Risk Management in Banks : An Introduction

1. Risk Management in Banks : An Introduction By A V Vedpuriswar June 14, 2014

2. The Rise of Risk Management

3. Evolution of Analytical Risk Management tools 2

4. Interest rate trends

5. The Real Crisis

6. The Ruble Crisis

7. The Asian currency Crisis

8. The Mexican Peso Crisis

9. Rupee Dollar rate : 1993-2013

10. 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

11. Examples of Risk There is a general downturn in the markets and clients reduce their trading volumes, reducing the commissions that we earn. A bank enters into a new business area, but the revenues do not meet expectations, and will not cover the costs of the investment made. A client a bank has lent money to goes bankrupt and the bank loses the funds. Share prices fall 10% globally and the bank loses money on our own positions. Due to a credit market dislocation, a bank is unable to borrow funds at an acceptable price to fund 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 the bank’s licence to conduct business in their country due to failures in internal controls. Wealth management clients move their money away from the bank, due to public revelation of problems. A counterparty who owes the bank money under an OTC derivative transaction defaults due to financial difficulty A counterparty who owes the bank money under an OTC derivative transaction refuses to pay and claims they were not authorised to enter the trade Which category? 10

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

13. 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

14. 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.

15. 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

16. 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

17. Operational Risk 16 • 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.

18. 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

19. 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

20. 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

21. 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. 20