Principles of Banking & Finance

Lecture 10
Risk Management in Banking
Nov 2012

Aims
Understand and explain the importance of risk
management for banks.
Illustrate the main techniques and models used by
banks to manage risks such as credit risk, interest
rate risk, liquidity risk and market risk.
Describe how banks apply techniques and models to
hedge against risk. Practical examples are required.

Learning outcomes
Explain why risk management is critical for banks.
Illustrate the major types of risks.
Explain the key techniques that banks management handle
credit risk of single loans and a portfolio of loans.
Explain the use of income gap analysis and duration gap
analysis implemented by banks to manage interest rate risk.
Explain the various methods of managing liquidity risk.
Explain the methodology in managing market risk (value-atrisk).
3

Introduction
Banks major objective : Maximise returns and minimise
risk for Shareholders a challenge since there is a linear
relationship between risk and return.
The Global Financial Crisis in 2007/09 reflected
inadequate risk management techniques.
It resulted in the bankruptcy of Lehman and AIA .
In addition, major banks such as Citigroup required
capital injection by government (TARP funding).
Regulators had to re-look at risk management
processes. (Basel 2 Second Pillar on Supervisory
Review)
Any instance of such example recurring today? 4

Types of risk
5 Risks faced by banks can be classified as follows based on
banking activities:
Credit Risk; SMCUD
Interest Rate Risk; Income effect (Maturity Gap Approach)
and MV effect (Re-pricing Approach); Income Gap (GAP=RSARSL) and Duration Gap (Macaulay Duration and Modified
Duration) Analysis;
Market Risk; (VaR)
Liquidity Risk; (A-L Management) and
Operational Risk.
Under Basel 2, the Basel Committee has proposed that
operational risk be considered as a new type of risk when
determining banks capital requirements. [RAR = Credit Risk
(updated) + Market Risk + Operational Risk + Supervisory and
Market Discipline Pillars]
Banks performance hinges significantly on how such financial
5
and operational risks are managed.

Credit risk
Credit risk related to potential defaults by borrowers
(defined as 90 days overdue); exceeding terms of trade
This includes inability/delays in paying interests and/or
principal (amortised loans) default risk. (sub-prime
interest rate)
Under this scenario, the present value of banks assets
will decline (asset bubble burst). This will negatively
impact on banks capital positions and solvencies. (Asset
Quality CAMELS)
This is the most important risk that commercial banks
have to manage risk-return implications affect
determination of interest charge.
6

Credit risk
In the US, credit quality of banks improved in the
1990s/early 2000s given:
An expanding economy in the 1990s; and
Improvements in measuring and managing credit
risks by banks.
However, credit quality deteriorated in the US
banking industry in 2007. This was largely due to
defaults on mortgage loans. (GFC 2007-2009 asset
quality fell value fell capital inadequacy)
From 2007, banks credit quality of loans deteriorated
rapidly. This was due to the sub-prime mortgage crisis
which led to the US banking crisis and recession.
7

Credit risk

Interest rate risk

The mismatch in banks assets and liabilities maturities
lead to interest rate risk (with changes in interest
rates).
This is given the shorter maturity of banks deposits
(their liabilities) versus the longer maturity of loans
(their assets). This is known as maturity transformation.
(Asset Transformation Risk Borrow short, lend long)
In the 1980s, a large number of US thrift institutions
(SLAs) faced insolvency when interest rates rose
unexpectedly. This was given the mismatch in their
assets and liabilities.
9

Interest rate risk

Financial institutions face two major risks when interest rates
rise:
A) Income effect
Potentially (7 February Debt Ceiling Issue) higher cost
of re-borrowing funds when interest rates rise versus
lower returns earned on assets (loans). This is known as
refinancing risk.
At the same time, the returns on assets reinvested are
lower than its cost of funds. This is known as
reinvestment risk asset returns are less than required
returns resulting in destruction of Shareholder value.
(Negative Interest Rate Spread)
10

Interest rate risk

B) Market value effect
This affects the present values of the cash flows
of banks assets and liabilities TVM effects.
Rising interest rates will result in lower prices for
assets and liabilities. This is given a higher
discount rate (= higher interest rate) that is
applied to their cash flows.
On the other hand, declining interest rates (=
lower discount rate) will result in higher prices of
asset and liabilities.
11

Interest rate risk

Banks attempt to match their assets and liabilities
maturities in an effort to hedge against interest rate
risk.
In practice, there is some degree of mismatch in
banks maturities. This is because active asset
transformation is done at the expense of lower
profitability shorter term loans require lower risk
premiums and therefore leads to lower profitability.
(Lower Interest Rate Spread)
In general, banks adopt income gap analysis and
duration gap analysis (Macaulay Duration and
Modified Duration) to manage interest rate risk.
12

Market risk
Banks earnings are subject to fluctuations in market
risk.
This arises from earnings volatility in its trading book
which is exposed to fluctuating exchange rates,
stock market conditions, commodity price risk and
interest rate movements.
Banks derive non-interest (FEE) income from its
trading books. It is different from its loan books
which generate (NET) interest income.
Increasingly, banks have stepped up their trading
activities to earn higher non-interest income. This is
given increasing competition in traditional banking
activities, namely deposit gathering and lending. 13

Market risk
The 2007/09 Global Financial Crisis (GFC) showed
the extent of the build-up of risk in banks trading
books.
However, some banks did not have adequate capital
to cushion against its trading book losses.
In particular, some banks trading books were very
exposed to credit risk as they held structured
securities such as mortgage-backed securities (MBS)
and collateralised debt obligations (CDOs).

14

Market risk
The market values of these structured securities were
linked to some underlying loans (a derivative
instrument). Thus, there is an indirect credit risk
exposure via these structured securities.
These structured securities were securities placed under
banks trading book (which require lower capitals for
banks). securitised loans 50% weight per Basel 1.
Banks prefer to securitise assets (greater security) and
place them under their trading books given the lower
capital requirements on their balance sheets.

15

Liquidity risk
Banks liquidity risk includes loss of funding on the
liability side of their balance sheets.
Banks largely depend on two types of funding, namely
retail and wholesale funding. However, tapping on
wholesale funding may be vulnerable for banks during
times of market distress when there is a credit freeze.
Liquidity risk from retail funding includes an
unexpected large withdrawal by retail depositors. This
may force banks to liquidate assets at distressed prices
(fire sales) over a short time period to meet retail
depositors demand (maturity transformation problem).
withdrawals due to loss of confidence or reducing cost
advantage disintermediation.
If many depositors demand their money, this may result
in a bank run and lead to systemic risk in the banking
system.
16

Liquidity risk
On banks balance sheet assets, liquidity risks include the
ability to liquidate and/or securitise assets to raise
funding. (quality issue)
It will depend on the prevailing market conditions and
hence is a market related liquidity risk.
During financial distress, banks may not be able to liquidate
and/or securitise assets at prevailing market prices quickly.
Prior to the 2007/09 Global Financial Crisis (GFC), many
banks depended on regular securitisation of mortgage
assets to finance new businesses.

17

Liquidity risk
However, this is not possible during financial distress
given the absence of buyers.
In the UK, Northern Rock encountered
illiquidity conditions during the GFC period.

severe

Banks will diversify their sources of funds to mitigate

this risk.
In addition, banks will own a higher proportion of
high quality liquid assets that can be liquidated
easily during financial distress. This illustrates the
importance of maintaining financial flexibility or
slack during unforeseen adversities.
18

Operational risk
The Basel Committee on Bank Supervision 2001, Bank
for International Settlements (BIS) 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.
BIS is the principal organisation of Central Banks. Its
committee has issued the Basel 1, 2 and 3 Capital
Accords.
Under Basel 2, the Basel Committee has proposed
that operational risk be considered as a new type of
risk when determining banks capital requirements. 19

Credit Risk Management

There are 5 ways to minimise credit or default risk:
Screening
Monitoring
Credit Rationing
Use of Collateral and Endorsement (TP Guarantees)
PG and CG
Diversification
20

Screening
Banks actively screen out potential bad credit risks
through credit risk management.
To achieve effective screening, banks will need
information on potential borrowers (Know Your
Customer aka KYC due diligence process).
This is to determine potential borrowers credit
risk, which is the probability of default. For
retailers, such information may be acquired from
external credit agencies for a fee or built up
internally. (customer data base data mining)

21

Screening
Various banks have their own models to assess
loan default risks.
These 3 models may be relatively qualitative
and/or highly quantitative:
(i) qualitative models;
(ii) credit scoring models; and
(iii) models based on financial market data.

22

Qualitative models
In the absence of public available information,
banks apply qualitative models or expert systems.
This is based on subjective judgments in
assessing the probability of defaults by borrowers.
Information will be based on private sources such
as credit and deposit files and commercial
external sources such as credit rating agencies.
(S&P, Fitch, Moodys and Value Line)

23

Qualitative models
The quantum of loan exposure will determine the amount
of information needed and cost incurred in gathering
data.
The overall credit decision may be classified as follows:
1. Borrower-specific factors
Information includes past credit history; borrowers
debt capacity; the likelihood of default in the event of
interest
rate
increases;
borrowers
earnings
profile/vulnerability.
2. Market-specific factors
Information includes the stage of the business cycle
and interest rate conditions risk-adjusted return
24
concept RF + RP.

Principles of Banking & Finance

Lecture 11
Risk Management in Banking
Nov 2012

Aims
Understand and explain the importance of risk
management for banks.
Illustrate the main techniques and models used by
banks to manage risks such as credit risk, interest
rate risk, liquidity risk and market risk.
Describe how banks apply techniques and models
to hedge against risk. Practical examples are
required.

26

Learning outcomes
Explain why risk management is critical for banks.
Illustrate the major types of risks.
Explain the key techniques that banks management handle
credit risk of single loans and a portfolio of loans.
Explain the use of income gap analysis and duration gap
analysis implemented by banks to manage interest rate risk.
Explain the various methods of managing liquidity risk.
Explain the methodology in managing market risk (value-atrisk).
27

Credit scoring models

Credit scoring models represent mathematical models
to assess loan applicants characteristics denoted by a
numerical score (about default probability).
It serves to rank borrowers in various default risk
classes.
Credit scoring models includes linear probability
models and linear discrimination analysis.

28

Credit scoring models

These are models to assess credit scores of
individuals and corporations.
The
variables
imputed
differ.
For
individuals, variables include age, sex,
marital status, number of children, income,
employment and past repayment histories
for loans and credit cards. For corporations,
financial ratios such as a companys
leverage ratio, interest cover or liquidity
and profitability ratios are used.
29

Credit scoring models

Data from past defaults and healthy borrowers are used in
the linear probability models.
This is to identify variables (such as income or leverage)
that are statistically significant.
Past performance is used to extrapolate the probability of
new borrowers defaulting.
Example: Suppose that there are two factors (Xi) affecting
the past default experience: the leverage ratio (D/E) and
the volatility of a borrowers earnings (EV). Based on past
experience, the linear probability model is estimated as:
Z = 0.5(D/E) + 0.5(EV), where Z is the expected probability
of default.
Assume that the borrower has D/E = 0.4 and EV = 0.25,
the expected probability of default (Z) = 0.5 (0.4) + 0.5
(0.25) = 0.33.
30

Credit scoring models

Linear discrimination models differentiate
borrowers into high or low default risks.
US publicly traded manufacturing companies, for
example, apply a widely used model developed by
Altman (1985).
The measure of the default risk (Zi) depends on the
value of various financial ratios of the borrower (Xi)
and the weighted importance of these ratios (based
on past experience of defaulting and non-defaulting
firms). Altmans discriminant function can be written
as:

31

Credit scoring models

There are several problems associated with
discrimination models:
The model discriminate between two extreme
cases: default and non-default status.
There is no economic rationale to expect weights
and variables to stay constant in the short term.
The model ignores important characteristics
such as reputational risk which is difficult to
quantify.

32

Credit Metrics
In 1997, J.P. Morgan and its co-sponsors implemented
CreditMetrics.
CreditMetrics use the value-at-risk (VaR) framework to measure
risk of non-tradable assets. These include banks loans.
The key question is: If next year is a bad year, how much will
the bank lose on its loans or loans portfolio? (Non-Performing
Loans or NPLs)
Each borrower is assigned a credit rating. A transition matrix is
used to assess the probabilities of borrowers credit rating
upgrade, downgrade or default.
CreditMetrics calculates portfolio values via random simulation
of each borrowers credit quality. Credit instruments are then
re-priced under each simulated scenario. A portfolio is
constructed with the aggregated new prices.
33

Credit Risk
Credit Suisse Financial developed the Credit Risk+
model.
This model estimates expected loss of loans and the
distribution of such losses.
It applies mathematical models used in the insurance
industry. The objective is to calculate banks required
capital reserves to meet losses.

34

Monitoring
Banks monitor the borrowers credit risks as follows:
incorporate covenants in loan contracts such as
dividend payout or gearing covenants; and
establish long-term relationships with borrowers
as part of the KYC due diligence process.
[This helps address the Moral Hazard problem brought
about by Asymmetric information.]

35

Loans covenants
Loan contract usually includes covenants which restrict or
encourage future actions for firms to improve repayment
probabilities.
Covenants may include loans being collateralised by
borrowers assets (example: mortgage loans) and/or its
stream of future cash flows (example: project based
financing) LTC or LTV basis.
It helps in reducing the problem of Moral Hazard.
Recap: 4 Kinds of Restrictive Covenants: Discourage
Undesirable Behaviour, Encourage Desirable Behaviour,
Maintain the value of the collateral and Provide
information. (Refer Role of FI Part 2)
36

Long-term relationship
(KYC Process)
There are lower costs of monitoring if long-term
relationships with borrowers have been established
(from previous loan contracts). This is because such
monitoring procedures have already been put in place.
Borrowers may thus enjoy lower interest rates for new
loans. This is given the lower monitoring costs by banks
on such known borrowers cost savings are shared
with the borrowers in the form of lower interest rates.

37

Credit rationing
Credit rationing may be implemented by:
1. Banks not granting any loans despite potential
borrowers willingness to pay higher interest rates; or
2. Reducing the loan quantum to borrowers based on
tightening of LTC/LTV ratios (example: during 2007 2009
GFC).
Credit rationing is due to the result of adverse selection
problem.
Higher interest rates are due to a risk premium imposed by
banks above the prevailing interest rate plus administration
costs. (sub-prime lending)
However, higher loan rates tend to increase the risk of
loan defaults.
38

Credit rationing
Credit rationing also aims to address the Moral Hazard
problem.
In general, larger loan amounts increase default probability as
borrowers tend to engage in more risky economic activities.
Retail lending rates are usually a very tight range of interest
rates.
In addition, the loan quantum is restricted based on some
criteria such as net worth or income stream (example: credit
cards issued by banks allow a spending limit of between 2 to 4
times of monthly income). (Singapore Property Cooling
Measures such as TDSR = 60%)
39

Collateral and endorsement

Collateral and endorsement are useful means of managing
credit risks.
Secured (fixed or floating charge) loans are those with
collateral requirements. Collateral is a form of guarantee for
loan repayment. Banks will resort to liquidating the collateral
in bankruptcy cases.
Assets used as collaterals by borrowers include real estates,
automobiles, equipment, inventories, accounts receivable,
securities and deposit accounts. (Property Bubble burst
leads to fall invalue of collateral GFC)
In general, the higher the volatility of collaterals value, the
lower its marketability and hence smaller loan quantum.
Banks usually lend up to 90% of high trade treasury bills and
up to 70% of large capitalization (market cap) stocks.
40

Collateral and endorsement

For commercial loans, banks may seek compensating
balances as a form of collateral.
Thus, the borrower keeps a required minimum sum (say 15%)
in a current account as one of the conditions to qualify for the
loan.
In the US, short term loans are largely unsecured. In contrast,
loans are either collateralised or endorsed by a third party in
the EU.
For loans endorsed by a third party (i.e. acting as a
guarantor), this third party is obliged to repay the loans in
case the borrower faces bankruptcy.
Endorsement examples include corporate or personal
guarantees lifts the corporate veil of legal entity concept
for limited corporations (Solomon vs Solomon).
41

Diversification
Portfolio diversification allows banks to reduce individual or
firm/asset specific credit risk (residual vs systematic risks).
However, banks are still exposed to systematic credit risk such
as recession which increases the likelihood of defaults by more
firms.
Banks thus will choose loans whose cash flows are negatively
correlated so as to achieve and cut down on non-systematic risk.
This will effectively reduce the riskiness of its overall loan
portfolio.
This concept of risk diversification will be discussed in greater
detail in the Risk & Return lecture.

42

Portfolio Diversification

Migration analysis
A loan migration matrix shows the probability of loans
being upgraded, downgraded or defaulting.
Under migration analysis, banks monitor the credit
ratings of firms in the industry.
Banks will cut back on lending to industry if firms
underlying credit rating decline faster than its historical
trend.

44

Migration analysis
Example: Consider the following hypothetical rating
migration matrix (each cell is made up of transition
probability):

45

Concentration limits
Banks set concentration limits such as the proportion of
the loan portfolio exposed to a single borrower or type of
borrower.
Banks usually put in place concentration limits to reduce
exposures to sectors and/or geographic zones.
Bank regulators typically place a limit on loan
concentration to individual borrowers that is equivalent to
10% of banks capital.

46

Interest Rate Risk Management

Under Asset-Liability Management (ALM), banks employ
the following 2 Gap Analysis to manage interest rate risk:
(generally two effects: Income Effect and Market Value
Effect)
Income Gap Analysis; (GAP = RSA RSL) and
Duration Gap Analysis: Macaulay Duration (years) &
Modified Duration (index %).

47

Income gap analysis

The difference between interest-sensitive assets and
interest-sensitive liabilities (income effect) is known as the
income gap.
The value of banks assets and liabilities are re-priced in
response to changes in interest rates (market value effect)
example: an amortised loan where market interest rates
change over the term of the loan. (see examples)
This is known as the maturity gap and re-pricing model
approach.
The US Federal Reserve Bank states that banks assets and
liabilities are classified according to maturities viz:
overnight; >one day3 months; >3 months6months; >6
months12 months; >12 months5 years; >5 years.
The key issue of the basic gap analysis is that assets and
liabilities that are not classified as interest-sensitive tend to
48
have different maturities.

Income gap analysis

For the income gap analysis (maturity gap approach), the
gap is defined as the difference between rate sensitive
assets (RSA) and rate sensitive liabilities (RSL) on their
balance sheets viz:
GAP = RSA RSL
There will be a positive GAP when interest sensitive assets
> interest sensitive liabilities. (see next slide for effects)
Increasing interest rates usually will cause banks interest
revenues to increase faster than interest costs. This will
lead to higher net interest margin and hence profitability.
Similarly, declining in interest rates lead to higher
liabilities costs relative to assets returns. This will result in
lower net interest margin and income for banks.
49

Income gap analysis

The income exposure is measured as changes in
interest rates in different maturity buckets, by
multiplying GAP times the change in the interest rate:
I = GAP * i
where:
I = change in the banks income
i = change in interest rate.

50

Issues with income gap analysis

Income gap analysis is book value accounting of cash
flow analysis between interest revenues and interest
costs over time. (Income Effect)
It ignores the market value impact from changes in
interest rates. (Changes in interest rates have an
impact on the market value of assets and liabilities due
to changes in the present value of their cash flows
TVM concept). (MV Effect)
Thus, income gap analysis does not present the whole
picture of the true interest rate exposure of a bank.

51

Issues with income gap analysis

The other problem with income gap analysis is that rateinsensitive assets and liabilities (whose interest rates are not repriced) actually have a component that is rate sensitive. A bank
receives a runoff cash flow from these rate-insensitive items
that can be reinvested at the current market interest rates.
Examples of these items are long-term assets and liabilities,
such as fixed-rate mortgages (amortised loans) and savings
deposits.

52

Issues with income gap analysis

For example, a 30-year maturity mortgage
may have only one year left before they
mature; that is, they are in their 29th year.
And virtually all long-term mortgages pay
at least some principal back to the bank
each month. As a result, the bank receives
a runoff cash flow from its conventional
mortgage portfolio that can be reinvested
at current market rates. Bank managers
can deal with this problem by identifying
for each rate-insensitive asset and liability
the estimated runoff cash flow.
53

Issues with income gap analysis

For example, 20 per cent of fixed-rate residential
mortgages (assets) are assumed to be repaid within one
year and 20 per cent of savings deposits (liabilities)
become rate-sensitive within one year. These runoff cash
flows are then added to the value of the rate-sensitive
assets and liabilities.
Furthermore, the income gap analysis ignores the effects of
changes in interest rates on off-balance sheet instruments.
Despite these problems, the income gap analysis provides
a picture of the overall balance sheet mismatches
(Maturity GAP/Mismatch Income Effect) and the cash flow
consequences of interest rate changes (Re-pricing Effect
Market Value Effect). It is used by most banks in
54
conjunction with other risk management tools.

55

References
M. Buckle (2012) Principle of Banking and Finance Subject
Guide, Chapter 6.
Essential reading
Allen, F. and D. Gale Comparing Financial Systems.
(Cambridge, Mass.: MIT Press, 2001) Chapter 3.
Mishkin, F. and S. Eakins Financial Markets and Institutions.
(Boston, London: Addison Wesley, 2009) Chapters 1, 2 and
10.
Further reading
Brealey, R.A., S.C. Myers and F. Allen Principles of Corporate
Finance. (Boston, London: McGraw-Hill/Irwin, 2010) Chapter
14.
Buckle, M. and J. Thompson The UK Financial System.
(Manchester: Manchester University Press, 2004) Chapter 1.
Freixas, X. and J.C. Rochet Microeconomics of Banking.
(Boston, Mass.: The MIT Press, 2008) Chapter 2.
Saunders, A. and M.M. Cornett Financial Institutions
Management: a Risk Management Approach. (New York,
McGraw-Hill/Irwin, 2007) Chapters 2,3, 4, 5 and 6.

Principles of Banking & Finance

Lecture 12
Risk Management in Banking
Nov 2012

Aims
Understand and explain the importance of risk
management for banks.
Illustrate the main techniques and models used by
banks to manage financial risks such as credit risk,
interest rate risk, liquidity risk and market risk.
Describe how banks apply techniques and models
to hedge against risk. Practical examples are
required.

57

Learning outcomes
Explain why risk management is critical for banks.
Illustrate the major types of risks.
Explain the key techniques that banks management
handle credit risk of single loans and a portfolio of loans.
Explain the use of income gap analysis and duration gap
analysis implemented by banks to manage interest rate
risk.
Explain the various methods of managing liquidity risk.
Explain the methodology in managing market risk (value58
at-risk).

Macaulay Duration and Modified

Duration
Duration has two main meanings:
Macaulay duration measures the average financial
life of an asset or liability; (The number of years to
recover the true cost of the bond) and
Modified duration expresses the interest rate
sensitivity of an assets or liabilitys value. The
relationship is an inverse one.

59

Macaulay Duration and Modified

Duration
Macaulay duration takes into account the time of
arrival (or payment) of all the cash flows (coupon
payment), as well as the maturity (redemption of
face value) of the asset (liability).
Technically the Macaulay duration is a weighted
average of the maturities of the cash payments,
where the weights are the relative present values of
each cash flow.
It measures the period of time required to recover
the initial capital investment.
60

Duration formula
The formula for the calculation of the Macaulay
duration of any fixed-rate security can be written as:

61

Duration calculation
Example: Consider a seven-year Eurobond with 8 per
cent coupon and yield; current market interest rate 11
per cent.

62

Macaulay duration
The Macaulay duration allows for the possibility that the
average life of an asset or liability differs from their
respective maturities.
The duration is lower than the maturity because the bond
pays some cash flows (i.e: coupon payments) prior to
maturity.
Note that it is only for pure discount loans such as zerocoupon bonds (bonds sold at a discount from face value on
issue, repaid at the face value on maturity, with no
intermediate cash flows) that Macaulay duration equals its
maturity.
63

Macaulay duration
The Macaulay duration of a portfolio of securities is
the weighted average of the durations of the
individual securities, with the weights reflecting the
proportion of the portfolio invested in each security.

64

Macaulay duration
There are three important features of duration:
Macaulay duration increases with the maturity
of a bond (this can be seen by calculating the
duration of a five-year Eurobond with the same
coupon (8 per cent) and market interest rate (11
per cent) as the Eurobond in the example above).

65

Macaulay duration
There are three important features of duration:
Macaulay
duration
decreases
as
market
interest rate increases: higher rates discount
later cash flows more heavily, and the weights of
those later cash flows decline when compared to
earlier cash flows.

Macaulay duration decreases as the coupon

interest rate increases: the larger the coupons,
the more quickly cash flows are received by
investors and the higher the weights of those
cash flows.
66

Modified duration
Modified duration is a direct measure of the
interest rate sensitivity of an asset or liability to its
value. The relationship is an inverse one.
It answers the question: how much will the security
price change for a given change in market interest
rates (when interest rate changes are
relatively small)? This can be written as:
(6.4)

67

Modified duration
The larger the Macaulay duration, the more the
price of an asset (or liability) is sensitive to changes
in market interest rates.
From equation (6.4), the so-called Modified duration
(MD) can be calculated as Macaulay duration
divided by 1 plus the market interest rate; that is:

(6.5)

68

Modified Duration: Example

What is the modified duration in the
previous exercise? (i=11%, D=5.502 years)
Modified duration = 5.502/
(1+0.11)=4.957%
Result: For every 1 percent change in
market interest rates, the market value of
the bond will move inversely by 4.957
percent.
69

Modified Duration is still used in Portfolio

Analysis by dealers and investment
managers.
i% expected to rise => bond prices will fall in
the future=> its better to hold shorter
maturity bonds => decrease the duration of
the portfolio
How? Adding shorter maturities to the portfolio or higher
coupon bonds

i% expected to fall => bond prices will rise in

the future => its better to hold long term
bonds=> increase duration of portfolio
How? Adding longer maturities to the portfolio or lower
coupon bonds
70

Duration gap analysis

Banks manage interest rate exposure, taking into
account the effects of changes in interest rates both on
income and market value, by using duration. Moreover,
knowledge of the duration of their assets and liabilities
enables banks to immunise their balance sheets against
interest rate risk. (Duration Gap)
The additive property of duration allows bank managers
to determine the effects of a change in interest rates on
the market value of net worth by calculating the
average duration for assets and for liabilities and then
using those figures to estimate the effects of the
change in interest rates on the value of assets and
liabilities see equation 6.7. and 2013 exam question.
71

Duration gap analysis

The overall duration gap (DURgap) can be
calculated as follows:

(6.6)

72

Duration gap analysis

Note that if the duration of assets and liabilities are
matched (DURgap=0), then the balance sheet is said to
be immunised against unexpected changes in interest
rates. Immunisation can be used to obtain a fixed yield
for a given period of time because both sides of the
balance sheet are protected against interest rate risk.
Duration gap can be used to calculate the change in the
market value of net worth (NW) as a percentage of
total assets induced by a change in interest rates (recall
equation 6.4):

(6.7)

73

Duration gap analysis

Example: Suppose a banks management
calculate that: Da = 5 years; Dl = 3 years.
Suppose also that interest rates are expected to
rise from 8 to 9 per cent. The banks balance sheet
is assumed to be:

Assets ($millions)

Liabilities and equity ($ millions)

A = 100

L =90
E =10

100

100

74

Duration gap analysis

The duration gap for the bank is:

The potential loss to equity holders net worth (as a

percentage of assets) is:

With total assets totalling $100 million, the fall in the

market value of net worth is $2.13 million.

75

Alternative Method
Change in A/ A = -Da*[change int/(1+int)]
Change in A = [-5*(0.01/1.08)]*100 = -4.63
New Asset = (100-4.63) = $95.37m
Change in L/L = -Dl*[change int/(1+int)]
Change in L = [-3*(0.01/1.08)]*90 = -2.50
New Liability = (90-2.50) = $87.50m
New Equity or NW = (95.37-87.50) =
$7.87m
Change in NW = (7.87-10.00) = -$2.13m
76

 Positive gap implies that when interest

rates rise, there will be a fall in the
market value (MV) of the bank.
The larger the (Macaulay) duration of a
security, the more sensitive it is to
changes in interest rates. (MD Rises)
A positive duration gap implies that the
value of assets will change more than
the value of liabilities.
Hence, an increase in interest rates will
lead to a larger fall in asset values,
compared to liability values.
As (A-L=NW), then NW (MV) will fall.

77

Duration gap analysis

Regulators (Federal Deposit Insurance Corporation and Basel
Committee) are increasingly suggesting the use of this
model to determine an appropriate level of capital reserves
for banks exposed to interest rate risk.
However, it is important to point out some problems with
the duration gap analysis.
First, the duration measure assumes a linear relationship
between interest rates and asset values (flat interest
rate yield curve and parallel shifts). However, the
relationship is normally convex. The greater the
convexity, the less useful is duration gap analysis.

78

Duration gap analysis

Second, duration gap analysis is based on the
approximation in Equation (6.4) and thus only works
well for small changes in interest rates.
In order to overcome these problems, banks use more
sophisticated approaches to measure interest rate risk,
such as the value-at-risk (VaR) analysis in Market
Risk Management.

79

Liquidity Risk Management

One important (Asset-Liability Management ALM)
strategy that banks can adopt in managing liquidity risk
is to maintain a stable deposit base.
One method of achieving this is for banks to diversify
their deposit base by attracting deposits from different
types of depositors. This will bring about a greater
independence of withdrawal risks as it is unlikely, unless
in times of crisis or loss of confidence in the bank, that
all depositors will look to withdraw deposits at the same
time.
Retail deposits generally provide banks with core
(stable) deposits, as these depositors tend to be more
loyal as they source other services from the bank and
have the protection of deposit insurance as a safety net.
80

Liquidity Risk Management

Another technique banks can use is to hold large
stocks of liquid assets that can be converted into
cash at times of liquidity need financial flexibility
or financial slack.
A bank holding a buffer of reliable high-quality liquid
assets, such as short-term government securities
(cash equivalents), can draw on them immediately
in the event of a sudden withdrawal of market
liquidity or an unexpected increase in its funding
requirement but greater liquidity means less risky
assets and lower returns on its assets. (Opportunity
Cost safety at the expense of profitability)
81

Liquidity Risk Management

Safe, liquid assets offer lower returns than other types
of assets, so there is an opportunity cost in maintaining
such a liquidity cushion on the balance sheet.
This opportunity cost led banks to seek alternative ways
of managing their liquidity risk in the 1970s and most
banks turned to liability management. This involves the
active management of its liability structure to manage
its liquidity requirements.
The greater emphasis placed on liability management
has allowed banks to reduce their holdings of liquid
assets over time. For UK banks, the average ratio of
liquid assets to total assets in the 1960s was
approximately 30 per cent. This ratio fell markedly over
the next 40 years so that in the years before the crisis it
was less than 5 per cent.
82

Liquidity Risk Management

Banks have increasingly relied upon liability management
and later securitisation to manage liquidity risk. Liability
management is conducted at both retail and wholesale
levels.
At the retail level, it involves setting interest rates, levels
of service etc. to maintain deposits. Of course if banks wish
to increase deposits they will need to offer a higher rate of
interest to retail depositors. This takes time and can be
costly as the higher rates are paid to all depositors.

83

Liquidity Risk Management

An alternative way of increasing deposits is to borrow
it from the wholesale markets (e.g. the inter-bank
market). This may involve paying a higher interest rate
as higher rates are generally paid on wholesale
deposits.
However, the higher rate is only paid on the marginal
amount raised from the wholesale markets. The lower
cost and flexibility of the use of wholesale funding has
led most banks to increase their reliance on wholesale
deposit funding.

84

Liquidity Risk Management

However,
the
financial
crisis
of
200709
demonstrated that wholesale funding is a more
risky source of funding.
Inter-bank markets effectively dried up as banks
became concerned about lending to other banks as
they were unsure which banks were sound.
In the search for yield in the years leading to the
financial crisis of 200709, there was a rapid
expansion of structured financial instruments.
85

Liquidity Risk Management

For example, where individual loans are packaged into
tradable securities, such as residential mortgagebacked securities, or where the risk of a pool of loans is
packaged into complex securities offering different
levels of exposure to the potential losses in the pool (a
collateralised debt obligation).
The demand for these structured financial instruments
allowed many banks to take advantage of the new
sources of funds available from securitisation of its
assets.

86

Liquidity Risk Management

Many banks tapped this new source of funding on a
large scale. However when the ability to securitise
disappeared at the start of the financial crisis, those
banks that had become dependent on the liquidity
provided by securitisation found themselves in severe
illiquidity situations.
The problems with heavy reliance on wholesale funding
and securitisation to manage liquidity in times of
financial stress has led regulators to force banks to hold
higher levels of good quality liquid assets. In other
words, banks are being forced to go back to the practice
of prudent asset management to manage liquidity risk.
87

Market Risk Management

Market risk measurement is important for several reasons:
It provides information on the risk exposure taken by a
banks traders, which has to be compared with the banks
capital resources. (Asset Quality Risk Exposure Capital
Inadequacy)
It enables banks to compare the returns to market risk in
different areas of trading in order to identify the areas with
the greatest potential returns per unit of risk where they
need to direct more capital and resources. (Reward-Risk
Ratio)
Under the current regulations of the Basel Committee on
Banking Supervision on market risk and capital requirements,
in certain cases banks are allowed to use their own (internal)
market risk models to calculate their capital requirements
Basel 1: credit risk with market risk adjustment using the
VaR market model.

Value-at-risk (VaR) approach

In its most general form, the Value-at-Risk (VaR)
measures the potential loss in value of a risky asset
or portfolio over a defined period for a given
confidence interval.
Thus, if the VaR on a portfolio is $10 million at a oneday, 95 per cent confidence level, there is a only a 5
per cent chance that the value of the portfolio will
drop more than $ 10 million over any given day.

89

Value-at-risk (VaR) approach

Another way of putting this is to say 95 days out of
every 100 the value of the portfolio will drop by no
more than $10 million.
Note that VaR is not a measure of the worst case
scenario as with a 95 per cent confidence interval 5
days out of every 100, the losses over one day on
the portfolio will exceed $10 million.
To calculate the VaR for an asset or portfolio, the
distribution of returns on the asset or portfolio needs
to be specified (3 Ways). This distribution can be
determined from historic data, from assuming that
returns follow a normal distribution or by a
90
technique called Monte Carlo simulation.

VaR
The historical method is based on an evaluation
of the past performance of the asset or portfolio on
the assumption that past performance is a fairly
accurate predictor of future performance.
The returns performance of the asset or portfolio
are then ordered and the desired percentile is read
off. For example, consider a dealer working for a
bank with a $20 million portfolio. Suppose the
dealer has compiled from historical information the
following information about the change in the value
of a portfolio over a one day period.

91

 From the above table, we can easily define the daily VaR
at a 95 per cent confidence interval, which is -$500,000.
There is a 4 per cent chance of a loss of between
$500,000 and $999,999 plus a one percent chance of a
loss of at least $1 million.
Thus, the bank can expect to lose at least $500,000 5 per
cent of the time or 95 per cent of the time, the loss to the
bank will be no more than $500,000. The bank can then
set aside an appropriate amount of capital to cover this
92
potential loss.

VaR
One problem with the historical method is that the
historical data used to produce the distribution should be
representative of all possible states of the portfolio. To
achieve this would require many years of returns data
which is unlikely to be available. (Data Collection Problem
periodicity/frequency and estimation period)
The second approach is to assume the returns on the
asset or portfolio follow some statistical distribution
(e.g. normal, lognormal etc.). A typical distribution
used for estimating a VaR is the normal bell shape
distribution. The advantage of this approach is that
relatively little information is needed to construct the
distribution and compute the VaR just the mean and
standard deviation of the distribution.
93

Statistics Recapitulation
How do you find the Z score of a 95%
confidence interval? 0.95/2 = 0.475, then
look at the Z-table and find 0.475
1.645.
The Z score of a number tells how far that
number is from the mean and by how
many units of standard deviation.
Example: if the Z score of a number is 1,
then that number is 1 standard deviation
away from the mean.
94

VaR

If a 95 per cent confidence level is required, meaning

we wish to have 5 per cent of the observations in the
left-hand tail of the normal distribution, this means that
the observations in that area are 1.645 standard
deviations away from the mean.
95

VaR
To take an example, if a portfolio of assets of value $10
million has a standard deviation of returns of 12.48 per
cent (note this standard deviation will have been
calculated using a portfolio approach and knowledge of the
covariances or correlations between returns on assets in
the portfolio):
The 95 percent VaR is equal to 1.645 * 0.1248 = 0.205296.
In $ terms, the VaR = $10 million * 0.205295 =
$2,052,960.

96

VaR
A stricter VaR would be one with a 99 per cent
confidence interval which implies one percent of
observations would lie in the left tail of the distribution.
This would mean that the losses incurred would exceed
the VaR on only 1 day out of every 100.
In this case, assuming a normal bell shape distribution,
the observations in the left hand tail of the distribution
would be 2.33 standard deviations away from the
mean.

97

VaR drawbacks
The main drawbacks of this approach are:
i. the variance-covariance approach assumes stable
correlations over time. We saw in the recent
financial crisis that during times of financial stress
the correlations between asset returns tend to
move towards +1.
ii. it assumes a normal distribution which is not
always appropriate. Returns in markets are widely
believed to have fatter tails than those of a
normal distribution. A fatter tail implies that
extreme events have a higher probability (i.e. a
greater chance of occurring) than that predicted by
98
a normal distribution.

VaR
This last technique of Monte Carlo Simulation
basically involves the development of a model for the
returns on an asset or portfolio and then randomly
generating outcomes for returns to determine the
distribution of outcomes.

99

Summary
The main objective of banks is to maximise Shareholder
value and risk management is crucial to the
achievement of this goal.
The chapter investigated the key financial risks modern
banks are exposed to (credit risk, interest rate risk,
liquidity risk and market risk), as well as operational risk
and considered how these risks should be managed.

100

Summary
The main techniques and models used by banks to manage
financial risks were grouped by types of risk: (Plus
Operational Risk)
Credit Risk Management of single loans uses screening
and monitoring, credit rationing, use of collateral,
endorsement; whereas diversification enables banks to
manage credit risk of their loan portfolio. (SMCUD)
Interest Rate Risk Management employs two main
approaches: income gap analysis and duration gap
analysis.
Liquidity Risk Management is achieved using
diversification of deposits, liability management and
holding a stock of good quality liquid assets. (ALM)
Market Risk Management mainly uses the value-at-risk
method. (VaR)
101

102

References

M. Buckle (2012) Principle of Banking and Finance Subject

Guide, Chapter 6.
Essential reading
Allen, F. and D. Gale Comparing Financial Systems.
(Cambridge, Mass.: MIT Press, 2001) Chapter 3.
Mishkin, F. and S. Eakins Financial Markets and Institutions.
(Boston, London: Addison Wesley, 2009) Chapters 1, 2 and
10.
Further reading
Brealey, R.A., S.C. Myers and F. Allen Principles of Corporate
Finance. (Boston, London: McGraw-Hill/Irwin, 2010) Chapter
14.
Buckle, M. and J. Thompson The UK Financial System.
(Manchester: Manchester University Press, 2004) Chapter 1.
Freixas, X. and J.C. Rochet Microeconomics of Banking.
(Boston, Mass.: The MIT Press, 2008) Chapter 2.
Saunders, A. and M.M. Cornett Financial Institutions
Management: a Risk Management Approach. (New York,
McGraw-Hill/Irwin, 2007) Chapters 2,3, 4, 5 and 6.