Risk Management

Risk Management
In in Financial
Institution
Financial Institution
Charlyn M. Tapdasan
• Charlyn M. Tapdasan
Charisma April Tancio
• Charisma April Tancio
Irish Gique
• Irish Gique Sherwin Lico
• Sherwin Lico Ryon Joy Sotto
• Ryon Joy Sotto Ryan Jhay Poda
• Ryan Jhay Poda Karyll Ann Cabilin
• Karyll Ann Cabilin
Types of risks
incurred by
financial
institutions

Charlyn M. Tapdasan
Credit risk - credit risk is defined as the
potential that a bank borrower or
counterparty will fail to meet its
obligations in accordance with agreed
terms.

Liquidity risk - the risk stemming from

the lack of marketability of an
investment that cannot be bought or
sold quickly enough to prevent or
minimize a loss.
Market risk - the risk of losses in the
bank’s trading book due to changes in
equity prices, interest rates, credit
spreads, foreign-exchange rates,
commodity prices, and other indicators
whose values are set in a public market
Interest rate risk - Potential losses due to
fluctuations in interest rate

Equity risk - Potential losses due to fluctuations in

stock price

Currency risk - Potential losses due to international

currency exchange rates (closely associated with
settlement risk)

Commodity risk - Potential losses due to

fluctuations in prices of agricultural, industrial and
energy commodities like wheat, copper and natural
gas respectively.
Reputational risk - reputation
risk as the possible loss of the
organization's reputational
capital.

Business risk - defines business

risk as the possibility that a
company will have lower than
anticipated profits, or that it
will experience a loss rather
than a profit
Types of risks
incurred by
financial
institutions

Charisma April Tancio

Foreign exchange - risk refers to the
losses that an international financial transaction
may incur due to currency fluctuations. Also known
as currency risk,

Country or sovereign - Sovereign risk is

the chance that a central bank will
implement foreign exchange rules that will
significantly reduce or negate the worth of its
forex contracts.
Technology – any potential for the technology
failures to disrupt your business such as
information security incidents or service outages.

Operational - operational risk is defined

as the risk of loss resulting from inadequate
or failed internal processes, people and
systems or from external events.
Human risk - Potential losses due to a
human error, done willingly or unconsciously

IT/System risk - Potential losses due to

system failures and programming errors

Processes risk - Potential losses due to

improper information processing, leaking or
hacking of information and inaccuracy of data
processing
Managing credit
risks on the
balance sheet

Irish Gique
 Outline
The bank balance sheet
 money
How do banks get funds and use
funds.
T-accounts
 business
 How do banks operate?
Bank management
 risk
 Manage risk to be within proper
limits
 The bank balance sheet
Balance sheet of a bank is a listing of its assets,
its liabilities and bank capital.

Assets:
what the bank owns, uses of funds
Liabilities
what the bank owes to others, sources of
funds
Bank capital
Bank’s net worth, defined to be the
difference between its assets and its
liabilities
Assets = Liabilities + Bank Capital
 Liabilities
Liabilities are a bank's sources of funds, it
specifies what the bank owes to others .

1. Checkable Deposits:
 checking accounts, etc.
 liquid, payable on demand, decline in importance
2. Nontransaction Deposits:
 interest-bearing savings accounts and time
deposits (e.g. CDs).
 the primary source of bank funds.
3. Borrowings:
 loans obtained from the Fed (discount loans),
other banks (in overnight Fed funds market),
corporations, etc.
 an increasingly important source of bank funds
 Assets

Bank assets indicate use of bank

funds.
1. Reserves:
vault cash + deposits in an
account at the Fed
required reserves + excess
reserves
2. Cash in the process of collection
3. Deposits at other banks
 T - account
Bank performs asset transformations.

‘borrows short and lends long’

Use T-account to keep track of bank’s
business.

T-account is a simplified balance

sheet, that lists only the changes that
occur in balance sheet items starting
from some initial balance sheet
position.
Managing
liquidity risk on
the balance
sheet
Sherwin Lico Sotto
Liquidity Management
- enough cash and liquidity assets to pay depositors
Asset Management
- diversifying investment
Liability Management
- low cost of getting funds
Capital Adequacy Management
- get enough bank capital as required by regulators
 Liquidity management
Banks need to have sufficient reserves or liquid
asset to meet obligations to depositors – satisfy
their withdrawals

No excess reserves
Bank Bank
Assets Liabilities Assets Liabilities
Reserves $10M Deposits $100 Reserves $0 Deposits $90M
M
Loans $90M Bank $10M Loans $90M Bank $10M
Capital Capital
Securities $10M Securitie $10M
s
 Borrow from other banks

Bank

Assets Liabilities

Reserves $9M Deposits $90M

Loans $90M Borrowing $9M

Securities $10M Bank Capital $10M

Managing Interest
rate risk and
insolvency risk on
the balance sheet

Ryon Joy Sotto

 Prevent bank failure

Bank failure - a bank cannot satisfy its

obligations to pay its depositors and have enough
reserves to meet its reserve requirements .

Insolvency risk is also known as bankruptcy

risk, and generally financial institutions like banks
assess this risk before granting a loan to a customer
and thus try to minimize the chances of the
customer defaulting on the loan.
 Prevent bank insolvency
 insolvent: liabilities > assets  neg. net worth
 Bank capital decrease the chance of insolvency

High Bank Capital Low Bank Capital

Assets Liabilities Assets Liabilities
Reserves $10M Deposits $90M Reserves $10M Deposits $96M
Loans $90M Bank Capital $10M Loans $90M Bank Capital $4M
n offs
writte
Loan

High Bank Capital Low Bank Capital

Assets Liabilities Assets Liabilities
Reserves $10M Deposits $90M Reserves $10M Deposits $96M
Loans $85M Bank Capital $5M Loans $85M Bank Capital -$1M
Interest rate risk - is the danger that the
value of a bond or other fixed-income investment
will suffer as the result of a change in interest rates.
Investors can reduce interest rate risk by buying
bonds that mature at different dates.
 Interest-rate risk

Bank

Assets Liabilities
Rate-sensitive assets $20M Rate-sensitive liabilities $50M
Fixed-rate assets $80M Fixed-rate liabilities $40M

 Interest rate increase 5%  interests earned

from asset increase $1M, interest cost from
liabilities increase $2.5M  profit decrease $1.5M
 If a bank has more rate-sensitive liabilities than
assets, a rise in interest rates will reduce bank
profits
Managing risk off
the balance sheet
with derivatives

Ryan Jhay Poda

&
Karyll Ann Cabilin
Off-balance-sheet (OBS)
-instruments such as forwards, futures, options,
and swaps to hedge the risks their financial
institutions (FIs) face

 interest rate risk

 foreign exchange risk
 credit risk

Financial Institutions also generate fee income

from derivative securities transactions
Spot contract
- is an agreement to transact involving the immediate
exchange of assets and funds

Forward contract
- is a negotiated agreement to transact at a point
in the future with the terms of the deal set today

Futures contract
- is an exchange-traded agreement to transact
involving the future exchange of a set amount of
assets for a price that is fixed today
Naïve hedge - is a hedge of a cash asset on a
direct dollar-for-dollar basis with a forward (or
futures) contract

R
P   D  P 
(1  R)

where
P = the initial value of an asset
D = the duration of the asset
R = the interest rate (and thus ΔR is the
change in interest)
 Hedging Considerations
Microhedging - is using futures (or forwards)
contracts to hedge a specific asset or liability

Macrohedging - is hedging the entire

(leverage-adjusted) duration gap of an FI

Routine hedging - In a full hedge or

‘routine hedge’ the bank eliminates all or most
of its risk exposure such as interest rate risk
Buying a call option on a bond

As interest rates fall, bond prices rise, and the

call option buyer has a large profit potential

As interest rates rise, bond prices fall, but the

call option losses are no larger than the call
option premium

Writing a call option on a bond

As interest rates fall, bond prices rise, and the
call option writer has a large potential loss

As interest rates rise, bond prices fall, but the

call option gains will be no larger than the call
option premium
Buying a put option on a bond

As interest rates rise, bond prices fall, and the

put option buyer has a large profit potential

As interest rates fall, bond prices rise, but the

put option losses are bounded by the put option
premium

Writing a put option on a bond

As interest rates rise, bond prices fall, and the

put option writer has large potential losses

As interest rates fall, bond prices rise, but the

put option gains are bounded by the put option
premium