Guy Hargreaves
ACE-102
Recap of yesterday
 How banks generate financial returns
 The key metrics used in bank financial management
 The advantages of economies of scale and
diversification
 The problems of asymmetric information, adverse
selection and moral hazard
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Today’s goals
 Appreciate the key risks managed by banks
 Understand the tools used to manage the various bank
balance sheet risks
 Discuss pros and cons of existing and new regulations
around balance sheet risk management
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Banks and risk
 Banks are in the risk business
 Risk is everywhere in banking
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Market risk
Liquidity risk
Credit risk
Operational risk
Country risk
Reputational risk
Systemic risk
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Banks and risk
 The profitability of banks is driven by how well they
manage risk “flows”:
Customers transfer their risk to banks
 Banks take on risk for principal trading
=> Managing all these risk flows as an ongoing viable business
has risk
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 Some risk is unmanageable and banks need to avoid
this.
 All risk needs to be properly priced and managed
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Major market risk types
 Interest rate risk:
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Exposure through a financial instrument to movements in
interest rates
Fixed rate bonds, interest rate swaps, bond futures – anything
with a long dated fixed cashflow
“Delta” – the change in the $ value of that instrument for a
0.01% change in interest rates
VAR – “Value at Risk” how much the bank would lose if a
significant move in interest rates occurred
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Major market risk types
 FX risk:
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Exposure through a financial instrument to movements in
foreign exchange rates
Spot FX, foreign exchange swaps, FX futures
“Delta” – the change in the $ value of that instrument for a
certain change in FX rates
Included in firmwide VAR
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Major market risk types
 Credit trading risk:
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Exposure through a financial instrument to movements in
credit margins
Corporate bonds, credit swaps, credit indices
“Delta” – the change in the $ value of that instrument for a
0.01% change in credit margins
Included in firmwide VAR
Not to be confused with credit default risk
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Major market risk types
 Commodity risk:
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Exposure through a financial instrument to movements in
commodity proves
Gold swaps, commodity futures
“Delta” – the change in the $ value of that instrument for a
certain change in commodity prices
Included in firmwide VAR
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Trading versus banking books
 Banks use two broad accounting regimes:
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Banking book – holds corporate and retail loans on an
“accruals” basis; uses a “loan provision” model for potential
impairments or losses from defaults; no market risk
Trading book – holds securities and marketable instruments
on a “mark-to-market” basis; gains and losses in market value
brought to P&L daily; all market risk
 Whether a financial instrument is held in a banking
book or a trading book is critical to the way it is risk
managed
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Liquidity (gap) risk
 The ongoing ability of a bank to fund itself
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Banks tend to “lend long” and “borrow short” – borrowers
want the certainty of funding for long periods whereas savers
don’t ant to lock up their funds for long periods
Liquidity or gap risk is the risk savers will not redeposit their
funds when they come due, leaving the bank repaying
deposits whilst the funds remain tied up in longer term assets
 Reinvestment or refinancing risk is the risk that when
a bank comes to refinance a deposit interest rates will
be higher – it’s not liquidity risk but actually interest
rate risk
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Credit (default) risk
 Loans in the banking book and bonds in the trading book
both have credit default risk
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The issuer will fail to repay a coupon or principal, or will go into
bankruptcy
Banks have Special Asset Management units which do nothing but
manage defaulted customers
Once in default, banks will often take control of the company as
“senior creditors”, sell all remaining company assets and use the
proceeds to repay “creditors” in order of seniority
If a bank receives less than it is owed following liquidation it has
suffered a recovery rate of < 100%
 Banks may make “provisions” in their balance sheets for
loans which they expect have a high chance of defaulting
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Operational risk
 Operational risk is defined as “the risk of loss resulting
from inadequate or failed internal processes, people
and systems or from external events”
 Regulators and banks are working towards a consistent
and standardised way of measuring and holding
capital against this risk
 Causes of operational risk include internal and
external fraud, employment practices and work safety,
illegal business practices (eg money laundering) and
physical or system failures
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Country risk
 International banks invest significant capital into
countries around the world to support their local
operations
 Some of these countries are risky emerging markets
(eg Argentina) where the risk that the local
government introduces foreign exchange controls or
other measures that might be harmful
 Sovereign risk is not country risk – it is the risk a
sovereign will default on its debt
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Reputational risk
 Banks have suffered scandals and bad media headlines
since the 2007-9 GFC
 Most of the criticism has been fully justified!
 As a result many banks have seen their reputations
with customers, governments and other important
stakeholders suffer badly
 When a bank earns a poor reputation its WACC
increases as savers become reluctant to deposit, and
borrowers are less willing to do business with banks
that have behaved badly
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Systemic risk
 The 2007-9 GFC showed up serious flaws in the
banking system and the way banks were regulated
 At a number of times the governments around the
world were forced to step in and “bail out” the banking
system
 Even good banks came under stress as the system
crashed – banks can not individually manage systemic
risk but together they must all employ good
management practices to ensure the system is sound
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Correlation risk
 “Correlation” is the relationship between two independent
variables. These variables might be financial asset prices,
default rates of FX rates for example
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Many financial market products have correlation assumptions built
into them. Banks also assume their loan and securities portfolios will
not be highly correlated
Correlation of 1 between assets A and B means if A increases in price
by 10% then B will increase in price by 10% also
 In financial crises often many assets become highly
correlated. This is a major problem even for diversified loan
books because default rates can increase across the
portfolio and wipe out bank capital
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Bank risk management tools
 Value at Risk (VAR) – banks look at 2-3 years of price
history and use probability models to determine to a
high degree of confidence how far a market can move
over say 1 or 5 days
 Traders are then given $ amounts they can potentially
gain or lose based on VAR – this sets the total amount
of a financial instrument a trader can have exposure to
in his/her trading book
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Bank risk management tools
 VAR example:
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Joe is an interest rate swaps trader and is given a $1m daily VAR limit
he can trade for the bank
Joe trades 3-year bonds which have a delta of $250 ie if Joe owns $1m
bonds and interest rates rise by 1 basis point or o.o1% Joe will lose
~$250 on a MTM valuation
Joe’s Risk Management team tell him based on their VAR models the
3-year bond is assumed to move 20 basis points or 0.2% maximum in
a day
Joe is offered $30m of 3-year bonds by an investor – can he buy
them?
if Joe bought the bonds he would have a delta of $250 * 30 = $7,500 ;
at worst the bond yield will increase by 20 basis points in a day and if
so Joe would lose $7,500 * 20 = $150,000 => Joe can buy the bonds as
he has a daily VAR limit of $1m
Joe could buy a maximum of $200m bonds under that limit
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Bank risk management tools
 Weaknesses in the VAR method have been shown up
since the 2007-9 GFC
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Markets have a capacity to move in much more extreme ways
than VAR models predict – especially highly correlated
markets or assets
VAR models may underestimate “tail risks” – so-called “black
swans” championed by Nassim Taleb
Regulators and bankers become too comfortable with VAR –
belief that it is worst case makes risk managers overly
comfortable
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Bank risk management tools
 Credit default risk management is a critical element of
banking book management
 “Credit Committees” (CC) establish maximum
exposure limits to individual, group and related party
borrowers
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Limits are set for loans, derivatives, settlement, FX and many
other financial products
CC monitors total exposure to the borrower or group
Bankers are forbidden to lend or trade in more volume with
the borrower or group than the limit set by CC
This prevents the bank from becoming overexposed to any
one borrower or group
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Bank risk management tools
 Critical to bank credit default risk management is to
lend to a broad diversified set of borrowers
 Diversification means investing in a broad range of
uncorrelated borrowers such that “systematic risk” can
be reduced in the portfolio
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“Don’t put all your eggs in one basket”!
Investing in $1 in each of 50 borrowers is far less risky than
investing $50 in just one
If all the borrowers are perfectly correlated with each other (ie
correlation of 1) then the diversification will not be effective
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Bank risk management tools
 Also critical to bank credit default risk management is
for banks to accurately analyse and a borrower’s credit
risk profile
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Highly specialised bank credit analysts review a borrowers
financial statements and estimate Probability of Default (PD)
and Loss Given Default (LGD)
PD estimates are usually quite accurate but LGD is much
harder to calculate
Expected Loss (EL) = PD * LGD * EAD
EAD is Exposure at Default and can often be larger than the
facilities granted if interest is unpaid
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Bank risk management tools
 Credit provisioning varies widely across the banking
system
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Large banks routinely take generic provisions against their
more diversified portfolios
Smaller banks make less provisions – more eggs in one basket!
 Since the late 1990’s credit swaps have been used to
manage loan, counterparty and other credit risks
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Limited to the larger borrowers that have a higher profile
borrowing base
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