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FINANCIAL
INSTRUMENTS
Lecture 1 – Introduction; Fundamentals
OUTLINE
• Introduction
–Administration
–Course overview
• Fundamentals of Risk Management
–Overview of banking business
–Typology of bank risks
–Principles & Framework
INTRODUCTION
Admin - need two coordinators to help:
1. Class time and venue: Mon 12 - 3?
2. Main text: Te (2016), Module 1
Course overview:
1. Course synopsis:
• risk fundamentals overview,
• principles/practices of credit, market and operations risk
• Interrelatedness of risk categories
2. Learning outcomes:
• risk management fundamentals
• credit, market and operational risk – objectives, framework, strategy, monitoring and
control
• relationship between risk categories
• characteristics of derivatives used
INTRODUCTION (continued)
Course overview (continued):
3. Course information:
• References
• Teaching plan
• Assessment
FUNDAMENTALS OF RISK MANAGEMENT
NON-FINANCIAL RISKS:
• Legal and compliance
• Strategic
• Reputational
• Model
B. TYPOLOGY OF BANK RISKS
MARKET RISK:
• Risk of losses in on- and off-balance sheet positions caused by changes in
market prices
• Two components: general/systematic & specific/unsystematic
• Four categories: i, fx, equity price, commodity price
CREDIT RISK:
• Risk of borrower/counterparty failing to pay its obligations
OPERATIONAL RISK:
Risk of losses caused by inadequate/failed processes, people, systems or
external events
C. PRINCIPLES & FRAMEWORK
Background:
• Managing risk is a core part of the banking business
• Past – accept risk as a result of doing banking business
• More recent - focus on managing risks independently and distinctly
Risk management:
• ISO31000 – coordinated activities to direct and control an organisation with
regard to risk
• Others:
• identifying, analysing and evaluating risks and thereby, taking actions to
manage risks so as to maintain or add value to the bank (Institut Bank-
Bank Malaysia - IBBM 2006)
• “measurement and ...mitigation of risk, with the ultimate goal of
maximising the value of a bank, while minimising the risk of bankruptcy”
(Schroeck 2002, p.28)
C. PRINCIPLES & FRAMEWORK
Risk Management definition (continued)
Coordinated effort bankwide
• Three lines of defence:
• Business (originator; address issues onset; embed risk management framework and
sound practices)
• Risk management function (develop, implement risk management framework)
• Internal audit (review effectiveness; recommend improvement)
Activities
• Structured and formal process
• Execute different activities
Direct and control
• Not to remove risks but to direct and control
• Make risk more manageable
C. PRINCIPLES & FRAMEWORK
Objectives:
• Increase chances of achieving business objectives
Banks have various stakeholders
Risk introduces uncertainty to achieving bank’s business objectives
Aims to increase chances of bank achieving objectives via designing
and implementing strategies
• Provides framework and process to mitigate the impact of risks
• Encourage proactive management of risks
• Comply with laws and regulations
• Lower cost of funds
• Efficient allocation of capital and resources
• Enhance competitive advantage
C. PRINCIPLES & FRAMEWORK
Principles:
• Creates and protects value
• Integral part of all firm processes
• Part of decision making
• Explicitly address uncertainty
• Systematic, structured and timely
• Based on best available information
• Tailored
• Considers human and cultural factors
• Transparent and objective
• Dynamic, iterative, responsive to change
• Facilities eg DBKL
C. PRINCIPLES & FRAMEWORK
Framework:
• Definition – a set of components that provides the foundations and
organisational arrangements (p42)
Elements – governance, culture, policy, organisation
Risk appetite – characteristics; elements
• Characteristics of effective risk appetite framework:
Process for communicating
Top-down and bottom-up[
Facilitate embedding risk appetite into risk culture
Evaluate opportunities for appropriate risk-taking; act as defence against excessive
risk-taking
Allow for statement to be used as tool to promote robust discussions
• Elements: statement, risk limits, roles & responsibilities
C. PRINCIPLES & FRAMEWORK
Risk culture:
• Norms and traditions of behaviour
• Elements – tone from top, accountability, effective communication and
challenge, incentives