R       I   S   K    1               1
What is Risk?―hazard, a chance of bad consequences, loss orexposure to mischance‖―any event or action that may adversely...
Risk is everywhere – future cannot bepredictedThe intuitive commonsense of Risk- Rewardcoupling     – No risk; no reward...
Risk is CostlyGreater risk imposes costs (reduces value)Example:Identical properties subject to damage. Greaterexpected p...
Importance of Indirect LossesDirect Losses often cause indirect lossesExample: What are the direct and indirect lossesif a...
Option 1: Do NothingCost of risk:Expected loss                   = Rs.60,000Cost of residual uncertainty    = Rs.40,000(as...
Option 2: Loss controlSpend Rs.20,000 to reduce probability of loss to 1/20Cost of risk:Expected loss                     ...
Option 3: Additional Loss controlSpend an additional Rs.20,000 to reduce probability ofloss to 1/40Cost of risk:Expected l...
Option 4: No loss control, but full insurancePremium = Rs.75,000Loading = premium - expected loss            = Rs.75,000 –...
Key points from example:Do NOT minimize risk, minimize cost of riskThere are cost tradeoffs:    Increase insurance coverag...
Problem: If in an ideal world of no risk, the value of Building & Plant including Machinery& Equipment = Rs.120,000,000/-....
Problem: If in an ideal world of no risk, the value of a Bank is Rs.765,906,169,000/-including all tangible & intangible a...
Enterprise-wide Risk                  1-Internal RiskPeople Risks  Fraud  Human Error  Health & Safety  Employment La...
Technology Risks  Data Security  Data Integrity  System Performance  Capacity Planning  Change Management           ...
Socio Economic Risk   External FraudIdentifying Business Risk Exposures  Property  Business income  Liability  Human...
Financial RiskWe are primarily concerned with the maincategories of financial risk:• Market Risk- Pricing Risk• Credit Ris...
•Market Risk — the risk of a change in thevalue of a financial position due to changes inthe value of the underlying compo...
2-Foreign exchange risk is the risk of negativeeffects on the financial result and capital of thebank caused by changes in...
•Liquidity Risk - the risk that it will not bepossible to sell a holding of a particularinstrument at its theoretical pric...
•Energy Risk- Increasing globalization andinterdependence of energy products, deliverymechanisms, and risk management tech...
Sovereign RiskProbability that the government of a country (oran agency backed by the government) will refuse tocomply wit...
What do you Mean by Risk Management?―An integrated framework for managing creditrisk, market risk, operational risk, econo...
Objective of Risk ManagementNeed for a RM Objective•Risk imposes costs on businesses and individuals.•Risk Management (e.g...
The Risk Management Process1. Identification of risks2. Evaluation of frequency and severity of   losses, including maximu...
Economic Capital - Capital is held to ensurethat a bank is likely to remain solvent, even if itsuffers unusually large los...
Function of Economic Capital1. To Address the unexpected loss at certain   confidential level for certain time horizon2. „...
State Bank of PakistanAs per the revision of capital requirements fornew entrants, banks in different modes ofoperations a...
IMPORTANT RATIOS1. Debt to Service Coverage Ratio=Net Operative   Income/ Debt Service   - It is used to measure the abili...
Bank Regulation and BaselImportant State Objective Bank-Stable Economic Environment for PrivateIndividuals and Businesses....
The worst case loss is the loss that is notexpected to exceed with some high degree ofconfidence. The high degree of confi...
Reason For Regulating Bank Capital― Bank regulation is unnecessary. Even if therewere no regulations, banks would manage t...
The capital a financial institution requiresshould cover the difference between expectedlosses over some time horizon and ...
Risk Based Assets = Total Asset - Cash and Equivalents -Fixed Assets                       ORRisk Based Assets = Other Ear...
The Road to Basel―Risk management: one of the most importantinnovations     of     the     20th    century.‖[Steinherr, 19...
• Large derivatives losses and other financialincidents raised banks‘ consciousness of risk.• Banks became subject to regu...
Some Dates• 1950s. Foundations of modern risk analysis arelaid by work of Markowitz and others onportfolio theory.• 1970. ...
• 1980s. Deregulation; globalization - mergerson unprecedented scale; advances in IT.           The Regulatory Process• 19...
The BIS Accord defined two minimum capitaladequacy requirements:1. The first standard was similar to that    existing prio...
Cooke ratio calculated both on-balance sheetand off-balance sheet.     Risk weight for on balance sheet items  Risk       ...
Calculate risk weighted assets (RWA), if theassets of the banks consist of $100 million ofcorporate loans, $10 million of ...
Off balance sheet items are expressed as CreditEquvilent AmountCredit Equvilent Amount is the loan principalthat is consi...
•1993. The birth of VaR. Seminal G-30 reportaddressing for first time off-balance-sheetproducts (derivatives) in systemati...
*Weatherstone Capital Management is a moneymanagement firm that utilizes active moneymanagement strategies that are desig...
•Credit Risk Capital charged in 1988•Amendment also apply to all on-balance sheetand off-balance sheet in the trading and ...
Where k=multiplicative factor, VaR= value at risk &SRC= specific risk chargeRWA for market risk capital is defined as   12...
•2001 onwards. Second Basel Accord, focusingon credit risk but also putting operational riskon agenda. Banks may opt for a...
Basel II: What is New?• Rationale for the New Accord: More flexibilityand risk sensitivity• Structure of the New Accord: T...
•Two options for the measurement of credit risk:    •Standard approach    •Internal rating based approach (IRB)For an on-b...
-Standardized approach (for small banks. InUSA, Basel II will apply only to the largestbanks and these banks must use the ...
• MRC (minimum regulatory capital) def = 8%of risk-weighted assets• Explicit treatment of operational riskThe Market Risk ...
Operational Risk: Banks have to keep capitalfor operational risk.Three approaches.- Basic indicator approach: operational ...
-Advanced measurement approach: the bankuses its own internal models to calculate theoperational risk loss that it is 99.9...
Calculation of total risk weighted assets under theBasel II standardized approach, if the assets of thebank consist of $10...
Problem: Calculate the risk weighted assets under the Basel II standardized approach, if the assetsof bank consist of Rs. ...
Adjustment for CollateralThere are two ways banks can adjust risk weights forcollateral.1- Simple Approach- the risk weigh...
Example: Suppose that an $80 million exposure to a particularcounterparty is secured by collateral worth $70 million. The ...
Expected losses are those that the bank knows withreasonable certainty will occur (e.g., the expecteddefault rate of corpo...
SBP Guidelines on Internal Credit Risk Rating SystemsThe banks are required to establish criteria to map theirinternal obl...
IRB (Internal rating based) approach – one-factor Gaussian copula model of time todefault. WCDR: the worst-case default ra...
Expected Loss (EL) CalculationLending institutions need to understand the lossthat can be incurred as a result of lending ...
The total exposure to credit risk is the amountthat the borrower owes to the lending institutionat the time of default; th...
The probability of default (PD) is thelikelihood that a loan will not be repaid and willfall into default. It must be calc...
For Example:A borrower (Company X) takes out a loan from BankABC for $10 million (EAD). Company X pledges $3million collat...
Loss given default (LGD) is the fractional loss due todefault. Continuing from the previous example:If Company X defaults ...
Back to our example, the recovery rate for Bank ABC= $3 million/ $10 million = 30%So % LGD= 1- 0.30 = 0.70 or 70%.$ LGD= 7...
Problems: Kamran & Sons is a company rated as A+ takes out a loan from Bank ABC for Rs.150million against the mortgage of ...
The VaR MeasureValue at Risk (VaR) is an attempt to provide asingle number that summarizes the total risk in aportfolio of...
Value at Risk: A loss that will not be exceededat some specified confidence level.We are X% certain that we will not lose ...
Using the VaR measure with N=10 and X=99. Thismeans that it focuses on the revaluation loss over a 10day period that is ex...
Expected Shortfall, like VaR, is a function of twoparameters:-N(the time horizon in days) and-X (the percentage confidence...
Properties of Risk MeasuresA risk measure used for specifying capitalrequirements can be thought of as the amount of cash9...
Homogeneity: Changing the size of a portfolio by afactor λ while keeping the relative amounts ofdifferent items in the po...
Example: Consider two $10 million one-year loans each of which has a 1.25% chanceof defaulting. If a default occurs on one...
Pure Risk Characteristics and ManagementGeneralizations:•Pure risk usually involves large potential lossesrelative to the ...
What Is Credit•Person‘s confidence in person.Credit Risk:•A Performance Risk: specifically, the risk of loss dueto a Borro...
The Principles of Good LendingThe Credit Analysis Process:•Information sources/data-gathering•Complete a comprehensive ana...
The principles of lending ensure that the Borroweris able to make payments as and when due:•To identify a clear purpose wi...
Steps of the Credit Process (how banks lend money)•Several sequential steps   Management Profile   Company Profile   In...
Steps and considerations when evaluating credits•Credit analysis process evaluates the borrower‘sability to repay•Assess t...
The 5 Cs (or 7 Cs) of Credit:1.Character2.Conditions3.Capital4.Capacity5.Collateral6.Common sense7.Control1- Character:Cha...
2- Conditions:Conditions focus on the economic and environmentsinfluences that may impact a company‘s financialposition an...
5- Collateral:Collateral protects the lender –when all else fails. Inlending, collateral represents a borrower‘s asset ple...
The Principles of Credit Risk through a review of aStructured Framework of Analysis-Business Risk-Financial Risk-Structura...
Include:•Economic environment•Business cycles•Industry and regulatory trends•Political risks•Other social issuesChanges to...
Financial RiskAffected by:•Quality of management•Company operation•Financial positionInclude:•Management strategy and skil...
Structural RiskReflect how the loan is structured:•Terms•Payments•Collateral•Other credit featuresThe borrower’s support o...
Loss DistributionsTo model risk we use language of probabilitytheory. Risks are represented by randomvariables mapping unf...
Portfolio Values and LossesConsider a portfolio and let Vt denote its valueat time t; we assume this random variable isobs...
The distribution of (Vt+1 − Vt) is known as theprofit-and-loss or P&L distribution.We denote the loss by Lt+1 = −(Vt+1 − V...
Risk FactorsGenerally the loss Lt+1 for the period [t, t + 1]will depend on changes in a number offundamental risk factors...
where l[t] : Rd ! R is a known function whichwe call the loss operator.The book contains examples showing how theloss oper...
The Conditional distribution of Lt+1 given givenFt = σ ({Xs : s t}), the history up to andincluding time t?The uncondition...
Value at Risk: A loss that will not be exceededat some specified confidence level.                 Risk MeasuresRisk measu...
Denote the distribution function of the lossL := Lt+1 by FL so thatP(L ≤ x) = FL(x).              1                       ...
1   95
KEY FINANCIAL RATIOS1. TOTAL ASSETS2. TOTAL EQUITY3. PRETAX PROFIT4. POST TAX PROFIT5. PRETAX PROFIT/ TOTAL ASSETS (av)6. ...
1. TOTAL ASSETSTotal assets represent resources with economic valuethat a corporation owns or controls with theexpectation...
3. PRETAX PROFITA measurement of financial profitability, pre-tax profitcombines all profits before tax, includingoperatin...
5. PRETAX PROFIT/ TOTAL ASSETS (av)The return on assets (ROA) percentage shows howprofitable a companys assets are in gene...
6. Pre-Tax Profit / Total Equity (Av)Return on equity (ROE) measures a corporationsprofitability by revealing how much pro...
7. Tier 1 Capital RatioTier 1 capital is the core measure of a banks financialstrength from a regulators point of view. It...
2 Risk Based Assets = Total Asset - Cash and Equivalents - Fixed AssetsORRisk Based Assets = Other Earning Assets excludin...
8. Total Capital RatioTotal capital Ratio or Capital Adequacy Ratio (CAR)measures a banks capital position and is expresse...
Total Capital Ratio is part of Capital Adequacy ratios of theBank . Where,1 Tier 1 Capital = Total Equity - Revaluation Re...
Total equity covers total equity reserves, total share capital and treasurystock.Net loans include loans to Banks or Credi...
11- Loan Loss Reserves / Gross Loans (Av)This ratio is part of Asset Quality ratios of the bankand determines the quality ...
The ratio determines the quality of loans of a bank.The higher the ratio, the more problematic the loansare and vice versa...
14- Total Deposits / Net Loans RatioTotal deposits / net loans ratio is a measure ofFunding Base Analysis of the bank and ...
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Risk Management

  1. 1. R I S K 1 1
  2. 2. What is Risk?―hazard, a chance of bad consequences, loss orexposure to mischance‖―any event or action that may adversely affectan organization‘s ability to achieve its objectivesand execute its strategies‖―the quantifiable likelihood of loss or less-than-expected returns‖ 1 2
  3. 3. Risk is everywhere – future cannot bepredictedThe intuitive commonsense of Risk- Rewardcoupling – No risk; no reward – Taking on more risk is sensible only if it results in greater likelihood of greater reward! – Appetite for risk determines what reward one seeksAnd the good news is – Risk can be Managed 1 3
  4. 4. Risk is CostlyGreater risk imposes costs (reduces value)Example:Identical properties subject to damage. Greaterexpected property loss lowers value ofproperty, all else equalGreater uncertainty about property loss oftenlowers value of property, all else equal 1 4
  5. 5. Importance of Indirect LossesDirect Losses often cause indirect lossesExample: What are the direct and indirect lossesif a manufacturing plant experiences a majorfire?.Cost of Risk ExampleFirm value in ideal world of no risk = Rs.1,000,000.Issues to be examined:What is firm value with risk of worker injuries?What is relation between firm value and cost of risk?Business is faced with one source of risk: Probability of worker injury = 1/10 Losses from a worker injury: medical expenses Rs.100,000 lost pay Rs.500,000 total Rs.600,000Expected loss = Rs1/10 * 600,000 = Rs60,000 1 5
  6. 6. Option 1: Do NothingCost of risk:Expected loss = Rs.60,000Cost of residual uncertainty = Rs.40,000(assumed)Cost of loss control = Rs.0Cost of loss financing = Rs.0Cost of internal risk reduction = Rs.0 Total cost of risk = Rs.100,000 Firm value = Rs.1,000,000 – Rs.100,000 = Rs.900,000 1 6
  7. 7. Option 2: Loss controlSpend Rs.20,000 to reduce probability of loss to 1/20Cost of risk:Expected loss = Rs.30,000Cost of residual uncertainty = Rs.30,000(assumed)Cost of loss control = Rs.20,000Cost of loss financing = Rs.0Cost of internal risk reduction = Rs.0 Total cost of risk = Rs.80,000 Firm value = Rs.1,000,000 – Rs.80,000 = Rs.920,000 1 7
  8. 8. Option 3: Additional Loss controlSpend an additional Rs.20,000 to reduce probability ofloss to 1/40Cost of risk:Expected loss = Rs.15,000Cost of residual uncertainty = Rs.27,000(assumed)Cost of loss control = Rs.40,000Cost of loss financing = Rs.0Cost of internal risk reduction = Rs.0 Total cost of risk = Rs.82,000 Firm value = Rs.1,000,000 – Rs.82,000 = Rs918,000 1 8
  9. 9. Option 4: No loss control, but full insurancePremium = Rs.75,000Loading = premium - expected loss = Rs.75,000 – Rs.60,000 = Rs15,000Cost of risk:Expected loss = Rs.60,000Cost of residual uncertainty = Rs.0Cost of loss control = Rs.0Cost of loss financing = Rs.15,000Cost of internal risk reduction =Rs.0 Total cost of risk = Rs.75,000 Firm value = Rs.1,000,000 –Rs.75,000 = Rs.925,000 1 9
  10. 10. Key points from example:Do NOT minimize risk, minimize cost of riskThere are cost tradeoffs: Increase insurance coverage ==> Increase loading paid Decrease residual uncertainty Additional loss control ==> Decrease expected losses Increase loss control costs 1 10
  11. 11. Problem: If in an ideal world of no risk, the value of Building & Plant including Machinery& Equipment = Rs.120,000,000/-. Calculate the value of Building & Plant with risk ofdamage on all undermention options:Losses from a Building & Plant:•Repair expenses = Rs.1,000,000/-•lost accrue due to change damage Machinery & Equipment = Rs.4,500,000/- Total = Rs.5,500,000/-What will be the Building & Plant value with risk of damage and the relation betweenBuilding &Plant value and cost of risk?Option 1:Firm face one source of risk with cost of residual uncertainty of Rs.500,000/- &Probability of loss = 1/5.Option 2:Spend Rs.90,000 to reduce probability of loss to 1/10 with cost of residualuncertainty of Rs.250,000/- .Option 3:Spend an additional Rs.80,000 to reduce probability of loss to 1/20 with cost ofresidual uncertainty of Rs.125,000/- .Option 4:Spend Rs.550,000 Insurance Premium against full coverage with no losscontrol and no cost of residual uncertainty. 1 11
  12. 12. Problem: If in an ideal world of no risk, the value of a Bank is Rs.765,906,169,000/-including all tangible & intangible assets. Calculate the value of Bank with risk of Cash& Valuable in lockers Burglary on all undermention options:Losses from Burglary :•Damage expenses =Rs.056,000,000/-•Loss accrue due to cash Burglary =Rs.474,500,000/-•Loss accrue due to lockers Burglary =Rs.113,908,000/- Total = Rs.644,408,000/-Option 1:Firm face one source of risk with cost of residual uncertainty ofRs.13,000,000/- , Probability of cash Burglary = 1/20 & Probability of lockers Burglary =1/10.Option 2:Spend Rs.22,500,000 to reduce Probability of cash Burglary = 1/10 &Probability of lockers Burglary = 1/8 with cost of residual uncertainty of Rs.12,250,000/- .Option 3:Spend an additional Rs.5,780,000 to reduce Probability of cash Burglary = 1/5& Probability of lockers Burglary = 1/4 with cost of residual uncertainty of Rs.6,125,000/-Option 4:Spend Rs.52,000,000 Insurance Premium against full coverage with no losscontrol and no cost of residual uncertainty. 1 12
  13. 13. Enterprise-wide Risk 1-Internal RiskPeople Risks Fraud Human Error Health & Safety Employment Law Training & DevelopmentProcess Risks Financial Process & Control Customer Relationship Management Project Management Supply Chain Management 1 13
  14. 14. Technology Risks Data Security Data Integrity System Performance Capacity Planning Change Management 2- External RiskFinancial Risks Credit Risk Market Risk Liquidly Risk etc;Non-financial Risks Political Risk Competitor Risk 1 14
  15. 15. Socio Economic Risk  External FraudIdentifying Business Risk Exposures Property Business income Liability Human resource External economic forces Earnings Physical assets Financial assets Medical expenses Longevity (durability) 1 15
  16. 16. Financial RiskWe are primarily concerned with the maincategories of financial risk:• Market Risk- Pricing Risk• Credit Risk- Default Risk• Operational Risk- Failing Processes/Systems•Liquidity Risk – Funds•Other Relevant Risks 1 16
  17. 17. •Market Risk — the risk of a change in thevalue of a financial position due to changes inthe value of the underlying components onwhich that position depends, such as stock andbond prices, exchange rates, commodity prices,etc.Value of Financial Position Changes due to:1- Interest rate risk is the risk of negativeeffects on the financial result and capital of thebank caused by changes in interest rates. 1 17
  18. 18. 2-Foreign exchange risk is the risk of negativeeffects on the financial result and capital of thebank caused by changes in exchange rates.Problem: To explore the new relation with thecustomer, during bank representative visit to thecustomer, who wish to have Forward cover against import ofgoods for 180days $600,000 Usance LC. If the Spot Rate isRs.87.98, profit on Foreign Currency is 5.85% andBorrowing Rate is 14.65%. Calculate the minimum rate with2% margin a bank can offer to its customer.• Credit Risk — the risk of not receivingpromised repayments on outstandinginvestments such as loans and bonds, because ofthe ―default‖ of the borrower. 1 18
  19. 19. •Liquidity Risk - the risk that it will not bepossible to sell a holding of a particularinstrument at its theoretical price.•Operational Risk — the risk of lossesresulting from inadequate or failed internalprocesses, people and systems, or externalevents.•Law, Compliance, Government Affairs-Legal Risk, Regulatory Risk, enforceability Risketc. 1 19
  20. 20. •Energy Risk- Increasing globalization andinterdependence of energy products, deliverymechanisms, and risk management techniques.•Exposure Risks include risks of bank‘sexposure to a single entity or a group of relatedentities, and risks of banks‘ exposure to a singleentity related with the bank.•Investment Risks include risks of bank‘sinvestments in entities that are not entities in thefinancial sector and in fixed assets. •Stand-alone Risk •Portfolio Risk 1
  21. 21. Sovereign RiskProbability that the government of a country (oran agency backed by the government) will refuse tocomply with the terms of a loan agreement duringeconomically difficult or politically volatile times.Although sovereign nations dont "go broke," they canassert their independence in any manner they choose,and cannot be sued without their assent. Sovereign riskwas a significant factor during 1970s afterthe oil shock when Argentina and Mexico almostdefaulted on their loans which had to be rescheduled. 1 21
  22. 22. What do you Mean by Risk Management?―An integrated framework for managing creditrisk, market risk, operational risk, economiccapital, and risk transfer in order to maximizefirm value.‖ 1 22
  23. 23. Objective of Risk ManagementNeed for a RM Objective•Risk imposes costs on businesses and individuals.•Risk Management (e.g., loss control and insurance)also is costly• Tradeoffs must be made•Need a criteria for making choices about how muchrisk management should be undertakenAppropriate CriteriaMinimize cost of risk - direct or overallCost distribution: one time, periodical, over a certaintime horizon. 1 23
  24. 24. The Risk Management Process1. Identification of risks2. Evaluation of frequency and severity of losses, including maximum probable loss = value at risk3. Choosing risk management methods4. Implementation of the chosen methods5. Monitoring the performance and suitability of the methods 1 24
  25. 25. Economic Capital - Capital is held to ensurethat a bank is likely to remain solvent, even if itsuffers unusually large losses.Available Economic Capital - The amount bywhich the value of all assets currently exceedsthe value of all liabilities.Required Economic Capital- The amount bywhich the value of all assets should exceed thevalue of all liabilities to ensure that there is avery high probability that the assets will still exceed 1 25
  26. 26. Function of Economic Capital1. To Address the unexpected loss at certain confidential level for certain time horizon2. „ Ensure solvency and stability of Financial Institutions in cases of market shocks3. „ May be aligned (associated) with the firm‘s risk appetite 1 26
  27. 27. State Bank of PakistanAs per the revision of capital requirements fornew entrants, banks in different modes ofoperations are required a minimum paid upcapital of Rs 10 billion, instead of Rs 2 billionpreviously, depicting a surge of Rs 8 billion or400 percent. Minimum Paid up Dead line by which Capital to be (Net of losses) increased Rs 5 billion - - Rs 6 billion - - Rs 10 billion - - Rs 15 billion - - Rs 19 billion - - 1 Rs 23 billion - - 27
  28. 28. IMPORTANT RATIOS1. Debt to Service Coverage Ratio=Net Operative Income/ Debt Service - It is used to measure the ability of prospect to meet the financial obligation. For example, if the net income available to shareholder= Rs.55,234,098/- and it‘s financial obligation against facility= Rs.24,777,980/-2. Loan to Value Ratio= Amount of Facility/ Value of Asset or Security - It is used to measure the security is to facility amount in order to recover the facility in case of default. 1 28
  29. 29. Bank Regulation and BaselImportant State Objective Bank-Stable Economic Environment for PrivateIndividuals and Businesses.-Providing Reliable Banking System & ProtectDepositors even in the event of Bank Failure.-Deposit insurance introduced to build thedepositors confidence.-Bank Regulators prescribe minimum level ofcapital to cover the worst case loss over sometime horizon (possibility). 1 29
  30. 30. The worst case loss is the loss that is notexpected to exceed with some high degree ofconfidence. The high degree of confidencemight be 99% or 99.9%.The expected losses are covered as productprice.For example: the interest charged by the bank isdesigned to recover expected loan losses.Capital is a cushion to protect the bank fromextremely un-favourable outcome. 30
  31. 31. Reason For Regulating Bank Capital― Bank regulation is unnecessary. Even if therewere no regulations, banks would manage theirrisks prudently and would strive to keep a levelof capital that is commensurate (matching) withthe risks they are taking.‖•Without state interventions, banks that tookrisks by keeping low levels of capital equity.•Deposit insurance may encourage banks forlow equity.•Due to cost of insurance, regulations on thecapital banks must hold. 1 31
  32. 32. The capital a financial institution requiresshould cover the difference between expectedlosses over some time horizon and ‗worst-caselosses‘ over the same time horizon. The idea isthat expected losses are usually covered by theway a financial institution prices its products.For example, the interest charged by a bank isdesigned to recover expected loan losses.Capital is a cushion to protect the bank from anextremely unfavorable outcome 1 32
  33. 33. Risk Based Assets = Total Asset - Cash and Equivalents -Fixed Assets ORRisk Based Assets = Other Earning Assets excluding Loans +Net Loans BaselBasel Accord: The Basel Committee onBanking Supervison‘s regulatory framework ofcapital standards for banks, established in 1988to protect bank owners, depositors, creditors,and deposit insurers (e.g., governments) againstfinancial distress. 33
  34. 34. The Road to Basel―Risk management: one of the most importantinnovations of the 20th century.‖[Steinherr, 1998]• The late 20th century saw a “revolution” onfinancial markets. It was an era of innovation— in academic theory, product development(derivatives) and information technology — andof spectacular market growth. 1 34
  35. 35. • Large derivatives losses and other financialincidents raised banks‘ consciousness of risk.• Banks became subject to regulatory capitalrequirements, internationally coordinated by theBasle Committee of the Bank of InternationalSettlements. 1 35
  36. 36. Some Dates• 1950s. Foundations of modern risk analysis arelaid by work of Markowitz and others onportfolio theory.• 1970. Oil crises and abolition of Bretton-Woods turn energy prices and exchange ratesinto volatile risk factors.• 1973. CBOE, Chicago Board OptionsExchange starts operating. Fisher Black andMyron Scholes, publish an article on the rationalpricing of options. [Black and Scholes, 1973] 1 36
  37. 37. • 1980s. Deregulation; globalization - mergerson unprecedented scale; advances in IT. The Regulatory Process• 1988. First Basel Accord takes first stepstoward international minimum capital standard.Approach fairly crude and insufficientlydifferentiated. 1 37
  38. 38. The BIS Accord defined two minimum capitaladequacy requirements:1. The first standard was similar to that existing prior to 1988 and required banks to have assets-to-capital multiple of at most 20. Assets-to-capital <+202. The second standard introduced what became known as the Cooke ratio.3. The Cooke RatioUsed to calculate what is known as the bank‘stotal risk-weighted assets (also sometimesreferred to as the risk-weighted amount). 1 38
  39. 39. Cooke ratio calculated both on-balance sheetand off-balance sheet. Risk weight for on balance sheet items Risk Asset CategoryWeight % 0 Cash, gold bullion, claims on OECD governments such as T. Bonds or insured residential mortgage 20 Claims on OECD Banks and OECD public sector entities such as securities issued by government agencies or claims on municipalities 50 Uninsured residential mortgage loans 100 All other claims, such as corporate bonds and less- developed country debt, claims on non-OECD Banks, real estate, premises, plant & equipment. 1 39
  40. 40. Calculate risk weighted assets (RWA), if theassets of the banks consist of $100 million ofcorporate loans, $10 million of OECDgovernment bonds, and $50 million ofresidential mortgages.RWA= 1.0*100 + 0.0*10 + 0.5*50 = $125 MillionProblem: Calculate the risk weighted assets, if the assets of bank consist of Rs. 579.59 million ofretail loan with the risk weight of 35.67%, Rs. 299.98 million of mortgages with the risk weightof 21.45%, Rs.987.09 million of corporate loans with risk weight of 16.79% and Rs.887.89million of state loans with risk weight of 0%.Problem: Calculate the risk weighted assets, if the assets of bank consist of Rs. 799.09 million ofcorporate loan with the risk weight of 19.75%, Rs. 199.98 million of T.B with the risk weight of0%, Rs.337.95 million of SME loans with risk weight of 36.79% and Rs.233.56 million of agri-loans with risk weight of 37.08%. 1 40
  41. 41. Off balance sheet items are expressed as CreditEquvilent AmountCredit Equvilent Amount is the loan principalthat is considered to have the same credit risk.Credit perspective are considered to be similarto loan, such as bankers acceptance, have aconversion factor of 100%. 1 41
  42. 42. •1993. The birth of VaR. Seminal G-30 reportaddressing for first time off-balance-sheetproducts (derivatives) in systematic way. Atsame time JPMorgan introduces the*Weatherstone 4.15 daily market risk report,leading to emergence of RiskMetrics.•1996. Amendment to Basel I allowing internalVaR models for market risk in larger banks.Also referred as BIS 98.The Amendment requires financial Institutions to holdcapital to cover their exposure to market risks as well ascredit risks. 1 42
  43. 43. *Weatherstone Capital Management is a moneymanagement firm that utilizes active moneymanagement strategies that are designed to generatestrong returns while reducing the level of risk that isfound in most stock and bond market investments.Goal is to provide investment programs that generatestrong returns relative to the amount of risk that istaken.Allows conservative and risk conscious investors theability to comfortably allocate a higher portion of theirinvestment portfolios to the segments of the financialmarkets that have historically generated the highestreturns. 1 43
  44. 44. •Credit Risk Capital charged in 1988•Amendment also apply to all on-balance sheetand off-balance sheet in the trading and bankingbooks, except positions in the trading books thatconsist of: •Debt and equity trade securities and •Positions in commodities and foreign exchange.The market risk capital requirement for banks byusing internal model-based approach k*VaR + SRC 1 44
  45. 45. Where k=multiplicative factor, VaR= value at risk &SRC= specific risk chargeRWA for market risk capital is defined as 12.5 *k*VaR + SRCThe total capital required for Credit and MarketRisk is given byTotal Capital= 0.8 x (Credit risk RWA + Market risk RWA) 1 45
  46. 46. •2001 onwards. Second Basel Accord, focusingon credit risk but also putting operational riskon agenda. Banks may opt for a more advanced,so-called internal-ratings-based approach tocredit.•July 2009 onwards, Second Basel Accord,focusing on Revised Securitisation and TradingBook Rules & implemented by Dec 2011.•Nov 2010 Third Basel (G 20 endorsement ofBasel III) will be implemented by Jan 2013-Jan2019. 1 46
  47. 47. Basel II: What is New?• Rationale for the New Accord: More flexibilityand risk sensitivity• Structure of the New Accord: Three-pillarframework: Pillar 1: minimal capital requirements (risk measurement) Pillar 2: supervisory review of capital adequacy Pillar 3: public disclosure 1 47
  48. 48. •Two options for the measurement of credit risk: •Standard approach •Internal rating based approach (IRB)For an on-balance-sheet item a risk weight isapplied to the principal to calculate risk-weighted assets reflecting the creditworthinessof the counterparty. For off-balance-sheet itemsthe risk weight is applied to a credit equivalentamount. This is calculated using either creditconversion factors or add-on amount. 1 48
  49. 49. -Standardized approach (for small banks. InUSA, Basel II will apply only to the largestbanks and these banks must use the foundationinternal ratings based (IRB) approach). riskweights for exposures to country, banks, andcorporations as a function of their ratings.•Pillar 1 sets out the minimum capitalrequirements (Cooke Ratio):total amount of capital ≥ 8% risk-weightedassetsTotal capital = 0.08*(credit risk RWA + Marketrisk RWA + Operational risk RWA). 1 49
  50. 50. • MRC (minimum regulatory capital) def = 8%of risk-weighted assets• Explicit treatment of operational riskThe Market Risk Capital Requirement:k * VaR + SRC,where SRC is a specific risk charge. The VaR isthe greater of the pervious day‘s VaR and theaverage VaR over the last 60 days.The minimum value for k is 3. 1 50
  51. 51. Operational Risk: Banks have to keep capitalfor operational risk.Three approaches.- Basic indicator approach: operational riskcapital = the bank‘s average annual grossincome (=net interest income + noninterestincome) over the last three years multiplied by0.15.- Standardized approach: similar to basicapproach, except that a different factor is appliedto the gross income from different businesslines. 1 51
  52. 52. -Advanced measurement approach: the bankuses its own internal models to calculate theoperational risk loss that it is 99.9% certain willnot be exceeded in one year.Tier 1 - Capital- Equity and similar sources ofcapitalTier 2 - Subordinated debt (life greater than fiveyears) and similar sources of capital.Tier 3 - Short –term subordinated debt (lifebetween two and five years). 1 52
  53. 53. Calculation of total risk weighted assets under theBasel II standardized approach, if the assets of thebank consist of $100 million of loans of corporationrated A (weighted risk=50%).$10 million ofgovernment bonds rated AAA(weighted risk=0%), and$50 million residential mortgages(weightedrisk=35%).Total Risk Weighted Assets= 0.5 *100 + 0.0*10 +0.35*50= $67.50 MillionProblem: Calculate the risk weighted assets under the Basel II standardized approach, ifthe assets of bank consist of Rs. 579.59 million of retail loan average rating of A+ Rs.299.98 million of mortgages , Rs.987.09 million of corporate loans average rating ofAA- and Rs.887.89 million of state loans average rating of AAA. 1 53
  54. 54. Problem: Calculate the risk weighted assets under the Basel II standardized approach, if the assetsof bank consist of Rs. 799.09 million of corporate loan with average rating of A-, Rs. 199.98million of T.B with average rating of AAA, Rs.337.95 million of SME loans with average ratingof A+ and Rs.233.56 million of agri-loans with average rating of BBB+. AAA A+ BBB+ BB+ B+ Below Unrated To To To To To B AA- A- BBB- BB- B- Country 0 20 50 100 100 150 100 Banks 20 50 50 100 100 150 50Corporations 20 50 100 100 100 150 100 1 54
  55. 55. Adjustment for CollateralThere are two ways banks can adjust risk weights forcollateral.1- Simple Approach- the risk weight of thecounterparty is replaced by the risk weight of thecollateral for the part of the exposure covered by thecollateral.2- Comprehensive Approach- banks adjust the size oftheir exposure upward to allow for possible increasesand adjust the value of the collateral downward toallow for possible decreases in the value of thecollateral. 1 55
  56. 56. Example: Suppose that an $80 million exposure to a particularcounterparty is secured by collateral worth $70 million. The collateralconsist of bonds issued by an A-rated company. The counterparty has arating of B+. The risk weight for the counterparty is 150% and the riskrate for the collateral is 50%. The risk –weighted assets applicable to theexposure using the simple approach is therefore 0.5 x 70 + 1.50 x (80 -70) = 50Consider next the comprehensive approach. Assume that the adjustmentto exposure to allow for possible future increases in the exposure is+10% and the adjustment to the collateral to allow for possible futuredecreases in its value is -15% (1.0 + 0.10) x 80 – (1.0 – 0.15) x 70 = 1.10 x 80 – 0.85 x70 =88 – 59.5= 28.50If the risk weight of 150% is applied to the exposure, the risk adjustedassets equal to 42.75 million (1.50 + .10) x 80 – (1.50 -.15)x70 =128 – 94.5 1?????? 56
  57. 57. Expected losses are those that the bank knows withreasonable certainty will occur (e.g., the expecteddefault rate of corporate loan portfolio or credit cardportfolio) and are typically reserved for in somemanner.Unexpected losses are those associated withunforeseen events (e.g. losses experienced by banks inthe aftermath of nuclear tests, Losses due to a suddendown turn in economy or falling interest rates).Banks rely on their capital as a buffer to absorb suchlosses.Risks are usually defined by the adverse impact onprofitability of several distinct sources of uncertainty. 1 57
  58. 58. SBP Guidelines on Internal Credit Risk Rating SystemsThe banks are required to establish criteria to map theirinternal obligor & facility ratings according to the broadregulatory definitions of rating grades 1 to12.Facility grades should be assigned according to the severity ofthe expected losses in case of default, keeping in view thefactors from A to F.OBLIGOR/ 1 2 3 4 5 6 7 8 9 10 11 12FACILITY A A1 A2 A3 A4 A5 A6 A7 A8 A9 A10 A11 A12 B B1 B2 B3 B4 B5 B6 B7 B8 B9 B10 B11 B12 C C1 C2 C3 C4 C5 C6 C7 C8 C9 C10 C11 C12 D D1 D2 D3 D4 D5 D6 D7 D8 D9 D10 D11 D12 E E1 E2 E3 E4 E5 E6 E7 E8 E9 E10 E11 E12 F F1 F2 E3 F4 F5 F6 F7 F8 F9 F10 F11 F12 1 58
  59. 59. IRB (Internal rating based) approach – one-factor Gaussian copula model of time todefault. WCDR: the worst-case default rateduring the next year that we are 99.9%certain will not be exceededPD: the probability of default for each loan inone yearEAD: The exposure at default on each loan (indollars)LGD: the loss given default. This is theproportion of the exposure that is lost in theevent of a default. 1 59
  60. 60. Expected Loss (EL) CalculationLending institutions need to understand the lossthat can be incurred as a result of lending to acompany that may default; this is knownas expected loss (EL).EL can be expressed as a simple formula: EL = PD * LGD * EAD 1 60
  61. 61. The total exposure to credit risk is the amountthat the borrower owes to the lending institutionat the time of default; the exposure at default(EAD). Generally, EAD will not be larger thanthe borrowing facility.PD & LGD are risk metrics employed in themeasurement and management of credit risk.The metrics are used to calculate EL. 1 61
  62. 62. The probability of default (PD) is thelikelihood that a loan will not be repaid and willfall into default. It must be calculated for eachborrower. The credit history of the borrower andthe nature of the investment must be taken intoconsideration when calculating PD. Externalratings agencies such as Standard and Poors orMoody‘s may be used to get a PD; however,banks can also use internal rating methods. PDcan range from 0% to 100%. If a borrower has50% PD it is considered a less risky companyvs. a company with an 80% PD. 1 62
  63. 63. For Example:A borrower (Company X) takes out a loan from BankABC for $10 million (EAD). Company X pledges $3million collateral against this loan (for simplicity, let’ssay the collateral is cash). The Company’s PD isdetermined by analyzing their credit risk aspects(evaluate the financial health of the borrower, takinginto account economic trends, borrower relationshipwith the bank, etc.) For Company X, let’s say the PD is0.99. This means that the Company is extremely risky;the probability of them defaulting on the loan is 99%. 1 63
  64. 64. Loss given default (LGD) is the fractional loss due todefault. Continuing from the previous example:If Company X defaults (is unable to pay back the $10million to Bank ABC), the Bank will be able to recover$3 million (this is the cash-secured collateral).So, how do we calculate the actual loss given default(LGD)?LGD = 1 – Recovery Rate (RR)The Recovery Rate (RR) is defined as the proportionof a bad debt that can be recovered. It is calculated as:RR = Value of Collateral/Value of the Loan 1 64
  65. 65. Back to our example, the recovery rate for Bank ABC= $3 million/ $10 million = 30%So % LGD= 1- 0.30 = 0.70 or 70%.$ LGD= 70% of a $10 million (EAD) loan is equal to$7 million.$ LGD = $7 millionExpected Loss (EL) is what a bank can expect to losein the case that their borrower defaults. It is calculatedbelow:EL = PD * LGD * EADEL= 0.99* 70% * $10 millionEL = $6.93 millionBank ABC can expect to lose $6.93 million 1 65
  66. 66. Problems: Kamran & Sons is a company rated as A+ takes out a loan from Bank ABC for Rs.150million against the mortgage of residential property having market value for Rs.160 Million &forced sale value for Rs.110 million(for simplicity, let’s say the collateral is cash). Calculate thePD, LGD, EAD and EL .Problems: If the loan wise credit exposure of a bank alongwith other data PD is given below:Type of Loan ExposureSecurity Cash Value RatingCorporate Loans 241,673,000,000 229.885,000,000 AA+Retail Loans 329,881,000,000 299,887,000,000 A-Agri- Loans 098,875,000,000 034,888,000,000 BB+State Loans 167,988,000,000 000 AAAOn the bases of above data calculate the EAD, LGD , EL & EL %.Problem: If the credit exposure against the medium term loans of a financial institution as perloan rating is given below:ExposureRating241,673,000,000 AAA329,881,000,000 AA-098,875,000,000 AA+167,988,000,000 B196,778,000,000 BB- On the bases of above data 1calculate the EAD, LGD ,EL & EL %. 66
  67. 67. The VaR MeasureValue at Risk (VaR) is an attempt to provide asingle number that summarizes the total risk in aportfolio of financial assets.VaR measure is used by the Basel Committee insetting capital requirements for banksthroughout the world. 1 67
  68. 68. Value at Risk: A loss that will not be exceededat some specified confidence level.We are X% certain that we will not lose more than $Vin the next N days.The Variable V is the VaR of the portfolio. It is afunction of two parameters the time horizon (N days)and the confidence level (X%).E.g; In 5 days (N=5), VaR is the loss corresponding tothe (100- 97)%=3 % (X=97%) of the distribution ofthe change in the value of the portfolio over 5 days.Portfolio gain is +ve & Loss is –ve. 1 68
  69. 69. Using the VaR measure with N=10 and X=99. Thismeans that it focuses on the revaluation loss over a 10day period that is expected to be exceeded only 1% ofthe time. VaR vs Expected ShortfallVaR is used in an attempt to limit the risks taken by atrader. Suppose that a bank tells a trader that the one-day 99% VaR of the trader‘s portfolio must be kept atless than $10 million.Trader can construct a portfolio with 99% chance thatthe the daily loss is less than $10 million but 1%chance of loss of $500 million. 1 69
  70. 70. Expected Shortfall, like VaR, is a function of twoparameters:-N(the time horizon in days) and-X (the percentage confidence level)Expected loss during an N-day period conditional onthe loss being greater than the Xth % of the lossdistribution.E.g; X=99 and N=10, the expected short-fall is theaverage amount lost over ten day period assuming thatthe loss is greater than 99th % of the loss distribution. 1 70
  71. 71. Properties of Risk MeasuresA risk measure used for specifying capitalrequirements can be thought of as the amount of cash9or capital) that must be added to a position to makeits risk acceptable to regulators.Proposed Properties that such a Risk Measure shouldhave:Monotonicity: If a portfolio has lower returns thananother portfolio for every state of the world, its riskmeasure should be greater.Translation invariance: If we add an amount of cashK to a portfolio, its risk measure should go down byK. 1 71
  72. 72. Homogeneity: Changing the size of a portfolio by afactor λ while keeping the relative amounts ofdifferent items in the portfolio the same should resultin the risk measure being multiplied by λ.Subadditivity: The risk measure for two portfoliosafter they have been merged should be no greater thanthe sum of their risk measure before they weremerged.First three conditions are risk acceptable by addingcash needed to the portfolio.Forth condition states that diversification helps reducerisks. 1 72
  73. 73. Example: Consider two $10 million one-year loans each of which has a 1.25% chanceof defaulting. If a default occurs on one of the loans, the recovery of the loan principalis uncertain, with all recoveries between 0% and 100% being equally likely. If the loandoes not default , a profit of $0.2 million is made. To simplify matters, we suppose thatif one loan defaults then it is certain that the other loan will not default.For a single loan, the one-year 99% VaR is $2 million. This is because there is a 1.25%chance of a loss occurring, and conditional on a loss there is an 80% chance that theloss is greater than $2 million. The unconditional probability that the loss is greater than$2 million is therefore 80% of 1.25% or 1%.Consider next the portfolio of two loans. Each loan defaults 1.25% of the time and theynever default together. There is therefore a 2.5% probability that a default will occur.The VaR in this case turns out to be $5.8 million. This is because there is a 2.5% chanceof one of the loans defaulting, and conditional on this event there is an 40% chance thatthe loss on the loan that defaults is greater than $6 million. The unconditionalprobability that the loss on the defaulting loan is greater than $6 million is therefore40% of 2.5%, or 1%. A profit of $0.2 million is made on the other loan showing thatthe one-year 99% VaR is $5.8% million.The total VaR of the loans considered separately is 2 + 2 = 4 million. The total VaRafter they have been combined in the portfolio is $1.8 million greater at $5.8 million.This is in spite of the fact that there are very attractive diversification benefits fromcombining the loans in a single portfolio. 1 73
  74. 74. Pure Risk Characteristics and ManagementGeneralizations:•Pure risk usually involves large potential lossesrelative to the expected loss and relative to availableresources.•Pure risk involves events that are firm-specific•Price risk affects many firms•Pure risk is managed by insurance•Price risk is managed by derivatives (forward &option contracts, hedging)•Pure risk involves wealth losses to society•Price risk often involves wealth redistributions insocietyNevertheless, we use the same framework for management of pure risk and price risk 1 74
  75. 75. What Is Credit•Person‘s confidence in person.Credit Risk:•A Performance Risk: specifically, the risk of loss dueto a Borrower‘s/Debtors non-payment of a loan orother obligation (i.e., the possibility that borrowerswill not repay their loans on time or at all).Borrowers:•Lenders distinguish between retail and commercialborrowers.•Banks customize products to meet each group‘sunique financial needs. 1 75
  76. 76. The Principles of Good LendingThe Credit Analysis Process:•Information sources/data-gathering•Complete a comprehensive analysis•The Five Cs of Credit•The structured framework of analysis•Rating agencies and other analytical tools 1 76
  77. 77. The principles of lending ensure that the Borroweris able to make payments as and when due:•To identify a clear purpose with defined terms•To understand the Borrower and Borrower needs•To understand the collateral/security• To understand repayment risk (liquidity or solvency)•To understand the future deterioration factors thatmay impact cash flow and thus, repayment of theobligation(s) 1 77
  78. 78. Steps of the Credit Process (how banks lend money)•Several sequential steps Management Profile Company Profile Industrial Review Credit History Facility Structure etc•Identify the credit opportunity•Evaluate credits•Monitor credits on an ongoing basis 1 78
  79. 79. Steps and considerations when evaluating credits•Credit analysis process evaluates the borrower‘sability to repay•Assess the borrower‘s financial position using severaldifferent methods and sources of informationBanking Book Management•Banks use various tools to reduce the overall risk oftheir loan portfolios 1 79
  80. 80. The 5 Cs (or 7 Cs) of Credit:1.Character2.Conditions3.Capital4.Capacity5.Collateral6.Common sense7.Control1- Character:Character is a lender‘s way to summarize a borrower‘sdetermination to manage its cash position and moreimportantly, honor its obligations (financial orotherwise). 1 80
  81. 81. 2- Conditions:Conditions focus on the economic and environmentsinfluences that may impact a company‘s financialposition and its ability to honor its obligations.3- Capital:The financing structure and level of capitalization(leverage) of a company.4- Capacity:The predictability and sustainability of the cash flowsof a company to service debt. 1 81
  82. 82. 5- Collateral:Collateral protects the lender –when all else fails. Inlending, collateral represents a borrower‘s asset pledgeto secure a loan (collateral is a lender‘s protection inthe event of a borrower‘s default).Structured Framework of Analysis*:•Banks must have credit risk management systemsthat:•Produce accurate and timely risk ratings•Accurate classification of the ratings•Well-managed credit risk rating systems promotebank safety and soundness by facilitating informeddecision making.1 82
  83. 83. The Principles of Credit Risk through a review of aStructured Framework of Analysis-Business Risk-Financial Risk-Structural Risk Business RiskInfluenced by:•Macro economic trends•Industrial Status•Micro economic trends 1 83
  84. 84. Include:•Economic environment•Business cycles•Industry and regulatory trends•Political risks•Other social issuesChanges to these factors have wide rangingimplications to business and credit 1 84
  85. 85. Financial RiskAffected by:•Quality of management•Company operation•Financial positionInclude:•Management strategy and skills•Management integrity•Company systems•The borrower‘s operating and financial performance 1 85
  86. 86. Structural RiskReflect how the loan is structured:•Terms•Payments•Collateral•Other credit featuresThe borrower’s support of repayment:•Collateral•The ability (willingness) to pay 1 86
  87. 87. Loss DistributionsTo model risk we use language of probabilitytheory. Risks are represented by randomvariables mapping unforeseen future states ofthe world into values representing profits andlosses.The risks which interest us are aggregate risks. Ingeneral we consider a portfolio which might be•a collection of stocks and bonds;•a book of derivatives;•a collection of risky loans;•a financial institution‘s overall position in riskyassets. 1 87
  88. 88. Portfolio Values and LossesConsider a portfolio and let Vt denote its valueat time t; we assume this random variable isobservable at time t.Suppose we look at risk from perspective oftime t and we consider the time period [t, t + 1].The value Vt+1 at the end of the time period isunknown to us. 1 88
  89. 89. The distribution of (Vt+1 − Vt) is known as theprofit-and-loss or P&L distribution.We denote the loss by Lt+1 = −(Vt+1 − Vt).By this convention, losses will be positivenumbers and profits negative.We refer to the distribution of Lt+1 as the lossdistribution. 1 89
  90. 90. Risk FactorsGenerally the loss Lt+1 for the period [t, t + 1]will depend on changes in a number offundamental risk factors in the time period, suchas stock prices and index values, yields andexchange rates.Writing Xt+1 for the vector of changes inunderlying risk factors, the loss will be given bya formula of the form 1 Lt+1 = l[t](Xt+1). 90
  91. 91. where l[t] : Rd ! R is a known function whichwe call the loss operator.The book contains examples showing how theloss operator is derived for different kinds ofportfolio. This is a process known as mapping. Loss DistributionThe loss distribution is the distribution of Lt+1 = l[t](Xt+1)?But which distribution exactly? 1 91
  92. 92. The Conditional distribution of Lt+1 given givenFt = σ ({Xs : s t}), the history up to andincluding time t?The unconditional distribution under assumptionthat (Xt) form stationary time series?Conditional problem forces us to model thedynamics of the risk factors and is most suitablefor market risk.Unconditional approach is used for longer timeintervals and is also typical in credit portfoliomanagement. 1 92
  93. 93. Value at Risk: A loss that will not be exceededat some specified confidence level. Risk MeasuresRisk measures attempt to quantify the riskinessof a portfolio. The most popular risk measureslike VaR describe the right tail of the lossdistribution of Lt+1 (or the left tail of the P&L).To address this question we put aside thequestion of whether to look at conditional orunconditional loss distribution and assume thatthis has been decided. 1 93
  94. 94. Denote the distribution function of the lossL := Lt+1 by FL so thatP(L ≤ x) = FL(x). 1 94
  95. 95. 1 95
  96. 96. KEY FINANCIAL RATIOS1. TOTAL ASSETS2. TOTAL EQUITY3. PRETAX PROFIT4. POST TAX PROFIT5. PRETAX PROFIT/ TOTAL ASSETS (av)6. PRETAX PROFIT/ TOTAL EQUIT(av)7. TIER 1 CAPITAL RATIO8. TOTAL CAPITAL RATIO9. TOTAL EQUITY/ NET LOANS10. NET LOANS/ TOTAL DEPOSITS11. LOAN LOSS RESERVES/ GROSS LOAN (av)12. LOAN LOSS RESERVES/ NET LOANS13. LOAN LOSS RESERVES/ NET LOANS (av)14. TOTAL DEPOSIT/ NET LOAN RATIO 1 96
  97. 97. 1. TOTAL ASSETSTotal assets represent resources with economic valuethat a corporation owns or controls with theexpectation that it will provide future benefit.Total assets are calculated from year end figuresgained from bank balance sheets.Formula = Cash and Equivalents + Other EarningAssets excluding Loans + Net Loans + Fixed Assets2. TOTAL EQUITYStockholders equity represents the equity stakecurrently held on the books by a firms equity investorsor shareholders.Formula = Equity Reserves + Total Share Capital 1 97
  98. 98. 3. PRETAX PROFITA measurement of financial profitability, pre-tax profitcombines all profits before tax, includingoperating, non-operating, continuing operations andnon-continuing operations.Formula = Total income - Total expenses (beforetaxes)4. POST TAX PROFITPost-tax profit is a measure of profitability andrepresents net income for the group as a whole. This iscalculated before deducting minority interests andpreference dividends.Formula = Pre-Tax Profit (PBT) – Taxes 1 98
  99. 99. 5. PRETAX PROFIT/ TOTAL ASSETS (av)The return on assets (ROA) percentage shows howprofitable a companys assets are in generatingrevenue. The ratio is considered an indicator of howeffectively a company is using its assets to generateearnings before payment of taxes and dividends.Formula = Pre-tax profits / Total Assets averageThe ratio is part of ‗Profitability‘ ratios of the bank, where:Pre-tax profits = Total income - Total expenses (before taxes)Total income includes interest income, commission, fees, other operatingincome, non operating income, exceptional and extraordinary income.Total Expenses includes interest expense, commission, fees, otheroperating expenses, non operating expenses, exceptional and 1 99extraordinary expenses.
  100. 100. 6. Pre-Tax Profit / Total Equity (Av)Return on equity (ROE) measures a corporationsprofitability by revealing how much profit a companygenerates with the money shareholders have invested.Formula = Pre-tax profit / Total Equity averageThe ratio is part of ‗Profitability‘ ratios of the bank, where:Pre-tax profits = Total income - Total expenses (before taxes)Total equity = Equity Reserves + Total Share CapitalEquity Reserves includes retained earnings, current year earnings, otherequity reserves, revaluation reserves and minority interests in reserves.Total share capital is sum of common shares/stock, preferredstock/shares, minority interest less treasury stock. 1 100
  101. 101. 7. Tier 1 Capital RatioTier 1 capital is the core measure of a banks financialstrength from a regulators point of view. It absorbslosses without a bank being required to cease trading.Formula = (Total Equity - Revaluation Reserves) /Risk Based AssetsTier 1 Capital Ratio is part of Capital Adequacy ratiosof the bank, where:1-Total equity = Equity Reserves + Total Share CapitalEquity Reserves includes retained earnings, current year earnings, otherequity reserves, revaluation reserves and minority interests in reserves.Total share capital is sum of common shares/stock, preferredstock/shares, minority interest less treasury stock. 1 101
  102. 102. 2 Risk Based Assets = Total Asset - Cash and Equivalents - Fixed AssetsORRisk Based Assets = Other Earning Assets excluding Loans + Net Loans3 Total Assets = Cash and Equivalents + Other Earning Assets excluding Loans + Net Loans + Fixed AssetsOther earning assets includes treasury and other bills, governmentsecurities, deposits with banks, trading, financial and other listedsecurities including bonds, other equity investments such as equityshare, non-listed securities, other assets and intangible assets such assoftware, patents etc.Net loans include loans to banks or credit institutions; customer netloans; HP, lease or other loans; mortgages; loans to group companies andassociates and trust account lending.Fixed assets include land and buildings and other tangible assets such asplant and machinery, 1furniture, fixtures and vehicles etc. 102
  103. 103. 8. Total Capital RatioTotal capital Ratio or Capital Adequacy Ratio (CAR)measures a banks capital position and is expressed asa ratio of its capital to its assets.It determines the capacity of the bank in terms ofmeeting the time liabilities and other risks such ascredit risk, operational risk, etc. CAR below theminimum statutory level indicates that the bank is notadequately capitalized to expand its operations. Theratio ensures that the banks do not expand theirbusiness without having adequate capital.Formula = (Tier 1 Capital + Tier 2 Capital) / RiskBased Assets 1 103
  104. 104. Total Capital Ratio is part of Capital Adequacy ratios of theBank . Where,1 Tier 1 Capital = Total Equity - Revaluation Reserves2 Tier 2 Capital = Revaluation Reserves + Subordinated Debt+ Hybrid Capital + Provisions including Deferred Tax+ TotalLoan Loss & Other Reserves3 Total equity = Equity Reserves + Total Share Capital9- Total Equity / Net LoansThis ratio forms part of the Capital and Funding ratiosof a bank, and measures a companys financialleverage by calculating the proportion of equity anddebt the company is using to finance its assets.Formula = Total Equity / Net Loans 1 104
  105. 105. Total equity covers total equity reserves, total share capital and treasurystock.Net loans include loans to Banks or Credit Institutions, Customer netLoans and loans to group companies.10- Net Loans / Total DepositsForming part of the Liquidity ratios of a bank, thisratio is often used by policy makers to determine thelending practices of financial institutions.The higher the Loan-to-deposit ratio, the more thebank is relying on borrowed funds.Formula = Net Loans / Total DepositsNet loans include: loans to banks or credit institutions; customer net loans; HP, lease orother loans; mortgages; loans to group companies and associates and trust accountlending.Total deposits cover customer deposits, central bank deposits, banks and other credit 1institution deposits and other deposits. 105
  106. 106. 11- Loan Loss Reserves / Gross Loans (Av)This ratio is part of Asset Quality ratios of the bankand determines the quality of loans of a bank. Thehigher the ratio, the more problematic the loans areand vice versa.Formula = Loan Loss Reserves / Gross LoansaverageGross loans average comes from the average of the gross loans of prioryear and the gross loans of the current year.12- Loan Loss Reserves / Net LoansThis financial ratio is a part of Asset Quality ratios ofthe bank and is calculated by loan loss reserves by netloans. 1 106
  107. 107. The ratio determines the quality of loans of a bank.The higher the ratio, the more problematic the loansare and vice versa.Formula = Loan Loss Reserves / Net Loans13- Loan Loss Reserves / Net Loans (Av)This ratio forms part of the Asset Quality ratios of thebank and determines the quality of loans of a bank.The higher the ratio, the more problematic the loansare and vice versa.Formula = Loan loss reserves / net loans averageNet loan average is defined as the average of net loansof the prior year and the net loans of the current year. 1 107
  108. 108. 14- Total Deposits / Net Loans RatioTotal deposits / net loans ratio is a measure ofFunding Base Analysis of the bank and calculates thedeposit drains. If the ratio is less than 1:1, it indicatesthat the bank is in danger of becoming insolvent.Formula = Total Deposits / Net LoansTotal deposits include customer deposits, central bankdeposits, bank and other credit institution deposits andother deposits.Net loans cover loans to banks or credit institutions;customer net loans; NP, lease or other loans;mortgages and loans to group companies. 1 108
  109. 109. 1 109

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