WORLD BANK

The Banking Risk Spectrum

Banking Risk Exposures

Financial Risks Operational Risks Business Risks Event Risks

Balance sheet Business strategy Legal risks Political risks

structure risk

Income statement
Macro Contagion risk
structure/ Internal systems Policy risks
profitability and operational
risks
Financial Banking crisis
Capital adequacy Infrastructure risk

Technology risk
Credit risk Systemic Other
(Country) risk exogenous
risks
Liquidity risk
Mismanagement
and Fraud
Interest rate risk

Reputational
Market Risk
Risk

Currency risk
 CREATING A RISK CULTURE WORLD BANK
“...All of life is the management of risk, not its
elimination…”

❧ What major strategic risks (from products or from

the environment) does the bank face?
❧ Planning and defining risk tolerance levels: Have
the board and executive management delineated
the level of business risk they are willing to
assume for each area and overall?
❧ Financial and Other Risk identification: How is the
risk in current operations identified?
❧ Risk supervision and management: How are
current and proposed operations managed?
❧ Risk monitoring: Evaluate the effectiveness of
control implementation
❧ How effectively are board-approved risk tolerance
levels communicated in the organization?
❧ Evaluate the manner in which risk is being
assumed, measured, limited, controlled, and
 WORLD BANK
THE RELATIONSHIP BETWEEN RISK ANALYSIS
BANK SUPERVISION AND GOOD MANAGEMENT
● Bank supervisors and financial analysts - including executive
management - should view the risk management process in a similar
manner:
– what happened

– why it happened

– the impact of events, and

– a credible future strategy to rectify unacceptable trends

● Off- and on-site analysis (supervision) is similar to the financial

analysis of information, to be tested through verification of preliminary
conclusions. On-site examination is essential, but could be performed
by supervisors, analysts, or external auditors
● Regulators and supervisors should ensure that all financial institutions
are supervised using a consistent philosophy, to ensure a level playing
field for financial intermediaries
● Properly utilized, banking analysis can enhance the institutional
development of the banks concerned
● The bottom line - “what will happen to the bank if…………”
 WORLD BANK

CREDIT RISK MANAGEMENT

-key messages-
● Heart of survival for the vast majority of banks.
● Profile of customers (WHO has been lent to) must be
transparent.
● Risks associated with the key banking products (WHAT
has been lent) must be understood and managed.
● Maturity profile of loan products (for HOW LONG the
loans have been made) interacts strongly with liquidity
risk management.
● Credit risk can be limited by reducing connected-party
lending , lending to related parties and large exposures
● Asset classification and subsequent provisioning:
• impacts value of the loan portfolio
• true underlying value of a bank’s capital
 WORLD BANK

Sources of Income Total

$’million
Interest income 23 195
Interest expense 17 390
Interest turn 5 805
Less: Provisions 1 146
Banking related fee income 1 971
Income from management of fnds 6 630
Operating expenses 7 119
Net LOSS from pure banking 489
Trading income net of mark-to-market adjustments 1 540
Investment income (net of provisions) 416
Knowledge based fee income 448
Other income 686
Interest on loan capital 81
Net income before tax 2 522
 WORLD BANK
CREDIT-RISK MANAGEMENT
-important areas-

• Credit portfolio management - requires sound lending /

risk management policies

• Organization of lending function and operations

• Non-performing loan portfolio

• Methods to limit or reduce credit risk

• large exposures

• related-party lending

• overexposure to geographical areas or economic sectors

• limits on renegotiated/ re-scheduling of debt

• Asset classification and loan loss provisioning policy -

ensuring credit portfolio quality
 WORLD BANK
CREDIT RISK MANAGEMENT
-some essential lending policies-
❧ Monetary limit on total outstanding loans - relative to deposits, capital, total assets

❧ Geographic limits - market knowledge / staff experience / geographical limitations

❧ Credit concentrations - single client, connected group, and/or economic activity

❧ Type of loans - based on expertise

❧ Distribution by category / product

❧ Maturities - determined by anticipated source of repayment / purpose / useful life of the

collateral

❧ Loan pricing - sufficient to cover the costs of funds / supervision / losses / costs or competitive
factors

❧ Lending authority - determined by size of a bank / products / types of customers

❧ Appraisal process- formal, standard appraisal procedures, reappraisals of renewals or

extensions

❧ Maximum ratio of loan amount to the market value of pledged securities (periodic pricing of
collateral)

❧ Appropriate reports to be submitted to the board

❧ Monitoring of client’s financial information - detail of the borrower’s credit standing

 WORLD BANK
CREDIT-RISK MANAGEMENT
-concerns -
● Security

• Valuation of security

• Obtaining of security

• Ownership of the security

• Registration of the security

• Custody of “proper” underlying securities

• The right to obtain information in respect of the person/entity supplying

the security or guarantee

● Adequacy and integrity of information

● Timeous problem identification -ongoing credit reviews,
● Follow-up procedures
● Reliability of management reporting
 WORLD BANK
Signs of Distorted Credit Culture
- per Federal Reserve Bank-
● Self-dealing/Insider lending - an over-extension of credit to directors / large
shareholders, or to their interests
• Compromise of credit principles – due to anxiety over income, competition or conflicts
of interest
• Anxiety over income
• Incomplete credit information - purpose of borrowing, the intended plan and source of
repayment should be specified
• Complacency - lack of adequate supervision of old, familiar borrowers, dependence on
oral information rather than reliable and complete financial data, ignore warning signs
regarding the borrower, economy, region, industry
• Lack of knowledge about the borrower’s affairs over the lifetime of the loan - lack of
supervision
• Technical incompetence - lack of technical ability among credit officers to analyse
financial statements and obtain and evaluate pertinent credit information
• Poor selection of risks.
• The extension of loans beyond the reasonable payment capacity of the borrower
• Loans to establish businesses in situations where the bank-financed share of required capital is large relative
to the equity investment of the owners. Loans for real estate transactions with narrow equity ownership also
falls into this category
• Loans based on the expectation of successful completion of a business transaction, rather than on the
borrower’s creditworthiness, and loans made for the speculative purchase of securities or goods
• Loans to companies operating in economically distressed areas or industries
• Loans made because of large balances on deposit in a bank
• Loans predicated on collateral of problematic liquidation value
 WORLD BANK
CREDIT RISK MANAGEMENT
-content of a loan review file-

• borrower’s name and line of business

• use of proceeds
• date credit granted
• loan maturity date, amount, currency, and interest rate
• principal source of repayment
• the nature and value of collateral/security (or valuation basis, if a fixed
asset)
• total outstanding liabilities, including loan principal and interest due
and all other real and contingent liabilities, in cases where the bank is
absorbing the credit risk
• delinquency or non-performance, if any
• description of monitoring activities undertaken for the loan
• financial information, including current financial statements and
other pertinent information
• specific provisions that are required and available
 WORLD BANK

MARKET-RISK MANAGEMENT
-key messages-

● Results from volatility of positions taken in the four

fundamental economic markets: interest-sensitive debt
securities, equities, currencies, and commodities.
● Volatility of each of these markets exposes banks to
fluctuations in the price or value of marketable financial
instruments.
● Banks in sophisticated market environments with sufficient
liquidity can normally hedge against market volatility.
● Resulting net effective open position determines the amount
of the portfolio that remains exposed to market risk.
● Capital has to be retained as a buffer against potential losses
due to market risk; such capital is referred to as Tier 3 capital.
 WORLD BANK

RISK ORGANIZATIONAL STRUTURE

Board of Directors
-capital/ solvency risk management-

General Management
-overall risk management-

Head Office
Branch Network
Treasury -operational/technology
credit risk management
risk management-

Domestic Foreign
Treasury Treasury

Forex Trading Desk

-currency risk
Investment management-
Money & Capital Funding Desk
Trading Desk Department
-liquidity risk
-interest-rate risk -price/position
management-
management- -risk management-
 WORLD BANK

EVALUATING THE RISK MANAGEMENT CULTURE

❧ Changes that appear necessary within the bank’s culture and managerial practices:
● The need for full sponsorship by the board and executive management
● The necessary enabling culture in which every manager is expected to consider risk (i.e.,
to identify, measure, and report on risk exposure
● After the assessment of evaluation, monitoring, and reporting systems that cover critical
risk functions
● The convenience of adopting appropriate risk objectives for each function and for the
bank as a whole
● The need to institute a formal process for the general manager or CEO of the bank and
the board to review and evaluate all expected and unexpected risks and all risk-taking
activities
● The convenience of designating a member of senior executive management for overseeing
all risk management, with authority to act on risk problems and ensure risk control

❧ The implications of the problems identified and for instituting a bank-wide risk management
function, the process and phases required for such action, and the role and function within the
organization of the risk management senior official.

❧ The manner in which risk management functions could be instituted in the bank.

❧ The feasibility of installing effective comprehensive bank-wide risk management, and their
implications for the bank.