This document discusses the various types of risks faced by banks, including credit risk, liquidity risk, market risk, operational risk, capital risk, and others. It provides definitions and considerations for evaluating each type of risk, such as key ratios to examine for credit risk, balance sheet items that influence liquidity risk, factors that affect market risk, and guidelines for sufficient capital levels. The document also covers risk management strategies, off-balance sheet activities, CAMELS ratings, and other performance characteristics important for banks.

1. Bank Management
RISK IN FINANCIAL
INTERMEDIATION
Session 6
William Chittenden edited and updated the PowerPoint slides for this edition.

2. Fundamental risks :
 Credit risk
 Liquidity risk
 Market risk
 Operational risk
 Capital or solvency risk
 Off-Balance Sheet Activities
 Foreign Exchange Risk
 Sovereign Risk
 Legal risk
 Reputational risk

3. Credit risk
…the potential variation in net income and
market value of equity resulting from
nonpayment or delayed payment on loans
and securities
 Three Question need to be addressed:
1. What has been the loss experience?
2. What amount of losses do we expect?
3. How prepared is the bank?

4. Credit ratios to consider
 What has been the loss experience?
 Net loss to average total LN&LS
 Gross losses to average total LN&LS
 Recoveries to avg. total LN&LS
 Recoveries to prior period losses
 Net losses by type of LN&LS
 What amount of losses do we expect?
 Non-current LN&LS to total loans
 Total Past/Due LN&LS - including nonaccrual
 Non-current & restruc LN&LS / Gross LN&LS
 Current - Non-current & restruc/ Gr LN&LS
 Past due loans by loan type

5. Credit ratios to consider (continued)
 How prepared are we?
 Provision for loan loss to: average
assets and average total LN&LS
 LN&LS Allowance to: net losses and
total LN&LS
 Earnings coverage of net loss

6. Liquidity risk
…the variation in net income and market value of
equity caused by a bank's difficulty in obtaining cash
at a reasonable cost from either the sale of assets or
new borrowings
 Banks can acquire liquidity in two distinct
ways:
1. By liquidation of assets
 Composition of loans & investments
 Maturity of loans & investments
 Percent of loans and investments pledged
as collateral
2. By borrowing
 Core deposits
 Volatile deposits
 Asset quality & stockholders’ equity

7. Market risk
…the risk to a financial institution’s
condition resulting from adverse movements
in market rates or prices
 Market risk arises from changes in:
 Interest rates
 Foreign exchange rates
 Equity, commodity and security prices

8. Interest rate risk
…the potential variability in a bank's net
interest income and market value of equity
due to changes in the level of market
interest rates
Example: Rs.100,000 Car loan
4 year fixed-rate car loan at 8.5%
1 year FD at 4.5%
Spread 4.0%
But for How long?
 Funding GAP
GAP = RSA - RSL,
where RSA = amount of assets expected to reprice in a
give period of time.
 In this example:
GAP1yr = Rs. 0 – Rs.100,000 = - Rs.100,000
This is a negative GAP.

9. Foreign exchange risk
… the risk to a financial institution’s
condition resulting from adverse movements
in foreign exchange rates
 Foreign exchange risk arises from changes
in foreign exchange rates that affect the
values of assets, liabilities, and off-balance
sheet activities denominated in currencies
different from the bank’s domestic (home)
currency.
 This risk is also often found in off-balance
sheet loan commitments and guarantees
denominated in foreign currencies; foreign
currency translation risk

10. Foreign exchange risk
 Foreign currency trading dominates direct portfolio
investments. Trading volume may look very large but overall
net exposure positions can be relatively small.
 Net exposure i = (FX asset i - FX liabilities i) + (FX bought i -
FX sold i )
 = Net foreign assets i + Net FX bought i
 where
 i = I th currency

11. Foreign exchange risk
 An FI can match its foreign currency assets to its liabilities in a given
currency and match buys and sells in its trading book in that foreign
currency to avoid FX risk.
 Or it can offset its imbalance in its foreign asset-liability portfolio by
an opposing imbalance in its trading book so that its net exposure
position in that currency would be zero.

12. Foreign exchange risk
 A positive net exposure position implies a FI is net long in a currency
and faces the risk that foreign currency falls in value against the
domestic currency. Failure to maintain a fully balanced position in
any given currency exposes a FI to fluctuations in the FX rate of that
currency against the dollar.
 The greater the FI's exposure in a foreign currency and greater that
currency's exchange rate volatility, greater the loss or gain potential
to an FI's earnings.

13. Foreign exchange risk
 Spot market for FX: The market in which
foreign currency is traded for immediate
delivery.
 Forward market for FX: The market in which
foreign currency is traded for future
delivery.
 Net exposure: The degree to which a bank is
net long or net short in a given currency.

14. Foreign exchange risk
 Net long in a currency: Holding more assets than liabilities in a
currency.
 Open position: An unhedged position in a particular currency.
 FX risks arise through mismatching foreign currency or foreign
asset-liability positions in individual currencies. These mismatches
can be profitable if FX forecasts prove to be correct.
 Unexpected outcomes and volatility can impose significant losses on
an FI.
 These risks can be minimised by hedging through matched foreign
asset-liability books, through forward contracts and hedging through
foreign asset and liability portfolio diversification.

15. Equity and security price risk
…change in market prices, interest rates and
foreign exchange rates affect the market values of
equities, fixed income securities, foreign currency
holdings, and associated derivative and other off-
balance sheet contracts.
 Large banks must conduct value-at-
risk analysis to assess the risk of loss
with their trading account portfolios.

16. Operational risk
…measures the cost efficiency of the bank's
activities; i.e., expense control or productivity;
also measures whether the bank has the proper
procedures and systems in place .
 Typical ratios focus on:
 total assets per employee
 total personnel expense per employee
 Non-interest expense ratio
 There is no meaningful way to estimate the
likelihood of fraud or other contingencies
from published data.
 A bank’s operating risk is closely related to
its operating policies and processes and
whether it has adequate controls.

17. Operational & Technology Risk
 OPERATING COST AND TECHNOLOGY RISK
 Financial risk is only one part of the risk profile of a
modern FI. They also have regular operations that
result in additional costs and revenues. They also
have to use various factors of production like
labour, capital and other inputs optimally. Cost of
these production factors has a direct bearing on the
profitability and solvency of an FI.

18. Operational & Technology Risk
 An efficient technological base for an FI can result
in:
 1. Lower costs by combining labour and capital in a
more efficient mix
 2. Increased revenues by allowing a broader array
of financial services to be produced or innovated
and sold to customers.
 Technology has the potential to increase FI's net
interest margin i.e. the difference between interest
income and interest expense and other net income.

19. Operational & Technology Risk
Impact of technology on Banking:
 * Faster reconciliation of accounts
 * Electronic fund transfer
 * Electronic initiation and transmission of letters of credit
 * Portfolio insurance
 * Faster clearance of cheques
 * Note counting machines
 * Automatic Teller Machines
 * Home banking
 * Treasury management software
 * Payment of telephone and electricity bills

20. Operational & Technology Risk
 Technological advances allow an FI to offer such products to
its customers which have potential to earn higher profits.
 The investment in many of these products is risky.
 Innovations may fail to attract sufficient business in relation
to initial cash outlay.
 Innovations in financial sectors get imitated fast.
 One benefit of technology is that it allows FI to cross-market
both new and existing products to customers.
 Technology increases the rate of innovation of new products.
 It improves the quality of service and lowers its cost. This is
possible due to economies of scale and economies of scope.

21. Operational & Technology Risk
 Improvement in technology has contributed more risk to
financial system
 Daylight Overdraft Risk: Bank's reserve account becomes
negative within the banking day. Risk of bank failure during
the transaction time is a major risk.
 International Technology Transfer Risk: Between 1974 and
1994 there has been a dramatic change in the position of
American Banks. Not one American bank figured in top twenty
in 1994 while top 20 positions were occupied by American
banks in 1974 inspite of heavy investment in technology and
financial services innovations in U S.

22. OFF-BALANCE-SHEET
ACTIVITIES
 Off-balance-sheet activities have both risk increasing and risk reducing
attributes.
 They are an important source of fee income for many FIs.
 They are less obvious and invisible to all but the very informed investor or
regulator.
 In economic terms they are contingent assets and liabilities that affect the
future rather than current shape of an FI's balance sheet.
 They have a direct impact on the future profitability and solvency
performance of the FI.
 Their efficient management is central to controlling overall exposure in a
modern FI.
 An activity is an off-balance-sheet asset if, when a contingent event occurs,
the off-balance-sheet item moves onto the asset side of the balance-sheet.
Similarly, when an item moves to liability side of balance-sheet on a
contingent event it is called an off-balance-sheet liability.

23. OFF-BALANCE-SHEET
ACTIVITIES
 The major types of off-balance-sheet activities for
banks are:
 * Loan Commitments
 * Letter of Credits
 * Bank Guarantees including DPGs
 * Futures, Forward contracts, Swaps and Options
 * Underwriting Commitments
 Although off-balance-sheet activities can be risk
increasing, they can also be used to hedge on-
balance-sheet exposures resulting in lower risk as
well as generating fee income to the FI.

24. Sovereign Risk
 Mexican crisis and Asian meltdown confirms the importance of
assessing the country or sovereign risk of a borrowing country in
making lending or other investment decision like buying foreign
bonds or equity.
 If a borrower refuses or is unable to repay its loans the lender would
probably seek to reschedule the promised interest and principal
payments on the loan into the future. Continued inability to pay
would result in liquidation of the firm's assets.
 Consider lending to a first class borrower in a foreign country.

25. Sovereign Risk
 The corporation may be doing well and repaying its debt as
per repayment schedule.
 However, the foreign exchange reserves of the country are
precarious and in order to conserve the foreign exchange
reserves, the government of that country refuses to allow any
further debt repayment in hard currency to outside creditors.
 This puts the foreign borrower automatically into default even
though the company is a good credit risk.
 These types of government action pose sovereign risk which
is independent of the credit standing of the individual loan to
the borrower.

26. Sovereign Risk
 Unlike legal remedy in case of domestic bankrupcy courts,
there is no international bankruptcy court to which the lender
can take the foreign government. Lender's legal remedies to
offset a sovereign country's default or moratoria decisions are
very limited.
 This means that making a lending decision to a party residing
in a foreign country is a two step decision.
 First, lender must assess the underlying credit quality of the
borrower and set an appropriate credit risk premium.
 Second, lenders must assess the sovereign risk quality of the
country in which the borrower resides. Even if the credit risk
is assessed as good but the sovereign risk is bad, the loan
should not be made.

27. Sovereign Risk
 A sovereign's negative decisions to its debt
obligations or the obligations of its public and
private organisation may take two forms:
 Repudiation: an outright cancellation of all current
and future debt obligations by a borrower. They
were very common before the second world war.
 Rescheduling: A country declares a moratorium or
delay on its current and future debt obligations and
then seeks to ease credit terms by rescheduling
debt maturity and renegotiation of interest rates.

28. Capital risk
… closely tied to asset quality and a bank's
overall risk profile
 The more risk taken, the greater is the
amount of capital required.
 Appropriate risk measures include all the
risk measures discussed earlier as well as
ratios measuring the ratio of:
 Tier 1 capital and total risk based capital to
risk weighted assets
 Equity capital to total assets
 Dividend payout, and growth rate in tier 1
capital

29. Definitions of capital
 Tier 1 capital is:
 Total common equity capital plus
noncumulative preferred stock, plus minority
interest in unconsolidated subsidiaries, less
ineligible intangibles.
 Risk-weighted assets are:
 The total of risk-adjusted assets where the
risk weights are based on four risk classes of
assets.
 Importantly, a bank's dividend policy affects
its capital risk by influencing retained
earnings.

30. Legal risk
…the potential that unenforceable contracts,
lawsuits, or adverse judgments can disrupt or
otherwise negatively affect the operations or
condition of the banking organization
 Legal risk includes:
 Compliance risks
 Strategic risks
 General liability issues

31. Reputational risk
 Reputational risk is the potential that
negative publicity regarding an
institution’s business practices,
whether true or not, will cause a
decline in the customer base, costly
litigation, or revenue reductions.

32. Strategies for Maximizing
Shareholder Wealth
 Asset Management
 Composition and Volume
 Liability Management
 Composition and Volume
 Management of off-balance sheet activities
 Net interest margin management
 Credit risk management
 Liquidity management
 Management of non-interest expense
 Securities gains/losses management
 Tax management

33. CAMELS
 Capital Adequacy
 Measures bank’s ability to maintain
capital commensurate with the bank’s
risk
 Asset Quality
 Reflects the amount of credit risk with
the loan and investment portfolios
 Management Quality
 Reflects management’s ability to
identify, measure, monitor, and control
risks

34. CAMELS (continued)
 Earnings
 Reflects the quantity, trend, and quality
of earnings
 Liquidity
 Reflects the sources of liquidity and
funds management practices
 Sensitivity to market risk
 Reflects the degree to which changes
in market prices and rates adversely
affect earnings and capital

35. CAMELS Ratings
 Regulators assign a rating of 1 (best)
to 5 (worst) in each of the six
categories and an overall composite
rating
1 or 2 indicates a fundamentally sound
bank
 3 indicates that a bank shows some
underlying weakness that should be
corrected
 4 or 5 indicates a problem bank

36. Performance Characteristics of Banks
by Business Concentration and Size
 Wholesale Banks
 Focus on loans for the largest
commercial customers and purchase
substantial funds from corporate and
government depositors
 Retail Banks
 Focus on consumer, small business,
mortgage, and agriculture loans and
obtain deposits form individuals and
small businesses

37. Financial Statement Manipulation
 Off-balance sheet activities
 Enron and “Special-Purpose Vehicles”
 Window dressing
 Eliminate Fed borrowing prior to
financial statement reporting date
 Increase asset size prior to year-end
 Preferred stock
 Meets capital requirements but causes
NIM, NI, ROE, and ROA to be
overstated

38. Financial Statement Manipulation
(continued)
 Non-performing loans
 Banks may lend borrower funds to
make payments on past due loans,
understating non-performance status
 Allowance for loan losses
 Management discretion and IRS
regulations may be in conflict

39. Financial Statement Manipulation
(continued)
 Securities gains and losses
 Banks often classify all investment
securities as “available for sale,”
overstating any true “gains or losses”
 Non-recurring sales of assets
 This type of transaction is not part of
the bank’s daily activities and typically
cannot be repeated; thus it overstates
earnings