Managing Credit Risk • A major part of the business of financial institutions is making loans, and the major risk with loans is that the borrow will not repay. • Credit risk is the risk that a borrower will not repay a loan according to the terms of the loan, either defaulting entirely or making late payments of interest or principal. • Concepts of adverse selection and moral hazard provides framework to understand the principles that is used to minimize credit risk, yet make successful loans.

1. Unit 4 - Risk Management in
Financial Institutions

2. Managing Credit Risk
• A major part of the business of financial institutions is making loans,
and the major risk with loans is that the borrow will not repay.
• Credit risk is the risk that a borrower will not repay a loan according
to the terms of the loan, either defaulting entirely or making late
payments of interest or principal.
• Concepts of adverse selection and moral hazard provides framework
to understand the principles that is used to minimize credit risk, yet
make successful loans.

3. Managing Credit Risk
• Adverse selection is a problem in the market for loans because those
with the highest credit risk have the biggest incentives to borrow
from others.
• Moral hazard plays as role as well.
• Once a borrower has a loan, she has an incentive to engage in risky
projects to produce the highest payoffs, especially if the project is
financed mostly with debt.

4. Managing Credit Risk
• Solving Asymmetric Information Problems:
• Financial managers have a number of tools available to assist in
reducing or eliminating the asymmetric information problem:
• Screening and Monitoring
• Specialization in Lending
• Risk Monitoring and Enforcement
• Long-term Customer Relationships
• Loan Commitments
• Collateral
• Compensating Balances
• Credit Rationing

5. Managing Credit Risk
• Screening and Monitoring: collecting reliable information
about prospective borrowers. This has also lead some
institutions to specialize in regions or industries, gaining
expertise in evaluating particular firms or individuals
• It also involves requiring certain actions, or prohibiting
others, and then periodically verifying that the borrower is
complying with the terms of the loan contact.

6. Managing Credit Risk
• Specialization in Lending helps in screening. It is easier to collect data
on local firms and firms in specific industries.
• It allows them to better predict problems by having better industry
and location knowledge
• Risk Monitoring and Enforcement also helps.
• Financial institutions write protective covenants into loans contracts
and actively manage them to ensure that borrowers are not taking
risks at their expense

7. Managing Credit Risk
• Long-term Customer Relationships: past information contained in
checking accounts, savings accounts, and previous loans provides
valuable information to more easily determine credit worthiness.
• Loan Commitments: arrangements where the bank agrees to provide
a loan up to a fixed amount, whenever the firm requests the loan.
• Collateral: a pledge of property or other assets that must be
surrendered if the terms of the loan are not met ( the loans are called
secured loans).

8. Managing Credit Risk
• Compensating Balances: reserves that a borrower must maintain in
an account that act as collateral should the borrower default.
• Credit Rationing:
a) lenders will refuse to lend to some borrowers, regardless of how much
interest they are willing to pay, or
b) lenders will only finance part of a project, requiring that the remaining part
come from equity financing.

9. Managing Interest-Rate Risk
• Financial institutions, banks in particular, specialize in earning a
higher rate of return on their assets relative to the interest paid on
their liabilities.
• As interest rate volatility increased in the last 20 years, interest-rate
risk exposure has become a concern for financial institutions.
• Following analysis are used for managing Interest Rate Risk
1. Income Gap Analysis
2. Duration Gap Analysis

10. Income Gap Analysis
• Income Gap Analysis: measures the sensitivity of a bank’s current
year net income to changes in interest rate.
• Requires determining which assets and liabilities will have their
interest rate change as market interest rates change

11. Duration Gap Analysis
• Owners and managers do care about the impact of interest rate
exposure on current net income.
• They are also interested in the impact of interest rate changes on the
market value of balance sheet items and the impact on net worth
• Duration Gap Analysis: measures the sensitivity of a bank’s current
year net income to changes in interest rate. Requires determining the
duration for assets and liabilities, items whose market value will
change as interest rates change

12. Duration Gap Analysis
• The basic equation for determining the change in market value for
assets or liabilities is
• Can be applied to banks as well as other financial institutions

13. Managing Interest-Rate Risk
• Risk Problems with GAP Analysis
• Assumes slope of yield curve unchanged and flat
• Manager estimates % of fixed rate assets and liabilities that are rate sensitive.
• Risk Strategies for Managing Interest-Rate Risk
• In example above, shorten duration of bank assets or lengthen duration of
bank liabilities
• To completely immunize net worth from interest- rate risk, set DUR gap = 0

14. Managing Liquidity Risk
Liquidity Management Tool Description / Aim
Static Funding Gap Defines the short fall in maturing liabilities required to
service maturing assets– it is usually calculated on a maturity
bucket basis and is calculated as the net asset position over
total liabilities
Dynamic Cash Flow Gap This includes a measurement based on maturing assets and
liabilities plus assumed marketable asset liquidation over a
given period.
Liquidity Asset Ratios This is the ratio of liquid assets to total liabilities with liquids
defined to include items such as cash and cash equivalents,
trading account securities, repos investments into
government securities, etc
Concentration Ratios This is an important ratio that reassures the funding from a
particular source compared to assets /liabilities or capital.
Liquidity Stress Measurement A number of ratios can be examined here looking at multiple
low stress and high stress scenarios

15. Managing Operational Risk
• The Risk of loss arising from
• Inadequate and/or failed internal processes, people and systems
• From external events
• Including legal risk
• Excluding reputation risk and strategic risk

16. Managing Operational Risk
Operational Risk
Management
Operational Risk
Identification
Operational Risk
Measurement
Operational Risk
Monitoring
Operational Risk
Mitigation

17. Operational Risk Identification
• Homogeneous and material bank operation
• Homogeneous
• The operation is conducted by a group of staff at a similar professional level
• The operation procedures are largely standardized
• The operation will result similar deliverables
• Material
• There are sufficient internal and/or external historical records of operational
failures to derive an operational loss distribution

18. Operational risk factors
• Loss amount
• The loss expressed in monetary
terms after an operational failure
has occurred
• Failure frequency
• The no. of operational failures in
the following ONE year
• Service period
• The time horizon over which the
operation will be carried on

19. Operational Risk Measurement
• Theoretical risk measures
1. Expected loss (EL)
• The probability weighted annual operational loss Cost of doing business
2. Loss standard deviation (LSD)
• The standard deviation of annual operational loss
3. Worst case loss (WCL)
• The annual operational loss at the 99.9th percentile confidence level
4. Unexpected loss (UL)
• WCL - EL

20. Operational risk modelling
• Historical simulation
• Very few model assumptions Simple
• Monte Carlo simulation
• Statistical model assumptions on loss amount and failure frequency
• Very flexible

21. Operational risk modelling
• Historical simulation – model assumptions
• History will repeat itself
• Loss amount observed in the pass will occur uniformly in the future
• Failure frequency observed in the pass will occur uniformly in the future
• Monte Carlo simulation – model assumptions
• Ln(Loss amount) follows a normal distribution
• Failure frequency follows a Poisson distribution

22. Operational Risk Monitoring
• Monitoring tools
• Operational loss database
• Backward looking
• Internal records
• External services
• Key risk indicator (KRI)
• Forward looking
• A numerical proxy of failure frequency, loss amount and/or annual
operational loss

23. Why KRI (Key Risk Indicators)
• Provide management with early warning of operational risk issues
• Provide management with predictive information
• Reflect potential sources of operational risk so that management can act on
issues before they become material to the bank
• Exhibit the critical operational risks facing, or potentially facing the bank
• Management tracking and escalation triggering of operational risk
• Facilitate communication of potential problems to a higher level of management
• Setting “goals or limits” or “escalation triggers”
• Early warning of
• an increase in operational risk
• a breakdown in operational risk management

24. Operational risk analysis with KRIs
• Peer analysis
• Which branch is the most risky?
• Which branch is the least risky?
• Trend analysis
• Is the operational risk increasing?
• Is the operational risk reducing?
• Threshold analysis
• At which level has material operational failure started to emerge?
• At which level has even minor operational failure never observed?
• Statistical analysis
• What is the average risk level?
• What is the distribution of risk level?

25. Disadvantages of KRIs
• Cost of doing businesses
• Highly customized for individual banks and individual bank operations
• Design of efficient and effective KRIs highly leverages on bank
operation experiences
• Require a sufficiently long history to build a statistically meaningful
KRI system
• Direct relationship between operational loss and KRIs not guaranteed
• Banks in general have less experience in implementing KRIs

26. Operational Risk Mitigation
Operational Risk Control Strategy
Loss Amount Reduction
• Insurance Risk Transfer
• Operational risk derivatives Risk Transfer
Failure frequency reduction
• Compliance programme Risk reduction
• Control Self assessment Risk reduction
Service Period reduction
• Temporary Suspension Risk avoidance
All
• Outsourcing to service providers Risk substitution
• Cease of Operation Risk elimination
Average Operational Loss
• Service Fee from Customers Risk acceptance

27. Insurance
• For high loss amount but low failure frequency operations
• To compensate the major part of an operational loss
• Customized for individual bank and individual operation
• Usually subject to
• Deductible amount
• Protection limit
• High insurance premium

28. Operational risk derivatives
• For high loss amount but low failure frequency operations arising
from external common events
• To hedge the systematic operational risk common to many financial
institutions, e.g. earthquake, hurricane, electricity breakout
• Tradable among financial institutions
• Catastrophe option
• Payoff subject to the no. of events and magnitude of events
• Catastrophe bond
• Interest rate subject to the no. of events and magnitude of events

29. Compliance programme
• Policies and procedures
• High level principles set out by senior management
• Detailed steps set out by frontline management
• Training and awareness
• To raise the importance
• To maintain the professional level
• Compliance check
• To ensure policies and procedures are performed
• To feedback and improve the policies and procedures