An Introduction to Risk Risk Management is the process of measuring or assessing the actual or potential dangers of a particular situation.
Risk Has Two Components • Uncertainty. • Exposure.
Types of Risk • Operational. • Credit. • Reputational.
Operational Risk The risk of loss resulting from inadequate or failed internal processes, people and systems, or from external events.
Operational Risks Include • Internal Fraud. • External Fraud. • Employment Practices and Workplace Safety. • Clients, Products and Business Practices. • Damage to Physical Assets. • Business Disruption and System Failures. • Execution, Delivery and Process Management.
Internal Fraud • Unauthorized Activity. • Transactions not reported. • Transaction type unauthorized. • Mismarking of position. • Theft and Fraud. • Fraud/credit fraud/worthless deposits. • Theft/extortion/embezzlement/robbery. • Misappropriation of assets. • Forgery. • Account take-over/impersonation. • Bribes/kickbacks. • Insider trading. • Money laundering. • Willful blindness.
External Fraud • Theft and Fraud. • Theft/robbery. • Forgery. • Check kiting. • Identity theft. • Elder financial abuse. • Systems Security. • Hacking damage. • Theft of information (with monetary loss).
Employment Practices and Workplace Safety • Employee Relations. • Compensation, benefit, termination issues. • Organized labor issues. • Safe Environment. • General liability (slips and falls). • Employee health and safety rules. • Workers’ compensation. • Diversity and Discrimination. • All discrimination types. • Harassment. • Equal Employment Opportunity (EEO).
Clients, Products and Business Practices • Suitability, Disclosure and Fiduciary. • Fiduciary breaches/guideline violations. • Suitability/disclosure issues. • Retail consumer disclosure violations. • Breach of privacy. • Aggressive sales. • Inadequate product offerings. • Account churning. • Misuse of confidential information. • Lender liability.
Clients, Products and Business Practices (CONTINUED) • Improper Business or Market Practices . • Antitrust. • Improper trade/market practice. • Market manipulation. • Insider trading (on firm’s account). • Unlicensed activity. • Money laundering.
Clients, Products and Business Practices (CONTINUED) • Selection, Sponsorship and Exposure. • Failure to investigate client per guidelines. • Exceeding client exposure limits. • Advisory Activities. • Disputes over performance or advisory activities.
Damage to Physical Assets • Disasters and Other Events. • Natural disaster losses. • Human losses from external sources (terrorism, vandalism).
Business Disruption and System Failures • Systems. • Hardware. • Software. • Telecommunications. • Utility outage/disruptions.
Execution, Delivery and Process Management • Transaction Capture, Execution and Maintenance. • Miscommunication. • Data entry, maintenance or loading errors. • Missed deadline or responsibility. • Model/system misoperation. • Accounting error/entity attribution error. • Other task misperformance. • Record retention. • Documentation maintenance. • Delivery failure. • Collateral management failure. • Reference data maintenance.
Execution, Delivery and Process Management(CONTINUED) • Monitoring and Reporting. • Failed mandatory reporting obligations. • Inaccurate external loss (loss incurred). • Customer Intake and Documentation. • Unapproved access given to accounts. • Incorrect client records (loss incurred). • Negligent loss or damage of client assets.
Execution, Delivery and Process Management (CONTINUED) • Customer/Client Account Management. • Unapproved access given to accounts. • Incorrect client records (loss incurred). • Negligent loss or damage of client assets. • Trade Counterparties. • Non-client counterparty misperformance. • Vendors and Suppliers. • Outsourcing. • Vendor disputes.
Operational Risk Checklist • Employee training. • Close management oversight. • Segregation of duties. • Employee background checks. • Procedures and process. • Purchase of insurance. • Exiting certain businesses. • Capitalization of risks.
Credit Risk Risk due to an uncertainty in a counterparty’s ability to meet its obligations in accordance with agreed upon terms.
Credit Risks Include: • Loans. • Acceptances. • Interbank transactions. • Trade financing. • FX transactions. • Futures. • Swaps. • Equities. • Letters of credit. • Options.
Sound Practices for Managing Credit Risk • Establish an appropriate credit risk environment. • Operate under a sound credit-granting process. • Maintain an appropriate credit administration, measurement and monitoring process. • Ensure adequate controls over credit risk.
Establish an Appropriate Credit Risk Environment • Board of Directors should review credit risk strategy periodically. • Senior management should implement credit risk strategy approved by the Board.
Operate Under a Sound Credit Granting Process • Criteria should include thorough understanding of the borrower, purpose/structure of credit and its source of repayment. • Establish overall credit limits at the level of individual borrowers/connected counterparties. • Have a clearly established process for approving new credits/extension of existing credits. • Extension of credit must be made on an arm’s length basis.
Maintain a Credit Administration, Measurement and Monitoring Process • Have in place a system for ongoing administration of various risk-bearing portfolios. • Develop an internal risk rating system for managing credit risk. • Have an information system and analytical techniques that enable management to measure credit risk of on/off balance sheet activities.
Maintain a Credit Administration, Measurement and Monitoring Process (CONTINUED) • System for monitoring overall composition and quality of the credit portfolio. • Consider future changes in economic conditions when assessing individual credits.
Ensure Adequate Controls Over Credit Risk • System of independent, ongoing credit review. • Credit granting function is properly handled and credit exposures are within limits. • System for managing problem credits.
Credit Risk Checklist • Stringent credit standards for borrowers and counterparties. • Strict portfolio risk management. • Constant focus on changes in economic or other circumstances that can lead to a deterioration in the credit standing of a bank’s counterparties.
Reputational Risk Reputational risk is the potential that negative publicity, whether true or not, will result in loss of customers, severing of corporate affiliations, decrease in revenues and increase in costs.
Benefits of Effective Reputation Management • Improving relations with shareholders. • Creating a more favorable environment for investment. • Recruiting/retaining the best employees. • Reducing barriers to development in new markets. • Securing premium prices for products. • Minimizing threats of litigation.
The key to managing reputational risk is sound risk management, coupled with straightforward communication about the problem the bank is facing.
Re-establishing a firm’s reputation takes a long time.
Reputational Risk Cases • Perrier – Toluene traces. • Exxon – Valdez spill. • Union Carbide – Bhopal, India. • Arthur Andersen – Enron shredding. • Firestone – Tires.
Reputational Risk Checklist • Processes for crisis management are planned and documented. • External perceptions of the bank are regularly measured. • Reputational threats are systematically tracked. • Employees are trained to identify and manage reputational risks. • Standards on environmental, human rights and labor practices are set publically. • Relationships and trust with pressure groups and other potential critics are established.
True or False? • Corporate reputation is one of the primary assets of my bank. • The risks involving a bank’s reputation have increased significantly over the past five years. • Reputational risk is harder to manage than other forms of risk. • My bank is proactive in enhancing and protecting its reputation.
True or False? • It is impossible to quantify the impact of reputational risks. • My bank usually thinks about its reputation only when things go wrong. • A well run bank doesn’t need to invest extra resources into guarding against reputational risk.
Risk Management Risk management is the process of monitoring and addressing the potential for loss.
Evolution of Risk Management • Emerged as a discipline during the early 1990s. • Used long before (1960s). • Typically used to describe techniques for addressing insurable risks.
“Old” Risk Management • Risk reduction through safety, quality control and hazard education. • Alternative risk financing, including self-insurance and captive insurance. • The purchase of traditional insurance products. • Use of derivatives to hedge or customize market risk exposures.
“New” Risk Management • Treats derivatives as a problem as much as a solution. • Focuses on reporting, oversight and segregation of duties within the organization.
By the Mid-1990s • Regulatory initiatives. • Concerns about derivatives. • Release of RiskMetrics. • Published losses.
Enron’s Experience with Risk Management • Maintained a risk management function. • Lines of reporting were reasonably independent. • Mark-to-market valuations were subject to adjustments by management. • Few career risk managers. • Fluid workforce. • Employees constantly looking for next transfer.
Regulatory Responses from the Financial Services Community • Basel II. • Sarbanes-Oxley Act of 2002. • Graam-Leach-Bliley Act. • Bank Secrecy Act/Anti-Money Laundering. • Insider Trading Rules. • Bank Bribery Act. • Fair and Accurate Credit Transactions Act (FACTA) • Fair Lending • Federal Conflicts of Interest Statutes. • Various record retention and reporting requirements.
Success Depends Upon • A positive corporate culture. • Actively observed policies and procedures. • Effective use of technology. • Independence of risk management professionals.
When risk management is done correctly you CAN sleep at night!
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