Risk Management in Banking

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An Introduction to Risk
Risk Management is the process of measuring or assessing the actual or potential dangers of a particular situation.

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Risk Has Two Components

Uncertainty. Exposure.

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Types of Risk

Operational. Credit.

Reputational.

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Operational Risk
The risk of loss resulting from inadequate or failed internal processes, people and systems, or from external events.

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Operational Risks Include

Internal Fraud. External Fraud.

Employment Practices and Workplace Safety.

Clients, Products and Business Practices. Damage to Physical Assets. Business Disruption and System Failures. Execution, Delivery and Process Management.
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Internal Fraud

Unauthorized Activity.

Transactions not reported. Transaction type unauthorized. Mismarking of position.

Theft and Fraud.

Fraud/credit fraud/worthless deposits. Theft/extortion/embezzlement/robbery. Misappropriation of assets. Forgery. Account take-over/impersonation. Bribes/kickbacks. Insider trading. Money laundering. Willful blindness.

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External Fraud

Theft and Fraud.

Theft/robbery. Forgery. Check kiting. Identity theft. Elder financial abuse. Hacking damage. Theft of information (with monetary loss).
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Systems Security.

Employment Practices and Workplace Safety

Employee Relations.

Compensation, benefit, termination issues. Organized labor issues. General liability (slips and falls). Employee health and safety rules. Workers compensation. All discrimination types. Harassment. Equal Employment Opportunity (EEO).

Safe Environment.

Diversity and Discrimination.

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Clients, Products and Business Practices

Suitability, Disclosure and Fiduciary.

Fiduciary breaches/guideline violations. Suitability/disclosure issues. Retail consumer disclosure violations. Breach of privacy. Aggressive sales. Inadequate product offerings. Account churning. Misuse of confidential information. Lender liability.
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Clients, Products and Business Practices (CONTINUED)

Improper Business or Market Practices .

Antitrust. Improper trade/market practice. Market manipulation. Insider trading (on firms account). Unlicensed activity. Money laundering.

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Clients, Products and Business Practices (CONTINUED)

Selection, Sponsorship and Exposure.

Failure to investigate client per guidelines. Exceeding client exposure limits. Disputes over performance or advisory activities.

Advisory Activities.

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Damage to Physical Assets

Disasters and Other Events.

Natural disaster losses. Human losses from external sources (terrorism, vandalism).

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Business Disruption and System Failures

Systems.

Hardware. Software. Telecommunications. Utility outage/disruptions.

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Transaction Capture, Execution and Maintenance.

Execution, Delivery and Process Management

Miscommunication. Data entry, maintenance or loading errors. Missed deadline or responsibility. Model/system misoperation. Accounting error/entity attribution error. Other task misperformance. Record retention. Documentation maintenance. Delivery failure. Collateral management failure. Reference data maintenance.

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Execution, Delivery and Process Management (CONTINUED)

Monitoring and Reporting.

Failed mandatory reporting obligations. Inaccurate external loss (loss incurred). Unapproved access given to accounts. Incorrect client records (loss incurred). Negligent loss or damage of client assets.

Customer Intake and Documentation.

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Customer/Client Account Management.

Execution, Delivery and Process Management (CONTINUED)

Unapproved access given to accounts. Incorrect client records (loss incurred). Negligent loss or damage of client assets. Non-client counterparty misperformance. Outsourcing. Vendor disputes.
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Trade Counterparties.

Vendors and Suppliers.

Operational Risk Checklist

Employee training. Close management oversight.

Segregation of duties.
Employee background checks. Procedures and process.

Purchase of insurance.
Exiting certain businesses. Capitalization of risks.
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Credit Risk
Risk due to an uncertainty in a counterpartys ability to meet its obligations in accordance with agreed upon terms.

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Credit Risks Include:

Loans. Acceptances. Interbank transactions.

Trade financing.
FX transactions. Futures. Swaps. Equities. Letters of credit. Options.
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Sound Practices for Managing Credit Risk

Establish an appropriate credit risk environment. Operate under a sound credit-granting process.

Maintain an appropriate credit administration, measurement and monitoring process.

Ensure adequate controls over credit risk.

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Establish an Appropriate Credit Risk Environment

Board of Directors should review credit risk strategy periodically. Senior management should implement credit risk strategy approved by the Board.

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Criteria should include thorough understanding of the borrower, purpose/structure of credit and its source of repayment.

Operate Under a Sound Credit Granting Process

Establish overall credit limits at the level of individual borrowers/connected counterparties.

Have a clearly established process for approving new credits/extension of existing credits. Extension of credit must be made on an arms length basis.
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Maintain a Credit Administration, Measurement and Monitoring Process

Have in place a system for ongoing administration of various risk-bearing portfolios. Develop an internal risk rating system for managing credit risk. Have an information system and analytical techniques that enable management to measure credit risk of on/off balance sheet activities.

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Maintain a Credit Administration, Measurement and Monitoring Process (CONTINUED)

System for monitoring overall composition and quality of the credit portfolio. Consider future changes in economic conditions when assessing individual credits.

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Ensure Adequate Controls Over Credit Risk

System of independent, ongoing credit review. Credit granting function is properly handled and credit exposures are within limits. System for managing problem credits.

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Credit Risk Checklist

Stringent credit standards for borrowers and counterparties. Strict portfolio risk management. Constant focus on changes in economic or other circumstances that can lead to a deterioration in the credit standing of a banks counterparties.

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Reputational Risk
Reputational risk is the potential that negative publicity, whether true or not, will result in loss of customers, severing of corporate affiliations, decrease in revenues and increase in costs.

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Benefits of Effective Reputation Management

Improving relations with shareholders. Creating a more favorable environment for investment. Recruiting/retaining the best employees. Reducing barriers to development in new markets. Securing premium prices for products. Minimizing threats of litigation.
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The key to managing reputational risk is sound risk management, coupled with straightforward communication about the problem the bank is facing.

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Re-establishing a firms reputation takes a long time.

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Reputational Risk Cases

Perrier Toluene traces. Exxon Valdez spill.

Union Carbide Bhopal, India.

Arthur Andersen Enron shredding. Firestone Tires.

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Reputational Risk Checklist

Processes for crisis management are planned and documented. External perceptions of the bank are regularly measured.

Reputational threats are systematically tracked.

Employees are trained to identify and manage reputational risks.

Standards on environmental, human rights and labor practices are set publically.
Relationships and trust with pressure groups and other potential critics are established.
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True or False?

Corporate reputation is one of the primary assets of my bank. The risks involving a banks reputation have increased significantly over the past five years. Reputational risk is harder to manage than other forms of risk. My bank is proactive in enhancing and protecting its reputation.
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True or False?

It is impossible to quantify the impact of reputational risks. My bank usually thinks about its reputation only when things go wrong. A well run bank doesnt need to invest extra resources into guarding against reputational risk.

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Risk Management
Risk management is the process of monitoring and addressing the potential for loss.

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Evolution of Risk Management

Emerged as a discipline during the early 1990s. Used long before (1960s).

Typically used to describe techniques for addressing insurable risks.

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Old Risk Management

Risk reduction through safety, quality control and hazard education. Alternative risk financing, including self-insurance and captive insurance. The purchase of traditional insurance products.

Use of derivatives to hedge or customize market risk exposures.

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New Risk Management

Treats derivatives as a problem as much as a solution. Focuses on reporting, oversight and segregation of duties within the organization.

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By the Mid-1990s

Regulatory initiatives. Concerns about derivatives.

Release of RiskMetrics.
Published losses.

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Enrons Experience with Risk Management

Maintained a risk management function. Lines of reporting were reasonably independent.

Mark-to-market valuations were subject to adjustments by management.

Few career risk managers. Fluid workforce. Employees constantly looking for next transfer.
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Basel II.

Regulatory Responses from the Financial Services Community

Sarbanes-Oxley Act of 2002. Graam-Leach-Bliley Act.

Bank Secrecy Act/Anti-Money Laundering.

Insider Trading Rules. Bank Bribery Act. Fair and Accurate Credit Transactions Act (FACTA) Fair Lending Federal Conflicts of Interest Statutes. Various record retention and reporting requirements.
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Success Depends Upon

A positive corporate culture. Actively observed policies and procedures.

Effective use of technology.

Independence of risk management professionals.

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When risk management is done correctly you CAN sleep at night!

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Our Pledge
Thank you for your interest in The Edcomm Group Bankers Academy. We are the #1 financial services training company in the world for three reasons:

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Dr. Linda Eagle Founder & President The Edcomm Group Banker's Academy +1 212 631 9400 +1 917 318 6650 linda.eagle@edcomm.com
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