RISK AND CAPITAL:

(Types of Risk, Overall Capital Calculations,

Regulatory vs Economic Capital)
 TYPES OF FINANCIAL RISKS
• Every saving and investment action involves
different risks and returns.
• In general, financial theory classifies
investment risks affecting asset values into
two categories:
• Systematic Risk and Unsystematic Risk.
• Broadly speaking, investors are exposed to
both systematic and unsystematic risks.
 TYPES OF FINANCIAL RISKS
• SYSTEMATIC RISKS
• Also known as market risks, are risks that can affect
an entire economic market overall or a large
percentage of the total market.
• Market risk is the risk of losing investments due to
factors, such as political risk and macroeconomic
risk, that affect the performance of the overall
market.
• Market risk cannot be easily mitigated through
portfolio diversification.
 TYPES OF FINANCIAL RISKS
• Other common types of systematic risk
• interest rate risk,
• inflation risk,
• currency risk,
• liquidity risk,
• country risk, and
• sociopolitical risk.
 TYPES OF FINANCIAL RISKS
• UNSYSTEMATIC RISKS,
• Also known as specific risk or idiosyncratic
risk, is a category of risk that only affects an
industry or a particular company.
• Unsystematic risk is the risk of losing an
investment due to company or industry-
specific hazard.
 TYPES OF FINANCIAL RISK
• In addition to the broad systematic and unsystematic
risks, there are several specific types of risk:
• 1. Business Risk
• refers to the basic viability of a business—the question
of whether a company will be able to make sufficient
sales and generate sufficient revenues to cover its
operational expenses and turn a profit.
• While financial risk is concerned with the costs of
financing, business risk is concerned with all the other
expenses a business must cover to remain operational
and functioning.
 TYPES OF FINANCIAL RISK
• 1. Business Risk
 The expenses include:
• salaries,
• production costs,
• facility rent,
• office and administrative expenses.
 The level of a company's business risk is influenced by factors such as:
• cost of goods,
• profit margins,
• competition, and
• overall level of demand for the products or services that it sells .
 TYPES OF FINANCIAL RISK
• 2. Credit Risk
• The risk that a borrower will be unable to pay the
contractual interest or principal on its debt
obligations.
• This type of risk is particularly concerning to
investors who hold bonds in their portfolios.
 TYPES OF FINANCIAL RISK
• 2. Credit Risk
• Government bonds, especially those issued by
the government, have the least amount of
default risk and, as such the lowest returns.
• Corporate bonds, tend to have the highest
amount of default risk, but also higher interest
rates.
 TYPES OF FINANCIAL RISK
• 2. Credit Risk
• Bonds with a lower chance of default are
considered investment grade, while bonds
with higher chances are considered high yield
or junk bonds.
• Investors can use bond rating agencies—such
as Standard and Poor’s, Fitch and Moody's—to
determine which bonds are investment-grade
and which are junk.
 TYPES OF FINANCIAL RISK
• 3. Country Risk
• The risk that a country won't be able to honor
its financial commitments.
• When a country defaults on its obligations, it
can harm the performance of all other
financial instruments in that country – as well
as other countries it has relations with.
 TYPES OF FINANCIAL RISK
• 3. Country Risk
• Country risk applies to stocks, bonds, mutual
funds, options, and futures that are issued
within a particular country.
• This type of risk is most often seen in
emerging markets or countries that have a
severe deficit.
 TYPES OF FINANCIAL RISK
• 4. Foreign-Exchange Risk
• When investing in foreign countries, it’s important to
consider the fact that currency exchange rates can change
the price of the asset as well.
• Foreign exchange risk (or exchange rate risk) applies to all
financial instruments that are in a currency other than
your domestic currency.
• Example:
• If you live in the U.S. and invest in a Canadian stock in
Canadian dollars, even if the share value appreciates, you
may lose money if the Canadian dollar depreciates in
relation to the U.S. dollar.
 TYPES OF FINANCIAL RISK
• 5. Interest Rate Risk
• The risk that an investment's value will change due
to a change in the absolute level of interest rates, the
spread between two rates, in the shape of the yield
curve, or in any other interest rate relationship.
• This type of risk affects the value of bonds more
directly than stocks and is a significant risk to all
bondholders.
• As interest rates rise, bond prices in the secondary
market fall—and vice versa.
 TYPES OF FINANCIAL RISK
• 6. Political Risk
• The risk an investment’s returns could suffer
because of political instability or changes in a
country.
• This type of risk can stem from a change in
government, legislative bodies, other foreign policy
makers, or military control.
• Also known as geopolitical risk, the risk becomes
more of a factor as an investment’s time horizon
gets longer.
 TYPES OF FINANCIAL RISK
• 7. Counterparty Risk
• The likelihood or probability that one of those
involved in a transaction might default on its
contractual obligation.
• Counterparty risk can exist in credit, investment,
and trading transactions, especially for those
occurring in over-the-counter (OTC) markets.
• Financial investment products such as stocks,
options, bonds, and derivatives carry counterparty
risk.
 TYPES OF FINANCIAL RISK
• 8. Liquidity Risk
• Liquidity risk is associated with an investor’s
ability to transact their investment for cash.
• Typically, investors will require some premium
for illiquid assets which compensates them for
holding securities over time that cannot be
easily liquidated.
ENTERPRISE AND CAPITAL RISK MGT WITHIN
FINANCIAL INSTITUTIONS
• When it comes to the risk management of
investment assets, either individually or on a
portfolio scale, there are a number of choices to
be made relative to the investment appetite of
the bank in question, and the risk profile of the
underlying exposures.
• Some of the well-known approaches adopted by
EU Banks in modeling and quantifying credit,
market and liquidity risks are enumerated below.
 COMMONLY USED RISK METRICS
• Credit Risk Metrics, such as LGD, PD, EAD.
• When a bank enters into a loan agreement, it creates a
risk for the bank as lender. The terms and conditions of
repayment may not be fulfilled as previously agreed.
• Credit risk factors are those that affect the borrower’s
probability of default, loss to the lender given default
and the lender’s exposure at default.
• Here may be events that are specific to the individual
borrower or market wide events that affect all
borrowers.
 COMMONLY USED RISK METRICS
• Credit Risk Metrics, such as LGD, PD, EAD.
• The modelling of a bank’s portfolio credit
risk requires a specification of credit loss.
• If the borrower does default, then the
Expected Loss (EL) is defined as:
• •EL = PD * LGD * EAD
 COMMONLY USED RISK METRICS
• where:
• PD = probability of default,
• which is the probability that the borrower will default at the
end of a pre-determined time period (e.g., one year) and
expressed as a percentage.
• Fundamentally, this depends on the on the credit spread of
the issuing entity, in conjunction with the Loss Given Default
(LGD).
• For liquid issuers this can be derived from credit default swap
curves, but for less liquid issuers it is necessary to assess the
contributing components of credit risk to establish a credit
spread.
• This is therefore dependent on the region, industry and state
of the issuer’s business, interest rate and economic climate.
 COMMONLY USED RISK METRICS
• LGD = expected loss given default
• •also defined as LGD = 1 – RR (where RR = expected
recovery rate and is usually expressed as a percentage).
• •In the event of default, the loss (or value recovered) is of
key importance to the valuation.
• •For synthetic credit products this is contractual, for
anything else this depends on the market.
• •Modelling this requires consideration of the seniority of
the assets, industry, issuer, historical recoveries and trends,
and an assessment of the current climate, as well as the
assets and liabilities of the issuer.
 COMMONLY USED RISK METRICS
• EAD = expected Exposure Amount at Default
• expressed in monetary amount.
• The EAD defines the value of the investment at risk in the
event of default, specifically, the maximum exposure to loss
at that time.
• It is quite possible that current exposure and future
exposures will be different, and as such this is linked to the
fair valuation of the assets (and liabilities) in question.
• The calculation of this requires the modelling of the
investment value now, and over the duration of the
investment life, which in turn depends on the evolution of
the market factors upon which the value of the investment
depends.
 COMMONLY USED RISK METRICS
• Credit Risk Metrics, such as LGD, PD, EAD.
• The modelling of a bank’s portfolio credit risk requires a
specification of credit loss.
• If the borrower does default, then the Expected Loss (EL)
is defined as:
• EL = PD * LGD * EAD
• Each of these metrics is quantified using a variety of
stochastic, market comparative and statistical
approaches, and in some instance by deriving volatility
from historical or implied means.
 Illustrative Problem 1
• Calculating expected loss (EL) and unexpected loss (UL)
• A Canadian bank recently disbursed a CAD 2 million loan, of which CAD
1.6 million is currently outstanding. According to the bank’s internal
rating model, the beneficiary has a 1% chance of defaulting over the
next year. In case that happens, the estimated loss rate is 30%. The
probability of default and the loss rate have standard deviations of 6%
and 20%, respectively. Determine the expected loss figures for the bank.

• EL = EA × PD × LR
Where:
EA = CAD 1,600,000
PD = 1%
LR = 30%
Thus,
EL=1,600,000 × 0.01 × 0.3 = CAD 4,800
What are the best possible ways or practices
that are followed to mitigate credit risk
management in banks?
• Lenders-banks can reduce credit risk by reducing the amount
of credit extended, either in total or to certain borrowers.
• Also, banks could have tighter loan terms and conditions
(such as loan covenants, interest rate, loan maturity etc,,,) in
order to mitigate the potential credit risk.
• For example, Covenants are undertakings given by a
borrower as part of a term loan agreement. Their purpose is
to help the lender ensure that the risk attached to the loan
does not unexpectedly deteriorate prior to maturity. From
the borrower's point of view covenants often appear to be an
obstacle at the time of negotiating a loan and burdensome
restriction during its term.
 What are the best possible ways or practices
that are followed to mitigate credit risk
management in banks?
• In principle, tightening loan terms and conditions, reducing
the amount of loans to a risky sector and to risky borrowers
works well and is one way to reduce credit risk (most
banking textbooks would agree with this). However, from a
policy point of view, international banks do not follow this
approach in recent times because lending to risky sectors (or
risky borrowers) offer higher interest rates to banks, and
seem to be more attractive to banks especially when the
government guarantees non-performing loans arising from
lending to such risky sectors. When this is the case, banks
would lend to risky sectors even if their credit risk
assessment shows that lending to such sector involves high
credit risk.
 What are the best possible ways or practices that are
followed to mitigate credit risk management in banks?

• Recently, the best practice for managing credit

risk by most international banks around the world
is to allocate risk capital for credit risk. Normally,
banks should allocate risk capital for 'credit risk',
'market risk', 'operational risk'. For credit risk,
banks will make a scenario assessment of possible
loan defaults under different assumptions, and
then allocate the relevant risk-weights capital to
mitigate credit risk, among other considerations.
 What are the best possible ways or practices
that are followed to mitigate credit risk
management in banks?
• The main argument against an out-right refusal to
lend to risky sectors (or risky borrowers) has been
that the refusal to lend to any sector (whether
risky or not) could lead to a significant reduction in
aggregate spending/consumption levels which in
turn might have a pro-cyclical effect on the
economy. Therefore, the continuous provision of
loans to risky and less risky borrowers is necessary
to maintain continuous spending/consumption by
firms and households(i.e. individual borrower).
What are the best possible ways or practices
that are followed to mitigate credit risk
management in banks?
• Finally, in addition to what other authors
suggested above, banks can manage credit
risk by:
• 1) allocating risk capital for credit risk, and
• 2) by improving bank monitoring of loans to
risky sectors/(or risky borrowers).
 Why does Credit Risk matter?
• Credit risk is one of the most fundamental types
of risk. After all, it represents the chance the
investor will lose his or her investment.
• All bonds, except for those issued by the
government, carry some credit risk. This is one
reason corporate bonds almost always have
higher coupon payment amounts than
government bonds.
THE END