Risk Management in Banks and Financial Institutions : A high level view

Risk Management in Banks and Financial Institutions : A high level view By A V Vedpuriswar November 1, 2010

The rise of risk management

The Real Crisis Ref : Prof. Werner Antweiler , http://fx.sauder.ubc.ca/

The Ruble Crisis Ref : Prof. Werner Antweiler , http://fx.sauder.ubc.ca/

The Asian currency Crisis Ref : Prof. Werner Antweiler , http://fx.sauder.ubc.ca/

The Mexican Peso Crisis Ref : Prof. Werner Antweiler , http://fx.sauder.ubc.ca/

Evolution of Analytical Risk Management tools 6

The more the business risk, the lower should be the financial risk.

Risk Categories Financial risks Primary Operational Transaction processing Legal Credit risk Market Risk Liquidity risk Compliance Liability Security Tax Business risks • Business environment • Economic cycles • Industry cycles • Industry trends • Technology change • Vision/strategy Reputation risk Source : UBS

Examples of Risk There is a general downturn in the markets and clients reduce their trading volumes, reducing the commissions that we earn. We enter into a new business area, but the revenues do not meet expectations, and will not cover the costs of the investment made. A client we have lent money to goes bankrupt and we lose the funds. Share prices fall 10% globally and we lose money on our own positions. Due to a credit market dislocation, we find ourselves unable to borrow funds at an acceptable price to fund our actual or proposed commitments A former employee sues the bank for discrimination. A CD containing confidential Wealth Management client data is lost A trader executes transactions, but does not enter them into the trading system until later, and only inputs the ones that have not lost money. A regulator suspends our licence to conduct business in their country due to failures in internal controls. Wealth management clients move their money away from us, due to public revelation of problems. A counterparty who owes us money under an OTC derivative transaction defaults due to financial difficulty A counterparty who owes us money under an OTC derivative transaction refuses to pay and claims they were not authorised to enter the trade which category? Source : UBS 9

Valuation & Risk Management approaches

Market risk • Risk of loss owing to movements in the level or volatility of market prices of stocks, interest rates, currencies, commodities.

A closer look at currency risk

Ref : Prof. Werner Antweiler , http://fx.sauder.ubc.ca/

The Dollar vs the rest Source: New York Fed

Long term interest rate movements Source: New York Fed

Short term interest rate movements Source: New York Fed

Stock Market Index movements Source: New York Fed

This refers to the possibility that the transaction cannot be conducted at the prevailing market prices owing to the size of the position relative to normal trading lots. • Liquidity risk may also arise because of the inability to meet payment obligations. • This is especially a risk for portfolios that are leveraged and subject to margin calls from the lender. • If cash reserves are insufficient, losses in market value may create a need for cash payments, leading to an involuntary liquidation of the portfolio at depressed prices. Liquidity Risk

Liquidity, model and market risks Liquidity, market and model risks are interrelated. Breakdown of markets leads to liquidity problems. When markets are not in place, models become necessary. Models pose various risks.

This risk arises because the counterparties may be unwilling or unable to meet contractual obligations. • Pre settlement risk arises over the life of the contract. • Settlement risk occurs when a counterparty defaults after the institution has already made its payment. • Settlement risk is very real for foreign exchange transactions which involve exchange of payments in different currencies at different times. Credit risk

The Nature of Credit Risk Less liquid positions Longer time horizons e.g. 1 year Negatively skewed distributions Potential for longer tails Correlations and concentrations

Credit Risk components Traditional banking products, e.g. Loans commitments to lend letters of credit Traded products e.g. OTC derivatives Repos (and reverse repos) Securities borrowing and lending Plus settlement risk on e.g. Foreign exchange

Operational Risk 32 This is the risk arising out of inadequate or internal processes, people and systems from external events. The best protection against operational risks consists of -redundancies of systems -clear separation of responsibilities with strong internal controls -regular contingency planning.

UBS Operational Risk Definitions Transaction Processing Risk (TPR) is the risk of financial loss due to deficiencies in transaction processing systems or internal controls front to back. Liability Risk is the risk of loss arising from potential or actual liability resulting from a legal or equitable claim, including contractual and legal claims, debt, and actions based on breach or default of contract, commitment of tort, violation of criminal law, infringement of trademark or anti-trust action. Compliance Risk is the risk of loss incurred by not adhering to the applicable laws, rules and regulations, local and international best practice (including ethical standards) and our own internal standards. Security Risk is the risk of loss or damage to the Bank’s reputation arising from a loss of confidentiality, integrity or availability of our information or assets. Legal Risk is the risk of financial loss resulting from the non-enforceability of rights arising under a contract or from property or under the general law. Tax Risk is the risk of loss due to tax authorities successfully opposing the Bank’s position in tax returns.

Impact of Operational Risk Operational risk is inherent in every banking activity. Impact of Operational Risk direct financial losses indirect (revenue foregone as a result of business suspension) damage to our reputation and franchise Objective is not to eliminate risk but reduce the riskas far as practical avoid high frequency, high impact mitigate or transfer high impact, low frequency manage high frequency, low impact events for which the cost of further risk reduction would exceed the reduction in losses accept low frequency, low impact but monitor them Source : UBS

Barings ( 1995) 233 year old bank collapses under $1.24 Billion loss Lack of Internal Controls No segregation of duties (Front and back office) Poor authorisation procedures Lack of management awareness of inherent risk Fraud Market risk

ING Financial Services Business News – 23 April 2007 34-year-old Bernard Santos, a former corporate actions clerk at ING Financial Services in New York, was arrested in connection with an alleged $523,000 fraud. From October 2005 to September 2006, Santos 'created fake client e-mails that requested payment of particular stock dividends, then transferred dividend payments to a bank account he controlled'. Santos was accused of netting more than $523,000 from the alleged scam.

Allfirst/Allied Irish Bank $674 million loss Major control deficiencies e.g. failure of back office to confirm bogus options and failure of middle office to obtain independently sourced exchange rates Missed opportunities to detect fraud e.g. poor supervision of rogue trader John Rusnak

Operational Risk Drivers High Profile Losses Reputational damage Regulatory Pressure SOX (Sarbanes – Oxley Act) Basle II MiFID (Markets in Financial Instruments Directive) Competitive Advantage Outsourcing / Offshoring Technology Advancement Business Growth (Trade volume and human capital) Product Complexity and Evolution Emerging Market Opportunity

Sarbanes Oxley (SOX) Enacted in response to a number of high-profile corporate and accounting scandals that resulted in a loss of public trust in corporate accounting and reporting practices (Enron). Establishes new or enhanced standards for corporate accountability and penalties for corporate wrongdoing. Section 404 - CEO and CFO attest that the firm's financial accounts and the controls over the processes used to produce them are sound.

Credit, market, settlement and Operational Risk - Illustration • A trader purchases £1 million spot from Bank A. The current rate is $1.5/£. This means two days from now, the trader will have to give $1.5 million and receive £1 million. The trader will then offload position in the market with another counterparty B. • Market Risk: If the spot rate changes to $1.4/£, loss for the trader = 1.5 – 1.4 = $100,000, assuming the deal with counterparty B is now stuck at 1.4. • Credit Risk: Say the next day, B goes bankrupt and the rate changes to $ 1.35/£. Instead of selling to B at 1.4, A will have to offload in the market to another bank, say at 1.35. Loss = $50,000 (loss per unit = 1.4 – 1.35). • Settlement risk: If $1.5 million is delivered but £ 1 million is not received, this is settlement risk. • Operational risk: $1.5 million is wired to the wrong bank. After two days, the money is received and remitted to the right bank with compensatory interest. The loss is the amount due. 40

Risk Management in Banks and Financial Institutions : A high level view