Concept of Risk Risk is an event that may causes damage to an institution’s income and reputation. In Simple words, A state of uncertainty where some of the possibilities involve a loss, catastrophe, or other undesirable outcome.
Contd… Non-Financial Risk Business Risk Strategic Risk
Sources of Risk Decision/Indecision Business Cycles/Seasonality Economic/Fiscal Changes Market Preferences Political Compulsions Regulations Competition Technology Non-Availability of Information
Risk Indicators Lack of Supervision of lending/investment activities by designated officers Lack of specific lending or treasury policies or failure to enforce the existing policies Lack of Code of Conduct or failure to enforce existing code Dominant figure allowed to exerting influence without restraint Lack of separation of duties Lack of accountability Lack of written policies and internal controls Entering into transactions where the institution lacks expertise High Rate high risk investments Lack of adequate credit analysis
The risk management process The risk management function addresses 1.Measuring, 2.Monitoring, 3.Management; of the Risk Indicators.
Identification of Risk
The Process The risk management process: Identify risk by each functional area and/or by corporate policy Categorize risk by Risk Profile – Risk Event – Probability of Occurrence – Magnitude of Impact – Risk Response
Contd… Anticipate the direction of risk is expected to take within next 12 months – Decreasing, stable or increasing Elaborate on systems established to monitor risk and frequency of monitoring State policy and procedure to control the risk identified
The risk management process
Requirement of Risk Management Risk Measurement needs to fulfill at least one of the 2 requirements: – Impact of risk factor on the profitability of the bank – On the economic value of the bank
Measuring Market Risk Market rate scenarios resulting in variations in its net interest earnings Factors Gap (Repricing/Mismatch risk) – ∆ NII = Change in Interest Rate x Gap Basis Embedded options Net Interest position Yield Curve
Liquidity Risk Factors giving rise to liquidity risk: – Commitments – Liquid Products – Markets Various liquidity ratios adopted by analysts while evaluating a bank: – Ratio of liquid assets of bank to its total assets – Ratio of liquid assets to demand deposits and short term borrowings – Ratio of net loans to total deposits (Credit Deposit ratio) – Ratio of non-deposit liabilities to total liabilities
Credit Risk Counter-Party defaults has a number of measures – Exposure as percentage to total outstanding – Credit Ratings – Ratio of impaired loans to total loans
Operational Risk Defined as risk of monetary losses resulting from: – Internal processes – People – Systems – External events Operational Risk includes legal risk but excludes reputational and strategic risks
Transaction Risk The risk of changes in the expected value of a contract between its signing and its execution as a result of unexpected changes in foreign exchange rates. Whoever makes a contract denominated in a foreign currency bears transaction risk.
Translation Risk Gains or losses from exchange rate changes that occur as a result of converting financial statements from one currency to another in order to consolidate them. Every company having at least one subsidiary using a different functional currency bears translation risk.