RISK MANAGEMENT

RISK ..

Risk can be traced to the Latin word Rescum

Risk is associated with uncertainty and reflected

by way of change on the fundamental/ basic

Reduction in firms value due to changes in

business environment

What is risk?
Danger

that
a
certain
unpredictable
contingency
can occur, which generates
randomness in cashflow
Concentrates
more
on
Systematic Risk

BUSINESS ARRAYS

Balance sheet

BANKING RISKS

RISK MANAGEMENT

Credit Risk

Credit

risk

financial

is

loss

the
if

potential
borrower

for
or

counterparty in a transaction fails to

meet its obligations.

Operational Risk

Operational risk is the risk of loss

resulting from inadequate or failed
internal

processes,

people

systems or from external events.

and

Liquidity risk

Liquidity risk relates to the banks

ability

to

meet

its

continuing

obligations, including financing its assets.

Systematic risk

Systematic risk is the risk of asset value change

associated with systematic factors. It is sometimes
referred to as market risk, which is in fact a somewhat
imprecise term. By its nature, this risk can be hedged,
but cannot be diversified completely away. In fact,
systematic risk can be thought of as undiversifiable
risk.

Market Risk
Market

risk is the potential for

loss from changes in the value of
financial instruments.
The value of a financial instrument
can be affected by changes in:
Interest rates;
Foreign exchange rates;
Equity and commodity prices;
Credit spreads.

Interest rate risk

Interest rate risk is the potential loss due to movements in

interest rates. This risk arises because bank assets (loans and bonds)
usually have a significantly longer maturity than bank liabilities
(deposits). This risk can be conceptualized in two ways. First, if interest
rates rise, the value of the longer term assets will tend to fall more than
the value of the shorter-term liabilities, reducing the banks equity.

Second, if interest rates rise, the bank will be forced to pay higher
interest rates on its deposits well before its longer term loans mature and
it is able to replace those loans with loans that earn higher interest rates.

Foreign Exchange risk

Foreign exchange risk is the risk that the

value of the banks assets or liabilities changes
due to currency exchange rate fluctuations.

Banks buy and sell foreign exchange on behalf of

their customers (who need foreign currency to
pay for their international transactions or receive
foreign currency and want to exchange it to their
own currency) or for the banks own accounts.

Commodity Risk

Commodity risk is the potential loss due to

an adverse change in commodity prices.

There are different types of commodities, including

agricultural

commodities

(e.g.,

wheat,

corn,

soybeans), industrial commodities (e.g.,metals),

and energy commodities (e.g., natural gas, crude
oil). The value of commodities fluctuates a great
deal due to changes in demand and supply.

Performance Risk

Performance risk exists when the transaction risk depends more on how the
borrower performs for specific projects or operations than on its overall credit
standing.

Performance risk appears notably when dealing with commodities. As long as

delivery of commodities occurs, what the borrower does has little importance.

Performance risk is transactional because it relates to a specific transaction.

Moreover, commodities shift from one owner to another during transportation.
The lender is at risk with each one of them sequentially.

Risk remains more transaction-related than related to the various owners

because the commodity value backs the transaction. Sometimes, oil is a major
export, which becomes even more strategic in the event of an economic crisis,
making the financing of the commodity immune to country risk.

SOLVENCY RISK

Solvency risk is the risk of being unable to

absorb losses, generated by all types of risks,
with the available capital.
Solvency risk is equivalent to the default risk of
the bank.
Solvency is a joint outcome of available capital
and of all risks. The basic principle of capital
adequacy, promoted by regulators, is to define
what level of capital allows a bank to sustain the
potential losses arising from all current risks and
complying with an acceptable solvency level.

Business risk
Business Risk derives from a reduction of
margins not due to market, credit or
operational risks, but to changes in the
competitive environment and in customer
behavior.
Specifically,
it mainly concerns future
changes in margins and their impact on the
Group's value and capitalization levels.

REAL ESTATE RISK

Real estate risk comprises potential losses

from adverse fluctuations in the market value
of the real estate portfolio owned by the
Group.

Customers'

mortgage
included.

and

properties

leased

subject

property

are

to
not

Reputational risk:

Reputational risk is the current or future risk

of a decline in profits as a result of a
negative perception of the bank's image by
customers,

counterparties,

bank

shareholders, investors or the regulator.

Strategic risk

Strategic risk arises from unexpected changes in the

competitive environment, from the failure to recognize
ongoing trends in the banking sector or from making
incorrect conclusions regarding these trends. The
impacts of decisions that are detrimental to long-term
objectives and that may be difficult to reverse are also
considered.

Legal Risk

Legal risks are endemic in financial contracting

and are separate from the legal ramifications of
credit, counterparty, and operational risks.
For example, environmental regulations have radically
affected real estate values for older properties and
imposed serious risks to lending institutions in this
area.

A second type of legal risk arises from the

activities of an institution's management or
employees. Fraud, violations of regulations or
laws, and other actions can lead to catastrophic
loss.

Country risk

Sovereign risk, which is the risk of default of sovereign issuers, such

as central banks or government sponsored banks. The risk of
default often refers to that of debt restructuring for countries.
A deterioration of the economic conditions. This might lead to a
deterioration of the credit standing of local obligors, beyond what it
should be under normal conditions. Indeed, firms default
frequencies increase when economic conditions
deteriorate.
A deterioration of the value of the local foreign currency in terms of
the banks base currency.
The impossibility of transferring funds from the country, either
because there are legal restrictions imposed locally or because the
currency is not convertible any more.
Convertibility or transfer risks are common and restrictive
definitions of country risks.
A market crisis triggering large losses for those holding exposures
in the local markets.

Model risk

Model risk is significant in the market universe, which

traditionally makes relatively intensive usage of models
for pricing purposes.
Model risk is growing more important, with the extension
of modelling techniques to other risks, notably credit
risk, where scarcity of data remains a major obstacle for
testing the reliability of inputs and models.

The model used to predict the relationship may not be

accurate

due

to

assumptions made.

the

variables

considered

and

RISK MANAGEMENT
PROCESS

VERTICAL
TOP DOWN
BOTTOM UP

HORIZONTAL

RISK MANAGEMENT
PROCESS

Transversal Process Building

Blocks

The three basic building blocks

of risk management processes

Overall views of risk processes

and riskreturn

Function of Central units and of the risk

department

ALM
ALM is the unit in charge of managing the
interest ra
The ALM Committee (ALCO)

is in charge of implementing ALM decisions,

The ALCO agenda includes global balance sheet
management and the guidelines for making the
business lines policy consistent with the global
policy.

SCOPE OF ALM

RISK DEPARTMENT

IT and RISK MANAGEMENT

MEASURES OF OVERALL
RISK
Standard deviation of stock
prices
Standard deviation of net
income
Standard deviation of ROE
and ROA

Credit risk measure

The ratio of non performing assets(past due
90 days or more) to total loans and leases
The ratio net charge offs(worthless and
written off) of loans to total loans and
leases
The ratio of annual provision for loan losses
to total loans and leases or to equity
capital.
The ratio of non performing assets to equity
capital
Total loans to total deposit ratio

Liquidity risk measure

Cash

and due from balances held

at other depository institutions
to total assets
Cash assets and government
securities to total assets.

MARKET RISK PRICE RISK

The ratio of book value of the asset to the
estimated market value of those same
assets
The ratio of book value of the equity to the
market value of the equity capital
The market value of the common and
preferred stock per share reflecting
investor perception of financial institution
risk.

Interest Rate Risk

The

ratio of interest sensitive

assets to interest sensitive
liabilities
IS Assets > IS Liabilities risk
when interest rate falls and vice
versa if IS Liabilities > IS Assets

CAPITAL RISK MEASURE

Interest rate spread between market yield

on debt issues and market yield on
government securities of the same maturity.
Risk if increase in spread

Ratio of stock price per share to EPS.

Risk if ratio falls

The ratio of equity capital to total assets.

Decrease in equity funding risk for the
shareholders and debtors