Risk Management Concepts

Question 1

Why risk take?

Answer 1

Risk v Reward relationship - banks must take on and amange risk in order to generate profits

Question 2

What are the sources of risk taking in banking?

Answer 2

1. Credit risk - financial losses occurring from when a counterparty fails to repay debt. Also arises when an entity’s credit rating is downgraded
2. Market risk - earnings or capital are adversely affected by changes in market prices. Includes interest rates, equity prices, FX, credit spreads, commodities prices
3. Capital/Prudential risk - risk of a bank having insufficient capital to meet regulatory requirements. Also known as prudential risk.
4. Liquidity risk - bank is unable to meet its financial obligations as they fall due. Failure may result in inability to support normal business activity.
5. Operational risk - risk of loss from inadequate/failed internal processes, people or systems. Covers transactions, new products, systems, suppliers and outsourcing
6. Financial Crime risk - risk of loss from internal or external fraud or itentional damage.
7. Technology risk - inadequate IT security, broken systems and inadequate design. Lack of support, no strategic IT policy and dependence on third parties
8. People risk - failure to manage key risks as an employer such as poor training, failure to manage performance and reward, and lack of resources
9. Regulatory risk - failure to comply with applicable laws and regs. Exists accross all locations in which the bank operates.
10. Financial Reporting risk - failure to comply with the codes and regs for the bank’s operations. Risk of sanctions by a regulator.
11. Legal risk - failure to comply with laws governing the bank’s operation. Includes liabilities to third parties and enforceability of contracts.
12. Strategic risk - risk of loss as a result of strategic plans. Can result in lower earnings. Strategy is also affected by external factors.
13. Change risk - cost of changes to operations if projects overrun or fail. Integration of acquired firms and changes in target operating models
14. Reputational risk - the risk to earnings or capital from negative public opinion. Can affect a bank’s ability to attract and retain customers
15. Insurance risk - risk of loss due to the timing, frequency and severity of insured events. Frequent small losses and infrequent material losses.

Question 3

What is the macro level source of risk?

How is it facilitated?

How is it managed?

Answer 3

1. Global financial markets are now interconnected - capital can flow easily between countries and customers can be located accross the world
2. Technology makers interconnection possible - thousands of securities can be traded accross the world in seconds
3. Regulation - interconnected global markets pose systemic risk problems. In the US the Dodd-Frank Act is designed to be a sweeping piece of regulatory reform to address some of the shortcomings in financial markets

Question 4

What is financial risk modelling?

Answer 4

Financial risk modelling is the use of formal econometric (quantitative analysis of actual economic phenomena through empirically derived relationships) techniques to determine the aggregate risk in a portfolio. It is required under Basel II for major international banking institutions.

Question 5

How does one predict future events?

Answer 5

By using historical data to create probability distributions that help predict the future.

Question 6

Give examples of probability distributions

Answer 6

Normal & Fat-tailed. One should be careful that they aren’t assuming a normal distribution when it is actually fat-tailed. A certain extreme event may be considered practically impossible in a normal distribution, but possible a fat-tailed distribution.

Question 7

What is Value at Risk (VaR) and its relation to confidence level?

Answer 7

Value at Risk is a statistical technique used to measure and quantify the level of financial risk within a firm/portfolio over a given time frame.

Typically used confidence levels are 95%, 97.5% and 99%. A 99% CL produces a VaR figure where in normal trading a loss/gain figure will only be exceeded once every 100 days.

Question 8

What influences how long should a Holding Period be?

Answer 8

The product/asset type derives how long a holding period should be. A position that could be liquidated in one day should have a one-day holding period.

Question 9

What is the Observation Period?

Answer 9

Data must be gathered with a view to predicting future prices in the observation period. Recent price history usually has the greatest relevance when assessing future prices.

Question 10

What are the Basel Requirements wrt risk management?

Answer 10

• Confidence Level = 99%
• Holding Period = 2 weeks (10 working days)
• Observation Period = 1 year (250 working days)

Question 11

How are modelling approaches applied and what should one be wary of?

Answer 11

1. Data – from both internal (loss events experienced by firm) and external (loss events experienced by peers) loss databases. One should be wary of:
   
   • Gaps in the data
   • Scaling issues
   • Is the data clean?
   • Are the outputs sensible?
2. Sensitivity analysis – the variation of a single variable in a complex model to show the impact of a unitary movement
3. Scenario modelling – model interpreted based on expertise and experience. Successful scenarios include:
   
   • Extreme events
   • Litigation
   • Regulatory breaches
   • IT failures
   • Fraud

Scenario modelling issues include:

• Outdate info
• Failure to generate challenging scenarios
• Inconsistency or lack of an aggregated view

Question 12

What is Earnings at Risk (EAR)? How does it differ to Value at Risk?

Answer 12

EaR assesses the amount the net income may change due to a change in market rates/prices over a specified period. VaR does this with a degree of confidence.

EaR warns of potential earning shortfalls over a range of maturity buckets. Earnings are non-economic and can be easily manipulated.

Question 13

What is the difference between Regulatory and Economic Capital?

Answer 13

• Regulatory Capital – the minimum level of capital a bank must hold due to regulatory requirements (e.g. Basel II)
• Economic Capital – the level of capital that a bank’s shareholders would want to hold in the absence of regulatory requirements.

Question 14

What is the Scorecard Approach?

Answer 14

The scorecard approach is a more qualitative view that can be challenged and supported by real loss data. It:

1. Must be discussed regularly with business managers
2. Is quick to put in place
3. Requires good business judgement and commitment to the approach
4. Needs training and competence

Question 15

What are the top 10 risks faced by all businesses?

Answer 15

1. Weak economies
2. Legislative changes
3. Increasing competition
4. Damage to reputation
5. Failure to attract top talent
6. Failure to innovate
7. Business interruption
8. Commodity price risk
9. Cash flow and liquidity risks
10. Political risk

Question 16

How does one deal with risk?

Answer 16

1. Having more timely and reliable info
2. Speed of response to risk
3. Experience of surviving similar crises in the past
4. Access to resources; cash and capital markets, superior tech, well trained staff
5. Greater operating, production or financial flexibility