FOREIGN EXCHANGE & RISK

MANAGEMENT
 1

FOREIGN EXCHANGE & RISK MANAGEMENT

RISKS FACED BY ALLIED BANK
SUBMITTED TO:
DR. WAQAS FAROOQ
SUBMITTED BY:
MISBAH JAMIL ROLL NO: E18MBA048
IRAM SHAHZADI ROLL NO: E18MBA016
AQSA SHAUKAT ROLL NO: E18MBA042
MAIRA FAYYAZ ROLL NO: E18MBA035
SHIZA SHABBIR ROLL NO: E18MBA012
 2

Acknowledgement

First of all, all admiration to Allah Almighty who bestowed upon us his blessings to
prepare this project. Following which, I would like to present our gratitude to Dr. Waqas
Farooq who contributed his great moral support and help to accomplish this assignment
smoothly.
 3

ALLIED BANK PRIVATE LTD.

The Bank started out in Lahore by the name Australasia Bank before independence in
1942; and became Allied Bank of Pakistan in 1974. In August 2004, because of capital
reconstruction, the Bank's ownership was transferred to a consortium comprising Ibrahim
Group; therefore, it was renamed as Allied Bank Limited in 2005.

VISION
To become a dynamic and efficient bank providing integrated solutions in order to be the
first choice bank for the customers.

MISSION
To provide value-added services to our customers. To provide high-tech innovative
solutions to meet customers’ requirements. To create sustainable value through growth,
efficiency and diversity for all stakeholders. To provide a challenging work environment
and reward dedicated team members according to their abilities and performance. To play
a proactive role in contributing towards the society.

CORE VALUES
Integrity
Excellence in Service
High Performance

TYPES OF BANK RISKS

CREDIT RISK
Risk that the Bank will incur losses owing to the failure of an obligor or counterparty to
meet its obligation to settle outstanding amounts. Credit risk is the biggest risk for banks.
It occurs when borrowers or counterparties fail to meet contractual obligations. An
example is when borrowers default on a principal or interest payment of a loan. Defaults
can occur on mortgages, credit cards, and fixed income securities. Failure to meet
obligational contracts can also occur in areas such as derivatives and guarantees
provided.
• Oversight is kept through guidance of Board of Directors and its sub-committee
“Board Risk Management Committee” as well as through management committee of
“Risk Management & Compliance Committee (RM&CC)”.
• Public sector advances are generally secured by sovereign guarantee or the equivalent
from the Government of Pakistan (GoP).
 Certain PSEs have a well-defined cash flow stream and appropriate business model,
based on which the lending may be secured through collaterals other than GoP
guarantee.
 4

When a lender offers credit to the counterparty (through loans, credits on invoices,
investing in bonds or insurance), then there is always a risk existed for the lender
that it might not receive the credited amount back from the counterparty. Such
risks are termed as credit risks or counterparty risks.

MARKET RISK
Market risk mostly occurs from a bank’s activities in capital markets. It is due to the
unpredictability of equity markets, commodity prices, interest rates, and credit spreads.
Banks are more exposed if they are heavily involved in investing in capital markets or sales
and trading.
 Commodity prices also play a role because a bank may be invested in companies
that produce commodities. As the value of the commodity changes, so does the
value of the company and the value of the investment. Changes in commodity prices
are caused by supply and demand shifts that are often hard to predict. So, to
decrease market risk, diversification of investments is important. Other ways banks
reduce their investment include hedging their investments with other, inversely
related investments.

Risk associated with fluctuations in interest rates, foreign currency rates, credit
spreads, equity prices and commodity prices

• Oversight is kept through guidance of Board of Directors and its sub-committee “Board
Risk Management Committee” as well as through management committee – “Asset &
Liability Committee
(ALCO)”.
• Comprehensive structure is in place aimed at ensuring that the Bank does not exceed its
qualitative and quantitative tolerance for market risk.
• Balanced approach towards risk taking in the market risk area while keeping exposures
within the defined risk acceptance criteria.
 5

OPERATIONAL RISK
Operational risk is the risk of loss due to errors, interruptions, or damages caused by
people, systems, or processes. The operational type of risk is low for simple business
operations such as retail banking and asset management, and higher for operations such as
sales and trading. Losses that occur due to human error include internal fraud or mistakes
made during transactions. An example is when a teller accidentally gives an extra $50 bill
to a customer.

• Risk of inadequate / failed internal processes and losses caused by

external events.
Oversight kept through Board of Director’s sub-committee “Board Risk Management
Committee” as well as through management sub-committee of “Risk Management &
Compliance Committee
(RM&CC)”.
• BOD approved Operational Risk Policy
• Detailed documented procedures
• Adequate system of internal controls designed to keep operational risk at appropriate
levels
FOREIGN EXCHANGE RISK FOR BANKS
Foreign exchange rate fluctuations affect banks both directly and indirectly. The direct
effect comes from banks’ holdings of assets (or liabilities) with net payment streams
denominated in a foreign currency. Foreign exchange rate fluctuations alter the domestic
currency values of such assets. This explicit source of foreign exchange risk is the easiest to
identify, and it is the most easily hedged. The indirect sources of risk are subtler but just as
important. A bank without foreign assets or liabilities can be exposed to currency risk
because the exchange rate can affect the profitability of its domestic banking operations.
 6

For example, consider the value of a bank’s loan to a U.S. exporter. An appreciation of the
dollar might make it more difficult for the U.S. exporter to compete against foreign firms. If
the appreciation thereby diminishes the exporter’s profitability, it also diminishes the
probability of timely loan repayment and, correspondingly, the profitability of the bank. In
this case, the bank is exposed to foreign exchange risk: a stronger dollar decreases its
profitability. In essence, the bank is “short” dollars against foreign currency. Any time the
value of the exchange rate is linked to foreign competition, to the demand for loans, or to
other aspects of banking conditions, it will affect even “domestic” banks.
Foreign exchange risk also may be linked to other types of market risk, such as interest
rate risk. Interest rates and exchange rates often move simultaneously. So, a bank’s
interest rate position indirectly affects its overall foreign exchange exposure. The foreign
exchange rate sensitivity of a bank with an open interest rate position typically will differ
from that of a bank with no interest rate exposure, even if the two banks have the same
actual holdings of assets denominated in foreign currencies. Again, the vulnerability of the
bank as a whole to foreign exchange fluctuations depends on more than just its holdings of
foreign exchange.

Measures of foreign exchange risk

The direct sources of foreign exchange risk can be gauged by tallying up the net positions
on a bank’s assets and liabilities that are denominated in foreign currencies. By itself, this
gauge of direct exposure can provide only a narrow assessment of the bank’s exchange
rate sensitivity since — as described above — the value of the bank’s domestic assets also
will vary with the exchange rate. Narrow as it is, this gauge provides the “standardized
method” for assessing a bank’s overall foreign exchange exposure; specifically, under the
aegis of the Basel Committee on Banking Supervision, central bankers from Europe, Japan,
and North America proposed in 1993 the use of such methods in assessing the exposure to
a variety of market risks, including foreign exchange risk.
The example of the bank’s loan to the exporter shows the limitations of the narrow,
standardized method most clearly. While the exporter’s loan by itself leaves the bank short
in dollars, the standardized method captures none of this indirect exposure. Further, if the
bank were to use the foreign currency market to hedge the short dollar position, then the
standardized method, having missed the original exposure, would mistakenly treat the
hedge as if it added to exposure. In general, if a bank chooses its foreign exchange holdings
to offset open positions arising from its other activities, then its holdings serve to reduce
its overall foreign exchange risk. Under such circumstances, treating the bank’s foreign
exchange holdings as though they contribute to risk as the standardized approach does is
inappropriate.
Responding in part to such limitations, the Basle Committee ultimately allowed for a more
flexible approach to evaluating foreign exchange and other market risks (Basle Committee
1996). By 1997, bank regulators in all of the represented countries may choose to assess
exposure (against which they must hold a cushion of capital) either by using the
standardized method or by using banks own proprietary in-house models. Use of the latter
option, known as the “internal models” approach, is subject to several requirements for
 7

prudence, transparency and consistency. When used appropriately, it can provide a

significant improvement over the standardized method.
The internal models approach enables banks to take a broader view of their foreign
exchange risk than does the standardized method. As described in the Basle Committee’s
“Amendment to the Capital Accord to Incorporate Market Risks,” released in January of
this year, the internal models approach focuses on evaluating the risks arising from banks’
trading activities. The approach is well-suited to incorporating the correlation between,
say, the value of interest rate instruments and the value of foreign exchange. In principle,
the internal models approach allows each bank to gauge its exposure carefully enough to
incorporate the relationships among even its non-trading operations. However, even at its
best, the internal models approach is limited in its range of coverage.
An even broader approach to assessing banks’ foreign exchange risks can be obtained from
an analysis of banks’ equity returns. Equity returns reflect changes in the value of the firm
as a whole. So, if the value of a bank as a whole is sensitive to changes in the exchange rate,
the bank’s equity returns will mirror that sensitivity. Whether from direct or indirect
sources, foreign exchange exposure will be reflected in the behavior of returns. Thus, the
exchange rate sensitivity of a bank’s equity returns provides a comprehensive measure of
its foreign exchange exposure.
One drawback of this equity approach is that it is not useful for evaluating the riskiness of
a particular action. The approach is not linked to an explicit model of the determinants of
foreign exchange exposure, so it cannot be used to trace out the implications of specific
decisions. However, the approach is useful for bankers and regulators as a tool to evaluate
the success of past management of foreign exchange risk. It is especially suitable for
comparing the exposure of an assortment of banks because it can be applied consistently
across banks and because it does not require access to their detailed internal models.
Moreover, its comprehensiveness makes it a good benchmark for evaluating other gauges
of exposure.

ANTI-MONEY LAUNDERING

Banks or the banking sector are under the obligation of Anti-Money Laundering because
they are at risk of financial crime. AML regulations contain measures that companies must
take to detect and prevent financial crimes, and these regulations are determined by AML
regulators and are a guide for businesses. There are hundreds of local and global
regulators in total, doing AML studies in the world. Although all regulators aim to prevent
financial crimes, regulations vary from country to country and from region to region.
Here we will examine the Financial Action Task Force (FATF), which are global AML
regulators in general, and the anti-money laundering regulations published by the
European Union and the AML obligations of the banking sector.

What Is Anti-Money Laundering for Banks?

Anti-Money Laundering represents the rules, regulations, and obligations set for the
detection and prevention of money laundering and other financial crimes. It is impossible
to determine the exact amount, but billions of dollars of financial crimes are committed
each year. Any financial crime that cannot be detected and prevented causes crime
 8

organizations to increase their criminal activities. Therefore, financial crimes have very
serious negative consequences. There are many local and global regulators to combat
financial crimes effectively. These regulators publish regulations, recommendations, and
obligations of organizations at risk.

Why Are Banks at Money Laundering Risk?

Banks have been the largest institutions in the field of finance since the past. Considering
that even a single local bank mediates thousands of financial transactions throughout the
day, when we look at the world, millions of financial transactions are realized through
banks every day. Criminal gangs need financial resources to survive and grow their gangs.
Criminal organizations try to launder the money in order to use the crime earnings they
get from crimes. According to the announced data, criminals carry out 97% of money
laundering activities through financial institutions. Considering that banks mediate
millions of financial transactions during the day, banks are at great risk against financial
crimes. For this reason, banks must identify the risks by fulfilling their AML obligations
and must take precautions for them. Get to know money laundering more closely.

Some measures to mitigate Banks Risk

AML Compliance Program of Banks
Banks' AML compliance programs are composed of all measures and controls applied to
ensure AML compliance of banks and to protect against regulatory penalties. The AML
compliance program should work perfectly from the outset to effectively combat financial
crimes and AML compliance. Failures in the AML compliance program will result in banks
being punished by regulators. Therefore, banks must create an effective AML compliance
program to meet the requirements of the regulations they are obliged to.

RISK-BASED APPROACH IN BANKING

The most important element of effective AML / CFT programs is the risk-based approach.
FATF, the European Union, and most local AML regulators agree with the implementation
of a risk-based approach to AML / CFT. According to the risk-based approach, the risk level
of each customer is different. In addition, countries have different risk levels. For this
reason, the businesses have to determine the risks of the customer and apply control
processes specific to these risks by taking a risk-based approach. Banks are obliged to
perform a risk assessment with customer due diligence and know your customer
procedures by applying a risk-based approach in customer account opening processes.
Banks then have to control their customers' transactions with the control mechanisms
they have developed in accordance with their risk levels.

Know Your Customer in Banking

Know Your Customer is the process of collecting customer information in banks' customer
account opening processes. It is a critical step as it is the first control step applied in the
AML program. Because an error made at this stage causes the entire AML program to be
dysfunctional, if we look at FATF, 4AMLD, and 5AMLD, Know Your Customer procedures
are mandatory for banks. Know Your Customer in Banking or Know Your Customer control
is the process of identifying the customer identity of banks when opening new customers.
 9

At this stage, customer information is collected, and banks check the accuracy of the
collected customer information. That is, banks have to make sure that customers and
customer information match. KYC process can be done with various methods such as
identity card verification, face verification, and invoice as proof of address.

CUSTOMER DUE DILIGENCE IN BANKING

Customer Due Diligence (CDD) is the control process implemented by banks to identify
potential money laundering and terrorist financing risks carried by customers. Although
these procedures are not exactly the same all over the world, the goal is the same: to
identify risks. After the Know Your Customer control process, the customer's risk
assessment is made with the correct customer information.
The customer's information is checked in the required databases in the region served by
the bank. These databases generally consist of sanctions, PEP, banned, and wanted lists.
The people on these lists carry high risks for money laundering and terrorist financing. In
addition, in the banks that provide global services, the nationality of the customer, and the
past financial transactions of the customer affect the risk level of the customer.

AML Name Screening Software

Our AML Screening and Monitoring Software automates banks' Customer Due Diligence
control processes. Banks can automatically scan their customers in global comprehensive
sanctions, PEP, and Adverse Media data during customer onboarding and customer
monitoring processes.

Transaction Screening Processes of Banks

Banks generally have a broad customer portfolio. In addition, the transactions mediated by
banks are not limited to their own customers. One customer of the bank can make
payments and transfer money to another bank's customer. An average-sized bank
mediates thousands of money transfers throughout the day.
Banks are obliged to control the buyer and the sender in these money transfer
transactions. Because if the bank mediates the payment sent to a banned or sanctioned
person, this is a big crime. The consequences of the crimes caused by the uncontrolled
reception of the receiver and the sender are very severe administrative and fines, and
banks lose their reputation. In today's technology, manual controls are a waste of time and
are dysfunctional. Banks need an automated transaction screening tool to carry out
customer transactions in accordance with AML regulations.
Our Transaction Screening tool provides banks to control the receiver and sender in
financial transactions in the global coverage AML database. Banks can automate the entire
control process by integrating their own systems and transaction screening tool with the
API. All AML screening takes place automatically against the background of the
transactions performed by the bank. If the system catches a match, it alarms and stops the
process. The scanning process takes place within seconds, and the customer process is not
delayed.

The Importance of Transaction Monitoring in Banking

 10

Only people in the sanction, PEP, and Adverse Media database do not commit financial
crime. Therefore, each customer carries a risk of financial crime for banks. For banks, any
transaction they intermediate can be a financial crime. There are a lot of money laundering
methods, and with the development of technology, these crime types increase even more.
It is impossible for banks that mediate thousands of transactions during the day to control
these transactions manually. In today's technology, transaction monitoring tools do this
automatically.
Banks create various rules with AML Transaction Monitoring software, and every
transaction they mediate is controlled automatically based on these rules. Banks were the
most audited institutions in this period when regulations and audits for AML increased.
Our AML transaction monitoring software enables banks to perform transactions they
mediate in accordance with AML regulations.

Transaction Monitoring Software

With our advanced features, banks can create dynamic rules and scenarios and test these
rules before they go live with the sandbox test environment. With real-time alarm
management, the AML department can instantly see the alarm level of all transactions and
assign tasks to teammates related to these transactions. All logs are recorded, and the bank
can show these logs as evidence in possible audits. With customizable settings, banks
make control processes more efficient and reduce AML false positives.

Independent AML Audits

Independent AML audits enable banks to control the AML compliance program end-to-end.
Although banks have their own AML departments, it is vital to control them with
independent audits. Deficiencies detected by independent audits may perhaps protect
banks from millions of dollars in fines and prevent reputation losses. According to the
independent audit reports, banks compensate for the deficiencies in AML compliance
programs and further develop the AML program. Therefore, banks should have the AML
program checked by performing an independent audit at one or two-year intervals.

Overview of AML Penalties in 2020

Regulators and supervisors increase their work year after year and impose heavy
administrative and fines on organizations that do not meet their obligations. In 2018,
$4.27bn fines were issued to organizations that did not meet AML obligations by
regulators. In 2019, the penalty amount increased by approximately two times and
became $ 8.14bn. Organizations facing penalties face major administrative penalties as
well as fines and lose their reputation. The fact that AML failures have such severe
consequences shows that this issue should never be neglected.
How Sanction Scanner Helps Banks?
Sanction Scanner provides Anti-Money Laundering solutions to strengthen banks' AML
compliance processes.
 Sanction Scanner's solutions include;
 AML Screening and Monitoring Software
 Transaction Screening Software
 11

 Transaction Monitoring Software

 Adverse Media Screening Software