chapter 6

• Main risks faced by banks

  • Credit risk
  • Liquidity risk
  • Market risk
  • Operational risk
  • Foreign exchange risk
• Credit risk

  The risk of default on loans and other debt securities. It is the risk that the promised cash flows from loans & securities held by banks may not be paid in full. Credit risk is related either to the risk of default of a specific borrower, or to the risk of delay in servicing the loan. In either case, the present value of the bank's assets declines, and this undermines the solvency of the bank
• Credit risk

  • Subprime mortgage crisis 2007 (NINJA unable to repay for the Adjustable Rate Mortgage caused many underwater loans, non-performing loans)
  • Dubai World crisis (a major government owned investment company asked for a 6-month delay on repaying its debts of $59billion or £35billion led to major credit rating agencies downgrading it credit position)
• Liquidity risk

  The risk that an unexpected massive withdrawal by depositors (and the consequent obligation for the bank to make payments) may oblige the bank to liquidate assets in a very short period of time and at low prices. However banks do not have sufficient assets in liquid form to meet large numbers of withdrawals
• Mechanisms used at the macro-economic level to limit the possible contagion of the liquidity problems

  • Deposit insurance
  • Lender of last resort
  • Capital requirements

  
• Liquidity risk

  • GFC 2008 (many banks include Lehman Brother Investment Bank failed liquidity problem caused by interbank loans, resulted US gov bailout)
• Interest rate risk

  The risk of market interest rates changing when the maturities of assets and liabilities are mismatched – hence a consequence of maturity transformation
• Elements of interest rate risk

  • Income effect (refinancing risk and reinvestment risk)
  • Market value effect (changes in the present value of the cash flows on assets and liabilities)
• Interest rate risk

  • Subprime mortgage crisis 2007 (rise of int rate in the ARM from 1% since 911 incident to more than 10%)
• Foreign exchange risk

  The risk that exchange rate changes can adversely affect the value of a bank's assets and liabilities denominated in foreign currencies
• Market risk

  The risk arising from changes in market determined rates of interest/prices that affect the value of assets in the trading book. It is the risk related to the uncertainty of a bank's earnings on its trading portfolio caused by changes in the market conditions, such as interest rates, equity return, exchange rates, market volatility, and market liquidity
• Market risk

  • Barings Bank (200-years old British failed due to trading losses of US1.2 billion in Feb 1995 caused by his trader Nick Leeson, involving the arbitrage of betted Nikkei Index futures between Tokyo and Singapore exchanges, but the index declined due to Kobe earthquake)
• Operational risk

  The risk arising from poor operating procedures, systems and people. It is the risk of direct or indirect loss resulting from inadequate or failed internal processes, people, and systems or from external events
• Operational risk

  • Baring Bank (see market risk example)
• The risks arising from the banking book (intermediation business) are liquidity risk and credit risk
• Market risk and Operation risk are not relevant to the banking book (intermediation business) as they are not caused by engagement in financial intermediation
• Operational risk

  Risk arising from inadequate or failed internal processes, people, and systems or from external events
• Operational risk is difficult to measure
• Operational risk became an issue after the collapse of Barings Bank due to poor operating procedures
• The greater importance of operational risk is recognised by additional capital requirement proposed under Basel 2 (effective from the end of 2006)
• Operational risk example

  • Barings Bank
• The failure of Barings is due to both market risk (loss due to trading activities) and operational risk (poor operating procedures)
• Risks arising from the banking book (intermediation business)

  • Liquidity risk
  • Credit risk
• Financial intermediation (business) exposes banks to liquidity risk and credit risk because it involves asset transformation (such as maturity/liquidity, size, risk) and these asset transformations give rise to liquidity risk and credit risk
• Market risk and operation risk are not relevant to the banking book as they are not caused by engagement in intermediation
• Risks arising from the trading book of banks are affected by market risk
• Trading involves taking short-term positions in assets/contracts with a view to making a profit. These assets are held in the trading book and this give rise to market risk
• Credit Risk Management/Techniques/ Methods/ Approaches

  • Screening
  • Monitoring
  • Credit rationing
  • Use of collateral and endorsement
  • Diversification
• Screening

  Banks have to screen out the bad credit risks from the good ones to reduce adverse selection in loan markets by acquiring information on the potential borrower

  
• Screening methods

  • Qualitative models (expert systems)
  • Credit scoring models (linear probability models & linear discrimination analysis)
  • Newer models based on financial market data
• Qualitative models

  Subjective judgment on the probability of default of the borrower and information are collected from private sources (i.e. credit & deposit files) and commercial external sources (i.e. credit rating agencies)

  
• Credit scoring models

  Models used to calculate the probability of borrower default or to sort borrowers into default classes
• Approaches used to construct credit scoring models

  • Linear probability models
  • Discriminant models
• Linear probability models

  Use data from past defaulters & non-defaulters to identify those factors that explain why a borrower defaults. The resulting model is then used to forecast the probability of a new borrower default
• Discriminant models

  Divide borrowers into high or low default risk classes on their observed characteristics
• Problems of discrimination models: 1) They usually discriminate only between two extreme cases: default and non-default status. 2) There is no economic rationale for expecting weights and variables to remain constant over short periods. 3) These models ignore important – but difficult to quantify – characteristics, such as reputation
• Altman's discriminant function

  Z = 1.2 X1 + 1.4 X2 + 3.3X3 + 0.6X4+ 1.0X5, where X1= working capital/total assets; X2 = retained earnings/total assets; X3= earnings before interests and taxes/total assets; X4 = market value of equity/book value of long-term debt; X5 = sales/total assets. The higher the value of Z, the lower the default risk.

  
• Newer models based on financial market data

  • CreditMetrics
  • Credit Risk+
• CreditMetrics

  Uses the value-at-risk (VAR) framework to value (and measure the risk) of non-tradable assets (e.g. loans). Each borrower is assigned a credit rating, and a transition matrix is used to determine the probabilities that the borrower's credit rating will be upgraded, downgraded, or defaults.

  
• Credit Risk+

  Attempts to estimate the expected loss of loans and the distribution of those losses. Based on mathematical models used in the insurance industry to calculate the bank's required capital reserves to meet losses above a certain level.