Topic 5: The Management of Risk in Banking

1. Topic 5: The Management of Risk in Banking

2. Lecture Outline • Types of risk faced by the modern bank • e.g. Credit Risk, Interest Rate Risk, Currency Risk • Approaches to the management of specific risks • e.g. GAP analysis, Duration Analysis, Derivatives • Key risk management techniques • Derivatives, asset securitisation

3. Introduction • All profit maximising firms/banks face two types of risks: • Microeconomic risk • Macroeconomic risk • Additional potential risks include: • Breakdown in technology; • Commercial failure of a supplier or customer; • Political interference; • National disaster • Additionally, banks manage the risk arising from on and off-balance sheet business.

4. Definitions of Risk • Credit Risk • Probability of default on a loan agreement. • Liquidity Risk • Risk of insufficient liquidity for normal operating requirements. This is called maturity mismatching. • Gearing or leverage risk • Banks are highly geared (more heavily leveraged) than other businesses.

5. Definitions of Risk • Interest Rate Risk • Interest rate risk arises from mismatches in both the value and maturity of interest sensitive assets and liabilities. • Market or Price Risk • Banks face market (or price) risk on instruments such as bonds or securities. • Foreign Exchange or Currency risk • Under flexible exchange rates a bank with global operations faces this type of risk if it relies upon foreign cash flows.

6. Credit Risk Management • Methods Employed to Manage Credit Risk include: • Accurate pricing of loans---more risky loans may be priced higher than the less risky loans. • Credit limits----credit limit may be imposed on the borrower according to their wealth or potential income in near future. • Collateral or security----loans should be properly secured against the wealth or assets of the borrower (houses or shares etc.) • Diversification---risky loans can be backed up through finding new loans markets.

7. Approaches to Credit Risk Management • The analysis of information is conducted according to two broad styles of approach: • Qualitative Methods - assessing annual reports (company) or debt-credit records of an account holder. May also include some regard towards macroeconomic factors (such as changes in interest rate). • Quantitative Methods - require the use of financial data to predict the probability of default by the borrower. (e.g. logit and probit models).

8. Interest Rate Risk Management • Interest rate risk managed through asset liability management (ALM). There are two popular types: • Gap analysis • The gap is the difference between interest sensitive assets and liabilities for a given time interval say six months. • A negative gap means sensitive liabilities are > sensitive assets. • A positive gap means sensitive assets are > sensitive liabilities. • Ideally, we would look for zero gap.

9. GAP Analysis-Example

10. Interest Rate Risk Management Duration analysis • Duration analysis allows for the possibility that the average life (duration) of an asset or liability differs from their respective maturities which makes matching of sensitive assets with sensitive liabilities quite difficult. • Suppose the maturity of a loan is six months and the bank opts to match this asset with a six months certificate of deposit (CD). If part of the loan is repaid each month, then the duration of the loan will differ from its maturity. •  The formula for duration is as: • Duration= Time to redemption {1- [coupon size//MPV*r)] } + (1+r) / [1-(DPV of redemption/MPV)] • Where: r: market or nominal interest rate; MPV: market present value; DPV: discounted present value

11. Duration Analysis - Example • Bond life: 10 years, Value: £100, Coupon rate: £5 annually, Redemption value: £100, Market interest rate: 10%.  Present value is calculated as: DF PV 0.91 5 4.55 0.83 5 4.13 0.75 5 3.76 0.68 5 3.42 0.62 5 3.10 0.56 5 2.82 0.51 5 2.57 0.47 5 2.33 0.42 5 2.12 0.39 105 40.48 69.27 Duration is calculated as: D = 10 ([1- (5 / 6.9277)] + (1.1) {1-[100(1.1) -10/69.277]}). D = 7.6 years rather than 10 years.  

12. Approaches to the management of liquidity and currency risks Liquidity risk management • Triggered on a ‘run’ for deposits. • Best way to control this is with good management, means to restore confidence and deposit insurance? Currency risk management • Foreign exchange or currency risk arises from exposure in foreign currencies. • In the foreign exchange markets, duration analysis is used to compute the changes in the value of foreign currency bond in relation to foreign currency interest rates, or domestic currency interest rates. • Gap analysis may also be employed in the foreign exchange market where the gaps that exist in individual currencies are identified.

13. Derivatives • A derivative is a contract which gives one party a claim on an underlying asset, or cash value of asset, at some fixed date in the future. • The other party is bound by the contract to meet the corresponding liability. • A derivative is a contingent instrument because: • it consists of of well-established financial instruments traded in world markets. • for example, currencies • or commodities for example, wheat • Key examples include: • Forward rate agreements, options, swaps, futures

14. Asset Securitisation • Asset securitisation involves turning traditional, non-marketed balance sheet assets (such as loans) into marketable securities, and moving them ‘off balance sheet’ • When a bank asset is securitised, different functions traditionally played by the bank are unbundled, and may be offered by other parties (known as “pass through”). • The unbundled items include: • Origination, Credit analysis, Funding function, Servicing function, Warehousing function • Benefits of securitisation include: • Separation of Types of Risk (an can sell ‘bundles’ of risk). • Potential increase in shareholder value • Compliance with Regulations (Basel Accord) • Main problem is early repayment on some assets.