Risk Management

Types of Risks Incurred

by Financial Institutions

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Risk
Effect of uncertainty on objectives
Effect is a positive or negative deviation from what is
expected
Uncertainty; a state that lacks or involves a deficiency of
information it leads to inadequate knowledge or
understanding
Risk management

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Risk Management
A set of activities and methods used to, minimize, monitor
and control the many risks that can effect its ability to
achieve objectives
Control the probability and impact of unfortunate events
or to maximize the realization of opportunities

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Risks at Financial Institutions

One
Oneof
ofthe
themajor
majorobjectives
objectivesof
ofaafinancial
financialinstitutions
institutions
(FIs)
(FIs)managers
managersisisto
toincrease
increasethe
theFIs
FIsreturns
returnsfor
forits
its
owners
owners
Financial
Financialinstitutions
institutions::an
anagent
agentthat
thatprovides
provides
financial
financialservices
servicesfor
forits
itsclients
clients

Banks
Banks
Insurance
Insuranceco
co
Leasing
Leasingcompanies
companies
Mutual
Mutualfunds
funds

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Financial Institutions
Banks:
Provides financial services including issuing money in
various forms, receiving deposits of money, lending money
Central Banks:
Responsible for monetary policy of country
Lender of last resort

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Financial Institutions
Investment Banks:
Help companies to raise money by issuing and selling
securities in the primary market.
Assist in raising funds in the capital markets as well
as provide services for mergers and acquisitions

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Financial Institutions
Leasing companies:
Right to use or occupy personal property given by a
lessor to a lessee
Lessee obtains possession of the property in return
for paying the lessor a fixed payment

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Financial Institutions
Mutual funds:
An investment of funds collected from investors for
the purpose of investing in securities
Managers attempt to produce capital gains income for
funds investors
Brokerage houses:
Stock brokers assist people in investing in capital
markets

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Financial Institutions
Insurance companies
Pool risk by collecting premiums from a large group who
want to protect themselves

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Financial Institution Function

Provide a service as intermediaries of the capital and
debt markets
Transfer funds from investors to companies
Facilitate the flow of cash through economy

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Financial Institution Function

Increased returns often come at the cost of increased
risk, which comes in many forms:

credit risk
liquidity risk
interest rate risk
market risk
off-balance-sheet risk

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foreign exchange risk

country or sovereign risk
technology risk
operational risk
insolvency risk

2009, The McGraw-Hill Companies, All Rights

Risks at Financial Institutions

Credit
Creditrisk
riskisisthe
therisk
riskthat
thatthe
thepromised
promisedcash
cashflows
flowsfrom
from
loans
loansand
andsecurities
securitiesheld
heldby
byFIs
FIsmay
maynot
notbe
bepaid
paidin
infull
full
FIs
FIsthat
thatmake
makeloans
loansor
orbuy
buybonds
bondswith
withlong
longmaturities
maturitiesare
are
relatively
relativelymore
moreexposed
exposedtotocredit
creditrisk
risk
aakey
keyrole
roleof
ofFIs
FIsinvolves
involvesscreening
screeningand
andmonitoring
monitoringloan
loan
applicants
applicantstotoensure
ensureonly
onlythe
thecreditworthy
creditworthyreceive
receiveloans
loans

FIs
FIsalso
alsocharge
chargeinterest
interestrates
ratescommensurate
commensuratewith
withthe
theriskiness
riskinessofofthe
the
borrower
borrower

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Risks at Financial Institutions

Credit
Creditrisk
risk(cont.)
(cont.)

FIs
FIscan
candiversify
diversifyaway
awaysome
someindividual
individualfirm-specific
firm-specificcredit
creditrisk,
risk,
but
butnot
notsystematic
systematiccredit
creditrisk
risk

firm-specific
firm-specificcredit
creditrisk
riskisisthe
therisk
riskofofdefault
defaultfor
forthe
theborrowing
borrowingfirm
firm
associated
associatedwith
withthe
thespecific
specifictypes
typesofofproject
projectrisk
risktaken
takenby
bythat
thatfirm
firm
systematic
systematiccredit
creditrisk
riskisisthe
therisk
riskof
ofdefault
defaultassociated
associatedwith
withgeneral
general
economy-wide
economy-wideorormacroeconomic
macroeconomicconditions
conditionsaffecting
affectingall
allborrowers
borrowers

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Risks at Financial Institutions

Liquidity
Liquidityrisk
riskisisthe
therisk
riskthat
thataasudden
suddenand
andunexpected
unexpected
increase
increasein
inliability
liabilitywithdrawals
withdrawalsmay
mayrequire
requirean
anFI
FIto
to
liquidate
liquidateassets
assetsin
inaavery
veryshort
shortperiod
periodof
oftime
timeand
andatatlow
low
prices
prices
day-to-day
day-to-daywithdrawals
withdrawalsby
byliability
liabilityholders
holdersare
aregenerally
generally
predictable
predictable
unusually
unusuallylarge
largewithdrawals
withdrawalsby
byliability
liabilityholders
holderscan
cancreate
create
liquidity
liquidityproblems
problems

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the
thecost
costof
ofpurchased
purchasedand/or
and/orborrowed
borrowedfunds
fundsrises
risesfor
forFIs
FIs
FIs
FIsmay
maybe
beforced
forcedtotosell
sellless
lessliquid
liquidassets
assetsatatfire-sale
fire-saleprices
prices

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Risks at Financial Institutions

Interest
Interestrate
raterisk
riskisisthe
therisk
riskincurred
incurredby
byan
anFI
FIwhen
whenthe
the
maturities
maturitiesof
ofits
itsassets
assetsand
andliabilities
liabilitiesare
aremismatched
mismatchedand
and
interest
interestrates
ratesare
arevolatile
volatile
ififan
anFIs
FIsassets
assetsare
arelonger-term
longer-termthan
thanits
itsliabilities,
liabilities,ititfaces
faces
refinancing
refinancingrisk
risk

the
therisk
riskthat
thatthe
thecost
costof
ofrolling
rollingover
overor
orre-borrowing
re-borrowingfunds
fundswill
willrise
rise
above
the
returns
being
earned
on
asset
investments
above the returns being earned on asset investments

ififan
anFIs
FIsassets
assetsare
areshorter-term
shorter-termthan
thanits
itsliabilities,
liabilities,ititfaces
faces
reinvestment
reinvestmentrisk
risk

the
therisk
riskthat
thatthe
thereturns
returnson
onfunds
fundstotobe
bereinvested
reinvestedwill
willfall
fallbelow
belowthe
the
cost
of
funds
cost of funds

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Risks at Financial Institutions

Interest
Interestrate
raterisk
risk(cont.)
(cont.)

all
allFIs
FIsface
faceprice
pricerisk
risk(or
(ormarket
marketvalue
valuerisk)
risk)

the
therisk
riskthat
thatthe
theprice
priceof
ofthe
thesecurity
securitychanges
changeswhen
wheninterest
interestrates
rates
change
change

FIs
FIscan
canhedge
hedgeor
orprotect
protectthemselves
themselvesagainst
againstinterest
interestrate
raterisk
riskby
by
matching
matchingthe
thematurity
maturityof
oftheir
theirassets
assetsand
andliabilities
liabilities

Market
Marketrisk
risk

the
thepossibility
possibilitytotoexperience
experiencelosses
lossesdue
duetotofactors
factorsthat
thateffect
effectthe
the
overall
overallperformance
performanceof
offinancial
financialmarkets,
markets,systematic
systematicrisk
risk
closely
closelyrelated
relatedtotointerest
interestrate
rateand
andforeign
foreignexchange
exchangerisk
risk

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Risks at Financial Institutions

Foreign
Foreignexchange
exchange(FX)
(FX)risk
riskisisthe
therisk
riskthat
thatexchange
exchangerate
rate
changes
changescan
canaffect
affectthe
thevalue
valueof
ofan
anFIs
FIsassets
assetsand
and
liabilities
liabilitiesdenominated
denominatedin
inforeign
foreigncurrencies
currencies
FIs
FIscan
canreduce
reducerisk
riskthrough
throughdomestic-foreign
domestic-foreignactivity/investment
activity/investment
diversification
diversification
FIs
FIsexpand
expandglobally
globallythrough
through

McGraw-Hill/Irwin

acquiring
acquiringforeign
foreignfirms
firmsor
oropening
openingnew
newbranches
branchesininforeign
foreigncountries
countries
investing
investingininforeign
foreignfinancial
financialassets
assets

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2009, The McGraw-Hill Companies, All Rights

Risks at Financial Institutions

Country
Countryor
orsovereign
sovereignrisk
riskisisthe
therisk
riskthat
thatrepayments
repayments
from
fromforeign
foreignborrowers
borrowersmay
maybe
beinterrupted
interruptedbecause
becauseof
of
interference
interferencefrom
fromforeign
foreigngovernments
governments
differs
differsfrom
fromcredit
creditrisk
riskof
ofFIs
FIsdomestic
domesticassets
assets

with
withdomestic
domesticassets,
assets,FIs
FIsusually
usuallyhave
havesome
somerecourse
recoursethrough
through
bankruptcy
courtsi.e.,
FIs
can
recoup
some
of
their
losses
bankruptcy courtsi.e., FIs can recoup some of their losseswhen
when
defaulted
defaultedfirms
firmsare
areliquidated
liquidatedor
orrestructured
restructured

foreign
foreigncorporations
corporationsmay
maybe
beunable
unabletotopay
payprincipal
principaland
andinterest
interest
even
evenififthey
theywould
woulddesire
desiretotodo
doso
so
foreign
foreigngovernments
governmentsmay
maylimit
limitororprohibit
prohibitdebt
debtrepayment
repaymentdue
duetoto
adverse
adversepolitical
politicalevents
events

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Risks at Financial Institutions

Country
Countryor
orsovereign
sovereignrisk
risk(cont.)
(cont.)

thus,
thus,an
anFI
FIclaimholder
claimholdermay
mayhave
havelittle
littleor
orno
norecourse
recoursetotolocal
local
bankruptcy
bankruptcycourts
courtsor
ortotoan
aninternational
internationalclaims
claimscourt
court
measuring
measuringsovereign
sovereignrisk
riskincludes
includesanalyzing:
analyzing:

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the
thetrade
tradepolicy
policyofofthe
theforeign
foreigngovernment
government
`potential
`potentialgovernment
governmentintervention
interventionininthe
theeconomy
economy
the
theforeign
foreigngovernments
governmentsmonetary
monetarypolicy
policy
capital
capitalflows
flowsand
andforeign
foreigninvestment
investment
the
theforeign
foreigncountrys
countryscurrent
currentand
andexpected
expectedinflation
inflationrates
rates
the
thestructure
structureof
ofthe
theforeign
foreigncountrys
countrysfinancial
financialsystem
system

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Risks at Financial Institutions

Technology
Technologyrisk
riskand
andoperational
operationalrisk
riskare
areclosely
closelyrelated
related

technology
technologyrisk
riskisisthe
therisk
riskincurred
incurredby
byan
anFI
FIwhen
whenits
its
technological
technologicalinvestments
investmentsdo
donot
notproduce
produceanticipated
anticipatedcost
costsavings
savings

the
themajor
majorobjectives
objectivesof
oftechnological
technologicalexpansion
expansionare
aretotoallow
allowthe
theFI
FItoto
exploit
exploitpotential
potentialeconomies
economiesofofscale
scaleand
andscope
scopeby:
by:
lowering
loweringoperating
operatingcosts
costs
increasing
increasingprofits
profits
capturing
capturingnew
newmarkets
markets

operational
operationalrisk
riskisisthe
therisk
riskthat
thatexisting
existingtechnology
technologyor
orsupport
support
systems
systemsmay
maymalfunction
malfunctionor
orbreak
breakdown
down
operational
operationalrisk
riskasasthe
therisk
riskofofloss
lossresulting
resultingfrom
frominadequate
inadequateoror
failed
failedinternal
internalprocesses,
processes,people,
people,and
andsystems
systemsor
orfrom
fromexternal
external
events
events

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Risks at Financial Institutions

Insolvency
Insolvencyrisk
riskisisthe
therisk
riskthat
thatan
anFI
FImay
maynot
nothave
have
enough
enoughcapital
capitalto
tooffset
offsetaasudden
suddendecline
declinein
inthe
thevalue
valueof
of
its
itsassets
assetsrelative
relativeto
toits
itsliabilities
liabilities

generally,
generally,the
themore
moreequity
equitycapital
capitaltotoborrowed
borrowedfunds
fundsan
anFI
FIhas
hasthe
the
less
lessinsolvency
insolvencyrisk
riskititisisexposed
exposedtoto
both
bothregulators
regulatorsand
andmanagers
managersfocus
focuson
oncapital
capitaladequacy
adequacyas
asaa
measure
measureof
ofaaFIs
FIsability
abilitytotoremain
remainsolvent
solvent

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2009, The McGraw-Hill Companies, All Rights