Chapter 6: Risk Management - Summary of Chapter 6

Summary of Chapter 6
The main objective of banks is to maximise profits and shareholder value added, and risk management
is crucial to the achievement of this goal.
The chapter investigated the key financial risks modern banks are exposed to, and considered how
these risks should be managed.

2. Taxonomy of risk
The major risks facing banks are: c r e d i t r i s k , i n t e r e s t r a t e r i s k , l i q u i d i t y r i s k ,
m a r k e t r i s k and o p e r a t i o n a l r i s k .

2a. Credit risk

Definition of Credit Risk: the risk that the p r o m i s e d c a s h f l o w s from loans and securities held
by banks may not be p a i d i n f u l l .
It is related to the risk of d e f a u l t or to the risk of d e l a y in servicing the loan.
The reduced present value of the bank’s assets will affect the s o l v e n c y of the bank.
Credit risk is the most important risk connected with the assets held by a bank.
Note: reasons for the improved credit quality over the 1990s; key factor of credit risk

 Credit risk management of single loans uses screening and monitoring, credit rationing, use of
collateral, endorsement; whereas diversification enables banks to manage credit risk of their loan
portfolio.

2b. Interest rate risk

Definition: Interest rate risk is the risk incurred by a bank when the m a t u r i t i e s of its assets and
liabilities are m i s m a t c h e d and there are changes in market i n t e r e s t r a t e s .
The source of risk comes from a primary function of bank, known as m a t u r i t y t r a n s f o r m a t i o n .
Example: S&L crisis in 1980s
Two main effect of interest rate change:

1. Income effect: which includes r e f i n a n c i n g r i s k and r e i n v e s t m e n t r i s k .

a. refinancing risk: the risk that the cost of r e b o r r o w i n g funds will be higher than
the r e t u r n s e a r n e d on asset investments, in the presence of l o n g e r - t e r m
a s s e t s relative to liabilities.
b. reinvestment risk: the risk that r e t u r n s on funds to be reinvested will be lower
than the c o s t of funds, when the bank holds s h o r t e r - t e r m a s s e t s relative to
liabilities.
2. M a r k e t v a l u e effect. This risk refers to the change in the p r e s e n t v a l u e of the cash
flows on assets and liabilities.

Note: relationship between asset price and interest rate.

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Chapter 6: Risk Management - Summary of Chapter 6

The best method to hedge interest rate risk is m a t c h i n g m a t u r i t y , but it is not consistent with the
a c t i v e a s s e t t r a n s f o r m a t i o n function and may also reduce p r o f i t a b i l i t y .

Interest rate risk management employs 2 main approaches: i n c o m e g a p analysis and d u r a t i o n

g a p analysis.

2c. Market risk

Definition: Market risk is the risk related to the u n c e r t a i n t y of a bank’s earnings on its t r a d i n g
p o r t f o l i o caused by changes in the market conditions,
such as interest rates, equity return, exchange rates, market volatility, and market liquidity.

Note the recent trend of rising trading activities; the build-up of risk during 2007-09; Regulatory arbitrage;
and regulatory response.

The method to measure market risk exposure is called the V a l u e a t R i s k (VaR) method.

2d. Liquidity risk

(Recall from Chapter 5.5f)
Liquidity is a s h o r t - t e r m concept referring to the i n a b i l i t y of a bank to meet deposit
w i t h d r a w a l s even though it is viable in the long run.

Liquidity risk for a bank comes both liability and asset side.

Liability side of liquidity risk: Loss of funding from r e t a i l f u n d i n g or wholesale funding.

Note: increased reliance on wholesale funding; retail funding risk from demand deposit; Risk of bank run
and systemic risk

Asset side of liquidity risk: Inability to sell or s e c u r i t i s e asset.

It is a m a r k e t - r e l a t e d liquidity risk depending on the s t a t e of the market.
Note: Market freeze up during stress in 2007-09.

Liquidity risk management includes d i v e r s i f y i n g funding sources and holding a greater stock of
high quality liquid assets.

Other liability management method to limit contagion of liquidity problems includes (Chapter 5)
d e p o s i t i n s u r a n c e ' , lender of last resort and c a p i t a l requirement.

2e. Operational risk

Definition: Operational risk is ‘the risk of direct or i n d i r e c t l o s s resulting from i n a d e q u a t e or
failed internal p r o c e s s e s , p e o p l e , and systems or from e x t e r n a l events’ (BIS definition)

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4a. Screening
Banks have to screen out the b a d c r e d i t r i s k s from the good ones in order to overcome
a d v e r s e s e l e c t i o n problem in loan markets.

The 3 main groups of assessment models are: q u a l i t a t i v e models, c r e d i t s c o r i n g models

and newer models based on financial market data.

Qualitative models depends on the s u b j e c t i v e judgment of the bank's manager and are used in
the absence of p u b l i c l y a v a i l a b l e information on the quality of the borrower.

The key information concerning credit decision are:

1. Borrower-specific factors that are i d i o s y n c r a t i c to each borrower, and

2. M a r k e t - s p e c i f i c factors that have an impact on all borrowers.

Credit scoring models are mathematical models used to observe the c h a r a c t e r i s t i c s of the
loan’s applicant, either

 (L i n e a r p r o b a b i l i t y model) to calculate the applicant’s probability of default (expressed by

a score) or
 (L i n e a r d i s c r i m i n a t i o n model) to sort borrowers into different default risk classes.

Note: Variables for scoring models; Altman's discriminant; Problem of discrimination models

Newer models based on financial market data includes CreditMetrics and Credit Risk+

 use of transition matrix in CreditMetrics

 calculate the required capital reserves to meet losses in Credit Risk+.

4b. Monitoring
Banks monitor the borrower’s activities (and their risk) in order to reduce the m o r a l h a z a r d
problem,
There are 2 ways of monitoring credit risk:

1. to write c o v e n a n t s into loan contracts and

2. to establish long-term customer relationships.

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4c. Credit rationing

There are 2 forms of credit rationing:

 A bank r e f u s e s to make a loan of any amount to a borrower, who is willing to pay a

higher interest rate.
o to reduce a d v e r s e s e l e c t i o n problem.
 A bank makes the loan but r e d u c e s t h e s i z e of the loan to a lower amount than the one
the borrower requires.
o to solve the m o r a l h a z a r d problem.

4d. Collateral and endorsement

Collateral are the assets used by the borrower to g u a r a n t e e the repayment of the debt.

Note: example of collateral; Factors in accepting collateral: price volatility & marketability;
Compensating balances; Practice in USA & Europe

Endorsement: If a loan is endorsed by a third party (just in case the borrower goes bankrupt), the
third party is c o m m i t t e d to repaying the debt.

4e. Diversification
A loan portfolio should allow the bank to diversify and reduce the o v e r a l l r i s k i n e s s of its loan
portfolio.
Diversification is achieved by lending to different types of borrowers (and avoiding a
c o n c e n t r a t i o n of loans to one type of borrower).

Note: Firm-specific & systematic credit risk; Remove non-systematic risk in negatively correlated
portfolio

Banks measure credit risk concentration in their loan portfolios by using M i g r a t i o n a n a l y s i s .

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5a. Income Gap Analysis

Banks usually set i n t e r e s t - s e n s i t i v e a s s e t s : assets whose interest rates will be repriced at

or near current market interest rates within a certain time horizon.

and i n t e r e s t - s e n s i t i v e l i a b i l i t i e s : liabilities whose interest rates will be repriced over given

future periods

Note: Time bucket (maturity bucket); Basic gap analysis; Problems of Basic gap analysis;

Maturity Gap in each maturity bucket is calculated as the difference between r a t e - s e n s i t i v e

a s s e t s (RSA) and r a t e - s e n s i t i v e l i a b i l i t y (RSL) on their balance sheets.

 GAP = RSA – RSL (6.1)

Interest rate + -

Effect on Net interest margin (GAP>0)

GAP < 0 - +

income exposure to changes in interest rates in different maturity buckets, by multiplying GAP times
the change in the interest rate: (6.2)

where:
ΔI = change in the banks’ income;
Δi = change in interest rate.

Problems of income gap analysis:

1. It ignored m a r k e t v a l u e effect
2. Rate-sensitive component of r a t e - i n s e n s i t i v e assets and liabilities
 example: R u n o f f cash flow
 solution: estimate them.
3. It ignored effect on o f f - b a l a n c e s h e e t instruments

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5b. Duration gap analysis

Two type of duration measurement:

 Macaulay duration measures the a v e r a g e f i n a n c i a l l i f e of an asset or liability

 Modified duration expresses the i n t e r e s t s e n s i t i v i t y of an asset or liability’s value.

Macaulay duration is a weighted average of the m a t u r i t i e s of the cash payments,

 where the weights are the r e l a t i v e p r e s e n t v a l u e s of each cash flow.

The formula to calculate the Macaulay duration is:

Note: Average life vs maturities; Zero-coupon bond: Macaulay duration = maturity;

The Macaulay duration of a portfolio of securities is the weighted average of the durations of the
individual securities,

 with the weights reflecting the p r o p o r t i o n of the portfolio invested in each security.

Important features of duration:

1. Macaulay duration i n c r e a s e s with the maturity of a bond

2. Macaulay duration decreases as market interest rate i n c r e a s e s
3. Macaulay duration decreases as the coupon interest rate i n c r e a s e s .

Modified duration is a direct measure of the interest rate sensitivity of an asset or liability and can be
written as (6.4):

Definition of percentage price change

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Calculation of Modified Duration (6.5):

Calculation Duration gap (DURgap) (6.6):

Note: Additive property of duration; Immunisation by matching duration;

Measure change in net worth by duration gap (6.7):

Note: Suggested use of duration gap analysis;

Problems of duration gap analysis:

1. Assume linear relationship for a c o n v e x relationship

2. It only works well for s m a l l c h a n g e s in interest rates.

 Solution: more sophisticated approach (VaR)

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6. Liquidity risk management

Main goal: maintain a stable deposit base
Methods:

 D i v e r s i f y deposit base by types of depositors

 Holding large stock of h i g h - q u a l i t y l i q u i d a s s e t s .

The other method involves active management of banks liability structure to manage its liquidity
requirements

 It involves both p o t e n t i a l l o s s in value of a risky asset or portfolio over a defined period for
a given c o n f i d e n c e i n t e r v a l .

note: VaR is not the worst case scenario; calculation of VaR using historic data;

Problem of historical method: data should represent all possible states

Second approach: using statistical model

 typical distribution: n o r m a l d i s t r i b u t i o n

Note: Advantage of using statistical distribution; Stricter VaR - 99% confidence interval;

Problems of statistical distribution:

1. Assume s t a b l e c o r r e l a t i o n s over time

2. F a t t e r t a i l s than normal distribution

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