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2. types of risks


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2. types of risks

  1. 1. What is Financial Risk? <ul><li>Risk is the probability that the realized return would be different from the anticipated/expected return on investment. </li></ul><ul><li>Risk is a measure of likelihood of a bad financial outcome. </li></ul><ul><li>All other things being equal risk will be avoided. </li></ul><ul><li>All other things are however not equal and that a reduction in risk is accompanied by a reduction in expected return. </li></ul>
  2. 2. Financial Risks Credit Interest Rate Market Liquidity Operational Foreign Exchange Other Risks, Country Risk, Settlement risk, performance risk Some major financial risks
  3. 3. Commercial Banking Investment Banking Trading Others Business Poles Business Lines Large Corporates Corporate-Middle Management Retail Financial Services Securitisation Commodities Asset Financing Banks & Financial Firms LBO Mergers & Acquisition Advisory Services Fixed Income Equity Derivatives Custody Identified borrowers & relationship banking Lending & Collecting Deposits and from/to Individuals, small businesses ‘ Structured Finance’ Traded Instruments
  4. 4. Main Product-Market Segments Markets Product Groups Specialise finance Financial Institutions Large Corporate firms Corporate- Middle market Consumers Market Transactions Specialised finance Off-balance sheet Corporat e lending RFS
  5. 5. Mapping Banking Business lines with various activities: Execution & full service. Retail Brokerage Retail Brokerage Pooled, segregated, retail, institutional, closed, open, private equity. Pooled, segregated, retail, institutional, closed, open Discretionary fund Non-discretionary fund Asset Management Escrow, depository receipts, securities lending (customers), corporate actions Issuer and Paying agent. Custody Corporate Agency Corporate Trust Agency Services Payments and collections, funds transfer, clearing and settlement. External clients Payment & Settlement Project finance, real estate, export finance, trade finance, factoring, leasing, lending, guarantees, bills of exchange. Commercial Banking Commercial Banking Retail lending & deposits, banking services, trust & estates. Private lending and deposits, banking services, trust and estate, investment advice. Merchant/commercial/corporate cards, private labels & retail. Retail Banking Private Banking Card Services Retail Banking Fixed income, equity, foreign exchange, commodities, credit, funding, own position securities, lending & repos, brokerage, debt, prime brokerage. Sales Market Making Proprietary Positions Treasury Trading & Sales Mergers & Acquisitions, Underwriting, Privatisations, Securitisations, research, debt (govt,high yield), equity, syndications, IPO, secondary private placements. Corporate Finance Municipal/Government Finance Merchant Banking Advisory Services Corporate Finance Activity Groups Sub-groups Business Lines
  6. 6. Banking Book & Trading Book Concepts. <ul><li>Market tradable transactions. </li></ul><ul><li>extends across geographical borders. </li></ul><ul><li>Buy & Trade. </li></ul><ul><li>Market Quotes. </li></ul><ul><li>Mark to Market Accounting. </li></ul><ul><li>More Turnover of transactions. </li></ul><ul><li>Lending & Borrowing. </li></ul><ul><li>Extends to local regions. </li></ul><ul><li>Buy & Hold. </li></ul><ul><li>Book Values. </li></ul><ul><li>Accrual Accounting </li></ul><ul><li>Less Turnover of transactions. </li></ul>Trading Book Banking Book
  7. 7. Exposure to Risk : Banking Book v/s Trading Book <ul><li>Banking Book: </li></ul><ul><ul><li>All assets & liabilities generate accrued revenues & costs, which are interest rate driven. </li></ul></ul><ul><ul><li>Asset liability mismatches result into excess or deficit funds. </li></ul></ul><ul><ul><li>Mismatches exist between interest references, like fixed or variable. </li></ul></ul><ul><ul><li>Asset side of banking book generates credit risk. </li></ul></ul><ul><ul><li>Liabilities side of the banking book contributes to interest rate risk, however does not generate credit risk. </li></ul></ul>
  8. 8. some forms of banking book risk <ul><li>Interest rate sensitive deposits/loans. </li></ul><ul><li>Net interest margins shrink. </li></ul><ul><li>Imbalances in funds positions. </li></ul><ul><li>Interest rate reference mismatches. </li></ul><ul><li>Non-repayment in loans. </li></ul>
  9. 9. Bank Book Risks – A comparative view <ul><li>Interest Rate Risk </li></ul><ul><li>Liquidity Risk </li></ul><ul><li>(No credit Risk) </li></ul><ul><li>Credit Risk </li></ul><ul><li>Interest Rate Risk </li></ul><ul><li>Liquidity Risk </li></ul><ul><li>(No market Risk) </li></ul>Liabilities Side Assets Side
  10. 10. Exposure to Risk : Banking Book v/s Trading Book <ul><li>Trading Book: </li></ul><ul><ul><li>Market portfolio generates market risk. </li></ul></ul><ul><ul><li>Trading book is also subject to market liquidity risk. </li></ul></ul><ul><ul><li>Over the counter products like derivatives are responsible for credit risk. </li></ul></ul><ul><ul><li>Exposure to country risk. </li></ul></ul>
  11. 11. some sources of trading book risk <ul><li>Price sensitivity of tradable instruments to macro-economic factors. </li></ul><ul><li>Market depth or volume. </li></ul><ul><li>Level of customisation. </li></ul><ul><li>Level of sophistication of products </li></ul>
  12. 12. Trading Book Risks – A comparative view <ul><li>Interest Rate Risk </li></ul><ul><li>Liquidity Risk </li></ul><ul><li>(No credit Risk) </li></ul><ul><li>Credit Risk </li></ul><ul><li>Interest Rate Risk </li></ul><ul><li>Liquidity Risk </li></ul><ul><li>Country risk </li></ul>Liabilities Side Assets Side
  13. 13. Schematic classification of some major Financial Risks <ul><li>Financial Risks </li></ul><ul><li>Credit Risk Liquidity Risk Interest Rate Risk Market Risk Forex Operational Risk </li></ul><ul><li>Mismatch Risk People oriented </li></ul><ul><li> Optionality Processes </li></ul><ul><li>Default Risk Procedural </li></ul><ul><li>Decline in credit standing Technology External events </li></ul><ul><li> Funding Risk </li></ul><ul><li> Market Liquidity Risk </li></ul><ul><li> Asset Liquidity Risk </li></ul>
  14. 14. Credit Risk: Composition <ul><li>Default Risk. </li></ul><ul><li>Risk of decline in credit standing of an obligor. </li></ul><ul><li>Market value loss due to change in credit standing of issuer. </li></ul><ul><li>Difficulty in measurement on ex ante basis. </li></ul>
  15. 15. Credit risk in banking portfolio: <ul><li>Prolonged Delinquency. </li></ul><ul><li>Deterioration in the credit standing of borrower </li></ul><ul><li>Restructuring of debt obligations. </li></ul><ul><li>Bankruptcies. </li></ul>
  16. 16. Credit risk in Trading portfolio: <ul><li>Deterioration in the rating of a debt. </li></ul><ul><li>Credit risk valued in market prices. </li></ul><ul><li>Pre & post default comparison. </li></ul><ul><li>Upward movement in the required yield. </li></ul><ul><li>Highly customised derivative. </li></ul>
  17. 17. Illustration : Downgrading of rating & movement in required yield on a security. <ul><li>Consider a one year commercial paper with a face value of Rs 100. </li></ul><ul><li>Case A: Annual Yield, when the paper has a AAA rating, Assume that the </li></ul><ul><li>market price of the instrument is 93.50, and its term to maturity is 254 </li></ul><ul><li>days. </li></ul><ul><li>yield = 100-93.50 X 365 = 9.98% </li></ul><ul><li> 93.50 254 </li></ul><ul><li>Case B: Annual Yield, when rating of paper changes to BB-, market price of </li></ul><ul><li>instrument is adjusted to move yield upwards. Assume there is no change in </li></ul><ul><li>term to maturity. </li></ul><ul><li>yield = 100-92.50 X 365 = 11.65% </li></ul><ul><li> 92.50 254 </li></ul>
  18. 18. Liquidity Risk: Composition <ul><li>Funding Risk. </li></ul><ul><li>Market Liquidity Risk. </li></ul><ul><li>Asset Liquidity Risk. </li></ul>
  19. 19. Funding Risk: <ul><li>Inability to raise funds at normal cost. </li></ul><ul><li>Market perception about a borrowing entity </li></ul><ul><li>Linkages of credit standing and cost of funds </li></ul>
  20. 20. Market Liquidity Risk: <ul><li>Liquidity crunches due to lack of volume. </li></ul><ul><li>Funding risk due to market weakness. </li></ul><ul><li>Distress on asset prices. </li></ul>
  21. 21. Asset Liquidity Risk: <ul><li>Asset specific rather than market created. </li></ul><ul><li>More prevalent in long term assets. </li></ul><ul><li>Exotic products. </li></ul>
  22. 22. Consequence of liquidity risk: <ul><li>Sale of asset on distressed prices. </li></ul><ul><li>Borrowing extremely high rates. </li></ul><ul><li>Depositors runs. </li></ul><ul><li>Refusal of Lenders to further funding. </li></ul><ul><li>Massive withdrawal of funds by financial institutions. </li></ul><ul><li>Brutal liquidity crisis leading to bankruptcy </li></ul>