Banking Risks

BANKING RISKS Risks are uncertainties resulting in adverse variations of profitability or in losses. Main Banking risks are: Credit risk Interest rate risk Market risk Liquidity risk Operational risk Foreign exchange risk Other risks ( Country risk, Settlement risk, Performance risk)

Credit Risk Credit risk comprises: Default risk : risk that customers default that is they fail to comply with their obligations to service debt. Default triggers a total or partial loss of any amount lent to the counter party. Decline in the credit standing of an obligor of the issuer of a bond or stock : Such deterioration does not imply default but it does imply that the probability of default increases. In a market universe, it also materialises into a loss because it triggers an upward move of the required market yield to compensate the higher risk and triggers a value decline. Issuer risk is the obligor’s credit risk which is distinct from the specific risk of a particular issue.

The credit risk is viewed differently for the banking portfolio and the trading portfolio. Banking Portfolio Credit risk arises out of defaults. Default of a small number of important customers can generate large losses potentially leading to insolvency. There are various default events-like delay in payment obligation, restructuring of debt obligations due to a major deterioration of the credit standing of the borrower and bankruptcies. Simple delinquencies or payment delays do not count as plain defaults. Restructuring is very close to default because it results from the view that the borrower will not face payment obligations unless its funding structure changes.

Plain defaults imply that the non-payment will be permanent. They may be due to bankruptcies, possible liquidation of the firm or merging with an acquiring firm. They all trigger significant losses. Credit risk is difficult to quantify on an ‘ex-ante’ basis because it requires an assessment of the likelihood of a default event and of recoveries under default. In addition, banking portfolios benefit from diversification effects that are much more difficult to capture because of the scarcity of data on interdependencies between default events of different borrowers.

Trading Portfolio Credit risk of traded debts is indicated by: Prices determined by capital markets Ratings of agencies assessing the quality of public debt issues Changes in the value of the issuer’s stock Credit spreads, the add-ons to the risk-free rate, defining the required market risk yield on debts.

The capability of trading the market assets mitigates the credit risk since there is no need to hold these securities until the deterioration of credit risk materializes into effective losses. If the credit standing of the obligor declines, it is still possible to sell these instruments in the market at a lower value. The loss due to credit risk depends on the value of these instruments and their liquidity. The selling price depends on the market liquidity. If the default is unexpected, the loss is the difference between the pre and post default prices. In case of over the counter instruments such as derivatives (swaps and options), sale is not readily feasible. The bank faces the risk of losing the value of such instruments when it is positive. The market movements during the residual life of the instrument determine the credit risk. The credit risk and market risk interact because these values depend on market moves. Credit risk measurement raises several issues. The major credit risk components are exposure, likelihood of default or deterioration of credit standing and the recoveries under default. Scarcity of data makes the assessment of these components a challenge.

Interest Rate Risk The interest rate risk is the risk of a decline in earnings due to the movements of interest rates. Most of the items of banks’ balance sheets generate revenues and costs that are interest rate driven. If the lending is at variable rates and deposits are at fixed rates, the bank suffers a loss in case of an interest rate decline. Another source of interest rate risk is the implicit options in banking products e.g prepayment of loans that carry a fixed rate or early withdrawls of deposits. Optional risks are indirect interest rate risks. They do not arise directly and only from a change in interest rates. They also result from the behaviour of customers such as geographical mobility or the sale of their homes to get back cash. Economically, fixed rate borrowers compare the benefits and costs of exercising options embedded in banking products and make a choice depending on market conditions. Measuring the option risk is more difficult than measuring the usual risk that arises from simple indexation to market rates.

Market Risk Market risk is the risk of adverse deviations of the mark-to-market value of the trading portfolio, due to market movements, during the period required to liquidate the transactions. The period of liquidation is critical to assess such adverse deviations. If it gets longer, so do the deviations from the current market value. Earnings for the market portfolio are profit and loss (P&L) arising from transactions. The P&L between two dates is the variation of the market value. Any decline in the value results in a market loss. Pure market risk is generated by changes in market parameters (interest rates, equity indexes, exchange rates). It does not include asset and market liquidity risks incidental to liquidation of assets. The market risk is captured through the VaR technique. Controlling market risk means keeping the variations of the value of a given portfolio within given boundary values through action on limits and hedging.

Liquidity Risk Liquidity risk has multiple dimensions: • Inability to raise funds at normal cost • Market liquidity risk • Asset liquidity risk Funding risk depends on how risky the market perceives the issuer and its funding policy to be. An institution coming to the market with unexpected and frequent needs for funds sends negative signals that might restrict the willingness to lend to this institution. If the perception of credit standing deteriorates, funding becomes more costly adversely affecting profitability. It also affects its ability to do business with other financial institutions and to attract investors. Market liquidity risk materialises as an impaired ability to raise money at a reasonable cost.

• Market liquidity is affected by volume of trading. Due to lack of volume, prices become highly volatile, sometimes embedding high discounts from par. • Asset liquidity risk results from lack of liquidity related to the nature of assets rather than to market liquidity. Holding a pool of liquid assets acts as a cushion against fluctuating market liquidity because liquid assets allow meeting short term obligations without recourse to external funding.

Some assets are less tradable than others because their trading volume is narrow. Similarly some stocks trade less than others. Exotic products might not trade easily because of their high level of customization., possibly resulting in depressed prices. In such cases, any sale might trigger price declines so that proceeds from progressive or one shot sale become uncertain and generate losses. To a certain extent, funding risk interacts with market liquidity and asset liquidity because the inability to face payment obligations triggers sale of assets possibly at depressed prices. Extreme lack of liquidity results in bankruptcy making liquidity risk a fatal risk. However, extreme conditions are often the outcome of other risks e.g. unexpected losses may trigger massive withdrawls. Asset Liability Management (ALM) restricts liquidity risk to bank specific factors and tries to manage future liquidity gaps ( the mismatch between time profiles of cash inflows and outflows). The market liquidity or asset liquidity are not considered.

Operational Risk • Operational risks are those of malfunctions of the information system, reporting systems, internal risk monitoring rules and internal procedures designed to take timely corrective actions or the compliance with internal risk policy rules. The new Basel Accord of January, 2001 defines operational risk as ‘the risk of direct or indirect loss resulting from inadequate or failed internal processes, people and systems or from external events.’ • In the absence of efficient tracking and reporting of risks, some important risks remain ignored, do not trigger any corrective action and can result in disastrous consequences.

Operational risks appear at different levels: • • • •

People Processes Technical Information Technology

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‘People ‘ risk designates human errors, lack of expertise, frauds and lack of compliance with existing procedures and policies.’Processes’ risk scope includes: (i) inadequate procedures and controls for reporting, monitoring and decision making. (ii) inadequate procedures for processing information such as errors in booking transactions and failure to scrutinize legal documentation.

(iii) organizational deficiencies (iv) risk surveillance and excess limits: management deficiencies in risk monitoring such as not providing the right incentives to report risks or not abiding by the procedures and policies in force. (v) errors in the transaction recording process. (vi) technical deficiencies of the information system or the risk measures. Technical risks relate to model errors, implementation and the absence of adequate tools for measuring risks. Information technology risks relate to deficiencies of the information system and the system failure.

• For operational risks, there are sources of historical data on various incidents and their costs that serve to measure the number of incidents and the direct losses attached to such incidents. Other sources are expert judgements, questioning local managers on possible events, pooling data from similar institutions and insurance costs that should relate to event frequencies and costs. • The general principle for addressing operational risk measurement is to assess the likelihood and cost of adverse events. The practical difficulties lie in agreeing on a common classification of events and on the data gathering process with several potential sources of event frequencies and costs. • The data-gathering phase is the first stage followed by data analysis and statistical techniques. They help in finding correlation and drivers of risks. For example, business volume might make some events more frequent while others depend on different factors. The process ends with some estimate of worst case losses due to event risks.

Foreign Exchange Risk The currency risk is that of incurring losses due to changes in the exchange rates. Variations in earnings result from the indexation of revenues and charges to exchange rates or of changes in the values of assets and liabilities denominated in foreign currencies. The conversion risk (translation risk) results from the need to convert all foreign currency denominated transactions into a base reference currency. This risk becomes significant if the capital base that protects the bank from losses is in local currency. A credit loss in a foreign country might result in magnified losses in local currency, if the local currency depreciates relative to the currency of the foreign exposure.

The time zone risk in relation to foreign currency arises out of time lags in settlement of transactions in different time zones. Three important issues in relation to foreign currency risk are: Nature and magnitude of exchange risk. Strategy to adopt Tools of managing exchange risk. The important tools for managing foreign exchange risk are forwards, futures, swaps and options (for non-linear exposures)

Country Risk Country risk is the risk of a ‘crisis’ in a country. There are many risks related to local crises, including: (i) Sovereign risk which is the risk of default of sovereign issuers such as central banks or government sponsored banks. The risk of default often refers to that of debt restructuring of countries. (ii) A deterioration in the economic conditions. This might lead to a deterioration of the credit standing of local obligors beyond what it should be under normal circumstances. Firms’ default frequencies increase when economic conditions deteriorate.

• (iii) A deterioration in the value of local foreign currency in terms of the bank’s base currency. (iv) The impossibility of transferring funds from the country either because there are legal restrictions imposed locally or because the currency is not convertible any more. (v) A market crisis triggering large losses for those holding exposures in local markets. The general country ratings serve as benchmarks for corporate and banking entities. The reason is that if transfers become impossible, the risk materializes for all corporates in the country.

Solvency Risk Solvency risk is the risk of being unable to absorb losses, generated by all types of risks with the available capital. It differs from bankruptcy risk resulting from defaulting on debt obligations and inability to raise funds for meeting such obligations. Solvency is a joint outcome of available capital and of all risks. The basic principle of capital adequacy promoted by regulators is to define what level of capital allows a bank to sustain the potential losses arising from all current risks and complying with an acceptable solvency level. This requires: (i) valuing all risks to make them comparable to the capital base of a bank. (ii) adjusting capital to a level matching the valuation of risks which implies defining a tolerance level for the risk that losses exceed this amount, a risk that should remain very low to be acceptable. VaR concept addresses these issues directly by providing potential loss values for various confidence levels.

Model Risk Model risk materializes as gaps between predicted values of variables (such as VaR) and the actual values observed from experience. Model risks arise because models ignore some parameters for practical reasons or due to errors of statistical technique, lack of observable data for obtaining reliable fits (e.g. in case of credit risk)