Financial Risk Management Framework and Overview

1. Risk Management Lecturer: Mr. Frank Lee Sessions 1&2 Financial Risk Management Framework and Overview

2. Course Overview • Sessions 1&2: • Overview, types of risk • Risk management in financial institutions • Corporate risk management and Derivatives • Session 3: • Sensitivity based measures of risk • Session 4: • Statistical measures of risk • Session 5: • Motivating risk management

3. Course Focus • Analytics of risk management • Generic and universal issues • Main frameworks, applications and tools • Practical application at an intermediate level

4. Prior Knowledge • The concept of risk and return in finance, Investments, Portfolio Management, MPT framework, CAPM etc. • Derivatives and hedging • Capital markets, financial instruments • Bonds, term structure of interest rates • Financial Institutions and intermediation • Basic maths and stats – derivatives calculus; normal distribution, mean, standard deviation, variance, covariance, correlation, sample statistics and hypothesis testing.

5. Sessions 1&2 Overview • Risk management framework • Main types of risk • Measures of risk • Risk Management in Financial Institutions • Corporate Risk Management and Derivatives

6. Risk Management Framework • Organisations face an increasingly complex and uncertain future. • Need to: • identify, • measure, • manage, and • control risk. • Strategic significance – broader scope • Functional focus – operational and organisational issues

7. What is risk? • Uncertainty of meeting objectives over a particular time horizon. (RiskMetrics Group 2006) • What are the right objectives? • Uncertainty and volatility of returns • Absolute and relative returns • Uncertainty of future earnings • Uncertainty of underperforming a benchmark

8. What is risk? • Risk vs uncertainty • Business vs financial risk • Firms specific vs all types of risk exposures

9. Types and sources of risks • Business risk • Market risk • Interest rate risk • Equity price risk • Foreign exchange risk • Commodity price risk • Credit risk • Reputation risk • Operational risk • Liquidity risk

10. Measures of Risk • Risk management relies on quantitative measures of risk. • Various risk measures aim to capture the variation of a given target variable (e.g. earnings, market value or losses due to default) generated by uncertainty. • Three types of quantitative indicators: • Sensitivity • Volatility • Downside measures of risk

11. Measuring Uncertainty • Quantitative risk measures do not capture all uncertainties • They depend on assumptions which can underestimate some risks • Quantitative techniques address only measurable risks - they are no substitute for judgment Quantitative measures facilitate feasibility and gain credibility

12. Emphasis on Quantitative Measures • When data become available risks are easier to measure - increased use of quantitative measures • Risks can be qualified and ranked even if they cannot be quantified (e.g. ratings agencies) • Regulators’ emphasis and requirements - e.g. banking industry capital requirements.

13. RISK MANAGEMENT IN FINANCIAL INSTITUTIONS

14. Risks of Financial Intermediation • The role of Financial Institutions • Complexity, risk pooling and risk taking activities • Evolution of risk management • Relevance to the course participants

15. General issues for financial system Securities market Savers Investors or borrowers Financial Intermediaries

16. Time, lumps and who can you trust? • Finance generally needed for firms because: • Payment and receipts come at different times • Some equipment or assets are lumpy (buildings, machinery, set up costs, etc.) • All loan markets are complicated by risk and diversity of interests between lenders and borrowers • Intermediaries exist in order to provide: • Specialist knowledge of borrowers • Spreading of risk • Maturity transformation

17. Financial Markets Money Primary Markets OTC Markets Secondary Markets

18. Financial Institutions Company Obligations Funds Intermediaries Banks Insurance Cos. Brokerage Firms

19. Financial Institutions Intermediaries Obligations Funds Investors Depositors Policyholders Investors

20. Risks faced by financial intermediaries • Interest rate risk – results from assets and liabilities maturities mismatch • Market risk – change in market prices of assets and liabilities on FI’s trading books (changes in interest rates, exchange rates, equities prices etc.) • Off-balance sheet risk – contingent assets and liabilities • Technology risk – technology investments and results • Operational risk – malfunction or breakdown in existing technology, auditing, monitoring, and other support systems

21. Risks faced by financial intermediaries • Foreign exchange risk – changes in exchange rate can affect the value of assets and liabilities denominated in non-domestic currencies • Country or sovereign risk – repayment (or repatriation of funds from) abroad may be interrupted because of restrictions, intervention or interference from foreign governments • Liquidity risk –sudden surge in liability withdrawals that may require liquidation of assets in a short period of time and at less than a market price • Insolvency risk- not enough capital to offset a sudden decline in the value of assets

22. Risks of Financial Intermediation • Interest rate risk resulting from intermediation: • Mismatch in maturities of assets and liabilities. • Balance sheet hedge via matching maturities of assets and liabilities is problematic for FIs. • Refinancing risk. • Reinvestment risk.

23. Central Bank and Interest Rate Risk • Effects of interest rate targeting. • Lessens interest rate risk • Implications of reserves target policy: • Increases importance of measuring and managing interest rate risk.

24. Market Risk • Incurred in trading of assets and liabilities (and derivatives). • Examples: Barings & decline in ruble. • Trend to greater reliance on trading income rather than traditional activities increases market exposure. • Trading activities introduce other perils as was discovered by Allied Irish Bank’s U.S. subsidiary, AllFirst Bank when a rogue trader successfully masked large trading losses on foreign exchange positions

25. Market Risk: • Market risk is the uncertainty resulting from changes in market prices . It can be measured over periods as short as one day. • Usually measured in terms of ‘dollar’ exposure amount or as a relative amount against some benchmark.

26. Pertinent Websites Bank for International Settlements www.bis.org Federal Reserve www.federalreserve.gov Citigroup www.citigroup.com RiskMetrics www.riskmetrics.com

27. Credit Risk • Risk that promised cash flows are not paid in full. • Firm specific credit risk • Systematic credit risk • High rate of charge-offs of credit card debt in the US and UK in the 80s and 90s • Obvious need for credit screening and monitoring • Diversification of credit risk

28. Credit Quality Problems • Problems with junk bonds, LDC loans, residential mortgage loans. • More recently, credit card loans and auto loans. • Crises in Asian countries such as Korea, Indonesia, Thailand, and Malaysia.

29. Web Resources • For further information on credit ratings visit: Moody’s www.moodys.com Standard & Poors www.standardandpoors.com

30. Off-Balance-Sheet Risk • Increased importance of off-balance-sheet activities - Letters of credit, Loan commitments, Derivative positions • Speculative activities using off-balance-sheet items create considerable risk • Off-balance-sheet activities are often designed to reduce risks through hedging with derivative securities and other means. • However, as several recent events demonstrate, OBS risk can be substantial.

31. OBS Activities • Infamous cases: • Barings. • Metallgesellschaft. • Banker’s Trust. • CSFB/Orange County, CA. • Sumitomo Corp.

32. OBS Activities and Solvency • Off-balance-sheet assets • Off-balance-sheet liabilities • Valuation of OBS items: • Delta of an option • Notional value of an OBS item • Delta equivalent or Contingent asset value = Delta × Face value of option

33. Technology and Operational Risk • Risk of direct or indirect loss resulting form inadequate or failed internal processes, people, and systems or from external events. • Some include reputational and strategic risk • Payment Systems - Technological innovation has seen rapid growth • Automated clearing houses • TARGET, CHAPS, CHIPS, Fedwire

34. Technology and Operational Risk • Risk that technology investment fails to produce anticipated cost savings. • Risk that technology may break down. • Bank of New York • Well’s Fargo • Back Office • Economies of scale. • Economies of scope.

35. Foreign Exchange Risk • Returns on foreign and domestic investment are not perfectly correlated. • FX rates may not be correlated. • Example: $/Euro may be increasing while $/¥ decreasing. • Undiversified foreign expansion creates FX risk.

36. Foreign Exchange Risk • Note that hedging foreign exposure by matching foreign assets and liabilities requires matching the maturities as well. • Otherwise, exposure to foreign interest rate risk is created.

37. Foreign Exchange Risk • Globalization of financial markets has increased foreign exposure of most FIs. • FI may have assets or liabilities denominated in foreign currency (in addition to direct positions in foreign currency). • Foreign currency holdings exceed direct portfolio investments.

38. Sources of FX Risk • Spot positions denominated in foreign currency • Forward positions denominated in foreign currency • Net exposure = (FX assets - FX liab.) + (FX bought - FX sold)

39. FX Risk Exposure • FI may have positions in spot and forward markets. • Could match foreign currency assets and liabilities to hedge F/X risk • Must also hedge against foreign interest rate risk (by matching durations, for example)

40. Trends in FX • Value of foreign positions has increased • Volume of foreign currency trading has decreased • Causes: • Investment bank mergers • Increased trading efficiency through technological innovation • Introduction of the euro

41. Web Resources • For statistics related to FX trading, visit: Bank for International Settlements www.bis.org

42. Country or Sovereign Risk • Result of exposure to foreign government which may impose restrictions on repayments to foreigners. • Lack usual recourse via court system. • Examples: South Korea, Indonesia, Thailand. • More recently, Argentina.

43. Sovereign Risk • In 1970s: • Expansion of loans to Eastern bloc, Latin America and other LDCs. • Beginning of 1980s: • Poland and Eastern bloc repayment problems. • Debt moratoria announced by Brazil and Mexico. • Increased loan loss reserves

44. Sovereign Risk • Late 1980s and early 1990s: • Expanding investments in emerging markets. • Peso devaluation. • More recently: • Asian and Russian crises. • Brady Bonds

45. Credit Risk versus Sovereign Risk • Governments can impose restrictions on debt repayments to outside creditors. • Loan may be forced into default even though borrower had a strong credit rating at origination of loan. • Legal remedies are very limited. • Need to assess credit quality and sovereign risk

46. Sovereign Risk • Debt repudiation • Since WW II, only China, Cuba and North Korea have repudiated debt. • Rescheduling • Most common form of sovereign risk. • South Korea, 1998 • Argentina 2001

47. Debt Rescheduling • More likely with debt financing rather than bond financing • Loan syndicates often comprised of same group of FIs • Cross-default provisions • Specialness of banks argues for rescheduling but, incentives to default again if bailouts are automatic

48. Country Risk Evaluation • Outside evaluation models: • The Euromoney Index • The Economist Intelligence Unit ratings • Institutional Investor Index

49. Web Resources • To learn more about the Economist Intelligence Unit’s country ratings, visit: The Economist www.economist.com

50. Liquidity Risk • Risk of being forced to borrow, or sell assets in a very short period of time. • Low prices result. • May generate runs. • Runs may turn liquidity problem into solvency problem. • Risk of systematic bank panics.