CHAPTER1
The Basics of Risk Management
INTRODUCTION
• Banks make money in one of two ways
– providing services to customers
– taking risks
• In this book we address the business of making
money by taking risk
• Bank takes more risk it can expect to make more
money
• Greater risk also increases the danger that the
bank could lose badly and be forced out of
business
The risk–return relationship in
banks
• While a positive risk-return relationship is
presented for profitable banks, the riskreturn relationship is negative for profitless
banks
• In theoretical, a bank taking a relatively
high risk is supposed to earn high profits
• However, bankruptcy costs may be
relatively high for a bank maintaining
higher risk exposure
INTRODUCTION
• Banks must run their operations with two goals
in mind
– generate profit
– stay in business.
• Two goals of risk management in this book
– Decide bank’s economic capital
• Ensure that the risk being taken is matched to the bank's
capital
• The bank’s capital is much enough to absorb the losses of
bad situations
– Allocate bank’s economic capital
• Help the CEO direct the limited resource of capital to the
opportunities that are expected to create the maximum return
with the minimum risk
INTRODUCTION
• Risk measurement attempts to answer the
following four questions:
– How much could we lose?
• Calculate the risk measure
– Can we absorb a significant loss without going
bankrupt?
• Decide the economic capital
– Is the return high enough for us to take that risk?
• Calculate the return after considering risk
– How can we reduce the risk?
• Risk hedge by some financial instruments in the market
(SWAP, Option, Forward and Futures)
• Diversification
THE ORGANIZATIONAL STRUCTURE OF
A TYPICAL BANK
• banks are typically organized into five
divisions
– corporate banking
– retail banking
– asset management
– Insurance
– support.
deals with the mass of
personal customers :
The corporate banking division
deals with other financial
institutions and corporate clients
such as large, industrial
corporations.
THE ORGANIZATIONAL STRUCTURE OF
A TYPICAL BANK
• Sales and Trading Group:
– Activities:
• Sells securities to investors, trades securities with other
banks
– Risks
• market risk and liquidity risk in trading
• ALM desk
– Activities:
• manages the bank's asset and liability mismatch
– Risks
• Interest rate and liquidity risk in funding
The 7% spread between the loans and deposits should
cover
the administrative costs
the credit loss on the loan
the interest-rate and liquidity risks due to the
mismatch
• There is a key problem with this situation:
• It is not possible to attribute
profitability/risk separately
THE ORGANIZATIONAL STRUCTURE OF
A TYPICAL BANK
• The commercial finance group
– Activities:
• Provides loans to company
• Advises companies on their financial structures
– For example, if a company wanted to fund a new
venture, the commercial finance group would advise it on
whether to use debt or equity to raise money
– Risks
• Credit risk or Default risk
– Company borrowers are unable to pay money back to
bank
THE ORGANIZATIONAL STRUCTURE OF
A TYPICAL BANK
• Retail Banking
– Activities
• take deposits from customers in the form of
checking accounts, savings, and fixed deposits,
then lend funds to other customers in the form of
mortgages, credit cards, and personal loans
• The division makes a profit by giving low interest
rates to depositors and charging high interest rates
to borrowers
– Risk
• Credit Risk or default risk
– Retail borrowers are unable to pay money back to bank
HOW BANKS CAN LOSE MONEY
• Market Risk
– Sales and Trading Group
• Sells securities to investors, trades securities with other
banks and in markets
– Market risk arises from the possibility of losses
resulting from unfavorable market movements
– Losing money because the value of an instrument
has changed
– Market risk factors:
• Stock price: for example, in a recession period, the S&P 500
index fall down, then the price of the security a bank holds
will fall down as well
• Exchange rate: for example, if a bank holds a foreign bond,
and the foreign currency depreciate
• Interest rate: for example, if a bank hold a bond, and the
interest rate increase
HOW BANKS CAN LOSE MONEY
• Credit Risk
– arises from defaults, when an individual, company, or
government fails to honor a promise to make a
payment
– There is a gray area between market risk and credit
risk
• The price of corporate bonds falling down is due to the
markets predicting the probability of a corporate default will
increase
• The risk before the default happens: market risk
• The actual default: credit risk
– Forms of Credit risk
• Default on a loan: failure to repay an amount that has been
lent
• Default on a bond: bond issuer fails to make the payments
promised by the bond.
HOW BANKS CAN LOSE MONEY
• Operating Risk
– the risk of direct or indirect losses resulting
from inadequate or failed internal processes,
people and systems or from external events
– Operating risk includes fraud and the
possibility of a mistake being made
HOW BANKS CAN LOSE MONEY
• Blends of Risks
– Often banks will lose money from an incident
that involves several forms of risk
– The case of Barings bank
– Nick Leeson was a trader in the Singapore
branch of Barings bank. He had seemingly
generated 20% of Barings' profits in 1994
– In fact, he had been making losses and hiding
them in a fictitious account. (Operating risk)
HOW BANKS CAN LOSE MONEY
– To recover the losses he tried a large, risky
gamble with derivatives on the Nikkei 225.
(Market risk)
– In 1995, he lost $1 billion and consumed out
Barings' capital. He was able to hide the
original losses because he was in charge of
both trading and accounting in the Singapore
office. (operation risk)
– He was able to take the final gamble because
senior management had no effective
measurement of the risks being taken.
HOW BANKS CAN LOSE MONEY
• Most of this book will concern risk
management and measurement at the
transaction and business-unit levels
• Several Risks we will discuss in this book
– trading risks or market risk
– asset/liability management
– credit risk
– operating risk
MANAGING RISK AT THE MACRO
LEVEL
• three keys for risk-management:
– deciding the target debt rating
– determining the amount of available capital
– allocating risk limits to each business unit
within the bank
MANAGING RISK AT THE MACRO
LEVEL
• Determining the Target Debt Rating
– The debt rating is a measure of the bank's
creditworthiness and corresponds to the bank's
probability of default
– A high debt rating corresponds to a low probability of
default
• For example, AAA-rated Bank vs. A-rated Bank
– The bank's creditworthiness is determined by
• (1)the amount of risks a bank takes
• (2)the amount of capital a bank hold
– Capital is the difference in value between the bank's
assets and liabilities. It can be viewed as the current
net worth of the bank
MANAGING RISK AT THE MACRO
LEVEL
• If the bank has a small amount of capital and takes a
large amount of risk, there is a high probability that the
losses will be greater than the capital, and the bank will
go bankrupt
• If the bank wants a high rating, it must hold a large
amount of capital in relation to its risks.
– But a bank have to pay cost for holding extra capital in hand
– For example, by given fixed total profit of a bank, the average
profit for per capital will decreases when the amount of capital
increases
• A low target debt rating has the advantage that the bank
can take on many risks and expect to earn a high rate of
return for the shareholders.
– However, a low debt rating means that debt holders will charge
higher interest rates to lend their money to the more risky bank
MANAGING RISK AT THE MACRO
LEVEL
• To conclude, a bank have to decide a
suitable debt rating for itself and then
decided the economic capital it has to
prepare
Determining the Amount of
Available Capital
• The available capital is the current value of the
assets minus the current value of the liabilities
• Capital = Nominal Asset Value-Liabilities
• If the board wishes to increase the capital
quickly, it can do so by issuing more bank
shares
• This gives the bank more cash without
increasing the liabilities to avoid default.
• Alternatively, the capital can be increased over
several years by retaining earnings and not
paying dividends to shareholders
Allocating Risk Limits
• Once the target debt rating is set and the
amount of available capital has been
calculated, the bank's total risk capacity is
fixed
• The next question is how to allocate the
total risk capacity to the different business
units
– trading, credit cards, and corporate lending
Allocating Risk Limits
• In doing this it must consider
– the expected return and risk from each unit
– the diversification of the risk between units
– In general, we will allocate most (not all) of
the risk capacity to the units that are expected
to make the highest returns