Introduction to Risk Management

Instructor: Balagopal Gopalakrishnan

Finance, Accounting, and Control Area

Indian Institute of Management Kozhikode

AFRM, April 2021

Adapted from Jorion and Credit Risk Management by Gestel and Baesens
AFRM batch work profile

Count
Incubator
2.7%
Transportation
2.7%
Energy
5.4%
IT
18.9%
Bank
51.4%
Pharma
2.7%

Fin Ser
16.2%
Get a bigger picture
What is Risk ?
Is it Uncertainty ?

I Uncertainty is defined as “indefinite, indeterminate” - unknown unknowns

Is it Volatility ?

I In finance, volatility is the measure of risk

I Risk also means opportunity - two sides of the same coin

I Short-termism in giving volatility the importance

I Value investors are agnostic about volatility - e.g. Oracle of Omaha

Risk is about permanent loss of capital

It is about known knowns and known unknowns, more things can happen than
will happen

In the corporate context, risk includes any event that might push a company’s
financial performance below expectations.
Role of risk in decisions
Forecast vs. Prediction

Pursuit is to make an estimate accurate

Accuracy has two components - Bias and Precision

Risk management facilitates better decision making

What is risk management?
Risk management is a relatively new concept ?

Risk is an age old problem, especially in finance

New wine in an old bottle ?

Revolutionary advances in computing has facilitated better risk management ?

Risk management is opposite to risk taking ?

Risk management framework
Risk management
Treatment and Control

Risk avoidance

Risk transfer

I Insurance

Risk mitigation

I Diversification

I Hedging

I Stop loss

Risk acceptance

I These are risks that you don’t want to hedge.

I You will profit by taking on these risks and winning at them.

Risk management framework (Integrated)
Quantitative assessment
Risk = Probability × Consequence
Risk management in non-financial institutions
Is risk management required in a non-financial firm ?

Is it value maximizing ?

The most compelling argument for managing risk is that adverse outcomes can
lead to financial distress and financial distress is costly.

Hedging financial exposures can be thought of as adding value by reducing the

owners’ risks and hence their required rates of return on investment

Investors must be fully aware of the firm’s actions to manage risks at minimal
cost
Risk management in non-financial institutions
Consider a firm with currency exposure – one way to hedge is to borrow in the
foreign currency (if assets are in foreign currency), or move production abroad
(if borrowings are in foreign currency).

I This is an “on-balance-sheet” transaction. However, these transactions

are costly, inflexible, and often irreversible.

Diversification vs Market Instruments

Derivatives are off-balance-sheet transactions - can manage exposure in a

similar manner, but at a much lower cost.

I Forwards

I Futures

I Swaps

I Options
Financial markets
Financial institutions and banks
What is special about banks?

Financial assets and liabilities should be considered as operating assets and

liabilities

Equity capital function as a cushion for economic risk

Value is maximized by leverage - dependent on trust/ rather the credit quality

of the assets

Opaqueness to customers and investors

Assets are mostly marked-to-market - liquid securities

Banking theory
Contemporary banking theory classifies banking function into four categories

I Access to a payment system - management of accounts as well as finality

or guarantee of payments, money changers, payment services such as
clearing and interbank payments etc

I Transforming assets - convenience of denomination (one can choose the

deposit amount as well as the loan amount), quality transformation
(giving legitimacy), and finally maturity transformation.

I Managing risks - assessing the risks of the loans, managing interest rate
and liquidity risk, off-balance-sheet operations.

I Monitoring and information processing - strengths of monitoring by

avoiding moral hazard of the entrepreneur.

In summary, banks have an important function in the economy because of the

demand for different types of products.

I A product that offers divisible money that is safe and are for short-term

I A product that offers indivisible money that is long-term, risky and

requires higher monitoring.
Balance Sheet Model of Banks/FI

Assets Liabilities

Cash Capital
Balances with banks Reserves and Surplus
Investments Deposits
Loans and Advances Borrowings
Fixed assets Other liabilities
What do banks do?
Sources of Bank Revenues
I Interest Income
I Investment / Dividend Income

I Treasury Income (Security Transactions and Forex transactions)

I Commission and Brokerage
I The sum of first two heads is interest income
I The sum of other items is noninterest income

Costs of Bank Operations

I Interest Expended
I Real Resource Expenses

Personnel Cost

Other Expenses including rent etc

I Loan loss provisions
Types of financial risks
Credit Risk

Market Risk

Operational Risk

Liquidity Risk

Model Risk
Approaches to Bank Risk Management
Risk aggregation: aims to get rid of non-systematic risks with diversification

Risk decomposition: tackles risks one by one

In practice banks use both approaches

Types of financial risks
Market Risk

I Loss in the value of a position caused by changes in market variables: for

example, interest rates, foreign exchange rates, equity prices, commodity
prices, etc.

Credit Risk

I Loss in the value of a loan or other credit instrument due to deterioration

in the credit quality of the borrower or counterparty.

Operational Risk

I Loss in value due to operating or systems errors within the firm.

Liquidity Risk

I Loss in value incurred during an unanticipated/ undesired extension of

the holding period due to market disruptions or a drop-off in market
activity.

Model Risk

I Loss in value incurred due to errors in a model: GIGO.

Are Banks regulated
Basel regulations - Risk management in Banks
Measures of global risk - VIX

CBOE Volatility Index: VIX

60

50

40
Index

30

20

10

0
1990 1995 2000 2005 2010 2015 2020

Source: Chicago Board Options Exchange fred.stlouisfed.org

Measures of global risk - Ted spread

TED Spread

3.5

3.0

2.5

2.0
Percent

1.5

1.0

0.5

0.0
1990 1995 2000 2005 2010 2015 2020

Source: Federal Reserve Bank of St. Louis fred.stlouisfed.org

Measures of global risk - EPU

Global Economic Policy Uncertainty Index: Current Price Adjusted GDP

440

400

360

320

280
Index

240

200

160

120

80

40
1998 2000 2002 2004 2006 2008 2010 2012 2014 2016 2018 2020

Sources: Baker, Scott R.; Bloom, Nick; Davis, Stephen J. fred.stlouisfed.org

Measures of global risk - India EPU

Economic Policy Uncertainty Index for India

320

280

240

200
Index

160

120

80

40

0
2004 2006 2008 2010 2012 2014 2016 2018 2020

Sources: Baker, Scott R.; Bloom, Nick; Davis, Stephen J. fred.stlouisfed.org

Pitfalls in risk management
Risk management can fail to ensure that the bank has the right amount of risk.

I can fail to uncover bad risks that should be eliminated

I can mismeasure good risks

I can fail in its task to measure the firm’s total risk

Risk management can be inappropriately inflexible

I Increases in risk are prevented even when they would be valuable to the
institution

“Striking the right balance between helping the firm take risks efficiently and
ensuring that employees within the firm do not take risks that destroy value is a
critical challenge for risk management in any bank.” - Stulz (2016)
Risk communication
Information must be provided objectively and placed in context so that risks can
be assessed and understood.

Experts and policy makers must be open about the extent of our knowledge
and our ignorance.

Transparency about what we know and what we don’t know, far from
undermining credibility, helps to build trust and confidence
Risk management failures
Failure to use appropriate risk metrics

I Daily VaR/Monthly VaR and Illiquidity

I Diversification and correlation

Mismeasurement of known risks

I Tail loss

Failure to take known risks into account

Failure in communicating risks to top management

Failure in monitoring and managing risks

What holds for the future ?
Thank you