MODULE 7

Principles of Risk

Minimum Correct Answers for this module: 4/8

Overall Objective:
To understand why risk is inherent in banks business models and why effective risk management is a
key driver for banks success. Candidates will be able to describe major risk groups: credit, market,
liquidity, operational, legal, regulatory, and reputation risk. They will understand the significance of
risk groups for different banking businesses and units. Candidates will also get an overview about
methods and procedures needed to manage these risk types and extend their understanding to
different risk/return profiles of shareholders, regulators and debt providers.
At the end of this section, candidates will be able to:
• Understand the following aspects of Market Risk:
o Types of market risk (Interest Rate, Equity, Currency, Commodity)
o Market Risk in the Trading Book : How it arises and accounting impact
o The use of Risk Measures: key concepts of Value at Risk (holding periods, confidence levels,
VaR calculation, Limitations of VaR, Expected Shortfall)
o The use of quantitative techniques (Risk Factors and Loss Distributions, Variance-Covariance
Method, Historical Simulation , Monte Carlo)
o Limit structures in the dealing room
o Capital treatment of market risk under Basel III
• Understand the following aspects of Credit Risk:
o Categories of credit risk: lending, issuer, settlement, counterparty credit risk
o Managing credit risk: Limits and safeguards, Credit approval authorities and transaction
approval process, Aggregating exposure limits by customers, sectors and correlations
o Credit mitigation techniques: collateral; termination clauses, re-set clauses, cash settlement,
netting agreements
o Documentation: covenants, ISDA / CSA and other collateral
o Fundamentals of credit risk capital measurement: probability of default (PD), exposure at
default (EAD), loss given default (LGD) and correlation
o Capital treatment of credit risk under Basel III (Standardised approach,
Foundation and advanced internal ratings based approaches, Regulatory capital treatment
for derivatives)
• Understand the following aspects of Operational Risk:
o Sources of operational risk; systems, people, processes and external events
o Reasons for banks to control operational risk: legal and regulatory requirements
o Best practice management procedures
• Understand the following aspects of Legal, Regulatory and Reputation Risk:
o Sources of reputation risk and relationship to other risk groups
• Understand the following aspects of Liquidity Risk:
o Objectives and importance of a funding strategy

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 o Lessons learned from crises in liquidity risk management; Off-balance sheet contingencies,
complexity, collateral valuation, intra-day liquidity risks and cross-border liquidity,
measuring and managing stress scenarios, Early warning indicators of liquidity risk
o Liquidity coverage ratio and Net stable funding ratio

Importance of risk management

Risk is inherent in the financial transactions and business activities of a bank, in fact one could say
that without these risks financial institutions would be unable to generate profits. It is the sound
management of these risks however that determines the long term value that a business can add to
their shareholders.

Risk management involves the identification, monitoring, measurement and control of these risks.

Types of risk
A useful classification of risks is one developed by the Basel Committee in 1994 into 6 categories as
follows:

Operational risk Settlement risk

Legal Risk Liquidity risk

Credit
Risk

Market risk
This is the risk to the institution’s exposure due to changes in market prices. Managing market risks
begins with the identification of the risk followed by its measurement and then policies and
procedures are laid down to control the risk.

Market risk can be broken down into various types:

 Foreign exchange
 Interest rate
 Equity and
 Commodity risks

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Foreign exchange risk
The impact of foreign exchange price volatility can impact a bank’s business in three different ways:

Transaction risk: A future transaction requires a foreign exchange trade to take place.
If the FX market price changes dramatically the related costs or
revenues of this transaction could vary significantly from
expectations.

Economic risk: The impact of FX price moves on a firm’s ability to compete with
overseas competitors in the global market.

Translation risk: This is the impact of FX moves on the assets and liabilities of a
business. For example an overseas subsidiary whose profits need to
be translated back into local currency for financial statements.

Interest rate risk

This is the effect of interest rates changing on the values of financial instruments such as bonds or
CD’s. Interest rate risk also effects the balance sheet of a business through the mismatch of timing
and resetting of interest rates for its loans and deposits. This re-pricing gap is managed within the
defined business limits with hedging instruments such as FRA’s, interest rate swaps and options.

A variation of interest rate risk is yield curve risk which covers the risks that are faced when interest
rates change across different maturities either in a parallel fashion or non-parallel (different
maturities see different interest rate adjustments)

Measuring market risk

Value-at-Risk (VaR) is a statistical approach to assessing risk which uses probable market price
changes over a given time period. VaR summarises the threshold loss value determined by three
variables, the amount of the potential loss, the probability of the loss (confidence level) and the time
frame.

For example if a banks overall VaR is $100 million with a Basel requires that the models must
99% confidence level and a 10 day time horizon, this means satisfy the following:
that if the position remains unchanged, within this 10 day  Holding period of at least 10 days
period there is a 99% chance that the losses sustained will  99% confidence level
be within the $100 million value. However there is a 1%  1 years observation period of
that the losses may exceed $100 million. data

There are three approaches to estimate the probability of market price changes:

1. Covariance or correlation method: Historical data is used to calculate the volatilities

and correlations of various risk factors. The method assumes the risk factors to be
normally distributed and the confidence level is chosen by the number of standard
deviations applied.

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 2. The historical simulation method for calculating VaR calculates the potential losses
using actual historical returns in the risk factors and applies it to the firm’s exposure
to simulate a distribution of returns of the business’s overall positions.

3. The Monte Carlo method does not use normal distributions instead allows the risk
manager to use actual historical distributions for the risk factors (similar to the
historical simulation method) and then relies on computer programmes to generate
a large number of simulations which is used to approximate the market price
outcomes.

𝑉𝑎𝑅 = 𝑆𝑡𝑑 𝐷𝑒𝑣𝑖𝑎𝑡𝑖𝑜𝑛 𝑥 𝑉𝑜𝑙𝑎𝑡𝑖𝑙𝑖𝑡𝑦 𝑥 𝐸𝑥𝑝𝑜𝑠𝑢𝑟𝑒

Standard Deviation: How clustered are the potential outcomes.

Volatility: How volatile is it
Exposure: What is the amount tied to the trader (Face Value)

Limitations of VaR
 Risk exposure as measured by VaR can be misleading in that many make the mistake of
translating the loss value as the maximum potential loss that the business faces. Even a 99%
confidence level suggests a 1% chance of the loss being greater than the VaR figure.
 VaR does not establish any value as to how great the loss could be for that 1% probability
given a 99% confidence level. Is it double the VaR value, triple or even worse?
 Each model outlined above may give a different Value-at-Risk value

Market risk controls

Once risk management techniques such as VaR have been employed to indicate the losses that
might be sustained, the next step is to lay down policies that ensure that the risk that has been
taken is acceptable. This usually takes the form of market risk limits that are placed on the
institution as a whole all the way down to dealer level. This limits can govern VaR, notional position
size or actual realised and unrealised loss potential.

Such limits include:

 Maximum overall position in a single instrument or currency

 Maximum position held by a particular desk
 Maximum position that may be held intra-day; or
 Maximum position that may be held for more than one day
 Maximum profit and loss limits managed through stop loss or take profit orders in
the market

Limits should not be exclusively restrictive but should deter unauthorised transactions. These
controls would not be effective if they were not enforceable which implies that an effective
information system and operational enforcement is necessary.

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Positions in financial instruments taken by dealers result in the business being faced with market
risks. Their positions must be monitored accurately at all times so that unexpected profits and losses
do not occur. The positions are managed on a mark to market basis which values the trades at
current market values calculating their unrealised profit or loss value. Only on the closing of a
position will the mark to market value be realised as a profit or loss.

Credit Risk
Credit risk is the risk that a counterparty will not perform on its obligations to an institution. Credit
risk can arise as a result of the default of a counterparty as a result on non-payment of principal or
interest on a loan as well as the failure to make delivery of a security (FX, CD etc.).

Credit risk can be realised as a replacement cost or take the form of the full settlement risk.

For example a FX forward has been transacted with a customer whereby the customer has bought
USD’s for a future settlement date at a fixed price. The bank now faces credit risk in two forms:

1. If the customer defaults before the contract falls due the bank will face potential
losses that may be categorised as replacement costs. The failure of the customer to
settle will leave the bank with an open position that they will have to offset at
current market prices. This mark-to–market value is a measure of their current
credit risk on this forward position
2. At maturity when the forward contract is due to settle, the credit risk known as
settlement risk becomes more prevalent. This is the risk that on exchange of the two
currencies, the bank makes payment without the customer making the reciprocal
payment and leaves the bank out of pocket for the full transaction. This is a
temporary risk borne until the counterparty settles. This risk is also known as
Herstatt risk named after Herstatt Bank which failed to settle on its FX transactions
on the day its banking license was withdrawn.

The credit risk known as default risk must also be managed; this is the risk that the issuer of the
securities is downgraded by a ratings agency thereby increasing the default risk level.

Managing credit risk

Paramount to managing credit exposure is to understand the likelihood of default of the
counterparty that credit is extended to through credit analysis.

Managing credit risks includes setting appropriate limits to a counterparty taking into account the
credit quality of the counterparty, the type of transaction involved and the institutions own ability to
absorb any losses should the counterparty default.

Controlling credit risk can be done in a number of ways including:

 Taking collateral, although collateral risk management may in itself bring its own set of risks.
 Monitoring the value of collateral held against open positions
 Setting a limit per transaction for the counterparty
 Setting overall limits for any open positions held with the counterparty
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  Setting limits to credit exposure to any particular country or industry
 Monitoring mark-to-market exposures to a counterparty
 Timely reconciliations of settlements and continuous linked settlement (CLS)
 The use of netting and payment vs payment (pvp) or payment vs delivery (pvd) where
necessary
 Establishing cut-off times for payments
 Having proper documentation in place such as ISDA

Netting
Netting is a way to reduce settlement risk by reducing the size of cash flow exchanges. Bilateral
netting involves payments and receipts between two institutions for the same day being netted and
only the net cash flows are exchanged. Multilateral netting involves netting payments between two
or more institutions. Multilateral netting can take place on the CLS system for foreign exchange
transactions.

Documentation
Documentation is vital within the credit environment and the most widely recognised is the ISDA
master agreement. This is internationally binding agreement and is accepted by all banks involved in
cash and derivative instruments across the interest rate, commodity, equity and foreign exchange
markets.

What does ISDA stand for?

 International swaps and derivatives association

Why do we use the ISDA?

 Standardised documentation and a starting point for negotiations

 Covers a wide range of products
 Multi-jurisdictional
 Internationally recognised
 Industry standard world-wide
 Reduces credit risk
 Cost effective
 Increases credit lines
Important provisions include:
 Single agreement
 Netting
 Events of default
 Termination events

Why do we net?
 Improves credit lines
 Reduces capital reserve requirements
 Protects against risks faced due to customer insolvency

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Operational risk
These are the unexpected losses that a business is exposed to due to inefficiencies in computer
systems, controls and even human error.

Managing operational risk

The institution can put in place measures and procedures to ensure that day-to-day functions are
carried out in an efficient error free manner with problem areas identified and rectified timeously.

Other measures employed to manage these risks include:

 Have a contingency plan for the possibility of computer systems failure

 Staff training
 Regular internal and external audits
 Timely reconciliations of accounts
 Clear separation of roles and reporting lines will help detect any rogue behaviour

Legal risks
Legal risk can surface in two ways:
 Whether transactions are documented properly such as through the ISDA document
covering issues like collateral, settlement procedures and default.
 Whether a counterparty is legally allowed to enter into a transaction making it legally
enforceable.

Managing Legal Risk

Procedures are necessary to make sure that proper documentation is in place before any transaction
is executed. For example it is unwise to conclude an OTC derivative deal with a counterparty before
having an ISDA signed as it will go a long way to prevent disputes.

Before any transaction is concluded make sure that processes are followed to ensure that the
counterparty is legally entitled to enter into such an agreement.

Liquidity risk
Liquidity describes the ease at which it is possible to convert a position back to cash without having
to significantly alter the price in order to encourage the transaction. If prices fluctuate wildly from
transaction to transaction in absence of significant market changes – the security is said to trade in
an illiquid market

In other words the most liquid of instruments is cash itself. Certain bonds that are in issue can be
very illiquid because they are bought and held by the purchasers which could result in the bond
going on ‘special’ in the repo market because a short position holder in the underlying bond has
difficulty in sourcing a repo counterparty.

Liquidity risks therefore come about in two ways:

The risk of illiquid markets hampering the sale or purchase of securities in the market (market
liquidity) and;

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The ability of the institution to obtain funds in order to finance its operations and business activities
(funding liquidity).

Managing liquidity risks

Market liquidity risks can be managed and controlled through the following measures that include
the dealing in only those markets that have depth and liquidity. Risk estimates like VaR can be used
to factor in holding periods so that exposure limits can be matched to the degree of market liquidity.

To manage funding liquidity risks a strategy can be employed to match the funding horizon with the
profile of the assets held through maturity gap analysis (cash matching). Institutions should also
diversify their finding sources to avoid concentration risk or being too reliant on one source of funds.

Risk capital measures (BASEL III)

The risks faced by institutions, as outlined above, come about from their various business activities
and although they look to maximise the profits from these risks taken, losses can occur. Institutions
therefore require capital which acts as a cushion to absorb such unexpected losses and allows the
bank to continue operating.

The regulations regarding this capital adequacy are governed by Basel III through the guidelines
called the capital adequacy directive (CAD).

CAD takes the approach that banks should have at least 8% Basel III stipulates that Tier 1 capital
risk capital backing its risk weighted exposures, whether must form at least 75% of the total 8%
they are on or off balance sheet. This 8% is also regulatory capital held (i.e. 6%)
supplemented by a conservation buffer of 2.5% bringing
the total to 10.5%.

The type of capital to be held is also outlined in the Basel III accord and is comprised of two tiers:
 Tier 1 capital is made up of ordinary shares, disclosed reserves and retained earnings
 Tier 2 capital is made up of long term (more than 5 years) and subordinated debt issues.

Capital adequacy for market risk

Two approaches are applied to calculate the capital required to cover market risk:

1. The Standardised approach which has complex rules for calculating the specific risk on each
position

2. The Internal model approach, which is allowed by the Basel Accord with supervisory
authority permissions, permits banks to use their own VaR models as long as the holding
period is for at least 10 days, the confidence level used is 99% and the data analysed is at
least one years’ worth.
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Capital adequacy for credit risk

Methods to measure credit risk are more elaborate but include two approaches:

1. The standardised approach is where the banks are required to use ratings from External
Credit Rating Agencies to quantify required capital for their credit risk. Four categories are
provided for; 20%, 50%, 100% and 150%. For example a loan made to a BB rated corporate is
assigned a risk weight of 100% which means its full value is included into the risk weighted
assets total.

2. Subject to certain minimum conditions and disclosure requirements, banks that have
received supervisory approval can use the Internal Ratings Based (IRB) approach. This allows
banks to rely on their own internal estimates of risk components in determining the capital
requirement for a given exposure.
The risk components include measures of the probability of default (PD), loss given default
(LGD), the exposure at default (EAD), and effective maturity (M).

Capital adequacy for operational risk

Approaches to measure operational risk are:

1. The Basic Indicator Approach stipulates that a bank must hold capital for its operational risk
equivalent to a fixed percentage of the average of the last three years of positive annual
gross income.
2. In the Standardized Approach, banks' activities are divided into eight business lines:
corporate finance, trading & sales, retail banking, commercial banking, payment &
settlement, agency services, asset management, and retail brokerage. The capital charge for
each business line is calculated by multiplying gross income by a factor assigned to that
business line. The total capital charge is calculated as the three-year average of the simple
summation of the regulatory capital charges across each of the business lines in each year.

3. The advanced measurement approach (AMA) is the third approach, under which the banks
themselves estimate statistically what could be the worst operational loss, taking into
account the frequency and potential magnitude of these losses.

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Accounting
From an accounting perspective, it is important to distinguish the motivation for transactions in
financial instruments, in other words are they for trading purposes or for hedging requirements.

If the instruments are designated for trading purposes, then they are treated according to mark-to -
market (MTM) accounting. A trading position taken in an Interest Rate Swap, for example, is
recorded when transacted and then thereafter, the known and implied future cash flows are marked
to market on a PV basis. A MTM gain is recorded as an unrealised profit and a negative MTM as an
unrealised loss. This mark to market process sees that any gains or losses are recognised in the
current income period.

In order for a transaction to be designated as a bona fide hedge, from an accounting sense, it will
qualify if it satisfies the following:

• There is a clear intention to hedge

• There is a clear correlation between the underlying item and the hedge transaction
• The hedge can be identified as such

In general terms a hedge can be designated as being one of three types:

1) Fair Value hedge

2) Cash Flow hedge
3) Hedges of net investments in foreign operations

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Module 7: Review Questions
1. Which risks are increased by taking collateral?
a) Operational risk
b) Legal risk
c) Liquidity risk
d) All of the above

2. Which of the following would be considered a “bona fide” hedge from an accounting point
of view, for a borrower who needs to raise $10mio for 3 months in 3month’s time?
a) Sell a 3x9 FRA in $10mio
b) Buy a 3 year Cap in $15 mio
c) Buy a 3x6 FRA in $5 mio and Sell a 6x9 FRA in $5mio
d) Buy a 3x6 FRA in $10 mio

3. What is the purpose of risk capital?

a) To pay for expected losses
b) To pay for unexpected losses
c) To comply with regulatory reserve requirements
d) To fund risky activities such as proprietary trading

4. What is a “nostro” account?

a) Your account in a foreign currency with another bank
b) Your account in domestic currency with another bank
c) An account held with your bank by another in a foreign currency
d) An account held with your bank by another in domestic currency

5. Interest rate risk and equity risk are:

a) Credit risks
b) Settlement risks
c) Operational risks
d) Market risks

6. Which of the following methods is a means of credit risk mitigation?

a) Investing only in sizeable and liquid markets
b) Entering into a cross currency swap
c) Entering into collateral agreements
d) Hedging foreign holdings exposure with forward contracts

7. What is the correct interpretation of a USD 10,000,000 overnight VaR figure with a 95%
confidence level?
a) A loss greater than $10mio can be expected in 95 out of the next 100 days
b) A maximum loss, no greater than $10mio can be expected in 5 out of the next 100 days
c) $10mio is exposed to market risk that can be expected to fluctuate by 95% over the next
10 days.
d) A loss greater than $10mio can be expected in 5 out of the next 100 days

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 8. Which one of the following situations is an example of wrong way risk?
a) A hedge fund is long US AAA residential mortgage-backed securities and short US
government bonds.
b) A German bank buys a bond issued by an Icelandic bank and enters into a CDS as a
protection buyer with another Icelandic bank on the same bond.
c) A German bank enters into a repo trade with an Icelandic bank, delivering bonds issued
by another Icelandic bank as collateral.
d) A German bank enters into an FX swap with a US investment bank and transfers EUR
350,000,000.00 to that bank.

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