Topic 5: The Management of
Risk in Banking
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Lecture Outline
 Types of risk faced by the modern bank
e.g. Credit Risk, Interest Rate Risk, Currency
Risk
 Approaches to the management of
specific risks
e.g. GAP analysis, Duration Analysis,
Derivatives
 Key risk management techniques
Derivatives, asset securitisation
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Introduction
 All profit maximising firms/banks face two types of
risks:
 Microeconomic risk
 Macroeconomic risk
 Additional potential risks include:
 Breakdown in technology;
 Commercial failure of a supplier or customer;
 Political interference;
 National disaster
 Additionally, banks manage the risk arising from on
and off-balance sheet business.
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Definitions of Risk
 Credit Risk
 Probability of default on a loan agreement.
 Liquidity Risk
 Risk of insufficient liquidity for normal operating
requirements. This is called maturity mismatching.
 Gearing or leverage risk
 Banks are highly geared (more heavily leveraged)
than other businesses.
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Definitions of Risk
 Interest Rate Risk
 Interest rate risk arises from mismatches in both
the value and maturity of interest sensitive assets
and liabilities.
 Market or Price Risk
 Banks face market (or price) risk on instruments
such as bonds or securities.
 Foreign Exchange or Currency risk
 Under flexible exchange rates a bank with global
operations faces this type of risk if it relies upon
foreign cash flows.
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Credit Risk Management

Methods Employed to Manage Credit Risk
include:
 Accurate pricing of loans---more risky loans may be
priced higher than the less risky loans.
 Credit limits----credit limit may be imposed on the
borrower according to their wealth or potential income
in near future.
 Collateral or security----loans should be properly
secured against the wealth or assets of the borrower
(houses or shares etc.)
 Diversification---risky loans can be backed up through
finding new loans markets.
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Approaches to Credit Risk Management
 The analysis of information is conducted
according to two broad styles of approach:
 Qualitative Methods - assessing annual reports
(company) or debt-credit records of an account
holder. May also include some regard towards
macroeconomic factors (such as changes in
interest rate).
 Quantitative Methods - require the use of
financial data to predict the probability of default
by the borrower. (e.g. logit and probit models).
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Interest Rate Risk Management

Interest rate risk managed through asset liability
management (ALM). There are two popular
types:
 Gap analysis
 The gap is the difference between interest sensitive
assets and liabilities for a given time interval say six
months.
 A negative gap means sensitive liabilities
are > sensitive assets.
 A positive gap means sensitive assets are >
sensitive liabilities.
 Ideally, we would look for zero gap.
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GAP Analysis-Example
Gap analysis for interest rate risk
Overnight > 3-6
> 6-12 > 1-2
-3 months months months years
Earning assets
notes and coins
£100
3-month bills
£20
interbank loans
£20
5 years bonds
overdrafts
£20
5-years loans
property
Funding sources (Liabilities)
retail deposits
£100
£50
£45
3-months wholesale
deposits
£5
Capital
£10
Net mismatch gap
£35
£20
-£50
-£55
Cumulative mismatch
gap
£35
£55
£5
-£50
> 2-5
years
> 5 years or
not stated
£20
£30
£20
£30
-£30
£0
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Interest Rate Risk Management
Duration analysis

Duration analysis allows for the possibility that the average
life (duration) of an asset or liability differs from their
respective maturities which makes matching of sensitive
assets with sensitive liabilities quite difficult.
 Suppose the maturity of a loan is six months and the bank
opts to match this asset with a six months certificate of
deposit (CD). If part of the loan is repaid each month, then
the duration of the loan will differ from its maturity.
 The formula for duration is as:
 Duration= Time to redemption {1- [coupon size//MPV*r)] } +
(1+r) / [1-(DPV of redemption/MPV)]
 Where: r: market or nominal interest rate; MPV: market
present value; DPV: discounted present value
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Duration Analysis - Example

Bond life: 10 years, Value: £100, Coupon rate: £5 annually,
Redemption value: £100, Market interest rate: 10%. Present
value is calculated as:
DF
0.91
0.83
0.75
0.68
0.62
0.56
0.51
0.47
0.42
0.39
5
5
5
5
5
5
5
5
5
105
PV
4.55
4.13
3.76
3.42
3.10
2.82
2.57
2.33
2.12
40.48
69.27
Duration is calculated as:
D = 10 ([1- (5 / 6.9277)] + (1.1)
{1-[100(1.1) -10/69.277]}).
D = 7.6 years rather than 10
years.
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Approaches to the management of liquidity and
currency risks
Liquidity risk management
 Triggered on a ‘run’ for deposits.
 Best way to control this is with good management,
means to restore confidence and deposit insurance?
Currency risk management
 Foreign exchange or currency risk arises from
exposure in foreign currencies.
 In the foreign exchange markets, duration analysis is
used to compute the changes in the value of foreign
currency bond in relation to foreign currency interest
rates, or domestic currency interest rates.
 Gap analysis may also be employed in the foreign
exchange market where the gaps that exist in individual
currencies are identified.
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Derivatives
 A derivative is a contract which gives one party a
claim on an underlying asset, or cash value of asset,
at some fixed date in the future.
 The other party is bound by the contract to meet
the corresponding liability.
 A derivative is a contingent instrument because:
 it consists of of well-established financial
instruments traded in world markets.
for example, currencies
or commodities for example, wheat
 Key examples include:
 Forward rate agreements, options, swaps, futures
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Asset Securitisation
 Asset securitisation involves turning traditional, nonmarketed balance sheet assets (such as loans) into
marketable securities, and moving them ‘off balance sheet’
 When a bank asset is securitised, different functions
traditionally played by the bank are unbundled, and may be
offered by other parties (known as “pass through”).
 The unbundled items include:
 Origination, Credit analysis, Funding function, Servicing
function, Warehousing function
 Benefits of securitisation include:
 Separation of Types of Risk (an can sell ‘bundles’ of risk).
 Potential increase in shareholder value
 Compliance with Regulations (Basel Accord)
 Main problem is early repayment on some assets.
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