BANKING RISKS

Risks are uncertainties resulting in adverse variations of

profitability or in losses.
Main Banking risks are:
Credit risk
Interest rate risk
Market risk
Liquidity risk
Operational risk
Foreign exchange risk
Other risks ( Country risk, Settlement risk, Performance
risk)
Credit Risk
Credit risk comprises:
Default risk : risk that customers default that is they fail to
comply with their obligations to service debt. Default triggers a
total or partial loss of any amount lent to the counter party.
Decline in the credit standing of an obligor of the issuer of a
bond or stock : Such deterioration does not imply default but it
does imply that the probability of default increases. In a market
universe, it also materialises into a loss because it triggers an
upward move of the required market yield to compensate the
higher risk and triggers a value decline.
Issuer risk is the obligor’s credit risk which is distinct from the
specific risk of a particular issue.
The credit risk is viewed differently for the banking portfolio
and the trading portfolio.
Banking Portfolio
Credit risk arises out of defaults. Default of a small number of
important customers can generate large losses potentially
leading to insolvency.
There are various default events-like delay in payment
obligation, restructuring of debt obligations due to a major
deterioration of the credit standing of the borrower and
bankruptcies.
Simple delinquencies or payment delays do not count as plain
defaults. Restructuring is very close to default because it results
from the view that the borrower will not face payment
obligations unless its funding structure changes.
Plain defaults imply that the non-payment will be
permanent. They may be due to bankruptcies, possible
liquidation of the firm or merging with an acquiring firm.
They all trigger significant losses.

Credit risk is difficult to quantify on an ‘ex-ante’ basis

because it requires an assessment of the likelihood of a
default event and of recoveries under default. In addition,
banking portfolios benefit from diversification effects that
are much more difficult to capture because of the scarcity
of data on interdependencies between default events of
different borrowers.
Trading Portfolio
Credit risk of traded debts is indicated by:

Prices determined by capital markets

Ratings of agencies assessing the quality of public debt

issues

Changes in the value of the issuer’s stock

Credit spreads, the add-ons to the risk-free rate, defining the

required market risk yield on debts.
The capability of trading the market assets mitigates the credit risk since
there is no need to hold these securities until the deterioration of credit
risk materializes into effective losses. If the credit standing of the obligor
declines, it is still possible to sell these instruments in the market at a
lower value. The loss due to credit risk depends on the value of these
instruments and their liquidity. The selling price depends on the market
liquidity. If the default is unexpected, the loss is the difference between
the pre and post default prices.
In case of over the counter instruments such as derivatives (swaps and
options), sale is not readily feasible. The bank faces the risk of losing the
value of such instruments when it is positive. The market movements
during the residual life of the instrument determine the credit risk. The
credit risk and market risk interact because these values depend on market
moves.
Credit risk measurement raises several issues. The major credit risk
components are exposure, likelihood of default or deterioration of credit
standing and the recoveries under default. Scarcity of data makes the
assessment of these components a challenge.
Interest Rate Risk
The interest rate risk is the risk of a decline in earnings due to the
movements of interest rates. Most of the items of banks’ balance
sheets generate revenues and costs that are interest rate driven. If the
lending is at variable rates and deposits are at fixed rates, the bank
suffers a loss in case of an interest rate decline.
Another source of interest rate risk is the implicit options in banking
products e.g prepayment of loans that carry a fixed rate or early
withdrawls of deposits. Optional risks are indirect interest rate risks.
They do not arise directly and only from a change in interest rates.
They also result from the behaviour of customers such as geographical
mobility or the sale of their homes to get back cash. Economically,
fixed rate borrowers compare the benefits and costs of exercising
options embedded in banking products and make a choice depending
on market conditions.
Measuring the option risk is more difficult than measuring the usual
risk that arises from simple indexation to market rates.
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. The period of liquidation is critical
to assess such adverse deviations. If it gets longer, so do the deviations
from the current market value.
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 the value results in a market loss.

Pure market risk is generated by changes in market parameters (interest

rates, equity indexes, exchange rates). It does not include asset and
market liquidity risks incidental to liquidation of assets.
The market risk is captured through the VaR technique. Controlling
market risk means keeping the variations of the value of a given
portfolio within given boundary values through action on limits and
hedging.
 Liquidity Risk
Liquidity risk has multiple dimensions:

• Inability to raise funds at normal cost

• Market liquidity risk
• Asset liquidity risk

Funding risk depends on how risky the market perceives the issuer and its
funding policy to be. An institution coming to the market with unexpected
and frequent needs for funds sends negative signals that might restrict the
willingness to lend to this institution. If the perception of credit standing
deteriorates, funding becomes more costly adversely affecting profitability.
It also affects its ability to do business with other financial institutions and
to attract investors. Market liquidity risk materialises as an impaired ability
to raise money at a reasonable cost.
• Market liquidity is affected by volume of trading. Due to
lack of volume, prices become highly volatile, sometimes
embedding high discounts from par.
• Asset liquidity risk results from lack of liquidity related to
the nature of assets rather than to market liquidity. Holding
a pool of liquid assets acts as a cushion against fluctuating
market liquidity because liquid assets allow meeting short
term obligations without recourse to external funding.
Some assets are less tradable than others because their trading volume
is narrow. Similarly some stocks trade less than others. Exotic
products might not trade easily because of their high level of
customization., possibly resulting in depressed prices. In such cases,
any sale might trigger price declines so that proceeds from progressive
or one shot sale become uncertain and generate losses.
To a certain extent, funding risk interacts with market liquidity and
asset liquidity because the inability to face payment obligations
triggers sale of assets possibly at depressed prices. Extreme lack of
liquidity results in bankruptcy making liquidity risk a fatal risk.
However, extreme conditions are often the outcome of other risks e.g.
unexpected losses may trigger massive withdrawls.
Asset Liability Management (ALM) restricts liquidity risk to bank
specific factors and tries to manage future liquidity gaps ( the
mismatch between time profiles of cash inflows and outflows). The
market liquidity or asset liquidity are not considered.
 Operational Risk

• Operational risks are those of malfunctions of the information

system, reporting systems, internal risk monitoring rules and
internal procedures designed to take timely corrective actions
or the compliance with internal risk policy rules. The new
Basel Accord of January, 2001 defines operational risk as ‘the
risk of direct or indirect loss resulting from inadequate or failed
internal processes, people and systems or from external events.’

• In the absence of efficient tracking and reporting of risks, some

important risks remain ignored, do not trigger any corrective
action and can result in disastrous consequences.
 Operational risks appear at different levels:

• People
• Processes
• Technical
• Information Technology

• ‘People ‘ risk designates human errors, lack of expertise, frauds and lack
of compliance with existing procedures and policies.’Processes’ risk
scope includes:

(i) inadequate procedures and controls for reporting, monitoring

and decision making.
(ii) inadequate procedures for processing information such as
errors in booking transactions and failure to scrutinize legal
documentation.
 (iii) organizational deficiencies
(iv) risk surveillance and excess limits: management
deficiencies in risk monitoring such as not providing
the right incentives to report risks or not abiding by
the procedures and policies in force.
(v) errors in the transaction recording process.
(vi) technical deficiencies of the information system or
the risk measures.
Technical risks relate to model errors, implementation and
the absence of adequate tools for measuring risks.
Information technology risks relate to deficiencies of the
information system and the system failure.
• For operational risks, there are sources of historical data on various
incidents and their costs that serve to measure the number of incidents and
the direct losses attached to such incidents. Other sources are expert
judgements, questioning local managers on possible events, pooling data
from similar institutions and insurance costs that should relate to event
frequencies and costs.

• The general principle for addressing operational risk measurement is to

assess the likelihood and cost of adverse events. The practical difficulties
lie in agreeing on a common classification of events and on the data
gathering process with several potential sources of event frequencies and
costs.

• The data-gathering phase is the first stage followed by data analysis and
statistical techniques. They help in finding correlation and drivers of risks.
For example, business volume might make some events more frequent
while others depend on different factors. The process ends with some
estimate of worst case losses due to event risks.
Foreign Exchange Risk
The currency risk is that of incurring losses due to changes in
the exchange rates. Variations in earnings result from the
indexation of revenues and charges to exchange rates or of
changes in the values of assets and liabilities denominated in
foreign currencies.

The conversion risk (translation risk) results from the need to

convert all foreign currency denominated transactions into a
base reference currency. This risk becomes significant if the
capital base that protects the bank from losses is in local
currency. A credit loss in a foreign country might result in
magnified losses in local currency, if the local currency
depreciates relative to the currency of the foreign exposure.
The time zone risk in relation to foreign currency arises out
of time lags in settlement of transactions in different time
zones.
Three important issues in relation to foreign currency risk
are:
Nature and magnitude of exchange risk.
Strategy to adopt
Tools of managing exchange risk.

The important tools for managing foreign exchange risk

are forwards, futures, swaps and options (for non-linear
exposures)
Country Risk
Country risk is the risk of a ‘crisis’ in a country. There are
many risks related to local crises, including:
(i) Sovereign risk which is the risk of default of sovereign

issuers such as central banks or government sponsored

banks. The risk of default often refers to that of debt
restructuring of countries.
(ii) A deterioration in the economic conditions. This might

lead to a deterioration of the credit standing of local

obligors beyond what it should be under normal
circumstances. Firms’ default frequencies increase
when economic conditions deteriorate.
• (iii) A deterioration in the value of local foreign currency
in terms of the bank’s base currency.
(iv) The impossibility of transferring funds from the
country either because there are legal restrictions
imposed locally or because the currency is not
convertible any more.
(v) A market crisis triggering large losses for those
holding exposures in local markets.
The general country ratings serve as benchmarks for
corporate and banking entities. The reason is that if
transfers become impossible, the risk materializes for all
corporates in the country.
Solvency Risk
Solvency risk is the risk of being unable to absorb losses, generated by all
types of risks with the available capital. It differs from bankruptcy risk
resulting from defaulting on debt obligations and inability to raise funds for
meeting such obligations. Solvency is a joint outcome of available capital
and of all risks.
The basic principle of capital adequacy promoted by regulators is to define
what level of capital allows a bank to sustain the potential losses arising
from all current risks and complying with an acceptable solvency level. This
requires:
(i) valuing all risks to make them comparable to the capital base of
a bank.
(ii) adjusting capital to a level matching the valuation of risks
which implies defining a tolerance level for the risk that losses
exceed this amount, a risk that should remain very low to be
acceptable.
VaR concept addresses these issues directly by providing potential loss
values for various confidence levels.
Model Risk

Model risk materializes as gaps between predicted values

of variables (such as VaR) and the actual values observed
from experience. Model risks arise because models ignore
some parameters for practical reasons or due to errors of
statistical technique, lack of observable data for obtaining
reliable fits (e.g. in case of credit risk)