Risk Management in Banks and Financial
Institutions : A high level view
By A V Vedpuriswar
November 1, 2010
The rise of risk management
Year
Event
1971
Breakdown of Bretton Woods
1973
Oil Shock
1987
Dow Jones crash
1989
Nikkei crash
1980s
Latin American debt crisis
1994
Mexican Peso crisis
1997
Asian currency crisis
1998
Rouble /LTCM crisis
2000
Dotcom bust
2001
WTC terrorist strikes
2007
Sub Prime crisis
2008
Collapse of Bear Stearns, Lehman
2009
Sovereign debt crisis
1
The Real Crisis
Ref : Prof. Werner Antweiler , http://fx.sauder.ubc.ca/
2
The Ruble Crisis
Ref : Prof. Werner Antweiler , http://fx.sauder.ubc.ca/
3
The Asian currency Crisis
Ref : Prof. Werner Antweiler , http://fx.sauder.ubc.ca/
4
The Mexican Peso Crisis
Ref : Prof. Werner Antweiler , http://fx.sauder.ubc.ca/
5
Evolution of Analytical Risk Management tools
1938
1952
1963
1966
1973
1983
1986
1988
1992
1993
1994
1997
1998
2000
Bond duration
Markowitz mean variance framework
Beta
Multiple factor models
Black Scholes, Greeks
Risk adjusted return on capital
Limits on exposure by duration
Limits on Greeks
Stress testing
Value-at-Risk
Risk Metrics
Credit Metrics
Integration of credit & market risk
Enterprise wide risk management
6
Types of risk
Risks can be broadly classified into two groups.
Business risks: Risks assumed willingly to create a
competitive advantage and to add value for shareholders.
Financial risks: Relate to possible losses owing to
financial market activities.
What is the linkage?
The more the business risk, the lower should be the financial risk.
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Risk Categories
Business risks
Financial risks
 Business environment
 Economic cycles
Primary
Operational
 Industry cycles
 Industry trends
 Technology change
Credit risk
Market Risk
Legal
Compliance
Liability
Security
Tax
Liquidity risk
 Vision/strategy
Reputation risk
Source : UBS
Transaction
processing
Examples of Risk
which category?
1. There is a general downturn in the markets
and clients reduce their trading volumes,
reducing the commissions that we earn.
2. We enter into a new business area, but the
revenues do not meet expectations, and
will not cover the costs of the investment
made.
3. A client we have lent money to goes
bankrupt and we lose the funds.
4. Share prices fall 10% globally and we lose
money on our own positions.
5. Due to a credit market dislocation, we find
ourselves unable to borrow funds at an
acceptable price to fund our actual or
proposed commitments
6. A former employee sues the bank for
discrimination.
Source : UBS
7. A CD containing confidential Wealth
Management client data is lost
8. A trader executes transactions, but does
not enter them into the trading system until
later, and only inputs the ones that have
not lost money.
9. A regulator suspends our licence to
conduct business in their country due to
failures in internal controls.
10. Wealth management clients move their
money away from us, due to public
revelation of problems.
11. A counterparty who owes us money under
an OTC derivative transaction defaults due
to financial difficulty
12. A counterparty who owes us money under
an OTC derivative transaction refuses to
pay and claims they were not authorised to
enter the trade
9
Valuation & Risk Management approaches
Derivatives Valuation
Principle
Focus
Horizon
Risk Management
Expected discounted
Distribution of future
value
value
Centre of distribution
Tails of distribution
Current value,
discounting
Future value
Precision
High precision needed
Less precision needed
Distribution
Risk neutral
Actual
10
Market risk
Risk of loss owing to movements in the level or
volatility of market prices of stocks, interest rates,
currencies, commodities.
11
A closer look at currency risk
12
Ref : Prof. Werner Antweiler , http://fx.sauder.ubc.ca/
13
Ref : Prof. Werner Antweiler , http://fx.sauder.ubc.ca/
14
Ref : Prof. Werner Antweiler , http://fx.sauder.ubc.ca/
15
Ref : Prof. Werner Antweiler , http://fx.sauder.ubc.ca/
16
Ref : Prof. Werner Antweiler , http://fx.sauder.ubc.ca/
17
Ref : Prof. Werner Antweiler , http://fx.sauder.ubc.ca/
18
Ref : Prof. Werner Antweiler , http://fx.sauder.ubc.ca/
19
Ref : Prof. Werner Antweiler , http://fx.sauder.ubc.ca/
20
Ref : Prof. Werner Antweiler , http://fx.sauder.ubc.ca/
21
Ref : Prof. Werner Antweiler , http://fx.sauder.ubc.ca/
22
The Dollar vs the rest
Source: New York Fed
23
Long term interest rate movements
Source: New York Fed
24
Short term interest rate movements
Source: New York Fed
25
Stock Market Index movements
Source: New York Fed
26
Liquidity Risk
This refers to the possibility that the transaction cannot be
conducted at the prevailing market prices owing to the size of
the position relative to normal trading lots.
Liquidity risk may also arise because of the inability to meet
payment obligations.
This is especially a risk for portfolios that are leveraged and
subject to margin calls from the lender.
If cash reserves are insufficient, losses in market value may
create a need for cash payments, leading to an involuntary
liquidation of the portfolio at depressed prices.
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Liquidity, model and market risks
Liquidity, market and model risks are interrelated.
Breakdown of markets leads to liquidity problems.
When markets are not in place, models become necessary.
Models pose various risks.
Credit risk
This risk arises because the counterparties may be unwilling
or unable to meet contractual obligations.
Pre settlement risk arises over the life of the contract.
Settlement risk occurs when a counterparty defaults after the
institution has already made its payment.
Settlement risk is very real for foreign exchange transactions
which involve exchange of payments in different currencies at
different times.
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The Nature of Credit Risk
Less liquid positions
Longer time horizons
– e.g. 1 year
Negatively skewed distributions
Potential for longer tails
Correlations and concentrations
Credit Risk components
– Traditional banking products, e.g.
– Loans
– commitments to lend
– letters of credit
– Traded products e.g.
– OTC derivatives
– Repos (and reverse repos)
– Securities borrowing and lending
– Plus settlement risk on e.g.
– Foreign exchange
Operational Risk
This is the risk arising out of inadequate or internal processes,
people and systems from external events.
The best protection against operational risks consists of
-redundancies of systems
-clear separation of responsibilities with strong
internal controls
-regular contingency planning.
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UBS Operational Risk Definitions
Transaction Processing Risk
(TPR) is the risk of financial loss due to
Liability Risk is the risk of loss
Compliance Risk is the risk of loss
arising from potential or actual liability
resulting from a legal or equitable claim,
including contractual and legal claims,
debt, and actions based on breach or
default of contract, commitment of tort,
violation of criminal law, infringement of
trademark or anti-trust action.
incurred by not adhering to the
applicable laws, rules and regulations,
local and international best practice
(including ethical standards) and our
own internal standards.
Security Risk is the risk of loss or
deficiencies in transaction processing
systems or internal controls front to
back.
damage to the Bank’s reputation arising
from a loss of confidentiality, integrity or
availability of our information or assets.
Legal Risk is the risk of financial loss
resulting from the non-enforceability of
rights arising under a contract or from
property or under the general law.
Tax Risk is the risk of loss due to tax
authorities successfully opposing the
Bank’s position in tax returns.
Impact of Operational Risk
Operational risk is inherent in every banking activity.
Impact of Operational Risk
– direct financial losses
– indirect (revenue foregone as a result of business suspension)
– damage to our reputation and franchise
Objective is not to eliminate risk but reduce the risk as
far as practical
– avoid high frequency, high impact
– mitigate or transfer high impact, low frequency
– manage high frequency, low impact events for which the cost of further
risk reduction would exceed the reduction in losses
– accept low frequency, low impact but monitor them
Source : UBS
Barings ( 1995)
233 year old bank collapses under $1.24 Billion loss
Lack of Internal Controls
No segregation of duties (Front and back office)
Poor authorisation procedures
Lack of management awareness of inherent risk
Fraud
Market risk
ING Financial Services
 Business News – 23 April 2007
34-year-old Bernard Santos, a former corporate actions
clerk at ING Financial Services in New York, was
arrested in connection with an alleged $523,000 fraud.
From October 2005 to September 2006, Santos 'created
fake client e-mails that requested payment of particular
stock dividends, then transferred dividend payments to a
bank account he controlled'.
Santos was accused of netting more than $523,000 from
the alleged scam.
Allfirst/Allied Irish Bank



$674 million loss
Major control deficiencies e.g. failure of back office to
confirm bogus options and failure of middle office to
obtain independently sourced exchange rates
Missed opportunities to detect fraud e.g. poor
supervision of rogue trader John Rusnak
Operational Risk Drivers
 High Profile Losses
 Reputational damage
 Regulatory Pressure
– SOX (Sarbanes – Oxley Act)
– Basle II
– MiFID (Markets in Financial Instruments Directive)
 Competitive Advantage
– Outsourcing / Offshoring
– Technology Advancement
– Business Growth (Trade volume and human capital)
– Product Complexity and Evolution
– Emerging Market Opportunity
Sarbanes Oxley (SOX)
 Enacted in response to a number of high-profile corporate and
accounting scandals that resulted in a loss of public trust in
corporate accounting and reporting practices (Enron).
 Establishes new or enhanced standards for corporate
accountability and penalties for corporate wrongdoing.
 Section 404 - CEO and CFO attest that the firm's financial
accounts and the controls over the processes used to produce
them are sound.
Credit, market, settlement and Operational Risk Illustration
A trader purchases £1 million spot from Bank A. The current rate is $1.5/£.
This means two days from now, the trader will have to give $1.5 million and
receive £1 million. The trader will then offload position in the market with
another counterparty B.
Market Risk: If the spot rate changes to $1.4/£, loss for the trader = 1.5 – 1.4
= $100,000, assuming the deal with counterparty B is now stuck at 1.4.
Credit Risk: Say the next day, B goes bankrupt and the rate changes to $
1.35/£. Instead of selling to B at 1.4, A will have to offload in the market to
another bank, say at 1.35.
Loss = $50,000 (loss per unit = 1.4 – 1.35).
Settlement risk: If $1.5 million is delivered but £ 1 million is not received, this
is settlement risk.
Operational risk: $1.5 million is wired to the wrong bank. After two days, the
money is received and remitted to the right bank with compensatory
interest. The loss is the amount due.
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