Fin Risk Management in Banks

AdvancedRiskManagement FNC615
MBAII Finance
DrNawazish Mirza
nawazish@nmirza.com
1
AdvancedRiskManagement FNC615 MBAII Finance AdvancedRiskManagement FNC615 MBAII Finance
AdvancedRiskManagement
LahoreSchoolofEconomics LahoreSchoolofEconomics
AdvancedRiskManagement FNC615 MBAII Finance
i f b f i h i h Itisfarbetter toforeseeevenwithoutcertainty than
nottoforesee atall......
HenriPoincar
(1854 1912)
All of life is the management of the risk and not its
LahoreSchoolofEconomics
Alloflifeisthemanagementoftherisk,andnotits
elimination.....
WalterWriston
(1919 2005)
MBAII Finance
DrNawazish Mirza
nawazish@nmirza.com
2
RiskManagement
RiskandItsWorlds
Ri k b d fi d l tilit f t d Risk can be defined as volatility of unexpected
outcomes, which can represent the value of
assets, equity or earnings.
Two Key Terms
Uncertainty
Exposure
p
Two broad categories of Risk are
Business risk
Financial Risk
RiskManagement
Business Risk is the one which the corporations assume
willingly to create competitive advantage and add value
for shareholders.
These include the business decisions companies make in
business environments in which they operate. Business
decisions include
Investment decisions
Investment decisions
Product development choices
Marketing strategies
Organizational structures
MBAII Finance
DrNawazish Mirza
nawazish@nmirza.com
3
RiskManagement
Financial Risk is the one which relate to possible
losses owing to financial market activities For losses owing to financial market activities. For
instance, gains or losses due to interest rate
movements, or defaults on financial obligations
Theprimaryfunctionoffinancialinstitutionsisto
managefinancialrisksactively.Theirpurposeisto
assume,intermediateoradviseonfinancialrisks.
RiskManagement
TheRiskMetrics
Identification Measurement Management
Risk
Identification Measurement Management
MBAII Finance
DrNawazish Mirza
nawazish@nmirza.com
4
RiskManagement
The recent growth of the risk management industry can be traced directly
to the increased volatility of the financial markets since the early 1970s.
C id th f ll i d l t Consider the following developments:
The fixed exchange rate system broke down in 1971, leading to flexible &
volatile exchange rates
The oilprice shocks starting in 1973 were accompanied by high inflations
and wild swings in interest rates
Deflation of Japanese stock price bubble in 1989
Asian turmoil of 1997
The Russian default in August 1998
Terrorist attacks on WTC September 11, 2001.
Sub Prime Mortgage Crisis 2008
Theonlyconstantintheseeventsistheir unpredictability
RiskManagement
EvolutionofAnalyticalRiskManagementTools
MBAII Finance
DrNawazish Mirza
nawazish@nmirza.com
5
RiskManagementinBanks
Expecting returns without exposing to risk is like
trying to live without being born trying to live without being born.
Risks are inherent in any walk of life in general and
in financial sectors in particular
Banks as Intermediary of Risk
Example of Risk Management
Non Performing Loans
NPLs are the legacy of the past in the present and Risk
Management System is the pro active action in the
present for the future
TypesofRisk
Risk in Financial Terms
Volatility (loss) in expected returns
Risk in Probability Terms
Comparison of odds of occurrence (favorable) and
non occurrence (unfavorable) of an event
MBAII Finance
DrNawazish Mirza
nawazish@nmirza.com
6
TypesofRisk
CaseofaCallOption
ContractCharacteristics
Europeanvs American
Strike/ExercisePrice
OptionPremium
Whywillyouwriteacall
option?
TimetoMaturity
ValueoftheOption
p
Intrinsic(IV) Profiton
ImmediateExercise
[MP EP]
Time(TV) Thevalueover
andaboveIV
>>ContingentClaims
TypesofRisk
Possible Loss due to Risk
Expected Loss
Change in Credit Quality
Tolerance Limit
Unexpected Loss
Change in Credit Quality
Beyond Limit
Advances
Borrower
Loan Pricing
Provisions
Absorbed by Bank
Capital Adequacy
Economic Capital
MBAII Finance
DrNawazish Mirza
nawazish@nmirza.com
7
CreditRisk
Credit Risk is
The potential that a bank borrower/counter party
fails to meet the obligations on agreed terms.
Inherent in Lending Business
The objective of credit risk management is to
minimize the risk and maximize banks risk
adjusted rate of return by assuming and
maintaining credit exposure within the
acceptable parameters.
CreditRisk
QuantityofRisk QualityofRisk y y
OutstandingLoan
BalanceonDate
ofDefault
MagnitudeoftheLoss
(expectedvs unexpected)
giventherecoveries
CreditMigration FallenAngels
CreditRatings
RiskonunfundedExposure
MBAII Finance
DrNawazish Mirza
nawazish@nmirza.com
8
CreditRiskManagement
ToolsofCreditRiskManagement
ExposureCeiling
LimitonIndividual/GroupExposure
Review/Renewal
MultiTierApprovalSystem
RiskRatingModels
RiskBasedPricing
CreditPortfolioManagement
MarketRisk
Market risk is the risk associated with changes in value of
assets due to changes in interest rates, equity prices,
di i d h commodity prices and exchange rates.
It is the risk that declining prices or volatility of prices in these
financial markets will result in a loss.
Market Risk includes:
Absolute risk
Volatility of total returns
Relative risk
f
Returns relative to a benchmark index or portfolio.
Basis risk
Divergence in price of hedging instrument with price of hedged asset
Volatility risk
ChangeinactualorimpliedVolatility
MBAII Finance
DrNawazish Mirza
nawazish@nmirza.com
9
LiquidityRisk
Dilemma of Commercial Banks
Financing (Deposits) sources have shorter maturity than Financing (Deposits) sources have shorter maturity than
advances
Warrants a cushion against withdrawal of deposits (anticipated
and unanticipated).
Funding Risk
It is the need to replace net out flows due to unanticipated
withdrawal/nonrenewal of deposit
Time Risk
Time Risk
It is the need to compensate for non receipt of expected inflows of
funds, i.e. performing assets turning into nonperforming assets.
Call Risk
It happens on account of crystallization of contingent liabilities
Examples?
OperationsRisk
At the end risk is all about Humans
Operational risk is any risk that is not categorized Operational risk is any risk that is not categorized
as market or credit risk and represents loss arising
from inadequate or failed internal processes,
people and systems or from external events.
How to Mitigate?
In order to mitigate this internal control and internal
In order to mitigate this, internal control and internal
audit systems are used as the primary means.
Difficulty?
Quantification

Fin Risk Management in Banks

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