losses that are large relative to the bank’s capital, total assets or overall
risk level. Concentration risk is one of the most common sources of credit problems for
banks.
This section discusses standalone or transactional credit risk. Standalone or transaction
credit risk exposure of a bank can be divided into four major types:
ŸŸRetail credit risk—section 6.2.1
ŸŸSovereign credit risk—section 6.2.2
ŸŸCorporate credit risk—section 6.2.3
ŸŸCounterparty credit risk—section 6.2.4
6.2.1
Retail Credit Risk
The retail banking business provides banking products and services to individual consumers
and small businesses. Recent regulatory reforms, particularly after the 2008 global financial
crisis, heightened the attractiveness of the retail banking business as a stable source of revenue
and funding for many banking organizations. This section discusses the nature of retail credit
exposure and the different drivers of retail credit risk.
Nature of retail credit exposure
Retail credit risk exposure arises from loans and advances granted to individual consumers
and small enterprises. The key feature of a retail credit risk exposure is that it is small or
insignificant on an individual exposure basis compared to other types of credit risk exposures.
However, when aggregated as a portfolio, it is significant. Diversification is another key feature
of retail credit risk exposures due to the number of individual credit exposures. This means
that there is no single individual default that can have a significant impact on the bank. This
is in contrast to other types of credit risk exposures where large exposures to single names, i.e.
concentration risk, are frequently an issue.
For these reasons, retail credit risk exposure is viewed as a more stable and predictable
exposure compared to other credit risk exposure types. Thus, retail credit risk exposure
generally attracts lower capital charge than other types of exposures.
In Table 6.6, we look at some of the distinguishing characteristics of retail credit risk
exposures based on the parameters set by the Basel Committee on Banking Supervision.
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Table 6.6 Characteristics of retail credit risk exposures
Distinguishing Characteristics of Retail Credit Risk Exposures
Orientation
Retail credit risk exposures typically arise from credit risk exposure to an individual person or a
small business.
Products
Retail credit risk exposure typically takes the form of:
ŸŸ Personal Loans
Personal loan is a type of borrowing granted to individual consumers for different purposes. The
loan is typically unsecured. This means that the individual borrower is not required to put up any
collateral or security to ensure the repayment of the loan. Thus, personal loans rely heavily on
the individual borrower’s creditworthiness. This is why personal loans typically attract higher
interest rates compared to other types of borrowings that are secured by collateral.
Examples of personal loans
mm Term loans
Term loan is a type of borrowing that has a specific repayment schedule.
mm Revolving loans
Revolving loan is a type of borrowing that has no specific repayment schedule. The
individual consumer can borrow up to an agreed credit limit.
mm Credit cards
Credit card is a popular form of borrowing for individual consumers, who are allowed
up to a pre-set credit limit. Credit cards are a convenient and efficient mode of payment
for individual consumers.
mm Overdrafts
Overdraft is a facility that allows an individual borrower to issue cheques or withdraw
cash from a bank account up to a pre-approved limit. This pre-approved limit is also
known as the overdraft limit, which is the maximum amount that the individual borrower
can overdraw.
ŸŸ Mortgage Loans
Mortgage loan is a type of borrowing that is secured by collateral or a property. Mortgage loans
can be classified as either fixed or floating.
mm Fixed rate mortgage has a fixed interest rate for the entire term of the mortgage loan.
mm Floating rate mortgage or adjustable rate mortgage is a type of mortgage loan where the
interest is periodically adjusted based on the prevailing interest rates.
Examples of mortgage loans
mm Residential mortgages
Residential mortgage is a type of loan that is secured by a real property used for living
or dwelling purposes.
mm Non-residential mortgages
Non-residential mortgage loans are secured or collateralized by non-owner occupied
property such as an office building or factory.
ŸŸ Small Business Loans
Small business loan is a type of financing obtained to start or expand a small business. The
definition of small business may vary from one jurisdiction to another.
Examples of small business loans
mm Startup small business loans
Startup small business loan is a type of small business loan intended for starting a new
business venture.
mm Franchise loans
Franchise loan is a type of small business loan that allows the borrower to purchase a
licence or access another business products, processes or trademarks.
Low value of
exposures
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Individual retail credit risk exposures are usually of low value. Many banks provide a maximum
threshold for an exposure to be classified as a retail credit exposure. Exposures to individual
consumers or borrowers are typically classified as retail credit risk exposures, regardless of the
size of the exposures.
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Distinguishing Characteristics of Retail Credit Risk Exposures
Exposures to small businesses, however, can only be classified as retail credit risk exposures if
the bank’s total exposure is less than an absolute threshold. For regulatory purposes, the absolute
threshold is €1 million. This means that, from a regulatory point of view, exposures to small
businesses exceeding €1 million cannot be classified as a retail credit risk exposure.
Large
number of
exposures
Granularity is one of the key characteristics of retail exposures. These exposures are typically
large in number. This means that the retail credit portfolio is diversified. As such, no individual
exposure could have a significant material consequence to the bank. The threshold is usually
set to ensure that no single exposure can materially affect the entire portfolio. For regulatory
capital purposes, the Basel Committee set a numerical limit that no aggregate exposure to one
counterpart can exceed 0.2% of the overall regulatory retail portfolio. This is the reason why retail
credit exposures are typically managed by the bank on a pooled and consolidated basis. The
diversification is an important feature of retail credit risk analysis. The credit risk characteristics of
the retail credit portfolio are in most part, driven by portfolio risk characteristics.
Retail credit scoring
At the transactional level, retail credit risk is influenced by factors or variables that affect the
individual borrower’s ability and willingness to repay its obligations. These drivers are assessed
using two different types of assessment methodologies. These are the expert systems and credit
scorecards.
ŸŸExpert systems
In the past, many banking organizations rely on expert systems in their credit-granting
decision process. Expert systems are subjective rule of thumb measures based on
experiences used to evaluate and assess a potential credit risk exposure.
One of the most popular expert systems for retail credit analysis is the 5Cs of credit,
which summarizes the basic components of retail credit analysis.
Character
Capacity to pay
Capital
5Cs
Collateral
Conditions
Figure 6.5 Components of the 5Cs of credit
Table 6.7 Five Cs of credit and the indicators
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The 5Cs
Description
Indicators
Character
ŸŸ This component of retail credit analysis aims to
assess the borrower’s integrity.
ŸŸ The borrower’s integrity can usually be quantified by
referring to its repayment track record. This means that
the borrower’s credit history is analyzed and assessed
on how it has behaved in its past borrowings.
ŸŸ Past repayment track record
ŸŸ Length of the relationship between
the borrower and the bank
ŸŸ Socio-demographic factors, e.g.
sex, education, marital status, age
Capacity to
pay
ŸŸ This component of retail credit analysis aims to
assess the borrower’s ability to repay its obligations.
ŸŸ This is usually measured by the borrower’s income,
the nature and source of the income or the stability of
the borrower’s employment.
ŸŸ One popular measure of capacity to pay is to calculate
the ratio of the level of the borrower’s debt relative to
its income. The higher the ratio, the higher the risk that
the borrower will not be able to repay its obligations.
ŸŸ Type of employment
ŸŸ Industry of employment
ŸŸ Income to expenses ratio
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The 5Cs
Description
Indicators
Capital
ŸŸ This component of retail credit risk analysis represents
the cumulative net assets of individual borrowers.
ŸŸ Capital or net worth serves as another source of
repayment should the current income be insufficient
for the borrower to repay its obligations.
ŸŸ Net worth
Collateral
ŸŸ For secured loans, the value of the collateral is an
important element of credit analysis.
ŸŸ Collateral is the second line of defence which the
bank can rely on.
ŸŸ Nature of collateral
ŸŸ Market value of collateral
ŸŸ Type of collateral
Conditions
ŸŸ Conditions are factors, such as environmental and
macroeconomic conditions, that could affect the
borrower’s ability to repay its obligations.
ŸŸ Another example of other conditions that could affect
the repayment likelihood is the nature and purpose
of the loan extended. Loans that are extended for
risky ventures are less likely to be repaid compared
to loans that are extended for more stable ventures.
ŸŸ Economic cycle
ŸŸ Use of loan proceeds
The 5Cs is a subjective process that considers both the lender’s historical experience
and forward-looking judgement on the borrower’s creditworthiness.
The 5Cs main strength is that it provides a simple and easy to understand framework
to form a picture of the credit risk exposure. It is also more flexible as the unique
circumstances of the individual borrower can easily be incorporated in the assessment
process.
The 5Cs main weakness is the subjective nature of the process, which makes
standardization of the credit-granting decisions difficult. Biases against or for one
particular parameter (e.g. nature of employment) could result in a less optimal credit
decision. Further, because the 5Cs approach relies on the past experience of the credit
decision-maker, the decision may be subject to the individual’s behavioural and cognitive
biases, which could unnecessarily distort the credit decision process.
ŸŸCredit scorecards
As retail lending transactions became more voluminous and computational technology
improved, the subjective expert systems were replaced with a more data-driven and
quantitative approach. The 5Cs approach was replaced with a numerical measure that
analyses the different factors of creditworthiness. This numerical expression of the
borrowers’ creditworthiness characteristics is referred to as credit scores.
Credit scoring refers to the use of statistical models to transform credit data into
numerical measures that guide credit decisions. Credit scorecards are normally used for
high-volume and low-value transactions. The main objective of credit scoring models is
to provide predictive information on the potential for default that may be used in the
credit-approval process.
Retail credit risk drivers typically range from a few dozens to hundreds of factors or
parameters that are deemed to be predictive of a credit risk or default. These parameters
are summarized to form individual credit scores, which are the basis for the creditgranting decision process. The higher the credit scores, the higher the likelihood that the
loan application is approved and the lower the interest rate will be.
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Chapter 6 Identification of Credit Risk
Parameter 1
Parameter 2
Parameter 3
Parameter 4
Parameter 5
Accept
Set interest
Credit
score
Parameter X
Reject
Figure 6.6 Credit scoring
The three main elements of a typical credit risk scorecard are:
mm Characteristics
mm Attributes
mm Scorecard
ŸŸCharacteristics
Scorecard characteristics are variables that are statistically determined to be predictive
in separating good and bad accounts. These characteristics are judged to be good
predictors of default risk. Table 6.8 provides some examples of characteristics that are
used in practice as predictors of default risk.
Table 6.8 Scorecard characteristics as predictors of default risk
ŸŸ
ŸŸ
ŸŸ
ŸŸ
ŸŸ
Demographics
Capacity to Pay
Existing Relationship with the Bank
Age
Years at job
Address
Years at residence
Education
ŸŸ Sources of income
ŸŸ Home ownership—rent or own
ŸŸ Net worth
ŸŸ Length of relationship with the borrower
ŸŸ Number of products sold to the borrower,
e.g. existing deposit account(s)
ŸŸ Past performance of the borrower
The scorecard characteristics should be based on the parameters described in Table 6.9.
Table 6.9 Parameters for scorecard characteristics
Characteristics of Scorecard
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Expected predictive
power
ŸŸ How effective are the selected characteristics in predicting the probability of default
by the borrower?
ŸŸ The selected characteristics should exhibit a strong ability to predict future default or
non-default.
ŸŸ The predictive power can be quantified using statistical or empirical data analysis.
Ease in data
collection and
future availability
of data
ŸŸ How practical is it to gather data on the characteristics?
ŸŸ The bank must balance the benefits of obtaining data on the characteristics and the
costs of gathering the data. In practice, it is frequently difficult to balance between
these two competing interests.
ŸŸ Another dimension that must be considered relating to the use of practicality is the
legality of gathering the data on characteristics. Data privacy principles and laws must
be observed in gathering the data on characteristics.
Objective and not
prone to subjective
interpretation
ŸŸ Is the data characteristic prone to subjective interpretation?
ŸŸ To ensure an objective assessment of a retail credit risk exposure, it is important that
the data collected is objective and not subject to interpretation or subjective evaluation.
This ensures uniformity and consistency in the output of the credit scoring process.
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ŸŸAttributes
Attributes describe and discriminate scorecard characteristics according to pre-defined
parameters. Each characteristic will be assigned an attribute. These attributes will
be the basis for discriminating between good and bad accounts. Attributes can either
be quantitative or qualitative. An illustrative example on the relationship between
characteristics and attributes is given below.
Illustrative Example
Characteristics and Attributes
Characteristics
Attributes
Age
< 18 years old
> 18−22 years old
> 22−25 years old
> 25−28 years old
> 28−32 years old
> 32−35 years old
> 35−40 years old
> 40−45 years old
> 45−50 years old
> 50 years old
Income
< $10,000
> $10,000−$20,000
> $20,000−$30,000
> $30,000−$50,000
> $50,000−$70,000
> $70,000−$100,000
> $100,000
Residential status
Own
Rent
ŸŸScorecard points
Each attribute is assigned scorecard points based on statistical data analysis. The points
allocated to each attribute should be tested, based on the statistical analysis of the
scorecard characteristics.
The scorecard points will differ from one entity to another as historical default
experience will not be the same for each banking organization. Hence, a one-size-fits-all/
template approach to assigning scorecard points may not be a sound assumption. The
bank should perform an extensive empirical analysis on whether the scorecard points
assigned are consistent with its past and expected future credit performance.
The scorecard points are statistically assigned to differential risks, based on the
predictive power of the characteristic variables, correlation between the variables, and
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Chapter 6 Identification of Credit Risk
other business considerations. The scorecard points should be based on a logical pattern
and trend. An example of how scorecard points are assigned for each attribute is given
below.
Illustrative Example
Attributes and Scorecard Points
Characteristics
Attributes
Scorecard Points
Age
< 18 years old
> 18−22 years old
> 22−25 years old
> 25−28 years old
> 28−32 years old
> 32−35 years old
> 35−40 years old
> 40−45 years old
> 45−50 years old
> 50 years old
100
110
120
130
140
150
170
190
210
190
Income
< $10,000
> $10,000−$20,000
> $20,000−$30,000
> $30,000−$50,000
> $50,000−$70,000
> $70,000−$100,000
> $100,000
100
120
140
160
180
200
250
Own
Rent
300
100
Residential status
After the scorecard points are assigned, the bank may now assign scorecard points for
each attribute. The bank may set a minimum total credit risk scorecard points before it
makes the credit-granting decision.
Is the credit score within
the minimum threshold?
YES
Grant the loan application
NO
Reject the loan application
Figure 6.7 Credit-granting decision flow chart
An example on how credit risk scorecards are used in the credit evaluation process is
illustrated on the next page.
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Risk Management in Banking: Principles and Framework
Illustrative Example
Accept or Reject a Loan
Attributes
Scorecard Points
Age
Characteristics
< 18 years old
> 18−22 years old
> 22−25 years old
> 25−28 years old
> 28−32 years old
> 32−35 years old
> 35−40 years old
> 40−45 years old
> 45−50 years old
> 50 years old
100
110
120
130
140
150
170
190
210
190
Income
< $10,000
> $10,000−$20,000
> $20,000−$30,000
> $30,000−$50,000
> $50,000−$70,000
> $70,000−$100,000
> RM100,000
100
120
140
160
180
200
250
Own
Rent
300
100
Residential status
In the loan application document, the account officer summarized the attributes of Borrower Elon:
ŸŸ Age: 27 years old
ŸŸ Income: $45,000
ŸŸ Borrower Elon does not own any home and is only renting.
Decide whether Borrower Elon should be granted the loan.
Solution:
Step 1: Determine the scorecard points per attribute
Characteristics
Age
Income
Attributes
Scorecard Points
27 years old
130
$45,000
160
Rent
100
Attributes
Scorecard Points
27 years old
130
$45,000
160
Rent
100
Residential status
Step 2: Calculate the total credit score points
Characteristics
Age
Income
Residential status
TOTAL
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Chapter 6 Identification of Credit Risk
Step 3: Decide based on credit scorecard threshold
Is the credit score
above 500?
YES
Grant the loan application
NO
Reject the loan application
Since the credit score is below the minimum threshold amount of 500 (credit score: 390), Bank
XYZ may reject the loan application.
External consumer credit scores are used by many banks to supplement the credit
decision process. External consumer credit scores calculate an individual credit score
for each borrower using proprietary parameters that are deemed to be determinants of
default risk.
In the United States, the Fair Isaac Corporation (FICO) credit score is one of the most
popular credit scores for individuals. According to FICO, it is used in more than 90% of
lending decisions. FICO issue credit scores between 300 to 850. A score of 300 indicates
a bad credit score and 850 indicates a perfect credit score.
300
(Bad)
850
(Great)
FICO credit scores are derived from an empirical analysis of three important factors
that affect borrower’s repayment:
mm Length of credit history
mm Payment history
mm Amounts owed
mm New credit
mm Types of credit used
Types of
credit
used
New credit 10%
10%
Payment history
35%
Length of credit
history
15%
Amounts owed
30%
Figure 6.8 Factors that affect a borrower’s repayment capability
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Risk Management in Banking: Principles and Framework
mm
mm
mm
mm
mm
Payment history (35%)
Payment history is the most important factor in the credit score. Credit payment
history is examined on many types of accounts, such as credit cards, retail accounts,
instalment loans, finance company accounts and mortgage loans.
Public records are also examined. Negative factors such as bankruptcies,
foreclosures, lawsuits, wage attachments, liens and judgements will adversely impact
one’s credit score. Bankruptcy, in particular, may adversely impact credit scores for
seven to ten years.
Details on late or missed payments are examined, particularly as to how late the
payments were, how much was owed, how recently they occurred and how many
instances were recorded.
Amounts owed (30%)
A borrower who uses a high percentage of its available credit indicates that it is
overextended, and is likely to be delinquent in future payments. Entities with higher
credit utilization ratio, particularly on multiple credit cards, is viewed as an indicator
that the individual borrower may be delinquent in the future. A larger number of
accounts with amounts owed can indicate higher risk of over-extension.
Length of credit history (15%)
In general, the longer the borrower’s credit history, the higher the credit score will be.
Credit scores examine the age of the borrower’s oldest account, the age of the newest
account and an average age of all the accounts.
New credit (10%)
Taking on new credit accounts within a very short period of time indicates higher
delinquency risk particularly for those with short credit history. Recent requests for
credit information may also indicate higher credit risk.
Types of credit used (10%)
Credit risk score is also affected by the mix of credit accounts a borrower holds. A
diversified credit portfolio mix of credit cards, retail accounts, instalment loans,
finance company accounts and mortgage loans could have a positive impact on an
individual’s credit score.
Real World Illustration
Central Credit Reference Information System (CCRIS)
The Credit Bureau of Malaysia collects credit information on borrowers from lending institutions
and furnishes the information collected back to the institutions in the form of a credit report via an
online system known as the Central Credit Reference Information System (CCRIS).
CCRIS is one of the sources of information used by financial institutions to help them establish a
view of the credit histories of potential or current borrowers.
Participating financial institutions submit the following information to the Credit Bureau:
ŸŸ Essential identification data on their borrowers, e.g. name, identification number and date of
birth
ŸŸ Relevant data on the loans, e.g. type of credit facilities, conduct of account and credit limit
As of the date of publication of this book, the database system contains credit information on about
9 million borrowers in Malaysia.
Source: Frequently Asked Questions on CCRIS, Credit Bureau (BNM website)
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6.2.2
Sovereign Credit Risk
Globalization and increasing cross-border trade and activities among different countries make
it imperative for every banking organization to take a closer look at the credit risk exposures
arising from their international exposures.
On a regional context, many banks in the member states of the Association of Southeast
Asian Nations (ASEAN) are aiming to have a more solid foothold on a regional scale by
expanding the scope of their banking activities and services to other countries in the region.
These developments will likely expose the banks to different countries with different risk
drivers.
Real World Illustration
Maybank ASEAN Strategy
We aim to become the leading ASEAN wholesale bank which will involve enhancing our corporate
relationship model. Strategic initiatives will include:
ŸŸ Improving domestic and regional market position for corporate and non-retail deposits
ŸŸ Building a regional investment bank
ŸŸ Increasing contributions to revenue from non-domestic markets and increasing the fee-toincome ratio contribution
ŸŸ We also aim to expand to the Middle East, China and India
The table below shows Maybank’s credit risk exposures.
Maybank—Credit Risk Exposures by Countries
Country
Exposure Rate
Malaysia
66%
Singapore
19%
Indonesia
7%
Hong Kong
3%
USA
1%
China
1%
UK
1%
Philippines
1%
Source: Maybank Annual Report 2013
Nature of sovereign credit exposure
Nagy (1984) defines sovereign risk as the:
Exposure to a loss in cross-border lending, caused by events in a particular country which are—
at least to some extent—under the control of the government but not under the control of a
private enterprise or individual.
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The definition broadly defines the exposure of a typical banking organization to the actions
of the sovereign or the government. The exposure of a bank operating in different markets can
be broadly classified into two levels, namely direct and indirect sovereign risks.
Direct sovereign risk exposure refers to the bank’s credit risk exposure from its lending
and other credit exposure generating activities with a government or other governmentguaranteed exposures.
Indirect sovereign risk exposure arises from the bank’s exposure of loss from its lending
and other credit exposure generating activities with a private company or an individual as
a result of adverse governmental action or political development, and not by the private
company or individual. This is also referred to as sovereign intervention risk—the risk that
governments will impose rules, regulations and policies that would adversely impact an entity’s
financial, investment and operating environment. Table 6.10 describes how governments
enforce sovereign interventions.
Table 6.10 Ways of governments enforce sovereign interventions
Types of Tools
Impact of Sovereign Interventions
Regulatory framework
Regulations imposed by the national government can establish or alter business
rules that can affect the ability of a private company or an individual (to which the
banking organization has exposure) to pay its obligations as they come due.
Fiscal policy or
taxation
The national government authority may impose taxation that could adversely affect
the ability of a private company or an individual to pay its obligations. Income taxes
are a substantial portion of the overall cash outlay of any organization.
The government may also impose tariffs, i.e. taxes paid by foreign companies trying
to sell their goods in the country. Tariffs are important factors to consider, particularly
their effect on the demand for goods.
Foreign exchange
controls
In times of financial stress, the government may impose foreign exchange controls
to minimize making payments on its foreign currency denominated obligations.
Foreign exchange controls affect corporations particularly if they are not able to
secure foreign currencies to repay their foreign currency obligations.
In both types of exposures, banks are adversely affected by the government actions.
Sovereign or country risk is the risk associated with conditions in the home country of a
foreign borrower or counterparty. This encompasses the entire spectrum of risks arising from
the economic, political and social environments of a foreign country that may have potential
consequences for the foreigner’s debt and equity investments in that country.
Sovereign exposures include claims from the national government authority or from the
central government. They also include exposures or claims with the sovereign’s central bank.
Some examples of sovereign exposures are central governments, central banks, multilateral
development banks (e.g. the IMF and The World Bank), public sector entities and exposures
guaranteed by sovereigns.
Sovereign credit risk drivers
This section focuses on direct sovereign credit risk identification and assessment. The
discussions in this section borrow heavily from the Sovereign Bond Ratings Methodology of Moody’s
Investor Services, one of the largest global credit rating agencies.
Moody’s approach to assigning sovereign credit risk ratings focus on the interplay of four
key factors—economic strength, institutional strength, fiscal strength and susceptibility to
event risk.
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Chapter 6 Identification of Credit Risk
ŸŸEconomic strength
The sovereign’s economic strength—measured by its growth potential, diversification,
competitiveness, national income and scale—is an important factor that determines a
sovereign’s resilience. The sovereign’s ability to generate revenue and service its debt over
the medium term relies on its economic strength.
Moody’s research of 29 sovereign defaults since 1997 shows that long-term economic
stagnation is the principal underlying cause of default in 10% of the cases and a
contributing factor to many others. In 41% of the cases, a high debt burden was the
principal driver of default. Moody’s concluded that the inability to generate sufficient
economic growth to service debt burden often makes high debt burden unsustainable.
Table 6.11 details the factors and indicators that Moody’s uses to assess a sovereign’s
economic strength.
Table 6.11 Specific factors and indicators used by Moody’s
Factors
Growth dynamics
Indicators for Assessing a Sovereign’s Economic Strength
Growth dynamics is one of the most important indicators of a sovereign’s economic
strength. Low growth prospects can render a high debt burden unsustainable.
Indicators
ŸŸ Recent performance and medium-term outlook for GDP
ŸŸ Volatility in the rate of recent GDP growth
ŸŸ Competitiveness and innovation ranking of the World Economic Forum (WEF)
Global Competitiveness Index.
Scale of the economy
Larger and more diversified economies are generally considered to be less vulnerable
to economic shocks compared to smaller countries. Scale of the economy is measured
by nominal GDP.
National income
GDP per capita, which is a measure of the income level per sovereign citizen, is given
a large weight in the sovereign risk rating (25% weighting in the methodology scorecard
for economic strength).
Adjustment factors
Moody’s incorporates two adjustment factors in its assessment for economic strength:
Credit boom adjustment
Credit boom adjustment measures how excessive credit growth is artificially increasing
economic strength indicators such as GDP growth, GDP per capita and nominal GDP
in an unsustainable manner. The credit boom-bust cycle may expose a sovereign to
years of declining GDP or even to a financial crisis.
Based on Moody’s research, in the years preceding the financial crisis (2003−2007),
Ireland’s annual credit growth exceeded nominal GDP growth by a multiple of 1.8 times
before the country went into a recession in 2008.
Diversification
Diversification adjustment factor takes into account the degree of a sovereign’s
economic diversification. The more diversified the country’s economy, the more flexible
it is to handle potential adverse shocks in a significant industry of the economy.
ŸŸInstitutional strength
The strength of a country’s political and economic institutions has been directly linked
to its ability and willingness to pay its obligations as well as its ability to implement
sound policies to further boost economic growth.
Based on Moody’s study, around 30% of past sovereign defaults have been directly
linked to weaknesses in the political and economic institutions of a country. These
weaknesses ranged from political instability to governance problems and sometimes
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Risk Management in Banking: Principles and Framework
even a political unwillingness to pay. Some countries defaulted due to institutional
weaknesses despite having relatively low debt-to-GDP levels.
Real World Illustration
Ecuador’s Political Unwillingness to Pay Debt
Ecuador’s President, Rafael Correa, said yesterday that his nation is defaulting on its foreign
debt, fulfilling his long-time populist pledge to leave international creditors in the lurch.
The default, Ecuador’s second in 10 years, could rattle already jittery investors who have pulled
billions of dollars out of emerging markets in recent months as the global financial crisis has
spread. It could also set back U.S. interests in Latin America, as Correa now seeks to deepen
financial ties with allies like Iran, which this week granted the South American nation a new
$40 million credit line.
While developing world economies have taken a sharp turn for the worse in recent months,
Ecuador is ceasing payments, not because the oil-rich countries cannot afford to pay, but it has
made a political decision not to.
Source: Washington Post, 13 December 2008
Table 6.12 outlines the measurement tool that Moody’s uses to assess institutional
strength.
Table 6.12 Moody’s measurement tool to assess institutional strength
Factors
Institutional
framework and
effectiveness
Indicators / Description
ŸŸ Moody’s uses The World Bank’s Worldwide Governance Indicators (WGI) in
assessing a country’s fundamental institutional framework. These indicators are
used with a policy effectiveness assessment of each country.
ŸŸ The World Bank’s Worldwide Governance Indicators reported aggregate and
individual governance indicators for 215 economies over the period 1996−2012.
ŸŸ Governance is defined as the traditions and institutions by which authority is
exercised. It includes the process by which governments are selected, monitored
and replaced; the capacity of the government to effectively formulate and implement
sound policies; and the respect of the citizens for the institutions that govern
economic and social interactions among them.
ŸŸ The WGI focuses on six dimensions of governance:
Voice and accountability
Political stability and absence of violence
mm Government effectiveness
mm Regulatory quality
mm Rule of law
mm Control of corruption
mm
mm
ŸŸ Moody’s focuses its credit risk assessment on government effectiveness, rule of law
and control of corruption.
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Government
effectiveness
Government effectiveness measures the quality of governmental bureaucracy and
administration. Government effectiveness captures policy planning, implementation
capabilities and independence of the bureaucracy.
Rule of law
Rule of law measures contract enforcement, property rights and independence of
judiciary.
Control of corruption
Control of corruption measures the extent and quality of transparency and accountability
in a country.
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Factors
Indicators / Description
Policy credibility and
effectiveness
ŸŸ This pertains to the government’s ability to consistently and effectively implement
economic reform measures.
mm Inflation performance
Inflation performance is the most important indicator for policy credibility and
effectiveness when assessing sovereign credit risk. This is because sustainable
economic growth can only be achieved with a stable inflation environment.
Inflation is also an important determinant of a country’s competitiveness.
High inflation frequently leads to economic and political instability. It also
erodes confidence in the domestic currency and leads to capital outflows and
even currency crises. Low inflation environment also gives central banks more
flexibility to intervene during a financial crisis.
Inflation performance of an economy shows the credibility and effectiveness
of the policies of an economy’s central bank or monetary authority.
mm Inflation volatility
Inflation volatility measures the degree of monetary policy uncertainty and the
central bank’s ability to control inflation.
mm Adjustment factors
The track record of default is also considered when assessing institutional
strength. The impact of past default in current credit assessment will depend on
how recent the default occurred and how large is the loss to investors.
ŸŸFiscal strength
Fiscal strength captures the overall health of a sovereign’s finances. This is measured
through three levels of assessment—debt burden, debt affordability and the government
debt structure.
Based on Moody’s study, more than 30% of sovereign defaults occurred because of
persistent external and fiscal imbalances, which had built up over time and resulted in an
unsustainably high debt burden due to either unsustainable government fiscal policies
or external trade shocks.
Real World Illustration
When is High too High? The Main Culprit—Excessive Government Debt
The Federal Reserve Bank of St. Louis, in a paper When is High Too High, discussed the often
discussed problem associated with sovereign debt—when is a government debt deemed to be
excessive and too high?
It is quite normal for governments to incur debt or to report a modest budget deficit, i.e. spending
is more than revenue. However, if the deficit or debt level is deemed to be excessive, there may
be fears that the government could no longer repay its debt obligations.
But how high is too high? Many economists frequently look at the debt-to-GDP (gross domestic
product) ratio as the gauge for determining whether the borrowing or debt level is excessive.
Debt-to-GDP ratio measures the ability of a government to repay its debt obligations with its
one-year economic output (measured by the GDP). There are, however, some concerns about
the focus on debt-to-GDP as it is observed that many countries with high debt-to-GDP have
been able to repay its obligations comfortably, while some countries with low debt-to-GDP have
defaulted on their obligations.
The author of the paper explained that both the ability and willingness to repay the obligations
should be considered in assessing default risk. He cited the case of Japan with a high debt-toGDP ratio of 200% but has not defaulted on its obligations. Brazil and Mexico, on the other hand,
have low debt-to-GDP of 50% but have defaulted in the early 1980s.
It is, therefore, important to consider the perceived willingness to repay government debt in
assessing default risk. The paper concluded that this perceived willingness to repay government
debt is a major factor in the European sovereign debt crisis.
Source: The Central Banker, Federal Reserve Bank of St. Louis, USA, Summer 2012
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Figure 6.9 illustrates the cyclical characteristics of sovereign defaults. Defaults occur
at very high debt-to-GDP and debt burden levels, which impair a country’s ability to
service its debt obligations.
Slow build-up
of debt
Dependence
on external
creditors
Deterioration in
debt affordability
Figure 6.9 Characteristics of sovereign defaults
Real World Illustration
High Interest Burden
In an article published by The Guardian on 22 July 2011, Jamaica’s debt burden was considered
one of the worst in the world. This was due mainly to its interest burden averaging 13% of the
country’s GDP over the last five years. Jamaica’s debt situation is ironic when compared to
Greece, considered to have the highest debt burden in the eurozone. Ironic because Jamaica’s
interest burden was twice as much as that of Greece averaging 6.7% of the country’s GDP. In
retrospect, Jamaica’s gross public debt was 123% of its GDP while Greece was at 166% of
its GDP. This goes to show that the more important number is the interest burden. The report
claimed that for the fiscal year 2009/2010, 45% of Jamaica’s government spending went to
interest payments that significantly impeded the country’s growth.
Source: The Guardian, 22 July 2011
Table 6.13 describes the indicators that Moody’s uses to assess a sovereign’s fiscal
strength.
Table 6.13 Indicators for assessing fiscal strength—Moody’s
Areas
Indicators
Debt burden
General government debt/GDP
This ratio measures the level of a sovereign’s debt against its economic output. It considers the
government’s gross debt including direct government debt to all regional and local governments.
High government debt-to-GDP ratio has a strong correlation with past sovereign defaults.
General government debt/revenues
This ratio measures the level of a sovereign’s debt against its revenues. It gives an indication
of a sovereign’s repayment capacity given its actual revenue base.
Debt
affordability
General government interest payments to revenue
This ratio indicates the degree to which a government’s debt service burden is within its revenuegeneration capacity. It may also indicate the willingness of creditors to finance government
deficits without demanding a high risk premium.
A high ratio means that a large share of revenues will be diverted to meeting interest
payments. This often leads to large fiscal deficits and constrain capital expenditure, which will
have an adverse impact on future growth.
This ratio measures the immediate capacity of revenues to service interest payments.
General government interest payments to GDP
This ratio measures the broader capacity of the economy to service interest payments by taking
a look at the overall economic output (GDP).
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Areas
Adjustment
factors
Indicators
Moody’s considers additional factors in assessing the fiscal strength of a sovereign:
Debt trend
Debt trend analysis focuses on the percentage point in debt level compared to GDP over time.
It offers retrospective and prospective views on the medium-term debt trajectory.
Debt sustainability analysis
Debt sustainability analysis focuses on the different scenarios with respect to nominal growth,
fiscal trajectory, interest rate development and stock-flow adjustments.
Foreign currency government debt
One of the common causes of sovereign default is a proportionately high foreign currencydenominated debt. In Moody’s 2010 default study, the 20 sovereigns covered in the analysis
exhibited an extremely high average foreign currency government debt ratio at 75.9%. This
follows a phenomenon where sovereigns rely on external borrowings and face high debt
service costs when a currency crisis or a macroeconomic shock happens, which causes the
debt value to spike in local currency terms.
Other public sector debt
Many public sector companies can drain fiscal resources from the central government. This can
lead to fiscalization of debt.
Public sector financial assets or sovereign wealth funds
The availability of government assets to be used to service debt obligations is considered in the
fiscal strength analysis. These assets provide support factors for government finances.
ŸŸSusceptibility to event risk
Susceptibility to event risk assesses the government’s ability to withstand shocks from
sudden, extreme events that may severely strain public finances and sharply increase the
likelihood of a sovereign defaulting.
The first three factors—economic strength, institutional strength and fiscal strength—
focus on the government’s ability to withstand shocks from a medium-term perspective.
The fourth factor focuses on very sudden and extreme events.
Susceptibility to event risk is analyzed in four risk areas. These are political risk,
government liquidity risk, banking sector risk and external vulnerability risk.
mm
Susceptibility to event risk: Political risk
Political risk is analyzed in two dimensions, namely domestic political risk and geopolitical
risk. Table 6.14 briefly discusses these two dimensions.
Table 6.14 Domestic political risk and geopolitical risk
Indicators for Analyzing Political Risk
Domestic
political risk
Domestic political risk is the risk arising from a country’s domestic politics. This risk can be
assessed based on two indicators:
ŸŸ The World Bank’s Voice and Accountability Index
The World Bank’s Voice and Accountability Index is a component of the Worldwide
Governance Indicators. Voice and Accountability (VA) captures the perception of the
extent to which a country’s citizens are able to participate in selecting their government
as well as freedom of expression, freedom of association and a free media.
ŸŸ GDP per capita
GDP per capita is used as a proxy for the potential of low income-related social unrest.
Geopolitical risk
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Geopolitical risk is harder to quantify compared to other factors. There are, however, few
countries that may be affected by geopolitical risk. Escalation of geopolitical risk could
lead to deterioration of creditworthiness. One example frequently cited is the credit rating
of South Korea. While South Korea has a strong credit rating, escalation of tensions with
North Korea could adversely impact South Korea’s creditworthiness.
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Real World Illustration
Kuwait Crisis Threatens Credit Rating Downgrade
In a report released by Reuters in October 2012, Fitch Ratings warned against the escalating
political turmoil in Kuwait, which could compromise the country’s AA sovereign credit rating
despite its strong balance sheet. The situation was brought upon by the dissolution of the
parliament by Sheikh Sabah al-Ahmed al-Sabah that eventually led to a new election which
would have serious impact on the country’s economy. Of all the Fitch-rated countries, Kuwait
has the strongest sovereign external balance sheet, which connotes that it can withstand further
political instability. Fitch said that Kuwait registered net foreign assets of about $323 billion or
equivalent to 191% of its GDP as of end of 2011.
Source: Reuters, October 2012
mm
Susceptibility to event risk: Government liquidity risk
Government liquidity risk is the risk that a sovereign will lose its access to liquidity
to enable it to service its debt obligations. Countries that have more diversified
sources of liquidity are generally considered to be more resilient. High private
savings and sophisticated financial system are examples of indicators of strong
liquidity sources. Table 6.15 details the main indicators of government liquidity
risk.
Table 6.15 Main indicators of government liquidity risk
Indicators of Government Liquidity Risk
Fundamental
metrics
ŸŸ Gross borrowing requirements related to the GDP gives an indication of the size of a
sovereign’s funding needs. The higher the borrowing requirements, the more susceptible
the sovereign is to liquidity risk.
ŸŸ Another important indicator is the share of general government debt held by non-residents.
The higher the share of foreign investors, the less captive the sovereign’s investor base is.
Market funding
stress
ŸŸ Market funding stress is a strong indicator of perceived or actual liquidity problems for a
sovereign. Indicators such as the sovereign’s credit default swap spread or bond-implied
ratings are used to monitor market-funding stress.
ŸŸ Market funding stress can be mitigated by tapping support programmes from other
sovereigns or from multilateral agencies, e.g. the International Monetary Fund (IMF).
Sovereigns which tap these support programmes are generally assigned non-investment
grade ratings. This is because the support programmes are usually the last-resort crisis
measure and therefore indicates significant credit weakness.
Susceptibility to event risk: Banking sector risk and other contingent liabilities
ŸŸ Sovereigns are sometimes exposed to liabilities that are not apparent. These liabilities
are the government’s off-balance sheet commitments that will only be triggered upon the
occurrence of an adverse event. These contingent liabilities may be converted into actual
liabilities on the part of the sovereign.
ŸŸ The most common form of such off-balance sheet liabilities is explicit sovereign guarantees
to cover debt repayments of third parties. There are also implicit guarantees where the
government may be compelled to support third-party obligations if a certain event is
triggered.
ŸŸ An example is the banking industry. The government typically supports banks in two ways:
mm Issuance of guarantees to facilitate bank debt issuance and other temporary liquidity
support measures
mm Direct injections of capital
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191
Indicators of Government Liquidity Risk
ŸŸ Banking sector liabilities may, therefore, be treated as a contingent liability for the sovereign.
Some indicators that is relevant to assess the sovereign’s vulnerability to banking risk are:
mm
mm
mm
Strength of the banking system
The strength of the banking system is measured by the average bank financial strength
assessment. It is a measure of the banking system’s ability to honour its debt obligations.
Size of the banking system
The larger the banking system relative to the sovereign’s GDP, the larger is the
sovereign’s contingent liabilities.
Funding vulnerabilities
Banking systems with a small deposit base and significant reliance on capital markets
funding are more vulnerable than banking systems with a large deposit base.
Real World Illustration
Ireland Blanket Guarantee Mistake
The government’s guarantee of Irish bank liabilities—that controversially saddled Irish taxpayers
with billions in debt—is to end next month. Irish Finance Minister, Michael Noonan, made the
announcement. Mr Noonan said the end of the scheme on 28 March signalled that Irish banking
had left the ‘emergency ward’ and was now in normal conditions.
The scheme was introduced in September 2008 in a panicked response to the financial crisis.
With Irish banks facing collapse, the government introduced a blanket guarantee of everything
within the system.
Ordinary deposits were already covered up to €100,000 (£86,000) under a Europe-wide scheme
and they remain covered at present. But this exceptional guarantee covered up to €400 billion
(£345 billion) in liabilities, commercial and inter-bank deposits, and bank bonds and debt.
The Irish government did not expect to have to pay out on the guarantee, but the banks’ financial
position proved much worse than realized at the time, and Irish taxpayers ended up bailing out
the failed institutions to the tune of €62 billion (£53 billion). The end of the guarantee had been
expected. Under the terms, covered banks paid fees to the Irish Exchequer—some €1.1 billion
(£947 million) last year.
The guarantee’s end will return savings to the banks and reduce income for the government,
but Minister Noonan said this had been built into the budget. In fact, he suggested the savings
for the banking sector should increase profitability and benefit taxpayers, who should see their
investment in Irish banks rise as a result.
The ending of the guarantee marks the latest step in addressing some of the consequences of
Ireland’s disastrous banking collapse.
Source: BBC News, 28 February 2013
Real World Illustration
Cyprus Banks 7.5 Times Larger than its Economy
In a Reuters report released on 21 March 2013, Cyprus needed to halve its oversized banking
sector by 2018 so as to qualify for the bailout set by the European Union. The prequalification for
the bailout must be met by Cyprus and match the average EU banking sector pegged at around
3.5 times of a country’s GDP as against the size of the Cypriot banking sector which was
7.5 times the size of its GDP. The sheer size of the Cypriot banking sector led by its three largest
banks produced almost $23.27 billion a year. However, the banking sector became vulnerable
and suffered heavy losses during the 2012 Greek sovereign debt restructuring, the Reuters
report claimed.
Source: Reuters, 21 March 2013
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mm
Susceptibility to event risk: External vulnerability risk
Some countries need to generate foreign currencies to pay their foreign currencydenominated obligations. Countries with high current account deficits and/or net
capital outflows may face balance of payment constraints. Table 6.16 describes some
important indicators of external vulnerability risks.
Table 6.16 Indicators of external vulnerability risks
Indicators of External Vulnerability Risks
Current account
and foreign direct
investment (FDI)
balance
Current account balance records all cross-border transactions between residents and
non-residents and flows of dividends and payments on foreign assets and liabilities.
A negative current account balance indicates that payments abroad exceed receipts.
Large and persistent current account deficits can lead to a build-up of external debt.
External
vulnerability
indicator
This measures the sovereign’s relative capacity to use immediately available
international reserves to make debt payments even if creditors refuse to roll over its
debt that is due within a given year. It measures a sovereign’s ability to withstand a
temporary loss of confidence resulting from a heightened risk perception or general
liquidity squeeze.
Net international
investment position
Net international investment position measures the difference between a country’s
foreign assets and its liabilities relative to its GDP.
6.2.3
Corporate Credit Risk
Corporate credit risk exposure primarily arises from short- and long-term loans and advances
granted to the bank’s corporate, partnership and proprietorship clients. These loans and
advances are granted to help the corporate clients finance their current operations or future
expansion plans. Corporate credit risk also arises from the bank’s different off-balance sheet
activities, e.g. providing commitments to lend, guarantees or hedging solutions to corporate
clients.
Banks also engage in specialized lending activities which provide customized solutions
specific to the individual client’s needs. These activities generate unique exposures for many
banks which require specialized knowledge and skill set. Table 6.17 describes some examples
of specialized lending activities.
Table 6.17 Specialized lending activities
Type of Lending
Project finance
Description
ŸŸ Project finance is a method of funding in which the bank looks primarily to the
revenues generated by a single project, both as the source of repayment and as
security for the exposure.
ŸŸ In a project finance transaction, the bank is usually paid solely or almost exclusively
out of the money generated by the contracts for the facility’s output.
ŸŸ The borrower is usually a special purpose entity (SPE) that is not permitted to perform
any function other than developing, owning and operating the installation.
ŸŸ The implication is that repayment depends primarily on:
mm Project’s cash flows
mm Collateral value of the project’s assets
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Type of Lending
Description
Object finance
ŸŸ Object finance refers to a method of funding the acquisition of physical assets where
the repayment of the exposure is dependent on the cash flows generated by the
specific assets that have been financed and pledged or assigned to the bank. A
primary source of these cash flows might be rental or lease contracts with one or
several third parties.
Commodities
finance
ŸŸ Commodities finance refers to structured short-term lending to finance reserves,
inventories or receivables of exchange-traded commodities. The exposure will be
repaid from the proceeds of the sale of the commodity, and the borrower has no
independent capacity to repay the exposure. The borrower generally has no other
activities or material assets on its balance sheet.
ŸŸ The structured nature of the financing is designed to compensate for the borrower’s
weak credit quality.
Income-producing
real estate
ŸŸ Income-producing real estate (IPRE) financing refers to a method of providing funding
to real estate where the prospects for repayment and recovery on the exposure
depend primarily on the cash flows generated by the assets.
ŸŸ The primary source of cash flows would generally be the lease or rental payments,
or the sale of assets.
ŸŸ The distinguishing characteristic of IPRE financing is the strong positive correlation
between the prospects for repayment of the exposure and the prospects for recovery
in the event of default, with both depending primarily on the cash flows generated by
a property.
High volatility
commercial real
estate
ŸŸ High-volatility commercial real estate lending is the financing of commercial real
estates that exhibit higher loss rate volatility (i.e. higher asset correlation) compared
to other types of specialized lending.
Nature of corporate credit risk exposures
Compared to retail credit risk exposures, a standalone corporate credit risk exposure is
frequently higher in value and lower in volume. Failure of a single corporate credit exposure
may have more impact to the bank than for retail credit exposures. This makes it more critical
to focus on assessing corporate credit risk exposures on a standalone level. On the other hand,
for retail credit risk exposures, credit risk assessment is frequently done on a portfolio level
due to the relatively more homogeneous character of the individual’s retail credit risk profile.
Another distinction between a corporate credit risk exposure and retail credit risk
exposure is the availability of information. Corporate governance, securities rules and local or
international regulations require corporate entities to disclose information to the investing
public. The information can come in various forms such as the annual or quarterly audited
financial statements—balance sheet, income statement and cash flow statement. The relevant
information allows the bank to proactively assess corporate credit exposures on an ongoing
basis.
Drivers of corporate credit risk
Corporate credit risk is driven by two major factors—business risk and financial risk.
ŸŸBusiness risk
Business risk is the risk associated with the operating environment of the corporate
credit. These are non-financial in nature. Business risk can be classified into three levels—
country-risk, industry risk and company-level risk.
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mm
Industry risk
Industry risk is defined as the risk of losing revenue or market share, or incurring
an overall financial decline as a result of industry changes, business cycles, product
obsolescence, changes in consumer preferences, changes in technology, reduction in
barriers to entry or an increase in competition.
Disruptions in the industry could significantly affect the company’s future
viability and ability to continue as a going concern. A recent example is the
mobile phone industry. The once-dominant players in mobile phones (e.g. Nokia
and Blackberry) faced significant market share erosion with the entrance of
smartphones. Another example is the personal computer industry—once dominated
by blue chip companies like HP and Dell—has been disrupted with the emergence of
new computing alternatives such as tablets and smartphones. Industry changes and
disruptions can affect the future earning capacity of corporations.
Former General Electric CEO, Jack Welch, once commented—“I would rather
invest in a bad company in a good industry than invest in a good company in a
bad industry.” The dynamics of the industry can strongly influence a company’s
performance. This is why a company is analyzed in the context of the industry in
which it operates.
Industry risk can be analyzed in three dimensions—sales and revenue prospects,
business cycle and industry structure.
–– Sales and revenue prospects
An industry’s sales and revenue trends as well as its prospects can have significant
implications on the assessment of a company’s own sales and revenue (S&P)
prospects, and therefore its credit strength.
The industry life cycle analysis is an important tool in understanding an
industry’s sales and revenue growth prospects. S&P classifies an industry into five
types—growth industry, mature industry, niche sector, global business and highly
cyclical.
Revenue is an important trend for measuring an industry’s growth, size
and general strength. Analyzing the revenue trend can provide insight into the
industry’s pricing power, which is defined as the industry’s ability to raise the price
of a product without affecting its demand. This occurs when demand exceeds
supply and buyers have little or no alternative.
Figure 6.10 illustrates the different growth patterns—growth, mature, niche,
global and highly cyclical—of different industries. While it is difficult to classify an
industry under one of the categories, the industry life cycle framework is a useful
tool to assess its growth potential.
Growth
Mature
Niche
Global
Highly cyclical
Figure 6.10 Industry life cycle
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Chapter 6 Identification of Credit Risk
Table 6.18 Industry life cycle—growth patterns
Growth Pattern
Description
Growth industry
ŸŸ A growth industry is one that has not yet achieved sales in all possible markets but has
great potential for growth in new markets, to new customers, for new products and at a
faster pace—defined in general as greater than 5%—than other industries.
ŸŸ Examples of companies in the growth industry are high technology start-up companies.
They are characterized by high market growth potential and untapped markets.
Mature industry
ŸŸ A mature industry is already selling to most possible customers and markets, and has
growth potential that is roughly average compared to that of other industries.
ŸŸ Mature industries are generally characterized by stable growth patterns. However, they
also experience constant shifts in supply and demand balances that affect sales growth
and pricing power.
ŸŸ New developments such as the entrance of new products for mature products could make
the analysis of sale and revenue trends more challenging. The results could widely diverge.
ŸŸ Examples of companies in the mature industry are food and beverage or consumer
companies in mature markets. These companies are characterized by a stable sales
growth pattern.
Niche sector
ŸŸ Niche sectors are small, narrow businesses or products within a larger industry where
the growth potential is meaningful and opportunistic for smaller participants, and usually
insignificant or marginally incremental for larger entities.
ŸŸ Niche companies typically take advantage of the inefficiencies of larger companies by
focusing on a narrow line of products to deliver better products at better prices.
ŸŸ Niche companies’ sales growth prospects and pricing power are generally viewed as
high risk.
ŸŸ Niche companies usually cater to specialized products or service requirements of customers
that are usually not met by larger entities. They usually service certain geographical areas
or demographics which are untapped by larger entities. Niche companies are typically of
smaller capitalization compared to large companies. Examples of niche companies are
banks that specifically focus on a certain target market. Banks that specialize in lending
to SMEs (which are sometimes not tapped by larger banks) may be considered as niche
institutions. Because of its limited market, the niche company’s asset or capital size is not
as large as those of large companies.
Global business
ŸŸ Global business is typically a mature business whose sales are achieved across country
boundaries. Therefore, sales and revenue growth opportunities for competitors in a
global industry can be substantial.
ŸŸ Global businesses encompass the risks and opportunities of a mature industry but they
are multiplied and complicated by scale of operations. Examples of global businesses
are multinational companies that operate in multiple markets.
Highly cyclical
ŸŸ Highly cyclical industries experience wide swings in demand and supply. A major
challenge for this sector is to achieve consistent sales growth performance.
ŸŸ Examples of highly-cyclical industries are commodity trading companies whose
revenues are largely dependent on movements in the prices of commodities, which are
highly volatile.
–– Business cycles
Business cycles are short-term fluctuations in the economy. These fluctuations can
be divided into two distinct phases—expansion and recession phases. The expansion
phase occurs during periods when economic activities tend to trend up. The
recession phase occurs during periods when the economy tends to trend down.
Every industry has its own unique business cycle. Understanding the business cycle
trend for a particular industry is important. Industries with shorter business cycle are
more exposed to business cycle risk. Those with unpredictable and volatile expansion
to recession transition patterns are more vulnerable from a credit risk perspective.
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Business cycle, however, should be distinguished from credit cycle. Credit cycle is
the fluctuation in the supply of credit. Similar to the business cycle, a credit cycle can
be described in distinct phases—expansion and contraction phases. Credit cycle,
therefore, describes the expansion and contraction of access to credit over time.
While it can be intuitively expected that the credit cycle can influence the course
of a business cycle, studies have shown that correlation between these two types of
cycles appears relatively weak.
In the paper, ‘Corporate Bond Default Risk: A 150-Year Perspective’ (Giesecke
et al, 2011), it was found that default cycles tend to be less frequent but more
persistent than the business cycle downturns.
–– Industry structure
Analyzing the structure of an industry in terms of the market structure—demand
and supply—will yield important insights into the industry’s ability to remain
resilient under changing economic conditions.
Real World Illustration
S&P Industries Ranked by Level of Inherent Risk
Highest-risk industries
ŸŸ Metals and mining firms
ŸŸ Large-scale manufacturers, particularly automakers and suppliers
ŸŸ Airlines and aerospace
ŸŸ Homebuilders and building materials suppliers
ŸŸ Merchant electricity generators and marketers
ŸŸ Paper and wood products manufacturers
Medium-risk industries
ŸŸ Oil and natural gas producers
ŸŸ Technology firms, including telecommunications equipment makers
ŸŸ Restaurants
ŸŸ Retail stores
One of the traditional frameworks to assess an industry’s profitability is the
classic five forces model—developed by Professor Michael Porter at Harvard Business
School. It provides important insights on the vulnerabilities of an industry to one
or more of the five forces. Figure 6.11 illustrates Porter’s five forces model, while
Table 6.19 discusses Porter’s five competitive forces.
Threat of new entrants
Bargaining power of suppliers
Rivalry
among
existing
competitors
Bargaining power of buyers
Threat of substitute products or services
Figure 6.11 Porter’s five forces
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Table 6.19 The five forces model
Porter’s Five Forces Competitive Model
Threat of new
entrants
New entrants to an industry bring new capacity, the desire to gain market share and
substantial resources. The seriousness of the threat of entry depends on the barriers
present and on the reaction from existing competitors. If the barriers to entry are high and
existing competitors are expected to retaliate aggressively, new entrants will not pose a
serious threat of entering. The six major sources of barriers to entry are described below.
Six Major Sources of Barriers of Entry
The extent of economies of scale will force a new entrant either to come
in a large scale or accept a cost disadvantage.
Product
differentiation
Brand identification creates a barrier by forcing new entrants to invest
heavily to overcome customer loyalty to existing competitors.
Capital
requirements
The need to invest larger resources in order to compete creates
a significant barrier of entry, particularly if capital is required for
unrecoverable upfront expenditures.
Cost
disadvantages
independent
of size
Existing competitors may have cost advantages not available to potential
rivals, regardless of their size and attainable economies of scale. These
advantages can be attributed to the effects of learning curves, proprietary
technology, access to reliable and better raw material sources, assets
purchased at pre-inflation prices, government subsidies or favourable
locations.
Access to
distribution
channels
New entrants must secure distribution of their products and services.
The more limited the distribution channels and current channels are
controlled by existing competitors, the higher this barrier of entry will be.
Government
policy
Government can limit entry to an industry with controls such as licence
requirements and limit access to raw materials.
Bargaining
power of
suppliers
Suppliers can exert bargaining power on an industry by raising prices or reducing the quality
of purchased goods and services. Powerful suppliers can squeeze profitability out of an
industry that is unable to recover cost increases from its own prices.
Bargaining
power of buyers
Customers can also force down prices, demand higher quality or more services, and play
competitors off against each other—all at the expense of industry profits.
Threat of
substitute
products or
services
Substitute products or services limit an industry’s potential by placing a ceiling on prices the
industry can charge. Substitute products that deserve the most attention strategically are
those that:
ŸŸ are subject to trends that improve their price-performance tradeoff with the industry’s
product
ŸŸ are produced by industries earning high profits
Rivalry among
existing
competitors
As an industry matures, its growth rate changes and results in declining profits. Rivalry
among existing competitors may force the players to use tactics like price competition,
product introduction, and advertising slugfests.
mm
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Economies of
scale
Company-specific risks
Company-specific risks can be defined as all the non-financial factors that can affect a
company’s financial performance and influence the specific strategy that its management
employs.
Business risk can be broken down into three aspects—company strength, product
and sales diversity and management.
–– Company strength
Market share is a key indicator of a company’s position in the industry. It is the
proportion of industry sales—measured in either units or revenue—the company
controls.
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–– Product and sales diversity
Stronger companies may have unique products or services that are desired by
customers. This serves as a competitive advantage as it creates a bargaining power
that translates into consistent sales demand. Table 6.20 discusses some indicators
that should be monitored to assess product and sales diversity.
Table 6.20 Indicators for monitoring product and sales diversity
Indicators for Monitoring Product and Sales Diversity
Consistency and
stability of growth
ŸŸ Consistency and stability of a company’s business is a key component of credit analysis.
ŸŸ Consistency and stability is measured in terms of:
mm Stability of revenue
mm Unit sales
mm Profitability
mm Cash flow
Operational
diversity
ŸŸ An organization’s breadth and scope can be an important ingredient that brings stability
to the business. Diversity helps smooth out the effects of business cycles. This means
that if there is a slowdown in one business line, this can be mitigated by relying on the
other aspects of the business.
ŸŸ Operational diversity could be several businesses, product lines, manufacturing plants,
distribution outlets or even types of customers.
Financial diversity
ŸŸ The concept of financial diversity is closely linked to operational diversity, which can
provide stability in financial performance by having multiple businesses delivering
varied portions of revenue and income. This gives management the flexibility to shift
resources among business units even during different business cycles.
Asset flexibility
ŸŸ Asset flexibility means having the flexibility to sell a company’s asset in times of need.
This is why the quality of a company’s assets should be evaluated.
Regulations
ŸŸ As discussed in an earlier section, regulations could have an important impact on the
financial performance of the industry in general and on the company in particular.
ŸŸ The objective of evaluating the regulatory environment is to understand its impact on a
company’s revenue and income, and its ability to compete.
–– Management
Corporate governance or the manner in which a company is managed is an
important factor in the analysis of credit risk. A company must be managed with
high integrity with regard to ethics, internal control and corporate culture.
Some indicators used by S&P to assess a company’s corporate governance are:
§§ Degree of aggressiveness in a company’s business model, growth and acquisition
strategy/patterns. Examples of signals that indicate high aggressiveness are
history of setting overly ambitious or optimistic growth; revenue growth
materially in excess of peer-group average; rapid growth through acquisitions
§§ Aggressiveness of expansion into new or unproven products, business lines,
industries and/or markets
§§ Major shifts in business/operating strategy
§§ History of restructurings, asset sales and layoffs
§§ Aggressiveness in shareholder value creation or equity price appreciation strategy
§§ Degree of aggressiveness or excessiveness of CEO and senior executive
compensation and benefits
§§ Overreliance on/excessive power of/domination by CEO or other senior executives
§§ High and/or unexpected senior management or board of director turnover/
departures
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Chapter 6 Identification of Credit Risk
§§ Aggressive corporate culture and practices
§§ Frequency of litigation and legal disputes against company
§§ History of government or regulatory actions
§§ Aggressiveness or complexity in corporate/operating/tax/ownership structure
§§ Aggressiveness/complexity in financial/leverage structure
§§ Financial stability
§§ Degree of reliance on derivatives and off-balance sheet structures for profitability
and/or capital management
§§ Aggressive strategy/history of revenue or income recognition and/or understating
costs or liabilities
§§ Aggressiveness, frequent changes and/or complexity in accounting practices and
reporting
ŸŸFinancial risk
Financial statements are usually the primary source in assessing an entity’s financial risk.
Financial statements are structured representation of an entity’s financial position and
financial performance.
A complete set of financial statements comprises a balance sheet, income statement,
cash flow statement, statement of changes in equity and notes to the financial statements.
Analyzing the financial statements may provide important information on the corporate
entity’s creditworthiness.
The borrower’s balance sheet can provide important indications on emerging credit
problems. Borrowers generate income and liquidity from their assets. It is, therefore,
important to understand the relationship of income and liquidity to the assets and how
they change over time. Capitalization and liquidity provide important insight on how
borrowers can withstand adverse economic events.
The borrower’s cash flow statement can provide indications on its credit condition.
Borrowers usually cut capital expenditures in order to generate cash to pay for debt
repayment. These reductions provide important insight on emerging credit conditions.
Table 6.21 describes some of the common ways to analyze financial risks using
financial statements.
Table 6.21 Using financial statements to analyze financial risks
Tools
Financial Risk Analysis
Common
sizing
analysis
Common sizing analysis involves assessing all items of the financial statements as a percentage of
total assets or revenues. It standardizes comparison of different entities or different time horizons.
An excerpt to an item in a common size financial statement is shown below:
Company 1
Company 2
Industry Level
75%
30%
25%
Long-term liabilities (percentage of total assets)
Company 1 clearly has significant long-term liabilities as a percentage of total assets particularly
when compared against Company 2 and the industry level. This could indicate a more leveraged
profile (three times the industry level) and may affect the bank’s appetite to continue to lend funds
to this company.
Long-term liabilities as a percentage
of total asset
Current Year
Previous Year
Previous Two Years
75%
23%
20%
Common sizing analysis can also uncover changes over a multiple-year period. It can be seen
that major increases in debt level was observed only this year. The credit risk analyst may want to
explore the causative event(s) or factor(s) for this significant change.
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Tools
Financial Risk Analysis
Trend
analysis
Trend analysis aims to show how financial statement items changed over time. It provides insights
into the company’s business performance across economic cycles.
Ratio
analysis
Ratio analysis involves the use of relative measures in the financial statements. It has the following
objectives:
ŸŸ Structural analysis—to clarify the relationship between items appearing on the financial
statements, i.e. balance sheet, income statement, cash flow statement, etc.
ŸŸ Time-series analysis—to match borrowers’ performance against historical levels
ŸŸ Cross-sectional analysis—to compare performance with benchmarks or industry averages
Ratio analysis involves the assessment of the following:
Focus of Analysis
Liquidity
Solvency
The ability of the corporate
entity to meet its short-term
obligations as they come due
The entity’s ability to meet its
obligations on a longer-term
basis
Common Ratios
Current Asset
Current Liabilities
Current Ratio =
Quick Ratio =
Current Assets – Inventories
Current Liabilities
Cash Ratio =
Cash and Cash Equivalents
Current Liabilities
Debt to Equity =
Equity Ratio =
Total Debt
Total Equity
Equity
Total Assets
Total Debt
Total Assets
EBITDA Leverage Ratio =
Debt Ratio =
Total Debt – Cash
Earnings before Interest, Taxes,
Depreciation and Amortization
Debt service
ability
The entity’s ability to meet its
interest payment obligations
using its earnings or cash
flows
Interest Cover Ratio =
Earnings before Interest and Tax
Interest Costs
Interest Costs
Sales
Interest to Sales Ratio =
Free Cash Flow Ratio =
Free Cash Flow – Capital Expenditure – Interest
Interest Cash Cover Ratio =
Cash Flow from Operating Activities
Interest Payments
Performance
ratios
Measure the performance of a
corporate entity
Sales Growth =
Current Sales – Previous
Sales
Previous Sales
Gross Profit Margin =
Gross Profit
Sales
Operating Profit Margin =
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Operating Profit
Sales
Net Profit Margin =
Net Profit
Sales
Return on Assets =
Net Profit
Average Total Assets
Return on Equity =
Net Profit
Equity
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In 1968, Professor Edward Altman conducted a study of publicly-listed, non-financial
companies to identify which accounting ratios are important in detecting financial
distress. The values are combined and weighted to produce a credit risk score that
discriminates between firms that will fail and those that will survive.
The five financial ratios that are determined to be most predictive of bankruptcy are:
Working capital to total assets ratio (X1)
mm Retained earnings to total assets ratio (X2)
mm Earnings befor e interest and taxes to total assets ratio (X3)
mm Market value of equity to book value of total liabilities ratio (X4)
mm Sales to total assets ratio (X5)
mm
From the financial ratios, a credit risk score—Altman Z-score—is calculated (see below). The
calculated Z-score is used as the basis for the approval or rejection of loan applications.
Original Z-score = (1.2 × 1) + (1.4 × 2) + (3.3 × 3) + (0.6 × 4) + (1.0 × 5)
6.2.4
Counterparty Credit Risk
The failure of Lehman Brothers at the height of the 2008 financial crisis highlighted
weaknesses in the way banks managed their counterparty risks. The results of a survey by the
Senior Supervisors Group showed that of the 20 major global financial institutions surveyed,
only nine had processes in place to actively manage their counterparty credit risk exposures in
line with industry best practices.
The Interagency Supervisory Guidance on Counterparty Credit Risk Management defines
counterparty credit risk as:
…the risk that a counterparty to a transaction could default or deteriorate in creditworthiness
before the final settlement of a transaction’s cash flows.
ŸŸCounterparty credit risk versus traditional lending exposure
In a traditional lending exposure, the lending bank is the established exposed
counterparty. The risk of loss only accrues to the lending bank.
Many derivative transactions, however, create a two-way credit or bilateral credit risk
exposure. This is because the market value of the transaction can either be positive or
negative to either counterparty.
Counterparty credit risk is influenced by two factors:
Exposure to the counterparty
mm Credit quality of the counterparty
mm
Both of these factors are sensitive to market changes.
ŸŸRight-way and wrong-way risk
The International Association of Swaps and Derivatives Association (ISDA) defines
wrong-way risk as the risk that occurs when exposure to a counterparty is adversely
correlated with the counterparty’s credit quality. It arises when both the counterparty
credit risk and derivative exposure increase together.
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Illustrative Example
Wrong-Way Risk
Company XYZ, a Malaysia-based company, entered into a forward transaction with Bank ABC
where it sells US$10,000,000 at an exchange rate of 3.4 (local currency value: MYR34,000,000).
If the MYR weakens against the US$ (i.e. US$ strengthens) to 3.5, Company XYZ is still required
to pay US$10,000,000 but will receive only MYR34,000,000 from Bank ABC. Had Company
XYZ not entered into this transaction, it would have been able to sell US$10,000,000 at a more
favourable rate of MYR35,000,000. This means that the hedge has a negative mark-to-market
value for Company XYZ and a positive mark-to-market value for Bank ABC.
Recall that Company XYZ is a Malaysia-based company. A weakening of the MYR (domestic
currency) may be an indication of a weakness in the domestic economy. This means that
Company XYZ’s creditworthiness may have deteriorated as well.
Bank ABC, therefore, is exposed to the correlation between the increase in exposure—positive
mark-to-market (MTM) value—and deteriorating creditworthiness of the counterparty.
Right-way risk, on the other hand, occurs when the exposure to the counterparty is
negatively correlated with the counterparty’s credit quality.
Illustrative Example
Right-Way Risk
Company DEF, a Malaysia-based company, entered into a forward transaction with Bank ABC
where it buys US$10,000,000 at an exchange rate of 3.4 (local currency value: MYR34,000,000).
If the MYR weakens against the US$ (i.e. US$ strengthens) to 3.5, Company DEF will receive
US$10,000,000 from Bank ABC but will pay only MYR34,000,000 to Bank ABC. The value of
US$10,000,000 in local currency terms is now MYR35,000,000. This means that Company DEF
has no incentive to default.
Bank ABC will have a positive MTM exposure to Company DEF in this transaction only if the MYR
strengthens against the US$.
If the MYR strengthens against the US$, this may indicate a generally positive development on
the local economy. This means that, holding other things constant, Company DEF, a Malaysiabased company, may be facing improving credit prospects.
In this transaction, Bank ABC’s exposure is negatively correlated to Company DEF’s credit
quality.
Given the complexity of counterparty credit risk exposures, banks should have a
comprehensive set of tools or metrics to understand and quantify counterparty credit
risk exposures. Table 6.22 discusses some exposure metrics that are widely used to
quantify counterparty credit risk.
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Chapter 6 Identification of Credit Risk
Table 6.22 Exposure metrics for quantifying counterparty credit risks
Exposure Metrics
Quantifying Counterparty Credit Risks
Current exposure or
replacement cost
Current exposure is the market value of a transaction or a portfolio of
transactions within a netting set with a counterparty that would be lost upon the
counterparty’s default, assuming no recovery on the value of those transactions
in bankruptcy. Current exposure allows banks to assess their counterparty’s
credit risk exposure at any given time.
Jump-to-default exposure
Jump-to-default exposure is the change in the value of the counterparty
transactions upon the default of a reference name in the credit default swap
positions. Jump-to-default exposure allows banks to assess the risk of a
sudden, unanticipated default before the market can adjust.
Expected exposure
Expected exposure is calculated as the average exposure to a counterparty
on a future date. Expected exposure is used as a measure of exposure at a
common time in the future.
Expected positive exposure
Expected positive exposure is the weighted average over time of expected
exposures where the weights are the proportion that an individual expected
exposure represents of the entire time interval.
Peak exposure
Peak exposure is a high percentile of the distribution of exposures—typically
95% or 99%—on any particular future date before the maturity date of the
longest transaction in the netting set. Peak exposure allows banks to estimate
their maximum potential exposures on a specified future date or over a given
time horizon with a high level of confidence.
6.3 OVERVIEW OF PORTFOLIO CREDIT RISK
LEARNING OBJECTIVE
6.3
DISCUSS credit risk in the portfolio context
6.3.1
Sources of Portfolio Credit Risks
The Basel Committee on Banking Supervision (BCBS) enumerates two important sources of
portfolio credit risk—systematic risk and idiosyncratic risk.
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Table 6.23 Systematic and idiosyncratic risks
Sources of Portfolio Credit Risks
Systematic risk
ŸŸ Represents the effect of unexpected changes in macroeconomic and financial market
conditions on the performance of borrowers.
ŸŸ Borrowers may differ in their degree of sensitivity to systematic risk. There are a few
firms (e.g. utility companies) that are completely indifferent to the wider economic
conditions in which they operate.
ŸŸ This is why the systematic component of portfolio risk is frequently referred to as
undiversifiable risks.
Idiosyncratic risk
ŸŸ Represents the effects of risks that are particular to individual borrowers.
ŸŸ As the portfolio increases in size and becomes more diversified, the largest individual
exposure accounts for a smaller share of the total portfolio exposure.
ŸŸ Idiosyncratic risk can be diversified away at the portfolio level.
Correlation of exposures in credit portfolios is an important aspect of portfolio credit risk.
Historical experience shows that concentration of risks in the loan asset portfolio has been one
of the major causes of bank failures.
Risk concentration is the single most important cause of major credit problems. Credit
concentrations are viewed as any exposures where the potential losses are large relative to a
bank’s capital, total assets or the bank’s overall risk level. Relatively large losses may reflect not
only large exposures, but also indicate the potential for an unusually high percentage losses
given default (LGD).
Credit risk concentrations can be grouped into two categories—conventional credit
concentrations and concentrations based on correlated risk factors.
Table 6.24 Types of credit risk concentrations
Categories of Risk Concentrations
Conventional credit
concentrations
ŸŸ Conventional credit concentrations would include concentrations of credits to:
Single borrowers or counterparties
Group of connected counterparties
mm Sectors or industries
mm
mm
Concentrations based on
common or correlated
risk factors
ŸŸ Concentrations based on common or correlated risk factors reflect subtler or
more situation-specific factors, and often can be uncovered through analysis.
ŸŸ The 1997 Asian financial crisis, the 1998 Russian default and the 2008 global
financial crisis illustrate how close linkages among emerging markets under
stress conditions and previously undetected correlations between market,
credit and liquidity risks can produce widespread losses.
The Basel Committee on Banking Supervision has identified the common reasons as to
the occurrence of credit concentration risks. In the competitive banking environment, banks
face a trade-off between focusing on key areas or diversifying their credit loan portfolio. Banks
that aim to gain market leadership frequently choose to specialize in key areas or prioritize
relationship over key counterparties. This sometimes leads banks to build up large exposures
to certain markets or certain counterparties.
At times, banks would identify ‘hot’ and rapidly-growing sectors or industries and use
overly optimistic assumptions about a sector or industry’s growth prospects. This has been the
common theme for some of the worst banking crises in history—from the emerging markets
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Chapter 6 Identification of Credit Risk
debacle in the 1980s and 1990s to the dotcom bubble in the early 2000s and the 2008 global
financial crisis.
The search for asset growth and market share sometimes results in banks loosening their
credit underwriting standards and taking on heightened concentration risk to certain single
counterparties, industries or markets.
Real World Illustration
Bank Negara Malaysia Guidelines on Risk Concentration
In February 2013, Bank Negara Malaysia issued the BNM/RH/GL 001-38 on Single Counterparty
Exposure Limit (SCEL) guideline. SCEL serves as a non-risk adjusted back-stop measure to
ensure that exposures to a single counterparty or a group of connected counterparties are within
prudent limits at all times.
The policy sets out:
ŸŸ BNM’s expectations of banking institutions in managing and monitoring exposures to a single
counterparty—role of the board of directors and senior management with respect to SCEL.
ŸŸ The prudential limit for exposures to a single counterparty—total exposure to a single
counterparty should not exceed 25% of the banking institution’s capital, treatment of guarantee
or credit derivatives protection.
ŸŸ Parameters for identifying connected counterparties that constitute a single counterparty—
definition of connected counterparties, power of control and economic dependence.
ŸŸ Scope and treatment of exposures applicable to a single counterparty—definition of exposures,
methods of measuring on- and off-balance sheet exposures, facilities and derivatives, and
collateralization.
ŸŸ Expectations with respect to on-going compliance with SCEL—SCEL should be observed at
all times, breach reporting.
General Principles for Concentration Risk Management
In September 2010, the European Banking Authority (EBA) released its Guidelines on the
Management of Concentration Risk under the Supervisory Review Process. The guidelines provide
high-level principles for concentration risk management from multiple perspectives—credit,
market and liquidity. This section focuses on the credit risk aspect of concentration risk.
The general risk management framework of a banking institution should clearly address
concentration risk and its management.
ŸŸBanks should address concentration risk in their governance and risk management
frameworks, assign clear responsibilities, and develop policies and procedures for the
identification, measurement, monitoring and reporting of concentration risk.
ŸŸManagement should understand and review how concentration risk derives from the
bank’s overall business model.
ŸŸBanks should have a definition on what constitutes a material concentration in line with
their risk tolerance.
ŸŸAny exceptions from the policies and procedures should be properly documented and
reported to the appropriate management level.
ŸŸBanks should have an integrated approach for looking at all aspects of concentration
risk within and across risk categories.
ŸŸConcentration risk can be analyzed in two main dimensions—intra- and inter-risk
concentrations.
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Table 6.25 Intra-risk and inter-risk concentrations
Dimensions of Concentration Risk
Intra-risk concentration
ŸŸ Refers to risk concentrations that may arise from interactions between different
risk exposures within a single risk category.
ŸŸ Intra-risk may be assessed in two ways:
mm
mm
Inter-risk concentration
as a separate risk category
fully embedded in the risk management framework
ŸŸ Refers to risk concentrations that may arise from interactions between risk
exposures across different risk categories.
ŸŸ These interactions between different risk exposures may stem from a common
underlying risk driver or from interacting risk drivers.
ŸŸ Inter-risk concentrations may not be fully considered when risks are identified
and measured on a silo basis. Banks should have a framework for identifying
inter-risk concentrations.
Banks should have a framework for the identification of intra- and inter-risk concentrations.
ŸŸThe risk concentration identification framework should be comprehensive enough to
consider all risk concentrations—which are significant to the institution—are covered
including on- and off-balance sheet risks, committed and uncommitted exposures,
across risk types, business lines and entities.
ŸŸBanks should consider economic developments that influence financial markets and
their actors and vice versa. An important element to consider is system-wide interactions
and feedback effects.
ŸŸBanks should constantly monitor the evolving interplay between the markets and the
economy to facilitate the identification and understanding of potential concentration
risks and the underlying drivers of these risks.
ŸŸStress testing in the form of both sensitivity analysis and scenario stress testing is a key
tool in the identification of concentration risk.
ŸŸBanks should have a framework for the measurement of intra- and inter-risk
concentrations.
ŸŸThe measurement framework should enable the bank to evaluate and quantify the
impact of risk concentrations on earnings/profitability, solvency, liquidity position and
compliance with regulatory requirements.
ŸŸMultiple methods or measures may be required to provide an adequate view of the
different dimensions of the risk exposure.
Banks should have adequate arrangements in place for actively controlling, monitoring and
mitigating concentration risk.
ŸŸActive management of risk concentration exposures is required to mitigate the potential
emergence of undesired concentrated exposures within portfolios.
ŸŸConstant assessment and adjustment of business and strategic goals are required.
ŸŸBanks should set top-down and group-wide concentration limit structures for exposures
to counterparties or groups of related counterparties, sectors or industries, specific
products or markets.
ŸŸThe limit structures and levels should reflect the bank’s risk tolerance and consider all
relevant interdependencies within and between risk factors.
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Chapter 6 Identification of Credit Risk
ŸŸBanks should carry out regular analyses of their portfolios and exposures. The analyses
could be on the following elements:
mm Risk environment in each particular sector
mm Economic performance of existing borrowers
mm Approval levels for businesses
mm Risk mitigation techniques—value and legal enforceability
mm Outsourced activities and contracts signed with third parties
mm Funding strategy
mm Business strategy
Banks should also assess whether the amount of capital is adequate, given the level of
concentration risk in the portfolios.
6.3.2
Credit Concentration Risk Management
Banks should have a definition of what constitutes a credit concentration. The definition
should encompass the sub-types of credit concentration such as:
ŸŸCounterparties
ŸŸGroups of connected counterparties
ŸŸCounterparties in the same economic sector
ŸŸCounterparties in the same geographical region
ŸŸCounterparties from the same activity or commodity
ŸŸExposures under the same credit risk mitigation technique
Banks should be able to aggregate and consolidate credit risk exposures and manage credit
limits in a robust manner. The models and indicators used to measure credit concentration
risk should adequately capture the nature of interdependencies between exposures.
Survey of industry practices
The Research Task Force Concentration Risk Group of the Basel Committee on Banking
Supervision conducted an informal survey of a small number of best practice institutions. The
results of the survey—published as a working paper in 2006—are briefly enumerated below:
ŸŸBanks have different measures in place to capture and manage concentration risk,
including:
mm Exposure limit systems—Depend on the bank’s strategic goals
mm Internal economic capital models—Measure risk contribution of exposures for risk
management purposes
mm Pricing tools—Allow banks to account for concentration risk in the pricing of a new
exposure
ŸŸThe more sophisticated banks employ internal economic capital models that can
adequately measure concentration risk. However, these are often constrained by data
problems.
ŸŸThe less sophisticated institutions employ simpler concentration measures such as the
Herfindahl-Hirschman Index, which does not allow the translation of concentration risk
into an economic capital figure.
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Real World Illustration
Herfindahl-Hirschman Index
The Herfindahl-Hirschman Index (HHI) is a widely-used measure of industry concentration. It
is often used as a measure to assess the extent to which an industry’s output is concentrated
among a few firms.
The HHI is calculated by squaring the market share of each firm competing in the market and
then summing the resulting numbers. The higher the HHI, the more concentrated the industry is.
ŸŸ HHI between 1,500 to 2,500: Moderately concentrated
ŸŸ HHI > 2,500: Highly concentrated
ŸŸLimit systems often do not capture concentration risk from distinct but correlated
exposures.
ŸŸLimits are often applied to single obligors or to specific geographical regions and less on
exposures to business sectors.
ŸŸLimits are decided on a variety of business considerations and strategic objectives of
which controlling concentration risk is only one aspect.
ŸŸBanks use a mix of vendor models and in-house built models to capture concentration
risk in their economic capital calculations.
ŸŸMulti-factor asset value models and sensitivity to industry and/or geographical factors
are measured through asset correlations. Correlations are estimated using either equity
correlations or correlation estimates derived from rating migrations or default events.
ŸŸCredit risk mitigation techniques are considered if economic capital models are used.
ŸŸConcentration risk is managed on a centralized basis through monitoring of exposures.
ŸŸBanks reported using different methods of stress testing for concentration risk. Test
scenarios include :
mm downgrade of all large exposures or of a large sector
mm increase of exposures to a cluster of borrowers
mm increase of the probability of default and/or the loss given default for a group of exposures
ŸŸConcentration risk stress tests are conducted on an ad hoc rather than on a regular basis.
ŸŸMeasuring concentration risk is a challenge due to lack of data. This is particularly true
for emerging markets where the markets are less liquid.
While credit concentration risk usually exists in the bank’s wholesale business activities,
there are also credit concentration risks in the retail side. For example, retail lending to certain
geographic regions or to a certain demographic characteristics—age, gender or religion—could
be an important source of credit concentration risk for banks.
CONCLUSION
This chapter provided important tools and the framework to help risk management students
identify the different credit risk exposures that a typical banking organization faces. Credit
risk is the most important risk for many banks. This risk arises in many aspects of the banking
business. While credit risk from loans and advances continue to be the single largest source of
credit risk for banks, it also exists in the bank’s investments portfolio and from other business
activities which generate off-balance sheet exposures.
Credit risk can be analyzed on two different levels—standalone or transactional level and the
portfolio level. Standalone credit risks can be further subdivided into retail credit risk, sovereign
credit risk, corporate credit risk and counterparty credit risk. Portfolio credit risks, on the other
hand, can be analyzed in two dimensions, namely systematic and idiosyncratic risks.
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C
7
P
HA
TE
R
OPERATIONAL
RISK
This chapter introduces risk management students to the topic on operational risk.
Operational risk has received far less attention compared to market risk and credit risk.
This is because compared to other types of risks, operational risk has been seen as a ‘soft’
risk—particularly, when compared with the other more quantitative ‘hard’ risks such
as market and credit risks. This is unfortunate given that one of the leading causes of
banking failures can be attributed to operational risk failures.
This chapter begins with a definition of operational risk. It then discusses the different
types of operational risk events. After which, the impact of operational risks is discussed.
The chapter ends with a discussion on operational risk governance and the operational
risk management process.
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Risk Management in Banking: Principles and Framework
Operational Risk
Definition of Operational
Risk
Operational Risk Events
Residual Definition
Internal Fraud
Causal Definition
External Fraud
Operational Risk Impact
Operational Risk
Governance and Process
Employment Practices
and Workplace Safety
Clients, Products and
Business Practices
Damage to
Physical Assets
Business Disruption and
Systems Failures
Execution, Delivery and
Process Management
Figure 7.1 Diagrammatic outline of this chapter’s topics
LEARNING OUTCOME
At the end of this chapter, your are expected to be able to:
DISCUSS basic principles of operational risk in the banking context
LEARNING OBJECTIVES
At the end of this chapter, you will be able to:
DEFINE operational risk
ENUMERATE the different types of operational risk events
DISCUSS the different types of operational risk consequences
DISCUSS the different elements of sound operational risk management practices
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Chapter 7 Operational Risk
7.1 DEFINITION OF OPERATIONAL RISK
LEARNING OBJECTIVE
7.1
DEFINE operational risk
Operational risk was recently recognized as a major banking risk when the Basel Committee
on Banking Supervision issued the Basel II framework. For the first time, operational risk was
accorded the same level of importance as credit risk and market risk. There were, indeed, many
banking failures which were attributed directly or indirectly to operational risks.
Prior to Basel II, there had been no universal consensus on the definition of operational
risk. Different banking organizations had different definitions of operational risk. The lack
of consensus on the definition made it difficult to come up with a standard approach to
identifying, assessing and measuring operational risk.
7.1.1
Operational Risk—the Residual Definition
Operational risk was originally defined as the ‘risk of everything other than market and credit
risks’. Prior to Basel II, market risk and credit risk were the only recognized risks for regulatory
capital-setting purposes. Operational risk was defined in a residual manner. The ‘residual’
definition did not recognize operational risk as a standalone risk. Rather, it was viewed as the
remaining risk after considering market and credit risks.
One of the major limitations of the residual definition of operational risk is that it does not
actually define what operational risk is. Rather, all failures or losses not considered as market
or credit risks are routinely attributed to operational risk. This is a problematic approach as it
does not create an incentive for banks to identify and assess operational risk as a standalone
risk.
It is also not accurate to attribute all the risks other than market or credit risks to operational
risk. While there are risks that are not market or credit risks, they are also not operational risk
in nature. An example is liquidity risk. This risk is neither a credit nor a market risk. It is also
not an operational risk either. This is why it is not accurate to attribute an event or failure that
is neither a market nor credit risk to operational risk.
7.1.2
Operational Risk—the Causal Definition
The definition of operational risk has evolved from the traditional ‘residual’ view to a more
precise definition on what it is. Basel II defines operational risk as:
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.
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This definition is a major improvement from the earlier ‘residual’ definition. Operational
risk is now recognized as a distinct risk and assigned equal importance as market and credit
risks. Towards this end, ‘total risk’ embraces multiple risk elements comprising:
ŸŸMarket risk
ŸŸCredit risk
ŸŸOperational risk
Basel II adopts a causal approach to defining operational risk. The definition is based on
what causes an operational risk event. Figure 7.2 shows the origination of operational risk
while Table 7.1 discusses the causes of operational risks in greater detail.
People
People risk is the risk that arises when people do not follow
the organization’s procedures, practices and/or rules.
Process
Process risk is the risk from faulty overall design and
application of business processes.
Systems
Systems risk is the risk of failure arising from deficiencies
in the bank’s infrastructure and information technology
systems.
External events
External events risk is the risk associated with events
outside the banking organization’s control.
Sources of
operational risks
Figure 7.2 Causes of operational risks
Table 7.1 Causes of operational risks—definitions and examples
Definition
Examples
People
People risk is the risk that people do not follow the
organization’s procedures, practices and/or rules. It is
the risk that people deviate from expected behaviours.
ŸŸ Operational losses due to
human errors
ŸŸ Employee fraud
Process
Process risk is the risk from faulty overall design and
application of business processes.
ŸŸ Inadequate segregation of duties
ŸŸ Absence of internal controls
ŸŸ Erroneous legal documentation
Systems
Systems risk is the risk of failure arising from
deficiencies in the bank’s infrastructure and
information technology systems
ŸŸ IT system breakdown resulting
in losses for the bank
ŸŸ Power outage
External
events
External events risk is the risk associated with events
outside the bank’s control.
ŸŸ Natural calamities
ŸŸ Wars
ŸŸ Terrorist attacks
People risk
People risk is the risk that people do not follow the organization’s procedures, practices and/
or rules. It is the risk that people deviate from expected behaviours. People risk is considered as
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the ‘softer’ aspect of operational risk, particularly when compared to other types of operational
risks. This is because people risk is harder to quantify than the other types of operational risks.
There are two different types of people risks:
ŸŸNon-deliberate deviations are deviations from expected behaviours or set of rules that
are not intended by the bank’s personnel. An example is human error.
ŸŸDeliberate deviations are deviations from expected behaviours or set of rules intended
to result in a personal or financial gain by the bank’s personnel. Fraud is a common
example.
People risk is an area of operational risk management that has received relatively little
attention compared to the more quantitatively measurable operational risk areas. People
risk has mostly been restricted to human resource (HR) processes. This is unfortunate
because people risk is an important source of risk for all organizations including financial
institutions. In a 2012 survey conducted at the OpRisk Europe Conference in London, more
than 60% of the respondents believed that people risk posed the biggest operational risk to
their businesses.
People risk is closely related to the bank’s risk culture. Unlike failures in other aspects of
operational risk, failure from people risk may be an indication of a more pervasive failure in
the organization’s corporate culture.
Process risk
Process risk is the risk arising from a faulty overall design and application of business processes.
Some examples of operational risks in the business processes are:
ŸŸMissing/Incorrect process descriptions
ŸŸBottlenecks and redundancies
ŸŸProject risk
Real World Illustration
Mortgage Lenders Still Falling Short of Settlement’s Terms
Shaila Dewan of the New York Times reported that many banks have failed to comply with a requirement
to inform borrowers of any documents that are missing from their applications. In an agreement with the
US regulators, banks are required to notify borrowers of missing documents within five days and give
30 days for borrowers to provide the missing documentation. The bank should make a decision within
30 days after an application is completed. Many banks failed to comply with the servicing
standards. The attorney general of Illinois noted that 60% of loan services failed to comply with
the missing documents notification requirement.
Source: Shaila Dewan, The New York Times, 19 June 2013
Process risk can be further classified into model risk, transaction risk and operational
control risk.
ŸŸModel risk
The Federal Reserve defines model risk as the risk of incurring adverse consequences,
including financial losses, as a result of making decisions based on models that are
incorrect or misused. The model can be a quantitative method, system or approach
that applies statistical, economic, financial or mathematical theories, techniques and
assumptions to process input data into quantitative estimates.
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Model risk occurs for two primary reasons:
The model may have fundamental errors and produces inaccurate output when
viewed against its design objectives and intended business uses.
mm The model may be used incorrectly or inappropriately due to misunderstanding about
its limitations and assumptions.
mm
ŸŸTransaction risk
Transaction risks are risks that occur due to failure on execution of transactions.
Examples are:
Execution error
mm Booking error
mm Settlement error
mm
ŸŸOperational control risk
Operational control risk is the risk that occurs due to failure of established controls to
work as intended.
Real World Illustration
Spreadsheet Errors and the J.P. Morgan’s ‘London Whale’
A J.P. Morgan Task Force found that the bank’s value at risk (VaR) was being calculated with an
Excel spreadsheet that ‘required time-consuming manual inputs to entries and formulas, which
increased the potential for errors’. At another point, the report found ‘the model operated through
a series of Excel spreadsheets, which had to be completed manually, by a process of copying
and pasting data from one spreadsheet to another’.
The news about Excel has bounced around blogs, like James Kwak’s Baseline Scenario, and
drawn comments from people who are as ‘Shocked, Shocked’ as Captain Renault in Casablanca
to find that manual Excel processes are playing a fundamental role in large and complex financial
operations.
Source: Forbes, 19 February 2013
Systems risk
Systems risk is the risk of failure arising from deficiencies in a bank’s infrastructure and
information technology systems. Infrastructure typically becomes a risk if it is either missing
or deficient. Examples are:
ŸŸOutdated measures or facilities
ŸŸInsufficient maintenance and repairs
ŸŸUnclear responsibilities that lead to mistakes in infrastructure procurement, management
and/or maintenance
ŸŸLack of practical tests
Risks associated with information technology systems are identified with deficiencies
or inadequacy in software quality, IT security, interruption of day-to-day operations and
outsourcing.
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Real World Illustration
Technology Breakdown at Knight Capital
The Trefis Team of Forbes published an article (3 August 2012) that revealed how the world’s
largest equities trader could be taken down to the hilt. Knight Capital suffered a staggering
$440 million worth of pre-tax loss after its new software went online on 1 August 2012. According
to the Trefis report, a small bug in the firm’s new software caused errors in the trading transactions
within a few minutes after the new software was launched. By the time the software was pulled
out of the system, it had already created billions of dollars’ worth of trades that left Knight Capital
with no other option but to close out those deals. The Knight Capital technology breakdown
resulted in an immediate plunge of the price of its shares from $10.30 at the beginning of
2 August to $2.50 upon closing the next day. The Trefis Team also reported that Knight Capital
had found a line of credit.
Source: Trefis Team, Forbes, 3 August 2012
External events risk
External events risk is the risk associated with events outside the bank’s control. Examples of
these events are:
ŸŸNatural disasters
ŸŸExternal crimes
ŸŸTerrorism
ŸŸWars
ŸŸPolitical risks
While these events are outside the entity’s internal processes and organization’s control,
external events risk can be mitigated by the bank’s operational risk process and infrastructure,
i.e. people, process and systems.
Real World Illustration
External Events Risk
The World Economic Forum (WEF) surveyed multi-stakeholder communities to explore the
nature of global risks that the world was facing in 2014. Its Global Risks 2014 report highlights
how global risks are not only interconnected but also have systemic impacts. The top 10 global
risks of highest concern are:
ŸŸ
ŸŸ
ŸŸ
ŸŸ
ŸŸ
ŸŸ
ŸŸ
ŸŸ
ŸŸ
ŸŸ
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Fiscal crises in key economies
Structurally high unemployment/underemployment
Water crises
Severe income disparities
Failure of climate change mitigation and adaptation
Greater incidences of extreme weather events
Global governance failures
Food crises
Failure of a major financial mechanism/institution
Profound political and social instability
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Legal risk
Legal risk can be caused by both internal and external risks. Legal risk is defined as the
possibility that lawsuits, adverse judgements or contracts that turn out to be unenforceable
can disrupt or adversely affect the bank’s operations or condition. Legal risk may arise from:
ŸŸPeople, e.g. violation of labour law
ŸŸProcess, e.g. violation of anti-money laundering law
ŸŸSystems, e.g. violation of contractual provisions
ŸŸExternal events, e.g. risks relating to changes in regulation
7.2 OPERATIONAL RISK EVENTS
LEARNING OBJECTIVE
7.2
ENUMERATE the different types of operational risk events
The Basel Committee recognizes that operational risk is a term that has a variety of meanings
within the banking industry, and therefore for internal purposes, banks may choose to adopt
their own definition of operational risk. Whatever the definition, banks should have a clear
understanding of what is meant by operational risk and that it is critical to the effective
management and control of this risk. The definition should consider the full range of material
operational risks the bank faces and capture the most significant causes of severe operational
losses.
The Basel Committee, in cooperation with the banking industry, has identified seven
operational risk event types that have the potential to result in substantial losses. These event
types are:
ŸŸInternal fraud
ŸŸExternal fraud
ŸŸEmployment practices and workplace safety
ŸŸClients, products and business practices
ŸŸDamage to physical assets
ŸŸBusiness disruption and systems failures
ŸŸExecution, delivery and process management
7.2.1
Internal Fraud
Internal fraud is an operational risk event that arises due to acts of a type intended to defraud,
misappropriate property or circumvent regulations, the law or company policy, excluding
diversity/discrimination events, which involves at least one internal party. The definition of
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internal fraud excludes violation of law or company policies related to discrimination and/or
diversity policies as these are covered in a separate operational risk event.
The two key distinguishing features of an internal fraud event are:
ŸŸThe involvement of one internal party (e.g. an employee) which made the occurrence of
the operational risk event possible.
ŸŸThe presence of intent to commit fraud, misappropriate assets or circumvent laws,
regulations and company policies.
Internal fraud can be further categorized into two types—unauthorized activity and theft or fraud.
Unauthorized activity
Unauthorized activities refer to acts by at least one internal party to violate laws, regulations
and company policies or to act beyond what is mandated or allowed by company policies.
Rogue trading is a type of unauthorized activity. Rogue trading occurs when a bank
employee engages in authorized trades on behalf of its employer.
Rogue trading has gained a lot of publicity in the recent years as many traders—individuals
or a group of individuals—single-handedly caused huge losses to their respective banking
organizations by engaging in risky trades in the hope of recouping trading losses or reporting
huge gains.
While the usual motivation for rogue trading is economic gain through compensation
arrangements, it is not the only motivation for rogue trading. Many traders engage in rogue
trading to hide or to correct an error. Regardless of the motivation, the main element that
defines rogue trading is the willful intent to engage in unauthorized trading.
Theft or fraud
Theft or fraud refers to an act involving at least one internal party to misappropriate or defraud
the bank. The following are examples of operational risk events that are classified as theft or
fraud:
ŸŸTheft—extortion, embezzlement, robbery, misappropriation of assets
ŸŸFraud—forgery, cheque kiting, credit card fraud, electronic fraud, willful tax evasion,
bribes/kickbacks, insider trading (not on firm’s account), account take-over/
impersonation
Real World Illustration
Internal Fraud Example: Ex-Merrill Trader is Banned for Mismarking Positions
The Financial Services Authority (FSA) has banned a former senior trader at Bank of America’s
Merrill Lynch unit in London for at least five years after he mismarked positions by $100 million
between January and March 2009 to hide losses. The senior trader admitted to the mistake and
blamed stressful working environment as one of the reasons for his action. Merrill Lynch was also
fined €2.75 million over the incident for failing to exercise adequate supervision over the actions
of its traders.
Source: Caroline Binham, Bloomberg, 16 March 2010
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7.2.2
External Fraud
External fraud is an operational risk event that arises due to acts of a type intended to defraud,
misappropriate property or circumvent the law, which involves a third party. In contrast to
internal fraud, this type of operational risk event does not involve an internal factor. These
operational risk events are caused by acts of external parties. External fraud arises from two
types of operational risk events:
(a) Theft and fraud
Theft and external fraud arises from willful misappropriation of assets or willful intent due to
the acts of external parties.
The most popular examples of theft is bank robberies, which has been romanticized in
many films and books. However, the prevalence of bank robberies has declined in many
advanced economies. This can be attributed to the increasing importance of electronic
banking transactions and banks’ investment in sophisticated security systems, which make
bank robberies less likely.
(b) Systems security
With more banking transactions being done electronically, banks are now more susceptible to
cyber-attacks. In a global survey conducted by PwC, cybercrime is the second most common
form of economic crime for financial services firms. Almost half of the respondents cited
that they had been victims of economic crimes. Financial services organizations believe that
cybercrime is becoming an increasing threat.
Real World Illustration
Distributed Denial of Service (DDOS)
In an article published in Bloomberg on 6 May 2013, Jordan Robertson recounted how hackers
would use less dangerous attacks on banks’ websites as smokescreens for potentially more
damaging attacks, such as stealing account information and creating fake debit cards. Information
security company Symantec Corp. noted that these two-pronged attacks were more common.
The distributed denial-of-service (DDOS) entails hackers flooding a computer system with data to
shut it down. Such attacks have not only damaged the websites of banks but have also, at times,
resulted in compromising client accounts.
Source: Jordan Robertson, Bloomberg, 6 May 2013
7.2.3
Employment Practices and Workplace Safety
Employment practices and workplace safety are operational risk losses arising from human
resource-related operational risk losses. These losses arise from acts inconsistent with
employment, health or safety laws or agreements, from payment of personal injury claims,
or from diversity/discrimination events. These types of losses arise from the following events:
(a) Employee relations
These are operational risk losses arising from policies and practices related to the management
of the banking organization’s employees. Examples of operational risk losses arising from
employee relations are compensation and benefit disputes, termination issues and organized
labour activities.
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Chapter 7 Operational Risk
(b) Safe environment
These are operational risk losses arising from injury, illness or other losses incurred by
employees in the workplace environment at the bank. An example of operational risks event
due to the work environment are the general liabilities that a bank may incur due to violation
of employee health and occupational safety regulations in the workplace.
(c) Diversity and discrimination
These are operational risk losses arising from violations or deviations from equal employment
opportunity regardless of age, sex, race, disability or national origin. Examples of operational
risk events due to diversity and discrimination are gender discrimination lawsuits filed by
bank employees.
Real World Illustration
Employment Practices and Workplace Safety: Wells Fargo Settles Discrimination Suit
In an article by Adam O’ Daniel published in the Charlotte Business Journal on 25 February 2011,
San Francisco-based Wells Fargo & Co. had to put aside a $32 million fund in order to settle a
class-action lawsuit, including legal feels, filed against its brokerage and wealth-management
arm Charlotte-based Wachovia Securities, now known as Wells Fargo Advisors. Furthermore, the
author said that the settlement was made after the firm was found liable for discriminating against
female financial advisers in terms of employee benefits such as promotions, compensation,
account assignments and training opportunities among others. On top of the settlement, the
firm had to implement changes in its policies relating to promotions and distribution of work to its
financial advisers. The firm had to pay damages to female financial advisers who worked at Wells
Fargo Advisors at any time between 17 March 2003 and 25 January 2011 or those who worked at
Wells Fargo Investments at any time between 31 December 2008 and 25 January 2011.
Source: Adam O’ Daniel, Charlotte Business Journal, 25 February 2011
7.2.4
Clients, Products and Business Practices
These are losses arising from unintentional or negligent failure to meet a professional
obligation to specific clients (including fiduciary and suitability requirements), or from the
nature or design of a product.
The business of banking is a business of trust. The bank has a duty of care to its clients. Failure
to fulfil this obligation will expose the bank to operational risk losses arising from either lawsuits
or lost business. This operational loss event risk can be categorized into two different types:
ŸŸFailure to perform the professional obligation to specific clients, e.g. suitability, disclosure
and fiduciary
ŸŸDefects in the nature or design of the product
Suitability, disclosure and fiduciary
Banking organizations have duties to their clients. Depending on the circumstances, the level
of duty or care will vary from one client to another.
ŸŸSuitability refers to the obligation that the bank needs to exercise due diligence to ensure
that the banking product offered is appropriate to its client’s risk appetite and capacity.
Failure to exercise due diligence on the product’s suitability will expose the bank to
liability due to mis-selling.
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ŸŸDisclosure refers to the bank’s obligation to be transparent on the material information
that the clients need to be aware of before deciding on a particular banking product.
ŸŸFiduciary refers to the legal relationship of trust between the bank and its clients. Fiduciary
requires a higher standard of prudent care.
Examples of operational risk events arising from failures in suitability, disclosure and
fiduciary are fiduciary breaches or guideline violations, suitability or disclosure violations,
aggressive sales, account churning, misuse of confidential information and lender liability.
Real World Illustration
Suitability, Disclosure and Fiduciary: RBS Reached Agreement on Lehman Brothers EquityLinked Notes
In July 2013, the Securities and Futures Commission (SFC) and the Hong Kong Monetary
Authority (HKMA) announced that a settlement has been reached between the regulators and
the Royal Bank of Scotland (RBS) for the sale of Lehman Brothers’ equity-linked structured notes
to retail clients for the period of July 2007 to May 2008. RBS had agreed to repurchase the notes
at 100% of the principal value. Eligible retail clients are those assessed with a risk tolerance
level that are more conservative than the risk rating that was assigned to the product sold. SFC
estimated that about 540 customers were eligible.
Source: Securities and Futures Commission, 18 July 2013
In the recent years, much focus has been made on combatting money laundering activities.
The Financial Action Task Force (FATF) defines money laundering as the processing of criminal
proceeds to disguise their illegal origin. This process enables the criminal to enjoy the profits
without jeopardizing their source.
Money laundering is usually effected through different stages and in each of these stages,
the criminal sometimes uses a bank to hide the origin or source of the illegal funds. Table 7.2
gives a brief outline of how criminals launder their illegal funds.
Table 7.2 Three-stage money-laundering process
Stage
Stage 1
Placement Stage
Stage 2
Layering Stage
Stage 3
Integration Stage
Description
ŸŸ Illegal profits introduced
to the financial system
(including banks) through
various means such
as breaking up large
amounts of cash into
smaller amounts or
purchasing a series of
monetary instruments.
ŸŸ Once illegal profits have
been introduced, these
funds are then converted
or moved to distance
them from their source.
ŸŸ This is effected by either
purchasing and selling of
financial instruments or
disguising the transfers
as payments for goods or
services.
ŸŸ These funds now re-enter
the formal, legitimate
economy and it is now
difficult to determine their
actual source.
Defects in the nature or design of a product
These operational risk losses arise from flaws in a product or in the bank’s business practices.
Table 7.3 describes some examples of defects in the nature or design of a product; the list is
not in any way, exhaustive.
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Table 7.3 Operational risk losses arising from defects in the nature or design of a product
Definition
Examples
Improper business or
market practices
ŸŸ These are operational risk losses arising
from flaws in the bank’s business practices or
market practices.
ŸŸ Business practices are the processes
employed by the bank to achieve its business
objectives.
ŸŸ Market practices, on the other hand, are
practices that are generally accepted by a
specific market.
ŸŸ Antitrust
ŸŸ Improper trade/market
practices
ŸŸ Market manipulation
ŸŸ Insider trading on the firm’s
account
ŸŸ Unlicensed activities
ŸŸ Money laundering
Product flaws
ŸŸ These are operational risk losses arising from
flaws in the design of a banking product.
ŸŸ Product defects, e.g.
products with legal defects
Selection, sponsorship
and exposure
ŸŸ These are operational risk losses arising
from flaws in the client selection process
and in managing overall client exposure in
accordance with the bank’s policies and
guidelines.
ŸŸ Know Your Customer (KYC)
flaws
ŸŸ Anti-money laundering
violations
ŸŸ Failure to investigate client
per guidelines
ŸŸ Exceeding client exposure
limits
Advisory activities
ŸŸ These are operational risk losses arising from
the bank’s advisory activities.
ŸŸ In advisory activities, banks are required to
perform a higher standard of prudent care as
the clients may rely on the bank’s advice.
ŸŸ Negligence in advisory role
performance
Real World Illustration
Improper Business or Market Practices: JPMorgan May Settle California Energy Market
Manipulation Case
According to an article published by the Financial Action Task Force in October 2009, Stephanie
McCorkle, spokeswoman for the California Independent System Operator (Cal-ISO), said
that JPMorgan may have to face charges filed by the Federal Energy Regulatory Commission
for manipulating the power market and accumulating an apparent unjust profit of more than
$100 million. The allegations stemmed from Cal-ISO’s suspicion in 2011 that JPMorgan was
involved in placing deceptive bids to gain profits from energy trading and inflated payments.
Furthermore, according to an unnamed source familiar with the matter, JPMorgan might end up
paying approximately $500 million including civil penalties. The fund would go first to the utilities and
then to the California utility customers through a California Public Utilities Commission proceeding.
Source: Financial Action Task Force, October 2009
7.2.5
Damage to Physical Assets
These are losses arising from loss or damage to physical assets due to natural disasters or other
events. Examples are natural disaster losses, human losses from external sources, e.g. terrorism
and vandalism.
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Real World Illustration
Damage to Physical Assets: Lessons Learned from Hurricane Katrina
In a Los Angeles Times report published on 18 July 2013, journalists Andrew Tangel and Marc
Lifsher wrote that Hurricane Katrina rendered financial institutions more vulnerable to physical
assets damages that they could ever imagine. In a joint effort to solicit lessons learned from
the effects of Hurricane Katrina, the Federal Financial Institutions Examination Council (FFIEC)
member agencies and the Conference of State Bank Supervisors came up with a summary of the
challenges that financial institutions had to contend with. Foremost among these challenges were
the outage of communication and utilities, inaccessibility to areas devastated by the hurricane
and facilities that sustained severe damages or had been completely wiped out. Some of these
facilities included ATMs which remained under water for several weeks as well as mail operations
that had been interrupted for months in some areas.
The journalists said that despite the major challenges encountered by the financial institutions,
they held a high regard for their extra efforts and improvisations in order to stay operable during
those difficult times. This meant that the business continuity plans that were put into place by the
financial institutions became their saving grace, with some institutions having to adjust their plans
in order to address situations that had exceeded their initial scope.
Source: Andrew Tangel and Marc Lifsher, Los Angeles Times, 18 July 2013
7.2.6
Business Disruption and Systems Failures
These are losses arising from disruption of business or system failures. Examples of systems
failures are hardware, software, telecommunications and utility outages or disruptions.
Real World Illustration
Business Disruption and System Failures: Bank of America Online and Phone Service Disrupted
A report by E. Scott Reckard in the Los Angeles Times on 1 February 2013 said that due to
unexplainable disruption in its online, mobile and telephone banking services, the Bank of
America Corp. struggled to return to its normal operations on the same day the report was
written. The journalist suspected a hacker attack had likely caused the shutdown although the
real reason remained unclear. Since September 2012, there had been hacker attacks by a Middle
East-based shadowy hacker group targeting the electronic operations of the largest banks such
as Bank of America, Wells Fargo & Co., JPMorgan Chase & Co., Citigroup Inc., US Bancorp
and PNC Financial Services. Reckard claimed that the electronic platforms came under attack
caused by a surge of automated requests for service until the latter broke down. But even worse
was a recent hacking case where the hacker was able to breach a bank’s security systems,
thereby gaining access to customers’ funds.
Source: E. Scott Reckard, Los Angeles Times, 1 February 2013
7.2.7
Execution, Delivery and Process Management
These are losses from failed transaction processing or process management and from relations
with trade counterparties and vendors. There are six categories of operational losses from
execution, delivery and process management. These are:
ŸŸTransaction capture, execution and maintenance—Examples are miscommunication,
data entry/maintenance/loading errors, missed deadlines or responsibility, model/system
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Chapter 7 Operational Risk
misoperation, accounting errors/entity distribution errors, other tasks misperformance,
delivery failures, collateral management failure and reference data maintenance
ŸŸMonitoring and reporting—Examples are failed mandatory reporting obligation,
inaccurate external report (loss incurred)
ŸŸCustomer intake and documentation—Examples are client permissions and/or
disclaimers missing, legal documents missing or incomplete
ŸŸCustomer/client account management—Examples are unapproved access given to
accounts, incorrect client records (loss incurred), negligent loss or damage to client assets
ŸŸTrade counterparties—Examples are non-client counterparty misperformance,
miscellaneous non-client counterparty disputes
ŸŸVendors and suppliers—Examples are outsourcing or vendor disputes
Real World Illustration
Execution, Delivery and Process Management: Is Outsourcing the Cause of RBS Debacle?
The article dated 25 June 2012 by the BBC News business editor, Robert Peston, mentioned that
the Royal Bank of Scotland had to address and resolve a technical failure that severely affected
the operations of NatWest, RBS and Ulster Bank. The criticism stemmed from the RBS’ failure
to allow its customers to view their up-to-date balances and that the bank’s warning that there
might be more technical difficulties. To Preston, it did not look like the problem would be resolved
immediately. In his view, there was a direct correlation between the bank’s ability to immediately
address the situation and maintain the confidence level of its customer base. In a similar case
which Preston also cited in the article, on 14 September 2007 Northern Rock also suffered the
same situation where its customers could not access their online accounts on the evening of
13 September. This was attributed to insufficient server capacity, thus creating a bottleneck in
their online traffic during peak hours, which is equivalent to 300% of the normal peak demand.
For this reason, the Financial Services Authority has since been urging banks to bolster their
server capacity so that they are able to handle any surge in demand for online services.
Source: Robert Peston, BBC News, 25 June 2012
7.3 OPERATIONAL RISK CONSEQUENCES
LEARNING OBJECTIVE
7.3
DISCUSS the different types of operational risk consequences
Given the pervasiveness of operational risk, a wide range of consequences can result from the
operational risk losses. The consequence can be described by the probability of the operational
risk loss occurring and the severity of an operational risk loss event.
The probability of an operational risk loss is the frequency of the occurrence of an
operational risk loss event. This probability or frequency can be expressed quantitatively and
qualitatively. If expressed quantitatively, this probability can range from 0% (no likelihood of
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occurrence) to 100% (virtual certainty of occurrence). If expressed qualitatively, the probability
or frequency of occurrence can range from high to low frequency.
The severity of an operational risk loss is the impact of the operational risk loss event. The
severity ranges from low to very high monetary impact.
PROBABILITY
SEVERITY
High
Low
High
High probability,
high severity
High probability,
low severity
Low
Low probability,
high severity
Low probability,
low severity
Figure 7.3 Probability and severity of operational risk loss events
The relationship between probability and severity can be jointly analyzed to come up with
different types of operational risk loss consequences.
ŸŸHigh probability, high severity
These operational loss events have high chances of occurring and the impact is also high.
These are operational risks that are of critical importance for the bank. The bank should
immediately address and mitigate these risks.
ŸŸHigh probability, low severity
These are operational risk losses that have low severity (impact) but are expected to occur
more frequently. In terms of prioritization, these risks may be considered as medium risks
given the expected low impact. However, the bank should address the high frequency of
operational risk losses by instituting effective preventive controls to lower the frequency
of occurrences.
ŸŸLow probability, low severity
These are operational risk losses that have low chances of occurring and the impact of losses
is also quite low. Given their low probability and low severity, these risks should be placed on
the lowest priority level. The bank may decide to do nothing about these low probability and
low severity operational risk loss events.
ŸŸLow probability, high severity
These are operational risk losses that have low frequency of occurrence but when they
occur, the impact is very high and may threaten the bank’s survival. These events are
also referred to as black swan events, which are high impact but low probability events.
Examples of low probability but high severity events are the rogue trading scandals that
resulted in huge losses to the banks or have threatened the survival of many banking
organizations.
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Chapter 7 Operational Risk
These risks need to be mitigated. Alternatively, the bank must build up sufficient
capital or buffer to withstand potential losses from such events.
7.4 OPERATIONAL RISK MANAGEMENT
GOVERNANCE AND PROCESS
LEARNING OBJECTIVE
7.4
DISCUSS the different elements of sound operational risk management practices
The Basel Committee on Banking Supervision’s paper on Principles for the Sound Management
of Operational Risk and the Role of Supervision outlines sound practices in operational risk
management that are relevant to all banks.
This section provides an overview of the overall operational risk management practices
for banking organizations. Operational risk is inherent in all banking products, activities,
processes and systems.
Sound practices address the following four areas in operational risk management:
ŸŸOperational risk governance
ŸŸOperational risk management framework
ŸŸOperational risk management process
ŸŸBusiness resiliency and continuity
7.4.1
Operational Risk Governance
Sound internal governance is the foundation of an effective operational risk management
framework. Sound operational risk governance should start at the top given the pervasiveness
of operational risk across all products, business activities and processes.
Operational risk governance applies the principles of governance to the identification,
assessment, management and communication of operational risks to ensure that the
operational risk-taking activities and the bank’s overall risk profile are aligned with its risk
appetite and risk-taking capacity.
Operational risk governance defines the roles and responsibilities of the board of directors
and senior management with respect to operational risk management.
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Table 7.4 Operational risk governance in a banking organization
Roles and Responsibilities of the Board and Senior Management
Board of
directors
The board of directors is responsible for the overall governance of the bank including ensuring
that its operational risk profile is in line with its risk appetite and capacity.
The board’s responsibility with respect to operational risk management can be divided into three
areas:
ŸŸ Operational risk culture
ŸŸ Operational risk framework
ŸŸ Operational risk appetite and tolerance
Responsibilities of the Board
Operational
risk culture
ŸŸ Strong risk management culture and ethical business practices minimize
the likelihood of occurrence of potentially damaging operational events
and equip the bank with the capacity to deal with those events more
effectively.
ŸŸ The board is responsible for establishing a strong risk management
culture.
ŸŸ The board should establish a code of conduct or ethics policy that sets
clear expectations for integrity and ethical values of the highest standard
and identify acceptable business practices and prohibited conflicts.
Operational
risk
framework
ŸŸ The board is responsible for developing, implementing and maintaining
an operational risk management framework which is fully integrated into
the bank’s overall risk management process.
ŸŸ The board of directors should:
Establish a management culture and supporting processes to
understand the nature and scope of operational risks; and to develop
comprehensive, dynamic oversight and control environments that
are fully integrated into or coordinated with the bank’s overall risk
management framework.
mm Provide senior management with clear guidance and direction
regarding the principles of the bank’s operational risk management
framework and approve the policies developed by senior management.
mm Regularly review the operational risk framework.
mm Ensure that the operational risk framework is subject to an effective
independent audit review.
mm Ensure that management is availing themselves of the advances in
best practices.
mm
Operational
risk appetite
and
tolerance
Senior
management
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ŸŸ The board of directors should approve and review a risk appetite and
tolerance statement for operational risk.
ŸŸ The board of directors should regularly review the appropriateness of
limits and the overall operational risk appetite and tolerance statement.
Responsibilities
ŸŸ Should develop a clear, effective and robust governance structure with well defined,
transparent and consistent lines of responsibility.
ŸŸ Responsible for consistently implementing and maintaining throughout the organization
policies, processes and systems for managing operational risk consistent with the bank’s
risk appetite and tolerance.
ŸŸ Should translate the operational risk management framework established by the board of
directors into specific policies and procedures that can be implemented and verified within
the different business units.
ŸŸ Responsible for assigning authority, responsibility and reporting relationships and for
ensuring the appropriateness of oversight process.
ŸŸ Should ensure that the personnel responsible for operational risk coordinates and
communicates with the staff responsible for managing market, credit and other risks.
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Chapter 7 Operational Risk
Governance structure
The bank’s operational risk management exposure is pervasive in all banking strategies and
activities. This is why the bank may create an operational risk management committee with
board-mandated responsibilities to oversee operational risk matters.
Table 7.5 Board-mandated operational risk committee
Operational Risk Management Committee
Structure
Composition
Operations
ŸŸ For large banks, the board
of directors may create an
enterprise-level committee for
overseeing all risks to which a
dedicated management-level
operational risk committee
should report.
ŸŸ The operational risk committee
may receive inputs by country,
by business or by functional
area.
ŸŸ For smaller banks, a flatter
organizational structure may be
allowed.
ŸŸ Operational risk committee
should include a combination of
members with:
mm Expertise in business
activities
mm Expertise in risk
management and financial
matters
ŸŸ Committee meetings should be
held at appropriate frequencies
with adequate time and
resources to permit productive
discussion and decisionmaking.
ŸŸ Records of committee
operations should be
maintained.
It can also include independent
non-executive board members.
Operational risk management is too complex and too broad to be handled by a single
function in the bank. Many banks adopt the ‘three lines of defence’ model in operational risk
management. It should be the responsibility of everyone in the banking organization. The
‘three lines of defence’ model comprises:
ŸŸFirst line of defence—Business line management
This is the business line management. It is responsible for identifying and managing risks
inherent in the products, activities, processes and systems for which it is accountable.
ŸŸSecond line of defence—Independent corporate operational risk management function, and
legal and compliance
This is an independent corporate operational risk management function. It complements
the business line’s operational risk management activities. As a best practice, particularly
for larger organizations, the corporate operational risk management function will have
a reporting structure that is independent of the risk-generating business lines; it is
responsible for the design, maintenance and ongoing development of the operational risk
framework within the bank. A key objective of this function is to challenge the business
lines’ inputs to, and outputs from, the bank’s risk management, risk measurement
and reporting systems. The second line of defence also includes the bank’s legal and
compliance department.
ŸŸThird line of defence—Independent review
This entails an independent review and challenge of the bank’s operational risk
management controls, processes and systems. Internal audit is responsible for verifying
the effectiveness of the bank’s operational risk framework.
The clear assignment and definition of roles and responsibilities is important and is integral
to the operational risk management framework.
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Real World Illustration
Organizational Structure
The Head of Operational Risk Management (ORM) chairs the Operational Risk Management
Committee (ORMC) which is a permanent sub-committee of the Risk Executive Committee
and is composed of the operational risk officers from our business divisions and our
infrastructure functions. It is the main decision-making committee for all operational risk
management matters.
Source: Annual Report 2012, Deutsche Bank
ŸŸOrganizational structure
Based on a Global Financial Services Industry Operational Risk Survey conducted
by Protiviti and Operational Risk magazine, there are generally three organizational
models to choose from when designing a dedicated operational risk management
function. These are the centralized, distributed or decentralized organizational
models.
Centralized
corporate
activities
‘Centralized’
‘Distributed’
‘Decentralized’
ORM officer/
committee
ORM officer/
committee
No centralized
corporate ORM
activities
Business line
activities
No dedicated
business line
support
Business line ORM
managers and/
or dedicated staff
members
Largely independent
ORM programmes
managed by each
business line
Figure 7.4 Organizational models under the operational risk management function
mm
mm
mm
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Centralized designs are those with a central operational risk management function at
the corporate level. This is usually characterized by an operational risk management
officer and/or operational risk committee with responsibility for the oversight of the
centralized operational risk management function.
Decentralized designs reflect the creation of operational risk management functions
within selected or all the business lines and infrastructure support areas,
e.g. technology and operations. The design does not usually have a unifying
organizational framework across the entity, and tends to be directed by the lineof-business management to address operational risks relevant to its own business
propositions.
Distributed designs represent a hybrid of the two prior approaches, with a core operational
risk management function at the corporate level and supplemented by operational
risk managers at the business unit level. The line-of-business risk managers can be
either dedicated or ‘part-time’ resources, and may report directly or indirectly to the
corporate operational risk function.
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7.4.2
Operational Risk Framework
Operational risk is ingrained in all business products, activities, processes and systems. It is
therefore important that banks understand the nature and complexity of the risks inherent in
the bank’s products, services and activities.
Banks should develop, implement and maintain an operational risk framework that is
fully integrated into the bank’s overall risk management process. This framework is a vital
means of understanding the nature and complexity of operational risks. An operational risk
management framework serves to inform employees of the essential objectives and components
of operational risk management.
A bank’s operational risk management framework includes:
ŸŸRisk organizational and governance structure
ŸŸPolicies, procedures and processes
ŸŸSystems used in identifying, measuring, monitoring, controlling and mitigating
operational risks
ŸŸOperational risk measurement system
The framework documentation should clearly:
ŸŸDefine operational risk;
ŸŸIdentify the governance structures used to manage operational risk, including reporting
lines and accountabilities;
ŸŸDescribe the risk assessment tools and how they are used;
ŸŸDescribe the bank’s accepted operational risk appetite and tolerance as well as thresholds
or limits for inherent and residual risks, and approved risk mitigation strategies and
instruments;
ŸŸDescribe the bank’s approach to establishing and monitoring the thresholds or limits for
inherent and residual risk exposures;
ŸŸEstablish risk reporting and management information systems (MIS);
ŸŸProvide for a common taxonomy of operational risk terms to ensure consistency of risk
identification, exposure rating and risk management objectives;
ŸŸProvide for appropriate independent reviews and assessments of operational risks; and
ŸŸProvide for the policies to be reviewed and revised, as required, whenever a material
change in the bank’s operational risk occurs.
Operational risk strategy
A bank’s operational risk strategy should reflect the nature and source of the organization’s
operational risks for all operational risk elements. The strategy should be current and reflect
material changes to the internal and external environment.
Real World Illustration
DZ Bank Group’s Risk Strategy
The DZ BANK Group aims to manage operational risk efficiently. The following substrategies
represent areas in which the DZ BANK Group has taken action, or is planning to take action, to
ensure this core objective is achieved:
ŸŸ Continuous enhancement of risk awareness, so that it is reflected in an appropriate risk
culture focusing not only on individual areas of responsibility but also on the overarching
interests of the group. Establishment of comprehensive, open communication systems to
support these aims.
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Risk Management in Banking: Principles and Framework
ŸŸ An open and largely penalty-free approach to operational risk promoting a problem-solving
culture.
ŸŸ Preference for a balanced relationship between opportunities and risks rather than a
general strategy of risk avoidance. Risk reduction, risk transfer and risk acceptance are core
management strategies in addition to risk avoidance.
ŸŸ Risk appetite defined in the form of upper loss limits and materiality limits for operational risk
and continuously adjusted in line with prevailing circumstances.
ŸŸ Individual methods for managing operational risk coordinated with each other to provide an
accurate, comprehensive picture of the risk situation coherently integrated into the overall
management of all risk types.
ŸŸ Mandatory rule for all material decisions to take into account the impact on operational risk;
this applies in particular to the new product process and to business continuity planning.
ŸŸ Subject to cost effectiveness, appropriate resources for managing operational risk to be made
available.
ŸŸ Incentive systems compatible with risk to ensure a sustained contribution based on
performance from the perspective of the entire business.
ŸŸ Management of operational risk on a decentralized basis.
ŸŸ Compliance with relevant regulatory requirements guaranteed at all times.
Source: Annual Report 2012, DZ Bank
Strong operational risk management culture
Banks with a strong culture of risk management and ethical business practices are less likely to
experience potentially damaging operational risk events and are placed to effectively counter
such risk events.
The Institute of Risk Management (IRM) defines risk culture as a term describing the values,
beliefs, knowledge and understanding about risk shared by a group of people with a common
purpose, in particular the employees of an organization.
Real World Illustration
What does a Good Risk Culture Look Like?
A successful risk culture would include:
1. A distinct and consistent tone from the top—from the board and senior management—in
respect of risk taking and avoidance (and also consideration of tone at all levels).
2. A commitment to ethical principles, reflected in a concern with the ethical profile of individuals
and application of ethics and the consideration of wider stakeholder positions in decisionmaking.
3. A common acceptance through the organization of the importance of continuous
management of risk, including clear accountability for and ownership of specific risks and
risk areas.
4. Transparent and timely risk information flowing up and down the organization with bad news
rapidly communicated without fear of blame.
5. Encouragement of risk event reporting and whistle-blowing, actively seeking to learn from
mistakes and near misses.
6. No process or activity too large or too complex or too obscure for the risks to be easily
understood.
7. Appropriate risk-taking behaviours rewarded and encouraged, and inappropriate behaviours
challenged and sanctioned.
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Chapter 7 Operational Risk
8. Risk management skills and knowledge valued, encouraged and developed, with a properly
resourced risk management function and widespread membership of, and support for,
professional bodies. Professional qualifications supported as well as technical training.
9. Sufficient diversity of perspectives, values and beliefs to ensure that the status quo is
consistently and rigorously challenged.
10. Alignment of risk culture management with employee engagement and people strategy to
ensure that people are supportive socially but also focused on the task in hand.
Source: Risk Culture Under the Microscope—Guidance for Boards, Institute of Risk
Management, 2012
The board should establish a code of conduct or ethics policy that sets clear expectations
for integrity and ethical values of the highest standard as well as identify acceptable business
practices and prohibited conflicts.
Strong and consistent senior management support for risk management and ethical
behaviour reinforces the code of conduct and ethics, compensation strategies and training
programmes.
7.4.3
Operational Risk Management Process
A sound operational risk management process is a comprehensive process of identifying
and assessing, monitoring and reporting, and control and mitigation of the operational risk
exposures that banking organizations face.
Control and
mitigation
Identification
and assessment
Monitoring and
reporting
Figure 7.5 The operational risk management process
Identification and assessment
Risk identification and assessment are fundamental characteristics of an effective operational
risk management system. Effective operational risk identification considers both internal and
external factors. The bank should ensure that all operational risks inherent in all material
products, activities, processes and systems are identified and comprehensively assessed.
Sound risk assessment allows the bank to better understand its risk profile and allocate risk
management resources and strategies most effectively. Banks should have an approval process
for all new products, activities, processes and systems that adequately considers operational
risk.
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Risk Management in Banking: Principles and Framework
A bank’s operational risk exposure is increased when the bank engages in new activities or
develops new products, enters into unfamiliar markets, implements new business processes
and systems and/or engages in businesses that are geographically distant from the head office.
The review and approval process should consider:
ŸŸInherent risks in the new product, service or activity
ŸŸChanges to the bank’s operational risk profile and appetite and tolerance, including risk
exposures from existing products and services
ŸŸNecessary controls, risk management processes and risk mitigation strategies
ŸŸResidual risk
ŸŸChanges to relevant risk thresholds or limits
ŸŸProcedures and metrics to measure, monitor and manage the risk of a new product or
activity
Monitoring and reporting
Banks should implement a process to regularly monitor operational risk profiles and material
exposures to losses. The quality of operational risk reporting should continuously be improved.
Banks should implement appropriate reporting mechanisms at the board, senior management
and business line levels to support proactive management of operational risk.
Reports should be comprehensive, accurate, consistent and actionable across business lines
and products. The reports should be manageable in scope and volume as well as prepared in
a timely manner.
Operational risk reports may contain internal financial, operational and compliance
indicators as well as external market or environmental information about events and
conditions that are relevant to decision-making. The reports should include:
ŸŸBreaches of the bank’s risk appetite and tolerance statement as well as thresholds or
limits
ŸŸDetails of recent significant internal operational risk events and losses
ŸŸRelevant external events and potential impact on the bank and operational risk capital
Operational loss data collection plays an important role in operational risk reports. This
will be discussed in more detail in Chapter 8.
Control and mitigation
Banks should have a strong control environment that utilizes policies, processes and systems,
appropriate internal controls and appropriate risk mitigation and/or transfer strategies.
The internal controls should be designed to provide reasonable assurance that the bank
will have efficient and effective operations, safeguard its assets, produce reliable financial
reports, and comply with applicable laws and regulations. Control processes and procedures
should include a system for compliance with existing policies. Examples of the system
elements are:
ŸŸTop-level reviews of progress towards stated objectives
ŸŸVerify compliance with management controls
ŸŸReview the treatment and resolution of instances of non-compliance
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Chapter 7 Operational Risk
ŸŸEvaluation of required approvals and authorizations to ensure accountability to an
appropriate level of environment
ŸŸTrack reports for approved exceptions to thresholds or limits, management overrides
and other deviations from established policies
An effective control environment should include the following aspects:
ŸŸAppropriate segregation of duties; assignments that establish conflict of duties for
individuals or team without dual controls or other countermeasures may enable
concealment of losses, errors or other inappropriate actions
ŸŸClearly established authorities and/or processes for approvals
ŸŸClose monitoring of adherence to assigned risk thresholds or limits
ŸŸSafeguards for access to, and use of, bank assets and records
ŸŸAppropriate staffing level and training to maintain expertise
ŸŸOngoing processes to identify business lines or products where returns appear to have
deviated from reasonable expectations
ŸŸRegular verification and reconciliation of transactions and accounts
ŸŸVacation policy that provides for officers being absent from their duties for a period of
not less than two consecutive weeks.
7.4.4
Business Resiliency and Continuity
Banks should have in place business resiliency and continuity plans to ensure an ability to
operate on an ongoing basis and limit losses in the event of severe business disruption.
The business continuity plan should ensure resiliency against risks of disruptive events. It
should take into account the different types of likely or plausible scenarios to which the bank
may be vulnerable. Continuity management should incorporate:
ŸŸBusiness impact analysis
ŸŸRecovery strategies
ŸŸTesting
ŸŸTraining and awareness programmes
ŸŸCommunication and crisis management programmes
Banks should identify critical business operations, key internal and external dependencies, and
appropriate resilience levels. Contingency plans should establish contingency strategies, recovery
and resumption procedures, and communication plans for informing management, employees,
regulatory authorities, customers, suppliers and, where appropriate, the civil authorities.
CONCLUSION
In this chapter, an overview of operational risk was discussed. The evolution of the definition of
operational risk from a residual definition to a causal definition was also discussed. The different
types of operational risk causes, events and consequences were enumerated. At the end of this
chapter, an overview of the sound practices in operational risk management was discussed.
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C
8
P
HA
TE
R
IDENTIFICATION
OF OPERATIONAL
RISK
In the previous chapter, an overview of operational risk was discussed. The redefinition of
operational risk from a ‘residual’ to a causal definition was also discussed. The different
types of operational risk events were enumerated. At the end of the chapter, an overview
of the sound practices in operational risk management was discussed.
This chapter focuses in greater detail on the first step in the operational risk
management process, i.e. operational risk identification. This is the process of finding,
recognizing and describing operational risks in a banking organization.
This chapter begins with an overview of the operational risk identification process.
It then discusses the different business lines that generate operational risks. Before the
conclusion, the risk management student will be introduced to an important tool in
identifying operational risk—the operational loss database.
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Risk Management in Banking: Principles and Framework
Identification of
Operational Risks
Sources of
Operational Risks
Basel II
Business Lines
Internal Operational
Loss Database
External Operational
Loss Database
Figure 8.1 Diagrammatic outline of this chapter’s topics
LEARNING OUTCOME
At the end of this chapter, you are expected to be able to:
IDENTIFY the different sources of operational risks in the banking context
LEARNING OBJECTIVES
At the end of this chapter, you will be able to:
EXPLAIN the different sources of operational risks
ENUMERATE the Basel II business lines and their importance in identifying operational risks
DISCUSS the role of internal operational loss data in identifying operational risks
DISCUSS the role of external operational loss data in identifying operational risks
ENUMERATE the operational risks associated with new products/business activities and
outsourced processes
8.1 SOURCES OF OPERATIONAL RISKS
LEARNING OBJECTIVE
8.1
EXPLAIN the different sources of operational risks
Operational risk is inherent in almost all banking strategies, products and business activities.
You will recall from the previous chapter that operational risk has received far less attention
compared to market and credit risks. In fact, in the area of risk measurement, operational risk
is still at the infancy stage particularly when compared against market and credit risks. This is
partly due to difficulty in setting a standard definition for this risk.
In the past, many risk practitioners adopted a residual mindset on operational risk
management. They simply affirmed that banks should accept operational risk as a residual
risk. However, the banking failures that occurred over the past few decades due to failures
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Chapter 8 Identification of Operational Risk
in operational risk management erased all doubts that banking organizations should elevate
operational risk to the same level as the other types of risks such as market and credit risks.
In fact, the Basel Committee on Banking Supervision (BCBS) had since formally recognized
operational risk as one of the three major types of risks that banks should, at a minimum, set
aside capital for. The BCBS has provided an important framework to better understand and
identify operational risk exposures.
Operational risk identification involves finding, recognizing and describing operational
risk. Given the broad scope of operational risks, it would be helpful to classify operational
risks in terms of sources, events and consequences.
Table 8.1 Classification of operational risks
Causes
Events
Consequences
Operational risk sources classify
operational risk types according to
their causes.
Understanding the causes
or sources is an important step
in identifying and assessing
operational risk, which is pervasive
in the bank’s products, business
activities and services. To get a full
picture of the bank’s operational
risk profile, it is important to identify
the different sources of operational
risks.
As discussed in the previous
chapter, Basel II has adopted
a causal approach in defining
operational risk. Operational risk
arises from the following causes:
Operational risk events describe
their types according to the
condition when the operational risk
happens.
These events describe the
different types and kinds of
operational risk failures.
Operational risk events
are useful tools for the bank
to understand the nature and
types of operational risk losses
it encountered in the past. An
operational risk loss can only arise
from an operational risk event.
Understanding the events that
trigger operational risks provide an
important framework that could help
the risk management practitioner
in structuring the operational risk
identification process.
Examples of operational risk
events as defined by Basel II are:
Operational risks can also be
classified according to the results
or outcomes of the operational risk
occurrences.
Operational risk can result in
either favourably or adversely
impacting the bank.
While the usual concern is on
the adverse or loss side, it would
be useful if operational loss data
are collected and assessed even if
the occurrence of an event resulted
in a gain. This is because all
operational risk events may provide
valuable insights into weaknesses
in the bank’s processes or systems
that must be addressed.
Operational risk consequences
can be assessed in two
dimensions:
ŸŸ Internal fraud
ŸŸ External fraud
ŸŸ Employment practices and
workplace safety
ŸŸ Clients, products and business
practices
ŸŸ Damage to physical assets
ŸŸ Business disruption and system
failures
ŸŸ Execution, delivery and process
management
Likelihood of occurrence refers
to the frequency of occurrence of
an operational risk event. It can
range from low to high frequency of
occurrences.
The severity of operational loss
event refers to the financial impact
on the bank if an operational risk
event occurs. The severity can
range from low to high impact.
ŸŸ
ŸŸ
ŸŸ
ŸŸ
People
Process
Systems
External events
From the definition of
operational risk, it can be inferred
that operational risks arise from
both internal and external events.
The first three—people, process
and systems—are internal in
nature. The last one—external
events—are external in nature.
The Basel II definition of
operational risk includes legal
risks that can be classified as both
internal and external operational
risks.
ŸŸ Likelihood of occurrence
ŸŸ Severity of occurrence
As will be discussed in a
later section, these events can
be used to better understand
the operational risk profile of the
whole banking organization by
relating these events to each of the
significant business lines.
In the operational risk identification process, it is important for risk management
practitioners to understand the operational risk sources, events and consequences
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Risk Management in Banking: Principles and Framework
independently as well as their interrelationships. Operational risk sources—ranging from
internal to external events—help the practitioner in understanding the underlying causes of
operational risk failures.
Operational risk events describe the operational risk failures. These events, which arise
from the different operational risk sources, provide valuable information that will trigger the
recognition of the occurrence of operational risk failures. These operational risk events result
in operational risk consequences for the bank.
Operational risk consequences help the bank in assessing, measuring and managing
operational risk events. Identifying the different operational risk consequences will enable
the bank to appropriately prioritize different operational risk losses. For instance, high
frequency and high severity operational risk losses should receive higher prioritization than
low frequency and low severity operational risk losses.
Identifying the different operational risk consequences sets the foundation for quantifying
the amount of operational risk capital required to support the bank’s risk-taking activities
and the design of strategies to mitigate the exposures. For example, the bank may purchase
insurance to hedge its low frequency but high severity operational loss events.
8.2 OPERATIONAL RISK BUSINESS LINES
LEARNING OBJECTIVE
8.2
ENUMERATE the Basel II business lines and their importance in identifying operational risks
The Basel Committee on Banking Supervision recognizes that operational risk is inherent
and pervasive in all banking business activities. This is why under the Basel II standardized
approach, the gross income for each business line is used as the basis for calculating the
minimum capital requirement for operational risk. The implicit assumption behind this is
that the larger the scale of business operations, the more susceptible the bank is to operational
risk management failures.
Table 8.2 enumerates the eight major Level 1 business lines from which the bank can map
the operational risk losses.
Table 8.2 Mapping operational risk losses from Level 1 business lines
Level 1 Business Lines of Banking Organizations
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Corporate finance
The corporate finance business line involves banking services that help clients—usually
corporations, governments and institutional investors—raise funds via the capital markets.
Trading and sales
Trading and sales business line helps clients buy and sell financial instruments such
as equity securities, debt securities, foreign exchange, commodities and derivatives. It
involves the use of a wide platform of products and services in the area of capital markets,
fixed income, foreign exchange, commodities and derivatives.
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Level 1 Business Lines of Banking Organizations
Retail banking
Retail banking business line refers to products and services offered by banks
to consumers and small businesses through their branch networks and online
infrastructure.
Commercial
banking
Commercial banking activities primarily involve granting of loans to households and
businesses from deposits or funds taken from depositors.
Payments and
settlements
The payments and settlements business line facilitates payments of goods and services
on behalf of clients. Bank branches, internet and mobile banking facilities, and automated
teller machines are some of the most popular channels of payments.
Agency services
Banks may act on behalf of their customers in managing and protecting their assets and
properties via the banks’ agency services business activities.
Asset
management
Asset management activities involve managing or providing advice on the individual
assets or investment portfolios of clients for a fee. Banks are usually compensated based
on a percentage of the total assets under their management.
Retail brokerage
Retail brokerage services are brokering services that primarily serve the trading and
investment requirements of retail investors.
Each major business line can be further subdivided into secondary Level 2 business lines
to better classify operational risk losses. Figure 8.2 depicts the different Level 2 business lines
classified under the respective Level 1 business lines.
Corporate
finance
Sales and
trading
Retail
banking
Corporate
finance
Sales
Retail
banking
Municipal/
government
finance
Market
making
Merchant
banking
Proprietary
positions
Advisory
services
Treasury
Private
banking
Card
services
Commercial
banking
Commercial
banking
Payments
and
settlements
External
clients
Agency
services
Asset
management
Custody
Discretionary
fund
management
Corporate
agency
Corporate
trust
Retail
brokerage
Retail
brokerage
Nondiscretionary
fund
management
Figure 8.2 Level 1 business lines with corresponding Level 2 business lines
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Risk Management in Banking: Principles and Framework
Additionally, each of the bank’s business activities should be mapped to the Level 1 business
lines. This is enumerated in Table 8.3.
Table 8.3 Business activities mapped against their Level 1 business lines
Activity Groups
Level 1 Business Lines
Mergers and acquisitions, underwriting, privatizations, securitization, research,
debt (government, high yield), equity, syndications, IPOs, secondary private
placements
Corporate finance
Fixed income, equity, foreign exchanges, commodities, credit, funding, own
position securities, lending and repos, brokerage, debt, prime brokerage
Trading and sales
Retail lending and deposits, private lending and deposits, banking services, trust
and estates, investment advice, merchant, commercial, corporate cards, private
labels and retail
Project finance, real estate, export finance, trade finance, factoring, leasing,
lending, guarantees, bills of exchange
Retail banking
Commercial banking
Payments and collections, funds transfer, clearing and settlements
Payments and
settlements
Escrow, depository receipts, securities lending (customers), corporate actions,
issuer and paying agents
Agency services
Pooled, segregated, retail, institutional, closed, open, private equity funds
Asset management
Execution and full services
Retail brokerage
Operational risks in support services should be allocated to the respective business line that
it supports.
8.3 INTERNAL OPERATIONAL RISK LOSS DATA
LEARNING OBJECTIVE
8.3
DISCUSS the role of internal operational loss data in identifying operational risks
The starting point in the operational risk identification stage is the collection and analysis of
operational loss data specific to the bank’s loss experience. This allows the bank to understand
and appreciate not only its operational risk profile but also the weaknesses in its processes.
The internal loss database is an essential prerequisite for developing the operational risk
measurement system. Unlike market risk data, the internal operational loss data is bank
entity-specific. The data collected is specific to the size, nature and risk-profile of the bank.
Therefore, the bank has to rely on its own loss experience.
Operational risk data is also unlike credit risk data. As discussed in the previous two chapters,
prior to Basel II, there was no universal definition of operational risk. This makes it difficult
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Chapter 8 Identification of Operational Risk
to gather operational loss data. Unlike in credit risk where default events are legally defined,
there has been no clear definition of operational risk until recently. This made gathering of
operational loss data more challenging than for credit risk data.
Before the details of the internal operational loss data collection are discussed, it would be
helpful to discuss the four different types of data that banks may collect. These data could
provide important insights into the bank’s operational risk profile. Table 8.4 describes these
events.
Table 8.4 Types of data for operational risk profiling
Description
Examples
Loss events
Event Type
These are operational risk events that
lead to actual losses for the bank.
ŸŸ Failure to execute a client’s order in a timely
manner which resulted in a loss.
ŸŸ Embezzlement which resulted in monetary
loss.
Near-miss events
These are operational risk events that
do not lead to a loss.
Systems disruption after banking hours which
did not result into a loss.
Operational risk
gain events
These are operational risk events that
generate a gain.
Erroneous execution of an order to buy a
financial instrument, i.e. executed a larger size.
The price of the financial instrument rallied on
the date of discovery, resulting in the recognition
of a gain on the date the financial instrument
was sold.
Opportunity costs/
lost revenues
These are operational risk events
that prevent undetermined future
businesses from being conducted.
Failure to offer a high-margin product or service
to the bank’s clients due to unavailability of
systems to process the product or service.
Analysis of loss events provides important insights into the causes of large losses and
information as to whether the failures in control are isolated cases or systematic. The lack
of data on actual losses from operational risk is one of the key problems in measuring and
modelling operational risk exposures. An internal operational loss database is a key input in
any effective operational risk management framework. Internal loss data is the foundation to
quantitatively estimate the bank’s operational risk exposure.
An internal operational loss database captures and accumulates individual loss events
across business units and risk types. The database is used to record and classify loss events.
The Basel Committee on Banking Supervision has set minimum standards for collecting and
tracking internal loss data. Table 8.5 describes these standards.
Table 8.5 Standards for the collection and tracking of internal loss data
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Data
Description
Relevance of historical
data
The bank must ensure that its internal historical operational loss data is clearly linked
to its current business activities, technological processes and risk management
procedures.
Quantum of data
To be used for calculating the minimum regulatory capital, the bank must gather a
minimum five-year observation period of internal loss data.
Internal loss data
mapping
The bank must be able to map the historical internal loss data to the relevant Level
1 business line categories. There should be an objective and documented policy for
allocating operational losses to the specified business lines and event types.
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Data
Description
Comprehensiveness
The internal operational loss data collection process should capture all material
activities and exposures. The bank may provide a de minimis gross loss threshold
for internal loss data collection, e.g. operational loss data of at least €10,000 will be
collected and documented in the internal operational loss database.
Minimum data required
The bank must collect the gross operational loss, i.e. gross of any recoveries. This is
to give a more accurate picture on the magnitude of the operational risk loss. Apart
from the gross operational loss amount, the following data should be collected:
ŸŸ Date of the operational loss event
ŸŸ Recoveries of gross loss amount
ŸŸ Descriptive information about the drivers or causes of the operational loss event
Allocation
The bank must develop specific criteria for assigning loss data arising from a
centralized function or an activity that serves more than one business line.
Relationship with other
types of risks
Credit risk
The bank may monitor operational losses that are related to credit risk for internal
operational risk management purposes. However, these losses would be treated as
credit risk for regulatory capital purposes and are not subject to the operational risk
charge.
Market risk
Operational losses that are related to market risk are treated as operational risk for
regulatory capital purposes.
8.3.1
Incident Reporting
Banks use the incident reporting mechanism for collecting internal operational loss data
across all business lines. The reporting mechanism allows each business line to report its
operational risk losses as they occur. This serves as the strategic starting point for many banks
in populating their internal operational loss database.
To ensure comparability across different types of operational losses, banks should
implement a standard and documented approach in reporting internal operational losses. As
an example, the incident reporting form will contain the following items:
ŸŸDate of report
ŸŸDate of occurrence
ŸŸDate of accounting
ŸŸGross loss amount
ŸŸRecovery amount
ŸŸBusiness line
ŸŸType of operational loss event
ŸŸDescription of operation loss event
Dates of occurrence of internal losses
Ideally, the operational loss event should be reported on the date of its occurrence.
Unfortunately, this is not always the case in practice. Operational loss events may be
discovered weeks or months after the date of their occurrences. Further, not all operational
losses will materialize on the date of occurrence or discovery. For example, losses from legal
cases normally take months or years to materialize. Table 8.6 depicts the three important dates
in the recognition of internal losses.
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Chapter 8 Identification of Operational Risk
Table 8.6 Recognition of internal losses
Important Dates for Recognition of Internal Losses
Date of occurrence
The date when the operational loss event happened.
Date of discovery
The date when the operational loss event was discovered.
Date of accounting
The date on which the bank is required to recognize losses for accounting purposes.
Under the accounting standards, there are specific requirements in recognizing
obligations or losses.
ŸŸ Remote possibility—no recognition or disclosure.
ŸŸ Possible but not probable—classified as a contingent liability; with disclosure but
not recognition.
ŸŸ Probable—may be recognized as a liability.
Based on the 2006 BIS survey on the range of practices on operational risk for the Advanced
Measurement Approach (AMA), banks tend to favour the use of date of occurrence or date of
discovery over the date of accounting, except for litigation cases.
Gross loss amount
Gross operational loss exposure is the gross amount of loss that the bank incurred before
recoveries. Net operational loss exposure is the net amount of loss incurred after recoveries
from clients, insurance or other sources. Based on the 2006 BIS survey, banks generally collect
information about the gross loss amount and the corresponding recovery.
In many cases, determining the gross operational loss exposure amount is less
straightforward. There is a variety of measurement approaches to derive an estimate of the
gross internal operational loss amount. Table 8.7 gives some examples.
Table 8.7 Estimating operational loss amount—some measurement approaches
Approaches for Determining Amount of Operational Loss Exposure
Book value
This refers to the value of the security or asset in the bank’s balance sheet.
Replacement value
This refers to the cost of replacing the asset at the current time.
Market value
This is the amount that would be received in selling an asset in an orderly transaction
between market participants.
Internal loss data collection threshold
Banks may provide for de minimis levels below which the loss amounts are not collected or
recorded in a bank’s internal loss database. In choosing an appropriate level of threshold, the
bank should be aware of the trade-off between the benefits of collecting smaller losses and the
cost of collecting such information.
In the results from the 2008 loss data collection exercise for operational risk, the Basel
Committee revealed that a majority of banking institutions had reported thresholds of less than
€10,000. The most common threshold was between €0 and €1,000. While the thresholds vary
from one bank to another, the quantum should be reasonable. Additionally, the thresholds
should not omit operational loss event data that are material for operational risk exposure
and for effective risk management. The choice of threshold for modelling should not adversely
impact the credibility and accuracy of the operational risk measures.
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Risk Management in Banking: Principles and Framework
Business lines and event types allocation
Another issue worth discussing is the allocation of internal operational loss event arising
from a single operational risk event that affects multiple business lines. For example, how
should a bank allocate operational risk losses that occur in a centralized function such as in
information technology? Table 8.8 details two common approaches that bank uses.
Table 8.8 Internal operational loss events—allocation mechanisms
Allocation Mechanisms
Alternative 1
Allocate the entire operational loss to the business line
for which the impact is the greatest.
8.3.2
Alternative 2
Allocate the loss on a pro rata basis across the affected
business line.
The 8 × 7 Matrix
The bank must be able to map its historical internal loss data into the relevant Level 1 supervisory
categories and provide these data to supervisors upon request. It must have documented objective
criteria for allocating losses to the specified business lines and event types.
Internal operational loss data can be categorized under two dimensions—by business lines
and event types.
Table 8.9 Categories of internal loss data by business lines and event types
Corporate
Finance
Trading
and
Sales
Retail
Banking
Commercial
Banking
Payments
and
Settlements
Agency
Services
Internal fraud
xxx
xxx
xxx
xxx
xxx
xxx
xxx
xxx
xxx
External fraud
xxx
xxx
xxx
xxx
xxx
xxx
xxx
xxx
xxx
Employment
practices and
workplace
safety
xxx
xxx
xxx
xxx
xxx
xxx
xxx
xxx
xxx
Clients,
products and
business
practices
xxx
xxx
xxx
xxx
xxx
xxx
xxx
xxx
xxx
Damage to
physical
assets
xxx
xxx
xxx
xxx
xxx
xxx
xxx
xxx
xxx
Business
disruption
and systems
failure
xxx
xxx
xxx
xxx
xxx
xxx
xxx
xxx
xxx
Execution,
delivery and
process
management
xxx
xxx
xxx
xxx
xxx
xxx
xxx
xxx
xxx
TOTAL
xxx
xxx
xxx
xxx
xxx
xxx
xxx
xxx
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Asset
Retail
Total
Management Brokerage
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Chapter 8 Identification of Operational Risk
8.3.3
Basic Statistical Analysis
The bank should conduct a basic statistical analysis on the internal loss data collected.
Examples of this statistical information are:
ŸŸNumber of incidents
ŸŸAverage loss
ŸŸVolatility or standard deviation
Table 8.10 Type of statistical information for analysis of internal loss data
Level 1 Business Lines
Loss
Events
Descriptive
Statistics
Retail
Banking
Commercial Trading Corporate
Asset
Banking
and Sales Finance Management
Payments
and
Settlements
Agency
Services
No. of
incidents
Internal
fraud
Average
Standard
deviation
No. of
incidents
External
fraud
Average
Standard
deviation
Employment
practices
and workplace
safety
Clients,
products
and business
practices
Damage to
physical
assets
Business
disruption
and systems
failure
Execution,
delivery and
process
management
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No. of
incidents
Average
Standard
deviation
No. of
incidents
Average
Standard
deviation
No. of
incidents
Average
Standard
deviation
No. of
incidents
Average
Standard
deviation
No. of
incidents
Average
Standard
deviation
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Real World Illustration
Loss Data Collection Faces Pitfalls
Practitioners agreed that incentivizing staff to report losses tops the list of challenges in loss data
collection, in a discussion at the OpRisk Asia Conference in Singapore. “We could do better than
rely only on people for our loss data collection, but rely on people is what we do,” said Anthony
Rizzo, risk executive for operational risk in the institutional banking and markets division of the
Commonwealth Bank of Australia.
Alongside the challenge of encouraging staff to share information about losses without fear of
those losses being held against them, practitioners spoke of the difficulty in testing the proportion
of losses they are accurately identifying.
“People are at the core of how we collect data,” said Rizzo, adding that for this reason educating
staff about how collecting loss data is valuable to the bank is essential. Employees will also need
to know that information they supply will not be used against them, he said.
“We can definitely close the gap in understanding,” said Yusuf Yasin, senior operational risk
officer at Standard Chartered in Singapore, emphasizing the need for operational risk managers
to improve their understanding of business units as well as the reverse.
Jennifer Koo, head of operational risk capital and reporting at Credit Suisse in Singapore, spoke of
the challenge of setting loss data collection policies for a global organization across countries and
business units in a way that is meaningful for front-line employees. She suggested firms might set
global high-level policies with additional supplemental guidance for specific lines of business and
local training on that guidance. This can be used to detail what losses might look like in specific
areas and set out the information risk managers would like to be recorded with relevant examples.
On the additional challenge of back-testing loss-data capture, she said doing so can be difficult
because operational risk losses often are recorded in a way that makes tracing their derivation
impossible. Losses due to incorrect mark-to-market valuations, for example, will be corrected in
the trading book and reflected in a bank’s general ledger, rather than a specific profit and loss
account. Practitioners also spoke of the special difficulties presented by operational risk events
that lead to a gain rather than a loss for the firm. In such cases, there is no incentive for the trader
involved to report the incident, Koo pointed out.
Yasin described a research exercise in which the distribution of operational risk events reported
within a firm was found to be unevenly skewed towards losses. This shows that traders were
under-reporting accidental gains, he said, since positive and negative outcomes from operational
risk events might be expected to be normally distributed—in fact, accidental gains were probably
either reported as deliberate trading profits, or unofficially used to offset losses elsewhere.
Source: Risk.net
8.4 EXTERNAL OPERATIONAL RISK LOSS DATA
LEARNING OBJECTIVE
8.4
DISCUSS the role of external operational loss data in identifying operational risks
The bank’s operational risk measurement system must use relevant external data particularly
if the bank is exposed to infrequent, yet potentially severe losses. External loss data comprises
operational risk losses experienced by third parties. Given this experience, the bank can use
this information to assess its own vulnerability.
It is important to supplement the internal loss data with external loss data, particularly
when the bank is exposed to low frequency but high severity operational risk losses. These
external data shall include:
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Chapter 8 Identification of Operational Risk
ŸŸData on actual loss amounts
ŸŸInformation on the scale of business operations where the event occurred
ŸŸInformation on the causes and circumstances of the operational loss events
ŸŸOther information that would help in assessing the relevance of the loss event for other
banks
External loss data can be compared with internal loss data or used to explore possible
weaknesses in the control environment or consider previously identified risk exposures. In the
2008 survey by the Basel Committee, one finding shows that most banks factored external loss
data in their operational risk capital estimates. There are three popular providers of external
loss data—ORX, bbaGOLD and ORIC.
Operational Riskdata eXchange Association (ORX)
The Operational Riskdata eXchange Association (ORX) is a not-for-profit industry association
dedicated to advancing the measurement and management of operational risk in the global
financial services industry. ORX was founded in 2002 with the primary objective of creating
a platform for the secure and anonymized exchange of high-quality operational risk loss
data. Today, ORX operates the world’s leading operational risk loss data consortium for the
financial services industry.
The ORX Global Operational Risk Database is the world’s largest operational risk loss data
resource. As of 31 December 2012, the database contained 299,672 loss events equating to a
total value of €151,559,050,244. The data that ORX collects is confidential. In general, ORX
only makes its data available to member institutions which contribute to the database.
Table 8.11 shows an aggregated data of total gross losses by event types and business lines.
Table 8.11 Global total gross losses by event types and business lines (2012)
Internal Fraud
External Fraud
Employment Practices
Clients, Products and
Business Practices
Disasters and Public
Safety
Technology and
Infrastructure
Execution Delivery and
Process Management
Malicious Damage
Total % by Business
Line
Aggregated Global Data of Total Gross Losses—2012
Corporate Finance
0.08%
0.42%
0.18%
24.79%
0.00%
0.00%
1.24%
0.00%
26.71%
Trading and Sales
1.34%
0.69%
0.30%
4.74%
0.00%
0.28%
7.00%
0.00%
14.35%
Retail Banking
1.97%
7.13%
2.12%
8.51%
0.33%
0.61%
7.46%
0.02%
28.17%
Commercial Banking
1.04%
2.10%
0.28%
3.35%
0.01%
0.09%
5.08%
0.00%
11.97%
Clearing
0.11%
0.26%
0.03%
0.31%
0.00%
0.08%
0.63%
0.00%
1.42%
Agency Services
0.02%
0.03%
0.04%
2.03%
0.00%
0.02%
0.69%
0.00%
2.84%
Asset Management
0.06%
0.05%
0.17%
3.11%
0.00%
0.02%
0.89%
0.00%
4.30%
Retail Brokerage
0.14%
0.09%
0.26%
1.57%
0.01%
0.01%
0.30%
0.00%
2.38%
Private Banking
0.55%
0.20%
0.11%
2.44%
0.00%
0.01%
0.65%
0.00%
3.96%
Corporate Hems
0.10%
0.07%
0.33%
1.28%
1.12%
0.03%
0.97%
0.01%
3.90%
Total % by Event Type
5.42%
11.04%
3.84%
52.14%
1.48%
1.15%
24.90%
0.03%
100.00%
Key>
1%–5%
5%–10%
>10%
Source: Operational Riskdata eXchange Association
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Risk Management in Banking: Principles and Framework
British Bankers’ Association (BBA) GOLD
bbaGOLD is the operational risk event data consortium managed by the British Bankers’
Association (BBA) using online services provided by Risk Business International Ltd. It
provides participating institutions with external information pertaining to their respective
risk management practice.
bbaGOLD has taken the basic Basel categorization of loss event types and business lines
and significantly expanded the range of available information on the events. For each event,
it is possible to assess its life cycle, the originating source of the occurrence, the business line
in question, the product or function involved, the contributing causal factors, which controls
failed, the nature of the loss event, the consequent impact and the amount of associated loss.
ORIC data
The Association of British Insurers (ABI) founded Operational Risk Consortium Ltd (ORIC) in
2005 together with 16 core insurers to provide thought leadership, and to enhance quantitative
and qualitative understanding of operational risk. The ABI is constantly growing both in the UK
and internationally, adding new members every year. It remains a not-for-profit organization, with
its current members being drawn from both life and non-life types of business.
ORIC deals with operational risk data—information on losses due to failed people, processes,
systems or external events. It provides a quality-controlled database to improve the members’
risk measurement and modelling skills.
The consortium had set a standard for the industry in terms of risk event categorization.
The Level 1 and 2 categories are consistent with the Basel II Accord. ORIC and its members have
developed a further Level 3 categorization system to increase the granularity of its database.
The ORIC ‘Loss’ database provides in-depth narratives of the events leading to losses. It also
captures the causes that lead risks to materialize and turn into loss events. The database design
suits ORIC’s international expansion as it captures the geography of losses and allows member
firms to submit data in various currencies. The database infrastructure supports data relating
to actual monetary losses as well as near misses. When it is not possible to accurately quantify
near miss losses in monetary terms, they can be stored in the ORIC database as ‘unquantifiable
near misses’.
The database currently stores over 3,016 loss events collected over the last five years, with
total gross operational risk losses of over €2 billion.
8.5 NEW PRODUCTS AND BUSINESS ACTIVITIES
AND OUTSOURCING ACTIVITIES
LEARNING OBJECTIVE
8.5
ENUMERATE the operational risks associated with new products/business activities and
outsourced processes
Entering into new products, engaging in new business activities and outsourcing internal
processes often expose the banking organization to new or emerging operational risks
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Chapter 8 Identification of Operational Risk
that could easily be overlooked. The Basel Committee on Banking Supervision (BCBS)
has discussed in detail the different operational risks that banks need to consider when
introducing new products, engaging in new business activities or when outsourcing internal
processes.
8.5.1
New Products and Business Activities
Entering into new banking products, markets or activities expose a bank to operational risks.
In many instances, the operational risk exposure is heightened when the bank introduces
new products and activities, or enters into new markets. Examples of these new products and
business activities are:
ŸŸDeveloping new banking products for clients
ŸŸEntering into unfamiliar markets
ŸŸImplementing new business processes or technology systems
ŸŸEngages in businesses that are geographically distant from the head office
Operational risk is especially heightened during the product or activity introduction stage
and when the bank starts to earn material revenue for new products or rely on the new activity
at a more critical level.
Introductory stage
Transition to growth
Figure 8.3 Heightening milestones in operational risk occurrence
In order to address the risks arising from the new products or new business activities, the
bank should have a process for the review and approval of new products, activities, processes
and systems. This review and approval process should consider the following aspects:
ŸŸInherent risks in the new product, service or activity
ŸŸChanges to the bank’s operational risk profile, and appetite and tolerance including the
risk of existing products or activities
ŸŸNecessary controls, risk management processes and risk mitigation strategies
ŸŸResidual risk
ŸŸChanges to the relevant risk thresholds or limits
ŸŸProcedures and metrics to measure, monitor and manage the risk of new products or
activities
ŸŸWhether the bank has appropriately and adequately invested in human resources and
technology infrastructure before introducing new products
8.5.2
Outsourcing in Financial Services
Banking organizations are increasingly using third parties to perform activities that they
would normally have handled using internal resources. Outsourcing is seen by many as a
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Risk Management in Banking: Principles and Framework
strategic tool that banks use to reduce costs and optimize their respective business practices.
Figure 8.4 depicts some of the commonly outsourced business processes.
Information
technology
Contract
functions
Commonly
outsourced
activities
Finance and
accounting
Back-office
processing and
administration
Figure 8.4 Banks’ commonly outsourced activities
In February 2005, the Joint Forum* issued a paper which enumerated the different risks
arising from the engagement of third parties to perform outsourcing services. Table 8.12
details these risks.
Table 8.12 Risk concerns when using outsourced service providers
Risk Type
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Major Concerns
Strategic risk
ŸŸ The third party may conduct activities on its own behalf which are inconsistent with the
bank’s strategic goals.
ŸŸ Failure to implement appropriate oversight of the outsource provider.
ŸŸ Inadequate expertise to supervise the outsource provider.
Reputation risk
ŸŸ Poor service from the third party.
ŸŸ Third-party provider’s interactions with customers are not consistent with the bank’s
standards.
ŸŸ Third-party provider’s practices are not in line with the bank’s stated practices.
Compliance risk
ŸŸ Privacy laws are not complied with.
ŸŸ Consumer and prudential laws are not adequately complied with.
ŸŸ Outsource provider has inadequate compliance systems and controls.
Operational risk
ŸŸ
ŸŸ
ŸŸ
ŸŸ
Technology failure.
Inadequate financial capacity to fulfil obligations and/or provide remedies.
Fraud or error.
Risk that the bank finds it difficult or costly to undertake inspections.
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Chapter 8 Identification of Operational Risk
*
Risk Type
Major Concerns
Exit strategy risk
ŸŸ The risk that appropriate exit strategies are not in place.
ŸŸ Limited ability to return services to home country due to lack of staff or loss of intellectual
history or knowledge.
Counterparty risk
ŸŸ Inappropriate underwriting or credit assessments.
ŸŸ Quality of receivables may diminish.
Country risk
ŸŸ Political, social and legal climate may create added risk.
ŸŸ Business continuity planning is more complex.
Contractual risk
ŸŸ Ability to enforce contract.
ŸŸ For offshoring, choice of law is important.
Access risk
ŸŸ Outsourcing arrangement hinders the bank’s ability to provide timely data and other
information to regulators.
ŸŸ Additional layer of difficulty in regulator understanding activities of the outsource
provider.
Concentration and
systemic risk
ŸŸ Overall industry has significant exposures to the outsource provider.
The Joint Forum was established in 1996 under the aegis of the Basel Committee on Banking Supervision, the International
Organization of Securities Commissions (IOSCO) and the International Association of Insurance Supervisors (IAIS) to deal with
issues common to the banking, securities and insurance sectors.
The Joint Forum has also drawn up a set of high-level principles on banks’ responsibilities
in their outsourcing activities. These are enumerated in Table 8.13.
Table 8.13 High-level principles on bank’s outsourcing activities
Responsibilities of Banks in Outsourced Services
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Outsourcing assessment policy
Banks should establish a comprehensive policy to guide its outsourcing
assessment process.
Outsourcing risk management
programme
Banks should establish a comprehensive outsourcing risk management
programme to address outsourced activities and the relationship with service
providers. Third-party practices are not in line with the bank’s stated practices.
Responsibility to clients and
regulators
Banks should ensure that outsourcing arrangements do not diminish their
ability to fulfil their obligations to customers and regulators.
Selection process
Banks should conduct appropriate due diligence in selecting third-party
service providers.
Documentation
Outsourcing relationships should be appropriately documented via written
contracts that clearly describe all the material aspects of the outsourcing
agreements.
Contingency plans
The bank and the third-party service providers should establish and
maintain contingency plans including a plan for disaster recovery and
periodic testing of back-up facilities.
Confidentiality
Banks should ensure that third-party service providers protect the
confidential information of both the bank and its clients from intentional or
inadvertent disclosure to unauthorized parties.
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CONCLUSION
This chapter provided important tools and framework for the operational risk identification
process. The chapter started with a review of the different sources of operational risk. It then
discussed the Basel II operational risk business lines, which provides an important foundation
in understanding and identifying operational risk exposures. Next, it discussed two of the
most important operational risk identification tools—the internal operational loss database
and the external operational loss database. The chapter ended with a discussion of two of the
most important sources of operational risks for a banking organization, i.e. new products and
outsourcing activities.
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C
9
P
HA
TE
R
MARKET RISK
Banking organizations engage in financial market activities both to service client
requirements and to hedge their risk exposures. As the global economy becomes more
integrated, financial markets play an increasing important role in the banking business
activities. For many banks, revenues earned from financial market-related activities make
up a sizeable share of their total revenue. This is why, for many banking organizations,
market risk is second only to credit risk in terms of importance.
Market risk is the risk associated with a bank’s financial market-related activities.
This chapter begins with an introduction to the importance of financial markets in the
business of banking. It then provides a formal definition of market risk. This is followed
with a detailed discussion on the different sources of market risks. At the end of this
chapter, an overview of the market risk management process is discussed. This chapter
covers only market risk identification. Book II will cover market risk measurement,
monitoring, control and mitigation.
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Market Risk
Financial Market
Activities
Definition of
Market Risk
Types of
Market Risks
Market Risk
Management Process
Foreign Exchange
Risk
Market Risk
Identification
Interest Rate
Risk
Market Risk
Assessment
Equity Price
Risk
Market Risk
Control
Commodity Price
Risk
Market Risk
Monitoring
and Reporting
Figure 9.1 Diagrammatic outline of this chapter’s topics
LEARNING OUTCOME
At the end of this chapter, you are expected to be able to:
DISCUSS the basic principles of market risk in the banking context
LEARNING OBJECTIVES
At the end of this chapter, you will be able to:
DISCUSS the roles of financial markets in the banking business activities
DEFINE market risk
ENUMERATE the different types of market risk exposures
DISCUSS the basic market risk management process
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Chapter 9 Market Risk
9.1 FINANCIAL MARKET ACTIVITIES
LEARNING OBJECTIVE
9.1
DISCUSS the roles of financial markets in the banking business activities
Before discussing market risk in detail, it is important for the risk management student to
be familiar with the roles of financial markets in banking business activities. This provides a
critical context for the student to understand the importance and objectives of market risk
management.
Financial market is a mechanism that allows buyers and sellers to exchange financial
instruments (e.g. equities, bonds, foreign exchange and derivatives) and commodities.
9.1.1
Functions and Roles of Financial Markets
Table 9.1 describes the roles of financial markets in an economy.
Table 9.1 Financial markets
Roles of Financial Markets
Access (or deploy) short-term
liquidity
Financial markets allow market participants with excess cash to deploy
liquidity, and market participants with temporary shortfall in cash to
access liquidity.
Efficient allocation of capital
Financial markets match borrowers—usually corporations—with longterm funding requirements with lenders or investors with long-term
investment requirements.
Risk transfer
Financial markets allow the efficient transfer of risk from a party which
has no capacity or is not willing to bear a specific risk to another party
which has the capacity and is willing to bear the same risk.
Facilitate international trade
Financial markets play a major role in international trade by allowing the
purchase and sale of foreign currencies and commodities. Importers
need to purchase foreign currencies for payment of goods or services.
Exporters need to sell foreign currencies earned from the sale of goods
or services rendered.
9.1.2
Types of Financial Markets
Financial markets can be broadly classified into the following types:
Chapter-09.indd 255
(a) Money market
(c) Foreign exchange market
(b) Capital market
(d) Derivatives market
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Money market
The money market is where borrowers with short-term credit requirements—usually one year
or less—are matched with lenders with short-term excess liquidity. Money market securities
are the simplest and one of the least risky instruments in the financial markets due to their
relatively short maturity.
Figure 9.2 illustrates how the money market allows borrowers with short-term or temporary
funding requirement to access funds. Investors with short-term investment requirement can
also deploy their excess liquidity to the money market.
Investors
with Excess
Liquidity
Short-Term
Investment
Money Markets Allow Short-Term
Borrowing and Lending
Short-Term
Funding
Borrowers with
Liquidity
Requirements
Figure 9.2 Money markets perform matching function
The matching function performed by money markets is a critical function that allows banks
and corporations to have a more stable cash flow by ‘smoothening’ their respective working
capital needs, i.e. short-term investment and borrowing.
Money markets are also the foundation of the more sophisticated capital markets, derivative
markets and foreign exchange markets. Money markets frequently serve as a benchmark for
these more sophisticated markets. Furthermore, a well-functioning money market is frequently
a prerequisite before the more sophisticated financial market is developed. Table 9.2 describes
some of the common types of money market instruments.
Table 9.2 Money market instruments
Common Types of Money Market Instruments
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Treasury bills
Treasury bills are short-term money market securities issued by the government. Their tenors
are usually one year or less. These bills are considered to be the safest type of investments.
Commercial
papers
Commercial papers are short-term promissory notes issued by corporations. In the U.S., the
maturities can range up to 270 days but average about 30 days.
Bank deposits
Bank deposits are funds placed in a bank and represent a legal liability owed by banks to depositors.
Time deposits are deposits placed with a bank with a fixed interest rate for a predefined deposit
period.
Banker’s
acceptance
A banker’s acceptance (BA) is a short-term money market instrument issued by a corporation
that is guaranteed by a commercial bank. BAs are usually used in international trade transactions
to finance shipment or storage of goods.
Certificate of
deposit
A certificate of deposit (CD) is a money market instrument with a fixed term and a fixed interest
rate. The key distinguishing feature between a CD and a regular deposit is that pre-termination
of the CD will usually incur a penalty.
Repurchase
agreement
A repurchase agreement (repo) is a contractual agreement between two parties, where one party
agrees to sell securities to another party at a specified price with a commitment to repurchase
the securities on a later date at another specified price.
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Capital market
Capital markets facilitate the efficient allocation of capital. They provide a venue for entities with
shortage of funds to borrow from entities with excess funds. This role is traditionally played
by the capital market.
Figure 9.3 illustrates how capital markets facilitate efficient allocation of capital.
Corporations with long-term funding requirements may access the debt or equity markets to
generate funding to finance their expansion. Investors with excess funds may invest in these
debt or equity securities. The capital market can be broadly divided into two different types:
(a) Debt capital markets
(b) Equity capital markets
Corporations
with Fund
Requirements
Fund Requirements
Capital Markets Facilitate
Efficient Allocation of Capital
Excess Funds
Investors with
Excess Funds
Figure 9.3 Capital markets facilitate allocation of capital
Foreign exchange market
The foreign exchange market is one where different currencies are traded. It facilitates the
exchange of goods, services and investments among different countries by allowing the
conversion of one currency to another.
Importer
Exporter
$
$
Malaysia
Malaysia
RM
$
Goods
Malaysian exporter converts
the USD received to MYR
(functional curency of
the exporter)
RM
Malaysian importer buys
USD using MYR
(functional currency of
the Malaysian importer)
Goods
USA
$
USA
Malaysian exporter sells palm
oil to U.S.-based company,
Malaysian exporter receives
USD as payment
Malaysian importer uses the
USD received to pay U.S.based company
Figure 9.4 Foreign exchange market facilitates international trade
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Exporter—An exporter sells goods or services to a buyer in a foreign market. In exchange,
the exporter receives payment in an international currency. The exporter then converts the
proceeds denominated in an international currency to its local currency through the foreign
exchange market.
Importer—An importer, on the other hand, buys goods or services from a foreign market. The
importer is required to pay for these goods/services in an international currency. To facilitate
this requirement, the importer converts its local currency to an international currency through
the foreign exchange market.
ŸŸForeign exchange rate
A foreign exchange rate is the price of one currency expressed in terms of another currency.
A spot transaction is a straightforward purchase or sale of one currency against another.
The International Organization for Standardization publishes a list of standard
currency codes referred to as the ISO 4217 code list. The ISO 4217 establishes
internationally recognized codes for the representation of currencies. Currency codes
comprise three characters. The first two characters represent the country codes, which
are frequently used as the basis for the national top-level internet domains. The third
character represents the currency unit.
Table 9.3 ISO currency codes
First Two Characters
(Country Code)
Third Character
(Currency Unit)
ISO Currency Code
US Dollar
US
Dollar
USD
Malaysian Ringgit
MY
Ringgit
MYR
Australian Dollar
AU
Dollar
AUD
Philippine Peso
PH
Peso
PHP
British Pound
GB
Pounds
GBP
mm
Trends in the foreign exchange market
As of April 2013, trading in the foreign exchange markets averaged US$5.3 trillion per
day. This is an increase from US$4.0 trillion in April 2010 and US$3.3 trillion in April
2007.
The role of the US dollar as the world’s dominant vehicle currency remains
unchallenged. In April 2013, foreign exchange deals with the US dollar on one side
of the transaction represents 87% of all deals initiated. The euro remains the second
most important currency worldwide. However, the international role of the euro
has shrunk since the beginning of the euro area sovereign debt crisis in 2010. The
Australian dollar (AUD) and New Zealand dollar (NZD) continue to be among the
most actively traded advanced economy currencies. Table 9.4 details the world’s most
actively-traded currencies.
Table 9.4 World’s most actively-traded currencies
Currency Unit
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Code
Turnover
US Dollar
USD
87%
Euro
EUR
33.4%
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Chapter 9 Market Risk
Currency Unit
Code
Turnover
Japanese Yen
JPY
23.0%
Great Britain Pound
GBP
11.8%
Australian Dollar
AUD
8.6%
Swiss Franc
CHF
5.2%
Canadian Dollar
CAD
4.6%
Mexican Peso
MXN
2.5%
Chinese Yuan (Renminbi)
CNY
2.2%
New Zealand Dollar
NZD
2.0%
Swedish Krona
SEK
1.8%
Russian Ruble
RUB
1.6%
Hong Kong Dollar
HKD
1.4%
Singapore Dollar
SGD
1.4%
Turkish Lira
TRY
1.3%
Source: Triennial Central Bank Survey, Foreign Exchange Turnover in April 2013, Bank for
International Settlements
mm
Foreign exchange rate regimes
To understand the market dynamics that influence the movements of foreign
exchange rates, it is important to appreciate the different exchange rate regimes.
Exchange rate regimes determine how a sovereign chooses to govern its exchange
rates.
At the end of one spectrum is the fixed exchange rate regime. At the other end is
the floating exchange rate regime. In the middle of this continuum of exchange rate
regimes are the hybrid exchange rate regimes that combine different features of the
fixed and floating exchange rates.
Fixed Rate
Regimes
Hybrid Regimes
Floating Rate
Regimes
Figure 9.5 Exchange rate regimes
–– Fixed rate regimes
Fixed rate regimes are characterized by foreign exchange rate regimes where a
government ties its exchange rate to gold or to another country’s currency—usually
an international currency such as the US dollar—or to a basket of currencies. This
is why the fixed rate regimes are also referred to as pegged exchange rates. Fixed rate
regimes can be broadly classified as:
§§ Hard exchange rate pegs
§§ Soft exchange rate pegs
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Full dollarization is a hard exchange rate peg
regime where a country officially adopts another
country’s currency for all financial transactions. This
arrangement is also known as an exchange rate
arrangement with no separate legal tender.
The key feature of a full dollarization regime is
that the foreign currency acts as the legal tender
for all financial transactions. A country adopting full
dollarization will usually result in its central bank
losing the role to act as the lender of last resort for
its banking system and to implement monetary policy
measures.
Hard exchange rate
pegs
Hard exchange rate
peg is an exchange rate
regime where a country’s
exchange rate is fixed
against the currency of
another country—usually,
the US dollar.
Currency or monetary union is a group of two or
more countries sharing a common currency.
Details
Classification
Examples
The euro is the most prominent example of a monetary union. It is the single
currency shared by 18 European Union member states. As of the date of this
publication, the following countries use the euro:
ŸŸ Austria
ŸŸ Belgium
ŸŸ Cyprus
ŸŸ Estonia
ŸŸ Finland
ŸŸ France
ŸŸ Germany
ŸŸ Greece
ŸŸ Ireland
ŸŸ Italy
ŸŸ Latvia
ŸŸ Luxembourg
ŸŸ Malta
ŸŸ Netherlands
ŸŸ Portugal
ŸŸ Slovakia
ŸŸ Slovenia
ŸŸ Spain
Source: IMF, ABC News
In January 2000, Ecuador announced that it would adopt full dollarization to avert
an economic crisis (7.5% contraction in 1999 and 60% inflation) and abandoned its
national currency, the sucre.
In January 2001, El Salvador decided to make the U.S. dollar as its official
currency in the context of sound macroeconomic fundamentals while inflation
was low and stable, and the economy was growing. The decision to adopt full
dollarization was to tighten links to the U.S. economy and spur foreign investment,
trade and growth.
Other countries using the U.S. dollar as legal tender are the Democratic Republic
of Timor-Leste, Marshall Islands, Micronesia, Palau, Panama and Zimbabwe.
Some countries, such as Kosovo, Montenegro and San Marino, have adopted
the euro as their legal currencies.
Table 9.5 Classification of fixed rate regimes
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Soft exchange rate pegs
Soft exchange rate peg is
a type of fixed rate regime
where the currency
maintains a stable
value against an anchor
currency or a composite
of currencies.
The anchor currency
or composite of anchor
currencies are usually
based on the currency
or currencies of the
country’s major trading or
financial partners.
Classification
Stabilized arrangement entails a spot market
exchange rate that remains within a margin of 2% for
six months or more with respect to a single currency
or basket of currencies.
Conventional peg is a soft exchange rate peg
arrangement where a country formally pegs its
currency at a fixed rate to another currency or basket
of currencies.
Equatorial Guinea, Niger and the Republic of Congo
Fiji, Kuwait, Libya, Morocco and Samoa
EUR
Composite
Macedonia
Vietnam
EUR
Composite
Countries
Cambodia, Iraq, Lebanon and the Republic of Maldives
USD
Currency
Examples of countries which adopted a stabilized arrangement with the following as
the anchor currency:
The Bahamas, Bahrain, Eritrea, Jordan, Oman, Qatar,
Saudi Arabia, United Arab Emirates and Venezuela
Countries
USD
Currency
The Moroccan exchange rate regime is a conventional peg based on a basket of
currencies consisting of the euro and the U.S. dollar. The euro is given a weight of
80% while the U.S. dollar is given 20%. The allocation broadly reflects Morocco’s trade
flows.
Examples of countries which have adopted the convention pegs with the
following exchange rate anchors are:
Countries which have adopted a currency board mechanism with the euro as the
anchor are Bosnia, Bulgaria, Herzegovina and Lithuania.
Source: Hong Kong Monetary Authority
Under the currency board system, the stability of the Hong Kong dollar exchange
rate is maintained within a convertibility zone (7.75–7.85). The Hong Kong Monetary
Authority may intervene to preserve exchange rate stability.
US$
1
The Hong Kong dollar is officially linked to the U.S. dollar at the rate HK$7.8 to US$1.
The linked exchange rate system through a currency board mechanism requires the
monetary base to be fully backed by foreign reserves and any change in the monetary
base is to be fully matched by a corresponding change in foreign reserves.
A currency board mechanism is a hard exchange
rate peg regime where the domestic currency can be
issued only to the extent that it is fully covered by the
country’s central bank holdings of foreign exchange.
The key feature of the currency board regime
is that it is complemented by a minimum backing
requirement for the domestic money in a foreign
currency.
HK$
7.8
Examples
Details
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Classification
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Malaysia is an example of a country with an exchange rate policy that is classified
as other managed arrangement. The country follows a fixed rate arrangement
which does not have an explicitly stated nominal anchor for its monetary policy but it
monitors various economic indicators.
Other countries classified by the IMF as having a managed arrangement regime
are Bangladesh, Belarus, Malawi, Myanmar, Nigeria, Russia and Switzerland.
Other managed arrangement is a fixed rate regime
that cannot be classified under any of the above.
Singapore
Composite
Only one country, Tonga, is classified by the IMF to be following this regime.
Croatia
EUR
Pegged exchange rate within horizontal bands
is an exchange rate arrangement where the value
of a currency is maintained within certain margins of
fluctuation of at least positive or negative 1% around
a fixed central rate or a margin between the minimum
and maximum value of the exchange rate that
exceeds 2%.
Ethiopia, Jamaica and
Kazakhstan
Countries
USD
Currency
Countries which follow the crawl-like arrangement are:
Source: MAS, Financial Times
Singapore’s exchange rate regime is known as the ‘basket, band and crawl’ system.
Its currency is managed against a basket of currencies of its major trading partners
and competitors. It is allowed to fluctuate within an undisclosed policy band. The
Monetary Authority of Singapore (MAS) usually steps in if the exchange rate moves
outside the band. The exchange rate, therefore, floats within a set policy band which
lets the currency crawl up or down.
Crawl-like arrangement is an exchange rate
arrangement where the currency must remain within a
narrow margin of 2% relative to a statistically identified
trend for six months or more.
Examples
Countries which adopted the crawling peg arrangement are Botswana (composite)
and Nicaragua with the U.S. dollar as the anchor currency.
Details
Crawling peg arrangement is an arrangement where
the currency is adjusted in small amounts at a fixed
rate or in response to changes of selected indicators
such as inflation differentials.
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Chapter 9 Market Risk
–– Floating rate regimes
Floating rate regimes are characterized by foreign exchange rate regimes where the
market primarily determines the level of the exchange rates. There are two main
types of floating rate regimes:
§§ Pure floating rate regimes
§§ Floating rate regimes with discretionary intervention
Table 9.6 Classification of floating rate regimes
Classification
Details
Examples
Pure floating
rate regimes
ŸŸ In a pure floating regime, the
exchange rate is determined in
the market without any public
sector intervention or public sector
intervention is only done on a very
exceptional basis.
ŸŸ IMF classifies a country as a pure
floating rate regime if intervention
is limited only to at most three
instances in the previous six months
each lasting no more than three
business days.
ŸŸ The Canadian Dollar (CAD) is one of the
examples of currencies that are determined
on a pure floating rate basis. The exchange
rate is determined solely by the demand and
supply of the currency in the foreign exchange
market.
ŸŸ The Central Bank does not intervene in the
foreign exchange markets.
ŸŸ Other countries which adopted a free
floating approach are Australia, Chile, Czech
Republic, Israel, Japan, Mexico, Norway,
Sweden and United Kingdom.
Floating rate
regimes with
discretionary
intervention
ŸŸ In floating rate regimes with
discretionary intervention, the
exchange rates are also largely
market determined. However, the
authorities can and do intervene.
ŸŸ Philippine exchange rate is determined by
forces of supply and demand. The Bangko
Sentral ng Pilipinas (BSP) intervenes in the
foreign exchange market to temper sharp
fluctuations in the exchange rate.
ŸŸ Countries with floating rate regimes with
discretionary intervention are Brazil, Colombia,
Peru, Philippines, New Zealand, Romania,
South Africa, India, Mongolia, Pakistan,
Thailand, Turkey, Korea, Hungary, Iceland,
Papua New Guinea, Sri Lanka, Afghanistan,
Madagascar, Turkey and Uruguay.
Derivatives market
Derivatives markets facilitate the efficient transfer of risks by allowing market participants
to access different types of risk management products. Figure 9.6 illustrates how financial
markets help facilitate the efficient transfer of risk through the derivatives market by providing
hedging tools for market participants.
Farmers and
Producers
Hedge against
Falling Prices
Derivatives Markets Facilitate
Efficient Transfer of Risks
Hedge against
Falling Prices
Food
Manufacturers
Figure 9.6 Derivatives markets facilitate transfer of risk
Hedging is a risk management strategy used to limit or offset the amount or probability of
losses from fluctuations in the prices of interest rates, foreign exchange, commodities and
other financial variables.
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Using examples, Figure 9.6 shows how farmers or producers hedge their revenues against
falling agricultural prices while food manufacturing companies also use the derivatives market
to hedge their costs against rising agricultural prices.
9.2 DEFINITION OF MARKET RISK
LEARNING OBJECTIVE
9.2
DEFINE market risk
The Basel Committee on Banking Supervision defines market risk as the:
Risk of losses in on- and off-balance sheet positions arising from movements in market prices.
In other words, market risk is the risk of loss in the value of a bank’s financial instruments
due to changes in market conditions. Market risk affects the bank in two ways:
(a) Earnings. Market movements may affect the bank’s earnings due to unrealized or realized losses; and
(b) Economic or balance sheet value. The economic or balance sheet value of a bank’s assets and liabilities
may also be affected by changes in market rates.
Table 9.7 is an excerpt from the income statement of HSBC, a global bank. It can be seen
that income from trading and investment activities represents a significant portion of the
bank’s total operating income.
Table 9.7 HSBC income statement (2013)
Consolidated income statement for the year ended 31 December 2013
2013
US$m
2012
US$m
2011
US$m
Interest income
51,192
56,702
63,005
Interest expenses
(15,653)
(19,030)
(22,343)
Net interest income
35,539
37,672
40,662
Free income
19,973
20,149
21,497
Fee expense
(3,539)
(3,719)
(4,337)
Net fee income
16,434
16,430
17,160
Trading income excluding net interest income
6,643
4,408
3,283
Notes
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Chapter 9 Market Risk
2013
US$m
2012
US$m
2011
US$m
Net interest income on trading activities
2,047
2,683
3,223
Net trading income
8,690
7,091
6,506
Changes in fair value of long-term debt issued and related derivatives
(1,228)
(4,327)
4,161
Net income/(expense) from other financial instruments designated at
fair value
1,996
2,101
(722)
768
(2,226)
3,439
2,012
1,189
907
322
221
149
Notes
Net income/(expense) from financial instruments designated at fair
value
3
Gains less losses from financial investments
Dividend income
Net earned insurance premiums
4
11,940
13,044
12,872
Gains on disposal of US branch network, US cards business and Ping
An Insurance (Group) Company of China, Ltd. (‘Ping An’)
25
–
7,024
–
Other operating income
2,632
2,100
1,766
Total operating income
78,337
82,545
83,461
9.2.1
Trading Book versus Banking Book
From a regulatory perspective, a bank’s assets are divided into two different and distinct
categories—the banking book and trading book.
Assets that are classified in the trading book portfolio are generally those that are liquid and
easy to trade. These assets are required to be fair valued on a daily basis with changes in the fair
value being reflected in the profit or loss (P&L). On the other hand, assets that are classified in
the banking book portfolio are generally those that are less liquid and are intended to be held
on a longer-term horizon.
Based on current practices, the decision as to whether a financial instrument is classified in
the trading book or banking book is largely intent-based. The decision to classify a financial
instrument in the trading book depends on the bank’s self-determined and largely undefined
intent to hold the financial instrument:
(a) For short-term resale
(b) To benefit from short-term price movements
(c) To take advantage of locked-in arbitrage profits
Financial assets that are classified in the trading book should be valued on a daily basis
at readily available closed-out prices. This means that the financial instruments should be
valued at market prices. There is no specific guidance under Basel II on the types of financial
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instruments to be classified in the trading book. There are, however, some instruments which
may not be classified in the trading book due to the bank’s significant inability to liquidate
their positions and provide a reliable mark-to-market value. Examples of these instruments
are:
(a) Equity stakes in hedge funds
(b) Private equity investments
(c) Positions in securitization warehouse
(d) Real estate holdings
The banking book positions are intended to be held for long term or until maturity or for the
purpose of hedging other banking book positions. Daily valuation is not required for financial
instruments held in the banking book.
Given the uncertainty in the values of the financial instruments held in the banking book,
higher regulatory capital charges are often assigned for banking book exposures. This led
many market participants to choose to classify financial instruments under the trading book,
which attract lower capital charges. Trading intent as a criterion has proven to be inherently
subjective.
One of the Basel Committee’s intended reforms is to strengthen the objectivity in defining
the boundary between trading and banking books. The Basel Committee is proposing a revised
boundary approach that introduces more objective rules for determining the classification of
financial instruments under either the trading book or banking book.
9.2.2
Daily Valuation and Mark to Market
The Generally Accepted Accounting Principles (U.S. GAAP) provides a useful definition of
financial instruments. They are defined as:
(a) Cash
(b) Ownership interest in a company or other entity or
(c) A contract that does both of the following:
(i) Imposes on one entity a contractual obligation either to deliver cash or another financial instrument to
a second entity, or to exchange other financial instruments on potentially unfavourable terms with the
second entity (financial liability)
(ii) Conveys to that second entity a contractual right either to receive cash or other financial instrument from
the first entity, or to exchange other financial instruments on potentially favourable terms with the first
entity (financial asset)
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This definition is clearly illustrated in Figure 9.7.
Financial Liability
First Party
Financial Asset
Second Party
First Party
Second Party
Right to receive cash or
other financial instrument
from the first party or to
exchange other financial
instruments on potentially
favourable terms with the
first entity
Obligation to deliver cash or
another financial instrument
to the second party or to
exchange other financial
instruments on potentially
unfavourable terms with the
second party
Figure 9.7 Definition of financial instruments
A bank’s investment in debt securities is an example of a financial instrument. The
investment represents a right on the bank’s part to receive cash in the future—both the
interest and principal—from the issuer of the debt security. From the bank’s perspective,
this represents a financial asset. On the other hand, the issuer of a debt security has
contractual obligations to repay the interest and principal in the future to the holder
of the debt security. From the issuer’s perspective, this represents a financial liability.
Market risk arises when the value of the financial instrument deteriorates due to changes
in market conditions.
Financial instruments are measured in a banking organization’s balance sheet either at
historical cost or at fair value.
ŸŸHistorical cost
Financial instruments that are measured at historical cost are measured at the initial
acquisition costs throughout their lives. Changes in the value of a financial instrument
measured at historical cost have no impact to the bank as long as there is no objective
evidence of impairment in the value of the financial instrument.
ŸŸFair value
Financial instruments that are measured at fair value are also measured at the initial
acquisition costs at inception. However, unlike the historical-cost accounting, the fair
values of these financial instruments are measured periodically—usually at each financial
reporting period or daily. Changes in fair value may impact a bank’s profit or loss (P&L)
or equity.
The process of periodically measuring the fair value based on current market prices
is called the mark-to-market process. The objective is to have a realistic appraisal of the
financial instrument’s value on a regular basis. The distinction between the historical
cost and fair value approaches is illustrated below.
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Illustrative Example
Mark to Market
Bank XYZ purchased an investment in the debt securities of JLN Corporation at $100. At the end
of the year, the investment in the debt securities traded lower at $80.
Discuss the different implications if Bank XYZ accounts for the investment at
(a)
(b)
historical cost
fair value
Solution:
(a)
If accounted for at historical cost, the investment in the debt securities will be reflected in
the balance sheet as a financial asset with an initial value of $100. Throughout the life of the
investment, it will be reflected at $100, unless the asset is impaired. Hence, the change in
fair value to $80 has no impact.
(b)
If accounted for at fair value, the investment in the debt securities will be reflected in the
balance sheet as a financial asset with an initial value of $100. However, the asset’s value
is re-appraised on a periodic basis through the mark-to-market process. Hence, at the end
of the year, the value of the investment is decreased from $100 to $80.
The $20 decrease (i.e. $100 – $20) is reflected as a loss on the value of the investment and
will affect Bank XYZ’s profitability.
9.3 TYPES OF MARKET RISKS
LEARNING OBJECTIVE
9.3
ENUMERATE the different types of market risk exposures
Banking organizations face four different types of market risk exposures:
(a) Foreign exchange risk
(b) Interest rate risk
(c) Equity price risk
(d) Commodity price risk
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9.3.1
Foreign Exchange Risk
Foreign exchange risk is the exposure of a bank’s earnings and financial condition to
fluctuations in exchange rates. The foreign exchange market helps facilitate international trade
and investment by allowing the conversion of one currency to another. The foreign exchange
rate is the price of one currency expressed in terms of another currency. A spot transaction is a
straightforward purchase or sale of one currency against another.
Foreign Exchange Gains and Losses
Foreign exchange gain or loss is the difference between the buying and selling rates of the
foreign exchange. Exchange differences arise from translating a given number of units of one
currency into another currency at different exchange rates. Foreign exchange gains/losses are
calculated based on the difference in the number of units between the sales proceeds (purchase
cost) and the actual spot rate as of the transaction date.
Assume that ABC Corporation bought US$10,000,000 at US$/MYR3.3. Assuming that
ABC Corporation was able to sell the US$ at US$/MYR3.0, calculate the foreign exchange
gains or losses from the foreign exchange transaction.
Solution:
MYR profit (loss) = Sales Proceeds – Purchase Cost
= (10,000,000 × 3.0) – (10,000,000 × 3.3)
= 30,000,000 – 33,000,000
= (MYR3,000,000)
There is a loss of MYR0.3 for every US$1 exposure as a result of the strengthening of the
MYR against the US$. This is equivalent to an absolute loss of MYR3,000,000.
For financial statement purposes, an entity needs to establish its functional currency.
Functional currency is the currency of the primary economic environment in which the entity
operates. The primary economic environment where an entity operates is normally the one in
which it primarily generates and expends cash.
Exchange differences arising from settlement of monetary items or on translating monetary
items at rates different from those at which they are translated on initial recognition during the
period or in previous financial statements shall be recognized in the profit and loss statement
during the period in which they arose.
The results and financial position of an entity whose functional currency shall be translated
into a different presentation currency is possible by using the following:
ŸŸAsset and liabilities—closing rate on the date of the statement of financial position
ŸŸIncome and expenses—exchange rates on the dates of the transactions
Foreign exchange risk can be classified into three types, i.e. transaction risk, business risk
and translation risk.
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(a) Transaction risk
Foreign exchange transaction risk arises from the impact of exchange rates on foreign currencydenominated receivables and payables. Transaction risk arises from the difference between the
price at which the receivables are collected or the payables are paid and the price at which they
are recognized in the bank’s financial statements.
Illustrative Example
Transaction Risk
Bank DEF is a bank with its functional currency denominated in MYR. Bank DEF has a US$denominated payable of $20,000,000 which is payable after one year. The spot exchange rate
as of the date of transaction was US$/MYR3.3. After one year, the US$/MYR weakened to 3.5.
Demonstrate how the fluctuation in exchange rates affected Bank DEF’s position.
Solution:
At the start of the transaction, Bank DEF (functional currency—MYR) has recognized a financial
obligation to pay MYR66 million (= $20,000,000 × spot exchange rate of 3.3).
After one year, the US$/MYR weakened to 3.5. This means that Bank DEF will need to buy
US$20,000,000 at a rate of US$/MYR3.5. The total cash that Bank DEF needs to pay will be
equal to MYR70 million.
The difference between the amount that Bank DEF actually paid—MYR70 million—and the
amount of payable initially recognized in the financial statements—MYR66 million—is referred to
as the foreign exchange transaction risk on the part of Bank DEF.
(b) Business risk
Business risk arises from the impact of exchange rates on a country’s or a company’s long-term
competitive position.
(c) Translation risk
Foreign exchange translation risk or revaluation risk is the risk brought about by changes in
the reported domestic currency accounting results of foreign operations due to changes in
foreign exchange rates. It is the risk that adverse developments in the exchange rates could
affect the value of an entity’s foreign currency-denominated assets or liabilities.
Illustrative Example
Maximum Amount of Exposure to Credit Risk Exposure
The Group is exposed to two sources of foreign exchange risk.
(a)
Transactional foreign exchange exposure
Transactional foreign exchange exposures represent exposures on banking assets and
liabilities, denominated in currencies other than the functional currency of the transacting
entity. The Group’s risk management policies prevent the holding of significant open
positions in foreign currencies outside the trading portfolio managed by Barclays Capital
which is monitored through DVaR.
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There were no material net transactional foreign currency exposures outside the trading
portfolio at either 31 December 2011 or 2010. Due to the low level of non-trading exposures
no reasonably possible change in foreign exchange rates would have a material effect on
either the Group’s profit or movements in equity for the year ended 31 December 2011 or
2010.
(b) Translational foreign exchange exposure
The Group’s investments in overseas subsidiaries and branches create capital resources
denominated in foreign currencies principally US$, Euro and South African Rand. Changes
in the Sterling value of the investments due to foreign currency movements are captured in
the currency translation reserve, resulting in a movement in Core Tier 1 capital.
During 2011, total structural currency exposures net of hedging instruments increased from
£15.3bn to £16.7bn, driven by the redemption of US$2bn Reserve Capital Instruments that
formed part of the economic hedges. Structural currency exposures pre-economic hedges
remained broadly flat. US$ exposures increased by US$8bn due to the restructuring of
our holding in BlackRock, Inc from a GBP entity to a US$ entity, offset by the increase in
US$ derivatives which hedge net investments. South African Rand exposures increased
£1.1bn as a result of a reduction in the hedging of the investment in Absa Group. Euro
exposures reduced by £0.8bn driven by the Spain goodwill write off, which had no impact
on Euro-denominated Core Tier 1 capital as goodwill is deducted for regulatory capital
purposes.
Source: Annual Report 2012, Barclays Capital
Banks may be exposed to foreign exchange risk in an indirect manner. A bank may be
exposed to foreign exchange risk even if it does not have any foreign currency denominatedassets or liabilities; an adverse movement in the foreign exchange rates could result in losses
to the bank. For example, the bank extends a loan facility to an exporter; a strengthening of
the domicile currency may weaken the exporter’s capability to pay its obligations to the bank.
Hence, the bank is exposed to additional credit risk.
9.3.2
Interest Rate Risk
Interest rate risk is the exposure of a bank’s earnings and financial condition to adverse
movements in interest rates. Interest rate risk can be subdivided into traded interest rate risk and
interest rate risk in the banking book.
(a) Traded interest rate risk
Traded interest rate risk arises from a bank’s position in debt securities. The value of the debt
securities is highly sensitive to changes in interest rates.
(b) Interest rate risk in the banking book (or gap risk)
Interest rate risk exists due to mismatched maturity positions of a bank’s assets and liabilities.
A typical bank normally sources its funding requirements from deposits. It then lends the
funds to corporations or borrowers. While deposits are typically very short term in nature,
lending is long term in nature.
This mismatch between the tenor of a bank’s deposit liabilities (short term) and its lending
assets (long term) is also referred to as a negative gap exposure. A negative gap exposure exists
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when the liability is of a shorter tenor than the asset. Figure 9.8 illustrates the maturity
mismatch.
Maturity Mismatch
DEPOSITORS
Short Term
BORROWERS
Long Term
Figure 9.8 Maturity mismatch
This mismatch creates an interest rate risk exposure. As interest rates increase, the bank’s
cost of funds—from deposits—increases as it replaces the maturing deposits. On the other
hand, the bank cannot adjust its interest income from its lending activities which will mature
on a longer-term basis.
Interest Rates and Bond Prices
Market interest rates and bond prices generally move in an inverse manner. Figure 9.9
illustrates the inverse relationship between market interest rates and bond prices. As market
interest rates increase, bond prices fall. Conversely, as market interest rates decrease, bond
prices rise. This means that as interest rates increase, the bank’s holdings in debt securities
decline in value.
Bond prices
decrease
Interest rates
increase
Interest rates
decrease
Bond prices
increase
Figure 9.9 Interest rates and bond prices—inverse relationship
Interest rate risk can be measured by quantifying the potential impact on the market value
of the position if interest rates move adversely. Potential losses from interest rate risk can be
quantified by taking the value of the position after an adverse interest rate scenario and its
current market value.
Interest rate risk arises primarily from debt securities. Debt securities are issued by an entity,
which represents a financial obligation that must be repaid on a specified maturity date at a
specified interest rate.
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Real World Illustration
Interest Rate Risk from QE Taper
The U.S. Federal Reserve Bank (the Fed), in an effort to contain the 2008 financial crisis,
implemented unprecedented monetary stimulus measures to ease liquidity and credit conditions
in the market. The unprecedented measures are collectively referred to as quantitative easing
(QE).
Quantitative easing entails massive asset purchases by the Fed to give cash to the banks. The
Fed is committed to keep interest rates near zero until the unemployment rate falls below a
certain target.
As interest rates are near zero and the banking system is flooded with cash, the banks would
either lend money to their clients or invest the excess cash in risky assets. Consequently, risky
assets rallied in prices (interest rates are low).
On 22 May 2013, Federal Reserve Chairman Ben Bernanke hinted that the unexpected recovery
in the U.S. economy could prompt the Fed to gradually unwind or withdraw the unprecedented
monetary stimulus. This would mean that the era of cheap money would be over. This move to
withdraw the monetary stimulus is frequently referred to as the QE taper.
The Federal Reserve will taper the quantitative easing measures by slowing down or cutting
its bond purchase programme, which will result in a decline in the prices of bonds. Banks will
face tighter liquidity as a significant source of liquidity—arising from the quantitative easing
measures—is being wound down. Scarce liquidity will result in higher interest rates.
This is why market participants, especially those in the bond markets, are wary of the unexpected
QE tapering.
9.3.3
Equity Price Risk
Equity price risk is the exposure of a bank’s earnings and financial condition to adverse
movements in equity indices and individual equity prices. There are two main aspects of equity
price risk—systematic risk and non-systematic risk.
(a) Systematic risk
Systematic risk or beta risk is the risk associated with the market and cannot be diversified
away. It is measured by a statistical measure called beta. This is a measure of an asset’s risk in
relation to the market, e.g. KLSE. It measures the degree to which an equity security fluctuates
in relation to the general market. The higher the beta, the more volatile the stock is and,
therefore, the riskier the stock.
Stocks with beta of less than one are generally considered to be less volatile than the
general market. They are generally referred to as defensive stocks or countercyclical stocks. The
performance of defensive stocks is generally seen as not highly correlated to the performance
of the general market and general economy. These stocks tend to remain stable even during
economic recessions. Some common examples of defensive stocks are utility stocks and food
manufacturing stocks. Utilities and food are considered to be essential, regardless of the
economic cycle.
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Stocks with a beta equals one are generally considered to be as volatile as the market. They
generally move in tandem with the general market. On the other hand, stocks with a beta
greater than one are generally considered to be more volatile than the general market. They
are referred to as cyclical stocks. They tend to display higher risk than the general market and also
offer higher potential return. Some examples of stocks with a high beta are high technology
stocks, consumer discretionary (non-essential) stocks and luxury stocks.
Table 9.8 Interpreting an investment’s beta
Beta Value
Interpretation
Examples
Beta <1
Equity security is less volatile than
the general market.
Utility industry stocks
Beta = 1
Equity security moves in conjunction
with the general market.
Equity indices that replicate the performance of the
general equity benchmark index, e.g. funds replicating the
performance of the S&P 500
Beta >1
Equity security is more volatile than
the general market.
High technology stocks, retail industry stocks, consumer
discretionary stocks, manufacturing stocks, small
capitalization companies, biotechnology companies
(b) Non-systematic risk
Non-systematic risks or specific risks are firm-specific risks that can be eliminated by
diversification. Examples are:
(i) Adverse industry developments
(ii) Negative news on a specific company
(iii) Labour problems
(iv) Weather disturbance in the primary place of operation
9.3.4
Commodity Price Risk
Commodity price risk is the exposure of a bank’s earnings and financial condition to fluctuations
in commodity prices. Commodities can be classified into hard commodities and soft commodities.
(a) Hard commodities
Hard commodities generally refer to energy, industrial metals and precious metals commodities.
They are generally storable and not perishable by nature. Examples are:
(i) Energy—crude oil, coal, jet fuel, gas, heating oil
(ii) Industrial metals—aluminum, copper, lead, mercury, nickel, zinc
(iii) Precious metals—gold, silver, platinum
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(b) Soft commodities
Soft commodities generally refer to agricultural commodities that are weather dependent and
perishable in nature. Examples are:
(i) Livestock—live cattle, live hogs, pork bellies
(ii) ‘Softs’—coffee, cocoa, cotton, orange juice, rubber, sugar, milk
(iii) Grains and seeds—barley, corn, canola, rice, soybeans
Price risk from commodities arises from two main components of commodity prices—
adverse movements in spot prices of commodities and investment demand.
Adverse movements in spot prices of commodities
Spot prices of commodities are generally driven by supply and demand factors. Spot prices of
different commodities are influenced by different factors.
ŸŸGold
The balance of supply and demand plays a less important role in gold prices. This is
because gold is not a perishable commodity and has a huge above-ground supplies—
174,100 tonnes as of end 2012. This indicates that an increase in demand can be met by
the large inventory held above ground.
mm
Demand factors
–– Investment. Since 2003, investment has represented the strongest source of growth
in demand for gold. One of the strongest reasons for investment demand is that
gold is perceived as a hedge against instability.
–– Exchange-traded funds. Gold exchange-traded funds (ETFs) are investment products
designed to provide investors with exposure to the price performance of gold
without the necessity of taking physical delivery of the commodity. These funds
have increased the appeal and accessibility of gold as an investment.
–– Central banks and governments. Central banks are one of the key players in the
gold market. As of end 2012, central banks held one-fifth of the global aboveground stocks of gold as reserve assets. On average, governments hold 15% of
their official reserves in gold. In 2009 and 2010, central banks and governments
were net buyers of gold—for the first time in 21 years—from the private sector
markets.
–– Technology. Gold has wide electronic, industrial, medical and dental applications.
Technological demand accounted for 11% of the gold demand as of end 2012.
–– Jewellery demand. Jewellery is the largest component of gold demand. The demand
is directly driven by consumers’ ability to spend more for gold. Gold demand rises
during periods of price stability or gradual rising of gold prices and declines during
periods of price instability. India and China continue to be the world’s largest
consumer of gold.
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Investment* (1,483 t) 36.3%
Technology (439 t) 10.8%
Jewellery (2,002 t) 49.0%
Central bank net purchases (160 t) 3.9%
Sources: Thomson Reuters GFMS, World Gold Council
*Investment excludes OTC investment and other stock flows
Figure 9.10 Gold demand trends—five-year average (2008–2012)
mm
Supply factors
–– Mine production. Gold is produced from several hundred gold mines around
the world. Supply from mine production has been relatively stable at around
2,690 tonnes per year over the last five years. Most of the time, new mines are
developed to replace current production rather than expand production levels.
Gold production does not respond quickly to a change in price outlook due to the
long 10-year lead time for production.
–– Recycled gold. Recycled gold is a potential source of readily-available supply when
needed. For the period 2008–2012, recycled gold contributed an average 39% to the
annual supply flows.
Mine production* (2,547 t) 61.4%
Recycled gold (1,600 t) 38.6%
Sources: Thomson Reuters GFMS, World Gold Council
*Net of producer hedging
Figure 9.11 Gold supply trends—five-year average (2008–2012)
ŸŸOil
Oil spot prices are driven by many factors. These drivers can be classified into macroeconomic
factors, political risk, supply chain consideration and investment demand.
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mm
Macroeconomic factors
Strong economic indicators, e.g. strong GDP, that signal increased economic activities
could drive oil prices higher. Increased economic activities indicate stronger future
demand for oil. Weak indicators, on the other hand, that signal decreased economic
activities could drive oil prices lower. Decreased economic activities indicate weaker
future demand for oil. Figure 9.12 illustrates this point. Note that oil consumption—
depicted by the bar graph—generally increases during periods when the GDP—depicted
by the line graph—increases, and vice versa.
per cent change (year-on-year)
14
Forecast
12
10
8
6
4
2
0
–2
–4
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
2013
2014
non-OECD liquid fuels consumption
non-OECD GDP
Sources: EIA Short-Term Energy Outlook, Thomson Reuters
Figure 9.12 Impact of economic growth on oil consumption
Political risk
Crude oil prices are affected by events that have the potentials to disrupt the flow of
oil products to the markets. These events create uncertainties over future oil supply
and demand, which can lead to higher price volatility, especially over the short run.
Crude oil prices react to several geopolitical and economic events. Figure 9.13
illustrates this point. Market participants are constantly assessing the possibility of
future disruptions and their potential impact. However, their influence tends to be
relatively short-lived.
mm Supply chain consideration
Crude oil is a finite resource. The available oil reserves, therefore, would have a significant
impact on oil prices. There are many differing definitions of oil reserves, which refer to
quantities available for production plus those that will become available within a certain
time frame through additional oil fields coming on stream, technological advances or
exploration.
mm
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price per barrel
(real 2010 dollars, quarterly average)
140
Global financial collapse
120
Iran-Iraq war
100
Low spare
capacity
80
Saudis abandon
swing producer role
U.S. spare
60
capacity
exhausted
9-11 attacks
Asian financial crisis
40
OPEC cuts targets
4.2 mmbpd
Iranian
revolution
20
0
1970
1975
1980
OPEC cuts targets
1.7 mmbpd
Iraq invades Kuwait
Arab oil embargo
1985
1990
1995
2000
2005
2010
imported refiner acquisition cost of crude oil
WTI crude oil price
Sources: U.S. Energy Information Administration, Thomson Reuters
Figure 9.13 Crude oil prices react to geopolitical and economic events
Crude oil production by the Organization of Petroleum Exporting Countries
(OPEC) is an important factor that affects oil prices. OPEC manages oil production
by seeking production targets which often act to balance the oil market. Historically,
oil prices tend to increase when the OPEC targets are reduced.
million barrels per day change (year-on-year)
6
per cent change (year-on-year)
150
4
100
2
50
0
0
–2
–50
–4
–100
–150
–6
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
2013
OPEC production targets
WTI crude oil price
Sources: U.S. Energy Information Administration, Thomson Reuters, 30 September 2013
Figure 9.14 Changes in OPEC production and crude oil prices
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In the 1970s, a popular theory called the peak oil theory had a significant influence
on crude oil prices. This theory contends that global conventional sources of crude
oil have reached, or about to reach, the maximum capacity by the mid-21st century. It
predicts that supply shortfalls could then lead to an oil price inflation.
The theory, however, applies only in respect of conventional oil sources and not to
non-conventional sources. According to the International Energy Agency (IEA), the
U.S. will surpass Saudi Arabia and Russia as the world’s largest oil producer by 2016.
This is because of a new technology the U.S. uses in extracting shale oil. Rich oilshale deposits are extracted using the horizontal drilling and hydraulic fracturing
processes. The EIA estimates that the U.S. production will reach 4.8 million barrels
per day by 2021.
mm
Investment demand
A growing number of investors have gained exposures to commodities through
investing in index funds that provide exposures to a basket of commodities. These
funds usually hold shares in various energy companies and commodities. Figure 9.15
illustrates the relationship between investment flows to commodity index funds and
commodity prices. Commodity index investment flows tend to move together with
commodity prices.
Commodity Index Assets under Management and Dow Jones Index Level
per cent change (year-on-year)
200
150
100
50
0
–50
–100
2006
2007
2008
2009
2010
2011
2012
2013
Dow Jones UBS commodity price index
assets under management (Five largest public U.S. commodity index funds)
commodity index assets under management reported to CFTC under ‘special call’
Sources: U.S. Commodity Futures Trading Commission (CFTC), Bloomberg
Published by: U.S. Energy Information Administration
Updated: Quarterly | Last updated: 30 September 2013
Figure 9.15 Oil prices and investment flows
Increased trading activities in commodity index funds are believed to have a
significant impact on energy prices. In one of the popular commodity index funds—the
Dow Jones UBS Commodity Index—energy commodities accounted for about one-third
of the 2013 target weights in the Index. Crude oil comprises 15% of the Index. Figure 9.16
shows the composition of the Dow Jones UBS Commodity Index. Note that crude oil
(WTI plus Brent) comprises 15% of the total allocation.
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Composition of the Dow Jones UBS Commodity Index 2013 Target Weights
Lean hogs: 1.9%
Live cattle: 3.3%
Nickel: 2.2%
Crude oil: WTI: 9.2%
Zinc: 2.5%
Crude oil: Brent: 5.8%
Silver: 3.9%
Aluminum: 4.9%
Natural gas: 10.4%
Copper: 7.3%
Heating oil: 3.5%
Gasoline: 3.5%
Gold: 10.8%
Corn: 7.0%
Cotton: 1.8%
Coffee: 2.4%
Soy meal: 2.6%
Soybean oil: 2.7%
Soybeans: 5.5%
Wheat: 4.8%
Sugar: 3.9%
Sources: Dow Jones Indexes, CME Group
Published by: U.S. Energy Information Administration
Updated: Annually | Last updated: 2013
Figure 9.16 Oil prices and investment flows
Many commodities—particularly gold and crude oil—are denominated in the U.S.
dollar. The U.S. dollar will, therefore, have an impact on commodity prices. There is
typically an inverse relationship between commodities and the U.S. dollar. This means
that when the U.S. dollar strengthens, prices of commodities typically drop. When the
value of the dollar increases, commodities buyers will have less purchasing power—
relative to their domestic currencies—thus, resulting in lower demands that will cause
a drop in commodity prices.
When the U.S. dollar weakens, prices of commodities typically rise. Given the lower
value of the U.S. dollar, commodities buyers will have more purchasing power—relative
to their domestic currencies—and the increased demand will result in an increase in
commodity prices.
9.4 MARKET RISK MANAGEMENT PROCESS
LEARNING OBJECTIVE
9.4
DISCUSS the basic market risk management process
The market risk management process is a continuous cycle of identification, assessment and
measurement, mitigation and control, and monitoring and reporting of all market risk exposures.
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Identification
Assessment and
measurement
Monitoring and
reporting
Mitigation and
control
Figure 9.17 Risk management process—a continuous cycle
9.4.1
Market Risk Identification
Market risk identification is usually the first step in the market risk management process. The
objective is to identify and enumerate all sources and types of market risk exposures arising from
every banking products and services.
Another important objective in this phase is the proper classification of financial
instruments in the trading or banking book. Based on current practices, financial instruments
that are held in trading books are usually liquid assets that are held for short-term profittaking. Financial instruments that are less liquid are held in the banking book.
In the trading book, market risks are categorized and classified under interest rate, equity,
foreign exchange or commodity. For each risk category, primary and secondary risk factors
are identified. The key output of the market risk identification phase is the identification and
selection of key market risk factors.
9.4.2
Market Risk Assessment
The next step in the market risk management process is the quantification or measurement
of risks. Quantification is an important prerequisite to risk management. As quality guru,
W. Edwards Deming once said, “You can’t manage what you can’t measure.”
Market risk assessment and measurement could be one of the most complex activities in
the market risk management process. The objective of this process is to generate potential
loss forecasts that are expressed in terms of severity and probability. Severity is the expected
magnitude of loss. Probability is the likelihood of loss.
A comprehensive suite of market risk measures should be used. Each tool serves different
purposes and is designed to complement each other. This will be discussed in more detail in
the succeeding chapter on market risk assessment and measurement.
Notional
exposure
Sensitivity
measures
Probabilistic/
statistical
measures
Scenario/
analysis
stress testing
Figure 9.18 Suite of market risk measurement tools
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Nominal or notional exposure
The use of the nominal or principal exposure as the basis for estimating market risk has been
one of the earliest and crudest forms of market risk estimation. Notional exposure is one of
the simplest ways of estimating market risk exposures. It involves using the face amount of the
transaction as the basis for quantifying risk.
Illustrative Example
Maximum Amount of Exposure to Credit Risk Exposure
Bank RST has a trading portfolio comprising the following:
ŸŸ $100 million investment in bonds
ŸŸ $50 million investment in commodities
ŸŸ $20 million holdings in gold bullion
ŸŸ $50 million equivalent of EUR cash
Determine Bank RST’s market risk exposure using the notional amount approach.
Solution:
The notional exposure is simply the additive value of each of the notional or principal exposures
to each asset type.
Investment in bonds
US$100,000,000
Investment in commodities
US$50,000,000
Holdings in gold bullion
US$20,000,000
EUR cash
US$50,000,000
Total notional exposure
US$220,000,000
The use of notional exposure as a market risk exposure is simple and straightforward but has
several disadvantages:
1. The use of nominal exposure does not distinguish between assets that have lower volatility
and those with higher volatility. It does not recognize that different assets have different
volatility. It assumes that a $10,000,000 investment in a low-volatility asset—therefore, a
low-risk asset—is as risky as a $10,000,000 investment in a high-volatility asset.
2. Nominal exposure does not recognize an exposure’s market value. Two investments
with nominal amount of $10,000,000 are treated similarly even if investment 1 (market
value—$40,000,000) is trading twice as high as investment 2 (market value—$20,000,000).
3. The use of nominal exposure does not take into consideration that different asset classes tend
to move positively or negatively against each other. Correlation measures the relationship
between different asset classes.
A strongly correlated relationship means that two assets tend to move in tandem with each
other. This means that if Asset 1 increases in value by 20%, a strongly correlated Asset 2 will
also increase in value by close to 20%.
Assets that have a low correlation tend to display a weak relationship between two assets.
This means that the two assets do not perform in the same way. If Asset 1 increases in value
by 20%, Asset 2 will increase in value by less than 20%.
Assets that have a low correlation against each other tend to have lower risks from a
portfolio perspective. This is because a poor performance in one investment can be offset by
a good performance of the other. This provides diversification benefits to the investor.
The problem with the use of nominal exposure is that it treats assets with a high correlation
against each other similarly as assets with a low correlation against each other. For example,
Bank XYZ has a $10,000,000 investment in Asset 1 and $10,000,000 investment in Asset 2
which is highly correlated to Asset 1. The nominal exposure is equal to $20,000,000.
Even if Asset 3 has a low correlation with Asset 1, a $10,000,000 investment each in Asset
1 and Asset 3 (low correlation) will have a notional exposure equal to $20,000,000. The use
of nominal exposure does not take into consideration that certain positions tend to cancel out
each other.
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Chapter 9 Market Risk
Sensitivity measures
The limitations of nominal exposure as a market risk measurement tool led to the use of
more sophisticated tools. Sensitivity measures calculate the potential loss due to adverse
movements in a single risk factor. The risk factor is a measurable variable that affects the value
of a financial asset, e.g. fixed income and currency. Sensitivity measures reflect the cause (risk
factor) and its adverse impact on the bank’s earnings.
Fixed
income
Interest
rates
Equity
Beta
Figure 9.19 Asset class and risk factor
Figure 9.19 exemplifies the relationship between an asset class and a risk factor. The value
of a fixed income or equity instrument is affected by movements in a risk factor—interest rates
and beta. There are three market risk sensitivity measures commonly used in practice:
ŸŸDuration
ŸŸBeta
ŸŸGreeks
Probabilistic/Statistical measures (value at risk)
Probabilistic measures of market risk provide a statistical estimate of potential losses, given
a confidence level and time horizon. Probabilistic measures are the most sophisticated risk
measures of market risk. Value at risk (VAR) is one of the most commonly-used probabilistic
measures of market risk. VAR is a widely-used model. In fact, even Basel II uses VAR as a basis
for setting the regulatory capital.
ŸŸHistory of VAR
The development of VAR as a statistical measure of a portfolio’s losses was credited to
J.P. Morgan. As a large commercial bank with diverse and complex exposures to various
securities, it needed a tool to measure and summarize all its risk exposures into a single
measure.
Sir Dennis Weatherstone, the chairman of J.P. Morgan, asked his staff to produce a
concise summary of the bank’s risk at the end of each trading day. It started with the
question—“How much can we lose on our trading portfolio by tomorrow’s close?” This
report is popularly known as the ‘4:15 Report’.
J.P. Morgan developed a firm-wide value-at-risk system that modelled several hundred
key risk factors. Each day, trading units would e-mail their risk positions with respect to
each key risk factor. These were aggregated to express the portfolio’s risk factors as a single
statistical measure.
With the VAR measure, J.P. Morgan replaced the crude system of notional market risk
limit with a system of VAR limits. Starting 1990, the VAR numbers were combined with
the P&L’s in a report for its daily ‘4:15 PM’ treasury meeting in New York. These reports
were then forwarded to Weatherstone. The use of VAR became prevalent, in part, when
J.P. Morgan decided in May 1995 to make its proprietary RiskMetrics publicly available.
ŸŸDefinition of VAR
VAR is a single, summary statistical measure of possible portfolio losses due to normal
market events. VAR captures the potential losses from market risk that can occur over
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a time interval given a certain confidence level. For example, if the VAR on an asset is
US$10,000,000 at a 10-day, 95% confidence level, there is only a 5% chance that the
value of the asset will drop by more than US$10,000,000 over a 10-day period. The VAR
is, therefore, the maximum loss for any 10-day period 95% of the time.
It is important to note the following three key considerations in the VAR
interpretation:
VAR is not an absolute measure of risk
The most common error is that the VAR is frequently misinterpreted as an absolute
maximum measure of loss. An important element that is missed in this interpretation
is that the VAR is a probabilistic/statistical measure. This means that the VAR statistics
should be interpreted with a confidence level (e.g. 95% confidence level) as part of the
interpretation.
mm VAR covers only normal market scenarios
VAR covers only potential losses arising from normal market losses. It does not answer
the ‘worst-case scenario’. VAR has received many criticisms for failing to anticipate the
2008 global financial crisis. While many of the criticisms against the VAR are not without
merit, it should be recalled that VAR measures potential maximum losses under normal
market conditions. It does not measure losses in black swan market events. VAR relies
heavily on assumed statistical distributions. The most common distribution used is
either the distribution of recent historical returns or normal distribution.
The term ‘black swan’ event was coined by Nassim Nicolas Taleb, one of the
most prominent critics of the VAR. It refers to events that are highly improbable or
unpredictable but can cause massive adverse consequences when they occur. Such
events are not captured by the VAR approach.
mm VAR applies only to a specific time horizon
VAR applies only to a selected time horizon. A calculated 10-day VAR should
apply only over the 10-day time horizon. A common misinterpretation is that the
calculated 10-day VAR is the absolute maximum loss at any time. This is an erroneous
interpretation. VAR cannot be viewed as an open-ended number.
mm
Stress testing/Scenario analysis
VAR is a statistical tool that measures the maximum loss assuming a holding period and a
given confidence level. Extreme losses beyond the confidence level are not captured.
Complementing the use of VAR with stress testing will provide information on the extreme
losses beyond the confidence level. VAR also provides a maximum loss measure that is based on
normal market conditions. Stress testing assesses potential losses based on breaks in normal
market conditions. VAR assumes that changes in risk factors are normally distributed. Stress
testing estimates extreme losses that may not be captured by the normal distribution assumption.
9.4.3
Market Risk Control
The objective of market risk control and mitigation step is to ensure that market risk exposures
are managed appropriately. It aims to ensure that proper response is made when risk limits are
exceeded. The two main components of market risk control and mitigation are:
ŸŸMarket risk limits
A well-designed market risk limit system is one of the key mechanisms for market risk
control and mitigation. Limits can be set on various risk measures:
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Chapter 9 Market Risk
Exposures
Sensitivity
mm Probabilistic/Statistical measures
mm Potential loss
mm Actual loss
mm
mm
ŸŸNew product approval
Developing and launching a new product should undergo a special process, namely the
new product approval process. This process covers the following situations:
mm New products or services
mm Significant changes in the features of existing products
mm Significant differences in new market segments where existing products are to be offered
mm New processes
9.4.4
Market Risk Monitoring and Reporting
The objective of the market risk monitoring and reporting phase is to ensure that information
is effectively prioritized and escalated to the bank’s key decision-makers.
ŸŸOrganizational responsibilities
mm Board of directors
The board of directors is primarily responsible for setting market risk policies,
strategies and objectives. At a minimum, the market risk policy should contain:
–– Roles and responsibilities of the board and senior management with regard to
market risk management
–– Organizational structure with roles and responsibilities for market risk management.
It should also enumerate the roles and responsibilities of the risk-taking unit, the
market risk management division and the back office. The organizational structure
should match the nature, scale, complexity and risk profile of the bank.
–– Policies on market risk limits
–– Policy on market risk identification, assessment, monitoring and mitigation of
market risks
The board should set the market risk appetite and ensure that it is reflected in the
bank’s business strategy and cascaded throughout the entity. It should also establish
and oversee an effective market risk governance structure and organizational structure
that complies with legal and regulatory requirements.
mm Board risk committee
The board may choose to perform its risk oversight responsibilities through a
dedicated group—the board risk committee. This committee’s responsibilities are:
–– Make recommendations regarding market risk appetite
–– Conduct period reviews of the bank’s market risk profile
–– Review strategic decisions and market risk consequences
–– Approve market risk policies, limits and delegations
–– Consider key market risk issues
–– Review market risk strategies, policies and controls
mm Market risk management function
There should be an independent market risk management function that is primarily
responsible for implementing the risk control framework on market risk. Its function
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should be adequately segregated and independent of the risk-taking functions within
the organization.
Staffing levels within the market risk management department should be
adequate to support its mandate. The market risk management function bears the
primary responsibility, together with the relevant risk-taking units, for assessing and
controlling market risk.
The market risk function should:
–– Independently collect and analyze information needed for market risk assessment
–– Implement and review market risk measurement methodologies
–– Estimate market risk levels
–– Prepare independent analysis to assist the board risk committee, the asset and
liability management committee, and other risk-related committees in developing
market risk policies and setting market risk limits
CONCLUSION
This chapter provided an important background on the role of financial markets in the
economy and in the business of banking. The different types of financial markets according to
the roles they play are then discussed. After which, market risk was defined according to the
different sources of market risks—interest rate risk, foreign exchange risk, equity price risk and
commodity price risk. The chapter ended with an overview of the market risk management
process.
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10
C
P
HA
TE
R
LIQUIDITY RISK
Before the 2008 global financial crisis, liquidity risk had received less attention than the
other major banking risks. The focus of international risk regulation had been on the
banks’ long-term solvency. Hence, the focus had been to set minimum capital standards
to cover for market, credit and operational risks.
An important lesson learned from the 2008 financial crisis is that despite many
banking organizations—such as Bear Stearns, Lehman Brothers and Northern Rock—
being adequately capitalized, they ceased to exist as going concerns when confronted
with a liquidity crisis. The financial crisis highlighted the importance of establishing
strong liquidity risk management standards to ensure short-term survival. It appeared
that focusing on long-term solvency was a necessary but not sufficient condition for
organizational survival. As the eminent economist, John Maynard Keynes once said, “In
the long run, we are all dead.” Indeed, for banks to survive it is no longer sufficient to
think about long-term solvency (capital) but also to ensure their ability to withstand
short-term shocks (liquidity).
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This chapter begins by discussing the role of liquidity risk management in the asset and
liability management (ALM) process and then the role of liquidity risk in the banking context.
This is followed by enumerating the different sources of liquidity. This chapter ends with a
discussion on sound practices in liquidity risk management. This chapter covers only liquidity
risk identification. The topics on liquidity risk measurement, monitoring, controlling and
mitigation will be discussed in Book II.
Liquidity Risk
Introduction to
Liquidity Risk
Sources of
Liquidity
Liquidity Risk
Strategy
Elements of Sound
Practices in
Liquidity Risk
Definition of
Liquidity Risk
Asset-based
Sources of Liquidity
Stored Liquidity
Management
Liquidity Risk
Management
Framework
Asset-based
Liquidity Risk
Liability-based
Sources of Liquidity
Purchased Liquidity
Management
Governance
Structure
Liability-based
Liquidity Risk
Measurement and
Management of
Liquidity Risk
Public Disclosure
Figure 10.1 Diagrammatic outline of this chapter’s topics
LEARNING OUTCOME
At the end of this chapter, you are expected to be able to:
DISCUSS the importance of liquidity risk in the banking context
LEARNING OBJECTIVES
At the end of this chapter, you will be able to:
DEFINE liquidity risk in the banking context
ENUMERATE the different sources of liquidity
DISCUSS the two main strategic approaches to managing liquidity risk
ENUMERATE the elements of a sound liquidity risk management practice
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Chapter 10 Liquidity Risk
10.1 INTRODUCTION TO LIQUIDITY RISK
LEARNING OBJECTIVE
10.1
DEFINE liquidity risk in the banking context
Asset and liability management (ALM) is a set of key structured activities for matching or
mismatching the mix of assets and liabilities in a bank’s balance sheet. ALM is concerned with
the strategic management of the bank’s balance sheet. While the scope of ALM is wide, there
are three main objectives:
ŸŸOptimize net interest income by maximizing interest income earned from loans and
investments; or by minimizing interest expenses incurred from funds generated—
interest income management.
ŸŸMaximize return on capital by choosing the optimal level of risk-weighted assets and the
appropriate level and quality of capital—capital management.
ŸŸManage liquidity by strategically deploying excess liquidity while ensuring that the
bank maintains sufficient level of liquidity that will allow it to withstand stress events—
liquidity management.
From the above discussion, the key ALM activities are:
ŸŸLiquidity risk management
ŸŸInterest risk in the banking book
ŸŸCapital management
The need to manage ALM risk arises from the mismatches in the bank’s balance sheet. To
recap—in the course of a bank performing its asset-transformation role, the bank carries a
structural mismatch in its balance sheet. The bank generates funds primarily from short-term
deposits and lends them to corporations, investors and individuals. The loan tenors are usually
medium to long term. Consequently, this generates a structural mismatch in its balance sheet,
exposing the bank to a maturity mismatch risk.
Maturity mismatch
DEPOSITORS
Short term
BORROWERS
Long term
Figure 10.2 Maturity mismatch risk
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ŸŸFrom an interest rate risk standpoint, as market interest rates rise, the bank’s funding cost
increases—interest expense—as it needs to pay higher interest rates to maturing deposits.
Interest income, however, does not change as this income from loans has already been
locked in for a longer tenor.
ŸŸFrom a capital management standpoint, the structural mismatch generates negative
income, which will impact the bank’s retained earnings and ultimately, its capital.
ŸŸFrom a liquidity management standpoint, this generates a mismatch, particularly in a
stress scenario. On the one hand, depositors may demand repayment at a shorter tenor.
On the other hand, banks cannot immediately liquidate the use of its funds as the tenor
of the loans and investments have typically longer time to maturity.
The three diverse but interrelated risks build the case for an integrated asset and liability
risk management.
10.1.1 Definition of Liquidity Risk
Liquidity refers to a bank’s ability to fund increases in assets and meet obligations as they
come due without incurring unacceptable losses.
Maturity transformation role of banks
The fundamental role of banks in the maturity transformation of short-term deposits into
long-term loans makes them inherently vulnerable to liquidity risk. Virtually every financial
transaction or commitment has implications for a bank’s liquidity.
Short-term
Long-term
Deposit
Lending
Figure 10.3 Maturity transformation of short-term deposits into long-term loans
Liquidity risk is the risk that the bank will not be able to fund increases in assets and meet
obligations as they come due without incurring unacceptable losses. This definition reveals
two important aspects of liquidity—the asset aspect and liability aspect of liquidity risk.
Liquidity risk arises for two main reasons, namely:
ŸŸAsset-based reason
ŸŸLiability-based reason
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Chapter 10 Liquidity Risk
10.1.2 Asset-based Liquidity Risk
One way a bank can fund its asset growth or pay its obligations as they come due is to sell
its existing assets. In liquidity term, assets that can easily be converted into cash are generally
considered to be of higher quality than those that are not. This enables the bank to fund
increases in assets and pay its obligations without incurring unacceptable losses.
Sell existing ASSETS to generate
cash to:
(a) Fund increases in the bank's assets
(b) Pay obligations as they come due
Long-term
Liquidity
Figure 10.4 Asset-based liquidity risk
Another important source of asset-based liquidity risk is the off-balance sheet commitments.
Banks frequently allow clients to borrow funds over a commitment period on demand. This is
referred to as a loan commitment transaction. When a client draws on its loan commitment,
the bank must immediately fund the obligation, thus creating a demand for liquidity.
10.1.3 Liability-based Liquidity Risk
A bank’s liquidity profile is also largely determined by the quality of its funding sources—the
liability side of the bank’s balance sheet. When liability holders demand cash by withdrawing
their deposits or lending, the bank needs to borrow additional funds or sell assets to meet the
withdrawals. The bank uses cash to satisfy the demands of its liability holders.
In times of liquidity stress, volatile sources of funds (liabilities) will force the bank to replace
the liabilities in order to continue to operate as a going concern. During such conditions, the
bank is forced to accept unacceptable increases in funding costs to replace its sources of funds.
However, if there are reliable or stable sources of funds, the bank has the flexibility of not
having to replace or raise funds when it is not conducive to do so.
Replace existing LIABILITIES to generate
cash to:
(a) Fund increases in the bank's assets
(b) Pay obligations as they come due
Figure 10.5 Liability-based liquidity risk
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10.2 SOURCES OF LIQUIDITY
LEARNING OBJECTIVE
10.2
ENUMERATE the different sources of liquidity
The two major sources of liquidity for banks are:
ŸŸAsset-based sources of liquidity
ŸŸLiability-based sources of liquidity
10.2.1 Asset-based Sources of Liquidity
A bank’s assets are one of the primary sources of its liquidity. Asset-based sources include:
ŸŸCash flows from the bank’s assets
ŸŸAbility to use the assets as collateral to raise funds
ŸŸLiquidation of the assets for cash
ŸŸSecuritization of the assets to raise cash
Cash flows from the bank’s assets
The primary source of a bank’s asset-based liquidity comes from the principal and interest
cash flows produced by its assets, i.e. loans and investment securities. Examples of assets in the
balance sheet that can be relied upon to provide liquidity are:
ŸŸInvestments
Investments can provide liquidity through cash flows that can be generated by:
mm Maturing securities
mm Sale of securities for cash
mm Use of these securities as collateral
The International Accounting Standards (IAS) No. 39 provides for the following
classifications of investment securities:
mm Held for trading
These securities are acquired principally for the purpose of selling or repurchasing in
the near term.
mm Held to maturity (HTM)
These are investments with fixed or determinable payments and fixed maturity that
an entity has the positive intention and ability to hold to maturity. HTM investments
may not be sold prior to maturity for liquidity sources. Otherwise, this will call into
question the bank’s ability and intent to hold these securities to maturity.
mm Available for sale
These types of financial assets are not classified as loans and receivables, HTM
investments or held for trading. Banks typically classify securities that will be used for
liquidity sources as available-for-sale (AFS) securities. AFS securities are not subject
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Chapter 10 Liquidity Risk
Real World Illustration
Assets by Contractual Maturity
Amounts presented in these tables by contractual maturity are the amounts as presented in the
balance sheet.
2012
Less than
1–3
3–12
1 month(1) months months
1–5
years
Over 5
years
Maturity
not
applicable
Total
Cash and balances with
central banks
15,447
15,447
Amounts due from banks
25,636
3,630
3,894
5,597
296
39,053
33,877
7,603
11,222
29,787
31,831
114,320
ŸŸ non-trading derivatives
231
115
650
3,971
4,108
9,075
ŸŸ designated as at fair
value through profit and
loss
288
40
806
722
912
2,768
ŸŸ available-for-sale
2,991
3,256
9,442
30,955
25,001
ŸŸ held-to-maturity
1,267
1,168
1,007
2,774
329
6,545
Loans and advances to
customers
63,981
13,752
31,944 125,556 306,313
541,546
Financial assets at fair value
through profit and loss
ŸŸ trading assets
Investments
Intangible assets
175
Assets held for sale
1,253
(1)
(2)
(3)
1,778
8,439
2,184
6,781
4,914
1,860
3,695
Remaining assets (for
which maturities are not
applicable)(3)
Total assets
74,279
6,781
(2)
Other assets
350
2,634
21,092
3,384
152,157
38,529
64,054 201,572 372,485
3,384
7,271 836,068
Includes assets on demand.
Assets held for sale consist of the assets of the disposal groups classified as held for sale as disclosed
in Note 10 ‘Assets and liabilities held for sale’. For these assets and liabilities, the underlying contractual
maturities are no longer relevant to ING. For businesses for which a binding sale agreement exists, all
related assets and liabilities held for sale are classified in accordance with the agreed or expected closing
date. For other businesses, for which no sale agreement exists, assets and liabilities held for sale are
included in ‘maturity not applicable’.
Included in remaining assets for which maturities are not applicable are property and equipment, real estate
investments and investments in associates. Due to their nature remaining assets consist mainly of assets
expected to be recovered after more than 12 months.
Source: Annual Report 2012, ING Bank
to the positive intention and ability to hold to maturity requirement as in the case of
HTM. AFS securities are regularly marked to market with changes in fair value that is
recognized as a separate equity component—other comprehensive income.
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ŸŸLoans and receivables
The loan portfolio is typically one of the largest items in a bank’s balance sheet. Like
investments, loans can be used as:
mm Collateral for secured borrowings
mm Sold for cash, if a secondary loan market exists
Use of assets as collateral
Banks may also use its existing assets as collateral to raise funds. Various types of assets
are routinely pledged to secure borrowings or line commitments. Secured or collateralized
borrowings generally are reliable sources of liquidity.
A repurchase agreement or repo is a collateralized arrangement between two parties whereby
one party agrees to sell a security at a specified price with a commitment to buy back the
security at a later date at another specified price—the repurchase price. Below is an illustration
of a repo transaction:
Illustrative Example
Repurchase Agreement Transaction
Bank A decides to raise funds via the repo market for the next 14 days. The bank currently has
$10,000,000 of U.S. Treasuries maturing in 2023. The accrued interest is $31,929.35. The bonds
are currently trading at par value (100%).
Trade date: 01 October 2013
U.S. Treasury
maturing in 2023
(Principal: $10,000,000)
Bank A
(Repo seller)
$10,032,208.01
Bank B
(Repo buyer)
ŸŸ On the trade date, Bank A (the repo seller) enters into a repurchase agreement with Bank B
(the repo buyer).
ŸŸ Assume that the repo rate is 1% per annum.
ŸŸ Assuming the U.S. Treasury 2023 series is currently trading at par value (100%) and Bank
B will not require any haircut, Bank B will lend $10,031,929.35—price of the bond including
accrued interest net of haircut.
ŸŸ Bank A was thus able to generate $10,032,208.01 in funding.
Repurchase/Termination date (after 14 days)
$10,032,208.01 +
3,901.31
(Repo interest)
Bank A
(Repo seller)
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U.S. Treasury
maturing in 2023
(Principal: $10,000,000)
Bank B
(Repo buyer)
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Chapter 10 Liquidity Risk
ŸŸ On the termination date, Bank B returns the U.S. Treasury. Bank A pays the loan amount
($10,031,929.35) plus the repo interest.
ŸŸ Repo interest calculation 1% × 14 days ÷ 360 × $10,031,929.35 = $3,901.31
T2 12 08/15/23 Govt
98-26/98-26+
Type Repo
Repo Information
Settlement Date
Price
Yield
All In
1) Send (VCON)...
2.637/2.635
BGN @ 23:00
Trade Date 10/01/13
23:00
Repo/Reverse Repo Analysis
91) Settings
CUSIP 912828VS6
ISIN US912828VS66
99) Feedback
10/01/13
Settlement
100.0000000
2.4998305
100.3192935
Fixed
Repo Rate
10000 M
Termination Date
10/15/13
(AI 0.414402 for 61 days)
Money At Termination
Wired Amount
)
Market
100-00 (AI 0.3192935)
2.4998305 (AI 47 days)
100.319293
Collateral
Face Amt
Floating
1.0000 % (Act/ 360
Haircut
OR
Settlement Money
OR
Term (# days)
Open Trade N
100.0000 %
Roll No
10,031,929.35
14
Call Notification
None
10,031,929.35
Repo Interest
3,901.31
Term money
10,035,830,.66
Source: Bloomberg
The following characteristics will affect the amount that the bank can raise via secured/
collateralized borrowings:
ŸŸCredit quality of the assets
ŸŸLiquidity of the instrument or collateral
ŸŸMarket value of the instrument or collateral
ŸŸCredit quality of the pledging bank
ŸŸCounterparty’s funding rates on the various types of collateral
Liquidation of assets for cash
Banks can raise funds by selling or liquidating assets. This is why banks need to have a portion
of their total assets that could be a liquidity source under adverse liquidity circumstances. The
assets must be unencumbered and marketable to be eligible for sale.
ŸŸUnencumbered assets
These are assets that are not pledged as collateral. The bank has the flexibility to sell or
transfer these assets to meet its liquidity needs.
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Encumbrance
Asset encumbrance arises from collateral pledged against secured funding and other
collateralized obligations. Barclays funds a portion of trading portfolio assets and other securities
via repurchase agreements and other similar secured borrowing and pledges a portion of
customer loans and advances as collateral in securitization, covered bond, and other similar
secured structures.
Barclays monitors the mix of secured and unsecured funding sources within the Group’s funding
plan and seeks to efficiently utilize available collateral to raise secured funding and meet other
collateralized obligations. Over the last 18 months, the proportion of term funding requirements
met with secured funding has increased, resulting in an increase in the encumbrance of loans
and advances to customers. We expect to moderately increase encumbrance of loans and
advances to customers through additional term secured funding in the Group’s Funding Plan,
however, this is not expected to materially impact the overall proportion of assets that are
encumbered.
As at 31 December 2012, only £231bn of the Group’s balance sheet assets were encumbered
(excluding reverse repurchase agreements), which primarily related to firm financing of trading
portfolio assets and other securities and to funding secured against loans and advances to
customers. In addition, £308bn of the total £359bn securities accepted as collateral, and held offbalance sheet, were on-pledged, the significant majority of which relates to matched-book activity
where reverse repurchase agreements are matched by repurchase agreements entered into
to facilitate client activity. The remainder relates primarily to reverse repurchases used to settle
trading portfolio liabilities as well as collateral posted against derivatives margin requirements.
Source: Annual Report 2012, Barclays Capital
Figure 10.6 Encumbrance—Barclays Capital (2012)
Banks must be able to monitor the amount of assets that are not encumbered and
that are available to be pledged. The level of available collateral must be monitored by the
legal entity and jurisdiction, and by currency exposures.
ŸŸMarketable assets
Assets that are highly marketable can be easily converted into cash. Those that are
marketable typically exhibit the following characteristics:
There is an active market for the asset.
Pricing is transparent.
mm Even during a liquidity stress scenario, an entity will be able to sell assets at acceptable
prices and not incur huge losses by selling at fire-sale prices, i.e. heavily discounted.
Market liquidity refers to the bank’s ability to trade its assets at a short notice, at low cost
and with little impact on their prices. Market liquidity risk is the risk that the bank will not
be able to sell an asset without incurring unacceptable losses. The degree of market liquidity
is traditionally measured on the basis of the following parameters:
mm
mm
Low bid-ask spread
Market depth
mm Market resilience
mm
mm
Securitization of assets
Securitization of assets is another option that a bank may consider to raise funds. It involves
pooling of assets and transforming them into securities that will redistribute the risk of the
collateral among different classes of investors. This enables the bank to monetize the assets
into liquid funds. It involves creating, combining and recombining categories of assets into
new forms.
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Banks that securitize assets transform a pool of assets into cash. Asset securitization
typically involves the transfer or sale of a bank’s balance sheet assets to a third party who issues
asset-backed securities that are sold to investors in the public debt market. Some of the assets
that are frequently used in securitization are:
ŸŸAuto loans
ŸŸCredit card receivables
ŸŸHome equity loans
ŸŸEquipment leases
ŸŸStudent loans
ŸŸCommercial loans
ŸŸResidential mortgages
Securitization converts illiquid assets or receivables that cannot be easily sold into liquid,
marketable securities.
Parties to the securitization
ŸŸOriginator
Originators are the sellers of the asset. They transfer the assets to the securitization entity.
ŸŸIssuer
Issuers of asset-backed securities typically are the special purpose vehicles (SPV) created
for the purpose of acquiring the underlying assets and issuing securities.
ŸŸRating agencies
Most securitizations will contain multiple tranches. Most will be rated by one or more
rating agencies. These multiple tranches are created to appeal to a wider variety of
investors. Some institutions are only allowed to invest in investment grade-rated tranches
while other institutions are allowed to invest in non-investment grade-rated tranches
and receive higher yields.
ŸŸCredit enhancement provider
One key reason behind the rapid expansion of securitizations is the availability of thirdparty credit enhancement. With credit enhancement, the credit profiles of asset-backed
securities are transformed and are viewed as safe, liquid and high-yielding investments.
Credit enhancement providers are used to create highly-rated tranches that can be
sold to credit risk conscious investors. Below are examples of credit enhancements:
mm Letters of credit
mm Senior subordination which involves over-collateralization. This involves division of
the product into two parts:
–– Senior tranche—to be sold to investors seeking limited credit risk
–– Subordinated tranche—to be sold to investors who have a higher risk appetite as
this is junior in payment priority versus the senior tranche
mm Cash collateral accounts
mm Financial guarantee or bond insurance
ŸŸLiquidity facility provider
Liquidity facilities are used in structures to cover potential time lags between inflows of
revenue from the securitization’s asset pool and its payment obligations.
ŸŸUnderwriter
Underwriters assume responsibility for both pricing and marketing the rated tranches in
a securitization. They take a lead role in structuring securitizations.
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ŸŸServicer
A servicer is responsible for routine asset portfolio administrative duties such as
making and processing collections, and administering the day-to-day operations of
the issuer.
Generic securitization structure
While there are many forms of securitization, the generic structure usually starts with the
originator bank transferring the financial assets to a special purpose vehicle (SPV). The SPV
is usually bankruptcy-remote. This means that this legal vehicle has to be isolated from any
bankruptcy or insolvency of the originator bank (the asset seller).
The SPV issues multiple tranches or classes of securities representing different slices of
payment streams from the pooled assets. Credit enhancements can also be obtained to ensure
a highly-rated tranche. Rating agencies will assign a higher rating to senior tranches.
Assets
Special Purpose
Vehicle
CASH
PROCEEDS
ORIGINATOR
Payment
Securities
Fees
CREDIT
ENHANCEMENT
UNDERWRITER
Enhancement
Investment
Issuance of securities
SENIOR TRANCHE
INVESTORS
SUBORDINATED
TRANCHE
Figure 10.7 Generic securitization structure
Figure 10.7 illustrates how banks generate liquidity through a generic securitization structure.
The bank sells assets to a SPV. Depending on the structure, the risks and rewards of owning
these assets should be transferred to the SPV. The SPV then issues securities. The performance
of these securities is linked to the SPV’s assets. These securities are issued to an underwriter who
sells them to investors.
The securities may be sold as two different tranches—senior tranche and subordinated
tranche. Senior tranche investors have higher level of protection and security compared to
the investors in the subordinated tranche. Therefore, the earnings are expected to be higher
for investors in the subordinated tranche to compensate for the additional risks taken.
Proceeds from the securities issued are then paid by the SPV to the bank in exchange for the
assets.
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10.2.2 Liability-based Sources of Liquidity
An alternative source to meet a bank’s liquidity needs is through its liability sources. There are
generally two sources of funding:
ŸŸStable sources of funding
ŸŸNon-stable sources of funding
The Basel Committee on Banking Supervision has defined the following as sources of stable
funding:
ŸŸCapital
ŸŸPreferred stocks with maturities of equal to or greater than one year
ŸŸLiabilities with effective maturities of one year or greater
ŸŸPortion of non-maturity deposits and/or term deposits with maturities of less than one
year that would be expected to stay with the institution for an extended period in an
idiosyncratic stress event
ŸŸPortion of wholesale funding with maturities of less than a year that is expected to stay
with the institution for an extended period in an idiosyncratic stress event
The sources of funding can also be divided into customer types:
ŸŸRetail deposits
ŸŸUnsecured wholesale funding
mm Small business customers
mm Operational deposits generated by clearing, custody and cash management
mm Deposits in institutional networks of cooperative banks
ŸŸSecured funding
ŸŸDeposit listing services
ŸŸBrokered deposits
Funds that are sourced from the capital markets (e.g. wholesale funding) are typically more
volatile than traditional retail deposits. For example, under conditions of stress, investors in
money market instruments may demand higher compensation for the risk exposure, require
rollover at considerably shorter maturities or refuse to extend financing.
The 2008 global financial crisis highlighted that reliance on full-functioning and liquidity
of financial markets may not be realistic as the assets and funding markets may dry up in times
of stress. Market illiquidity may make it difficult for a bank to raise funds by selling assets and
thus, increase the need for funding liquidity.
Given that a bank’s liability profile can affect its liquidity risk, it should establish a
funding strategy that provides effective diversification and sources, and tenor of funding.
The bank should diversify available funding sources for the short, medium and long term.
Diversification targets should be part of the medium- to long-term funding plans and aligned
with the budgeting and business planning process. Funding plans should take into account
the correlations between sources of funds and market conditions. The desired diversification
should include limits by:
ŸŸCounterparties
ŸŸSecured versus unsecured market funding
ŸŸInstrument types
ŸŸSecuritization vehicles
ŸŸCurrencies
ŸŸGeographic markets
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A bank needs to identify alternative sources of funding towards strengthening its capacity
to withstand liquidity shocks. Some potential sources of funding are:
ŸŸDeposit growth
ŸŸLengthening the maturities of liabilities
ŸŸNew issues of short- and long-term debt instruments
ŸŸIntragroup fund transfers or new capital issues
ŸŸDrawing down committed facilities
ŸŸBorrowing from the central bank’s marginal lending facilities
Diversification of our funding profile in terms of investor types, regions, products and instruments is an important
element of our liquidity risk management framework. Our most stable funding sources are capital markets and
equity retail, and transaction banking clients. Other customer deposits and borrowing from wholesale clients are
additional sources of funding. Discretionary wholesale funding represents unsecured wholesale liabilities sourced
primarily by our Global Markets Finance business. Given the relatively short-term nature of these liabilities, they
are primarily used to fund cash and liquid trading assets.
To ensure the additional diversification of our refinancing activities, we hold a Pfandbrief licence allowing us to
issue mortgage Pfandbriefe.
In 2012, we continued to focus on increasing our most stable funding components, and we have seen increases of
€12.2 billion (4.4%) and €21.4 billion (12.4%) from retail and transaction banking clients respectively. We maintain
access to short-term wholesale funding markets, on both a secured and unsecured basis.
Discretionary wholesale funding comprises a range of unsecured productse, e.g. Certificates of Deposit (CDs),
Commercial Paper (CP) as well as term, call and overnight deposits across tenors primarily up to one year. In
addition, included within Financing Vehicles is €8.6 billion of asset-backed commercial paper (ABCP) issued
through conduits.
The following chart shows the composition of our external funding sources that contribute to the liquidity risk
position as of 31 December 2012 and 31 December 2011, both in EUR billion and as a percentage of our total
external funding sources.
Composition of external funding sources in € bn
300
291
225
202
279
213
194
193
173
202
150
109 110
133
93
75
18 23
0
18% 19%
26% 24%
Capital
Retail
markets and
equity
18% 15%
Transaction
banking
10% 10%
Other
customers1
8% 12%
18% 18%
Discretionary Secured
wholesale
funding and
shorts
2% 2%
Financing
vehicles2
31 December 2012: total €1,101 billion
31 December 2011: total €1,133 billion
1
2
Others include fiduciary, self-funding structures (e.g. X-markets), margin/prime brokerage cash balances
Includes ABCP-conduits
Source: Annual Report 2012, Deutsche Bank
Figure 10.8 Funding diversification—Deutsche Bank
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10.3 LIQUIDITY RISK STRATEGY
LEARNING OBJECTIVE
10.3
DISCUSS the two main strategic approaches to managing liquidity risk
Saunders and Cornett (2012) proposed two major approaches in addressing both asset and
liability-based liquidity risks. These approaches are:
ŸŸStored liquidity management
ŸŸPurchased liquidity management
10.3.1 Stored Liquidity Management
Stored liquidity management relies on asset-based sources of liquidity to address either assetbased or liability-based liquidity risk.
Illustrative Example
Stored Liquidity Management
Case Study 1—Liability-based Liquidity Risk
Summary balance sheet of Bank XYZ:
Balance Sheet of Bank XYZ (in MYR billion)
Cash
10
Deposits
90
Other assets
90
Borrowings
5
Equity
Total assets
100
Total liabilities and equity
5
100
Liability-based liquidity risk occurs when the liability holders (e.g. depositors) decide to withdraw
their funds. Suppose the depositors collectively demanded to withdraw MYR5 billion in deposits;
there will be a reduction in deposits by MYR5 billion. This will result in a deficit of MYR5 billion—
liability side is lower than the asset side.
Balance Sheet of Bank XYZ (in MYR billion)
Cash
10
Deposits
85
Other assets
90
Borrowings
5
Total assets
100
Equity
5
Total liabilities and equity
95
To address this deficit, the bank may pursue a stored liquidity management strategy. This
means that the bank will rely on the asset side of the balance sheet to address this deficit. The
bank can use its available cash reserves to cover the deficit.
Balance Sheet of Bank XYZ (in MYR billion)
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Cash
5
Deposits
85
Other assets
90
Borrowings
5
Total assets
95
Equity
5
Total liabilities and equity
95
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Suppose the depositors collectively demanded to withdraw MYR20 billion instead of
MYR5 billion. This will result in a deficit of MYR20 billion—assets exceed liabilities. The impact
on the balance sheet is illustrated below:
Balance Sheet of Bank XYZ (in MYR billion)
Cash
10
Deposits
70
Other assets
90
Borrowings
5
Total assets
100
Equity
5
Total liabilities and equity
80
To address the deficit, the bank may use its existing cash reserves to pay the obligations. This,
however, will not be enough to cover the MYR20 billion deficit. The bank may need to sell its other
assets to meet its obligations. Given the need to cover the deficit immediately, the bank may be
forced to sell the other assets at low fire-sale prices. This will result in losses for the bank. The
MYR20 billion deficit can be funded by:
ŸŸ Paying cash—currently at MYR10 billion only
ŸŸ Sale of other assets
Balance Sheet of Bank XYZ (in MYR billion)
Cash
0
Deposits
70
Other assets
80
Borrowings
5
Equity
5
Total liabilities and equity
80
Total assets
80
Case Study 2—Asset-based Liquidity Risk
Asset-based liquidity risk occurs when certain asset-side on- and off-balance sheet items
could trigger a demand for liquidity. An example is when a client decides to tap on the bank’s
commitment to lend (the client) over a certain period (commitment period). Suppose the client
decides to borrow on demand MYR5 billion from the bank’s off-balance sheet commitment to
lend; this will generate an excess on the asset side by MYR5 billion.
Balance Sheet of Bank XYZ (in MYR billion)
Cash
10
Deposits
90
Other assets
90
Borrowings
5
Loan receivables
5
Equity
5
Total assets
105
Total liabilities and equity
100
This excess needs to be funded immediately. The bank may do so by pursuing a stored liquidity
management strategy. This means that it will use asset-based sources of liquidity to fund this
new asset. This will close the excess asset.
Balance Sheet of Bank XYZ (in MYR billion)
Cash
5
Deposits
90
Other assets
90
Borrowings
5
Loan receivables
5
Equity
5
Total assets
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Total liabilities and equity
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Chapter 10 Liquidity Risk
10.3.2 Purchased Liquidity Management
Purchased liquidity management relies on asset-based sources of liquidity to address either
asset-based or liability-based liquidity risk.
Illustrative Example
Purchased Liquidity Management
Case Study 1—Liability-based Liquidity Risk
Summary balance sheet of Bank XYZ:
Balance Sheet of Bank XYZ (in MYR billion)
Cash
10
Deposits
90
Other assets
90
Borrowings
5
Equity
5
Total assets
100
Total liabilities and equity
100
Liability-based liquidity risk occurs when liability holders (e.g. depositors) decide to withdraw their
funds. Suppose the depositors collectively demanded to withdraw MYR5 billion in deposits; there
will be a reduction in deposits by MYR5 billion. This will result in a deficit of MYR5 million—liability
side is lower than the asset side.
Balance Sheet of Bank XYZ (in MYR billion)
Cash
10
Deposits
85
Other assets
90
Borrowings
5
Equity
5
Total liabilities and equity
95
Total assets
100
To address the deficit, the bank may pursue a purchased liquidity management strategy, i.e.
the bank will rely on the liability side of the balance sheet to address this deficit. This can be done
by raising new funds to cover the shortfall.
Balance Sheet of Bank XYZ (in MYR billion)
Cash
10
Deposits
85
Other assets
90
Borrowings
10
Total assets
100
Equity
Total liabilities and equity
5
100
Case Study 2—Asset-based Liquidity Risk
Suppose a client decides to borrow on demand MYR5 billion from the bank’s off-balance sheet
commitment to lend; this will generate an excess of MYR 5 billion on the asset side.
Balance Sheet of Bank XYZ (in MYR billion)
Cash
10
Deposits
90
Other assets
90
Borrowings
5
Loan receivables
5
Equity
5
Total assets
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105
Total liabilities and equity
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This excess needs to be funded immediately. The bank may do so by pursuing a purchased
liquidity management strategy. This means that it will use its liability-based sources of liquidity
to fund this new asset. This will close the excess asset balance. The bank may do this by raising
fresh fund either from deposits or borrowings.
Balance Sheet of Bank XYZ (in MYR billion)
Cash
10
Deposits
90
Other assets
90
Borrowings
10
5
Equity
Loan receivables
Total assets
105
Total liabilities and equity
5
105
10.4 ELEMENTS OF SOUND LIQUIDITY RISK
MANAGEMENT PRACTICES
LEARNING OBJECTIVE
10.4
ENUMERATE the elements of a sound liquidity risk management practice
The Basel Committee on Banking Supervision segregates sound liquidity risk management
practices into four different elements:
ŸŸLiquidity risk framework
ŸŸLiquidity risk governance
ŸŸMeasurement and management of liquidity risk
ŸŸPublic disclosure
This section discusses these four elements in detail.
10.4.1 Liquidity Risk Management Framework
The bank should establish a robust liquidity risk management framework that is well integrated
into its bank-wide risk management process. The objectives of a liquidity risk management
framework are:
ŸŸEnsure a high degree of confidence that the bank is in a position to address its daily
liquidity obligations.
ŸŸEnsure the bank is able to withstand a range of stress events affecting both its secured
and unsecured funding.
ŸŸEnsure the bank holds an adequate liquidity cushion of unencumbered, high-quality
liquid assets commensurate with its liquidity profile.
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Chapter 10 Liquidity Risk
Real World Illustration
Liquidity Risk Framework
Barclays has a comprehensive Liquidity Framework for managing the Group’s liquidity risk.
The Liquidity Framework is designed to deliver the appropriate term and structure of funding
consistent with the Liquidity Risk Appetite set by the Board.
The Liquidity Framework incorporates a range of ongoing business management tools to
monitor, limit and stress test the Group’s balance sheet and contingent liabilities. Limit setting
and transfer pricing are tools that are designed to control the level of liquidity risk taken and drive
the appropriate mix of funds, which together reduce the likelihood that a liquidity stress event
could lead to an inability to meet the Group’s obligations as they fall due. The stress tests assess
potential contractual and contingent stress outflows under a range of scenarios, which are then
used to determine the size of the liquidity buffer that is immediately available to meet anticipated
outflows if a stress occurred.
In addition, the Group maintains a Contingent Funding Plan which details how liquidity stress
events of varying severity would be managed. Since the precise nature of any stress event
cannot be known in advance, the plans are designed to be flexible to the nature and severity of
the stress event and provide a menu of options that could be used as appropriate at the time.
Barclays also maintains Recovery Plans which consider actions to generate additional liquidity in
order to facilitate recovery in a severe stress and is developing documentation to meet Resolution
Planning in line with regulatory requirements. The overall framework therefore provides the
necessary tools to manage the continuum of liquidity risk as summarized below:
Ongoing business
management
Early signs/Mild
stress
Severe stress
• Liquidity Limits
• Pricing and
Incentives
• Early Warning
Indicators
• Risk Appetite and
Planning
• Monitoring and
review
• Low cost actions
and balance sheet
optimization
• Activate
Contingency
Funding Plan
• Balance sheet
reductions and
business limitations
Recovery
• Asset and Liability
actions to generate
additional liquidity
Source: Annual Report 2011, Barclays Capital
10.4.2 Governance Structure
Liquidity risk tolerance
The board of directors is ultimately responsible for the liquidity risk assumed by the bank and
the manner in which this risk is managed. The board, therefore, should establish the bank’s
liquidity risk tolerance in the light of its business objectives, strategic direction and overall
risk appetite. The liquidity risk tolerance should:
ŸŸDefine the level of liquidity risk that the bank is willing to assume. This should be
appropriate and consistent with the bank’s business strategy, its role in the financial
system and reflect the bank’s financial condition and funding capacity.
ŸŸEnsure that the bank manages its liquidity during normal times in such a way that it is
able to withstand a prolonged period of stress.
ŸŸBe articulated in such a way that all levels of management clearly understand the tradeoff between risks and profits.
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Liquidity risk management strategy
Senior management is responsible for developing and implementing the liquidity risk
management strategy in accordance with the bank’s risk tolerance. The liquidity risk
management strategy should include:
ŸŸSpecific policies on liquidity risk management
mm Composition of assets and liabilities
mm Maturity of assets and liabilities
mm Diversity and stability of funding sources
mm Approach to managing liquidity in different currencies, across borders and across
business lines and legal entities
ŸŸApproach to intraday liquidity management
ŸŸAssumptions on liquidity and marketability of assets
ŸŸStrategy on liquidity needs under normal conditions as well as under periods of liquidity
stress
ŸŸHigh-level quantitative and qualitative targets
The board of directors should endeavour to do the following:
ŸŸApprove the liquidity risk management strategy and critical policies and practices, and
review them at least annually.
ŸŸEnsure that senior management translates the strategy into clear guidance and
operating standards in the form of policies, controls or procedures.
Senior management should determine the structure, responsibilities and controls for
managing liquidity risk and for overseeing the liquidity positions of all legal entities, branches
and subsidiaries in the jurisdictions in which the bank is operating, and outline these elements
clearly in the bank’s liquidity policies.
Organizational structure
The structure for managing liquidity (i.e. the degree of centralization or decentralization
of a bank’s liquidity risk management) should take into account any legal, regulatory or
operational restrictions on the transfer of funds. In some cases, there may be strict regulatory
restrictions on funds being transferred between entities or jurisdictions. Whatever the
structure, senior management should be able to monitor the liquidity risks across the
banking group and at each entity on an ongoing basis.
Liquidity risk pricing
Senior management should incorporate liquidity costs, benefits and risks in the internal
pricing, performance measurement and new approval process for all significant business
activities.
Liquidity transfer pricing is a process that attributes the costs, benefits and risks of liquidity
to respective business units within the bank. The objective is to transfer liquidity costs and
benefits from the business units to a centrally-managed pool. The basic idea of the liquidity
transfer pricing process is to charge the users of funds (i.e. assets/loans) for the cost of
liquidity and give the benefit of liquidity to the providers of funds (i.e. liabilities/deposits).
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Chapter 10 Liquidity Risk
Liquidity transfer pricing (LTP) also requires recouping the cost of carrying liquidity cushion
by charging contingent commitments based on their expected use of liquidity. Figure 10.9
shows a graphical representation of the LTP process:
A graphical representation of the LTP process
Business unit 1 receives credits from
treasury based on the commitment of
funds provided. Credits are reduced
by any charges against contingent
commitments, such as deposit run-off.
Interbank market:
provides funds
Business unit 2 incurs charges from
treasury based on the commitment
of funds required. Additional charges
will apply to contingent commitments,
such as lines of credit.
Internal treasury
(central pool)
Business unit 1:
provides funds
Business unit 2:
uses funds
Liquidity
cushion
Trading business
The trading business uses funds,
provides funds (through the sale
of
marketable
securities)
and
receives charges against contingent
commitments, such as collateral calls
on derivative positions.
Figure 10.9 Liquidity transfer pricing
Importance of the LTP process
As discussed in an earlier section, the business of banking involves maturity transformation, i.e.
banks make money by funding long-term loans (assets) with short-term deposits (liabilities).
This makes banks inherently vulnerable to liquidity risk. LTP should be used to account for
the costs, benefits and risks of liquidity in the following:
ŸŸProduct pricing
ŸŸNew product approval processes
ŸŸProfit and performance assessments
An efficient and effective LTP process leads to banks playing a more effective role in the
maturity transformation process. Banks with poor LTP practices are more likely to accrue
larger amounts of long-term illiquid assets, contingent commitments and shorter-dated
volatile liabilities, thereby substantially increasing their vulnerability to liquidity risk.
Different approaches to LTP
ŸŸZero cost of funds approach
The zero cost of funds approach views funding liquidity as essentially free. This means
that no charge is attributed to the assets for the cost of funding liquidity and, likewise,
no credit/benefit is attributed to the liabilities for providing funding liquidity.
ŸŸPooled cost of funds approach
The pooled cost of funds approach entails the calculation of a single average rate based
on the cost of funds across all existing funding sources. All assets, irrespective of their
maturities, are charged the same rate for the use of the funds.
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Illustrative Example
Different Approaches to Liquidity Transfer Pricing (LTP)
Suppose Bank XYZ has the following sources of funds:
Volume
Cost per annum
Deposit 1
MYR100 million
2%
Deposit 2
MYR200 million
1.5%
Deposit 3
MYR300 million
1%
1 Determine the charge for the use of funds on the following transactions:
(a) 1-year MYR10 million loan
(b) 5-year MYR 10 million loan
(c) 10-year MYR10 million loan
2
Determine the benefit to be credited for the following sources of funds:
(a) 1-week MYR10 million deposit
(b) 30-day MYR10 million deposit
(c) 5-year MYR10 million deposit
Solution:
Step 1: Calculate the total interest expense
Volume
Cost per annum
Total Interest Expense
MYR100 million
2%
MYR2 million
MYR200 million
1.5%
MYR3 million
MYR300 million
1%
MYR3 million
Total interest expense
MYR8 million
Step 2: Calculate the average interest expense
Average interest expense =
=
Total interest expense
Total volume
MYR8 million
MYR600 million
= 1.33%
1 Charge for use of funds
Loan 1
Tenor
Loan 2
Loan 3
1 year
5 years
10 years
Principal
MYR10,000,000
MYR10,000,000
MYR10,000,000
Charge (%)
1.33%
1.33%
1.33%
MYR133,000
MYR133,000
MYR133,000
Charge for use of funds
Note:
Under the pooled cost of funds approach, the charge for the use of funds will be the same
regardless of the maturity of the asset. This is because the basis for charging the use of funds is
the average cost of funds. There are two main problems under this approach:
ŸŸ Longer-tenor assets/loans are generally more risky—less liquid and more sensitive to interest
rate risk—than a similar shorter-tenor asset. By charging the same rate for the use of funds,
the bank may be incentivized to build up longer-tenor assets.
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Chapter 10 Liquidity Risk
ŸŸ The single rate that was used is the blended average cost of funds. Longer-tenor deposits
should theoretically fund longer-tenor assets. A longer-tenor deposit is generally more
expensive than a comparable shorter-tenor deposit. By charging a single average rate, the
shorter-tenor assets, which should be charged less than the average, are in effect subsidizing
the longer-tenor assets, which should be charged more than the average rate.
2 Credit for sources of funds
Tenor
Principal
Charge (%)
Credit for providing liquidity
Loan 1
Loan 2
Loan 3
1 week
30 days
5 years
MYR10,000,000
MYR10,000,000
MYR10,000,000
1.33%
1.33%
1.33%
MYR133,000
MYR133,000
MYR133,000
Note:
Under the pooled cost of funds approach, the credit for the source of funds will be the same
regardless of the maturity of the liability. There are two main problems under this approach:
ŸŸ Longer-tenor sources of liability are generally considered to be more stable compared to
shorter-tenor sources of liability. Under the pooled cost of funds approach, no additional credit
is provided for generating longer-tenor sources of funding.
ŸŸ By charging a single pooled rate, the bank will be encouraged to promote unhealthy maturity
transformation. The bank will tend to book long-term assets—as it earns higher yields—
because it does not receive higher charges for the use of funds over a longer period. Banks
are also discouraged to raise long-term liabilities because there is no premium credited to
long-term liabilities that provide funding for longer periods of time.
ŸŸMatched maturity of funding approach
The matched maturity of funding approach is the current best practice for assets and
liabilities. Under the matched maturity cost of funds approach, rates charged—for the
use of fund—and rates credited—for the benefit of funding—are based on term liquidity
premiums corresponding to the maturity of the transaction.
Internal control
Senior management should have adequate internal controls to ensure the integrity of its
liquidity risk management process. Senior management should ensure that operationally
independent, appropriately trained and competent personnel are responsible for implementing
the internal controls. Internal audit should regularly review the implementation and
effectiveness of the agreed framework for controlling liquidity risk.
10.4.3 Measurement and Management of Liquidity Risk
The measurement and management of liquidity risk is one of the key elements of sound
liquidity risk management practices. At the height of the 2008 global financial crisis, many
banks lacked the ability to properly measure and monitor their liquidity risk exposures in an
effective and timely manner. This significantly hampered their ability to manage their liquidity
risk exposures as the crisis unfolded.
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Risk Management in Banking: Principles and Framework
A bank should have a sound process for identifying, measuring, monitoring and controlling
liquidity risk. Figure 10.10 depicts this process.
Controlling
liquidity risk
Identifying
liquidity risk
Monitoring
liquidity risk
Measuring
liquidity risk
Figure 10.10 Process of managing liquidity risk
Identifying liquidity risk
A bank should define and identify the liquidity risk to which it is exposed. A bank’s liquidity
needs and sources of liquidity to meet those needs depend significantly on the following:
ŸŸBank’s business and product mix
ŸŸBalance sheet structure
ŸŸCash flow profiles of its on- and off-balance sheet obligations
Measuring liquidity risk
Liquidity measurement involves assessing a bank’s cash inflows against its outflows and the
liquidity value of its assets to identify the potential for future net funding shortfalls.
Monitoring liquidity risk
A bank should monitor and control vulnerabilities to liquidity risk by observing the following
time horizons:
ŸŸIntraday liquidity risk
ŸŸDay-to-day liquidity risk
ŸŸLiquidity needs over short- and medium-term horizons up to one year
ŸŸLonger-term liquidity needs over one year
Banks should be able to monitor emerging concentration risks in the bank’s liquidity
profile. Reliance on one source of funding may threaten the bank’s liquidity position. This is
what happened at the height of the 2008 global financial crisis when many investment banks
relied on wholesale funding which disappeared, leaving them exposed to the risk that they
would no longer be able to repay their obligations as they came due.
Controlling liquidity risk
A bank should set limits to control its liquidity risk exposures and vulnerabilities. It should
regularly review such limits and corresponding escalation procedures. Limits should be
relevant to the business in terms of its location, complexity of activities, nature of products,
currencies and markets served. Limits should be used for managing day-to-day liquidity within
and across lines of business and legal entities under normal conditions. The limit framework
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Chapter 10 Liquidity Risk
should include measures aimed at ensuring that the bank can continue to operate in a period
of market stress, bank-specific stress or a combination of the two.
10.4.4 Public Disclosure
Banks should publicly disclose information on a regular basis to market participants to
enable them to make an informed judgement on the soundness of the bank’s liquidity risk
management framework and liquidity position. The minimum contents of public disclosure
of the bank’s liquidity risk are:
ŸŸOrganizational structure for liquidity risk management
The bank should explain the roles and responsibilities of its relevant committees as well
as those of different functional and business units.
ŸŸFramework for the management of liquidity risk
The bank should indicate the degree to which the treasury function and liquidity risk
management is centralized or decentralized. It should describe this structure with regard
to its funding activities, limit-setting systems and intra-group lending strategies.
Governance and organization
Barclays Treasury operates a centralized governance control process that covers all of the Group’s liquidity risk
management activities. The Barclays Treasurer is responsible for designing the Group Liquidity Risk Management
framework (the Liquidity Framework) which is sanctioned by the Board Risk Committee (BRC). The Liquidity
Framework incorporates liquidity policies, systems and controls that the Group has implemented to manage
liquidity risk within tolerances approved by the Board and regulatory agencies. The Board sets the Group’s Liquidity
Risk Appetite (LRA), being the level of risk the Group chooses to take in pursuit of its business objectives and in
meeting its regulatory obligations. The Treasury Committee is responsible for the management and governance of
the mandate defined by the Board and includes the following sub-committees:
ŸŸ The Group Funding and Liquidity Management Committee is responsible for the review, challenge and approval
of the Liquidity Framework. The Liquidity Framework is reviewed regularly by the Treasury Committee and BRC;
ŸŸ The Group Asset and Liability Management Committee oversees the management and governance of asset
and liability management including behavioural mismatch, structural risk and transfer pricing; and
ŸŸ The Investment Advisory Group supervises the investment of a portion of the Group liquidity pool in longerdated liquid assets. The Investment Advisory Group approves a detailed allocation framework across assets
and tenors, and reviews the performance and risks associated with these holdings. The holdings are subject to
limits set by the BRC and by the independent Group market and credit risk functions.
Liquidity is recognized as a key risk and the Barclays Treasurer is the Group Key Risk owner, supported by
Key Risk Owners at regional and country levels. Execution of the Group’s liquidity risk management strategy is
carried out at country level, with the country Key Risk Owners providing reports to Barclays Treasury to evidence
conformance with the agreed risk profile. Further oversight is provided by country, regional and business level
committees.
Governance and organization
Barclays Treasury Committee
Group Funding and
Liquidity Management
Committee
Group Asset and
Liability Management
Committee
Investment Advisory
Group
Source: Annual Report 2012, Barclays
Figure 10.11 Governance and organization
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Risk Management in Banking: Principles and Framework
ŸŸQuantitative information about the bank’s liquidity position
Examples of quantitative disclosures on liquidity risk:
mm Size and composition of a bank’s liquidity cushion
mm Additional collateral requirements as a result of a credit rating downgrade
mm Values of internal ratios and other key metrics that management monitors
mm Limits placed on those metrics
mm On- and off-balance sheet items broken down into a number of short-term maturity
bands and the resultant cumulative liquidity gaps
The bank should provide sufficient qualitative discussion of the metrics to enable
market participants to understand them, the organizational level to which the metric
applies and other assumptions utilized in measuring its liquidity position, liquidity risk
and liquidity cushion.
ŸŸA bank should disclose additional qualitative information that provides market
participants with further insight into how it manages liquidity risk
Examples of these disclosures are:
Aspects of liquidity risk to which the bank is exposed and that it monitors
Diversification of the bank’s funding sources
mm Techniques used to mitigate liquidity risk
mm Concepts utilized in measuring its liquidity position and liquidity risk
mm Explanation of how asset market liquidity risk is reflected in the bank’s framework for
managing funding liquidity
mm Explanation of how stress testing is used
mm Description of the stress testing scenarios modelled
mm Outline of the bank’s contingency funding plans and indication of how the plan
relates to stress testing
mm Bank’s policy on maintaining liquidity reserves
mm Regulatory restrictions on the transfer of liquidity among group entities
mm Frequency and type of internal liquidity reporting
mm
mm
CONCLUSION
This chapter provided a timely introduction to liquidity risk in the banking context. It started
with a brief definition of liquidity risk and then discussed why liquidity risk is pervasive and
inherent in the business of banking. After which, two different types of liquidity risks were
discussed—asset-based and liability-based liquidity risks.
The second section further discussed the different sources of liquidity for a typical banking
organization. Asset- and liability-based liquidity sources were discussed in detail. The two
types of liquidity risk management strategies, i.e. purchased liquidity and stored liquidity,
were then discussed.
The chapter ended with a discussion of the best practices in liquidity risk management
based on the guidance issued by the Basel Committee on Banking Supervision.
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Format 260 x 190 mm / ext 328 / spine 13.3mm / 80 gsm matt art
Principles and Framework
This book offers a broad-based understanding of the types of risk faced by banks and how these risks may be
identified, assessed and managed. It aims to provide general banking practitioners with insights into key risk
management concepts and practices, as well as intelligently discuss developments in bank risk management.
The contents are organized and presented in an easily readable format to enable learners to understand
key qualitative risk factors and how they impact risk management. Each chapter contains numerous
illustrative examples and case studies of real life situations to enable students to relate theories to real world
events.
Key features of the book:
• Chapter overview complete with clear learning objectives
• Real world illustrations that relate theories to real world events
• Illustrative examples that contextualize and elaborate on new and complex concepts
The other title in this series:
Risk Management in Banking: Risk Models, Capital and Asset Liability Management
About the Author
Philip Te
Philip Te is the Programme Director for the Quantitative Finance and Risk Management Series at the Ateneo
Centre for Continuing Education—the largest continuing education institution in the Philippines. He has lectured
extensively on financial risk management, Basel II/III, derivatives, IAS 39/IFRS 9, option pricing, corporate treasury
management and hedging strategies. He is the author of Bank Risk Management Primer, published by the Bankers’
Association of the Philippines.
A Chartered Financial Analyst (CFA), Philip is also a certified Financial Risk Manager (FRM) and
Energy Risk Professional (ERP), both awarded by the Global Association of Risk Professionals (GARP).
He is also a Certified Public Accountant (CPA).
Philip is currently a vice president at the Client Solutions Group of a global commercial bank. Prior to this, he
was the head of the Structured Products and Financial Engineering Department of a local commercial bank and
a senior associate at the Ernst & Young Financial Services Risk Management (FSRM) and Quantitative Advisory
Services (QAS) group.
Risk Management in Banking Principles and Framework
Risk Management
in Banking
Risk Management
in Banking
Principles and Framework
Philip Te