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Re: Second forum

Post  Admin on Fri 23 Mar 2012 - 15:58

1) Analyse various risks in banking?
Risk is bound to be for a bank,as it deals with money. Where there is money there is risks. risks can be financial and non financial that a bank has to face. A definition of risk would be a probability or threat of a damage,injury,liability,loss or other negative occurrence that is caused by external or internal vulnerabilities: and that may be neutralized through pre emptive measures
Financial risks can be:
a) Credit Risk: it is the risk that bank incur if debtor fails to pay its obligation towards them. In simple words: borrowers will not be able to repay principle and interest as arranged.(also known as default risk)

b)Market Risk: is the risk of losses resulting from changes in the value of assets and liabilities due to fluctuation in risk factors. Market risk can be divided into 2 sections namely liquidity and interest rate risk:

Interest Rate Risk is the risk that fluctuation in the interest rates may impact on profitability of the bank. For example: Decline in net interest income will result from changes in relationship between interest income and interest expense.

Liquidity Risk is the risk faced by the bank when it does not have sufficient funds to lend to customers. For example: There will not be enough cash and/or cash equivalents to meet the needs of depositors and borrowers.

c) Foreign Exchange Risk is the risk that can be incurred due to changes in exchange rate. For example: Appreciation or depreciation of a currency will result in a loss or an naked position.

Non Financial Risk can be
a) Operation Risk: It is risk that occurred due to human incapability. For Example: Failure of data processing equipment will prevent the bank from maintaining its critical operations to the customers satisfaction

b) Technological Risk: that is when technology becomes outdated and obsolete,for the bank to operate it takes more time thus causing dissatisfaction to customers.
veev
c) Staff Risk: staff that are not motivated ,will do lots of mistakes. There will be high labour turnover,causing staff and clients to leave the bank.

d) Systemic Risk: is the risk associated with the entire financial system. Suppose among 4 banks 1 of them close,depositors will remove their money from that bank and other depositors will remove their money in the three respective banks also.It is the domino effect

e) Delivery Risk: Buyer and seller of a financial instrument or foreign currency will not be able to meet associated delivery obligations on their maturity.

Kaveer Rughoonauth (student Id: 111436)

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Re: Second forum

Post  Admin on Fri 23 Mar 2012 - 15:59

(1) Analyse the various risks in banking.

Banking is one of the key drivers of any economy. Why? It provides the liquidity needed for families and businesses to invest for the future. Bank loans and credit means families don't have to save up before going to college or buying a house, and companies can start hiring immediately to build for future demand and expansion. Credit has gotten a bad name, thanks to the 2008 financial crisis, but that's only because it was unregulated, used for consumption instead of investment, and allowed to create a bubble.Therefore,it is certain that banks also faces some risk.What are the risk?

There is two types of risk faced by banks;financial risk and non-financial risk.

What is a financial risk?

Financial risk an umbrella term for multiple types of risk associated with financing, including financial transactions that include company loans in risk of default.[1][2] Risk is a term often used to imply downside risk, meaning the uncertainty of a return and the potential for financial loss.

What is a non financial risk?

Non-monetory would refer to anything that is not monetary or that which cannot be associated or viewed in money terms.A risk is anything that if it occurs, the resultant consequences thereof will be to the detriment of the benefactor. Therefore a non-financial risk is that which if it happens there won't be any monetory consequence.

Most common types of risk faced by banks:

Repaying Creditors

Banks often use their clients' invested or deposited money to issue loans or make other types of investments designed to make money for the bank. The bank pays their clients for renting their money by giving them a small percentage of the interest rate the bank charges for loans. However, if every bank client wanted to withdraw his money at the same time, a bank with insufficient funds available would not be able to pay the money back to its all customers or creditors. This could cause a bank to fail.This was the case in the late 1930 which sent America into the great depression.The main problem was that at that time,there was no system to ensure that everyone who invested will receive a part of money back.


Being Paid by Debtors

Banks regularly loan money to people or businesses, charging the borrower interest on the loan and requiring monthly payments while allowing the borrower an extended period to pay back the loan. The banks make money based on interest rates they charge and other fees. However, the bank may lose money if the loan is not paid back. While a bank can destroy someone's credit and take legal action against the borrower, the loan remains a financial risk. This is why banks need knowledgeable and perceptive loan officers to decide who should be issued loans.

Human or Electronic Error

Banks operate like other companies, which means electronic equipment and human judgment are involved. Errors can be made, sometimes for large sums of money that can be costly to the bank.An example can be when a couple in the New Zeland obtained $ 8 Million and fled the country, essentially stealing the money and costing the bank a large amount of money. While this rarely happens, banks are vulnerable to this type of risk.

Market risk

Market Risk may be defined as the possibility of loss to bank caused by the changes in the market variables. It is the risk that the value of on-/off-balance sheet positions will be adversely affected by movements in equity and interest rate markets, currency exchange rates and commodity prices.

Country Risk

This is the risk that arises due to cross border transactions that are growing dramatically in the recent years owing to economic liberalization and globalization. It is the possibility that a country will be unable to service or repay debts to foreign lenders in time.

Operational Risk

Always banks live with the risks arising out of human error, financial fraud and natural disasters. Operational risk involves breakdown in internal controls and corporate governance leading to error, fraud, performance failure, compromise on the interest of the bank resulting in financial loss.

Forex Risk
Foreign exchange risk is the risk that a bank may suffer loss as a result of adverse exchange rate movement during a period in which it has an open position, either spot or forward or both in same foreign currency.

Systemic risk

Systemic risk is the risk of collapse of an entire financial system or entire market, as opposed to risk associated with any one individual entity, group or component of a system.

Above are Fiancial ana Non Financial risk faced by nearly all banks around the world.Many banks are also engaged and investing a lot of money to find solution to these above problems.That is what we will see in the next question.

(2) Explain how banks manage these risks.

To control those financial risk,banks use what we call Financial risk management.What is financial risk management?Financial risk management is the practice of creating economic value in a firm by using financial instruments to manage exposure to risk, particularly credit risk and market risk. Other types include Foreign exchange, Shape, Volatility, Sector, Liquidity, Inflation risks, etc. Similar to general risk management, financial risk management requires identifying its sources, measuring it, and plans to address them.Financial risk management can be qualitative and quantitative. As a specialization of risk management, financial risk management focuses on when and how to hedge using financial instruments to manage costly exposures to risk.

How to control these risk by using Finacial risk management?

Credit Risk
Many firms operate a credit risk department whose role is to assess the financial health of their customers and decide whether to extend credit or not. They may use software to analyze such risks and assess how to avoid, reduce, or transfer any credit risk. Credit rating companies such as Standard & Poor’s, Moody’s, and Dun and Bradstreet also sell financial intelligence to firms needing external assistance in managing credit risk with their clients.Companies can lessen their credit risk by, for example, cutting their payment terms to 15 days, limiting the amount of goods or services available on credit per transaction, or even insisting on payment up-front. Strategies such as these cut exposure to risk, but the downside is that they can affect the volume of sales and subsequent cash flow.

Interest rate risk
Interest rates is very important for any bank.Banks, in particular, rely on interest rate calculations as a way to determine profit and losses over the course of time. Interest rate risk management approaches allow banks to contain potential risks and predict the types of effects interest rate changes will have over different periods of time.

FOreign exchange risk

Managing foreign exchange risk requires a clear understanding of the amount at risk and the impact of changes in exchange rates on this foreign currency exposure. To make these determinations, sufficient information must be readily available to permit appropriate action to be taken within acceptable, often very short, time periods.It is only through the accurate and timely recording and reporting of information on exchange transactions and currency transfers that foreign currency exposure can be measured and foreign exchange risk controlled. Accordingly, each institution engaged in foreign exchange activities needs to have an effective accounting and management information system in place that accurately and frequently records and measures:
its foreign exchange exposure; and
the impact of potential exchange rate changes on the institution.
At a minimum, each institution should have in place monitoring and reporting techniques that measure:
the net spot and forward positions in each currency or pairings of currencies in which the institution is authorised to have exposure;
the aggregate net spot and forward positions in all currencies; and
transactional and translational gains and losses relating to trading and structural foreign exchange activities and exposures.

How to manage non financial risk?

TEchonological risk

When the bank management has gained an understanding of the pivotal role of information technology in enabling the delivery of its products and services, they also acquire an insight into the vulnerabilities and the threats to the system. The end product of this exercise is for the bank management to make decisions on the management of technology risk. There are three basic approaches, which are not mutually exclusive and therefore can be used singly or in combination.
Managing technology risk through internal processes and controls. This alternative assumes that the organisation has the resources and internal expertise that can be used to develop and administer the security mechanisms and control procedures necessary to protect the bank.
Managing technology risk by outsourcing. In the absence of internal resources and expertise, the bank can consider engaging temporary contractors to provide the security mechanisms on a project basis, or outsourcing the activity to an appropriately equipped service provider.
Managing technology risk by transferring risk through insurance. This is still a nascent field in insurance, but it is now possible to find insurance policies that address technology risk.

Operational risk

Banks generally calculate their operational-risk cover by estimating the probability that a particular event might occur and the resulting financial loss—such as the fine for breaking a rule or the sum pocketed by an embezzler. But operational crises also upset shareholders and can lead to a decline in market value.Few institutions, however, factor such potential market losses into their risk-cover calculations or operational-risk-management plans. New research suggests that they should. The decline in market value following an operational crisis can be far greater than the financial loss. The first step for banks will be to measure and understand the full extent of their operational risk.

Systemic Risk

Private-market incentives play a major role in limiting systemic risk and that the government should always be highly sensitive to whether its actions are undermining or reinforcing the private mechanisms (Kaufman 1996). The latter is especially important in relation to the design and use of various safety-net measures.

Shriyans Teeluck (111442)

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Re: Second forum

Post  Admin on Fri 23 Mar 2012 - 16:03

1. Analyse the various risks in banking

Risk
Risk is the potential loss of an asset or a portfolio that is likely to suffer due to a variety of reasons.
Banking Risk


1.1 Credit risk
Credit risk refer to the risk of an investor, who has lent money to the borrower, who does not make the return payments as originally agreed. There are a number of circumstances where a credit risk may arise such as a consumer or a business missing payments on a mortgage or any other type of loan, a business or consumer who does not pay an invoice when it is due, a business who does pay an employee's wages when they are due and many others.
1.1.1 TYPES OF CREDIT RISKS

1.1.2 Transaction Risk
Risk relating to specific trade transactions, sectors or groups.

1.1.3Portfolio Risk
Risk arising from lending to sectors non related to the core competencies of the Bank / concentrated credits to a particular sector / lending to a few big borrowers.

1.2 MARKET RISK
Market risk is the risk to a bank’s financial condition that could result from adverse movements in market price. It is the risk that an investment or trading portfolio will decrease in value due to change in the market.

1.2.1 TYPES OF MARKET RISK

1.2.2Interest Rate Risk
Risk felt, when changes in the interest rate structure put pressure on the net interest margin of the Bank. Interest rate risk is the risk that the relative value of a security, especially a bond, will worsen due to an interest rate increase. This risk is commonly measured by the bond's duration

1.2.3 Liquidity Risk
Risk arising due to the potential for liabilities to drain from the Bank at a faster rate than assets. It arises from situations in which a party interested in trading an asset cannot do it because nobody in the market wants to trade that asset. Liquidity risk becomes particularly important to parties who are about to hold or currently hold an asset, since it affects their ability to trade.

1.2.4FOREX RISK
Foreign exchange risk is the risk that a bank may suffer loss as a result of adverse exchange rate movement during a period in which it has an open position, either spot or forward or both in same foreign currency.
This risk can be classified into three types.

Transaction Risk is observed when movements in price of a currency upwards or downwards, result in a loss on a particular transaction.

Translation Risk arises due to adverse exchange rate movements and change in the level of investments and borrowings in foreign currency.

Country Risk. The buyers are unable to meet the commitment due to restrictions imposed on transfer of funds by the foreign govt. or regulators.
When the transactions are with the foreign govt. the risk is called as Sovereign Risk.

1.3 Non-financial risk

1.3.1 Operational Risk arises as a result of failure of operating system in the bank due to certain reasons like fraudulent activities, natural disaster, human error, omission or sabotage etc.

Example of operational risk
1. Technology failure
2. business premises becoming unavailable
3. inadequate document retention or record-keeping
4. poor management, lack of supervision,accountability and control
5. errors in financial models and reports
6. attempts to conceal losses or make personalgains (rogue trading)
7. third party fraud


1.3.2 Systemic Risk is seen when the failure of one financial institution spreads as chain reaction to threaten the financial stability of the financial system as a whole.

1.3.3 Political Risk arises due to introduction of Service tax or increase in income tax, freezing the assets of the bank by the legal authority etc.

1.3.4 Human Risk like labour unrest, lack of motivation, inadequate skills, problems faced by the bank after implementation of VRS lead to Human Risk.

1.3.5Technology Risk like obsolescence, mismatches, breakdowns, adoption of latest technology by competitors, etc, come under technology risk.

2.Explain how banks manage these risks.

Objective of risk management by banks:
1. Survival of the banks
2. Efficiency in Operations
3. Uninterrupted Operations
4. Identifying and achieving acceptable level of risk
5. Earning Stability
6. Continued and sustained Growth
Management credit risk
1. Measurement through Credit Rating / scoring

EXPOSURE CEILINGS :Setting of prudential norms related to the Bank’s exposure to a single borrower / group borrowers / sectorial borrowers

REVIEW / RENEWAL : This involves multi-tier credit approving authority, constitution wise delegation of powers, higher delegated powers for better rated borrowers, discriminatory time for credit review / renewal, hurdle rates / benchmarks for fresh exposures & periodicity for renewal based on risk rating.


2. Quantification through estimate of expected loan losses

3. Pricing on a scientific basis : Linking loan pricing to expected loss

4. Controlling through Effective loan review mechanism and portfolio management

4.1 LOAN REVIEW MECHANISM : This should be done independent of credit operations & administration and cover all the loans above certain cut-off limit ensuring that at least 30 – 40% of the portfolio is subjected to LRM in a year.

4.2 Portfolio management: : Stipulate quantitative ceiling on specific rating categories, distribution of borrowers in various industries / business groups , rapid portfolio reviews, on-going system for identification of credit weaknesses well in advance, initiate steps to preserve the desired portfolio quality and integrate portfolio reviews with credit decision making process

Credit risks of the borrowers are managed as follows:
• limits for industrial sectors are established (volume of lending to companies of one industry must not exceed 20 % of credit portfolio);
• possible lending limits are established by credit products (with regard to risks accepted by the bank under the credit products); upper margins of limit are stipulated for each credit product;
• Limits of lending to separate borrowers are established and reviewed on a constant basis (credit status analysis at the first consideration of a credit application, and also monitoring of borrower’s current financial condition during validity of loan agreement).

Liquidity risk

Liquidity Risk of bank is assessed through gap analysis for maturity mismatch based on residual maturity in different time buckets & management of same is done through prudential limits fixed thereon.
Bank is also monitoring the liquidity through various stock options.
The Bank is proactively using duration gap and interest rate forecasting to minimize impact of interest rate changes.
Advance techniques such as Stress testing, simulation, sensitivity analysis etc, are conducted at regular intervals to draw contingency funding plan under different liquidity scenarios.
Bank’s liquidity risk management implies analysis and monitoring of the following components:
• the gap between the assets and liabilities duration
• specific weight of liquid funds in net assets
• acid-test ratio, i.e. the Bank's ability to promptly settle call liabilities
• current liquidity showing the Bank's liabilities cover up to 30 days with matching liquid assets
• critical liquidity characterizing the status of meeting commitments by the Bank
• analysis of operations in the domestic interbank market showing bank's position in the domestic interbank market and bank’s liquidity dependence of the borrowings from the market
• assessment of long-term liquidity giving equation of the Bank's assets and liabilities with the maturity term exceeding 1 year

Market risk management

Market risk monitoring is applicable to the Bank’s speculative and investment portfolios.
Market risk management includes the following techniques:
• assessment of market risk for a given portfolio;
• possible restructuring of the investment portfolio aimed at VaR minimization;
• loss provisions do not exceed provisions for the Bank’s own transactions with securities;
• open position capping by means of limiting maximum size of possible investments in specific financial instrument;
• fixing stop orders for market prices of financial assets.

Operational risk

Operational risks are managed and minimized through:
• compliance with recommendations published by the Basel Committee on Banking Supervision
• monitoring based on the results of the Bank’s day-to-day operations
• employment of the automated banking systems that are updated annually
• regular and frequent tests of the existing IT systems
The Bank also has emergency schemes and sufficient equipment in place to ensure that any data affected by operational risks is recovered within a reasonable time so that the Bank’s business is not affected to any material extent.

Interest rate risk management
Evaluation is crucial to the management of interest rate risk and will discover exactly how a firm might be affected, thus guiding the response to the risk. Evaluation techniques include: sensitivity analysis, modeling changes in a variable against its effect; and value at risk (VaR) analysis, based on volatilities to calculate the chances of certain outcomes.


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Mayur Mowjsing (111424)


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Re: Second forum

Post  Admin on Fri 23 Mar 2012 - 16:24

Question 1
Analyse the various risks in banking?(15 marks)
Risks are uncertainties resulting in adverse variations of profitability or in losses. Taking risk can almost be said to be the business of bank management. Financial institutions that are run on the principle of avoiding all risks will be stagnant and will not adequately service the legitimate credit needs of the community; as such on the other hand, a bank that takes excessive risks is likely to run into difficulty. Banking risks can be defined and classified in many ways and it is possible to draw up a long list of the types of risks to which banks are exposed. The various types of financial and non-financial risks that the banks faces are:-
1. Credit Risk
2. Liquidity Risk
3. Interest Rate Risk
4. Market Risk
5. Country Risk
6. Forex Risk (foreign exchange Risks)
7. Solvency Risk
8. Operational Risk
9. Technology risk
10. Systematic risk
11. Model Risk
12. Staff Risk
Financial risks which a bank faces:-
1. Credit Risk :- credit risk is the risk that a counterparty to a financial transaction (the borrower) will fail to comply with its obligation to service debt, or that the counterparty will deteriorate in its credit standing.
2. Liquidity Risk: - Liquidity risk covers all risks that are associated with a bank finding itself unable to meet its commitments on time, or only being able to do so by recourse to emergency borrowing.
3. Interest Rate Risk :- Interest rate risk relates to risks of losses incurred due to changes in market rates, for example, through reduced interest margins on outstanding loans or reduction in the capital values of marketable assets.
4. Market Risk :- Market risk relates to the risk of loss associated with adverse deviation in the value of the trading portfolio, which arises through fluctuations in, for example, interest rates, equity prices, foreign exchange rates or commodity prices. It arises where banks hold financial instruments on the trading book or where banks hold equity as some form of collateral.
5. Country Risk:- Country risk is associated with the risks of incurring financial losses resulting from the inability or unwillingness of borrowers within a country to meet their obligations. It is thus a credit risk on obligations advanced across borders. Assessment of country risk relies on the analysis of economic, social and political variables that relates to the particular country in question.
6. Forex (Foreign exchange risk) :- Foreign exchange risk is a classical field of international finance,such risk may occur heavy losses due to changes in foreign exchange rate of all countries .it consist of (1) Transaction risk is the risk that an exchange rate will change unfavorably over time. It is associated with the time delay between the entering into a contract, the greater the transaction risk, because there is no more time for the two exchange rates to fluctuate. (2) Translation risk is an accounting concept. It is proportional to the amount of assets held in foreign currencies. Changes in the exchange rate over time will render a report inaccurate and so assets are usually balanced by borrowings in that currency.
7. Solvency risk:- This relates to the risk of having insufficient capital to cover losses generated by all types of risks, and is thus effectively the risk of default of the bank. From a regulatory viewpoint, the issue of adequate capital is critically important for the stability of the banking system.

Non-Financial risks which a bank faces:-
1. Operational Risk:- Operational risk arises from shortcomings or deficiencies at either a technical level (for example in a bank’s information system or risk measures) or at an organizational level, (for example in a bank’s internal reporting monitoring and control systems.) Technical operational risk arises in a multitude of forms (such as errors in recording transactions, deficiencies in information systems or the absence of adequate tools for measuring risks). According to Bessis, the Basel Committee adopts a standard industry definition of operational risk as the risk of direct or indirect resulting from inadequate or failed internal processes, people and system or from external events
2. Technology Risk:-Technology Risk relate to deficiencies of the information system and system failure. Technology risk is the risk incurred by an FI when its technological investments do not produce anticipated cost savings. For example if an FI spends millions on upgrading its system but is not able to recapture its cost because its productivity has not increased commensurately or because the technology has already become obsolete, it has invested in a negative NPV investment in technology.
3. Systematic risk :- ( The Domino Effect ) That the financial system may undergo contagious failure following other forms of shock or risks.
4. Model Risk :-Models are subjected to misspecifications, because they ignore some parameters for practical reasons. Model implementation suffers from errors of statistical technique dealing, lack of observable data for obtaining reliable fits (credit risk) and judgmental choices on dealing with “outliers” ,those observations that models fail to capture with reasonable accuracy.
5. Staff Risk :- Staff Risk occurs when the working staff are not or do not feel motivated to work. As such they deliver a poor working skills, they do a lot of mistakes, there working pace gradually decreases, thus in the long run this creates a high labour turnover. Therefore this will interrupt the continuity and progress of the bank as without a good team/staff the bank will not perform well.



Question 2
Explain how Banks manage these risks? (15 marks)
Risk management is both a set of tools and techniques and a process that is required to optimize risk-return trade-offs. The aim of the process is to measure risks in order to monitor and control them. There are four stages that are usually followed in risk management
(1) Identify the areas where risk can arise
(2) Measure the degree of risk this could range from evaluating an individual customer risk to reviewing the risks inherent in a particular sector or industry.
(3) Balance risk and return trade-offs, and determine prudent levels of total risk exposure by individual, firm, country or business activity, within the agreed level of overall risk
(4) Establish appropriate monitoring and control procedures within the bank
The outcomes of this process have several important functions, including implementation of strategy, development of competitive advantages, ensuring capital adequacy and solvency, aiding decision-making, reporting and control of risks and management of portfolio of transactions.

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1. Manage Credit Risk
Banks need to manage the credit risk inherent in the entire portfolio as well as the risk in individual credits or transaction. Banks should also consider the relationship between credit risk and the other risk, The effective management of credit risk is a critical component of a comprehensive approach to risk management and essential to the long-term success of any banking organization.
Since exposure to credit risk continues to be the leading source of problems in banks world-wide, banks their supervisors should be able to draw useful lessons from past experiences. Banks now have keen awareness of the need to identify, measure, monitor and control credit risk as well as to determine that they hold adequate capital against these risks and that they are adequately compensated for risks incurred. The Basel Committee is issuing this document in order to encourage banking supervisors globally to promote sound practices for managing credit risk. Although the principles contained in this paper are most clearly applicable to the business of lending, they should be applied to all activities where credit risk is present.

2 Manage Liquidity Risk.
Another ever-present risk in banking is the likelihood that customer demand for funds will require the sale or forced collection of assets at a loss. Banks require liquidity for four major reasons:
• as a cushion to replace net outflows of funds
• in order to compensate for the non-receipt of expected inflows of funds
• as a source of funds when contingent liabilities fall due
• as a source of funds to undertake new transactions when desirable.

Liquidity risk relates to the eventuality that banks cannot fulfil one or more of these needs. Banks must ensure that they have a satisfactory mix of various assets or liabilities to fulfil their liquidity needs. The choice among the variety of sources of liquidity should depend on several factors, including:
• purpose of liquidity needed
• access to liquidity markets
• management strategy
• costs and characteristics of the various liquidity sources
• interest rate forecasts.

Seasonal liquidity requirements tend to be repetitive in extent, duration and timing. Forecasts of seasonal needs are usually based on past experience. Because seasonal requirements are enerally predictable, only moderate risk is associated with the use of bought-in forms of liquidity to cover seasonal liquidity requirements. On the other hand, liquidity requirements relating to cyclical needs are much more unpredictable.Bought-in funds to provide liquidity needs during booming economic cycles tend to be costly. Credit demands are high during such periods and liability

sources tend to become expensive. They may be limited by the moneymarket’s lack of confidence in a bank’s ability to repay its obligations and the market may be restricted to only the larger operators. Large banks with broad access to money market sources have few problems during such periods, whereas smaller banks tend to rely on their (less costly) non-bought-in liquid asset holdings.

The longer-term liquidity needs of banks are more complex than the aforementioned seasonal and cyclical requirements. If loan growth exceeds deposit growth, banks must budget for longer-term liquidity. Such net growth can be financed by selling liquid assets or purchasing funds. The major problem with fulfilling such longer-term liquidity demands is that the supply of saleable assets and the amount of borrowing permissible are limited. In addition, a bank should always limit its use of bought-in liquidity, so as to have enough ‘borrowing capacity’ if future unpredictable liquidity needs occur.

Liquidity risk is often an inevitable outcome of banking operations. Since a bank typically collects deposits which are short term in nature and lends long term, the gap between maturities leads to liquidity risk and a cost of
liquidity. The bank’s liquidity situation can be captured by the time profiles of the projected sources and uses of funds, and banks should manage liquidity gaps within acceptable limits.

3 Manage Market Risk
This relates to the risk of loss associated with adverse deviations in the value of the trading portfolio, which arises through fluctuations in, for example, interest rates, equity prices, foreign exchange rates or commodity prices. It arises where banks hold financial instruments on the trading book, or where banks hold equity as some form of collateral.3 Many large banks have dramatically increased the size and activity of their trading portfolios, resulting in greater exposure to market risk.


Regulators are increasingly focusing on requiring banks to measure their market risk using an internally generated risk measurement model. The industry standard for dealing with market risk on the trading book is the Value-at-Risk (VaR) model (pioneered by JP Morgan’s RiskmetricsTM). This model is used to calculate a VaR-based capital charge.4 The aim of VaR is to calculate the likely loss a bank might experience on its whole trading book. The validity of a bank’s estimated VaR is assessed by backtesting, whereby actual daily trading gains or losses are compared to the estimated VaR over a particular period. Concerns would arise if actual results were frequently
worse than the estimated VaR. A bank may measure its specific risk through a valid internal model or by the ‘standardised approach’. The latter uses a risk-weighting process developed by the Basle Committee on Banking Supervision. Some banks supplement the VaR estimate with stress tests,which estimate losses under extreme adverse market events.


4 Manage Interest Rate Risk
Interest rate risk relates to the exposure of banks’ profits to interest rate changes which affect assets and liabilities in different ways. Banks are exposed to interest rate risk because they operate with unmatched balance sheets. If bankers believe strongly that interest rates are going to move in a certain direction in the future, they have a strong incentive to position the bank accordingly: when an interest rate rise is expected, they will make assets more interest-sensitive relative to liabilities, and do the opposite when a fall is expected. Assets and liabilities can obviously be mixed to increase or decrease exposures, and techniques such as interest-margin variance analysis (IMVA)2 are used to evaluate current and project future exposures.


The impact of interest rate changes in the macro economy on the risk exposure of banks is a matter of significant concern to both bankers and regulators. For example, a monetary environment that produces marked interest rate volatility may threaten banking stability. Because banks engage in maturity transformation, unexpected and significant market rate changes may lead to an unacceptable number of banks and other financial institutions encountering difficulties, or even failing. Full awareness of such costs is needed in order to evaluate policy alternatives. At the same time, management needs to understand and manage its own exposure to interest rate risk.

With bank costs and revenues both being increasingly related to market interest rates, the net effects of interest rate changes on bank profits are becoming increasingly difficult to measure. Another important dimension of bank interest rate risk concerns other changes in the bank balance sheet that may be associated with the interest rate cycle. For example, a bank faced with significant profit variance related to market interest rate changes may alter its balance sheet volume and mix of earning assets in order to help stabilize earnings. Although some such volume and mix effects may be initiated by the bank itself, other factors may be external and uncontrollable in a deregulated banking environment. Faced with this complex set of relationships, the concept of interest rate risk and its measurement is becoming ever more sophisticated. Banks use the concept of matching to minimise their interest rate exposure. This requires the classification of assets and liabilities according to their interest rates. The aim of such matching is to show how each side of the bank’s balance sheet is related to particular rates of interest, and how it is exposed to changes in market rates. There can never be perfect matching, because of three factors:

• Some risk is unavoidable (some interest rates are fixed or quasi-fixed, such as rates on cheque accounts and savings accounts, and these may be considered to be structurally mismatched with respect to variable interest rates on assets).

• Some interest rate risks have to be accepted to accommodate clients.
• There can be no certainty that the banks’ borrowing costs in all cases will move in step with market rates.

The interest rate gap links variations in interest margin to variations in interest rates, and is a standard measure of a bank’s exposure to interest rate risk.



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chikhooree purushkaar ,student id (111414)

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Re: Second forum

Post  Admin on Fri 23 Mar 2012 - 16:29

Analyse the various risks in banking [15 marks]
Banking consists of risks and uncertainties. These risks may be described using probability analysis (business cycle, company failures), while events subject to uncertainty cannot be exactly predicted (financial crises, wars etc.) The financial market is extremely volatile due to the influence of various factors, the banks are aware that of the fact that maximizing profit implies a permanent incur of risks. The risk may have a considerable impact over the banks, the impact of it may consist of direct losses incurred, and also impact consisting effects on the customer, staff, business partners and even over the banking authorities. Banking risks are also those risks confronted in their current operation and not only the risks specific to the classic banking activity.

Types of banking risks:
(i) Financial risk: risks that arises from any business transaction undertaken by a bank which is exposed to potential loss. They are:

1. Credit Risks
It is where the counterparty of a financial transaction will fails to performs according to the terms and conditions of the contract. This failure may result in bankruptcy or temporary change in market condition. An example is where a customer fails to repay his loan. Credit exposure extends to large variety of bank’s activities including extension of commitments and guarantees, trade finance transactions, placements and a wide range of capital instrument such as foreign exchange, futures, swap, bonds, option and equities. Credit risk may also arise from off balance sheet transactions, that is a bank guarantee a client’s performance under a contract in return of a fee, bank may be called to fulfill its guarantee if clients fails to meet contractual obligations. Another credit risk ma take the form of a delivery or settlement risk. Where bank buys securities from a third party or transfer securities under repurchase agreement, it faces a risk that the counterpart will unable to deliver the securities on the due date leaving the bank exposed to the possibility that it will not be able to replace the securities at the same price.

2. Interest rate risk
One of the most fundamental banking objectives is to borrow funds at one rate and lend them at higher rate. Sometimes known as funding risks, involves the effect in the bank profitability of changes on the market interest rates.
It refers to the financial risks caused by the interest rate fluctuations that affect both the profit obtained by the client and the indebtedness degree to the bank. A major increase of interest rate may determine a financial pressure for the client’s activity, which will to failure of repayment of amount due.

3. Liquidity risk
It is the risk that occurs when the bank will not be able to meet its cash or payment obligations as they fall due. The risks arises because cash flows on assets and liabilities do not match. Due to the size and spread of the resources, the bank is often called to borrow “short” and lend “long”. This give rise to the risk that depositors may seek to withdraw their funds and the bank may not be able to effect repayment except by raising additional deposits at a higher cost, or by a forced sale of assets, perhaps at loss.
The customer may withdraw money whenever they and if banks are not able to meet their obligations toward their customers, customer’s trust in banks will diminish, they will not wish anymore to deposit their money in banks, this may lead to a of massive withdrawals of funds from banks and resulting in a negative effect over the national economy. Exception are deposit certificate which have fixed rates.
Erosion of confidence on the banks, unstable market situation, dependence on one market, extensive “short” borrowing or “long” terms lending are risks factors for banking liquidity.

4. Foreign exchange risks
It is related to the interest rate risk and liquidity risk. It arises from a mismatch: the time currency and assets and liabilities. Thus, the currency may fluctuate in an unexpected direction or higher it has been anticipated. This risk is determine by exchange operation, that affects the situation of the clients who obtain credit in foreign currency and do not performs exports or those revenues from exports do not cover the debt contracted. Transaction affected include both on balance sheet (e.g. loans, deposits) and off-balance sheet (e.g. forward currency contracts) items. Other factor that increase currency risk is volatility of exchange rates.

Deliver risks include the following risks: operational, technological, new product and strategic risk

Operational risk- it is the ability of the bank to deliver its financial services in a profitable manner. Both the ability to deliver services and to control the overhead associated with them are important elements.
New-product risk- it is the danger associated with the introduction of new products and services. Lower than anticipated demand, higher than anticipated cost, the lack of management talents in new markets can lead to severe problems with new products.
Technological risk- It refers to the risk that a delivery system may become inefficient
Strategic risk- it refers to the ability of the bank to select geographic and product areas that will be able for the bank in a complex future environment.

-The environmental risks include the following risk: defalcation, economic, competition, regulatory risk.
Defalcation risk- it is the risk of theft or fraud by the bank officer or employees
Economic risk—it is the risks associated with national and regional factors that can affect the bank performance.
-Competitive risk arises because more and more financial and non-financial firms can offer most bank products and services.
Regulatory risk- it involves living with some rules that place a bank at competitive disadvantages and ever present danger that legislators and regulators will change the rules in an unfavorable manner to the bank.

-Business risk
It is the risk that all the business line will succumb because of the competition. One example is that a bank is not ready or not able to become competitive in anew activity. Such as in the activity of cards issuance, some banks postponed this process and they could not earn a competitive advantage in this field. This conservatory attitude of waiting for the market itself to develop represent a risk

-Human resources risks
This represents the subtlest type of risk, very difficult to be measured, resulting from the personnel policy: recruitment, training, motivation and maintenance of specialists. If one specialists leaves, the whole activity is compromised

-Fraud risk
The fraud risk is defined as a deception or an act either by stating what is false or by suppression of the truth in order to deceive another, gain an advantage over another. The fraud does not represent a risk only for a bank but also for its depositors that entrusted their capital.

-Country risk
It is defined as the non-reimbursement act generated by an insolvency determined by the debtor’s financials position and not by the deterioration of his financial situation. It does not represent a credit risk because the debtors’ insolvency does not appear.
-Market risk
It refers to the unfavorable variations of the market value of the positions during minimum period of the time needed to the settlement of the positions. The market risk appears due to the fact that the prices of these financial values are determined and they are modified.


Explain how banks manage these risks [15 marks]
At the present time, there is no generally accepted system for risk management. By their nature commercials banks often their profit by performing their activity in certain segments of the market. Banks capacity to ensure against risks depends on:
 Capital size
 Its banks management quality
 Its technical expertise
 Personnel experience in their correspondent market segment.

Some of the prudential measures of taken by banks are:
 Bank must have clear policies, as well as risk measurement and control procedures
 Bank management must establish the internal limits of risks
 Periodical reports must be concluded, analysed and controlled.

Banks management of risks includes:

 The ALM is the unit in charge of managing the interest rate risk and liquidity of the bank.
Measure and control of risks:
- Compliance, Hedging
- Recommendations: balance sheet actions
- Transfer pricing systems
- Reporting to general management:

 Market Risk
Measure and control of risks
- Compliance, Monitoring, Hedging, Business actions
- Reporting to general management

 Risk Department
Monitoring and control of all risks:
- Credit & market, in addition to ALM, Decision-making, Credit policy, Setting limits
- Development of internal tools and risk data warehouses
- Risk-adjusted performances
- Portfolio actions
- Reporting to general management

 Portfolio Management
- Trading credit risk, Portfolio reporting, Portfolio restructuring, Securitizations, Portfolio actions
- Reporting to general management

 Control
- Accounting, Regulatory compliance, Cost accounting, Budgeting and planning, Monitoring and control
- Monitoring performances
- Reporting to general management

Doorvesh Bahadoor
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Re: Second forum

Post  Admin on Fri 23 Mar 2012 - 16:36


sorry sir, have been posting it to ur e mai address first

Analyse the various risks in banking. [15 marks]
The risks in banking
First of all, we should know what is a risk? – Danger that a certain unforeseen event can happen, which can ultimately generates randomness in cash flow. Risk definitions have gained precision over the years. Risk and uncertainty are risks that may be described using probability analysis (Business cycle, company failures), while events subject to uncertainty cannot (financial crises, wars etc.) On the other hand, risk and variability – variability alone may not involve risk as long as known for sure stake. The nature of qualitative asset transformation do gives rise to risks because of mismatched balance sheet. As a matter of fact, this discussion of risks in banking could not deny a brief assessment of issue of credit rationing which is an issue of both microeconomic and macroeconomic significance.


Main forms of risk

Credit risk – risk that party to contract fails to fully discharge terms of contract. Here, default triggers a total or partial loss of any amount lent to the counterparty. The view of credit risk differs for the banking portfolio and the trading portfolio. For the banking portfolio, credit risk is critical since the default of a small number of important customers can generate large losses, potentially leading to insolvency. There are various default events: delay in payment obligations; restructuring of debt obligations due to a major deterioration of the credit standing of the borrower; bankruptcies. Alternately, for the trading portfolio, capital markets value the credit risk of issuers and borrowers in prices. Unlike loans, the credit risk of traded debts is also indicated by the agencies’ ratings, assessing the quality of public debt issues, or through changes of the value of their stocks. In addition to that, credit risk is also visible through credit spreads, the add-ons to the risk-free rate defining the required market risk yield on debts.

Interest rate risk – risk deriving from variation of market prices owing to interest rate change. Legal and fiscal rules do make the measure of interest rate sensitivity of assets and liabilities to market rates more complex.

Market risk – more general term for risk of market price shifts. Earnings for the market portfolio are Profit and Loss (P&L) arising from transactions. The P&L between two dates is the variation of the market value. Any decline in value results in a market loss. The potential worst-case loss is higher when the holding period gets longer because market volatility tends to increase over longer horizons. However, it is possible to liquidate tradable instruments or to hedge their future changes of value at any time. This is the rationale for limiting market risk to the liquidation period. In general, the liquidation period varies with the type of instruments. It could be short (1 day) for foreign exchange and much longer for ‘exotic’ derivatives. The regulators provide rules to set the liquidation period. They use as reference a 10-day liquidation period and impose a multiple over banks’ internal measures of market value potential losses.


Liquidity risk – risk asset owner unable to recover full value of asset when sold (or for borrower, credit not rolled over).Liquidity risk is a financial risk due to uncertain liquidity. An institution might lose liquidity if its credit rating falls, it experiences sudden unexpected cash outflows problems, or some other event causes counterparties to avoid trading with or lending to the institution. A firm is also exposed to liquidity risk if markets on which it depends are subject to loss of liquidity.
Liquidity risk tends to compound other risks. If a trading organization has a position in an illiquid asset, its limited ability to liquidate that position at short notice will compound its market risk. Suppose a firm has offsetting cash flows with two different counterparties on a given day. If the counterparty that owes it a payment defaults, the firm will have to raise cash from other sources to make its payment. Should it be unable to do so, it too we default. Here, liquidity risk is compounding credit risk.

Market liquidity risk – risk that a traded asset market may vary in liquidity of the claims trade. Market liquidity is the ease of trading an asset. Its risk is the potential loss, because a security can only be traded at high or prohibitive costs. While the omnipresence and importance of market liquidity is widely acknowledged, it has long remained a more or less vague concept. Treatment of liquidity risk are said to be still under development.


Other risks
o operational risk
o risk of fraud
o reputation risk

Systemic risk – that the financial system may undergo contagious failure following other forms of shock/risk. Systemic risk may apply to a certain country or industry, or to the entire global economy. Researchers have shown that it is impossible to reduce systemic risk for the global economy (complete global shutdown is always theoretically possible), but one may mitigate other forms of systemic risk by buying different kinds of securities or by buying in different industries. For example, oil companies have the systemic risk that they will drill up all the oil in the world; an investor may mitigate this risk by investing in both oil companies and companies having nothing to do with oil. Systemic risk is also called systematic risk or undiversifiable risk.






Explain how banks manage these risks. [15marks]
Banks are forced to manage these risks as there are uncertain probability of default, given cost of bankruptcy, asymmetric information and incomplete contracts. And hence there is the importance of monitoring (moral hazard) and screening (adverse selection). Banks do analysis of financial statements, financial and operating information. They also consider the organization’s reputation, net worth, control and commitment as devices to reduce problems.

Banks as a financial intermediate do help by bringing the surpluses and deficits into contact. But this is done with a parallel view of making some positive yield. It also caters for loans and investments. Hence, loans and investments are both forms of debt finance – fixed return, sanctions for default.

Bank loan types are working capital, transactions, term loans, combinations, consumer loans, mortgages.
Bank securities types are of banker’s acceptances, CP, Government bonds and securitized loans

Credit analysis and credit information (screening)
Analysis seeks to assess ability and willingness of borrower to repay.
Underlying issue – bank owns asset while borrower buys call option and, thus banks view such point and assess the risks of trading with such individual or not.

As lending to an individual, trading organization or the state will be a form of debt finance. It is a normal that the credit movement has risks. As such it could cater for the factors of credit analysis and consequently consider the risks involved by the data received.

Capacity - legal and economic capacity to borrow.
Character – desire to repay judged by reputation, history of debt repayment
Capital - resolves agency problems arising from asymmetric information (more equity, less moral hazard - as call option is worth less - and signal of confidence in firm)
Collateral – asset on which bank has first claim if default occurs. Distinguish inside and outside collateral
Cost of collateral – repossession and monitoring costs
Benefits (i) Collateral can directly reduce bank risk
(ii) Signaling willingness to avoid risk (avoid adverse selection)
(iii) Avoid moral hazard problems such as asset substitution (borrower seek riskier projects owing to option), inadequate effort supply
Conditions - affecting borrower’s ability to repay

Sources of credit information
- Internal, interview, records, risk model
- External, e.g. financial statements of borrower. This can constitute the:
o Income statement for long term loan
o Balance sheet for short term loans

Customer relationships, risks could also be reduced by keeping a good customer relation. Link to “commitment” paradigm of intermediation. It reduces moral hazard as firm knows it will need the bank again. Need for the bank to commit itself to be time consistent.
Private information reusability
- Reduces costs for bank
- Improved credit terms
- Facilitates debt restructuring rather than bankruptcy
- Could lead to exploitation of borrower

As Reference:
Risk in lending did caused the Swedish banking crisis
Financial liberalization – banks and authorities unfamiliar with liberalized regime

Growth in bank lending (140% 1985-90) and private sector debt, particular focus on real estate lending, encouraged by tax deductibility

Market share competition among banks

Shocks - global recession, high interest rates to hold exchange rate, tax reform abolishing interest deductibility

Majority of banks insolvent, non performing assets 14% of GDP

Cost of public rescue 4.5% of GDP

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Re: Second forum

Post  Admin on Fri 23 Mar 2012 - 16:41

Analyse the various risks in banking. [15 marks]
The risks in banking
First of all, we should know what is a risk? – Danger that a certain unforeseen event can happen, which can ultimately generates randomness in cash flow. Risk definitions have gained precision over the years. Risk and uncertainty are risks that may be described using probability analysis (Business cycle, company failures), while events subject to uncertainty cannot (financial crises, wars etc.) On the other hand, risk and variability – variability alone may not involve risk as long as known for sure stake. The nature of qualitative asset transformation do gives rise to risks because of mismatched balance sheet. As a matter of fact, this discussion of risks in banking could not deny a brief assessment of issue of credit rationing which is an issue of both microeconomic and macroeconomic significance.


Main forms of risk

Credit risk – risk that party to contract fails to fully discharge terms of contract. Here, default triggers a total or partial loss of any amount lent to the counterparty. The view of credit risk differs for the banking portfolio and the trading portfolio. For the banking portfolio, credit risk is critical since the default of a small number of important customers can generate large losses, potentially leading to insolvency. There are various default events: delay in payment obligations; restructuring of debt obligations due to a major deterioration of the credit standing of the borrower; bankruptcies. Alternately, for the trading portfolio, capital markets value the credit risk of issuers and borrowers in prices. Unlike loans, the credit risk of traded debts is also indicated by the agencies’ ratings, assessing the quality of public debt issues, or through changes of the value of their stocks. In addition to that, credit risk is also visible through credit spreads, the add-ons to the risk-free rate defining the required market risk yield on debts.

Interest rate risk – risk deriving from variation of market prices owing to interest rate change. Legal and fiscal rules do make the measure of interest rate sensitivity of assets and liabilities to market rates more complex.

Market risk – more general term for risk of market price shifts. Earnings for the market portfolio are Profit and Loss (P&L) arising from transactions. The P&L between two dates is the variation of the market value. Any decline in value results in a market loss. The potential worst-case loss is higher when the holding period gets longer because market volatility tends to increase over longer horizons. However, it is possible to liquidate tradable instruments or to hedge their future changes of value at any time. This is the rationale for limiting market risk to the liquidation period. In general, the liquidation period varies with the type of instruments. It could be short (1 day) for foreign exchange and much longer for ‘exotic’ derivatives. The regulators provide rules to set the liquidation period. They use as reference a 10-day liquidation period and impose a multiple over banks’ internal measures of market value potential losses.


Liquidity risk – risk asset owner unable to recover full value of asset when sold (or for borrower, credit not rolled over).Liquidity risk is a financial risk due to uncertain liquidity. An institution might lose liquidity if its credit rating falls, it experiences sudden unexpected cash outflows problems, or some other event causes counterparties to avoid trading with or lending to the institution. A firm is also exposed to liquidity risk if markets on which it depends are subject to loss of liquidity.
Liquidity risk tends to compound other risks. If a trading organization has a position in an illiquid asset, its limited ability to liquidate that position at short notice will compound its market risk. Suppose a firm has offsetting cash flows with two different counterparties on a given day. If the counterparty that owes it a payment defaults, the firm will have to raise cash from other sources to make its payment. Should it be unable to do so, it too we default. Here, liquidity risk is compounding credit risk.

Market liquidity risk – risk that a traded asset market may vary in liquidity of the claims trade. Market liquidity is the ease of trading an asset. Its risk is the potential loss, because a security can only be traded at high or prohibitive costs. While the omnipresence and importance of market liquidity is widely acknowledged, it has long remained a more or less vague concept. Treatment of liquidity risk are said to be still under development.


Other risks
o operational risk
o risk of fraud
o reputation risk

Systemic risk – that the financial system may undergo contagious failure following other forms of shock/risk. Systemic risk may apply to a certain country or industry, or to the entire global economy. Researchers have shown that it is impossible to reduce systemic risk for the global economy (complete global shutdown is always theoretically possible), but one may mitigate other forms of systemic risk by buying different kinds of securities or by buying in different industries. For example, oil companies have the systemic risk that they will drill up all the oil in the world; an investor may mitigate this risk by investing in both oil companies and companies having nothing to do with oil. Systemic risk is also called systematic risk or undiversifiable risk.






Explain how banks manage these risks. [15marks]
Banks are forced to manage these risks as there are uncertain probability of default, given cost of bankruptcy, asymmetric information and incomplete contracts. And hence there is the importance of monitoring (moral hazard) and screening (adverse selection). Banks do analysis of financial statements, financial and operating information. They also consider the organization’s reputation, net worth, control and commitment as devices to reduce problems.

Banks as a financial intermediate do help by bringing the surpluses and deficits into contact. But this is done with a parallel view of making some positive yield. It also caters for loans and investments. Hence, loans and investments are both forms of debt finance – fixed return, sanctions for default.

Bank loan types are working capital, transactions, term loans, combinations, consumer loans, mortgages.
Bank securities types are of banker’s acceptances, CP, Government bonds and securitized loans

Credit analysis and credit information (screening)
Analysis seeks to assess ability and willingness of borrower to repay.
Underlying issue – bank owns asset while borrower buys call option and, thus banks view such point and assess the risks of trading with such individual or not.

As lending to an individual, trading organization or the state will be a form of debt finance. It is a normal that the credit movement has risks. As such it could cater for the factors of credit analysis and consequently consider the risks involved by the data received.

Capacity - legal and economic capacity to borrow.
Character – desire to repay judged by reputation, history of debt repayment
Capital - resolves agency problems arising from asymmetric information (more equity, less moral hazard - as call option is worth less - and signal of confidence in firm)
Collateral – asset on which bank has first claim if default occurs. Distinguish inside and outside collateral
Cost of collateral – repossession and monitoring costs
Benefits (i) Collateral can directly reduce bank risk
(ii) Signaling willingness to avoid risk (avoid adverse selection)
(iii) Avoid moral hazard problems such as asset substitution (borrower seek riskier projects owing to option), inadequate effort supply
Conditions - affecting borrower’s ability to repay

Sources of credit information
- Internal, interview, records, risk model
- External, e.g. financial statements of borrower. This can constitute the:
o Income statement for long term loan
o Balance sheet for short term loans

Customer relationships, risks could also be reduced by keeping a good customer relation. Link to “commitment” paradigm of intermediation. It reduces moral hazard as firm knows it will need the bank again. Need for the bank to commit itself to be time consistent.
Private information reusability
- Reduces costs for bank
- Improved credit terms
- Facilitates debt restructuring rather than bankruptcy
- Could lead to exploitation of borrower

As Reference:
Risk in lending did caused the Swedish banking crisis
Financial liberalization – banks and authorities unfamiliar with liberalized regime

Growth in bank lending (140% 1985-90) and private sector debt, particular focus on real estate lending, encouraged by tax deductibility

Market share competition among banks

Shocks - global recession, high interest rates to hold exchange rate, tax reform abolishing interest deductibility

Majority of banks insolvent, non performing assets 14% of GDP

Cost of public rescue 4.5% of GDP
TREEBHOWON DHEERAJ(111444)

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Re: Second forum

Post  Admin on Fri 23 Mar 2012 - 16:59

Question 1.

The Federal Reserve System has established a banking risk framework that consists of these risk factors:

1.Credit risk ;

The potential for loss due to failure of a borrower to meet its contractual obligation to repay a
debt in accordance with the agreed terms.Credit events include bankruptcy, failure to pay, loan restructuring, loan moratorium, accelerated loan payment. For banks, credit risk typically resides in the assets in its banking book (loans and bonds held to maturity.


2.Market risk;

Market risk is the potential loss due to changes in market prices or values. Market Risk may be defined as the possibility of loss to bank caused by the changes in the market variables. It is the risk that the value of on-/off-balance sheet positions will be adversely affected by movements in equity and interest rate markets, currency exchange rates and commodity prices. Market risk is the risk to the bank’s earnings and capital due to changes in the market level of interest rates or prices of securities, foreign exchange and equities, as well as the volatilities, of those prices. Market Risk Management provides a comprehensive and dynamic frame work for measuring, monitoring and managing liquidity, interest rate, foreign exchange and
equity as well as commodity price risk of a bank that needs to be closely integrated with the bank’s business strategy.
Scenario analysis and stress testing is yet another tool used to assess areas of potential problems in a given portfolio. Identification of future changes in economic conditions like – economic/industry overturns, market risk events, liquidity conditions etc that could have unfavourable effect on bank’s portfolio is a condition precedent for carrying out stress testing. As the underlying assumption keep changing from time to time, output of the test should be reviewed periodically as market risk management system should be responsive and sensitive to the happenings in the market.

a) Liquidity risk,

Bank Deposits generally have a much shorter contractual maturity than loans and liquidity management needs to provide a cushion to cover anticipated deposit withdrawals. Liquidity is the ability to efficiently accommodate deposit as also reduction in liabilities and to fund the loan growth and possible funding of the off-balance sheet claims. The cash flows are placed in different time buckets based on future likely behaviour of assets, liabilities and off-balance sheet items. Liquidity risk consists of Funding Risk, Time Risk & Call Risk.

Funding Risk : It is the need to replace net out flows due to unanticipated withdrawal/nonrenewal of deposit

Time risk : It is the need to compensate for nonreceipt of expected inflows of funds,i.e. performing assets turning into nonperforming assets.

Call risk : It happens on account of crystalisation of contingent liabilities and inability to undertake profitable business opportunities when desired.



b) Interest Rate Risk

Interest Rate Risk is the potential negative impact on the Net Interest Income and it refers to the vulnerability
of an institution’s financial condition to the movement in interest rates. Changes in interest rate affect earnings,
value of assets, liability off-balance sheet items and cash flow. Hence, the objective of interest rate risk management is to maintain earnings, improve the capability, ability to absorb potential loss and to ensue the adequacy of the compensation received for the risk taken and effect risk return trade-off.



3.Operational risk,
Always banks live with the risks arising out of human error, financial fraud and natural disasters. The recent happenings such as WTC tragedy, Barings debacle etc. has highlighted the potential losses on account of operational risk. Exponential growth in the use of technology and increase in global financial inter-linkages are the two primary changes that contributed to such risks. Operational risk, though defined as any risk that is not categorized as market or credit risk, is the risk of loss arising from inadequate or failed internal processes, people and systems or from external events. In order to mitigate this, internal control and internal audit systems are used as the primary means.Risk education for familiarizing the complex operations at all levels of staff can also reduce operational risk. Insurance cover is one of the important mitigators of operational risk. Operational risk events are associated with weak links in internal control procedures. The key to management of operational risk lies in the bank’s ability to assess its process for vulnerability and establish controls as well as safeguards while providing for unanticipated worst-case scenarios. Operational risk involves breakdown in internal controls and corporate governance leading to error, fraud, performance failure, compromise on the interest of the bank
resulting in financial loss. Putting in place proper corporate governance practices by itself would serve as an effective
risk management tool. Bank should strive to promote a shared understanding of operational risk within the organization, especially since operational risk is often interwined with market or credit risk and it is difficult to isolate.


4.Foreign exchange risk,

Foreign exchange risk is the risk that a bank may suffer loss as a result of adverse exchange rate movement during a period in which it has an open position, either spot or forward or both in same foreign currency. Even in case where spot or forward positions in individual currencies are balanced the maturity pattern of forward transactions may produce mismatches. There is also a settlement risk arising out of default of the counter party and out of time lag in settlement of one currency in one
center and the settlement of another currency in another time zone. Banks are also exposed to interest rate risk, which arises from the maturity mismatch of foreign currency position. The Value at Risk (VaR) indicates the risk that the bank is exposed due to uncovered position of mismatch and these gap positions are to be valued on daily basis at the prevalent forward market rates announced by FEDAI for the remaining maturities. Currency Risk is the possibility that exchange rate
changes will alter the expected amount of principal and return of the lending or investment. At times, banks may
try to cope with this specific risk on the lending side by shifting the risk associated with exchange rate fluctuations to the borrowers. However the risk does not get extinguished, but only gets converted in to credit risk. By setting appropriates limits-open position and gaps, stop-loss limits, Day Light as well as overnight limits for each currency, Individual Gap Limits and Aggregate Gap Limits, clear cut and well defined division of responsibilities between front, middle and back office the risk element in foreign exchange risk can be managed/monitored.


5.Solvency risks;

This relates to the risk of having insufficient capital to cover losses generated by all types of risks, and is thus effectively the risk of default of the bank. From a regulatory viewpoint, the issue of adequate capital is critically
important for the stability of the banking system. The regulatory approach to ensuring sufficient capital to minimise banks’ solvency risk was discussed in detail in Chapter 2.To address solvency risk, it is necessary to define the level of capital which is appropriate for given levels of overall risk. The key principles involved can be summarised as follows:
• Risks generate potential losses.
• The ultimate protection for such losses is capital.
• Capital should be adjusted to the level required to ensure capability to absorb the potential losses generated by all risks.To implement the latter, all risks should be quantified in terms of potential losses, and a measure of aggregate potential losses should be derived from the potential losses of all component risks.


6.Country risk;

Another type of risk that is important in international banking is country risk. Country risk refers to the ability and willingness of borrowers within a country to meet their obligations. It is thus a credit risk on obligations
advanced across borders. Assessment of country risk relies on the analysis of economic, social and political variables that relate to the particular country in question. Although the economic factors can be measured objectively, the
social and political variables will often involve subjective judgments.Country risk can be categorised under two headings. The first sub-category of country risk is sovereign risk, which refers to both the risk of default by a sovereign government on its foreign currency obligations, and the risk that direct or indirect actions by the sovereign government may affect
the ability of other entities in that country to use their available funds to meet foreign currency debt obligations. In the former case, sovereign risk addresses the credit risk of national governments, but not the specific
default risks of other debt issuers. Here, credit risk relates to two key aspects: economic risk, which addresses the government’s ability to repay its obligations on time, and political risk, which addresses its willingness to
repay debt. In practice, these risks are related, since a government that is unwilling to repay debt is often pursuing economic policies that weaken its ability to do so.


7.Systemic risk.
This is when the financial system may undergo contagious failure following other forms of shock/risk

Question 2.

1) Credit Risk Management.

The instruments and tools, through which credit risk
management is carried out, are detailed below:

a) Exposure Ceilings:

Prudential Limit is linked to Capital Funds – say 15% for individual borrower entity, 40% for a group with additional 10% for infrastructure projects undertaken by the group,Threshold limit is fixed at a level lower than
Prudential Exposure; Substantial Exposure, which is the sum total of the exposures beyond threshold limit should not exceed 600% to 800% of the Capital Funds of the bank (i.e. six to eight times).

b) Review/Renewal:
Multi-tier Credit Approving
Authority, constitution wise delegation of powers, Higher delegated powers for better-rated customers; discriminatory time schedule for review/renewal, Hurdle rates and Bench marks for fresh exposures and periodicity for renewal based on risk rating, etc are formulated.

c) Risk Rating Model:
Set up comprehensive risk scoring system on a six to nine point scale. Clearly define rating thresholds and review the ratings periodically preferably at half yearly intervals. Rating migration is to be mapped to estimate the expected loss.

d) Risk based scientific pricing:
Link loan pricing to expected loss. High-risk category borrowers are to be priced high. Build historical data on default losses. Allocate capital to absorb the unexpected loss. Adopt the RAROC framework.

e) Portfolio Management :

The need for credit portfolio management emanates from the necessity to optimize the benefits associated with diversification and to reduce the potential adverse impact of concentration of exposures to a particular borrower, sector or industry. Stipulate quantitative ceiling on aggregate exposure on specific rating categories, distribution of borrowers in various industry, business group and conduct rapid portfolio reviews. The existing framework of tracking the non-performing loans around the balance sheet date does not signal the quality of the entire loan book. There should be a proper & regular on-going system for identification of credit weaknesses well in advance. Initiate steps to preserve the desired portfolio quality and integrate portfolio reviews with credit decision-making process.

f) Loan Review Mechanism :
This should be done independent of credit operations. It is also referred as Credit Audit covering review of sanction process, compliance status, review of risk rating, pick up of warning signals and recommendation of corrective action with the objective of improving credit quality. It should target all loans above certain cut-off limit ensuring that at least
30% to 40% of the portfolio is subjected to LRM in a year so as to ensure that all major credit risks embedded in the balance sheet have been tracked. This is done to bring about qualitative improvement in credit administration. Identify loans with credit weakness. Determine adequacy of loan loss provisions. Ensure adherence to lending policies and procedures. The focus of the credit audit needs to be broadened from account level to overall portfolio level. Regular, proper & prompt
reporting to Top Management should be ensured.Credit Audit is conducted on site, i.e. at the branch that has appraised the advance and where the main operative limits are made available. However, it is not required to visit borrowers factory/office premises.


2) Market Risk Management:


i) Liquidity risk management


The Asset Liability Management (ALM) is a part of the overall risk management system in the banks. It implies examination of all the assets and liabilities simultaneously on a continuous basis with a view to ensuring a proper balance between funds mobilization and their deployment with respect to their
a) maturity profiles,
b) cost,
c) yield,
d) risk exposure, etc.
It includes product pricing for deposits as well as advances, and the desired maturity profile of assets and liabilities. Tolerance levels on mismatches should be fixed for various maturities depending upon the asset liability profile, deposit mix, nature of cash flow etc. Bank should track the impact of pre-payment of loans & premature closure of deposits so as to realistically estimate the cash flow profile.



ii) Interest rate risk management

Management of interest rate risk aims at capturing the risks arising from the maturity and re-pricing mismatches and is measured both from the earnings and economic value perspective.Earnings perspective involves analyzing the impact of
changes in interest rates on accrual or reported earnings in the near term. This is measured by measuring the changes in
the Net Interest Income (NII) equivalent to the difference between total interest income and total interest expense.
In order to manage interest rate risk, banks should begin evaluating the vulnerability of their portfolios to
the risk of fluctuations in market interest rates. One such measure is Duration of market value of a bank asset or
liabilities to a percentage change in the market interest rate. The difference between the average duration for
bank assets and the average duration for bank liabilities is known as the duration gap which assess the bank’s
exposure to interest rate risk. The Asset Liability Committee (ALCO) of a bank uses the information contained in the duration gap analysis to guide and frame strategies. By reducing the size of the duration gap, banks can minimize the interest rate risk.


3. Foreign Exchange risk


Currency Risk is the possibility that exchange rate changes will alter the expected amount of principal and
return of the lending or investment. At times, banks may try to cope with this specific risk on the lending side by
shifting the risk associated with exchange rate fluctuations to the borrowers. However the risk does not get extinguished, but only gets converted in to credit risk. By setting appropriates limits-open position and gaps,stop-loss limits, Day Light as well as overnight limits for each currency, Individual Gap Limits and Aggregate Gap Limits, clear cut and well defined division of responsibilities between front, middle and back office the risk element in foreign exchange risk can be managed/monitored.


4. Operational Risk Management

Over a period of time, management of credit and market risks has evolved a more sophisticated fashion than operational risk, as the former can be more easily measured, monitored and analysed. And yet the root causes of all the financial scams and losses are the result of operational risk caused by breakdowns in internal control mechanism and staff lapses. So far, scientific measurement of operational risk has not been evolved. Hence 20% charge on the Capital Funds is earmarked for operational risk and based on subsequent data/feedback, it was reduced to 12%. While measurement of operational risk and computing capital charges as envisaged in the Basel proposals are to be the ultimate goals, what is to be done at present is start implementing the Basel proposal in a phased manner and carefully plan in that direction. The incentive for banks to move the measurement chain is not just to reduce regulatory capital but more importantly to provide assurance to the top management that the bank holds the required capital.

Basel's new capital accord

Bankers’ for International Settlement (BIS) meet at Basel situated at Switzerland to address the common issues concerning bankers all over the world. The Basel Committee on Banking Supervision (BCBS) is a committee of banking supervisory authorities of G-10 countries and has been developing standards and establishment of a framework for bank supervision towards
strengthening financial stability through out the world. In consultation with the supervisory authorities authorities of a few non-G-10 countries including India, core principles for effective banking supervision in the form of minimum requirements to strengthen current supervisory regime, were mooted. The 1988 Capital Accord essentially provided only one option for measuring the appropriate capital in relation to the risk-weighted assets of the financial institution. It focused on the total amount of bank capital so as to reduce the risk of bank solvency at the potential cost of bank’s failure for the depositors. As an improvement on the above, the New Capital Accord was published in 2001, to be implemented by the financial year 2003-04. It provides spectrum of approaches for the measurement of credit, market and operational risks to determine the capital required. The spread and nature of the ownership structure is important as it impinges on the propensity to induct additional capital. While getting support from a large body of shareholders is a difficult proposition when the bank’s
performance is adverse, a smaller shareholder base constrains the ability of the bank to garner funds. Tier I capital is not owed to anyone and is available to cover possible unexpected losses. It has no maturity or repayment requirement, and is expected to remain a permanent component of the core capital of the counter party. While Basel standards currently require banks to have a capital adequacy ratio of 8% with Tier I not less than 4%, RBI has mandated the banks to maintain CAR of 9%. The maintenance of capital adequacy is like aiming at a moving target as the composition of risk-weighted assets gets
changed every minute on account of fluctuation in the risk profile of a bank. Tier I capital is known as the core capital providing permanent and readily available support to the bank to meet the unexpected losses. In the recent past, owner of PSU banks, the government provided capital in good measure mainly to weaker banks. In doing so, the government was not acting as a prudent investor as return on such capital was never a consideration. Further, capital infusion did not result in
any cash flow to the receiver, as all the capital was required to be reinvested in government securities yielding low
interest. Receipt of capital was just a book entry with the only advantage of interest income from the securities.


Ashneema Seebun
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Re: Second forum

Post  Admin on Fri 23 Mar 2012 - 17:11

(i) Analyse the various risks in banking [15 marks]

The very nature of core banking activities involves risk taking and risk management remains a banking process. Banks in their role of financial intermediaries migrate risk from fund lenders onto themselves prior to allocating capital resources to seekers. Investment banking, bancassurance, portfolio management, equity trading and derivatives trading would require banks to shift their risk appetite level to accommodate these exposures in their quest for increasing profitability and shareholders’ wealth. Banks are exposed to two types of risks – (i) Financial and (ii) Non-financial risks.

This dichotomy of banking risks classifies exposures as follows:

Financial Risks:

1. Credit Risk,
Exposure arising due to counterparty’s misperformance and/or failure to honour contractual debt agreement.

2. Liquidity Risk,
Exposure arising in the case that risk asset owner unable to recover full value of asset when sold or can also be deemed as recurring traces balance sheet illiquidity which restrains banks from complying to their financial commitments.

3. Market Risk,
Exposure arising due to adverse shifts in asset prices and/or trading portfolios.

4. Interest Rate Risk,
Exposure arising due to volatility in interest rates (linked to interest-bearing instruments).

5. FOREX Risk,
Exposure emanating from fluctuations in the price of currency pairs (linked to Net Open Positions taken and Revaluation Rates).

6. Solvency Risk,
Risk of having insufficient/limited capital to cushion losses generated by all types of risks – banking default risk.

7. Sovereign Risk,
Exposure that arises if a foreign central bank will alter its foreign-exchange regulations thereby significantly reducing or completely nulling the value of foreign-exchange contracts.

Non-financial Risks:

1. Operational Risk,
Risk that arises from deficiencies in the banks internal systems, procedures and processes – include technological risk, staff risk and model risk.

2. Regulatory/Compliance Risk,
Exposure arising due to failure to comply to regulatory requirements.

3. Legal Risk,
Risk arising due to non-compliance to statutory and/or contractual requirements that triggers legal costs or penalties.

4. Reputational Risk,
Reputational risk in banking and financial services is associated with the possibility of loss in the going-concern value of the financial intermediary.

5. Herstatt/Settlement Risk,
Risk that a counterparty does not deliver a security or its value in cash as per agreement when the security was traded after the other counterparty or counterparties have already delivered security or cash value as per the trade agreement.

6. Country Risk
Exposure that refers to the risk of investing in a country – includes prevailing political risk, economic risk and environmental risk factors.


(ii) Explain how banks manage these risks [15 marks]

The aftermath of the global financial crisis taught the importance of having sound and comprehensive risk governance. In addition to being a regulatory requirement in most jurisdictions, risk management not only allows banks to identify risks – their causes and potent mitigations but also to direct capital resources to the best bundles of risk-reward ratios.

Bank risk mitigation strategies include the following:

1) Credit Risk Management –

The management of credit risk includes:
i. Measurement and appraisal through credit rating/ scoring model,
ii. Default exposure quantification through estimate of potential future exposures (PFEs),
iii. Exposure ceilings,
iv. Collateral and covenants enforcement,
v. Use of credit derivatives.


2) Liquidity Risk Management –

The Asset Liability Management (ALM) is a risk management tool used to circumvent illiquidity issues. Banks use ALM to match their balance sheets’ Assets and Liquidity sides. ALM requires all the assets and liabilities are examined to be properly balanced and matched. Assets and liabilities are aligned in terms of:
(i) Time horizons,
(ii) Yield,
(iii) Risk exposure,
(iv) Size.

Asset-liability mismatches may cause liquidity problems, (which can be further worsened by high credit risk) and trigger bank runs; thus exposing banks to systemic risk.

3) Interest Rate Risk Management –

Interest rate exposure can be measured and monitored by following tools:
(i) Maturity Gap Analysis,
(ii) Duration Gap Analysis,
(iii) Simulation/forecasting of future money market rates,
(iv) Value-at-risk computation.

Interest rate risk is contained by using the accounting principle of bifurcating interest-bearing balance sheet instruments, based on their maturity profiles, into either the short/medium term Trading Book or the longer term Banking Book. Trading Book would hold short maturity items for profit generation and realization while the Banking Book would contain items contracted basically on account of relationship or for steady income and statutory obligations and are generally held till maturity/payment by counter party.

4) FOREX Risk Management –

FX Exposure is managed by setting appropriates limits-open position and gaps, stop-loss limits, Day Light as well as overnight limits for each currency, Individual Gap Limits and Aggregate Gap Limits, clear cut and well defined division of responsibilities between front, middle and back office the risk element in foreign exchange risk can be managed/monitored. Hedging techniques can be used through the use of derivatives.

5) Operational Risk Management –

Operational Risk exposure is monitored and mitigated by the establishing proper controls and key risk indicators around mission critical processes around banking procedures and core activities. Controls would include segregation of duties, use of the four-eye principle, oversight from Risk integrity and auditors, regular assessments of and permanent stress-testing on control areas.

6) Legal/ Regulatory Risk Management –

Examining of regulatory universe to enforce compliance.
Keshav Seetaram(111440)

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Re: Second forum

Post  Admin on Fri 23 Mar 2012 - 17:33

Please read chapter 2 of this book and do some research on the internet + answer the following:

1. Analyse the various risks in banking [15 marks]

Financial risk

• Credit risk is the risk that the counterparty to a financial transaction (‘the borrower’) will fail to comply with its obligations to service debt, or that the counterparty will deteriorate in its credit standing.

• Liquidity risk covers all risks that are associated with a bank finding itself unable to meet its commitments on time, or only being able to do so by recourse to emergency borrowing.

• Interest rate risk relates to risk of loss incurred due to changes in market rates, for example, through reduced interest margins on outstanding loans or reduction in the capital values of marketable assets.

• Market risk relates to risk of loss associated with adverse deviations in the value of the trading portfolio.

• Country risk is associated with the risks of incurring financial losses resulting from the inability and/or unwillingness of borrowers within a country to meet their obligations.

• Solvency risk relates to the risk of having insufficient capital to cover losses generated by all types of risks.

Non-financial risk

1. Operational risk
An operational risk is a risk arising from execution of a company's business functions. It is a very broad concept which focuses on the risks arising from the people, systems and processes through which a company operates. It also includes other categories such as fraud risks, legal risks, physical or environmental risks.
2. Systemic risk
Systemic risk is the risk of collapse of an entire financial system or entire market, as opposed to risk associated with any one individual entity, group or component of a system. It can be defined as "financial system instability, potentially catastrophic, caused or exacerbated by idiosyncratic events or conditions in financial intermediaries". It refers to the risks imposed by interlinkages and interdependencies in a system or market, where the failure of a single entity or cluster of entities can cause a cascading failure, which could potentially bankrupt or bring down the entire system or market


3.Technology Risk

Technology permeates the operations of an entire institution and therefore technology risk cannot be compartmentalized as a process that focuses on a particular area. Technology enables key processes that a company uses to develop, deliver, and manage its products, services, and support operations.



2. Explain how banks manage these risks [15 marks]

How to manage financial risk?
Credit Risk Management
Credit Risk Covers techniques for measuring credit risk for derivative products and techniques for the mitigation of pre-settlement/settlement risks such as netting, margin and collateral requirements.


Market Risk Management
Market Risk Management cover overs the various sources of market risk, which include Interest Rate Risk, Foreign Exchange Risk, Equity Risk and Commodity Risk. Introduces the learner to ways of measuring market risk using Value at Risk (VaR).



Liquidity risk management

Before the crisis, the management of liquidity risks was not an issue because banks were accustomed to a functioning interbank money market which usually was a reliable source for short-term funding. Nowadays sound liquidity risk management has gained significant importance and is emphatically required by public and regulators. All firms active in the financial markets should be equipped with an adequate framework to identify measure, manage and monitor their liquidity risks. The aims of a comprehensive liquidity risk management, based on a well-founded knowledge and understanding of the institution's liquidity profile, are included in (but not limited to) the following aspects:
• Securing the institution's ability to meet its financial obligations at all times, and possessing a graduated and detailed plan for different stress situations at hand
• Creation of revenue possibilities by controlled maturity transformation and resulting in applicable steering recommendations
• Optimisation of liquidity costs (e.g. the composition of the liquidity buffer)

How to manage non-financial risk?

Operational Risk Management
Operational Risk Management helps the learner comprehend aspects of Operational Risk such as Methodology, Risk Mitigation, Measuring and Managing Operational Risk. It helps to understand Risk Models, Legal Risk, Emerging Challenges and Operational Risk Systems and Software.


Systematic risk management

Systematic risk management is expecting the unexpected – it is a tool which helps control risks in construction projects. Its objective is to introduce a simple, practical method of identifying, assessing, monitoring and managing risk in an informed and structured way. It provides guidance for implementing a risk control strategy that is appropriate to control construction projects at all levels.

Technology Risk Management

An effective risk management process is an important component of a successful IT security program. The principal goal of an organization’s risk management process should be to protect the organization and its ability to perform their mission, not just its IT assets. Therefore, the risk management process should not be treated primarily as a technical function carried out by the IT experts who operate and manage the IT system, but as an essential management function of the organization.







Regards,
SOODEELAH Kaleendee


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Re: Second forum

Post  Admin on Fri 23 Mar 2012 - 19:08

1. Analyse the various risks in banking.

Risk is inherent in any walk of life in general and in financial sectors in particular. Till recently, due to regulated environment, banks could not afford to take risks. Banks are exposed to same competition and hence are compeled to encounter various types of financial and non-financial risks.

Credit risk
It is the first of all risks in terms of importance. Default risk, it is a major source of loss that customers fail to comply to service debt. It is a total or partial loss of any amount lent to the customers. It is an investors risk of loss arising from a borrower who does not make payments on time.

Liquidity risk
It refers to multiple dimensions, the inability to raise funds at normal cost. It is the risk that a given security or asset cannot be traded quickly enough in the market to prevent a loss. A type of liquidity is the market liquidity- an asset cannot be sold due to lack of liquidity in the market essentially a sub set of market risk.

Market risk
It is the risk that is associated with adverse deviations in the value of the trading of port folio and will decrease due to the change in value of the market risk factors.

Foreign exchange risk
The currency risk is that of incurring losses due to changes in exchange rates. For example, if money must be converted to another currency to make a certain investment, then any changes in the currency exchange rate will cause that investment's value to either decrease or increase when the investment is sold and converted back into the original currency.

Solvency risk
it relates to risks of having insufficient capital to cover losses generated by all types of risks.


2. Explain how banks manage these risks.

The instruments and tools, through which credit risk management is carried out, are:

1. Exposure Ceiling
2. Review/Renewal
3. Risk Rating Model
4. Risk based scientific pricing
5. Portfolio Management
6. Loan Review Mechanism

Interest rate risk management

A maturity mismatch approach is a commonly used tool to measure a banking company’s exposure to interest rate risk. Interest rate risk occurs when a banking company is exposed to operating gains and losses arising because the maturities of its fixed-rate assets and liabilities do not match.

At times, banks may try to cope with this specific risk on the lending side by shifting the risk associated with exchange rate fluctuations to the borrowers. However the risk does not get extinguished, but only gets converted in to credit risk. The bank can take risk more consciously, anticipates adverse changes and hedges accordingly, it becomes a source of competitive advantage, as it can offer its products at a better price than its competitors. The effectiveness of risk measurement in banks depends on efficient Management Information System,computerization and net working of the branch activities. The data warehousing solution should effectively interface with the transaction systems like core banking solution and risk systems to collate data.

Regards from
Beekarry Dhiraj



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Re: Second forum

Post  Admin on Fri 23 Mar 2012 - 19:19

(i) Analyse the various risks in banking.
Banking risks are defined as adverse impacts on profitability of several distinct sources
of uncertainty. There rae two types of risks nanmely financial and non-financial risk:
• Financial Risk
• Non-financial Risk
Financial risk is further subdivided into several categories:
 Credit Risk
Credit risk is the first of all risks in terms of importance. Default risk, a major source of loss, is the risk that customers default, meaning that they fail to comply with their obligations to service debt.
 Market risk
Market risk is the risk of adverse deviations of the mark-to-market value of the trading portfolio, due to market movements, during the period required to liquidate the transactions.
 Interest rate risk
It relates to risk of loss incurred due to changes in market rates for example through reduced interest margins on outstanding loans.
 Liquidity risk
Liquidity risk covers all risks that are associated with a bank finding itself unable to meet its commitments on time, or only being able to do so by recourse to emergency borrowing.
 Solvency risk
Solvency risk is the risk of being unable to absorb losses, generated by all types of risks, with the available capital.
 Foreign exchange risk
Foreign exchange risk is the risk that a bank may suffer loss as a result of adverse exchange rate movement during a period in which it has an open position, either spot or forward or both in same foreign currency.
Non-financial Risks are:
 Operational risk
Operational risk involves breakdown in internal controls and corporate governance leading to error, fraud, performance failure, compromise on the interest of the bank resulting in financial loss.
 Technological risk
It refers to the risk that a delivery system may become inefficient because of new technologies and that the technologies in place have become outdated.
 Systemic risk
Systemic risk is the risk of collapse of an entire financial system or entire market, as opposed to risk associated with any one individual entity, group or component of a system.
 Country Risk
This is the risk that arises due to cross border transactions that are growing dramatically in the recent years owing to economic liberalization and globalization.


(ii) Explain how banks manage these risks.
Commercial banks are in the risk business. In the process of providing financial services, they assume
various kinds of financial risks as well as non-financial risk such as:
 Credit Risk Management
Banks can use these different methods to manage credit risk:
• Exposure Ceilings
• Portfolio Management
• Risk Rating Model
• Risk based scientific pricing
• Loan Review Mechanism

 Liquidity Risk Management
The Asset Liability Management (ALM) is a part of the overall risk management system in the banks. Examination of all the assets and liabilities simultaneously on a continuous basis to ensure proper balance between funds mobilization and their deployment with respect to:
i) Yield
ii) Risk exposure
iii) Maturity profiles

 Operational Risk Management
The general principle for operational risk management is to access the like-lihood and cost of adverse events. Data gathering process, data analysis and statically techniques help in finding core relation and drivers of risk. There should be expert judgments, possible operational events and their implications, pooling data from insurance costs and other institutions related to event frequencies and cost.
 Interest Rate Risk Management
Interest rate is a key in the banking sector. It is important to know because it is the interest rate that determines profits or losses of the institution. Interest rate risk management approaches allow banks to contain potential risks and predict the types of effects interest rate changes will have over different periods of time.
 FOREX Risk Management
To determine the various exchange risks which the treasurer of the selected bank is exposed to in its foreign exchange transaction and to investigate how these risks can be effectively managed and to identify risk and exposure management. Techniques required for treasury management.

Regards,
Abdel Sahebally
Id : 111437

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Re: Second forum

Post  Admin on Fri 23 Mar 2012 - 19:21

Sorry sir for the delay I have a problem with my internet connection which was very slow and I hope you understand me
(i) Analyse the various risks in banking
Banks face a number of risks in order to conduct their business, and how well these risks are managed and understood is a key driver behind profitability, and how much capital a bank is required to hold. It is divided into two parts, that is, financial risks and non-financial risks.

Financial risks which include:
• Credit risk is the risk of loss arising from the borrower who does not make payments as promised and it is also known as default risk. Credit risk is an importance risk that must be taken into consideration as it is one of the factors that contributed to the financial crises. Default risk may impact all credit-sensitive transactions, including loans, securities and derivatives. The use of credit derivatives in bank is to reduce credit risk exposure.
• Market risk can be in two forms which is liquidity risk and interest rate risk. Liquidity risk arises when the bank faces funding problems and the bank don’t have sufficient fund to give to customers. Interest rate risk is the risk that fluctuates in interest rate and may impact on the profitability of the bank.
• Solvency risk is defined as the degree of variability in surplus, where surplus is a function of its scenario (uncontrollable future events) and strategy (controllable future events) determinants.
• Foreign exchange risk is the risk that the exchange rate will change unfavorably before the currency is exchanged. It incurs losses due to the changes in the exchange rates.

Non-Financial risks may include
• Operational risk arises from execution of a company's business functions. It is a very broad concept which focuses on the risks arising from the people, systems and processes through which a company operates. It also includes other categories such as fraud risks, legal risks, physical or environmental risks. Example of the bank can be Bramer Bank and Barclays Bank that faced these problems.
• Technological risk arises when the technology become outdated and relate to deficiencies of the information system and system failure. An example can be that the internet banking that the Mauritius Commercial Bank proposed had been hacked by people which create a huge cost for the bank.
• Staff risk occurs when the staffs are not motivated and they do a lot of mistakes as a result there might be a high labour turnover which affects the operation of the business environment.
• Systemic risk is the risk of the whole banking system fails which has a domino effect on other banks which are owed money by the first bank in trouble, causing a cascading failure.

(ii)Explain how banks manage these risks
For most banks, loans are the largest and most obvious source of credit risk. Banks are increasingly facing credit risk (or counterparty risk) in various financial instruments other than loans, including acceptances, interbank transactions, trade financing, foreign exchange transactions, financial futures, swaps, bonds, equities, options, and in the extension of commitments and guarantees, and the settlement of transactions. Since exposure to credit risk continues to be the leading source of problems in banks world-wide, banks and their supervisors should be able to draw useful lessons from past experiences. Banks should now have a keen awareness of the need to identify, measure, monitor and control credit risk as well as to determine that they hold adequate capital against these risks and that they are adequately compensated for risks incurred. The Basel Committee is issuing this document in order to encourage banking supervisors globally to promote sound practices for managing credit risk.
Market risk is managed by using the VaR and the market risk of trading operations involves projecting portfolio profit-and-loss distributions over short time horizons and then summarizing that information into single numbers, such as value at risk (VaR) and expected shortfall. While VaR has long been an industry standard for estimating market risk, the means by which it is calculated and used in practice to manage risk present a number of modeling, data management and reporting challenges.

Non-financial risk
Operational risk involves failures during operations in daily business, the key steps in operational risk management involve improving internal control environment, designing and developing procedures to implementing the risk management processes and employing risk transfer techniques, such as insurance, to mitigate the loss arising from operational risk. Credit rating agencies have started rating banks based on their risk control and management frameworks. Investor awareness has also increased to the extent that banks with robust risk management frameworks are able to attract strategic investments with less effort.
Technology risk is managed through internal processes and controls. This alternative assumes that the organisation has the resources and internal expertise that can be used to develop and administer the security mechanisms and control procedures necessary to protect the bank. Managing technology risk by outsourcing. In the absence of internal resources and expertise, the bank can consider engaging temporary contractors to provide the security mechanisms on a project basis, or outsourcing the activity to an appropriately equipped service provider. Managing technology risk by transferring risk through insurance. This is still a nascent field in insurance, but it is now possible to find insurance policies that address technology risk.


Regards,
Cedric Rose (ID 111435)




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