RISK ANALYSIS MANAGEMENT MAY 2012 - SOLUTIONS
Section A
Q1
i.
ii.
Below are two types of risk:
a)
Pure and Clear
b)
Downside and Upside
c)
Speculative and Pure √
d)
One-way and Pure
In running a business you must learn to take risks:
a) Whose consequences can be tolerated
b) That can be mitigated
c) That offer rewards
d) All of the above √
iii. People react to risk in different ways and according to how circumstances change. This
is known as:
a) The Prospect theory √
b) The Retrospective theory
c) The Respect theory
d) None of the above
iv.
The cost of risk may take several forms. These include:
a) Reputational cost, emotional Cost and spiritual Cost
b) Brand cost, spiritual cost and opportunity cost
c) Physical cost, tangible cost and opportunity cost
d) Emotional cost, reputational cost and opportunity cost √
v.
Any costing of risks must take into account the following;
a) Direct and indirect cost
b) Economical and political costs
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c) (a) and (b) √
d) None of the above
vi.
Examples of areas of focus for Strategic risk management are:
a) Capital adequacy, Market movement, Customer demand and Competitor
response,
b) Acquisitions, Divestments, Investments and Hostile bids
c) (a) only is correct
d) Both (a) and (b) are correct √
vii.
What are the main three objectives of Corporate Governance?
a) Financial stability, reducing criminal activity and ensure accountability. √
b) Financial stability, Econimic stability and Bank viability
c) Proper accountability, Bank viability and economic stability
d) Bank viability, financial stability and profitability
viii.
Systemic risk sometimes is referred as:
a) Market risk √
b) Deversifiable risk
c) Business risk
d) Technological risk
ix.
What is liquidity?
a- At its simplest level, liquidity is having cash
b- Liquidity is having immediate access to cash
c- To a bank, liquidity means disbursing more loans
d- (a) and (b) are correct. √
x.
The overall objective of a bank Asset and Liability Management is:
a) Shareholder wealth maximization √
b) Interest rate management
c) Management of assets
d) Mitigation of the bank’s risks
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Q2
Mr. Chiphwanyamchenga has been a tobacco farmer eversince childhood and
throughout the years he has never been disappointment with his farming except for
last year. Tobacco sales for the just ended season have been terrible to say the least,
such that his losses are enormous. However, instead of him perhaps trying other
crops this year, he has again gone flat out farming tobacco.
Required:
In terms of risk theories, mention the relevant theory to this attitude and briefly
explain how it works.
(15 marks)
This is called the Prospect theory: - 2 marks
If gains have already been made in a venture there is a great reluctance to lose gains
made and greater hesitation in going for the next stage.
3 marks
Conversely as people lose more, they are likely to become less risk averse (or more
risk loving) as they seek to recoup their gains by taking greater gambles or risks.
For example, a currency or derivative trader who has incurred a loss will in most
cases tries to deal his way out of the situation by taking greater risks. The
psychological thinking is that as he has already made a loss and hurt or damaged
his reputation, then the magnitude of that damage will be largely unaffected if the
loss is increased – but if he succeeds he will not lose his reputation. In effect,
therefore, he has nothing further to lose. The logical or rational procedure, of
course, would be to admit to an error and take it on the chin – but human beings are
largely irrational and emotional and therefore large losses can be run up often
frighteningly quickly – with catastrophic results if proper controls are not in place.
The example of Barings Bank where Nick Leeson’s losses brought down the entire
bank illustrates this point well.
10 marks
Q3
a) Financial Risks are the risks that threaten the erosion of economic value of a firm.
These risks are normally quantifiable in monetary terms. Mention any five different
types of risk under the Financial Risk Category.
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(5marks)

Market

Interest rate

Credit

Currency fluctuations

Counterparty

Cash flow/solvency

Fraud/embezzlement

Gearing/capitalization

Revenue recognition/depreciation policy

Money laundering
b) Political risks are the costs and opportunities that arise as a result of the actions and
inactions of governments which can affect a business entity. Briefly describe four
components of these political risks and their impact on a business. (10 marks)
1- Political Instability (Social unrest, government instability, political violence) –
business prospects poor and investors and kept at bay
2- Economic Failures (Currency risks, economic failures, unemployment) – very
difficult to conduct business resulting in losses
3- Institutional Risk (Poor intellectual property (IP) protection, unstable succession
process, politicized institutions, lack of legal redress, poor transparency) – unsafe
place to prosper
4- Bribery and corruption – integrity absent and zero trust therefore more losses
through infuriated figures, theft etc
Q4
Malawian financial institutions are regulated by the Central Bank, the Reserve Bank of
Malawi, which endeavors to produce guidelines on how these financial institutions can
conduct business profitably but without excessively disregarding risks inherent in their
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businesses. Briefly explain five reasons why the Central Bank regulates the Financial
Institutions.
(15 marks)
There are many reasons why legislation is passed, and usually, but not always, it is to
reduce risk in some way:

Protection

To maintain the soundness of financial institutions

To ensure proper behavior by corporations

Financial stability

To reduce criminal activity

To ensure proper accountability

To give a level playing field
SECTION B
Q5
Briefly explain any five characteristics of risk.
(20 marks)
I. Things must be variable – there is no risk that the sun will not rise for the
foreseeable future (event if you cant see it some days), but there is a risk that the
weather may be bad or that the power to a factory might fail, that an employee
might not turn up, or that you might be subject to fraud.
II. It is circumstantial - e.g. bad weather makes a simple road journey into a
potentially dangerous trip and can make it very risky indeed (thick ice or black
ice or hard rain and wind, very muddy and slippery road surface through a
village).
III. There must be an exposure to the risk or hazard – The fact that there is a war in a
country does not affect you unless you live in it or near it, are involved in it in
some way or have a financial or other interest in it. Similarly, a person living in
the UK is not affected by a car crash involving a total stranger in South Africa.
IV. There must be a cause - if you have an open long F/X (foreign Exchange)
position, then an adverse movement in rates will affect the value, if you do not
have such a position then you are unaffected
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V. There must be a possible adverse outcome - there is no risk in receiving a
birthday card
VI. The assessment of the risk is subjective based on our expectations - you do not
expect to be knocked down or shot ordinarily even though it is theoretically
possible (because it is improbable)
VII. It must be quantifiable as to whether it will occur (otherwise it is just an
uncertainty).
Q6
Risk management practices are an integral part of strategic planning. A company is said to
have low strategic risk if it meets certain criteria. Explain five of these criteria. (20 marks)

Strategic goals, objectives, corporate culture, and behavior are effectively
communicated and consistently applied throughout the institution.
Strategic
direction and organizational efficiency are enhanced by the depth and technical
expertise of Management.

Management has been successful in accomplishing past goals and is appropriately
disciplined.

Management information systems effectively support strategic direction and
initiatives.

Exposure reflects strategic goals that are not overly aggressive and are compatible
with developed business strategies.

Initiatives are well conceived and supported by appropriate communication
channels, operating systems, and service delivery networks. The initiatives are
supported by capital for the foreseeable future and pose only nominal possible
effects on earnings volatility.
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
Strategic initiatives are supported by sound due diligence and strong risk
management systems. The decisions can be reversed with little difficulty and
manageable costs.
Q7
Under the Principles of Sound Corporate Governance there are Eight principles which the
Basel Committee identifies as the key principles that need to be followed in corporate
governance. Breifly give an overview on any five of the Eight principles. (20 marks)
Principle 1
Board members should be qualified for their positions, have a clear understanding of their
role in corporate governance and be able to exercise sound judgment about the affairs of
the bank.
Principle 2
The board of directors should approve and oversee the bank’s strategic objectives and
corporate values that are communicated throughout the banking organisation.
Principle 3
The board of directors should set and enforce clear lines of responsibility and
accountability throughout the organisation.
Principle 4
The board should ensure that there is appropriate oversight by senior management
consistent with board policy.
Principle 5
The board and senior management should effectively utilise the work conducted by the
internal audit function, external auditors, and internal control functions.
Principle 6
The board should ensure that compensation policies and practices are consistent with the
bank’s corporate culture, long-term objectives and strategy, and control environment.
Principle 7
The bank should be governed in a transparent manner.
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Principle 8
The board and senior management should understand the bank’s operational structure,
including where the bank operates in jurisdictions, or through structures, that impede
transparency (i.e. “know-your-structure”).
Q8
What is the objective of the Central Bank Directive on Asset Classification? Give three
objectives and their rationale.
(20 marks)
Solution:
Objectives of the Directive
-
To ensure that banks are in proper compliance with capital adequacy
requirements as called for in Section 16 of the Banking Act of 1989,
especially: sub-section a) valuation of assets, b) depreciation of assets, and c)
provision for bad and doubtful debts;
-
To ensure banks are quantitatively identifying their non-performing credit
facilities in order to help ensure collection efforts are undertaken;
-
To ensure banks present balance sheets and income statements that properly
reflect the financial impact of non-performing credit facilities.
Rationale
-
Banks need to, in an accounting sense, recognize problem assets using a
quantitative definition of non-performing and then properly treat such assets with
regard to accrual of interest, classification according to ultimate collectibility, and
to make adequate provisions based on such classification;
-
The recognition of such non-performing assets stimulates collection efforts and
thus helps reduce the possibility of loss on such assets;
-
Supervisory authorities worldwide have recognized that their effectiveness is
dependent on the integrity of balance sheets and income statements resulting from
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proper identification and accounting treatment of non-performing assets; failure to
set such standards can lead to fictitious profits and misleading balance sheets to the
supervisory authority and other interested parties.
This Directive ensures the risk of banks ignoring “trouble signs” in loans they disburse,
thereby having large risk exposure of depositors’ funds and bank’s own capital.
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